FIN4274 Page1of11

Spring2012
MidtermExam


INSTRUCTIONS
Pleaseclearyourdeskofallmaterialexceptacalculatorandwritinginstruments.No
notesorextrasheetsofpaperarepermitted.Youmaynotreceiveassistanceofanykind
whiletakingthetest.Youmaynotusetelephoneswhiletakingthetest.Calculatorsmay
notbeshared.

Readeachquestioncarefully.Youmustanswereachofthe4equallyweighted
questions.

Neatnessisimportant.IdontgradeanswerswhichIhavetroublereading.Partial
creditisawardedonlyifIcaneasilyfollowandunderstandyouranswer.
Carynumericalanswersoutto2decimalplaces,example,r=4.35%orbeta=1.32.

Youhave1hourand15minutestocompletethistest.After75minutesyouwillbetold
that5minutesremaintosubmityourtest.Youlose10pointsforeveryminutethetest
islate.

Atleastonememberoftheclasshasnottakenthetest.Youarenottodiscussthetest
withanyonebeforenoononFriday,3/16.

IstrictlyenforcetheVirginiaTechHonorCode.
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Question1
a. (1/3)ExplainWarrenBuffettsprincipleofeconomicreality,notaccounting
reality.Provideanexample.

ANSWER
Buffetts point is that consolidated GAAP reports blur performance since they
ignore critical characteristics needed of a firms capacity to create value. Many
examplesexistincluding:
Intangibleassets
Specialknowhow
Reputation
Longtermprospects
Qualityofmanagement

b. (1/3)ExplainthedifferencebetweenEstimationuncertaintyandReal
uncertainty.

ANSWER
EstimationUncertainty:Evenifourinformationsourcesareimpeccable,we
havetoconvertrawinformationintoinputsandusetheseinputsinmodels.Any
mistakesorincorrectassessmentsthatwemakeateitherstageofthisprocess
willcauseestimationerror.

RealUncertainty:
FirmspecificUncertainty:Thepaththatweenvisionforafirmcanprove
tobehopelesslywrong.Thefirmmaydomuchbetterormuchworse
thanweexpectedittoperform,andtheresultingearningsandcashflows
willbeverydifferentfromourestimates.
MacroeconomicUncertainty:Evenifafirmevolvesexactlythewaywe
expecteditto,themacroeconomicenvironmentcanchangein
unpredictableways.Interestratescangoupordownandtheeconomy
candomuchbetterorworsethanexpected.Thesemacroeconomic
changeswillaffectvalue.

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c. (1/3)TheDamodarantextdiscusses3estimationbiasesoftenfoundinvaluation.
Identifyandexplainoneofthethreebiasesandprovideanexample

ANSWER
Inputstothevaluation:Ourassumptionsaboutmargins,returnsoncapital,
growthandriskareinfluencedbyourbiases.

Postvaluationtinkering:Themostobviousmanifestationofbiasoccursafterwe
finishthevaluationwhenweaddpremiums(synergy,control)andassess
discounts(illiquidity)forvariousfactors.Ifwearebiasedtowardshighervalues,
wetendtousepremiums;ifbiasedtowardslowervalues,wediscount.

Qualitativefactors:Whenwerunoutofallotherchoices,wetendtoexplain
awaythedifferencebetweenthepricewearepayingandthevalueobtainedby
givingitaname(strategicconsiderations)
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Question2
Onthelasttradingdayof2011youpurchased1,300sharesofHokieInc.
commonstockexdividendattheyearendclosingpriceof$57.00pershare.
Marketdataandyourexpecteddividendandearningsforecastforthenext
3yearsarebelow.Attheendof2014youexpectthestocktotradeata
trailingP/Eratioof11.5.

30yearU.STreasurybond 5.00%
Expectedreturnonthemarket 12.30%
HokieInc.stockBeta 1.40

Year
end DPS EPS Price

2011 $4.00 $6.50 $57.00
2012 $4.16 $3.05
2013 $4.75 $6.22
2014 $5.05 $6.28

a. (3/4)Calculatetheannualcompoundrateofreturnyouexpecttoearnifyou
holdyoursharesuntiltheendof2014andsellthemcumdividend.

ANSWER

( )
( )
( )
( )
3 2
1
5 . 11 28 . 6 05 . 5
1
75 . 4
1
16 . 4
00 . 57
R R
R
+
+
+
+
+
+
=
SolveforRusingIRRfunctionincalculator.
TerminaltrailingPE 11.5
Yearend DPS EPS Price CF
2011 $4.00 $6.50 $57.00 ($57.00)
2012 $4.16 $3.05 $4.16
2013 $4.75 $6.22 $4.75
2014 $5.05
$6.28
$77.27
15.72%

b.
You are given a trailing P/E of 11.5 and 2014 EPS of $6.28. P
2014
=11.5
x $6.28 = $72.22. CF
2014
= 72.22 + $5.05 = $77.27
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(1/8)Howwelldidyoudoonyourinvestment?

