Solution to Quiz

Fall 1997
Problem 1
Dividends on Index = 3% of 1050 = 31.50
Value = 1050 = 31.50 (1.06)/(r-.06)
Solving for r,
r = 9.18%
Implied Risk Premium = 9.18% - 6.5% = 2.68%
If you assumed that the dividend yield was based on next year's dividends,
Value = 1050 = 31.50/(r-.06)
Sovling for r,
r = 9.00%
Implied Risk Premium = 9% - 6.5% = 2.5%
This answer can also be obtained by adding the dividend yield to expected growth
and subtracting out the risk free rate
[This is how we got cost of equity for Southwestern Bell in the notes.]

Problem 2
Net Income $ 100.00 (1000 * .10 = Normal Net Income)
- (Net Cap Ex * .75) $ 10.50 (Capital Expenditures: $ 80 mil; Depreciation = $ 60(1.1) = $ 66; D/(D+E) = 500/(500+1500))
- Chg in WC * .75 $ 15.75 (WC this year = .10 *1500 = 150; WC next year = .095 * 1800 = 171; Chg in WC = 21)
= FCFE $ 73.75

Problem 3
Expected Growth Rate in Operating Income = 10%( 5%
Expected FCFF next year
EBIT (1-t) $ 105.00
Reinvestment $ 52.50
FCFF $ 52.50

Spring 1998: Quiz 1

Problem 1
Note that the value of a firm is the Cash flow dicounted back at a discount rate.
For investors who are not diversified (REITs, Venture cap funds), the discount rate will always be lower than it is for
investors who are diversified (Specialized venture capitalists, private real estate investors). For the latter to have
more value, then, they have to have the capacity to generate higher cash flows than the diversified investor. For specialized
venture capit䁡lists this may come from knowing a particular sector well, having localized information on that sector and
providing management expertise to firms in that sector. Similarly, for real estate investors, it may come from knowing the
local real estate market well.
A. Firms where information about the firm is easily available to all,
and which have good management in place
Specialized investors gain an advantage through their access to private and localized
information and by providing management support to the companies that they provide
capital to.
While firms which require more capital may seem like a logical choice, note that this will have to come at the expense
of diversification.

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 Solution to Quiz

B. Real estate value is being driven less by localized information and more by market forces.
The question that has to be addressed here is the change over the last decade. While it is true that investors want to be
want to be diversified in real estate, why would that need be greater today than it was 10 years ago? (REITs have been around
for 25 years.) REITs have tax advantages over corporations but not over individual real estate investors, since the income flows
through, because of the dividend payment restriction, to the investors in these firms, who get taxed at their individual tax rates
anyway.

Problem 2
Sector Beta D/E Ratio Unlevered Beta
Steel 1.18 30% 1
Financial Services 1.14 70% 0.8028169

Unlevered Beta for the company = 0.7 (1) + 0.3 (.8) = 0.94
Levered Beta for the company = 0.94 (1+(1-.3)(1.5)) = 1.93

Riskless Rate = Government bond rate - Default spread = 10% ! If I use the 12%, I may double count risk.
Country risk premium = Default spread * Relative equity market volatility = 4.00%
Cost of Equity for the Company = 10% + 1.93 (5.5% + 4%) = 28.34%

Problem 3
Expected Operating Income next year = 235*1.10 = 258.5
- Reinvestment Needed = .40 * 258.5 = 103.4
FCFF next year = 155.1

Return on Capital = 235/940 = 25%

Expected Growth Rate = Reinvestment Rate * Return on Capital
10% = Reinvestment Rate * 25%
Reinvestment Rate = 10%/25% = 0.40

Fall 1998: Quiz 1

Problem 1
Spread Based on Bond Rating = 3%
Equity SD/ Indonesian Bond SD = 4
Country Risk Premium = 12%

Beta for the firm 0.75

Lambda (for country risk) = 0.25 (Proportion from non-dollar sources for paperfirm = 0.2
Proportion from non-dollar sources for average firm = 0.8
Exposure to country risk = 0.20/0.80 = 25%
Cost of Equity for Firm = 15% + 0.75 (5.5%) + 0.25 (12%) = 22.125%

Problem 2
Unlevered Beta for Entertainment Software= 1.42
Beta for Cash = 0
Beta for InfoSoft = 1.41 (0.8) + 0 (0.2) = 1.13 I also gave full credit if you used a net debt ratio of -20%, leading to a beta of 1.25.

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 Solution to Quiz

Problem 3
Year 1 2 3 4
Expected Growth Rate 12% 10% 8% 6%

EPS $ 2.24 $ 2.46 $ 2.66 $ 2.82

- (Cap Ex - Deprec'n) (1-DR) $ 0.90 $ 0.75 $ 0.60 $ 0.45
- Change in WC (1 - DR) $ 0.36 $ 0.34 $ 0.30 $ 0.24 (WC numbers slightly different: rounding error)
FCFE $ 0.98 $ 1.38 $ 1.77 $ 2.13
Terminal Price $ 47.36 (Terminal Price = $2.13/(.105-.06) = $ 47.36)
Present Value $ 0.87 $ 1.08 $ 34.83
Value Per Share = $ 36.78 [Value = $0.98/1.1325 + $1.38/(1.1325*1.1215) + ($1.77 + $47.36)/(1.1325*1.1215*1.1105)
This is how I got the numbers for each year:
Cap Ex - Depreciation 1.2 1 0.8 0.6
Change in Working Capital $ 0.48 $ 0.45 $ 0.39 $ 0.32
Revenues per share $ 22.40 $ 24.64 $ 26.61 $ 28.21

Beta 1.5 1.3 1.1 1

Cost of Equity 13.25% 12.15% 11.05% 10.50%

Spring 1999
Problem 1
Unlevered Beta = (0.60) (1.25) + 0.25 (0.8) + 0.15 (0) = 0.95
Levered Beta = 0.95 (1 + (1-.3)(1.5)) = 1.9475
Country risk premium for Indonesia = 3% (3.0) = 9%
Cost of Equity = 5% + 1.95 (6% + 9%) = 0.3425

Problem 2
EBIT = Net Income + Interest Expenses = -50 + 100 = $ 50.00 ! No taxes since firm is losing money
Capital expenditures = 100* 2 = $ 200.00
FCFF = 50 - (200 - 100) = $ (50.00)

Problem 3
Return on Equity = 25/125 = 20%
Retention Ratio = 20/25 = 80% ! Note that book value of equity increased by $ 20 million and firm
had net income of 25 million
Expected Growth in EPS = 0.8 * 20% = 16%

Spring 2000
Riskfree Rate Beta Risk Premium
Soft-drink: US 6.50% 0.7 6%
Soft-drink: Mexico 6.50% 0.7 13.60%
Consumer Products: US 6.50% 0.9 6%
Consumer Products: Mexico 6.50% 0.9 13.60%

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 Solution to Quiz

a. Operating Income from soft drinks: 0.6*1.5 + 0.5*1 = 1.4

Operating Income from consumer products = 0.4*1.5+0.5*1 = 1.1
Unlevered beta for the firm = 0.7(1.4/2.5) + 0.9 (1.1/2.5) = 0.788

b. Beta for US operations = 0.6*.7+0.4*.9 = 0.78 ! Business mix is different in two

Cost of equity for US operations = 6.5% + 0.78 (6%) 11.18% countries

c. Beta for Mexican operations = 0.5*.7+0.5*.9= 0.8

Cost of equity for Mexican operations = 6.5% + 0.8(6% + 2*3.8%) = 17.38%

Problem 2
If we assume that amortization is not tax deductible
EBIT + EBITDA - Depreciation = 500 - 80 = 420
EBIT (1- tax rate) = 252
Capital Expenditures = Cap Ex + Acquisitions = 120 + 150

EBIT (1-t) 252

- Net Cap Ex = 270 - 80 = 190 ! If you do not subtract out amortization to g
- Chg in Working Capital = 50 do not add it back. If you get this answer, and
FCFF 12 you ignored amortization, let me know and I w

If we assume that amortization is tax deductible

EBIT = EBITDA - Depreciation - Amortization = 500 - 80 - 40 = 380
EBIT (1 - tax rate) = 228
Capital Expenditures = Cap Ex + Acquisitions = 120 + 150 = 270

FCFF
EBIT (1-t) = 228
- Net Cap Ex = 270 - 120 = 150
- Chg in Working Capital = 50
FCFF 28

Problem 3
Return on Equity = 150/1200 = 12.50%
Retention Ratio = 1-(60+15)/150 = 50.00%
a. Expected Growth Rate = .125*.5 = 6.25%

b. If ROE increases to 15%,

Expected growth = .5*15%+ (.15-.125)/.125 = 27.50%

Spring 2001
Problem 1
a. Implied Equity Risk Premium

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 Solution to Quiz

Expected dividend next year = .05 (800) (1.10) = 44

800 = 44 / (r - .10)
Solving for r,
r= 15.50%
Implied risk premium = 6.50% ! 15.5% - 9%

b. Unlevered beta for retailers = 1.20/(1 + (1-.4) (.45)) = 0.94488189

Debt to Equity Ratio for Baklak Stores = 0.25
Levered beta = 0.94 (1 + (1-.4) (.25)) = 1.08661417
Cost of Equity = 9% + 1.09 (6.5%) = 16.09%

c. Cost of capital = 16.09% (2400/3000) + 11% (1-.4) (600/3000) = 14.19%

Problem 2
a. PV of Operating leases = $335.50
Adjusted Operating Income = $176.84 ! Added .08*335.50 as imputed
Adjusted Return on capital = 12.70%
b. Reinvestment rate = 78.74% ! Growth rate/ ROC
Expected cash flow next year:
EBIT (1-t) $116.71 ! 176.84 *(1-.4)*1.10
- Reinvestment = $91.90 ! Reinvestment rate * EBIT (1
FCFF $24.81

Spring 2002
Problem 1
a. Unlevered bottom-up beta
Business Revenues Value/Sale Estimated Unlevered Weights Weight * Beta
Retailing 400 2 800 0.85 26.67% 0.23 ! Use value weights: If you used revenue weights you lost a point
Sotware 400 3 1200 1.15 40.00% 0.46
Travel 800 1.25 1000 1.35 33.33% 0.45
3000 1.14
b. Estimated market value of debt
Book value = 1200 ! Use pre-tax cost of debt to compute prese
Interest expense= 60 I f you use after-tax cost of debt, you lost
Maturity = 5 Assorted mathematical errors: -
Interest rate = 7%
Market value of bonds = ###

c. Levered Beta
Levered beta = 1.14 (1+ (1-.4) (1101.60/1000)) = 1.89 ! Use market value of debt and e

