CHAPTER 15

COMPANY ANALYSIS AND STOCK VALUATION

TRUE/FALSE QUESTIONS

(f) 1 A growth company is one whose stock is undervalued by the market.

(t) 2 A cyclical company's sales and earnings are heavily influenced by aggregate
business activity.

(t) 3 A stock with low systematic risk is considered to be a defensive stock.

(f) 4 A growth company is a firm that has the opportunities and ability to invest capital in
projects that generate rates of return greater than the firm's cost of debt.

(t) 5 With a differentiation strategy, a firm seeks to identify itself as unique in its industry in
an area that is important to buyers.

(f) 6 By definition growth companies have growth stocks.

(f) 7 Turnarounds are firms with valuable assets that are hidden on the balance sheet.

(t) 8 Present value of free cash flow to equity resembles the present value of earnings
concept except that it includes the capital expenditures required to maintain and
grow the firm and the change in working capital required for a growing firm.

(t) 9 In the present value of operating free cash flow technique, the firm's operating free
cash flow to the firm is discounted at the firm's weighted average cost of capital
(WACC).

(t) 10 The best known measure of relative value for common stock is the P/E ratio.

(f) 11 Price-to-book value ratio can not be used to estimate the value of firms with negative
earnings or negative cash flows.

(t) 12 The price/cash flow ratio has grown in prominence and use for valuing firms because
many analysts contend that a firm's cash flow is less subject to manipulation than the
firm's earnings per share.

(f) 13 Price-to-sales ratio is still considered the predominant firm valuation technique.

(t) 14 The constant growth dividend growth model is not appropriate for the valuation of
growth companies.

(t) 15 A negative EVA (Economic Value Added) for the year implies that the firm has not
earned enough during the year to cover its capital of capital and the value of the firm
has declined.

(t) 16 While EVA is considered an internal performance measure, MVA is considered to be
an external performance measure.

15 - 1

MULTIPLE CHOICE QUESTIONS

(b) 1 A speculative stock possesses a _______ probability of _______ return and is
currently _________.
a) High, negative, underpriced.
b) High, negative, overpriced.
c) High, positive, overpriced.
d) Low, negative, overpriced.
e) Low, positive, underpriced.

(d) 2 A _____________ stock possesses a high probability of low or negative rates of
return and a low probability of normal or high rates of return.
a) Growth
b) Defensive
c) Cyclical
d) Speculative
e) Value

(c) 3 A growth company is one that has the ability to
a. Acquire capital at a low cost and is able to invest in projects that yield an
average return.
b. Acquire capital at a low cost and is able to invest in projects that yield a
below average return.
c. Acquire capital at an average cost and is able to invest in projects that yield
an above average return.
d. Acquire capital at an average cost and is able to invest in projects that yield
an average return.
e. Acquire capital at an above average cost and is able to invest in projects that
yield an average return.

(c) 4 Porter contends that and are two important
competitive strategies.
a) Low cost leadership, barrier to entry
b) New entrant deterrent, differentiation
c) Low cost leadership, differentiation
d) Differentiation, monopolistic
e) Monopolistic simulation, differentiation


(d) 5 In a ________ strategy, a firm seeks to identify itself as unique within its industry.
a) Defensive
b) Offensive
c) Low-cost
d) Differentiation
e) None of the above

(e) 6 In SWOT analysis, one examines all of the following factors, except
a) Strengths.
b) Weaknesses.
c) Opportunities.
d) Threats.
e) Turnarounds.
15 - 2

(b) 7 Which of the following statements concerning SWOT analysis is false?
a) Strengths are the factors that give the firm a comparative advantage in the
marketplace.
b) Weaknesses result when the company has potentially exploitable advantages
over other firms.
c) Opportunities are environmental factors that favor the firm.
d) Threats are environmental factors that can hinder the firm in achieving its
goals.
e) None of the above (that is, all statements are true)

(d) 8 Peter Lynch identified a number of attributes of firms that may result in favorable
stock market performances, including
a) Products that are faddish, people like change.
b) Firms that have competitive advantages over their rivals.
c) Firms that can benefit from cost reductions.
d) Choices b and c only
e) All of the above