ANSWER
Youmustcompareyourreturntoabenchmark.AccordingtoCAPMtherequired
returnforthisinvestmentis15.22%soyouearned50basispointsabovethe
requiredreturn

( )
22 . 15
3 . 7 4 . 1 00 . 5
00 . 5 30 . 12 4 . 1 00 . 5
=
+ =
+ =
k
k
k

c. (1/8)Explainhowyouranswertopartbwouldchangeifgiventhesamesetof
earningsanddividendexpectations,youplannedtoholdthestockforonlyone
yearsellingitattheendof2012cumdividend.Nocalculationsareneeded.

ANSWER
Theanswercoulddramaticallychange.NotethedecreaseinEPSlikelytohavea
significantimpactonthepriceandPEratiotherebypossiblyreducingthe1year
return.Theriskpremiumand/orbetacouldbedifferent.Theresultcouldbean
improvedperformanceordiminishedperformancewhencomparinga1yearholding
periodtoa3yearholdingperiod.

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Question3
YouhavebeenaskedtoestimatethecostofequityforHoltonHoldings,aprivatefirm
withoperationsinthreedifferentbusinesses:retailing,hotelsandtravel.Youplanto
usetheCAPMandhavecollectedinformationonthefirmsoperationsandof
comparablefirmsineachofHoltonsbusinesses

Comparablefirms Revenues Unleveredbeta

Firmvalue/
Sales
Retailing $400million 0.85 2.00
Software $400million 1.15 3.00
Travel $800million 1.35 1.25

a. (1/2)EstimatetheunleveredbetaforHoltonHoldings.

ANSWER
Comparable
firms Revenues
Unlevered
beta
Firm
value/
Sales
Firm
value Weight
Retailing $400 0.85 2 $800 26.67%
Software $400 1.15 3 $1,200 40.00%
Travel $800 1.35 1.25 $1,000 33.33%
$3,000 100.00%
Unleveredbeta= 1.14

14 . 1
3333 . 35 . 1 4000 . 15 . 1 2667 . 85 .
000 , 3
000 , 1
000 , 3
200 , 1
000 , 3
800
=
+ + =
+ + =
U
U
TU SU RU U
|
|
| | | |

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7
b. (1/2)HoltonHoldingshas$1.2billion(bookvalue)oflongtermdebtand100
millionsharesofcommonstocktradingat$10ashare.EstimateHoltons
leveredbeta.Assumeamarginaltaxrateof40%.

ANSWER
Debt=$1.2billion
Equity=$10x100millionshares=$1,000million=$1.0billion
Debt/Equity=$1.2/$1.0=1.20

( ) | |
( ) | |
96 . 1
2 . 1 4 . 1 1 14 . 1
1 1
=
+ =
+ =
L
L
U L
E
D
|
|
t | |

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8
Question4
YouhavebeenaskedtoestimateGobblerEnterprises2011freecashflowtothefirm
(FCFF)andhavecollectedthefollowinginformation:

- Gobblerreported2011earningsbeforeinterest,taxes,depreciationand
amortizationof$350milliononitsrevenuesof$1,600million.

- 2011depreciationandamortizationchargesamountedto$100millionand
grosscapitalexpenditureswere$200million.

- Gobblerspent$100milliononresearchanddevelopmentin2011,following
R&Dexpendituresof$60million(2008),$75million(2009)and$90million
(2010).YoubelievethatR&Dexpenditureshaveanamortizablelifeof3years
(straightline).

- Theworkingcapitalitemsforthe2011and2010arereportedbelow.
Millions$
2011 2010
Cash 100 80
Accountsreceivable 80 90
Inventory 150 100
Accountspayable 130 110
Shorttermdebt 150 130

Notes:
Shorttermdebtisconsideredpermanentcapital
Gobblerstaxrateis40%.

a. (1/3)EstimatethevalueofGobblers2011R&Dasset.

ANSWER
Year
R&D
Ex pense
Amor t i zat i on
t hi s y ear
Remai ni ng
Val ue
2011 $100 $0 $100
2010 90 30 60
2009 75 25 25
2008 60 20 0
$75 $185
2011 Book Value of research asset = $185

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b. (1/3)EstimateGobblers2011operatingincome(EBIT)adjustedforR&D
expenditures.
ANSWER

EBI T $250
+ Current year' s R&D 100
- Amort izat ion of R&D 75
Adj ust ed EBI T $275

c. (1/3)EstimateGobblers2011freecashflowstothefirm.

ANSWER

FirstcalculateEBIT(1t)
Adj ust ed EBI T ( 1- t ) $165
add t ax benefit 10
Adj ust ed EBI T ( 1- t ) wit h t ax benefit $175

Less: Net cap Ex 125

Less Change in non- cash WC 20
Free Cash Flow t o t he Firm 30

This is the difference in

taxes actually paid $250
x .40 = $100. Tax based
on the adjusted EBIT
would be $ 275 x .40 =
$110. But the firms tax
bill was $100.
Or from the Adjusted
EBIT of $275 simply
subtract the unadjusted
tax of $250 x .40 =
$100. The after tax
Adjusted EBIT is the
same

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