Problem 2

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 Solution to Quiz

a. Value of Research Asset

Year R&D AmortizatioRemaining Value
current 100 0 100 ! Any mechanical error: -0.5 poi
-1 90 30 60
-2 75 25 25
-3 60 20 0
75 185
Value of research asset = 185

b. Corrected operating income

EBIT 250 ! Any mechanical error: -0.5 poi
+ Current year's R&D 100
- Amortization of R&D 75
Adj EBIT 275

EBIT (1-t) 150

+ Current year's R&D 100
- Amortization of R&D 75
Adj EBIT (1-t) 175

c. Free Cashflow to the Firm

EBIT (1-t) 175 ! Correct EBIT (1-t) from b: 1 po! If you used 275 (1-.4), you have to explic
- Net cap Ex 125 ! Add in R&D - Amortization
- Change in non-cash WC 20 ! Ignore both cash and short te ! Correct change in non-cash WC: 1 point
FCFF 30

Fall 2002
Problem 1
a. Levered Beta for Rojas
Unlevered beta = 0.5* 1.15 + 0.5*0.6 = 0.875
levered beta = 0.875 (1 + (1-.4) (1/2)) = 1.18125
b. Country Risk Premium = Country default spread * (Eq Std Dev/ Bond std dev) = (8-5) *(32/20) = 4.80%
c. Lambda for Rojas = 1/.8 = 1.25 (Rojas gets 100% of its revenues in Mexico; Average firm gets 80%)
Cost of equity in $ = 5% + 1.18 (4%) + 1.25 (4.80%) = 15.73% ! You cannot use 8% since it includes the default spread for Mexico…
d. Peso cost of equity = (1.1573) * (1.07/1.02) -1 = 21.40% ! You would get full credit if you also worked through from the peso riskfree rate, but you don't
have a peso riskfree rate. The peso bond rate of 12% includes default risk.
Problem 2
a. Debt value of operating leases = 100 (PV of annuity for 3 years) + 80 (PV of annuity for 3 years) (PV of FV for 3 years)
= 100 (PVA,3 yrs, 7%) + 80 (PVA,3 yrs, 7%)(PVF,3 years, 7%) = $433.81 ! If you assume beginning of the year, this goes up to $ 464 million.
b. Firms with long amortizable lives and growing R&D will have the biggest operating earnings effect since the R&D will be large and the amortization will be low.
c. You will over value the firm. The cash flow effect will dominate the cost of debt effect.
d. You should include all acquisitions.

Spring 2003
Problem 1

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 Solution to Quiz

Business Levered BeD/E Ratio Unlevered Beta

Chemicals 1.15 25% 1
Env Cleanup 1.34 12% 1.25

a. Unlevered beta for Environ Systems = 1.05 ! Chemical business is 80% of 2.5 billion = $ 2 billion; Env Cleanup = $0.5 billion
Levered beta from Environ Systems = 1.2075 ! 1.05*(1+(1-.4)*(500/2000))

b. If the firm borrows $1.5 billion and expands env clean up

Debt/Equity Ratio = 1 ! Debt jumps to $ 2 billion to match to equity
New unlevered beta for Environ Systems = 1.125 ! Chemical business is $ 2 billion; Env Cleanup = $0.5 billion + $1.5 billion = $ 2 billion
Weights are 50% each
Levered beta from Environ Systems = 1.8

Problem 2
Effective tax rate = 0.3
If you used information from problem 1, you could have estimated a marginal tax rate of 40%. (I gave full credit for both answers)
With 40% tax rate With 30% tax rate
EBIT (1-t) 180 EBIT (1- tax rate) = 210
+ Depreciation = 150 + Depreciation = 150
- Cap Ex = 250 - Cap Ex = 250 ! Include acquisitions
- Chg in non-cash WC= 40 - Chg in non-cash WC= 40 ! Working capital increased by $20 million; Cash dropped by $ 5 million
FCFF 40 FCFF 70

Return on capital = 0.08571429 Return on capital = 10.00%

Reinvestment rate = 0.77777778 Reinvestment rate = 66.67%
Expected growth rate= 0.06666667 Expected growth rate = 6.67%

if return on capital increases to 12%

Growth rate next year = .12 *.6667 + (.12-.10)/.10 = 28.00% ! With 30% tax rate
49.33% ! With 40% tax rate

Spring 2004
Problem 1
Part a
Business Revenues EV/Sales Estimated Weights Unlevered beta
Transportation $1,000 1.5 1500 0.3 1.2 ! You shouldf not be using revenue weights, when you
Real Estate $2,000 0.75 1500 0.3 0.6 can compute values for the divisions….
Financial Services $2,000 1 2000 0.4 0.7
Firm 5000 0.82

The unlevered beta for the firm is 0.82

Part b
Levered beta = 1.066 ! 0.82 (1+(1-.40) (1500/3000))

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 Solution to Quiz

Lambda = 0.25 ! 0.20/0.80

Mexico = 5.40% ! Cannot use the Mexican peso rate since it is in different currency. 3% *1.8
Cost of equity = 9.86% ! 4.25%+1.066*4%+0.25*5.4%

Problem 2
Part a
Effective tax rate = 30.00% ! Taxable income = 100-10 = 90; Taxes = 27 If you divide taxes paid by earnings before interest and taxes, you will double count the tax benefit from

EBIT (1-t) 70 ! Interest income should not be includes since it cashflow to the firm
- (Cap Ex - Depr) 50 ! Cap Ex = 40 + 60 = 100; Include acquisition in cap ex; Depreciation = 50
- Chg in WC -10 ! Working capital went from 20 million (4%) to 10 million (2%)
FCFF 30

Part b
Interest coverage ratio = 4 ! Include interest expenses in both numerato ! You can divide the EBIT by interest expenses but you will overrate the firm (and give it a AA rating)
Synthetic rating= BBB
Pre-tax cost of debt = 6% !4.25% + 1.75%
PV of lease commitments = $147.20

New FCFF (using approximation)

EBIT (1-t) $76.18 ! Add imputed interest expense (147.20*.06) to EBIT
- (Cap Ex - Depr) $50.00
- Chg in WC -$10.00
FCFF $36.18

New FCFF (Long way)

Depreciation on leased asset = $14.72 ! Divide PV of leases by 10 years (the lease commitment period)

EBIT(1-t) $73.70 ! Add back lease expense (20) and subtract out depreciation (14.72)
- (Cap Ex - Depr) $35.28 ! Add depreciation of 14.72 to existing depreciation.
- Chg in WC -$10.00
FCFF $48.42

Spring 2005
Problem 1
Expected payout ratio in perpetuity = 0.6 Errors
Earnings last year = 1050 ! Index/ PE 1. Did not use (1+g) to get to next year's dividends: -0.5
Earnings next year = 1102.5 2. Used earnings instead of dividends: -1.5
Dividends next year = 661.5 3. Used riskfree rate as growth rate: -0.5 to -1

Value = 10500 = 661.5/ (r -.05)

Solve for r,
Expected return on equity = 0.113
Riskfree rate = 0.052
Equity risk premium = 0.061

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 Solution to Quiz

b. Implied equity risk premium declined over the course of the year, since the index increased by more than earnings. Note that the expected
growth rate did not change and neither did the riskfree rate.
c. iii. If you use the historical risk premium to value stocks, you will find more stocks to be overvalued (estimated value is less than the stock price)
than undervalued. The historical risk premium is higher than the implied premium. Using it will give you too high a discount rate, which will depress values
across the board.

Problem 2 Errors
a. Operating Income 250 1. Wrong working capital change: -1 point
EBIT (1-t) 150 ! Tax rate = 80/200 2. Wrong tax rate: -1 point
+ Depreciation 150 3. Wrong net cap ex: -1 point
- Cap Ex 225
- Change in non-cash WC 20 ! (-40-(-60))
FCFF 55

b. Net Income 120

+ Depreciation 150 1. Wrong net debt number: -1
- Cap Ex 225 2. Used debt ratio instead of net debt: -1
- Change in non-cash WC 20
- Net Debt 40 ! Cash outflow because debt paid
FCFE -15

c. None of the above. Paying dividends has no effect on FCFE, since dividends are paid out of FCFE. FCFF is before debt payments.

Fall 2007
Problem 1
Yrs 1-5
Revenues $1,000
- Operating Expenses $600
EBIT $400
- Interest expenses $100
Taxable Income $300
- Taxes $105
Net Income $195

a. Cash flow to the firm = EBIT (1-t) - (Cap ex - Deprcn) - chg in WC ! 1. Used worng cash flow (195
= 400 (1-.35) = 260 2. Discounting error: -0.5
(Tax rate = Taxes/ Tasable income = 105/300 = 35.00%
Value of the asset = PV of $260 million annuity for 5 years = $985.60

b. There are two ways you can correct the computation

1. You can convert the real cash flows into nominal cash flows 1. Added inflation rat
1 2 3 4 5 2. Mechanical errors:
Real cash flow 260 260 260 260 260
Nominal cash flow 265.2 270.504 275.9141 281.4324 287.061

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 Solution to Quiz

PV at 10% 241.0909 223.557 207.2983 192.2221 178.2423

Value of asset = $1,042.41
2. You can use a real cost of capital to discount the cash flow
Real cost of capital = (1.10/1.02)-1 = 7.84%
PV of $260 million at real cost of capital = ###
(Being the kind and benevolent person that I am, I did accept the approximate real
cost of capital of 8% as an acceptable answer as well)

Problem 2
US Mexico
Publishing $500 $250
Entertainment $500 $750

a. US Publishing
Riskfree rate = 4.50% 1. Used wieighted bet
Beta = 0.9 2. Used wrong riskfre
Risk premium 4.00%
Cost of eequity = 8.100%

b. Mexico entertainment
Riskfree rate (peso) = 7% ! 7.50% - Default spread of 0.5 1. Used wrong riskfree rate: -0.5
Beta = 1.2 2. Used wrong beta: -0,5
Risk premium = 5% ! Mature market premium + Default spread * Relative equity volat3. Used wrong country risk premium: -0.5
Cost of equity = 13.00% ! Also gave ful credit if you added 1% to cost of equity to get 12

c. Value of publishing = 750 ! Value of US publishing = Rev 1. Wrong weights: -1

Value of entertanment = 1250 ! Value of US entertainment = 2. Mechanical errors:
Weighted beta = 1.0875 ! 0.375*0.9+0.625*1
Cost of equity = 8.8500%

Problem 3
The debt ratio will increase. All or nothing on thes
(The beta might or might not go down. If it is a regression beta, it will be unaffrecte
If it is a bottom-up beta, it will depend on whether the firm has more operating leases than comparabl fir

much the company is

reinvesting for future growth

We will overstate the value of

the company
(You will assume that the company can defer taxes forever)

