Exam questions Flashcards
A student is calculating the cost of capital of the firm. She is using the book values of debt and
equity from the last available balance sheet to estimate the weights of debt and equity.
Describe why this is wrong.
Answer: Financing costs depend on how a firm will look in the future not how it looks currently
on paper. Market values reflect a firm’s true ability to generate future cash flows and hence
service its obligations associated with its financing. Using the historical values of debt and
equity may therefore be misleading in scenarios when a firm’s prospects have changed. The
student should hence use market value weights of debt and equity while computing the cost
of capital.
You are valuing a company with a changing capital structure using the Free Cash Flow to the
Firm (FCF/WACC) method. The capital structure is expected to become more debt heavy.
Describe the variables that you would need to change and in which direction the change would
be (for example: X will increase).
You would need to make the following changes:
‐ The D/V ratio will increase;
‐ The cost of debt will increase as debt becomes more risky;
‐ The beta of equity will increase (which affects the cost of equity) re-calcualate the
levered equity beta from the unlevered equity beta (or asset beta) with the changed D/E
ratio in each period.
You would not need to change cash flows. FCFF is capital-structure invariant.
Imagine two companies that are highly similar in terms of the factors that affect their EV/EBITDA ratio: their cash flows, long-run growth prospects, their riskiness and so on. A hurricane strikes one of the companies, lowering EBITDA and raising reinvestment for the next year – other than that, the damage is temporary and the firm will return to its growth path. Which company should temporarily trade at a higher EV/EBITDA ratio or will they be the same? You don’t need to know or mention any formulas to answer this question; it can be answered purely based on common sense.
Answer: The hurricane strike causes temporary damage to the company. This is likely to affect EBITDA, short-run reinvestment and EV and lower all of these three. Crucially however, since we expect the firm to return to its pre-hurricane growth path, the impact on EV should be lower than the impact on EBITDA and long-run reinvestment rates should be the same. After this, it becomes a simple mechanical exercise: EBITDA falls and EV falls, but the fall in current EBITDA will be much larger, so therefore the EV/EBITDA ratio (based on current year EBITDA) of the affected firm
will rise. Once the firm recovers, the two firms should trade at the same ratio.
Explain the steps and inputs involved in calculating the implied equity risk premium for a stock market index and the assumptions required for the methodology to be valid. You do not need to state assumptions about the investor being diversified etc. Instead, discuss the assumptions underlying the
inputs of the implied ERP model.
Answer: The implied ERP is calculated by “reverse-engineering” the valuation of the index by using a DCF. That is, decide on an appropriate forecast horizon, find out expected cash flows from the index (from for instance analyst reports) and the discount rate for each period. The current level of the index is the valuation of the index and you have information on cash flows as well as the risk-free part of the discount rate. If we assume that CAPM is the appropriate risk model, we are left with one unknown – the ERP. We work backwards from the valuation to determine the one missing input into the valuation and hence get a forward-looking measure of risk.
For this to work, we have to assume we are using a similar model the marginal market participant – that is, we have to assume that our choice of forecast horizon is correct and that analyst estimates accurately proxy for the market’s growth expectations and cash flows. We also have to assume that the CAPM is indeed the correct measure of risk.
You are an analyst at a hedge fund. Your boss suggests that Fujiba, a Japanese conglomerate with two divisions, computing equipment and nuclear power, would unlock value if it were split into two separate companies (one focusing on computing equipment and the other on nuclear power). Your boss asks you to value the nuclear power operations as a standalone company. How would you estimate the CAPM beta of the nuclear operations? Explain the process step-bystep.
You may assume that the marginal investor in Fujiba is Japanese.
Answer: We cannot determine a regression beta since we do not have a price history for the nuclear arm, only for the entire company. Therefore we have to use the bottom-up beta method. The steps involved are:
(i) Determine a group of peer firms (same industry, ideally same country, so nuclear
firms in Japan. You can use nuclear firms in other countries if necessary – the exact
peer specification were not the important thing here).
(ii) Calculate regression betas for these firms for an appropriate time horizon (e.g. daily
data, one year).
(iii) Calculate the asset beta (industry beta) by unlevering these betas – that is, adjust for
the capital structures of the peer firms.
(iv) Take the unlevered beta and re-lever it for the expected capital structure of the
standalone nuclear firm (either from current financial statements if available, though
we do not know the value of equity, or based on some sort of target)
A student is calculating the return on invested capital (ROIC) of European airline firms and observes that there is a significant decrease in ROIC between 2018 and 2019. However, she does not observe any significant decline in revenues or other costs. Explain to her what might be causing this decline and how she can make the ROIC figures across years comparable.
The decline in ROIC is due to the fact that under IFRS operating leases were capitalized starting 2019. This means that lease expenses which were previously classified as operating expenses are no longer treated as such but are capitalized in the balance sheet and recognized as long-term debt on the liabilities side (tangible asset in the asset side). This increases the invested capital, which is the denominator in the ROIC
calculation causing the decline in ROIC in 2019. To make the figures comparable across years, the student should capitalize the operating leases in 2018.
Explain with the help of a numerical example why a firm’s growth rate in the longrun cannot exceed the growth rate in its industry. For the purposes of illustration you may assume that there are only two firms in the industry.
Consider the argument: “Firm A has a constantly higher net profit margin than Firm B, therefore it should trade at a higher P/E (price-to-earnings) multiple.” Firms A and B are identical in all other ways.
