FINA 410 – Exercises

Estimating the Beta

1. You are analyzing the beta for Hewlett Packard and have broken down the company into
four broad business groups with market values and betas for each group.

Business Group Market Value of Equity Beta

Mainframes $2.0 billion 1.1
Personal Computers $2.0 1.5
Software $1.0 2.0
Printers $3.0 1.0
Total $8.0 1.275

a. Estimate the beta for Hewlett Packard as a company. Is this beta going to be equal to the
beta estimated by regressing past returns on HP stock against a market index. Why or
Why not?

We need to compute the weighted average of betas. Where, the weights are determined by the
market value of equity of each division.
Beta = (2/8)1.1 + (2/8)1.5 + (1/8)2 + (3/8)1 = 1.275

b. If the Treasury bond rate is 7.5% and market risk premium is 5.5%, estimate the cost of
equity for Hewlett Packard. Estimate the cost of equity for each division. Which cost of
equity would you use to value the printer division?

Business Group MV of Equity Beta Unlevered beta COE

Mainframes $2.0 billion 1.1 1.1/(1+(1-.36)*(1/8)) 13.10%
PC $2.0 1.5 1.5/(1+(1-.36)*(1/8) 15.13%
Software $1.0 2.0 2.0/(1+(1-.36)*(1/8) 17.68%
Printers $3.0 1.0 1.0/(1+(1-.36)*(1/8) 12.59%
Total $8.0 1.275 1.275/(1+(1-.36)*(1/8) 14%

(Disclaimer: this is my answer and may be different than the one suggested by the original
author).

Note: We need to unlevered the beta and than calculate the COE. The total value of the firm is
MV Equity + MV Debt = $8B +$1B = $9 Billion’s

It depends. If HP is interested to spawn-off the printers division, than we would have used the
COE relevant to the printers division. Otherwise, we would have used the COE applicable to all
of HP business. The reason is that the printers division has a share in the FCFE of the firm that is
not given here. Moreover, There are some returns to scales that can be considered (e.g.: lower
CAPEX in the combined firm compared to the stand alone firm).

c. Assume that HP divests itself of the mainframe business and pays the cash out as a
dividend. Estimate the beta for HP after the divestiture. (HP had $1 billion in debt
outstanding).
 - The betas computed in (a) were levered betas. We now need to account for firm value as a
whole (MV D and MV E).
o Total firm value = MV Equity+MV Debt = $8 + $1 = $9
o Assume a tax rate 36%
- What will the company receive from selling its mainframe business?
o A simple answer is 2 billions. However, this is not a standalone value. As it must also
include the portion of debt used to finance its operations.
o The mainframe business is 25% of MV of equity and assumes it is also 25% of MV
of debt. Therefore, it will be sold at $2.25 billions. Thus the total enterprise value is
9-2.25 = $6.75 billions.
 Total MV Equity = $6 B
 Total MV Debt = $0.75B
o To calculate beta of HP we need to repeat (a) and (b) with new weights
 Levered beta =

Business Group MV of Equity Beta Unlevered beta

PC $2.0 1.5 1.5/(1+(1-.36)*(0.75/6.75)
Software $1.0 2.0 2.0/(1+(1-.36)*(0.75/6.75)
Printers $3.0 1.0 1.0/(1+(1-.36)*(0.75/6.75)
Total $6 1.333 1.333/(1+(1-.36)*(0.75/6.75)

2. The following table summarizes the percentage changes in operating income, percentage
changes in revenue and betas for four pharmaceutical firms.

Firm % Change in revenue % Change in operating income Beta

PharmaCorp 27% 25% 1.00
SynerCorp 25% 32% 1.15
BioMed 23% 36% 1.30
Safemed 21% 40% 1.40

a. Calculate the degree of operating leverage for each firm.

DOL = % Change in operating income/% Change in revenue
Firm % Change in % Change in operating Beta
revenue income
PharmaCorp 27% 25% 1.00 0.92
SynerCorp 25% 32% 1.15 1.15
BioMed 23% 36% 1.30 1.3
Safemed 21% 40% 1.40 1.4

b. Use the operating leverage to explain why these firms have different betas.
- There is a clear relationship between the degree of operating leverage and the beta.
The greater the degree of operating leverage, the more responsive income (and
presumably stock returns) will be to changes in revenue which are correlated with
changes in market movements.

3. Battle Mountain is a mining company, which mines gold, silver and copper in mines in
South America, Africa and Australia. The beta for the stock is estimated to be 0.30. Given
the volatility in commodity prices, how would you explain the low beta?
- Recall that the company can hedge its exposures to these commodities by entering a
forward (or buying a future) contracts. That is, if commodity prices affect the
 overall market, than hedging practices will mitigate the correlation between returns
and market fluctuations.
- If commodities do not affect the market, than the low beta is explained in the sense
that commodity prices will not reflect on the market risk component of overall firm
risk but on the individual risk component (which in theory can be diversified away).

