Chapter 16 Edited

CHAPTER 16
Problem 1:
ABV Inc. has earnings before interest and taxes of $250 million, expected to grow 5% a year
forever; the tax rate is 40%. Its cost of capital is 10%, reinvestment rate is 33.33% and it has 200
million shares outstanding. The firm has $500 million in cash and marketable securities, and
$750 million in debt outstanding.
a- Estimate the value of equity per share.

b- How would your answer in a) change if you were told that ABV had options outstanding,
for 50 million shares, and that each option had a value of $5.
c- If you were told that the average exercise price of the 50 million options in the previous
question was $6, estimate the value per share for ABV, using the treasury stock approach.
Solution:
a- Value of operating assets = FCFF1 / (rwacc – g)
= EBIT0(1-t)(1+g)(1-reinvestment rate) / (rwacc – g)
= [250 x 106 x (1-0.4) x 1.05(1-0.3333)] / (0.1 – 0.05)
= $2,000,100,000
Value of equity = Value of operating assets + Cash and marketable securities – Debt outstanding
= $2,000,100,000 + $500,000,000 - $750,000,000
= $1,750,100,000
Value of equity per share = $1,750,100,000 / 200,000,000 = $8.7505
b- Value of equity = Previous value of equity – Value of options outstanding

= $1,750,100,000 - $5 x 50,000,000
= $1,500,100,000
c- Proceeds from exercising the options = $6 x 50,000,000 = $300,000,000

Value of equity per share = (Value of equity + Proceeds from options) / (number of shares
outstanding + number of options outstanding)
= ($1,750,100,000 + $300,000,000) / (200,000,000 + 50,000,000)
= $8.2004
Problem 2:
LSI Logic has 1 billion shares outstanding, trading at $25 per share. The firm also has $5 billion
in debt outstanding. The cost of equity is 12.5% and the cost of debt, after taxes, is 5%. If the
firm has $3 billion in cash outstanding and is fairly valued, estimate how much the firm earned
in operating income in the current year. (The return on capital is 15%, the tax rate is 30% and
earnings are growing 6% a year in perpetuity).
Solution:
Debt to capital ratio = 5 / (5+25)
rwacc = (5/30)*5% + (25/30)*12.5% = 11.25%
Value of equity = Value of operating assets + Cash and cash equivalents – Value of Debt
25 x 109 = [EBIT0(1-t)(1+g)(1-reinvestment rate) / (rwacc-g)] + 3 x 109 – 5 x 109
27 x 109 = EBIT0(1-0.3)(1- 0.06/0.15)(1+0.06) / (0.1125 – 0.06)
EBIT0 = $3,183,962,264
Problem 3:
Lava Lamps Inc. had $800 million in earnings before interest and taxes last year. It has just
acquired a 50% stake in General Lamps Inc., which had $400 million in earnings before interest
and taxes last year. Because Lava Lamps has a majority active stake, it has been asked to
consolidate last year's income statements for the two firms. What earnings before interest and
taxes would you see in the consolidated statement?
Solution:
You would expect to see $1,200 million, which is the sum of the total operating earnings of the
two firms. Consolidation requires that you show 100% of the operating earnings of the
subsidiary.
Problem 4:
Genome Sciences is a biotechnology firm that had after-tax operating income of $300 million
last year; these earnings are expected to grow 6% a year forever, the reinvestment rate is 40%
and the firm has a cost of capital of 12 %. Genome also owns 10% of the stock of Gene
Therapies Inc., another publicly traded firm. Gene Therapies has 100 million shares outstanding,
trading at $50 per share. If Genome has $800 million in debt outstanding, estimate the value of
equity per share in Genome Sciences. (Genome has 50 million shares outstanding).
Solution :
Value of equity = Value of operating assets + Value of cross-holdings – Value of debt

= [EBIT0(1+g)(1-reinvestment rate) / (rwacc-g)] + Cross-holdings – Debt
= [300 x 106 x 1.06(1-.04) / (0.12-0.06)] + 0.1(100 x 106 x 50) – 800 x 106
= $2,880,000,000
Problem 5:
Fedders Asia Closed End fund is a closed-end equity fund that holds Asian securities with a
market value of $1 billion. Over the past 10 years, the fund has earned a return of 9% a year, 3%
less than the return earned by index funds investing in Asia. You expect annual returns in the
future to be similar to those earned in the past, both for your fund and for index funds in general.
a. Assuming no growth in the fund and investment in perpetuity, estimate the discount at which
you would expect the fund to trade.
b. How would your answer change if you expect the fund to be liquidated in 10 years?
Solution:
a- The value of the discount is [(9% - 12%) / 12% ] x 109 = $250,000,000

Therefore, the fund should be traded at $750,000,000.
b- We need to take into account the growth that will occur ten years from now. The fund
should be traded at (1.09 / 1.12)10 x 109 = $762,227,744.5
In other words, the value of the discount is 109 – 762,227,744.5 = $237,772,255.5
Problem 6:
You have been asked to review another analyst's valuation of System Logic Inc., a technology
firm. The analyst estimated a value per share of $11 while the stock was trading at $12.50 per
share. In making this estimate, however, she divided the value of equity by the fully diluted 1.4
million shares outstanding. Reviewing this number, you discover that the firm has only 1 million
shares outstanding and that the remaining 400,000 shares represent options with an average
maturity of three years and an average exercise price of $5.
a. Estimate the correct value per share, using the treasury stock approach.
b. If the standard deviation in the stock price is 80% and the risk free rate is 5%, estimate the
value of the options using an option pricing model (and the current stock price) and the correct
value per share. Assume no tax benefits associated with exercising options.
Solution:
a- $11 = Value of equity / 1,400,000  Value of equity = $15,400,000