Discuss whether the argument is incorrect and why / why not.
You are valuing a firm and notice that it trades at a lower P/E (price-to-earnings) multiple than its peer firms. The peer firms are from the same industry and country as the firm you are valuing.
What factors would you need to account for before concluding that the firm is undervalued?
Answer: You need to decompose the P/E ratio to examine the drivers of the ratio. In particular, you need to ensure that the peer group has similar growth prospects, similar ROE, similar payout ratios and similar risk before you can conclude anything. You also need to ensure that the peer group have similar accounting standards and reporting horizons.
Additional answers which received points: Ensuring that the firms have similar liquidity and ownership structures (private/public).
Valuation professionals typically use the book value of debt to proxy for the market value of debt when calculating the D/E (debt-to-equity) ratio.
In what kind of firms does this approximation lead to large errors and what could be done to correct for them (assuming a market value of debt is not available)?
Answer: The approximation will lead to large errors when the book value of debt differs significantly from the market value of debt. Since it is very unlikely that the market value will be considerably higher than the book value, the most common situation where this might happen is with distressed firms, where the market value is well below the book value. In these
cases, using book D to calculate D/E will lead to the largest errors (please note: partial credit awarded to those who said “when the two are different” – an example, such as distressed firms, is needed for full marks). In order to correct for these errors, some kind of discount must be applied to the book value
of debt (partial credit for noting this). You may for instance look at how the market value of similarly traded debt relative to its book value and apply a similar discount. Alternatively, you could look at yields-to-maturity on similarly rated (but traded) debt and calculate a “market value” of your firm’s debt using this.
A student is calculating the cost of capital of the firm. She is using the book values of debt and equity from the last available balance sheet to estimate the weights of debt and equity.
Explain to her what is wrong with her approach.
Financing costs depend on how a firm will look in the future not how it looks currently on paper. Market values reflect a firm’s true ability to generate future cash flows and hence service its obligations associated with its financing. Using the historical values of debt and equity may therefore be misleading in scenarios when a firm’s prospects have changed. The student should hence use market value weights of debt and equity while computing the cost
of capital.
A student is calculating the implied stable long-run growth rate of a firm by multiplying the expected return on newly invested capital in nominal terms by the expected reinvestment rate in the stable growth phase. Explain to him what is problematic with his reasoning.
Answer: The student is ignoring the fact that even in the absence of reinvestments a firm could still grow in nominal terms by indexing up the price of its products by inflation. He would calculate the nominal growth rate to be zero when the firm is not reinvesting into new assets (i.e., reinvestment rate = 0). As a result, the free cash flow in nominal terms will be a constant in the post-projection period (or terminal period), which would then mean that firm value will be decreasing in real terms over time.
Suppose the projected long-run growth rate in real GDP is 1.8% while the 30-year real interest rate is 2.10%.
Is this scenario possible? Why or why not? If it is not possible, would the alternate scenario be possible (i.e., the projected real GDP growth rate > long-run real interest rate)? What would the alternative scenario then imply?
A student is valuing a privately-held firm. He is using the CAPM to calculate the asset beta of the firm’s publicly-traded peers and their average D/E (debt-to-equity) ratio (in market value terms) to calculate its cost of levered cost of equity.
Explain to him why this is not appropriate.
Answer: The CAPM assumes that the marginal investor holds a diversified portfiolio and
therefore expects compensation for only non-diversifiable risk, which is captured by the beta
measure of publicly-traded firms. The marginal investor (the owner) in a private firm does not
hold a diversified portfolio and (s)he therefore expects compensation for firm-specific as well
as non-diversifiable risk. The beta estimated based on publicly-listed peers understates the risk and hence the cost of equity of the privately-held firm.
Consider a firm owned and managed by an individual owner. Explain why a control premium exists in the context of private-held targets. Suppose the current value of a privately-held firm in the hands of its owner who owns 100% is $1 million and that an outside investor things that with better management the firm would be worth $1.5 million. The current owner is aware of the magnitude of the potential value surplus in the hands of the outside investor. Assume that
the owner sells either 49.9% of the firm or 50.1% of the firm. What is the implicit control premium?
Answer: In privately-held firms, the controlling shareholder (i.e., the owner and/or the founder)
is also typically the manager of the firm. If an outside investor wants to increase value by reducing potential mismanagement, (s)he will need to acquire majority ownership. The owner will ask for a premium to give up control which the acquirer or outside investor has to pay a premium to be able to realize the value increase – i.e., control premium.
Control premium = (50.1% * $1.5 M) – (49.9% *$1 M)
Imagine two firms. The firms are identical in all except one way. One of the firms has a higher operating (i.e., EBIT divided by sales) and net margin (i.e, net income divided by sales) than the other. That is, the firms have the same EBIT and net income, but the revenue of one firm is higher than that of the other.
Should one of the firms trade at a higher Price-to-Earnings (P/E) multiple than the other? Why or why not?
Imagine two firms. The firms are identical in all except one way. One of the firms has a higher operating (i.e., EBIT divided by sales) and net margin (i.e, net income
divided by sales) than the other. That is, the firms have the same EBIT and net income, but the revenue of one firm is higher than that of the other. Should one of the firms trade at a higher Enterprise value to sales (EV/Sales) multiple than the other? Why or why not?
