# Finance-RSM 333 (2015) – ASSIGNMENT #2

Question

RSM 333 (2015) – ASSIGNMENT #2

Due Monday, August 10th, 2015 (4:00pm) at the Rotman Commerce Office

Please submit a cover page. You will find the template on the course portal.

The total available marks is 100. (Please show your work in detail.)

Problem 1 – Cost of Capital (40 Marks)

Please select from the list of companies below to complete this problem. In addition to the company’s investor

relations webpage you may use other finance-related resources (e.g. Yahoo! Finance).

GROUP A COMPANIES (Consumer Goods – Textile – Apparel Clothing)

Columbia Sportswear Company (COLM)

o

Ralph Lauren Corporation (RL)

o

http://investor.columbia.com/financials.cfm

http://investor.ralphlauren.com/phoenix.zhtml?c=65933&p=irol-irhome

Michael Kors Holdings Limited (KORS)

o

http://investors.michaelkors.com/corporate-overview/default.aspx

GROUP B COMPANIES (Consumer Goods – Toys & Games and Entertainment – Diversified)

Mattel Inc. (MAT)

o

Hasbro Inc. (HAS)

o

http://investor.shareholder.com/mattel/index.cfm

http://investor.hasbro.com/index.cfm

The Walt Disney Company (DIS)

o

http://thewaltdisneycompany.com/investors

Optional: You may refer to a past winning CFA Investment Research Challenge report for ideas.

http://www.cfainstitute.org/community/challenge/about/Pages/past_champions.aspx

Page 1 of 6

RSM 333 (2015) – ASSIGNMENT #2

Due Monday, August 10th, 2015 (4:00pm) at the Rotman Commerce Office

Complete this problem twice by choosing 2 companies (i.e. 1 from Group A and 1 from Group B).

You work in the corporate finance and treasury department and have just been assigned to the team estimating

the company’s WACC. You must estimate this WACC in preparation for a team meeting later today. You quickly

realize that the information you need is readily available online.

1. Go to the Yahoo! Finance website, http://finance.yahoo.com/ . Under "Market Data," you will find the

yield to maturity for 10-year treasury bonds. Collect this number as your risk-free rate.

2. In the box, "Quote Lookup", type in the company’s ticker symbol and press enter. Once you see the basic

information, find and click on "Key Statistics". From the key statistics, collect the information for the

company’s market capitalization (its market value of equity), enterprise value (market-value equity + net

debt) (note: enterprise value is the total market value of a firm’s equity and debt, less the value of its cash

and marketable securities), cash and beta.

3. To get the cost of debt, you will need the yield to maturity on the firm’s existing long-term bonds. Go to

the Financial Industry Regulatory Authority’s website, www.finra.org , click on "Investors" and then, under

"Market Data Center," click on "Bonds." Under "Search," click on "Corporate" and type in the ticker

symbol. A list of the company’s outstanding bond issues will appear. Find the yield to maturity for your

chosen bond issue (i.e. close to 10 years from maturity) (it is in the column titled "Yield") and use this as

your pre-tax cost of debt. (Note: If this information is not available or hard to obtain with FINRA then use

as a reference, comparable companies with similar credit ratings.)

4. Compute the weights for equity and debt based on the market value of equity and market value of debt.

5. Calculate the company’s cost of equity capital using the CAPM, the risk-free rate you collected, and a

market risk premium of 5%. If the company has preferred shares, you will need to consider cost of

preferred shares.

6. Assume that the company has a tax rate of 35%, calculate the effective (after-tax) cost of debt capital.

7. Calculate the company’s WACC using the market value of equity and debt.

8. Calculate the company’s net debt by subtracting its cash (collected in step 2) from its debt. Recalculate

the weights for the WACC using the market value of equity, net debt, and enterprise value (note:

enterprise value is the total market value of a firm’s equity and debt, less the value of its cash and

marketable securities). Recalculate the company’s WACC using the weights based on the net debt. How

much does it change?

9. How confident are you of your estimates in steps 7 and 8? Which implicit assumptions did you make

during your data collection efforts?

Page 2 of 6

RSM 333 (2015) – ASSIGNMENT #2

Due Monday, August 10th, 2015 (4:00pm) at the Rotman Commerce Office

Problem 2 – Capital Structure and Dividend Irrelevance (20 Marks)

ABC Inc. is an all-equity firm with no debt that is exempt from paying any taxes. The firm has CAD$100 thousand

of assets (e.g. cash). It also expects to generate additional free cash flow of CAD$50 thousand per year into

perpetuity starting from next year (assume that the investment has already been made and accounted for in the

value of existing assets). The cost of assets of ABC (cost of equity of the unlevered firm) is 10% and there are 20

thousand shares outstanding. The Board of Directors of ABC is planning to use the CAD$50 thousand of its cash on

the balance sheet to either pay a special dividend or to repurchase the firm’s shares.

1. What will be the percentage change in the share price of ABC on the ex-dividend date if ABC uses CAD$50

thousand to pay a special dividend?

2. If the firm uses CAD$50 thousand to repurchase some of its common stock and pays the entire free cash

flow as regular dividends in the future, what would be the amount of such regular dividend per share?

Now assume that the Board of Directors of ABC has decided to use the CAD$50 thousand of its cash on the

balance sheet to repurchase some of its common stock. You are an investor in ABC owning 5,000 shares of the

firm’s common stock. However, you are unhappy with the decision of ABC’s Board of Directors about the stock

repurchase and would have preferred that the firm used this money to pay a special dividend instead. You are

also unhappy with the fact that ABC is an all-equity firm and would have preferred that the firm had debt with the

40% leverage ratio (as measured by D/V). The cost of debt (=interest rate) is 5%.

