CHAPTER 11

CORPORATE VALUATION AND VALUE-BASED MANAGEMENT

(Difficulty: E = Easy, M = Medium, and T = Tough)

True/False

Easy:
(11.1) Corporate valuation model Answer: b Diff: E
1
. The corporate valuation model cannot be used unless a company doesnt
pay dividends.

a. True
b. False

(11.2) Free cash flows and valuation Answer: a Diff: E

2
. Free cash flows should be discounted at the firms weighted average cost
of capital to find the value of its operations.

a. True
b. False

(11.3) Value-based management Answer: b Diff: E

3
. Value-based management focuses on sales growth, profitability, capital
requirements, the weighted average cost of capital, and the dividend
growth rate.

a. True
b. False

(11.5) Corporate governance Answer: b Diff: E

4
. Two important issues in corporate governance are (1) the rules that
cover the boards ability to fire the CEO and (2)the rules that cover
the CEOs ability to remove members of the board.

a. True
b. False

Medium:
(11.3) Return on invested capital and MVA Answer: b Diff: M
5
. If a companys expected return on invested capital is less than its cost
of equity, then the company must also have a negative market value added
(MVA).

a. True
b. False

Chapter 11: Valuation and Value-Based Management Page 1

(11.5) Corporate governance Answer: b Diff: M
6
. A poison pill is also known as a corporate restructuring.

a. True
b. False

(11.5) Stock options Answer: b Diff: M

7
. The CEO of DAmico Motors has been granted some stock options that have
provisions similar to most other executive stock options. If DAmicos
stock underperforms the market, these options will necessarily be
worthless.

a. True
b. False

(11.6) ESOP Answer: a Diff: M

8
. ESOPs were originally designed to help improve worker productivity, but
today they are also used to help prevent hostile takeovers.

a. True
b. False

Multiple Choice: Conceptual

Medium:
(11.2) Corporate valuation model Answer: b Diff: M
9
. Which of the following statements is NOT CORRECT?

a. The corporate valuation model can be used both for companies that pay
dividends and those that do not pay dividends.
b. The corporate valuation model discounts free cash flows by the
required return on equity.
c. The corporate valuation model can be used to find the value of a
division.
d. An important step in applying the corporate valuation model is
forecasting the firms pro forma financial statements.
e. Free cash flows are assumed to grow at a constant rate beyond a
specified date in order to find the horizon, or terminal, value.

(11.3) Value-based management Answer: a Diff: M

10
. Which of the following does NOT always increase a companys market
value?

a. Increasing the expected growth rate of sales.

b. Increasing the expected operating profitability (NOPAT/Sales).
c. Decreasing the capital requirements (Capital/Sales).
d. Decreasing the weighted average cost of capital.
e. Increasing the expected rate of return on invested capital.

Page 2 Chapter 11: Corporate Valuation and Value-Based Management

(11.5) Corporate governance Answer: a Diff: M
11
. Which of the following is NOT normally regarded as being a barrier to
hostile takeovers?

a. Abnormally high executive compensation.

b. Targeted share repurchases.
c. Shareholder rights provisions.
d. Restricted voting rights.
e. Poison pills.

(11.6) ESOP Answer: c Diff: M

12
. Which of the following is NOT normally regarded as being a good reason
to establish an ESOP?

a. To increase worker productivity.

b. To enable the firm to borrow at a below-market interest rate.
c. To make it easier to grant stock options to employees.
d. To help prevent a hostile takeover.
e. To help retain valued employees.

Multiple Choice: Problems

Easy:
(11.2) Corporate valuation model, horizon value Answer: e Diff: E
13
. Akyol Corporation is undergoing a restructuring, and its free cash flows
are expected to be unstable during the next few years. However, FCF is
expected to be $50 million in Year 5, i.e., FCF at t = 5 equals $50
million, and the FCF growth rate is expected to be constant at 6% beyond
that point. If the weighted average cost of capital is 12%, what is the
horizon value (in millions) at t = 5?

a. $719
b. $757
c. $797
d. $839
e. $883

(11.2) Corporate valuation model, horizon value Answer: a Diff: E

14
. Simonyan Inc. forecasts a free cash flow of $40 million in Year 3, i.e.,
at t = 3, and it expects FCF to grow at a constant rate of 5%
thereafter. If the weighted average cost of capital is 10% and the cost
of equity is 15%, what is the horizon value, in millions at t = 3?

