Fin 3321 (Moore-1)Fourth ExaminationSummer 2014

Exam 4 (Final Examination Period)

Finance 3321 (Moore) – Spring 2014

Exam Number: ______Name:______

Ethical conduct is an important component of any profession. The Texas Tech University Code of Student Conduct is in force during this exam. Students providing or accepting unauthorized assistance will be assigned a score of zero (0) for this piece of assessment. Using unauthorized materials during the exam will result in the same penalty. Ours’ should be a self-monitoring profession. It is the obligation of all students to report violations of the honor code in this course. By signing below, you are acknowledging that you have read the above statement and agree to abide by the stipulated terms.

Student’s Signature:______

Do not open this exam booklet until you are instructed to do so.

You must close the exam booklet when the end of the exam has been announced. Failure to do so WILL result in a grade of zero (0) on this exam.

PossibleEarned

Multiple Choice:21______

Short Problem 1: 9______

Short Problem 2:10______

Discounted Dividends Valuation: 20______

Free Cash Flow Valuation: 20______

Residual Income Valuation: 20______

Total Exam Points Earned______

Multiple Choice Questions: (3.0 Points Each)Total for Section = 21 Points

Clearly Circle the BEST response for each of the following questions:

1.Residual Income valuation models require which of the following discount factors?

a.WACC and the free cash flow growth rate

b.Cost of Debt and Cost of Equity

c.Cost of Debt and the dividend growth rate

d.Cost of Equity and negative terminal value growth rates

e.Cost of Equity and positive terminal value growth rates

2.Assume a firm will pay its first dividend in 2 years. This initial period’s dividend is forecast to be $3.00 per share and is expected to grow at 6% per year in perpetuity. Assume WACC = 12%; the cost of equity is 14%; the cost of debt is 8% and the risk-free rate is 5%. The best estimate the today’s share value using the discounted dividends method is:

a.$18.80

b.$21.42

c.$28.86

d.$32.89

e.$37.50

3.The main benefit of the residual income valuation model (as compared to free cash flows and discounted dividends) is that:

a.Dividend payments are too variable compared with price variability

b.The implied investment horizon to recover value is unrealistically short.

c.The price variability explained by residual income variability is relatively small.

d.The valuation is not as sensitive to terminal value growth rates as compared to free cash flow and dividend valuation models.

e.Residual income is easier to predict than the other measures.

4.Assume a firm’s revenues and net income are projected to grow by 10% per year into the foreseeable future. What terminal value growth rate is most appropriate for the free cash flow valuation model when WACC is 11%?

  1. -40%
  2. -10%
  3. 0%
  4. 5%
  5. 15%

5.Assume a firm’s revenues and net income are projected to grow by 10% per year into the foreseeable future. What terminal value growth rate is most appropriate for the Residual Income valuation model?

  1. -30%
  2. 0%
  3. 5%
  4. 15%
  5. 40%

6.Consider the Residual Income Valuation model and the sensitivity analysis you performed on your projects by varying the cost of equity and the terminal value perpetuity growth rates. Suppose you were looking at the valuations of XYZ company in a sensitivity analysis table and find the price at the 15% Ke line to be $23.50 per share when a -10% terminal value growth rate is use but $29.00 per share when you move to a -40% terminal value growth rate for the same cost of equity. Which one of the following must be true?

  1. The terminal value perpetuity begins as a negative value
  2. The terminal value perpetuity begins as a positive value
  3. The terminal value perpetuity begins at zero
  4. Year by Year residual income is increasing
  5. Year by Year residual income is decreasing

7.Why must terminal value perpetuities for the residual income models have negative growth rates?

  1. You must have positive residual income.
  2. You must always outperform your cost of capital in the perpetuity
  3. You must always underperform your cost of capital in the perpetuity
  4. Negative growth rates ensure you return to the equilibrium cost of capital, eventually.
  5. Positive growth rates always cause Residual Income or AEG to become more positive.

Question 1: (9 Points)

Rank-order the intrinsic valuation models we have covered in class (and briefly explain) in terms of:

1)Reliability (or confidence) of forecast inputs

2)The statistical explanatory power of each model in terms of its ability to explain variability of observed stock prices.

3)The sensitivity of each model to errors in growth rates or cost of capital estimates

4)The inherent compatibility of each model in helping to explain or understand the strategy and structure of the firm being valued.

Question 2: (10 Points)

Moore’s Consulting and Crawfish Shack has a before tax WACC of 14% and an After-tax WACC of 10%. A professional business valuation firm valued this business at $2,800,000. The cash flows to the firm’s assets were assumed to be a constant perpetuity on a going-forward basis and tax laws were assumed not to change.

Compute the annual before-tax and after-tax cash flows that were used in this valuation.

Page 1 of 5