4. Genting Berhad is a Malaysian conglomerate, with holding in plantations and tourist

resorts. The beta estimated for the firm, relative to the Malaysian stock exchange, is 1.15,
and the long term government borrowing rate in Malaysia is 11.5%.
a. Estimate the expected return on the stock
b. If you were an international investor, what concerns, if any, would you have about
using the beta estimated relative to the Malaysian Index? If you do, how would
you modify the beta?

The firm business depends on tourists coming in. Therefore, it revenues depends
more on the economic situation of the global economy and not the domestic
Malaysian economy.

Capitalizing expenditures

1. Zif Software is a firm with significant research and development expenses. In the most
recent year, the firm had $100 million in research and development expenses. R&D
expenses are amortizable over 5 years and the R& D expenses over the last 5 years are as
follows:

Year R&D Expenses

Current $ 100 Million
-1 $ 90
-2 $ 80
-3 $ 70
-4 $ 60
-5 $ 50

Assuming a linear amortization schedule (over 5 years), estimate:

a. Value of research asset
b. The amount of R&D amortization this year
c. The adjustment to operating income

Year R&D Current year Unamortized % of original

Expenses amortization Amount expense
Current $ 100 0 100 100%
-1 $ 90 18 72 = 90*0.8 80%
-2 $ 80 16 48=80*0.6 60%
-3 $ 70 14 28 = 70*0.4 40%
-4 $ 60 12 12 = 12*0.2 20%
-5 $ 50 10 0 0
 Total 70 260

a. The value of the research asset equals $260 million.

b. The amount of R&D amortization this year is $70 millions.
c. The adjustment to operating income is to reduce it by 100-70 or $30 millions.

Free Cash Flow to Equity Valuation

1. Kimberly-Clark, a household product manufacturer, reported earnings per share of $3.20

in 1993 and paid dividends per share of $1.70 in that year. The firm reported depreciation
of $315 million in 1993 and capital expenditures of $475 million. (There were 160
million shares outstanding, trading at $51 per share.) This ratio of capital expenditures to
depreciation is expected to be maintained in the long term. The working capital needs are
negligible. Kimberly-Clark had debt outstanding of $1.6 billion and intends to maintain
its current financing mix (of debt and equity) to finance future investment needs. The firm
is in steady state and earnings are expected to grow 7% a year. The stock had a beta of
1.05. (The Treasury bond rate is 6.25%.)

 Estimate the value per share, using the Dividend Discount Model.
 Estimate the value per share, using the FCFE Model.
 How would you explain the difference between the two models and which one
would you use as your benchmark for comparison to the market price?

- EPS (1993) = $3.2

- DPS (1993) = $1.7
- Depreciation = $315M
- CAPEX = $475M
- 160 Miliion shares
- P/share = $51
- CAPEX/Depreciation = Constant
- Change WC = 0
- BV of Debt = $1.6 B with constant financing mix
- Steady growth! g = 7%
- Beta = 1.05 , Rf = 6.25% and Risk premium = 5.5%

 Based on the DDM: V = D(0)*(1+g)/(k-g) = 36.2

 We need to translate into per share basis.
i. Net Capex per share = $1.03
ii. FCFE/Share = 3.2-1.03 = $2.17
iii. Based on FCFE : V = $2.17*(1+g)/(k-g) = 46.2
 The diffidence is explained by the fact that the company did not distribute the
entire potential of dividends (as measured by the FCFE).

2. Dionex Corporation, a leader in the development and manufacture of ion chromography

systems (used to identify contaminants in electronic devices), reported earnings per share
 of $2.02 in 1993 and paid no dividends. These earnings are expected to grow 14% a year
for five years (1994 to 1998) and 7% a year after that. The firm reported depreciation of
$2 million in 1993 and capital spending of $4.20 million, and had 7 million shares
outstanding. The working capital is expected to remain at 50% of revenues, which were
$106 million in 1993, and are expected to grow 6% a year from 1994 to 1998 and 4% a
year after that. The firm is expected to finance 10% of its capital expenditures and
working capital needs with debt. Dionex had a beta of 1.20 in 1993, and this beta is
expected to drop to 1.10 after 1998. (The treasury bond rate is 7%)

a. Estimate the expected free cash flow to equity from 1994 to 1998, assuming that
capital expenditures and depreciation grow at the same rate as earnings.
b. Estimate the terminal price per share (at the end of 1998). Stable firms in this
industry have capital expenditures that are 150% of revenues and maintain
working capital at 25% of revenues.
c. Estimate the value per share today, based upon the FCFE model.