(d) 9 Peter Lynch categorizes companies into six categories. Which of the following is not
such a category?
a) Slow growers
b) Fast growers
c) Cyclicals
d) Turnovers
e) Stalwarts

(b) 10 __________ are expected to have faster earnings growth, but because of their
consistent growth, large stock price changes are unlikely.
a) Fast growth
b) Stalwarts
c) Cyclicals
d) Asset plays
e) Turnarounds

(e) 11 Which of the following is not a technique for valuing a firm's common stock?
a) Present value of free cash flow to equity
b) Present value of dividends
c) Price-earnings ratio
d) Price-book value ratios
e) Price-cost of goods sold ratio

(d) 12 Which of the following is not considered when looking at free cash flow to equity
technique?
a) Depreciation expense
b) Change in working capital
c) Principal debt repayments
d) Change in competitive environment
e) Net income

(a) 13 Under the present value of operating free cash flow technique, the firm's operating
free cash flow to the firm is discounted at the firm's
a) Weighted average cost of capital.
b) Cost of debt.
15 - 3
c) Internal rate of return.
d) External cost of new equity.
e) Net present value.

(d) 14 Which of the following is not considered a relative valuation technique?
a) Price-earnings ratio
b) Price/cash flow ratio
c) Price/book value ratio
d) Price/cost of goods sold ratio
e) Price/sales ratio

(d) 15 Which of the following is not considered in the price-earnings ratio technique?
a) Firm's required rate of return on equity (k)
b) Firm's dividend payout ratio (D/E)
c) Firm's expected growth rate of dividends (g)
d) All of the above are components of P/E ratio
e) None of the above are components of P/E ratio

(c) 16 Evidence that a firm has high business risk would be provided by its volatile
______________.
a) Fixed costs.
b) Profit after taxes.
c) Operating profit.
d) Sales.
e) Employee turnover.

(b) 17 Which of the following factors does not indicate market liquidity?
a) Number of shareholders
b) High price volatility
c) Number of shares outstanding
d) Number of shares traded
e) Institutional interest

(d) 18 A growth company can invest in projects that generate a return greater than the
firms
a) Return on equity.
b) Cost of debt.
c) Cost of equity.
d) Cost of capital.
e) Return on assets.

USE THE FOLLOWING INFORMATION FOR THE NEXT TWO QUESTIONS
(1) The firm's expected rate of growth of earning per share
(2) The amount of capital invested in growth investments
(3) The rate of return earned on the funds relative to the required rate of return
(4) The required rate of return on the security based on its systematic risk
(5) The firm's dividend payout ratio
(6) The time horizon when these growth investments will be available

(c) 19 In the listing above, which three factors influence the capital gain component of a
growth company?
a) 1, 3, and 5
b) 2, 3, and 4
15 - 4
c) 2, 3, and 6
d) 3, 4, and 5
e) 3, 4, and 6

(a) 20 In the listing above, which three factors influence the earnings multiple for a stock?
a) 1, 4, and 5
b) 1, 4, and 6
c) 2, 4, and 6
d) 2, 5, and 6
e) 4, 5, and 6

(e) 21 An inconsistency between a stock's P/E ratio and growth rate can be attributed to all
of the following, except
a) A major difference in the risk involved.
b) Inaccurate growth estimates.
c) An undervaluation of the stock.
d) An overvaluation of the stock.
e) Competition.

(d) 22 A set of performance measures called are directly related to the
capital budgeting techniques used in corporate finance.
a) Dividend discount model
b) Aggressive growth indexes
c) Growth indexes
d) Value added
e) Profit sensitization

(e) 23 Economic profit is analogous to in capital budgeting.
a) Weighted average cost of capital
b) Internal rate of return
c) Composite discount rates
d) Discounted cashflows
e) Net present value

(d) 24 Which of the following is not a value added performance measure?
a) Economic Value Added (EVA)
b) Market Value Added (MVA)
c) Franchise Factor
d) Company Value Added (CVA)
e) None of the above (that is, all are value added performance measures)

(a) 25 Market value-added is a measure of performance.
a) External
b) Internal
c) Competitive
d) Economic
e) None of the above
15 - 5

(e) 26 Which of the following statements concerning global company analysis is false?
a) Analysis of companies within industries should be extended to include foreign
companies.
b) There is a problem in obtaining data that is required for a thorough company
analysis of foreign companies.
c) Foreign companies' financial risk should be evaluated over time.
d) Differences in relative measures can be explained by the variations in
accounting procedures among countries and investors attitudes within each
country.
e). None of the above (that is, all statements are true)

(d) 27 The following are tenets of Warren Buffett
a) Business tenets.
b) Financial tenets.
c) Management tenets.
d) All of the above.
e) None of the above.