Count the growth from acquisitions when computing projected earnings and include acquisitions in your forecasted capital expenditures
(If you ignore the growth and the acquisitiions, you are being consistent but you are eliminati

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 Solution to Quiz

potential value added or destroyed by the acquisition process

Spring 2008
Problem 1
a. The average unlevered beta across entertainment companies (1.05)
(I would not use the regression beta for the US firm because it is likely to have high standard error
and the Mexican index is too narrow to yield a good estimate of beta. I would use the unlevered beta
because this is an all-equity funded deal.
b.
Nominal peso 10-year rate = 7.25% ! The problem asks for a nominal peso cost of equity.
Default spread for AA rating = 1.25% ! Used the default spread on the dollar denominated bonds which have the same rating
Nominal peso riskfree rate = 6.00%

c.
Default spread for Mexico = 1.25% ! Computed country risk premium incorrectly: -1 point
Relative equity market volatility = 2 ! Mechanical errors: -0.5 point
Country risk premium for Mexico = 2.50%
Total equity risk premium = 7.00%

Cost of equity = 6% + 1.05 (7%) = 13.35%

Problem 2
Market value of interest bearing debt 47.89381811 ! PV of $2.5 millioin for 5 years + PV of $ 50 million in year 5 (@6 ! Failed to compute market value of bank debt: -1 point
PV of operating leases = 93.14690716 ! PV of $15 million each year for next 8 years ! Used wrong tax rate: -0.5 point
Total market value of debt 141.0407253 ! Mechanical errors: -0.5 point
Market value of equity = 150 ! 12 *10+ 2.5*12 ! Used only voting shares for equity: -1 point
Debt to capital ratio = 48.46%

Cost of equity = 10%

After-tax cost of debt = 3.60% ! ^$ (1- .40): Use marginal tax rate
Cost of capital = 6.90%

Problem 3
R&D expenseUnamortized Amortization this year
Current 5 5 ! Did not compute amortization correctly: -1 point
Year -1 4 3.2 0.8 ! Mechanical errors: -0.5 point
Year -2 3 1.8 0.6
Year -3 2 0.8 0.4
10.8 1.8
Value of Research assets capitalized 10.8

b. Adjusted after-tax operating income

After-tax operating income $5.00 ! Mangled the tax effect: - 0.5 point
+ R& D expense $5.00 ! Math errors: -0.5 point
- Amortization of R&D $1.80

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 Solution to Quiz

Adjusted after-tax operating income $8.20

Fall 2008
Problem 1 Grading Guidelines
a. Riskfree Rate = 6.00% ! 9% - 3% (Default spread for Baa3 rated bond) ! All or nothing: -1 if wrong
b. Country Risk Premium = 6% ! 2 * 3% (Relative market volatility * Default Spread) ! -0.5 point if double counted mature market risk
c. Lambda = 0.333333333 ! Revenue proportion/ Avg co revenue proportion ! All or nothing
d. Cost of equity = 13.400% ! 6% + 1.2 (4.5%) + 0.333 (6%) ! -0.5 point for each error not already counted in previous sections.

Problem 2
Year Training expeUnamortized Amortization
0 5 5 0 ! Errors in adjusting net income: - 0.5 to -1 point
1 4 3 1 ! Did not adjust book value of equity: -1.5 point
2 3 1.5 0.75 ! Other math errors: -0.5 point each
3 2 0.5 0.5
4 1 0 0.25
10 2.5
Correct pre-tax operating income = 7.5 ! 5 + 5 -2.5
Correct book value of equity = 25 ! 15 + 10
ROE = 30.00%

Problem 3
a. Payout ratio 25.00% ! ROE wrong: -0.5 point
Return on equity = 20% ! Retention ratio wrong: -0.5 point
Expected growth rate= 15.00%

b. New net income = $1.60 ! I gave full credit if you used a retention ratio of 80% and a ROE of 13.33% to arrive at same answer as I did
New book value of equity= $15.00 ! In year 1, you will have a drop in earnings. For those of you who recorded this drop, there was no loss of points
Expected growth rate = 10.67%
Retention ratio = 1
Expected growth rate = 10.67%

Fall 2009
Problem 1
Riskfree Rate = 6.00% ! Peso 10-year bond rate - Default spread ! Wrong riskfree rate: - 1 point
Beta = 0.9 ! Did not compute lambda: -1 point
Mature market ERP = 5% ! Did not scale up default spread: -0.5 point
Lamnda for Mexico = 0.5 ! Prop of Jarlisco's revenues/ Avg co revenues ! Other errors: -0.5 point each
CRP for Mexico = 3.60% ! Efault spread * Rel Equity Mkt Volatility
Cost of Equity = 12.30%

Problem 2
Loan Type Face Interest Interest
Value Rate Expenses ! Did not compute interest coverage ratio: -1 point

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 Solution to Quiz

Secured bank loan 200 7.00% 14 ! Wrong synthetic rating/default spread: -1 point
Subordinated bank loan 150 8.00% 12 ! Used effective tax rate: -1 point
Unsecured short term bank 150 6.00% 9
loan
Total Interest Expense 35
Interest coverage ratio = 4 ! 140/35
Rating = A- ! See table
Cost of debt = 8.00% ! 5% + 3%
After-tax cost of debt = 4.80% ! 8% (1-.4)

Problem 3
a. (D) The reported earnings
will increase for firms that
have seen R&D expenses ! Adjusted Earnings = Stated Earnings + Current year's R&D - Amortization of R&D
increase
b. B. Theover
booktime
value of assets
and equity will increase. ! Adjusted BV of Assets (Equity) = Stated BV + Capitalized R&D
C. The cost of capital will be ! No effect. Market value of equity is unaffected by amortization

Fall 2010
Problem 1 Points
First, solve for the US $ cost of equity used by the analyst : Did not solve for cost of equity: -1 point
Equity value = FCFE next year / (Cost of equity -g) ! Wrong CRP: -1 point
1000 = 50/ (Cost of capital - .05) ! Lambda incorrect: -1 point
Cost of equity = 10% ! Inflation adjustment wrong: -1 point

Second, estimate the correct $ cost of equity, including country risk

Default spread for Peru = 2% ! 5% -3%
Convert to country risk premium = 3.00% ! 2% * 1.5
Estimate lambda = 1.25 ! 100/80
Estimate correct $ cost of equity = 13.7500% ! 10% + 1.25(3%)

Third convert to Peruvian Sul cost of equity

Peruvian Sul cost of equity = 18.21% !(1+ $ cost of equity) (1+inflation rate in Sul)
/ (1+ inflation rate in US $)
Correct value of equity = 378.478664 ! 50/ (.182-.05)

Problem 2
Estimate values of the two businesses ! Wrong weights: -1 point
Value of food processing = 400 ! D/E ratio wrong: -1 point
Value of restaurant = 600 ! Cost of equity wrong: -1 point
Unlevered beta = 0.60 (400/1000) + 1.20 (600/1000) = 0.96

Pre-tax cost of debt = 5% ! 3.5% +1.5%

Page 13
 Solution to Quiz

PV of leases = 323.160638
Total debt = 423.160638
D/E ratio = 0.70526773 ! 423/600
Levered beta= 0.96 (1+ (1-.4) (.7053)) = 1.36623421

Cost of equity = 9.65%

Problem 3
Capitalize R&D
Year R&D Unamortized Amortization
Current 200 200 ! R&D adjustment: -1 point
-1 160 120 40 ! Wrong tax: - 1/2 point
-2 120 60 30 ! WC wrong: -1/2 point
3 80 20 20 ! FCFF computation: -1 point
4 40 0 10
400 100

Adjusted EBIT = 300 + 200 - 100 = 400 ! EBIT + Current year R&D - R&D amortization
Adjusted Cap Ex = 380
Adjusted Depreciation = 200

EBIT (1-t) 240 ! Use tax rate based on taxes paid/taxable income
- Net cap ex = 180 ! Includes R&D and amortization of R&D
- Chg in WC 30 ! Excluding cash: -10-20 = -30
+ Tax benefit of R&D 40
FCFF 70

Fall 2011
Problem 1
Ulysses Inc Lowie Inc.
Cost of equity 9% 12%
Cost of capital 7.50% 10%
Cash flows are to capital (since they are before debt payments) and more reflective of Lowie (movie business)
Right discount rate is therefore Lowie's cost of capital of 10% 1. Wrong discount rate: -1 to -2 points
0 1 2 3 4 5 2. Error on PV: -1 point
Revenues $100 $110 $125 $140 $160
- COGS (includes depreciation) $40 $44 $50 $56 $64
Operating income $60 $66 $75 $84 $96
- Taxes $18 $20 $23 $25 $29
EBIT (1-t) $42 $46 $53 $59 $67
- Net cap ex $80 $0 $0 $0 $0 $0
- Chg in WC $5 $5 $5 $5 $5
Cash flow -$80 $37 $41 $48 $54 $62
Value of stake (@10%) = -$80.00 $33.64 $34.05 $35.69 $36.75 $38.62 $98.74
If you argued that there were toy-related revenues in these cash flows and used a weighted average of the costs

Page 14
 Solution to Quiz

of capital of the two firms, I gave you full credit.

