1. Suppose that Boston Scientific is considering making an investment of $500 million in a new stent production technology. The Net Present Value of the project is very positive and the Internal Rate of Return on the project is 250%. The Company's WACC is 15%. The Board is very impressed with the 250% IRR. Based on these numbers, should the project be accepted? Is the 250% IRR a good measure of the project's annual percentage rate of return? If not, describe an improved method for measuring the annual rate of return and note why it is an improvement.
2. Assume that Thompson, Inc. generated free cash flow of $1,000 last year. Thomson's weighted average cost of capital is 11%. Estimate the value of Thomson's equity under the following growth rate of free cash flow assumptions.
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Year 1
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25%
|
|
Year 2
|
20%
|
|
After Year 2 through Year 10
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Declining linearly from 20% to 5%
|
|
Beyond Year 10
|
Continuing at 5% per year indefinitely
|
|
Value of Debt
|
$10,000
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3. Now we will explore seven changes. There are three multiple-choice questions for each of the following changes (each considered independently, holding everything else constant). Choose the effect of the change on this year's NOPAT (first question), Investment (second question), and Free Cash Flow (third question).
1) A decrease in the operating profit margin.Choose the effect on this year's NOPAT.
Increase
Decrease
No Effect
1) A decrease in the operating profit margin.
Choose the effect on this year's Net Operating Capital.
Increase
Decrease
No Effect
1) A decrease in the operating profit margin.
Choose the effect on this year's Free Cash Flow.
No Effect
Increase
Decrease
Question 6
2) An increase in Beta.
Choose the effect on this year's NOPAT.
Increase
Decrease
No Effect
Question 7
2) An increase in Beta.
Choose the effect on this year's Net Operating Capital.
Increase
Decrease
No Effect
Question 8
2) An increase in Beta.
Choose the effect on this year's Free Cash Flow.
Increase
No Effect
Decrease
Question 9
An increase in accounts receivable.
Choose the effect on this year's NOPAT.
Increase
No Effect
Decrease
Question 10
3) An increase in accounts receivable.
Choose the effect on this year's Net Operating Capital.
Increase
No Effect
Decrease
Question 11
3) An increase in accounts receivable.
Choose the effect on this year's Free Cash Flow.
No Effect
Increase
Decrease
Question 12
4) A decrease in plant and equipment (No depreciation impact).
Choose the effect on this year's NOPAT.
Decrease
No Effect
Increase
Question 13
4) A decrease in plant and equipment (No depreciation impact).
Choose the effect on this year's Net Operating Capital.
Decrease
No Effect
Increase
Question 14
4) A decrease in plant and equipment (No depreciation impact).
Choose the effect on this year's Free Cash Flow.
No Effect
Increase
Decrease
Question 15
5) An increase in revenue growth without any increase in assets.
Choose the effect on this year's NOPAT.
Increase
Decrease
No Effect
Question 16
5) An increase in revenue growth without any increase in assets.
Choose the effect on this year's Net Operating Capital.
Increase
Decrease
No Effect
Question 17
5) An increase in revenue growth without any increase in assets.
Choose the effect on this year's Free Cash Flow.
No Effect
Increase
Decrease
Question 18
6) A decrease in accounts payable.
Choose the effect on this year's NOPAT.
No Effect
Increase
Decrease
Question 19
6) A decrease in accounts payable.
Choose the effect on this year's Net Operating Capital.
No Effect
Increase
Decrease
Question 20
6) A decrease in accounts payable.
Choose the effect on this year's Free Cash Flow.
No Effect
Decrease
Increase
Question 21
7) An increase in the tax rate.
Choose the effect on this year's NOPAT.
Decrease
Increase
No Effect
Question 22
7) An increase in the tax rate.
Choose the effect on this year's Net Operating Capital.
No Effect
Increase
Decrease
Question 23
7) An increase in the tax rate.
Choose the effect on this year's Free Cash Flow.
No Effect
Increase
Decrease
24. Suppose that Proctor and Gamble is considering instituting a bonus system for all of its business units. The bonus calculation will be based on growth in revenue and growth in operating profit. Critique this bonus system and identify a problem that might arise. Suggest a performance target, other than growth in revenue and growth in operating profit, that might alleviate this problem. Explain.
Suppose Apple has excess cash invested in US Treasury Bonds earning 3%. They are considering acquiring a web-based telecommunications company, which is similar to Apple's existing business, for $20 billion. Apple's WACC is 12%. What is the appropriate discount rate to use in evaluating the acquisition? Explain clearly and concisely why this is the appropriate discount rate.