(a) 28 Which of the following is a business tenet of Warren Buffett
a) Long term prospects.
b) Resistance to institutional imperative.
c) Creation of one dollar of market value for every dollar retained.
d) Purchase at discount to intrinsic value.
e) Product is not faddish

(b) 29 Which of the following is a management tenet of Warren Buffett
a) Long term prospects.
b) Resistance to institutional imperative.
c) Creation of one dollar of market value for every dollar retained.
d) Purchase at discount to intrinsic value.
e) Product is not faddish

(c) 30 Which of the following is a financial tenet of Warren Buffett
a) Long term prospects.
b) Resistance to institutional imperative.
c) Creation of one dollar of market value for every dollar retained.
d) Purchase at discount to intrinsic value.
e) Product is not faddish.
f)
(d) 31 Which of the following is a market tenet of Warren Buffett
a) Long term prospects.
b) Resistance to institutional imperative.
c) Creation of one dollar of market value for every dollar retained.
d) Purchase at discount to intrinsic value.
e) Product is not faddish

(c) 32 Studies that have examined the relationship between EVA and MVA have found
a) An inverse relationship.
b) A positive relationship.
c) A poor relationship.
d) EVA always exceeded MVA.
e) MVA always exceeded EVA.
15 - 6

(d) 33 The franchise P/E is a function of
a) Relative rate of return on new business opportunities
b) Size of superior return opportunities.
c) Duration of earnings growth.
d) a) and b)
e) a), b) and c)

MULTIPLE CHOICE PROBLEMS

(d) 1 What is the implied growth duration of Bowe Industries given the following:
S&P 400 Bowe Industries
P/E Ratios 10 25
Average Growth (%) 5.0 15.0
Dividend Yield .06 .02
a) 3.2 years
b) 6.6 years
c) 9.6 years
d) 17.2 years
e) 18.6 years

(b) 2 What is the implied growth duration of Casey Industries given the following:
S&P 400 Casey Industries
P/E Ratios 15 20
Average Growth (%) 10.0 15.0
Dividend Yield .04 .06
a) 3.2 years
b) 4.8 years
c) 9.6 years
d) 13.2 years
e) 18.6 years

(c) 3 What is the implied growth duration of J ones Industries given the following:
S&P 400 J ones Industries
P/E Ratios 12 15
Average Growth (%) 6.0 16.0
Dividend Yield .05 .03
a) 1.2 years
b) 4.9 years
c) 3.2 years
d) 12.9 years
e) 15.2 years

(a) 4 What is the implied growth duration of Freed Industries given the following:
S&P 400 Freed Industries
P/E Ratios 19 22
Average Growth (%) 11.0 16.0
Dividend Yield .06 .08
a) 2.5 years
b) 1.3 years
c) 5.0 years
d) 4.5 years
e) 3.5 years
15 - 7

(e) 5 What is the implied growth duration of Howard Industries given the following:
S&P 400 Howard Industries
P/E Ratios 14 19
Average Growth (%) 6.0 12.0
Dividend Yield .07 .04
a) 1.5 years
b) 6.8 years
c) 2.6 years
d) 9.4 years
e) 11.6 years


USE THE FOLLOWING INFORMATION FOR THE NEXT TWO PROBLEMS

Modular Industries currently has a 16% annual growth rate while the market average is 6
percent. The market multiple is 10.

(e) 6 Determine the justified P/E ratio for Modular Industries assuming Modular can
maintain its superior growth rate for the next 5 years.
a) 6.4
b) 13.1
c) 16.5
d) 23.8
e) 15.7

(b) 7 Determine the P/E ratio for Modular Industries assuming Modular can maintain its
superior growth rate for the next 8 years.
a) 6.4
b) 20.5
c) 16.5
d) 23.8
e) 29.5

USE THE FOLLOWING INFORMATION FOR THE NEXT TWO PROBLEMS

Harcourt Industries currently has an 18% annual growth rate while the market average is 8
percent. The market multiple is 12.