Using the treasury stock approach, the price per share is equal to:
Price per share = (Value of equity + Proceeds from exercising the options) / (number of shares
outstanding + number of options outstanding)
= ($15,400,000 + $5 x 400,000) / 1,400,000
= $12.43
b- S = $12.50
σ = 0.80
rf continuous = ln(1+ 5%) = 4.879%
t = 3 years
K = $5
Number of shares outstanding: 1,000,000 shares
Number of options outstanding: 400,000 shares
1st iteration: Adjusted S = S x number of stocks / (number of stocks + number of options)

= 12.50 x 1,000,000 / 1,400,000
= $8.929
d1 = [ln(S/K) + (rf + σ / 2) x t] / (σ√t) = [ln(8.929 / 5) + (0.04879 + 0.82/2) x 3] / (0.8√3)
2
= 1.22
d2 = d1 - σ√t = 1.22 – 0.8√3 = - 0.166
N(d1) = 0.5 + 0.3888 = 0.8888 ; N(d2) = 0.5 – 0.0675 = 0.4325
C = S.N(d1) – K.e- rf x t.N(d2)
C = 8.929 x 0.8888 – 5e – 0.04879 x 3 x 0.4325 = $6.068
Price per share = (value of equity – C x number of options) / (number of shares outstanding)
= (15,400,000 – 6.068 x 400,000) / 1,000,000
= $12.9728
2nd iteration: Adjusted S = (12.9728 x 1,000,000 + 6.068 x 400,000) / 1,400,000 = $11

d1 = [ln(11/5) + 3(0.04879 + 0.82/2)] / (0.8√3) = 1.37
d2 = 1.37 – 0.8√3 = - 0.02
N(d1) = 0.5 +0.4147 = 0.9147 ; N(d2) = 0.5 – 0.008 = 0.492
C = 11 x 0.9147 – 5e – 0.04879 x 3 x 0.492 = $7.937

Price per share = (value of equity – C x number of options) / number of shares outstanding
= (15,400,000 – 7.937 x 400,000) / 1,000,000
= $12.2252
3rd iteration: Adjusted S = (12.2252 x 1,000,000 + 7.937 x 400,000) / 1,400,000 = $11

d1 = [ln(11/5) + 3(0.04879 + 0.82/2)] / (0.8√3) = 1.37
d2 = 1.37 – 0.8√3 = - 0.02
N(d1) = 0.5 +0.4147 = 0.9147 ; N(d2) = 0.5 – 0.008 = 0.492
C = 11 x 0.9147 – 5e – 0.04879 x 3 x 0.492 = $7.937
Price per share = (value of equity – C x number of options) / number of shares outstanding
= (15,400,000 – 7.937 x 400,000) / 1,000,000
= $12.2252
The price per share is $12.2252 and the price of a call option is $7.937.

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CHAPTER 16

a- Estimate the value of equity per share.

a- Value of operating assets = FCFF1 / (rwacc – g)

= EBIT0(1-t)(1+g)(1-reinvestment rate) / (rwacc – g)

= [250 x 106 x (1-0.4) x 1.05(1-0.3333)] / (0.1 – 0.05)

= $2,000,100,000 + $500,000,000 - $750,000,000

Value of equity per share = $1,750,100,000 / 200,000,000 = $8.7505

b- Value of equity = Previous value of equity – Value of options outstanding

c- Proceeds from exercising the options = $6 x 50,000,000 = $300,000,000

Debt to capital ratio = 5 / (5+25)

rwacc = (5/30)*5% + (25/30)*12.5% = 11.25%

25 x 109 = [EBIT0(1-t)(1+g)(1-reinvestment rate) / (rwacc-g)] + 3 x 109 – 5 x 109

27 x 109 = EBIT0(1-0.3)(1- 0.06/0.15)(1+0.06) / (0.1125 – 0.06)

Value of equity = Value of operating assets + Value of cross-holdings – Value of debt

a- The value of the discount is [(9% - 12%) / 12% ] x 109 = $250,000,000

a- $11 = Value of equity / 1,400,000  Value of equity = $15,400,000

1st iteration: Adjusted S = S x number of stocks / (number of stocks + number of options)

C = S.N(d1) – K.e- rf x t.N(d2)

C = 8.929 x 0.8888 – 5e – 0.04879 x 3 x 0.4325 = $6.068

2nd iteration: Adjusted S = (12.9728 x 1,000,000 + 6.068 x 400,000) / 1,400,000 = $11

C = 11 x 0.9147 – 5e – 0.04879 x 3 x 0.492 = $7.937

3rd iteration: Adjusted S = (12.2252 x 1,000,000 + 7.937 x 400,000) / 1,400,000 = $11

C = 11 x 0.9147 – 5e – 0.04879 x 3 x 0.492 = $7.937

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rwacc = (5/30)5% + (25/30)12.5% = 11.25%