Valuation Problem Set (A)
Exhibit TN -1
Total value of B/s / No. of shares
ROE= PAT/ Net Worth
EPS= PAT/ No. of shares
Data on Alternative Capital Structures for American Home Produc
Debt Ratio
[ Debt/ ( Debt + Equity)]
Earnings per share
Dividends per share
Book value per share
Return on Equity
Interest Coverage [ EBIT/Interest]
Total Debt/ Lending Formula*
Stock Price at P/E of 9.43
Break-even P/E for price of $ 30
Dividend yield at price o $ 30
Price at dividend yield of 6.33 %
Present value of tax-savings at
t= ( additional debt + reduction in cash)
Aggregate ( $ millions)
Per beginning share ( 155.50 million shares)
Earnings available to security holders**
Change from actual
Cash Flow to security Holders***
Change from actual
Taxes, change from actual
Control
Percent shares bought in
Percent owned by largest shareholder
J.P. Morgan 2.50 %
Risk
Impact on net income of 10 % reduction in EBIT
Break-even EBIT for 30 % and 70 %
Stable sales and earnings ( see exhibit 1)
Financing Flexibility
Don't need externl funds
 Sustainable growth at 60 % payout ratio

Availability & Access

Can pay quickly with internal funding

Timing
Ruled out, no information

* * ( Lending Formula is 90 % of Accounts Receivable plus 50 % of In

This is conservative because it ignores $360.30 million in cash tra
** Earnings available to security holders equals interest plus preferre
*** Cash Flow to security holders equals interest plus preferred divide

Calculation
No of shares
ctures for American Home Products (AHP)

Actual Proforma
0.90% 30% 50% 70%
( Given)

llion shares)

eduction in EBIT
 ccounts Receivable plus 50 % of Inventory
gnores $360.30 million in cash transactions plus $ 450.50 million (at cost) of net fixed assets
olders equals interest plus preferred dividends plus earnings avaialble to common shares
quals interest plus preferred dividends plus common dividends
Remarks

e.p.s increases
Stock market & analysts expect increase in dividends

30%

30.104 Dividend yield 0.056666667

tax shield Important

Example

From : Introdcution to Financial Management :Chapter 12; Meggison /Smart

Next Generation Technology Solutions (NGTS)

Current Proposed
Assets 15000000 15000000
Equity 7500000
Debt 0 7500000
Debt-to-equity 0 1
Shares outstanding 400,000 200,000

Share Price 37.5 37.5

Interest Rate 0 8%

EBIT Weight
Optimistic 2250000 1/3
Realistic 1500000 1/3
Pessimistic 750000 1/3

Expected EBIT = (1/3) * 22,50,000+ (1/3) * 15,00,000+ (1/3) * 7,50,000

= 1,500,000

Table 2 : payoff to NGTS and its security holders, for the current & proposed capital structu
economy grows at a nominal rate & EBIT equals 1,500,000

Current capital structure Proposed Capital

All Equity Financing Structure
EBIT 1,500,000 1,500,000
- Interest @ 8 % 0 600,000
Net Income 1,500,000 900,000

SharesOutstanding 400,000 200000

earnings per share 3.75 4.5

Return on equity 10% 12%

( Price of Equity = 37.50 per share)
Table 3

Expected cash flows to shareholders & bondholders under the current &
proposed capital structure fot NTGS

Recession Normal Growth

EBIT 750000 1,500,000

All Equity 50% Debt All Equity

50% Equity

- Interest @ 8 % 0- 600,000 -
Net Income 0 150,000 -

SharesOutstanding 400,000 200000 400,000

earnings per share 1.875 0.75 3.75

Return on equity 5% 2% 10%

( Price of Equity = 37.50 per share)

1,200,000 is the break-even level of operating profits for the proposed capital

The fundamental principle of financial leverage:

Substituting long-term debt for equity in a capital structure
increases both the level of expected returns to the shareholders
measured by earnings pers share or ROE -and the risk ( dispersion)-
of those expected returns.
 ( MARKET CAPITALISATION)

urrent & proposed capital structure, assuming the

osed Capital
mal Growth Boom Break even

2,250,000 1,200,000

50% Debt All Equity 50% Debt 50% Debt

50% Equity 50% Equity 50% Equity

- 600,000 - 600,000 - 600,000

900,000 1,650,000 600,000

200000 400,000 200000 200000

4.5 5.625 8.25 3

12% 15% 22% 8%

No profit no loss

g profits for the proposed capital structure