(e) 8 Determine the justified P/E ratio for Harcourt Industries assuming Harcourt can
maintain its superior growth rate for the next 9 years.
a) 5.98
b) 13.13
c) 21.20
d) 58.68
e) 26.65

(c) 9 Determine the P/E ratio for Harcourt Industries assuming Harcourt can maintain its
superior growth rate for the next 3 years.
a) 4.25
b) 12.50
c) 15.67
d) 30.10
e) 42.80
15 - 8



USE THE FOLLOWING INFORMATION FOR THE NEXT TWO PROBLEMS

The Valentine Company currently has a 14% annual growth rate while the market average is
4 percent. The market multiple is 15.

(e) 10 Determine the justified P/E ratio for the Valentine Company assuming Valentine can
maintain its superior growth rate for the next 10 years.
a) 3.0
b) 9.2
c) 16.6
d) 28.6
e) 37.6

(a) 11 Determine the P/E ratio for the Valentine Company assuming Valentine can maintain
its superior growth rate for the next 5 years.
a) 23.7
b) 16.4
c) 15.3
d) 8.3
e) 3.8

(c) 12 Given Gitech's beta of 1.55 and a risk free rate of 8 percent, what is the expected
rate of return assuming a 14 percent market return?
a) 12.4%
b) 14.3%
c) 17.3%
d) 20.4%
e) 29.7%

(b) 13 The expected rate of return on Research Industries is twice the 12 percent expected
rate of return from the market. What is Research's beta if the risk free rate is 6
percent?
a) 2
b) 3
c) 4
d) 5
e) 6

(b) 14 Given Birdchip's beta of 1.25 and a risk free rate of 6 percent, what is the expected
rate of return assuming a 12 percent market return?
d) 1%
a) 10%
b) 11%
c) 12%
e) 31%

(c) 15 The expected rate of return on Rewind Industries is 2.5 times the 12 percent
expected rate of return from the market. What is Rewind's beta if the risk free rate is
6 percent?
a) 2
b) 3
15 - 9
c) 4
d) 5
e) 6

(b) 16 Given Gilberts beta of 1.10 and a risk free rate of 5 percent, what is the expected
rate of return assuming a 10 percent market return?
a) 21.5%
b) 10.5%
c) 5.5%
d) 15.5%
e) 16.5%

(a) 17 The expected rate of return on Rooter Industries is 1.5 times the 16 percent expected
rate of return from the market. What is Research's beta if the risk free rate is 8
percent?
a) 2
b) 3
c) 4
d) 5
e) 6

(d) 18 ABC Co. has paid annual dividends in the past five years of $.20, $.25, $.28, $.33,
and $.36. Calculate the average growth rate of its dividends.
a) 1.16%
b) 1.80%
c) 12.47%
d) 15.83%
e) None of the above

USE THE FOLLOWING INFORMATION FOR THE NEXT TWO QUESTIONS

Wal-Blue Industry
DPS 1.00 1.50
Total Asset Turnover 3.20 2.50
Net Profit Margin 3.50% 3.00%
EPS 4.00 3.00
Total Assets/Equity 3.00 4.00


(d) 19 What are the ROE's for Wal-Blue and its industry?
a) 24.3% and 27.0%
b) 29.7% and 27.0%
c) 29.7% and 30.0%
d) 33.6% and 30.0%
e) 34.5% and 31.5%

(a) 20 What are the expected sustainable growth rates for Wal-Blue and its industry?
a) 25.2% and 15.0%
b) 30.0% and 17.5%
c) 25.2% and 17.5%
d) 27.5% and 12.5%
e) 30.0% and 15.0%


15 - 10
(d) 21 A firm has a current price of $40 a share, an expected growth rate of 11 percent and
expected dividend per share (D1) of $2. Given its risk you have a required rate of
return for it of 12 percent. Your expected rate of return and investment decision is as
follows:
a) 10% - do not buy
b) 12% - do not buy
c) 14% - buy
d) 16% - buy
e) 18% - buy