a. $840
b. $882
c. $926
d. $972
e. $1,021

Chapter 15: Valuation, Governance Conceptual Questions Page 3

(11.2) Corporate valuation model, value of operations Answer: c Diff: E
15
. Suppose Yon Sun Corporations free cash flow during the just-ended year
(t = 0) was $100 million, and FCF is expected to grow at a constant rate
of 5% in the future. If the weighted average cost of capital is 15%,
what is the firms value of operations, in millions?

a. $948
b. $998
c. $1,050
d. $1,103
e. $1,158

(11.2) Corporate valuation model, value of operations Answer: d Diff: E

16
. Suppose Leonard, Nixon, & Shull Corporations projected free cash flow
for next year is $100,000, and FCF is expected to grow at a constant
rate of 6%. If the companys weighted average cost of capital is 11%,
what is the value of its operations?

a. $1,714,750
b. $1,805,000
c. $1,900,000
d. $2,000,000
e. $2,100,000

Medium:
(11.2) Corporate valuation model, value of operations Answer: b Diff: M
17
. Zhdanov Inc. forecasts that its free cash flow in the coming year, i.e.,
at t = 1, will be -$10 million, but its FCF at t = 2 will be $20
million. After Year 2, FCF is expected to grow at a constant rate of 4%
forever. If the weighted average cost of capital is 14%, what is the
firms value of operations, in millions?

a. $158
b. $167
c. $175
d. $184
e. $193

(11.2) Corporate valuation model, value of operations Answer: a Diff: M

18
. Leak Inc. forecasts the free cash flows (in millions) shown below. If
the weighted average cost of capital is 11% and FCF is expected to grow
at a rate of 5% after Year 2, what is the Year 0 value of operations, in
millions? Assume that the ROIC is expected to remain constant in Year 2
and beyond (and do not make any half-year adjustments).

Year: 1 2
Free cash flow: -$50 $100

a. $1,456
b. $1,529
c. $1,606
d. $1,686
e. $1,770

Page 4 Chapter 11: Corporate Valuation and Value-Based Management

(11.2) Corporate valuation model, value of operations Answer: e Diff: M
19
. A company forecasts the free cash flows (in millions) shown below. The
weighted average cost of capital is 13%, and the FCFs are expected to
continue growing at a 5% rate after Year 3. Assuming that the ROIC is
expected to remain constant in Year 3 and beyond, what is the Year 0
value of operations, in millions?

Year: 1 2 3
Free cash flow: -$15 $10 $40

a. $315
b. $331
c. $348
d. $367
e. $386

(11.2) Corporate valuation model, value of equity Answer: d Diff: M

20
. Based on the corporate valuation model, Bernile Inc.s value of
operations is $750 million. Its balance sheet shows $50 million of
short-term investments that are unrelated to operations, $100 million of
accounts payable, $100 million of notes payable, $200 million of long-
term debt, $40 million of common stock (par plus paid-in-capital), and
$160 million of retained earnings. What is the best estimate for the
firms value of equity, in millions?

a. $429
b. $451
c. $475
d. $500
e. $525

(11.2) Corporate valuation model, P0 Answer: b Diff: M

21
. Based on the corporate valuation model, the value of a companys
operations is $1,200 million. The companys balance sheet shows $80
million in accounts receivable, $60 million in inventory, and $100
million in short-term investments that are unrelated to operations. The
balance sheet also shows $90 million in accounts payable, $120 million
in notes payable, $300 million in long-term debt, $50 million in
preferred stock, $180 million in retained earnings, and $800 million in
total common equity. If the company has 30 million shares of stock
outstanding, what is the best estimate of the stocks price per share?

