Section A: Answer any TWO out of FOUR questions.

Question 1.
You have learnt various equity valuation approaches including the dividend discount
model (DDM), residual income valuation model (RIVM), abnormal earnings growth
model (AEG) and P/E multiple. Your boss asks you to demonstrate the consistency
of the results to your colleagues in the investment group. She has provided you the
following information.
AABB is an all equity firm. Current book value of AABB is 400 pence per share. The
forecast earnings and dividends are as follows:
Earnings per share: 30 pence in year 1 and 35 pence in year 2;
Dividends per share: 3 pence in year 1 and 3.5 pence in year 2;
For year 3 and beyond, you can assume a growth rate in book values and earnings
to be 4%.
You can use the CAPM to estimate the cost of capital. The firm has a beta of 1.3 and
the market risk premium is 4.5%. Assume the risk-free rate is 2%.
REQUIRED:
(a) Estimate earnings, dividends and closing book values for years 3 and 4.
(15 marks)
(b) Estimate the residual income and abnormal earnings growth for years 2-4.
(13 marks)
(c) Calculate the current value of AABB using the DDM, RIVM and AEG models.
Also, calculate the value of the company at the end of year 2 by using these
three models.
(42 marks)
(d) Calculate the value of the company using the P/E approach at the end of year
2.
(10 marks)
(e) Compare and contrast the DDM, RIVM, AEG and P/E models.
(20 marks)
(Total 100 marks)

Question 2.
You are working for an aggressive private equity fund. You want to evaluate a
possible acquisition of SuperDry Retail plc (SDR), which specialises in selling
swimwear and beach clothing. SDR has recently floated on AIM (the Alternative
Investment Market), has a modest level of leverage, and has a market value of debt
plus equity (i.e. enterprise value) of approximately £4m. You would have to offer a
total value of £4.5 to £5m to acquire SDR to set up “NewSDRCo”, with £3m in debt
and the balance in equity. The forecasts of the free cash flows (FCF) at firm level for
the next 3 years would be:
Year 1 Year 2 Year 3
100k 110k 130k
Beyond year 3, you think growth will be 4% per annum.
Your intention is to float the firm back on AIM at the end of year 3. From analogue
firms, you find the following CAPM parameters and other information that typically
apply in the retail industry:
Analogue Estimates
Levered equity beta 1.2
Debt beta 0.3
Debt/(Equity+Debt) 0.45
Equity/(Equity+Debt) 0.55
Tax rate 25%
Assume the current risk-free rate is 2%. Your estimate of the expected return on the
equity market is 8.5%. Prior to flotation you will apply 100% of the FCF to paying
down the debt. On flotation, you will assume the typical industry leverage structures
(as above) will apply. You will use any flotation proceeds to retire debt and apply
Ruback (2002) active debt management policy.
REQUIRED
(a) Estimate the cost of equity, after-tax cost of debt, cost of unlevered equity and
weighted average cost of capital (WACC) at flotation. (10 marks)
(b) Estimate the enterprise value of SDR, unlevered firm value and value of tax
shield at flotation. (25 marks)
(c) Calculate the value of debt at the end of years 1-3. To have the target
leverage ratio of 45% (as above), how much equity must be raised to pay off
the debt? (20 marks)
(d) Estimate the value of tax shield, enterprise value and equity value today.
(25 marks)
(e) Describe difference between the passive debt management policy and active
debt management policy.
(20 marks)
(Total: 100 marks)
4

Question 3.
The reorganized balance sheet and income statement for Lewis Plc are given below.
Reorganized balance sheet
Today Year 1
Operating working capital 100.000 105.000
Net property and equipment
(PPE) 700.000 735.000
Invested capital 800.000 840.000
Debt 330.000 346.500
Shareholders’ equity 470.000 493.500
Invested capital 800.000 840.000
Income Statement
Today Year 1
Revenues 1000.000 1050.000
Operating costs -800.00 -840.000
Depreciation -50.000 -52.500
Operating profits 150.000 157.500
Interest -12.000 -13.200
Earnings before taxes 138.000 144.300
Taxes -27.600 -28.860
Net Income 110.400 115.440
Assume the cost of equity is 9% and cost of debt before tax is 4%. The operating tax
rate (also marginal tax rate) is 20 percent. Assume the market value of debt equals
book value of debt. From year 2, operating working capital, PPE, debt, equity and
revenues all are expected to grow at a rate of 3% in perpetuity. Assume that ratio of
operating costs/revenues = 80% and ratio of depreciation/revenues = 5% forever.
REQUIRED:
(a) Determine the following values for years 1 and 2: net operating profit after tax
(NOPLAT), the free cash flow to firm (FCFF), and free cash flow to equity holders
(FCFE). (25 Marks)
(b) Calculate Lewis’ current equity value, and values for years 1 and 2 by using the
free cash flow to equity holders (FCFE) model. (16 Marks)
(c) Calculate the current weighted average cost of capital (WACC) and its value for
year 1. (14 Marks)
(d). Estimate the enterprise economic profit (RIF) for years 1 and 2, as well as the
current enterprise value and value for year 1 using the economic profit model.
(25 Marks)
(e) Discuss the main difference between direct and indirect approaches in equity
valuation using the residual income valuation (RIVM) and discounted cash flows
(DCF) models. (20 Marks)
(Total 100 Marks)
5