• EPS = $2.2 (no dividends)

• g for 5 years = 14% (1994-1998)
• g after 1998 = 7%
• depreciation $2 millions, CAPEX = $4.2 millions (7 million shares)
• WC = 50%Revenues = 0.5*106 millions dollars
• g revenues((1994-1998) = 6% and 4% after
• D/(E+D) = 0.1
• Beta = 1.2 (expected to drop to 1.1 after 1998)
• Rf = 7%

1993 1994 1995 1996 1997 1998 1999

EPS $2,02 $2,30 $2,63 $2,99 $3,41 $3,89 $4,16
CAPEX/Share $0,60 $0,68 $0,78 $0,89 $1,01 $1,16 $0,88
Depreciation/share $0,29 $0,33 $0,37 $0,42 $0,48 $0,55 $0,59
Net Capex/Share $0,31 $0,36 $0,41 $0,47 $0,53 $0,61 $0,29

Revenues/share $15,14 $16,05 $17,01 $18,04 $19,12 $20,26 $21,08

WC $7,57 $8,03 $8,51 $9,02 $9,56 $10,13 $5,27
Change in WC $0,45 $0,48 $0,51 $0,54 $0,57 $(4,86)
D/(D+E) 10,0% 10,0% 10,0% 10,0% 10,0% 10,0% 10,0%
FCFE/Share $1,28 $1,49 $1,73 $2,01 $2,33 $7,75
Beta 120,0% 120,0% 120,0% 120,0% 120,0% 120,0% 110,0%
Market premium 5,5% 5,5% 5,5% 5,5% 5,5% 5,5% 5,5%
Rf 7,0% 7,0% 7,0% 7,0% 7,0% 7,0% 7,0%
COE 13,60% 13,60% 13,60% 13,60% 13,60% 13,60% 13,05%

Terminal Price 128,0452193

PV 1,125301811 1,154609878 1,182325476 1,208556442 1,2334034 59,57902339
Value $65,48

3. Biomet Inc. designs, manufactures and markets reconstructive and trauma devices and
reported earnings per share of $0.56 in 1993, on which it paid no dividends (It had
revenues per share in 1993 of $2.91). It had capital expenditures of $0.13 per share in
1993 and depreciation in the same year of $0.08 per share. The working capital was 60%
of revenues in 1993 and will remain at that level from 1994 to 1998, while earnings and
revenues are expected to grow 17% a year. The earnings growth rate is expected to
decline linearly over the following five years to a rate of 5% in 2003. During the high
growth and transition periods, capital spending and depreciation are expected to grow at
the same rate as earnings, but are expected to offset each other when the firm reaches
steady state. Working capital is expected to drop from 60% of revenues during the 1994-
1998 period to 30% of revenues after 2003. The firm has no debt currently, but plans to
finance 10% of its net capital investment and working capital requirements with debt.

The stock is expected to have a beta of 1.45 for the high growth period (1994- 1998) and
it is expected to decline to 1.10 by the time the firm goes into steady state (in 2003). The
treasury bond rate is 7%.

a. Estimate the value per share, using the FCFE model.

b. Estimate the value per share, assuming that working capital stays at 60% of
revenues forever.
c. Estimate the value per share, assuming that the beta remains unchanged at 1.45
forever.
 1 2 3 4 5 6 7 8 9 10 11
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
EPS 0,56 0,66 0,77 0,90 1,05 1,23 1,41 1,58 1,73 1,86 1,95 2,05
Rev/Share 2,91 3,40 3,98 4,66 5,45 6,38 7,31 8,20 9,01 9,67 10,16 10,67
Growth 17% 17% 17% 17% 17% 17% 15% 12% 10% 7% 5% 5%
CAPEX/Share 0,13 0,15 0,18 0,21 0,24 0,29 0,33 0,37 0,40 0,43 0,45
Dep/Share 0,08 0,09 0,11 0,13 0,16 0,21 0,28 0,38 0,53 0,76 1,11
Net Capex 0,05 0,06 0,07 0,08 0,08 0,08 0,05 (0,01) (0,13) (0,33) (0,66) -
WC 1,75 2,04 2,39 2,80 3,27 3,83 4,39 4,92 5,40 5,80 6,09 3,20
dWC 0,30 0,35 0,41 0,48 0,56 0,56 0,54 0,48 0,40 0,29 (2,89)
D portion 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10% 10%
beta 1,45 1,45 1,45 1,45 1,45 1,45 1,45 1,45 1,45 1,45 1,1 1,1
Rf 7%
Market
premium 5,50%

FCFE 0,33 0,39 0,46 0,55 0,66 0,86 1,11 1,42 1,80 2,28 4,66
COE 14,98% 14,98% 14,98% 14,98% 14,98% 14,98% 14,98% 14,98% 14,98% 13,05% 13,05%
PV 0,29 0,30 0,30 0,31 0,33 0,37 0,42 0,46 0,51 0,67
PV(Terminal) 16,97
Value 20,94