Problem 2
Country 10-year govRating Default spr Std dev of Std dev of LaFua ReveAvg company revenues
Brazil 8% Baa1 1.50% 25% 20% 50% 80%
US 2% Aaa 0% 20% 15% 30% 75%
Portugal 10% Caa 6.00% 30% 20% 20% 60%

Brazil US Portugal Unlevered BeEV/Sales ratio

Movies $2.00 $1.40 $0.60 1.2 1.00
TV Broadcasting $0.50 $0.10 $0.40 0.9 3.00 1. Wrong risk free rate: -1 point
Total $2.50 $1.50 $1.00 2. Wrong beta: -0.5 to -1 point
Start with nominal BR$ riskfree rate 3. Wrong country risk premium: -1 point
Government bond rate (in reais) 8.00% 4. Lambda based on 20%: -0.5 point
- Default spread for Brazil 1.50%
Riskfre rate in reais = 6.50%
Then get the beta for the business mix in Portugal
Business Revenues EV/Sales Estimated va Weights Unlev Beta
Movies $0.60 1.00 $0.60 33.33% 1.2
TV Broadcasting $0.40 3.00 $1.20 66.67% 0.9
Beta for business = $1.80 1.00
Since the firm has no debt outstanding, levered beta = unlevered beta
Levered beta = 1.00
Use the implied premium of 7% for the US as mature market premium
Next, estimate the lambda for Portugal
% of Revenues from Portugal 100.00% ! Remember these are just the Portuguese operations
Avg company's revenues in Portugal 60.00%
Lambda 1.67
Finally, get the country risk premium for Portugal
Default spread for Portugal 6.00%
Relative equity mkt volatility 1.50
Country risk premium for Portugal 9.00%
Bring them all together
Cost of equity in reais (Portugal) = 28.50%

Problem 3
Most recent 1 year ago 2 years ago 3 years ago
Revenues $1,000 $700 $400 $200 ! Error on amortization: -1 point
Pre-tax Operating Income -$200 -$300 -$200 -$100 ! Error on operating expenses: -1 point
Book value of equity 100 ! Error on adjustment: -1 point
Most recent 1 year ago 2 years ago 3 years ago Sum
Operating expense $1,200 $1,000 $600 $300
Customer acq cost $600.0 $500.0 $300.0 $150.0

Page 15
 Solution to Quiz

Amortization this year 0 $166.67 $100.0 $50.0 316.666667

Unamortized acq cost $600.0 $333.33 $100.0 0

Stated pre-tax operating income = -$200.0

+ Customer acquisiton costs $600.0
- Amortization of past costs 316.666667
Adjusted pre-tax operating income $83.3
Adjusted after-tax operating income $83.3 ! The company pays no taxes

Fall 2012
Problem 1 GRADING TEMPLATE
Cash flow in pesos = ### 1. Did not adjust dollar cost of equity for inflation differential: -1 point
Expected growth rate in pesos = 5% 2. Did not adjust cost of equity for country risk: -1 point
Cost of equity in US dollars = 9.20% 3. Other errors: -1/2 point each
Implied beta = 1.2 ! (9.2% -2%)/6%
Cost of equity in US dollars for Sosa 12.80%
Cost of equity in pesos for Sosa = 17.27% ! I gave you full credit if you just added the 3% inflation differential to the $ cost of equity to get 16.8%
Value of equity in firm = ### In fact, I gave credit for a multitude of answers, where you effectively adjusted for both inflation and country risk.

Problem 2
US Brazil
Software $800 $200
Electronics $400 $600

a.
Beta for software business = 1.2 1. Used wrong risk free rate: -1/2 point
Riskfree rate in US$ = 2% 2. Error on country risk premium for Brazil: -1/2 point to -1 point
Default spread for Brazil = 1.50% ! Brazilian $ bond rate - US treasury bon 3. Other errors: -1/2 point each
CRP for Brazil = 2.50% ! 1.59% (25%/15%)
ERP for software business = 6.50% ! 6% (800/1000) + 8.5% (200/1000)
Cost of equity for software = 9.800%

b.
Beta for Brazil = 0.975 ! 1.2 (200/800) +0.9 (600/800) 1. Wrong riskfree rate: -1 point
Riskfree rate in Brazil $R = 10.500% ! 12% - 1.50% = 10.50% 2. Other errors: -1/2 point each
ERP for Brazil = 8.50% ! Mature market premium of 6% + CRP of 2.5%
Cost of equity in $R = 18.787500%

Problem 3
Analyst estimates Corrected values
Revenue $1,200.00 Operating in $600.00
- Operating Expenses $600.00 + Operating $100.00
Operating Income $600.00 - Depreciati $69.27
- Interest Expenses $150.00 Adjusted Ope $630.73 ! Use 35% tax rate
Taxable Income $450.00 After-tax Op $409.97

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 Solution to Quiz

- Taxes $157.50 + Depreciati $169.27

Net Income $292.50 - Cap ex $250.00 1. Did not adjust for operating leases: -1 point
+ Depreciation $100.00 - Change in $40.00 2. Wrong tax computation: -1 point
- Cap Ex $200.00 FCFF $289.25 3. Cap ex wrong: -1/2 point
- Change in Working Capital $50.00 4. Working capital not adjusted: -1/2 point
FCFF $142.50

Tax rate = 35% ! 157.5/450

PV of lease commitments = $346.36 ! PV of $80 million each year

Depreciation on leased asset = $69.27

An alternate solution (using the short cut)

Operating Income $600.00
+ Imputed interest expense- lease de $17.32
Adjusted Operating Income $617.32
After-tax Operating Income $401.26
+ Depreciation $100.00 ! No lease depreciation in this approach
- Cap ex $250.00
- Change in WC $40.00
FCFF $211.26

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 Solution to Quiz

e weights you lost a point

Page 18
 Solution to Quiz

ate, but you don't

Page 19
 Solution to Quiz

will double count the tax benefit from interest expenses

ate the firm (and give it a AA rating).

Page 20
Solution to Quiz

Page 21
 Solution to Quiz

e answer as I did
was no loss of points

Page 22
Fall 1997
Problem 1
Dividends on Index = 3% of 1050 = 31.50
Value = 1050 = 31.50 (1.06)/(r-.06)
Solving for r,
r = 9.18%
Implied Risk Premium = 9.18% - 6.5% = 2.68%
If you assumed that the dividend yield was based on next year's dividends,
Value = 1050 = 31.50/(r-.06)
Sovling for r,
r = 9.00%
Implied Risk Premium = 9% - 6.5% = 2.5%
This answer can also be obtained by adding the dividend yield to expected growth
and subtracting out the risk free rate
[This is how we got cost of equity for Southwestern Bell in the notes.]

Problem 2
Net Income $ 100.00 (1000 * .10 = Normal Net Income)
- (Net Cap E $ 10.50 (Capital Expenditures: $ 80 mil; Depreciation = $ 60(1.1) = $ 66; D/(D+E) = 500/(500+1500))
- Chg in WC $ 15.75 (WC this year = .10 *1500 = 150; WC next year = .095 * 1800 = 171; Chg in WC = 21)
= FCFE $ 73.75

Problem 3
Expected Growth Rate in O 5%
Expected FCFF next year
EBIT (1-t) $ 105.00
Reinvestment $ 52.50
FCFF $ 52.50
 Spring 1998

Spring 1998: Quiz 1

Problem 1
Note that the value of a firm is the Cash flow dicounted back at a discount rate.
For investors who are not diversified (REITs, Venture cap funds), the discount rate will always be lower than it is for
investors who are diversified (Specialized venture capitalists, private real estate investors). For the latter to have
more value, then, they have to have the capacity to generate higher cash flows than the diversified investor. For specialized
venture capit䁡lists this may come from knowing a particular sector well, having localized information on that sector and
providing management expertise to firms in that sector. Similarly, for real estate investors, it may come from knowing the
local real estate market well.
A. Firms where information about the firm is easily available to all,
and which have good management in place
Specialized investors gain an advantage through their access to private and localized
information and by providing management support to the companies that they provide
capital to.
While firms which require more capital may seem like a logical choice, note that this will have to come at the expense
of diversification.
B. Real estate value is being driven less by localized information and more by market forces.
The question that has to be addressed here is the change over the last decade. While it is true that investors want to be
want to be diversified in real estate, why would that need be greater today than it was 10 years ago? (REITs have been around
for 25 years.) REITs have tax advantages over corporations but not over individual real estate investors, since the income flows
through, because of the dividend payment restriction, to the investors in these firms, who get taxed at their individual tax rates
anyway.

Problem 2
Sector Beta D/E Ratio Unlevered Beta
Steel 1.18 30% 1
Financial Ser 1.14 70% 0.8028169

Unlevered Beta for the company = 0.7 (1) + 0.3 (.8) = 0.94
Levered Beta for the company = 0.94 (1+(1-.3)(1.5)) = 1.93

Riskless Rate = Government bond rate - Default spread 10% ! If I use the 12%, I may double count risk.
Country risk premium = Default spread * Relative equity market volatility = 4.00%
Cost of Equity for the Company = 10% + 1.93 (5.5% + 4%) = 28.34%

Problem 3
Expected Operating Income next year = 235*1.10 = 258.5
- Reinvestment Needed = .40 * 258.5 = 103.4
FCFF next year = 155.1

Return on Capital = 235/940 = 25%

Expected Growth Rate = Reinvestment Rate * Return on Capital
10% = Reinvestment Rate * 25%
Reinvestment Rate = 10%/25% = 0.40

Page 25
 Spring 1998

ave been around

the income flows
ividual tax rates

Page 26
 Fall 1998

Fall 1998: Quiz 1

Problem 1
Spread Based on Bond Rating 3%
Equity SD/ Indonesian Bond 4
Country Risk Premium = 12%

Beta for the firm 0.75

Lambda (for country risk) = 0.25 (Proportion from non-dollar sources for paperfirm = 0.2
Proportion from non-dollar sources for average firm = 0.8
Exposure to country risk = 0.20/0.80 = 25%
Cost of Equity for Firm = 15% + 0.75 (5.5%) + 0.25 (12% 22.125%

Problem 2
Unlevered Beta for Entertain 1.42
Beta for Cash = 0
Beta for InfoSoft = 1.41 (0.8) 1.13 I also gave full credit if you used a net debt ratio of -20%, leading to a beta of 1.25.

Problem 3
Year 1 2 3 4
Expected Growt 12% 10% 8% 6%

EPS $ 2.24 $ 2.46$ 2.66 $ 2.82

- (Cap Ex - Dep $ 0.90 $ 0.75$ 0.60 $ 0.45
- Change in WC $ 0.36 $ 0.34$ 0.30 $ 0.24 (WC numbers slightly different: rounding error)
FCFE $ 0.98 $ 1.38$ 1.77 $ 2.13
Terminal Price $ 47.36 (Terminal Price = $2.13/(.105-.06) = $ 47.36)
Present Value $ 0.87 $ 1.08 $ 34.83
Value Per Share $ 36.78 [Value = $0.98/1.1325 + $1.38/(1.1325*1.1215) + ($1.77 + $47.36)/(1.1325*1.1215*1.1105)
This is how I got the numbers for each year:
Cap Ex - Deprec 1.2 1 0.8 0.6
Change in Worki $ 0.48 $ 0.45 $ 0.39 $ 0.32
Revenues per sh $ 22.40 $ 24.64 $ 26.61 $ 28.21

Beta 1.5 1.3 1.1 1

Cost of Equity 13.25% 12.15% 11.05% 10.50%

Page 27
 Fall 1998

0%, leading to a beta of 1.25.

erent: rounding error)

(1.1325*1.1215*1.1105)

Page 28
 Spring 1999

Spring 1999
Problem 1
Unlevered Beta = (0.60) (1.25) + 0.25 (0.8) + 0.15 (0) = 0.95
Levered Beta = 0.95 (1 + (1-.3)(1.5)) = 1.9475
Country risk premium for Indonesia = 3% (3.0) = 9%
Cost of Equity = 5% + 1.95 (6% + 9%) = 0.3425

Problem 2
EBIT = Net Income + Interest Expenses = -50 + 100 = $ 50.00 ! No taxes since firm is losing money
Capital expenditures = 100* 2 = $ 200.00
FCFF = 50 - (200 - 100) = $ (50.00)