a. $24.90
b. $27.67
c. $30.43
d. $33.48
e. $36.82

Chapter 11: Corporate Valuation and Value-Based Management Page 5

(11.2) Corporate valuation model, P0 Answer: c Diff: M
22
. Based on the corporate valuation model, the value of a companys
operations is $900 million. Its balance sheet shows $70 million in
accounts receivable, $50 million in inventory, $30 million in short-term
investments that are unrelated to operations, $20 million in accounts
payable, $110 million in notes payable, $90 million in long-term debt,
$20 million in preferred stock, $140 million in retained earnings, and
$280 million in total common equity. If the company has 25 million
shares of stock outstanding, what is the best estimate of the stocks
price per share?

a. $23.00
b. $25.56
c. $28.40
d. $31.24
e. $34.36

(11.2) Corporate valuation model, P0 Answer: d Diff: M

23
. Based on the corporate valuation model, Hunsaders value of operations
is $300 million. The balance sheet shows $20 million of short-term
investments that are unrelated to operations, $50 million of accounts
payable, $90 million of notes payable, $30 million of long-term debt,
$40 million of preferred stock, and $100 million of common equity. The
company has 10 million shares of stock outstanding. What is the best
estimate of the stocks price per share?

a. $13.72
b. $14.44
c. $15.20
d. $16.00
e. $16.80

Tough:
(11.2) Corporate valuation model, value of operations Answer: b Diff: T
24
. Vasudevan Inc. forecasts the free cash flows (in millions) shown below.
If the weighted average cost of capital is 13% and the free cash flows
are expected to continue growing at the same rate after Year 3 as from
Year 2 to Year 3, what is the Year 0 value of operations, in millions?

Year: 1 2 3
Free cash flow: -$20 $42 $45

a. $586
b. $617
c. $648
d. $680
e. $714

Page 6 Chapter 11: Corporate Valuation and Value-Based Management

 CHAPTER 11
ANSWERS AND SOLUTIONS

Chapter 11: Corporate Valuation and Value-Based Management Page 7

1. (11.1) Corporate valuation model Answer: b Diff: E

2. (11.2) Free cash flows and valuation Answer: a Diff: E

3. (11.3) Value-based management Answer: b Diff: E

4. (11.5) Corporate governance Answer: b Diff: E

5. (11.3) Return on invested capital and MVA Answer: b Diff: M

6. (11.5) Corporate governance Answer: b Diff: M

7. (11.5) Stock options Answer: b Diff: M

8. (11.6) ESOP Answer: a Diff: M

9. (11.2) Corporate valuation model Answer: b Diff: M

10. (11.3) Value-based management Answer: a Diff: M

Statement a is correct, because investors recognize that companies sometimes try to grow too fast, at the expense
of maintaining profit margins.

11. (11.5) Corporate governance Answer: a Diff: M

12. (11.6) ESOP Answer: c Diff: M

Statement c is the correct answer, because firms can easily grant stock options to employees without an ESOP.

13. (11.2) Corporate valuation model, horizon value Answer: e Diff: E

FCF5: $50
g: 6%
WACC: 12%

HV5 = FCF6/(WACC g) = FCF5(1 + g)/(WACC g)

= $50(1 + 0.06)/(0.12 0.06) = $53/0.06 = $883

14. (11.2) Corporate valuation model, horizon value Answer: a Diff: E

FCF3: $40
g: 5%
WACC: 10%

HV3 = FCF4/(WACC g) = FCF3(1 + g)/(WACC g)

= $40(1 + 0.05)/(0.10 0.05) = $42/0.05 = $840

15. (11.2) Corporate valuation model, value of operations Answer: c Diff: E

FCF0: $100
g: 5%
WACC: 15%

Value Ops = FCF1/(WACC g) = FCF0(1 + g)/(WACC g)

= $100(1 + 0.05)/(0.15 0.05) = $105/0.1 = $1,050

16. (11.2) Corporate valuation model, value of operations Answer: d Diff: E

FCF1: $100,000
 g: 6%
WACC: 11%

Value Ops = FCF1/(WACC g) = FCF0(1 + g)/(WACC g)

= $100,000/(0.11 0.06) = $100,000/0.05 = $2,000,000

17. (11.2) Corporate valuation model, value of operations Answer: b Diff: M

FCF1: -$10
FCF2: $20
g: 4%
WACC: 14%

First, find the horizon, or terminal, value:

HV2 = FCF2(1 + g)/(WACC g) = $20(1.04)/(0.14 0.04) = $20.8/0.10 = $208.00

Then find the PV of the free cash flows and the horizon value:
Value of operations = -$10/(1.14)1 + ($20 + $208)/(1.14)2
= -$8.772 + $175.439 = $167

18. (11.2) Corporate valuation model, value of operations Answer: a Diff: M

FCF1: -$50
FCF2: $100
g: 5%
WACC: 11%

First, find the horizon, or terminal, value:

HV2 = FCF2(1 + g)/(WACC g) = $100(1.05)/(0.11 0.05) = $1,750.00

Then find the PV of the free cash flows and the horizon value:
Value of operations = -$50/(1.11) + ($100 + $1,750)/(1.11)2 = $1,456

19. (11.2) Corporate valuation model, value of operations Answer: e Diff: M

Year: 1 2 3
FCF: -$15 $10 $40

g: 5%
WACC: 13%

First, find the horizon, or terminal, value:

HV4 = FCF3(1 + g)/(WACC g) = $40(1.05)/(0.13 0.05) = $525

Then find the PV of the free cash flows and the horizon value:
Value of operations = -$15/(1.13) + $10/(1.13)2 + ($40 + $525)/(1.13)3 = $386

20. (11.2) Corporate valuation model, value of equity Answer: d Diff: M

Value of operations: $750

Short-term investments: $50
Notes payable: $100
Long-term debt: $200

Assuming that the book value of debt is close to its market value, the total market value of the company is:
Total Value of Value of
market value = operations + non -operating assets
= $750 + $50 = $800.
 Value of Equity = Total MV Long- and Short-term debt = $500.

The book value of equity figures are irrelevant for this problem. Also, the accounts payable are not relevant
because they were netted out when the FCF was calculated.

21. (11.2) Corporate valuation model, P0 Answer: b Diff: M

Value of operations: $1,200

Short-term investments: $100
Notes payable: $120
Long-term debt: $300
Preferred stock $50
Shares outstanding: 30

Assuming that the book value of debt is close to its market value, the total market value of the company is:
Total Value of Value of
market value = operations + non -operating assets
= $1,200 + $100 = $1,300.

Value of Equity = Total MV Long- and Short-term debt and preferred = $830
Stock price = Value of Equity/Shares outstanding = $27.67

The book value of equity figures are irrelevant for this problem. Also, the working capital account numbers are not
relevant because they were netted out when the FCF was calculated.

22. (11.2) Corporate valuation model, P0 Answer: c Diff: M

Value of operations: $900

Short-term investments: $30
Notes payable: $110
Long-term debt: $90
Preferred stock $20
Shares outstanding: 25

Assuming that the book value of debt is close to its market value, the total market value of the company is:
Total Value of Value of
market value = operations + non -operating assets
= $900 + $30 = $930.

Value of Equity = Total MV Long- and Short-term debt and preferred = $710
Stock price = Value of Equity/Shares outstanding = $28.40

The book value of equity figures are irrelevant for this problem. Also, the working capital account numbers are not
relevant because they were netted out when the FCF was calculated.

23. (11.2) Corporate valuation model, P0 Answer: d Diff: M

Value of operations: $300

Short-term investments: $20
Notes payable: $90
Long-term debt: $30
Preferred stock $40
Shares outstanding: 10

Assuming that the book value of debt is close to its market value, the total market value of the company is:
 Total Value of Value of
market value = operations + non -operating assets
= $300 + $20 = $320.

Value of Equity = Total MV Long- and Short-term debt and preferred = $160
Stock price = Value of Equity/Shares outstanding = $16.00

The book value of equity figures are irrelevant for this problem. Also, the working capital account numbers are not
relevant because they were netted out when the FCF was calculated.

24. (11.2) Corporate valuation model, value of operations Answer: b Diff: T

Year: 1 2 3
Free cash flow: -$20 $42 $45

WACC: 13%
First, find the growth rate: g = $45/$42 1.0 = 7.14%

Second, find the horizon, or terminal, value, at Year 2

HV2 = FCF3/(WACC g) = $45/(0.13 0.0714) = $768

Now find the PV of the FCFs and the horizon value:

Value of operations = -$20/(1.13) + ($42 + $768)/(1.13)2 = $617