3. Show exactly how you can create a homemade dividend to get the same combination of cash and stock

after the share repurchase as if ABC paid the special dividend.

4. Show exactly how you can create homemade leverage to get the same leverage ratio with your holdings

as if the firm is levered as you had preferred (Hint: consider 3 different scenarios of perpetual annual cash

flows (in thousands) starting in year 1: Recession: earnings=FCF=$40; Expected: earnings=FCF=$50; and

Expansion: earnings=FCF=$60.)

Page 3 of 6

RSM 333 (2015) – ASSIGNMENT #2

Due Monday, August 10th, 2015 (4:00pm) at the Rotman Commerce Office

Problem 3 – Firm Valuation and M&A (40 Marks)

(Consider using an Excel Spreadsheet to solve this problem.)

You are the CFO of GreatFood, a large chain of grocery stores. You are planning to expand your business by

acquiring the GoodWine winery that has recently been put up for sale by the owners. You think that this

acquisition may turn out to be a good investment so you want to have solid financial background for the deal to

present at the upcoming Shareholders Meeting on August 10th, 2015. You have the following information about

the GoodWine winery (the “Target”) and your firm (the “Acquirer”).

GoodWine winery (“Target”)

Some important accounting numbers projected for the next 5 years are as follows (all numbers are before-tax, as

of the end of the fiscal year and in $ thousands):

2016

2017

2018

2019

2020

2327.0

2863.0

2984.0

3447.0

3743.0

EBITDA

581.8

715.8

746.0

861.8

935.8

Capital expenditures

500.0

350.0

200.0

180.0

150.0

50.0

60.0

65.0

70.0

75.0

175.0

180.3

185.7

191.2

197.0

Sales

Increase in NWC

Depreciation

After year 5, the winery’s free cash flow (FCF) will grow at an annual rate of 3% into perpetuity. There are 200

thousand shares outstanding. The market value of equity is currently $3,500 thousand and the market value of

outstanding debt is $450 thousand (assume that the share price, the value of equity, and the value of debt are

given at the valuation date, i.e. August 10th, 2015). The firm faces the (marginal) tax rate of 40%. The asset beta of

the target (the beta of the same but all-equity firm) is 1.15.

GreatFood (Acquirer)

The acquirer expects to have the following estimated synergies from the M&A and all figures are before-tax, as of

the end of the fiscal year and in $ thousands:

Synergies

EBITDA

2016

2017

2018

2019

2020

134.0

150.0

171.0

216.0

223.0

After year 5, the free cash flow (FCF) from synergies will grow at an annual rate of 2% into perpetuity. The firm

faces the (marginal) tax rate of 40%. The asset beta of the acquirer (the beta of the same but all-equity firm) is

0.8.

Note: The fiscal years of both your firm and the target end on August 10 (i.e. all projected numbers are given at the

end of the fiscal year starting from exactly one year from the date of valuation).

Page 4 of 6

RSM 333 (2015) – ASSIGNMENT #2

Due Monday, August 10th, 2015 (4:00pm) at the Rotman Commerce Office

Information about the deal/market conditions

The target leverage (D/V) after the deal is completed is expected to be 25% (applies to both the target and the

synergies). The borrowing rate (cost of capital) is 8% and the Treasury bond rate (risk-free rate) is 5.5%. The

market risk premium is 5%.

1.1. What is the maximum price per share that your firm can pay for the target based on DCF and APV methods?

You can build your analysis on the following steps in your valuation:

a) Estimate the value of the levered target firm:

a. Calculate the cost of assets (unlevered equity return, i.e. cost of equity of the same but all-equity

firm) for the target using CAPM

b. Calculate the cost of equity (levered equity return) for the target

c. Calculate the weighted average cost of capital (WACC) for the target

d. Estimate free cash flow (FCF) for years 2016-2020

e. Calculate the terminal value in 2020 using the APV method and the WACC method separately

f. Calculate the value of the levered target firm using the APV method (Hint: since leverage is

expected to change, D*t is not an appropriate way of estimating tax shields – derive tax shields

from the relation between the levered and unlevered values of the firm)

g. Calculate the value of the levered target firm using the WACC method

b) Calculate the value of synergies:

a. Calculate the cost of assets for the acquirer using CAPM

b. Calculate the cost of equity (levered equity return) for the acquirer

c. Calculate the weighted average cost of capital (WACC) for the acquirer

d. Estimate free cash flow (FCF) from synergies for years 2016-2020 using beta and growth rate of

the acquirer

e. Calculate the terminal value of synergies in 2020 using the APV method and the WACC method

separately

f. Calculate the value of the levered synergies using the APV method (do not forget about the tax

shields)

g. Calculate the value of the levered synergies using the WACC method

c) Find the value of the target’s equity to the acquirer:

a. Calculate the value of the levered target to the acquirer by adding the value of synergies to the

value of the levered target firm

b. Subtract the amount of outstanding debt to get the value of equity

d) Calculate the maximum price per share that the acquirer can pay for the target

1.2. If your firm announces the deal on August 10th, 2015, what is the expected return on the target’s equity at the

announcement (based on both DCF and APV methods)?

Page 5 of 6

RSM 333 (2015) – ASSIGNMENT #2

Due Monday, August 10th, 2015 (4:00pm) at the Rotman Commerce Office

Hint: The following relationship will be useful for you in Problem 3.

D

D

PV (TS ) VL TC and VL VU PV (TS ) => PV (TS ) VU PV (TS ) TC

V

V

L

L

D

D

D

D

TC PV (TS ) TC => 1 TC PV (TS ) VU TC

V

V

V

VL

L

L

L

=> PV (TS ) VU

D

VU TC

V

L

=> PV (TS )

D

1 TC

V

L

Page 6 of 6

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