Problem 3
Return on Equity = 25/125 = 20%
Retention Ratio = 20/25 = 80% ! Note that book value of equity increased by $ 20 million and firm
had net income of 25 million
Expected Growth in EPS = 0.8 * 20% = 16%

Page 29
Spring 1999

Page 30
 Spring 2000

Spring 2000
Riskfree Rate Beta Risk Premium
Soft-drink: US 6.50% 0.7 6%
Soft-drink: Me 6.50% 0.7 13.60%
Consumer Prod 6.50% 0.9 6%
Consumer Prod 6.50% 0.9 13.60%

a. Operating Income from soft drinks: 0.6*1.5 + 0.5*1 = 1.4

Operating Income from consumer products = 0.4*1.5+0.5*1 = 1.1
Unlevered beta for the firm = 0.7(1.4/2.5) + 0.9 (1.1/2.5) = 0.788

b. Beta for US operations = 0.6*.7+0.4*.9 = 0.78 ! Business mix is different in two

Cost of equity for US operations = 6.5% + 0.78 (6%) 11.18% countries

c. Beta for Mexican operations = 0.5*.7+0.5*.9= 0.8

Cost of equity for Mexican operations = 6.5% + 0.8(6% + 2*3.8%) = 17.38%

Problem 2
If we assume that amortization is not tax deductible
EBIT + EBITDA - Depreciation = 500 - 80 = 420
EBIT (1- tax rate) = 252
Capital Expenditures = Cap Ex + Acquisitions = 120 + 150

EBIT (1-t) 252

- Net Cap Ex = 270 - 80 = 190 ! If you do not subtract out amortization to g
- Chg in Working Capital = 50 do not add it back. If you get this answer, and
FCFF 12 you ignored amortization, let me know and I w

If we assume that amortization is tax deductible

EBIT = EBITDA - Depreciation - Amortization = 500 - 80 - 40 = 380
EBIT (1 - tax rate) = 228
Capital Expenditures = Cap Ex + Acquisitions = 120 + 150 = 270

FCFF
EBIT (1-t) = 228
- Net Cap Ex = 270 - 120 = 150
- Chg in Working Capital = 50
FCFF 28

Problem 3
Return on Equity = 150/1200 = 12.50%
Retention Ratio = 1-(60+15)/150 = 50.00%
a. Expected Growth Rate = .125*.5 = 6.25%

b. If ROE increases to 15%,

Expected growth = .5*15%+ (.15-.125)/.125 = 27.50%

Page 31
 Spring 2001

Spring 2001
Problem 1
a. Implied Equity Risk Premium
Expected dividend next year = .05 (800) (1.10) = 44
800 = 44 / (r - .10)
Solving for r,
r= 15.50%
Implied risk premium = 6.50% ! 15.5% - 9%

b. Unlevered beta for retailers = 1.20/(1 + (1-.4) (.45)) = 0.94488189

Debt to Equity Ratio for Baklak Stores = 0.25
Levered beta = 0.94 (1 + (1-.4) (.25)) = 1.08661417
Cost of Equity = 9% + 1.09 (6.5%) = 16.09%

c. Cost of capital = 16.09% (2400/3000) + 11% (1-.4) (600/3000) = 14.19%

Problem 2
a. PV of Operating leases = $335.50
Adjusted Operating Income = $176.84 ! Added .08*335.50 as imputed
Adjusted Return on capital = 12.70%
b. Reinvestment rate = 78.74% ! Growth rate/ ROC
Expected cash flow next year:
EBIT (1-t) $116.71 ! 176.84 *(1-.4)*1.10
- Reinvestment = $91.90 ! Reinvestment rate * EBIT (1
FCFF $24.81

Page 32
 Spring 2002

Spring 2002
Problem 1
a. Unlevered bottom-
Business Revenues Value/Sale Estimated Unlevered Weights Weight * Beta
Retailing 400 2 800 0.85 26.67% 0.23 ! Use value weights: If
Sotware 400 3 1200 1.15 40.00% 0.46
Travel 800 1.25 1000 1.35 33.33% 0.45
3000 1.14
b. Estimated market v
Book value 1200 ! Use pre-tax cost of debt to compute prese
Interest e 60 I f you use after-tax cost of debt, you lost a
Maturity = 5 Assorted mathematical errors: -.
Interest ra 7%
Market value of bond ###

c. Levered Beta
Levered beta = 1.14 (1+ (1-.4) (1101.60/1 1.89 ! Use market value of debt and e

Problem 2
a. Value of Research
Year R&D AmortizatioRemaining Value
current 100 0 100 ! Any mechanical error: -0.5 poi
-1 90 30 60
-2 75 25 25
-3 60 20 0
75 185
Value of research ass 185

b. Corrected operatin
EBIT 250 ! Any mechanical error: -0.5 poi
+ Current 100
- Amortiza 75
Adj EBIT 275

EBIT (1-t) 150

+ Current 100
- Amortiza 75
Adj EBIT (1 175

c. Free Cashflow to th
EBIT (1-t) 175 ! Correct EBIT (1-t) from b: 1 po! If you used 275 (1-.4), you have to explic
- Net cap 125 ! Add in R&D - Amortization
- Change i 20 ! Ignore both cash and short ter ! Correct change in non-cash WC: 1 point
FCFF 30

Page 33
 Spring 2002

! Use value weights: If you used revenue weights you lost a point

Page 34
 Fall 2002

Fall 2002
Problem 1
a. Levered Beta for Rojas
Unlevered beta = 0.5* 1.15 + 0.5*0.6 = 0.875
levered beta = 0.875 (1 + (1-.4) (1/2)) = 1.18125
b. Country Risk Premium = Country default spread * (Eq Std Dev/ Bond std dev) = (8-5) *(32/20) = 4.80%
c. Lambda for Rojas = 1/.8 = 1.25 (Rojas gets 100% of its revenues in Mexico; Average firm gets 80%)
Cost of equity in $ = 5% + 1.18 (4%) + 1.25 (4.80%) = 15.73% ! You cannot use 8% since it includes the default spread
d. Peso cost of equity = (1.1573) * (1.07/1.02) -1 = 21.40% ! You would get full credit if you also worked through fr
have a peso riskfree rate. The peso bond rate of 12% incl
Problem 2
a. Debt value of operating leases = 100 (PV of annuity for 3 years) + 80 (PV of annuity for 3 years) (PV of FV for 3 years)
= 100 (PVA,3 yrs, 7%) + 80 (PVA,3 yrs, 7%)(PVF,3 years, 7%) = $433.81 ! If you assume beginning of the year, this
b. Firms with long amortizable lives and growing R&D will have the biggest operating earnings effect since the R&D will be large and the
c. You will over value the firm. The cash flow effect will dominate the cost of debt effect.
d. You should include all acquisitions.

Page 35
 Fall 2002

irm gets 80%)

it includes the default spread for Mexico…
if you also worked through from the peso riskfree rate, but you don't
he peso bond rate of 12% includes default risk.

me beginning of the year, this goes up to $ 464 million.

he R&D will be large and the amortization will be low.

Page 36
 Spring 2003

Spring 2003
Problem 1
Business Levered BeD/E Ratio Unlevered Beta
Chemicals 1.15 25% 1
Env Cleanup 1.34 12% 1.25

a. Unlevered beta for Environ Systems = 1.05 ! Chemical business is 80% of 2.5 billion = $ 2 billion; Env Cleanup =
Levered beta from Environ Systems = 1.2075 ! 1.05*(1+(1-.4)*(500/2000))

b. If the firm borrows $1.5 billion and expands env clean up

Debt/Equity Ratio = 1 ! Debt jumps to $ 2 billion to match to equity
New unlevered beta for Environ Systems = 1.125 ! Chemical business is $ 2 billion; Env Cleanup = $0.5 billion + $1.5
Weights are 50% each
Levered beta from Environ Systems = 1.8

Problem 2
Effective tax rate = 0.3
If you used information from problem 1, you could have estimated a marginal tax rate of 40%. (I gave full credit for both answers)
With 40% tax rate With 30% tax rate
EBIT (1-t) 180 EBIT (1- tax rate) = 210
+ Depreciation = 150 + Depreciation = 150
- Cap Ex = 250 - Cap Ex = 250 ! Include acquisitions
- Chg in non-cash WC= 40 - Chg in non-cash WC= 40 ! Working capital increased by $25 million; Cash droppe
FCFF 40 FCFF 70

Return on capital = 0.08571429 Return on capital = 10.00%

Reinvestment rate = 0.77777778 Reinvestment rate = 66.67%
Expected growth rate= 0.06666667 Expected growth rate = 6.67%

if return on capital increases to 12%

Growth rate next year = .12 *.6667 + (.12-.10)/.10 = 28.00% ! With 30% tax rate
49.33% ! With 40% tax rate

Page 37
 Spring 2003

= $ 2 billion; Env Cleanup = $0.5 billion

Cleanup = $0.5 billion + $1.5 billion = $ 2 billion

dit for both answers)

d by $25 million; Cash dropped by $ 15 million

Page 38
 Spring 2004

Spring 2004
Problem 1
Part a
Business Revenues EV/Sales Estimated Weights Unlevered beta
Transport
ation $1,000 1.5 1500 0.3 1.2 ! You shouldf not be using revenue weights, wh
Estate $2,000 0.75 1500 0.3 0.6 can compute values for the divisions….
Financial
Services $2,000 1 2000 0.4 0.7
Firm 5000 0.82

for the firm is 0.82

Part b
Levered
beta = 1.066 ! 0.82 (1+(1-.40) (1500/3000))
Lambda = 0.25 ! 0.20/0.80
premium
for
Mexico = 5.40% ! Cannot use the Mexican peso rate since it is in different currency. 3% *1.8
Cost of
equity = 9.86% ! 4.25%+1.066*4%+0.25*5.4%

2
Part a
Effective
tax rate = 30.00% ! Taxable income = 100-10 = 90; Taxes = 27 If you divide taxes paid by earnings before inte

EBIT (1-t) 70 ! Interest income should not be includes since it cashflow to the firm
- (Cap Ex
- Depr) 50 ! Cap Ex = 40 + 60 = 100; Include acquisition in cap ex; Depreciation = 50
WC -10 ! Working capital went from 20 million (4%) to 10 million (2%)
FCFF 30

Part b
Interest
coverage
ratio = 4 ! Include interest expenses in both numerator ! You can divide the EBIT by interest expenses
Synthetic
rating= BBB
cost of
debt = 6% !4.25% + 1.75%
lease
commitme
nts = $147.20

approximation)
EBIT (1-t) $76.18 ! Add imputed interest expense (147.20*.06) to EBIT
- (Cap Ex $50.00

Page 39
 Spring 2004

WC -$10.00
FCFF $36.18

way)
on on
leased
asset = $14.72 ! Divide PV of leases by 10 years (the lease commitment period)

EBIT(1-t) $73.70 ! Add back lease expense (20) and subtract out depreciation (14.72)
- (Cap Ex $35.28 ! Add depreciation of 14.72 to existing depreciation.
WC -$10.00
FCFF $48.42

Page 40
 Spring 2004

sing revenue weights, when you

r the divisions….

d by earnings before interest and taxes, you will double count the tax benefit from interest expenses

BIT by interest expenses but you will overrate the firm (and give it a AA rating).