Question 4.
You are asked to use the Ohlson (1995) model and an extended Ohlson model,
namely the Pope and Wang (2005) model to value Monson plc.
At 1st January 2019, the company had a book value of equity of £750m. Earnings for
the year ended 31st December 2019 were £70m and dividends were £30m.
Analysts’ consensus forecast for the year ended 31st December 2020 will be £75m
and book value of equity grows at 3% per year. Assume the clean surplus
relationship holds. The cost of equity capital is 8%.
First, you use the Dechow, Hutton and Sloan (1999) approach to estimate the ‘other
information’ parameter by making it equal to the difference between analysts’
forecast and the abnormal profits implied by the Ohlson model estimate for the year
ended 31st December 2019. You agree with the DHS parameter estimates for the
Ohlson model, i.e.    0.62 and 0.32. 
Second, you want to adjust accounting conservatism in the Ohlson LID by using the
Pope and Wang (2005) extended model:
11 2 1 , 1
1 , 1
[(1 ) ] , 0 1
, 0 1
t t t t tx t
t tt
RI RI r b b
r 
    
   
 
 
      
  
You estimate that suitable parameter estimates for the Pope and Wang model,
1 2    0.23, 0.02 and 1.01.  
REQUIRED
(a) Calculate the abnormal earnings: o RI j for years 2019-2021 and the value of
‘other information’: o  j for years 2019-2020 based on the Ohlson model.
(20 marks)
(b) Calculate the abnormal earnings: pw RIj for years 2019-2021 and the value of
‘other information’: pw  j for years 2019-2020 based on the Pope and Wang
model. (25 marks)
(c) Calculate the implied earnings and dividends for year 2021 based on the two
models. (15 marks)
(d) Compute the firm’s intrinsic values: O V and PW V on the 1st January 2020
based on the two models. (20 marks)
(e) Explain the difference between the Ohlson model and the Pope and Wang
model. In your view, which might be able to explain the observable stock price
better and why? (20 marks)
(Total 100 Marks)
6
BEAM038 / BEFM016 Turn over
Section B: This is a compulsory question.
Question 5.
Markets seem to make extensive use of price multiples in equity (and firm) valuation.
REQUIRED:
(a) List three commonly used valuation multiples and explain how they are related to
the DCF (RIVM) valuation.
(40 marks)
(b) Explain the normal procedure to do a relative valuation.
(20 marks)
(c) Discuss the difference between conventional P/E and Shiller’s CAPE10 ratio.
(10 marks)
(d) Explain the rationale to introduce the price-earnings growth ratio (PEG).
(10 marks)
(e) Discuss the potential problems in applying valuation multiples in practice.
(20 marks)
(Total 100 marks)
7
BEAM038 / BEFM016 End of Paper
Appendix
You may find the following formulae useful to refer to in the examination.
(1)   0 1
1
1 (1 ) [ ],
1 (1 ) ( ) 1
t n
t n tt
t n t
t e ee e
d d g dEV EV EV
r r rg r



 
 
   
(2)
2
11 1 1
0 2 3
(1 ) (1 ) … 1 (1 ) (1 )
d d gd g d EV
r r r rg
 
   
  
(3)   0 1
1
1 (1 ) [ ],
1 (1 ) ( ) 1
t n
t n tt
t n t
t
FCFF FCFF g FCFF FV FV FV
WACC WACC WACC g WACC



 
 
   
(4)
2
11 1 1
0 2 3
(1 ) (1 ) … 1 (1 ) (1 )
FCFF FCFF g FCFF g FCFF FV
WACC WACC WACC WACC g
 
   
  
(5)   0 0
1
1 (1 ) [ ]
1 (1 ) ( )
t n
t n
t n
t
RI RI g EV b
r r rg



 
    , where RI e r b tt t   1
(6) 1
0 0 ( )
RI EV b
r g
  
(7) The relation between levered and unlevered beta:
e u ud   ZD
E     and u e d
E DZ
E ZD E ZD    
 
where: 1 or 1 Z T   C .
Value of tax shield V TD txa c  or ( ) c d
u
T rD
r .
(8) 0
1
P 1 q
E r g
  
(9)      
1 23 4
0 2 3
1 ….. 1 1 1
e AEG AEG AEG P
rr r r r
 
    
    
where AEGt+1 = et+1+r.dt – (1+r).et.
(10) 1 2
0
e AEG 1 P
r rrg
 
      
(11) An extended Ohlson model-the Pope and Wang model:
1 2
1
11 1
(1 ) 1
11(1 )(1 ) t t t t t
r r P b RI b
r r rr
  
   
 
  
   
where
11 2 1 , 1
1 , 1
[(1 ) ] ,

BEAM038-BEFM016-20May

CITATION