(a) 22 Assuming that you expected the stock price in the prior question to increase to $42
during the investment period, your expected rate of return and decision would be:
a) 10% - do not buy
b) 12% - do not buy
c) 14% - buy
d) 16% - buy
e) 18% - buy



(a) 23 Based on the information provided, calculate the intrinsic value in 1999 of a share of
INV Corp. using the FCFF (free cash flow to the firm ) model. For 1999 the FCFF
was $15,000, total debt was $20,000, and there 12000 shares outstanding. The
required rate of return is 9% and the estimated growth rate in FCFF is 6.5%.
a) $51.58
b) $53.25
c) $12.50
d) $54.92
e) $50.45

(a) 24 Based on the information provided, calculate the intrinsic value in 1999 of a share of
INV Corp. using the Present Value of Earnings Model (infinite holding period). For
1999 Net Income was $250,000, total debt was $50,000, and there 11,000 shares
outstanding. The required rate of return is 12% and the estimated growth rate in
earnings is 5.5%.
a) $19.43
b) $23.98
c) $28.52
d) $22.73
e) $15.50

(d) 25 You are provided with the following information about J avier Corporation. Sales for
the year 2000 were $500,000, the Net Profit Margin (NPM) was 15%. Analysts
project sales to grow by 12% next year, that is 2001. However, because of more
competition, the NPM is expected to decline by 10% for the year 2000. The expected
P/E multiple for the year 2001 is 22. The total number of shares outstanding is
20,000. Use the earnings multiplier model to calculate the expected price for J avier
Corporation in the year 2001.
a) $74.25
b) $61.6
c) $82.5
d) $83.16
e) $101.64

15 - 11
USE THE FOLLOWING INFORMATION TO ANSWER THE NEXT FIVE QUESTIONS

You are provided with the following information on Kayray Corporation. Your ultimate objective is to
calculate the EVA for the firm.

LIFO reserve 60
Net plant, property, and equipment 1325
Other assets 30
Goodwill 325
Accumulated Goodwill amortized 65
PV of Operating leases 140
Tax benefit from interest on expenses 10
Tax benefit from interest on leases 5
Taxes on non-operating income 2
Implied interest on op. lease 9.5
Increase in LIFO reserve 12
Goodwill amortization 15
Operating profit 550
Income tax expense 215
Net working capital 440
WACC 0.12

(a) 26 Calculate the adjusted operating profits before taxes.
a) $586.5
b) $225.64
c) $825.23
d) $831.56
e) $692.5

(b) 27 Calculate the cash operating expenses for the firm
a) 225
b) 228
c) 232
d) 242
e) 252

(d) 28 Calculate the capital for the firm
a) 1725
b) 1953
c) 2524
d) 2385
e) 1987

(a) 29 Calculate the dollar cost of capital
a) 286.2
b) 207
c) 234.36
d) 238.44
e) 302.9

(b) 30 Calculate the firms EVA
15 - 12
a) 85.2
b) 72.3
c) 65.8
d) 89.5
e) 78.2

(a) 31 The Peterson Company has FCFF of $1000. FCFF is expected to grow by 12% next
year. The cost of capital is 12% and the level of debt is $5000. The number of shares
outstanding is 500. Calculate the firms share price.
a) $44
b) $55
c) $34.19
d) $47.23
e) $50

(d) 32 The Pekay Company has FCFE of $800. FCFE is expected to grow by 7% next year.
The cost of capital is 7% and the level of debt is $4000. The number of shares
outstanding is 700. Calculate the firms share price.
a) $44.25
b) $65.12
c) $38.19
d) $40.76
e) $50.56