Page 41
 Spring 2005

Spring 2005
Problem 1
Expected payout ratio in perpetuity = 0.6 Errors
Earnings last year = 1050 ! Index/ PE 1. Did not use (1+g) to get to next year's dividends: -0.5
Earnings next year = 1102.5 2. Used earnings instead of dividends: -1.5
Dividends next year = 661.5 3. Used riskfree rate as growth rate: -0.5 to -1

Value = 10500 = 661.5/ (r -.05)

Solve for r,
Expected return on equity = 11.30%
Riskfree rate = 5.20%
Equity risk premium = 6.10%

b. Implied equity risk premium declined over the course of the year, since the index increased by more than earnings. Note that the expected
growth rate did not change and neither did the riskfree rate.
c. iii. If you use the historical risk premium to value stocks, you will find more stocks to be overvalued (estimated value is less than the stoc
than undervalued. The historical risk premium is higher than the implied premium. Using it will give you too high a discount rate, which w
across the board.

Problem 2 Errors
a. Operating Income 250 1. Wrong working capital change: -1 point
EBIT (1-t) 150 ! Tax rate = 80/200 2. Wrong tax rate: -1 point
+ Depreciation 150 3. Wrong net cap ex: -1 point
- Cap Ex 225
- Change in non-cash WC 20 ! (-40-(-60))
FCFF 55

b. Net Income 120

+ Depreciation 150 1. Wrong net debt number: -1
- Cap Ex 225 2. Used debt ratio instead of net debt: -1
- Change in non-cash WC 20
- Net Debt 40 ! Cash outflow because debt paid
FCFE -15

c. None of the above. Paying dividends has no effect on FCFE, since dividends are paid out of FCFE. FCFF is before debt payments.

Page 42
 Spring 2005

to next year's dividends: -0.5

dividends: -1.5
wth rate: -0.5 to -1

rnings. Note that the expected

ated value is less than the stock price)

high a discount rate, which will depress values

hange: -1 point

before debt payments.

Page 43
 Fall 2007

Fall 2007
Problem 1
Yrs 1-5
Revenues $1,000
- Operating Exp $600
EBIT $400
- Interest expen $100
Taxable Income $300
- Taxes $105
Net Income $195

a. Cash flow to the firm = EBIT (1-t) - (Cap ex - Deprcn) - ! 1. Used worng cash flow (195
= 400 (1-.35) = 260 2. Discounting error: -0.5
(Tax rate = Taxes/ Tasable income = 35.00%
Value of the asset = PV of $260 million annuity fo $985.60

b. There are two ways you can correct the compu

1. You can convert the real cash flows into nomin 1. Added inflation rat
1 2 3 4 5 2. Mechanical errors:
Real cash flow 260 260 260 260 260
Nominal cash flo 265.2 270.504 275.9141 281.4324 287.061
PV at 10% 241.0909 223.557 207.2983 192.2221 178.2423
Value of asset = ###
2. You can use a real cost of capital to discount
Real cost of capital = (1.10 7.84%
PV of $260 million at real cost of capit ###
(Being the kind and benevolent person that I am, I did accept the appr
cost of capital of 8% as an acceptable answer as

Problem 2
US Mexico
Publishing $500 $250
Entertainment $500 $750

a. US Publishing
Riskfree rate = 4.50% 1. Used wieighted bet
Beta = 0.9 2. Used wrong riskfre
Risk premium 4.00%
Cost of eequity 8.100%

b. Mexico entertainment
Riskfree rate (pe 7% ! 7.50% - Default spread of 0.5
Beta = 1.2
Risk premium = 5% ! Mature market premium + Default spread * Relative equity volati
Cost of equity = 13.00% ! Also gave ful credit if you added 1% to cost of equity to get 12

c. Value of publi 750 ! Value of US publishing = Rev 1. Wrong weights: -1

Value of ente 1250 ! Value of US entertainment = 2. Mechanical errors:

Page 44
 Fall 2007

Weighted beta 1.0875 ! 0.375*0.9+0.625*1

Cost of equity 8.8500%

Problem 3
The debt ratio
will increase. All or nothing on thes
(The beta might or might not go down. If it is a regression beta, it will
If it is a bottom-up beta, it will depend on whether the firm has more operating leases than

much the
company is
reinvesting for
future growth

value of the
company
(You will assume that the company can defer taxe

Count the growth from acquisitions when computing projected earnings and include acquisitions in your forecasted c
(If you ignore the growth and the acquisitiions, you are being consistent but you a
potential value added or destroyed by the acquisi

Page 45
 Fall 2007

worng cash flow (195

nting error: -0.5

1. Added inflation rat

2. Mechanical errors:

1. Used wieighted bet

2. Used wrong riskfre

1. Used wrong riskfree rate: -0.5

2. Used wrong beta: -0,5
3. Used wrong country risk premium: -0.5
st of equity to get 12

1. Wrong weights: -1
2. Mechanical errors:

Page 46
 Fall 2007

All or nothing on thes

quisitions in your forecasted capital expenditures

Page 47
 Spring 2008

Spring 2008
Problem 1
a. The average unlevered beta across entertainment companies (1.05)
(I would not use the regression beta for the US firm because it is likely to have high standard error
and the Mexican index is too narrow to yield a good estimate of beta. I would use the unlevered beta
because this is an all-equity funded deal.
b.
Nominal peso 10-year rate = 7.25% ! The problem asks for a nominal p
Default spread for AA rating = 1.25% ! Used the default spread on the dollar denominated bonds which have the same rating
Nominal peso riskfree rate = 6.00%

c.
Default spread for Mexico = 1.25% ! Computed country risk premium
Relative equity market volatility = 2 ! Mechanical errors: -0.5 point
Country risk premium for Mexico 2.50%
Total equity risk premium = 7.00%

Cost of equity = 6% + 1.05 (7%) = 13.35%

Problem 2
Market value of interest bearing de 47.8938181 ! PV of $2.5 millioin for 5 years + PV of $ 50 million in year 5 (@6
PV of operating leases = 93.1469072 ! PV of $15 million each year for next 8 years
Total market value of debt 141.040725
Market value of equity = 150 ! 12 *10+ 2.5*12
Debt to capital ratio = 48.46%

Cost of equity = 10%

After-tax cost of debt = 3.60% ! ^$ (1- .40): Use marginal tax rate
Cost of capital = 6.90%

Problem 3
R&D expenseUnamortized Amortization this year
Current 5 5
Year -1 4 3.2 0.8
Year -2 3 1.8 0.6
Year -3 2 0.8 0.4
10.8 1.8
Value of Research assets capitalize 10.8

b. Adjusted after-tax operating income

After-tax operating income $5.00
+ R& D expense $5.00
- Amortization of R&D $1.80
Adjusted after-tax operating incom $8.20

Page 48
 Spring 2008

! The problem asks for a nominal peso cost of equity.

nds which have the same rating

! Computed country risk premium incorrectly: -1 point

! Mechanical errors: -0.5 point

! Failed to compute market value of bank debt: -1 point

! Used wrong tax rate: -0.5 point
! Mechanical errors: -0.5 point
! Used only voting shares for equity: -1 point

! Did not compute amortization correctly: -1 point

! Mechanical errors: -0.5 point

! Mangled the tax effect: - 0.5 point

! Math errors: -0.5 point

Page 49
 Fall 2008

Fall 2008
Problem 1 Grading Guidelines
a. Riskfree Rate = 6.00% ! 9% - 3% (Default spread for Baa3 rated bond) ! All or nothing: -1 if wrong
b. Country Risk Premi 6% ! 2 * 3% (Relative market volatility * Default Spread) ! -0.5 point if double counted mature market
c. Lambda = 0.33333333 ! Revenue proportion/ Avg co revenue proportion ! All or nothing
d. Cost of equity = 13.400% ! 6% + 1.2 (4.5%) + 0.333 (6%) ! -0.5 point for each error not already counted

Problem 2
Year Training exp Unamortized Amortization
0 5 5 0 ! Errors in adjusting net income: - 0.5 to -1 point
1 4 3 1 ! Did not adjust book value of equity: -1.5 point
2 3 1.5 0.75 ! Other math errors: -0.5 point each
3 2 0.5 0.5
4 1 0 0.25
10 2.5
Correct pre-tax operating income = 7.5 ! 5 + 5 -2.5
Correct book value of equity = 25 ! 15 + 10
ROE = 30.00%

Problem 3
a. Payout ratio 25.00% ! ROE wrong: -0.5 point
Return on equity = 20% ! Retention ratio wrong: -0.5 point
Expected growth rate= 15.00%

b. New net income = $1.60 ! I gave full credit if you used a retention ratio of 80% and
New book value of eq $15.00 ! In year 1, you will have a drop in earnings. For those of y
Expected growth rate 10.67%
Retention ratio = 1
Expected growth rate 10.67%

Page 50
 Fall 2008

ng: -1 if wrong
double counted mature market risk

or each error not already counted in previous sections.

ome: - 0.5 to -1 point

of equity: -1.5 point

ed a retention ratio of 80% and a ROE of 13.33% to arrive at same answer as I did
drop in earnings. For those of you who recorded this drop, there was no loss of points

Page 51
 Fall 2009

Fall 2009
Problem 1
Riskfree Rate = 6.00% ! Peso 10-year bond rate - Default spread ! Wrong riskfree rate: - 1 point
Beta = 0.9 ! Did not compute lambda: -1 poin
Mature market ERP = 5% ! Did not scale up default spread: -
Lamnda for Mexico = 0.5 ! Prop of Jarlisco's revenues/ Avg co revenues ! Other errors: -0.5 point each
CRP for Mexico = 3.60% ! Efault spread * Rel Equity Mkt Volatility
Cost of Equity = 12.30%

Problem 2
Loan Type Face Interest Interest
Value Rate Expenses ! Did not compute interest coverag
Secured bank loan 200 7.00% 14 ! Wrong synthetic rating/default sp
Subordinated bank loan 150 8.00% 12 ! Used effective tax rate: -1 point
Unsecured short term bank 150 6.00% 9
Total Interest Expense 35
Interest coverage ratio = 4 ! 140/35
Rating = A- ! See table
Cost of debt = 8.00% ! 5% + 3%
After-tax cost of debt = 4.80% ! 8% (1-.4)

