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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 ) ] ,

Question?