15 - 13

CHAPTER 15


ANSWERS TO PROBLEMS



1 ln (25/10) =T ln [1 +.15 +.02)/(1 +.05 +.06)]
T =17.4 years

2 ln (20/15) =T ln [1 +.15 +.06)/(1 +.10 +.04)]
T =4.8 years

3 ln (15/12) =T ln [1 +.16 +.03)/(1 +.06 +.05)]
T =3.2 years

4 ln (22/19) =T ln [1 +.16 +.08)/(1 +.11 +.06)]
T =2.5 years

5 ln (19/14) =T ln [1 +.12 +.04)/(1 +.06 +.07)]
T =11.6 years

6 ln (X) =5 ln (1.16/1.06)
ln (X) =5 ln (1.094)
ln (X) =5 (.090) =0.45 X =1.57

Thus, the P/E ratio would be 1.57 x 10 =15.7

7 ln (X) =8 ln (1.16/1.06)
ln (X) =8 ln (1.094)
ln (X) =8 (.090) =0.72 X =2.05

The P/E would be 10 x 2.05 =20.5

8 ln (X) =9 ln (1.18/1.08)
ln (X) =9 ln (1.093)
ln (X) =9 (.089) =.801 X =2.22

The P/E would be 2.22 x 12 =26.65

9 ln (X) =3 ln (1.18/1.08)
ln (X) =3 ln (1.093)
ln (X) =3 (.089) =.269 X =1.306

The P/E would be 12 x 1.306 =15.67

10 ln (X) =10 ln (1.14/1.04)
ln (X) =10 ln (1.096)
ln (X) =10 (.092) =.92 X =2.51

Thus, the P/E ratio would be 2.51 x 15 =37.6

11 ln (X) =5 ln (1.14/1.04)
15 - 14
ln (X) =5 ln (1.096)
ln (X) =5 (.092) =.46 X =1.584

The P/E would be 15 x 1.584 =23.7

12 K
1
=8 +1.55 (14 - 08) =17.3%

13 24 =6 +(12 - 6)
18 =(6) ===> =3

14 K
1
=6 +1.25 (12 - 8) =11.0%

15 30 =6 +(12 - 6)
24 =(6) ===> =4

16 K
1
=5 +1.10 (10 - 5) =10.5%

17 24 =8 +(16 - 8)
16 =(8) ===> =2

18 Average dividend growth rate =[D
n
/D
0
]1/n - 1
=[$.36/$.20]1/4 - 1
=[1.80]1/4 - 1
=1.1583 - 1 =.1583 or 15.83%

19 ROE =Total asset turnover x Net profit margin x Total assets/equity

ROE (Wal-Blue) =3.20 x .035 x 3.00 =.336 or 33.6%

ROE (Industry) =2.50 x .03 x 4.00 =.300 or 30.0%

20 g =ROE x RR =ROE x (1 - dividend payout)

g (Wal-Blue) =.336 x (1 - 1.00/4.00) =.336 x .75 =.252 or 25.2%

g (Industry) =.300 x (1 - 1.50/3.00) =.300 x .50 =.150 or 15.0%

21 Expected rate of return =D
i
/P
0
+g
=$2.00/$40.00 +11%
=5% +11% =16%

Buy, expected return (16%) exceeds required return (12%).

$42.00 - $40.00 +$2.00
22 Expected rate of return = =$4.00/$40.00 =10%
$40.00

Do not buy, expected return (10%) does not exceed the required return (12%).


23 price = 12000 / 20000
065 . 09 .
) 065 . 1 ( 15000

=$51.58
15 - 15

24 price = 11000 / 50000
055 . 12 .
) 055 . 1 ( 250000

=$19.43

25 The price is calculated as follows

Sales for 2001 =500,000(1.12) =560,000

New NPM =.15(1 - .1) =.135

2001 NPM =560,000(.135) =75,600

EPS =75,600/20,000 =$3.78

Price =3.78(22) =$83.16
15 - 16

The answers to problems 26 to 30 are provided below

Operating profit 550
+implied interest on op. lease 9.5
+an increase in LIFO reserve 12
+goodwill amortization 15
=Adjusted Operating profits before taxes 586.5 (26)

Income tax expense 215
+tax benefit from interest on expenses 10
+tax benefit from interest on leases 5
- taxes on non-operating income 2
=Cash Operating expenses 228 (27)

Net working capital 440
+LIFO reserve 60
+Net plant, property, and equipment 1325
+Other assets 30
+Goodwill 325
+Accumulated Goodwill amortized 65
+PV of Operating leases 140
=Capital 2385 (28)

WACC 0.12

Dollar cost of
capital =Capital x WACC 286.2 (29)

EVA 72.3 (30)

EVA =586.5 228 286.2 =72.3

31 price = 500 / 5000
08 . 12 .
) 08 . 1 ( 1000

=$44

32 price = 700 /
07 . 10 .
) 07 . 1 ( 800

=$40.76
15 - 17