Problem 3
a. (D) The reported earnings
will increase for firms that
have seen R&D expenses ! Adjusted Earnings = Stated Earnings + Current year's R&D - Amortization of R&D
increase over time
b. B. The book value of
assets and equity will ! Adjusted BV of Assets (Equity) = Stated BV + Capitalized R&D
increase.
C. The cost of capital will be
unaffected. ! No effect. Market value of equity is unaffected by amortization

Page 52
 Fall 2009

! Wrong riskfree rate: - 1 point

! Did not compute lambda: -1 point
! Did not scale up default spread: -0.5 point
! Other errors: -0.5 point each

! Did not compute interest coverage ratio: -1 point

! Wrong synthetic rating/default spread: -1 point
! Used effective tax rate: -1 point

rtization of R&D

Page 53
 Fall 2010

Fall
2010
Problem 1 Points
First, solve for the US $ cost of equity used by the analyst : Did not solve for cost of equity: -1 point
Equity value = FCFE next year / (Cost of equity -g) ! Wrong CRP: -1 point
1000 = 50/ (Cost of capital - .05) ! Lambda incorrect: -1 point
Cost of equity = 10% ! Inflation adjustment wrong: -1 point

Second, estimate the correct $ cost of equity, including country risk

Default spread for Peru = 2% ! 5% -3%
Convert to country risk pr 3.00% ! 2% * 1.5
Estimate lambda = 1.25 ! 100/80
Estimate correct $ cost of equity = 13.7500% ! 10% + 1.25(3%)

Third convert to Peruvian Sul cost of equity

Peruvian Sul cost of equity 18.21% !(1+ $ cost of equity) (1+inflation rate in Sul)
/ (1+ inflation rate in US $)
Correct value of equity = 378.478664 ! 50/ (.182-.05)

Problem 2
Estimate values of the two businesses ! Wrong weights: -1 point
Value of food processing = 400 ! D/E ratio wrong: -1 point
Value of restaurant = 600 ! Cost of equity wrong: -1 point
Unlevered beta = 0.60 (400/1000) + 1.20 (600/1000) = 0.96

Pre-tax cost of debt = 5% ! 3.5% +1.5%

PV of leases = 323.160638
Total debt = 423.160638
D/E ratio = 0.70526773 ! 423/600
Levered beta= 0.96 (1+ (1-.4) (.7053)) = 1.36623421

Cost of equity = 9.65%

Problem 3
Capitalize R&D
Year R&D Unamortized Amortization
Current 200 200 ! R&D adjustment: -1 point
-1 160 120 40 ! Wrong tax: - 1/2 point
-2 120 60 30 ! WC wrong: -1/2 point
3 80 20 20 ! FCFF computation: -1 point
4 40 0 10
400 100

Adjusted EBIT = 300 + 200 - 100 = 400 ! EBIT + Current year R&D - R&D amortization
Adjusted Cap Ex = 380
Adjusted Depreciation = 200

EBIT (1-t) 240 ! Use tax rate based on taxes paid/taxable income
- Net cap ex 180 ! Includes R&D and amortization of R&D
- Chg in WC 30 ! Excluding cash: -10-20 = -30

Page 54
 Fall 2010

+ Tax benef 40
FCFF 70

Page 55
Fall 2011
Problem 1
Ulysses Inc Lowie Inc.
Cost of equit 9% 12%
Cost of capita 7.50% 10%
Cash flows are to capital (since they are before debt payments) and more reflective of Lowie (movie business)
Right discount rate is therefore Lowie's cost of capital of 10% 1. Wrong discount rate: -1 to
0 1 2 3 4 5 2. Error on PV: -1 point
Revenues $100 $110 $125 $140 $160
- COGS (includes deprecia $40 $44 $50 $56 $64
Operating income $60 $66 $75 $84 $96
- Taxes $18 $20 $23 $25 $29
EBIT (1-t) $42 $46 $53 $59 $67
- Net cap ex $80 $0 $0 $0 $0 $0
- Chg in WC $5 $5 $5 $5 $5
Cash flow -$80 $37 $41 $48 $54 $62
Value of sta -$80.00 $33.64 $34.05 $35.69 $36.75 $38.62 $98.74
If you argued that there were toy-related revenues in these cash flows and used a weighted average of the costs
of capital of the two firms, I gave you full credit.

Problem 2
Country 10-year govRating Default sp Std dev of Std dev of LaFua ReveAvg company revenues
Brazil 8% Baa1 1.50% 25% 20% 50% 80%
US 2% Aaa 0% 20% 15% 30% 75%
Portugal 10% Caa 6.00% 30% 20% 20% 60%

Brazil US Portugal Unlevered BeEV/Sales ratio

Movies $2.00 $1.40 $0.60 1.2 1.00
TV Broadcast $0.50 $0.10 $0.40 0.9 3.00 1. Wrong risk free rate: -1 point
Total $2.50 $1.50 $1.00 2. Wrong beta: -0.5 to -1 point
Start with nominal BR$ riskfree rate 3. Wrong country risk premium: -1 point
Government bo 8.00% 4. Lambda based on 20%: -0.5 point
- Default spr 1.50%
Riskfre rate i 6.50%
Then get the beta for the business mix in Portugal
Business Revenues EV/Sales Estimated va Weights Unlev Beta
Movies $0.60 1.00 $0.60 33.33% 1.2
TV Broadcast $0.40 3.00 $1.20 66.67% 0.9
Beta for business = $1.80 1.00
Since the firm has no debt outstanding, levered beta = unlevered beta
Levered beta 1.00
Use the implied premium of 7% for the US as mature market premium
Next, estimate the lambda for Portugal
% of Revenue 100.00% ! Remember these are just the Portuguese operations
Avg company' 60.00%
Lambda 1.67
Finally, get the country risk premium for Portugal
Default sprea 6.00%
Relative equit 1.50
Country risk 9.00%
Bring them all together
Cost of equity 28.50%

Problem 3
Most recent 1 year ago 2 years ago 3 years ago
Revenues $1,000 $700 $400 $200 ! Error on amortization: -1 po
Pre-tax Oper -$200 -$200 -$200 -$100 ! Error on operating expenses
Book value of equity 100 ! Error on adjustment: -1 poi
Most recent 1 year ago 2 years ago 3 years ago Sum
Operating ex $1,200 $900 $600 $300
Customer acq $600.0 $450.0 $300.0 $150.0
Amortization 0 $150.00 $100.0 $50.0 300
Unamortized $600.0 $300.00 $100.0 0

Stated pre-tax operating i -$200.0

+ Customer acquisiton cos $600.0
- Amortization of past cost 300
Adjusted pre-tax operating $100.0
Adjusted after-tax operati $100.0 ! The company pays no taxes
e (movie business)
1. Wrong discount rate: -1 to -2 points
2. Error on PV: -1 point

ny revenues

k free rate: -1 point

a: -0.5 to -1 point
ntry risk premium: -1 point
sed on 20%: -0.5 point
! Error on amortization: -1 point
! Error on operating expenses: -1 point
! Error on adjustment: -1 point
Fall 2012
Problem 1 GRADING TEMPLATE
Cash flow in ### 1. Did not adjust dollar cost of equity for inflation differential: -1 poin
Expected grow 5% 2. Did not adjust cost of equity for country risk: -1 point
Cost of equit 9.20% 3. Other errors: -1/2 point each
Implied beta 1.2 ! (9.2% -2%)/6%
Cost of equit 12.80%
Cost of equit 17.27% ! I gave you full credit if you just added the 3% inflation differential to the $ cost of equity to get 16.8%
Value of equi ### In fact, I gave credit for a multitude of answers, where you effectively adjusted for both inflation a

Problem 2
US Brazil
Software $800 $200
Electronics $400 $600

a.
Beta for soft 1.2 1. Used wrong risk free rate: -1/2 point
Riskfree rate 2% 2. Error on country risk premium for Brazil: -1/2 point to -1 point
Default sprea 1.50% ! Brazilian $ bond rate - US treasury bond3. Other errors: -1/2 point each
CRP for Brazi 2.50% ! 1.59% (25%/15%)
ERP for softw 6.50% ! 6% (800/1000) + 8.5% (200/1000)
Cost of equit 9.800%

b.
Beta for Braz 0.975 ! 1.2 (200/800) +0.9 (600/800) 1. Wrong riskfree rate: -1 point
Riskfree rate 10.500% ! 12% - 1.50% = 10.50% 2. Other errors: -1/2 point each
ERP for Brazi 8.50% ! Mature market premium of 6% + CRP of 2.5%
Cost of equit 18.787500%

Problem 3
Analyst estimates Corrected values
Revenue $1,200.00 Operating in $600.00
- Operating $600.00 + Operating $100.00
Operating In $600.00 - Depreciatio $69.27
- Interest Ex $150.00 Adjusted Ope $630.73 ! Use 35% tax rate
Taxable Inco $450.00 After-tax Ope $409.97
- Taxes $157.50 + Depreciati $169.27
Net Income $292.50 - Cap ex $250.00 1. Did not adjust for operating leases: -1 point
+ Depreciati $100.00 - Change in $40.00 2. Wrong tax computation: -1 point
- Cap Ex $200.00 FCFF $289.25 3. Cap ex wrong: -1/2 point
- Change in $50.00 4. Working capital not adjusted: -1/2 point
FCFF $142.50

Tax rate = 35% ! 157.5/450

PV of lease $346.36 ! PV of $80 million each year

Depreciation $69.27
An alternate solution (using the short cut)
Operating In $600.00
+ Imputed in $17.32
Adjusted Op $617.32
After-tax Op $401.26
+ Depreciati $100.00 ! No lease depreciation in this approach
- Cap ex $250.00
- Change in $40.00
FCFF $211.26
 inflation differential: -1 point
ry risk: -1 point

of equity to get 16.8%

y adjusted for both inflation and country risk.

zil: -1/2 point to -1 point

ses: -1 point
Problem 1
Estimated value = 1200
1200 = Expected cash flow next year/ (.12-.02)
Expected cash flow next year 120 ! In US dollars
Expected real growth rate = 2.00%
Expected inflation rate = 1.50%
Nominal cost of capital in US$= 12.00%
Nominal growth rate in US $= 3.53% ! (1.02)(1.015)-1 or just use 3.5% as an approximation
Value in US $ $1,416.77 ! In nominal US dollars

Alternatively, you can do this:

Real cost of capital = 10.34% ! (1.12/1.015)-1 or just use 10.5% as shortcut
Real growth rate = 2.00%
Real cash flow next year = $118.23 ! Make nominal cash flow next year into real
Value in real terms= $1,416.77