Consider the data in Exhibit 8 of the Pepsico, Inc.: Cost of Capital case and the following information. Assume a risk-free rate of 8.3%, a market risk premium of 7.2%, and a tax rate of 38%. Use total debt to measure debt and market value of equity to measure equity.
Part A
Use the pure-play method (including adjusting for financial risk), to estimate an adjusted weighted average cost of capital for the snack foods segment. Use Goodmark Foods as the pure-play company for snack foods.
Part B
Why is it important for Pepsi to estimate an adjusted cost of capital for each segment?
Use the information in Question 28 to answer Questions 29-32.
Exhibit 10.0 below presents a recent discounted cash flow valuation of State Street contained in an analyst's report prepared by Atlantic Equities, LLP. Review the analysis and answer the following questions. Note that in this valuation, interest expense is deducted in determining free cash flow; hence the free cash flow is to equity and is discounted at the cost of equity to arrive at the estimated value of equity. Assume the value of State Street's debt is $20 billion.
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Assumptions
|
|
|
|
Risk-free rate
|
4.36% 10-year Treasury
|
|
Equity risk premium
|
4.50% Historical equity risk premium
|
|
Beta
|
1.15 Adjusted daily beta
|
|
Cost of equity
|
9.54%
|
|
|
Revenue growth 06 to 08
|
12.50%
|
|
|
Revenue growth 09 to 14
|
6.50%
|
|
|
Terminal growth rate
|
5.5% GDP
|
|
|
Margin-stable @30% going forward
|
|
Estimate of 35% of cash flow to be reinvested
|
|
($MM)
|
2004
|
2005
|
2006
|
2007
|
2008
|
2009
|
2010
|
2011
|
2012
|
2013
|
2014
|
Terminal
|
|
Year
|
0
|
1
|
2
|
3
|
4
|
5
|
6
|
7
|
8
|
9
|
10
|
10
|
|
Revenues
|
5,153
|
5,721
|
6,436
|
7,240
|
8,145
|
8,675
|
9,238
|
9,839
|
10,479
|
11,160
|
11,885
|
310,748
|
|
Margin
|
28.55%
|
30.63%
|
30.00%
|
30.00%
|
30.00%
|
30.00%
|
30.00%
|
30.00%
|
30.00%
|
30.00%
|
30.00%
|
30.00%
|
|
Pre-tax income
|
1,471
|
1,752
|
1,931
|
2,172
|
2,444
|
2,602
|
2,772
|
2,952
|
3,144
|
3,348
|
3,566
|
93,224
|
|
Tax rate
|
33.20%
|
34.00%
|
34.00%
|
34.00%
|
34.00%
|
34.00%
|
34.00%
|
34.00%
|
34.00%
|
34.00%
|
34.00%
|
34.00%
|
|
After-tax income
|
983
|
1,157
|
1,274
|
1,434
|
1,613
|
1,718
|
1,829
|
1,948
|
2,075
|
2,210
|
2,353
|
61,528
|
|
Maintenance capital
|
344
|
405
|
446
|
502
|
564
|
601
|
640
|
682
|
726
|
773
|
824
|
21,535
|
|
Free cash flow
|
639
|
752
|
828
|
932
|
1,048
|
1,116
|
1,189
|
1,266
|
1,349
|
1,436
|
1,530
|
39,993
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
2004 DCF
|
$23,504
|
|
|
|
|
|
|
|
|
|
|
|
|
Shares outstanding
|
344
|
|
|
|
|
|
|
|
|
|
|
|
|
Near-term value
|
$68.25
|
|
|
|
|
|
|
|
|
|
|
|
29. Part A: Use the data provided to estimate the cost of equity for State Street. Do you agree with the 9.54% figure?
30. Part B: Estimate the terminal value at the end of year 10. Do you agree with the $39,993 figure?
31. Part C: Suppose that it is now the end of 2004 and that State Street generated $639 million of free cash flow in 2004. You expect free cash flow to grow at a constant annual rate of 5%. The discount rate is 9.54%. Estimate the value per share of State Street's equity with these assumptions.
32. Part D: Suppose that it is now the end of 2004 and that State Street generated $639 million of free cash flow in 2004. You expect free cash flow growth to decline from 15% to 4% over the next fifteen years, after which it will remain at 4%. The discount rate is 9.54%. Estimate the total value of State Street's assets with these assumptions.