Question

• Develop a 1 page summary note sheet ( 1⁄2 page of concepts and 1⁄2 page of equations) for the following topics based upon the exam study guide concepts:

  o Chp 3: DuPont Identity, External Funds Forecasting & Sustainable growtho Chp 9 & 13: Stock and Firm Valuation
  o Chp 13: Cost of Capital – revise as needed to suit your own learning.

• Develop a 1 page summary of the three note sheets you’ve developed.

  For an abbreviated example of the structure of the topic summaries, see the example for COC in the announcement area. Note that it is not necessarily complete. You will need to adapt as necessary. For example, you may choose to identify specific HW problems that help you remember the concepts.

  Once you create the three 1 page summaries, the next step is to translate these into a 1 page summary of all three. This final 1 page summary is what you may bring into Exam 2.

  Part 2 (3 pts)

  PixNet expects sales revenues of $145 million in the next year (T1). The WACC is 8%. Operating expenses, not including depreciation, are estimated at 77% of sales while depreciation averages 7% of sales. These relationships are expected to hold indefinitely.
  The CFO has noted that PixNet plans on immediately investing $11 million in expanding overseas and will require additional working capital of $7 million to support sales the new sales growth. Both investments are expected to occur immediately. Because PixNet believes it mature, it expects its free cash flow to the firm to grow at a constant 4% rate in perpetuity. PixNet has a tax rate of 35%. PixNet currently holds $11.75 million of non- operating marketable securities in excess of its normal operating needs. Its long term debt is $25 million. PixNet has 50,000 shares of stock outstanding. PixNet has never paid a dividend and does not expect to pay one in the future.

  Questions:

  • Estimate the total firm value of PixNet. Show all steps.

  • Estimate the value per share of PixNet’s stock. Show all steps.

  • Make assumptions as needed to answer the question and get points. If you do so, write them

    down and why you made them.
    You may set this up in Excel and print out your solution to hand in.

Answer 1

DuPont Identity

At the outset stating the DuPont equation,

Return on equity=Profit margin*Total Asset TurnOver*Equity Multiplier (Or Financial Leverage)

ie. ROE=PM*ATO*EM

ie. Net Income/Total equity=(Net Income/Sales)*(Sales/Total Assets)*(Total Assets/Total Equity)

From the baove ,it can be noted that --

Return to Total equity can be split & analysed for causes ledaing to variations in the ratio --as where excatly the firm has performed well or otherwise

ie. Whether profit margin has increased or decreased?

or, asset utilistion--$ sales generated per $ of total asset employed has improved or deteriorated ?

or, the % age of funding of total assets by debt or equity--the former will lead to more interest expenses /the latter will deny the firm tax davantages of interest expenses.

Thus, DuPont's equation helps to fix the exact cause behind a good/bad ROE.

External Funds Forecasting

When growth in sales is expected, the firms do an external funds needed forecasting

Formula for EFN= Required Increase in assets-Spontaneous increase in Liabilities-Increase in Retained Earnings

ie.

When the firm is operating at full or 100% capacity, it may need to buy additional fixed & current assets to support the increased production due to increase in sales.These assets increase in direct proportion to sales.

The above increase is partly met by

increase in current /spontaneous liabilities(for purchase of current assets like merchandise inventory)--that also increases in direct proportion.

&

increase in Retained earnings due to the increased sales,ie. New Sales*Profit Margin*(1-Div.Payout)

Sustainable growth(SGR)

SGR=ROE*RR

ie. SGR is the growth rate which the firm can achieve with its own internally generated funds, ie Net after-tax income generated , that is retained in the business, after distribution of dividends.

ROE=Net Income/Total Equity   &

RR=Retention ratio=(1-Dividend pay-out ratio),ie. 1-(Dividends/Net Income), which gives the proportion of net income , that is retained in the business, for internal growth & use.

This metric helps to know the requirement for outside debt.

Cost of Capital:

As we saw in the above example, Cost of capital is the weighted average cost of different funds available to the firm --which is used in discounting of cash flows expected when new projects /investments are made.

This is to ensure if the investment will at least earn the cost of the funds that are going to be employed ,in the said project/investment.

This is sometimes, the opportunity cost of the funds , meant to be deployed in some other income-earning proposition also.

Valuation of firm/stock

Value of any investment is the Present value of its future cash flows .

As in the example, a firm's future cash flows are discounted at the cost of capital/required return , to get the present value or value of the firm --from which PV of debt funds are subtracted to know the PV /Value of the firm's equity

This is the value to the firm , the potential investor attaches .

From this, price/share can be found out, given the no.of common shares o/s.

This way, the investor, discounts either the dividends or the FCFs, at his own required rate of return.

2…	Yr.1
Sales	145
Opg. Exp.(Sales*77%)	-111.65
Depn.(Sales*7%)	-10.15
EBIT	23.2
Less: Tax at 35%	-8.12
EAT	15.08
Add back: Depn.	10.15
OCF	25.23
NWC reqd.	-7
CAPEX	-11
FCF1=	7.23
PV of perpetual FCFs	FCF1/(Reqd. return-Growth rate)

We need to know the investor's reqd. return for this investment
to know the Present value of the future FCFs
Now, if we construct the PixNet's balance sheet with the above forecasts,
Liabilities		Assets
LT debt	25	OCF	25.23
Equity (Bal.fig.)	29.98	NWC	7
		CAPEX	11
		Non-opg. Mkt.sec.	11.75
Total	54.98	Total	54.98
The proportion of LT debt & equity ,in the above Balance Sheet are
LT debt=25/54.98=45.47%
Equity=29.98/54.98=54.53%
Now, if we further suppose the after-tax cost of debt to be 4% & cost of equity to be 10%,
then the reqd. return for PixNet will be the WACC, ie.
(45.47%*4%)+(54.53%*10%)=
7.27%
This WACC 7.27% that is the reqd. return , with which to dsicount the above perpetual FCFs
So, Value of firm=
PV of perpetual FCFs	7.23/(7.27%-4%)=
	221.10
Less:Value of Debt	25
Value of equity	196.10
No.of common shares o/s(in mlns.)	5
Value/share	39.22
NOTE:
Assumptions made
1.After-tax cost of debt=4%
2.Cost of Equity= 10%
3. No.of common shares o/s- 5 millions (instead of 50000 given)