Problem 2
a. CRP for Brazil = 1.88% ! Default spread = 4.00%-2.75% = 1.25%; CRP = 1.25% *1.5 = 1.875%
CRP for Argentina = 9.00% ! Default spread = 8.75%-275% =6%; CRP = 6% *1.5
CRP for Latin America 4.25% ! Weighted by revenues: 1.875% (4/6)+9% (2/6)
ERP for Latin America = 10.00% ! Add mature market premium to this

b. Beta for Latin America = 1.26 ! Weights are based on revenues in Latin America

c. Cost of equity in US $ = 15.35% ! 2.75% + 1.26 (10.00%)

Problem 3
Last fiscal ye 3rd Qtr, 2013 3rd Qtr, 2012 First 3 Qtrs, First 3 Qtrs, 2012
Revenues $1,200 $400 $325 $1,100 $850
EBITDA $400 $120 $95 $350 $300
Depr & Amort (DA) $100 $30 $25 $90 $75
EBIT $300 $90 $70 $260 $225
Interest expenses $75 $25 $15 $70 $55
Taxable Income $225 $65 $55 $190 $170
Taxes $68 $26 $22 $57 $51
Net Income $158 $39 $33 $133 $119
Cap Ex $150 $45 $35 $130 $110
Non-cash WC (End of period) $70 $80 $100 $80 $100

Trailing 12 month EBIT = $335 ! 300 +260-225

Tax rate = 30% ! (68+57-51)/(225+190-170(with rounding, it is 30.2%
EBIT (1-t) $234.50 ! 335 (1-.4)
+ Trailing 12 month DA $115 ! 100+90-75
- Trailing 12 month Cap Ex $170
- Change in non-cash WC -$20 ! End of qtr 3, 2013 - End of qtr 3, 2012
FCFF $199.50
Note: While it is justifiable to use marginal tax rates for forecasts, the actual FCFF for last year should be based upon
the effective tax rate. Thus, using the tax rate from the last quarter will give you the wrong FCFF. I do see, though, what
you were trying to do and it should cost you relatively little (-0.5 point)'
 Grading guidelines
Did not back out expected cash flow from value: -1 point
! Expected inflation in US $ incorrect: -1 point
! Did not match cash flows to discount rates: -1 point
! Math errors: -1/2 point

pproximation

%; CRP = 1.25% *1.5 = 1.875%

! CRP incorrect: -1/2 point each
! Weighting incorrect: -1 point

! All or nothing

! All or nothing, given parts (a) & (b)

First 3 Qtrs, 2012

! Used actual taxes paid: -1 point

! Change in WC incorrect: -1 point
! Used tax rate from last quarter: -0.5 point (see below)
ould be based upon
I do see, though, what
Problem 1
Expected cash flow to equity next ye 150 ! It is net income (equity income) and equal to cash flow, since depreciation = capital ma
Expected growth rate (in Rupee term 4% Grading Template
Cost of equity in Euro terms = 8% ! Use cost of equity, since cash flows are 1. Used cost of capital instead of cost of equity
Country risk premium for India = 3% ! Added to cost of equity in Euros 2. Did not adjust for differential inflation: -1 po
Cost of equity for Indian project in 11% 3. Did not adjust for country risk: -1 point
Expected inflation rate in Rupees = 5% 4. Cash flow incorrect: -1 point
Expected inflation rate in Euros = 1%
Cost of equity in Rupees 15.40% ! If you use short cut and just add 4% to get to 12%, I still gave you full credit
Value of equity in toll road = 1316.24674

Problem 2
Unlevered
Colombia US Beta
Food Processing $1,000 $0 0.90 1. Unlevered beta incorrect: -1/2 to -1 point
Groceries $500 $1,000 0.60 2. D/E ratio wrong: -1/2 to -1 point
Government Bond rate (in US $ 4.00% 2.50% 3. Used Colombian tax rate: -1/2 point
Government Bond rate (in Peso 6.00% NA
Marginal tax rate 25.00% 40%
Debt outstanding $500

a. Cost of equity
Unlevered Beta Values Weights Unlevered Beta
Value of food processing business = $1,000 0.4 0.90 ! Value = Revenues * EV/Sales
Value of Grocery business = $1,500 0.6 0.60
$2,500 0.72
Levered Beta
Debt = 500 ! You can try to compute the levered beta for each
Equity = 2000 you then have to use the estimated equity value fo
D/E ratio = 0.25 to weight the levered betas.
Marginal tax rate = 40% ! Debt is used in US operations
Levered Beta = 0.828
ERP
Cost of Equity 1. Mature market premium missing: -1/2 point
Value Weight ERP 2. Country risk premium incorrect: -1/2 point
Value of Colombia operations = $1,500.00 60% 8.00% 3. Did not weight by country: -1/2 point
Value of US operations = $1,000.00 40% 5.00% 4. Wrong risk free rate: -1/2 point
$2,500.00 6.80%
Cost of equity I accepted almost any mature market ERP from 3%
Cost of equity in US dollars = 8.13% ! 2.5% + 0.828 (6.8%) weighted average premium that you should get sh
your Mature market ERP + 1.8%. The latter is 60%
c. After-tax cost of debt for Colombia which is 3% (1.50% *2= 3.00%)
Pre-tax cost of debt = 5.2500% ! 2.5% + 1.5% + 1.25% 1. Did not add Colombian default spread: -1/2
After-tax cost of debt = 3.15% ! 5.25% (1-.4) 2. Used wrong tax rate: -1/2 point
(As a Colombian-based company, it should bear at least some of the country default risk. I added the entire 1.5% which is the Colombia cou
default spread on, but I gave full credit even if you added a portion of it or at least addressed why it would not be exposed.)
Problem 3
a.
ii. 240 million (1000 -400)*.4
b.
iv. Decreased operating income, no chang (Operating income + Current year R&D - R&D amortization)
With declining R&D, Current year R&D < R&D amortization
c.
iv. 88.89% EBIT (1-t) = (80-20) (1-.25) = $45
Reinvestment = (50-20)+10 = 40
Reinvestment Rate= 40/45 = 88.89%
d.
v. 34% Expected growth = .60 (.15)+(.15-.12)/.12 = .34
(I also gave full credit for 32.2%, since you can make the argument that next year's growth is driven by this year's R
w, since depreciation = capital maintenance

of capital instead of cost of equity: -1 point

just for differential inflation: -1 point
just for country risk: -1 point
incorrect: -1 point

till gave you full credit

beta incorrect: -1/2 to -1 point

wrong: -1/2 to -1 point
mbian tax rate: -1/2 point

te the levered beta for each country but

he estimated equity value for each country

rket premium missing: -1/2 point

sk premium incorrect: -1/2 point
ight by country: -1/2 point
k free rate: -1/2 point

mature market ERP from 3%-7%. The

mium that you should get should be
RP + 1.8%. The latter is 60% of the CRP
3% (1.50% *2= 3.00%)
d Colombian default spread: -1/2 point
g tax rate: -1/2 point
e 1.5% which is the Colombia country
not be exposed.)

wth is driven by this year's ROC & reinvestment rate)

Problem 1
Most recent year
Next year
Revenues 1,000.0€ 1,015.0€
Operating Income after taxes 200.0€ 203.0€
- Reinvestment 80.0€ 81.2€
FCFF 120.0€ 121.8€

Expected growth rate in Euros 1.50%

Cost of capital (equity) in $R 20.00%
Inflation rate in $R = 8.00%
Inflation rate in Euros = 1.00%
Cost of capital (equity) in Eur 12.22% ! Approximate answer = 17% - (8% -1%) = 10%
Country risk for Brazil = 3.00% ! I also gave you credit if you reversed the sequence and took out country risk first.
Cost of capital (equity) in Eur 9.22% ! Your discount rate would have been (1.17)(1.01/1.0)- 9.42%

Value of Dietz = $1,577.27 ! 121.8/(.0922-.015)

Problem 2
Govt Bond Passenger Freight
Rate (in Govt Bond Revenues Revenues
local Rate (in (in (in
Country Currency currency) Euros) millions) millions) Total
Poland Zloty 6.00% 2.25% PLN 500.00 PLN 250.00 PLN 750.00
Hungary Forint 5.00% 2.50% PLN 250.00 PLN 250.00 PLN 500.00
Germany Euros 1.00% 1.00% PLN 250.00 PLN 500.00 PLN 750.00
Sum ### ###
Part a
Unlevered beta Weight
Passenger traffic 1.25 50.00%
Freight traffic 0.75 50.00%
Company 1.00

Debt/Equity Ratio 0.5 ! 500/1000

Levered Beta 1.375

Part b
Risk free Rate in Euros = 1.00%

Country Default Spread CRP ERP Weight

Poland 1.25% 1.875% 7.875% 37.50%
Hungary 1.50% 2.250% 8.250% 25.00%
Germany 0.00% 0.000% 6.000% 37.50%
Company ###

Cost of equity in Euros = 10.99%

Part c
Risk free rate in Euros = 1.00%
Default spread for company = 2.00%
Default spread for Poland = 1.25% ! I gave full credit if you used a weighted averate default spread across the countries
Pre-tax cost of debt = 4.25%
Tax rate = 25%
After-tax cost of debt = 3.19%

Problem 3
PV of lease commitments at
after-tax cost of debt $201.98 ! Discount at 4% pre-tax cost of debt

Problem 4
Amortizatio Unamortize
R&D expense n this year d portion
Current $100.00 $0.00 $100.00
Year -1 $90.00 $30.00 $60.00
Year -2 $60.00 $20.00 $20.00
Year -3 $30.00 $10.00 $0.00
Total amortization of R&D $60.00
Unamortized R&D $180.00

Operating Income -$ 15.00

+ Current year's R&D $ 100.00
- Amortization of R&D $ 60.00
Adjusted Operating Income $ 25.00
 GRADING TEMPLATE
1. Did not adjust for inflation differential correctly: -1 point
2. Did not adjust for country risk: -1 point
3. Did not use next year's cash flow: -1/2 point
4. Other math errors: -1/2 point each

d took out country risk first.

1. Did not compute unlevered beta correctly: -1/2 point

2. Error on D/E ratio or in levering beta: -1/2 point

1. Used wrong risk free rate: -1/2 point

2. ERP computed incorrectly: -1/2 point
3. Did not weight ERP across countries: -1/2 point
4. Did not use beta to get to cost of equity: -1/2 point
 1. Did not add country default spread: -1/2 point
2. Did not after-tax cost of debt: -1/2 point
ult spread across the countries

All or nothing

1. Did not add back R&D expenses: -1/2 point

2. Did not amortize past R&D correctly: -1/2 to -1 point
3. Other math errors: -1/2 point