Cost of equity
For questions 1-4, use the following information for Nike, Inc, and define the cost of equity using the Capital Asset Pricing Model.
After tax interest cost = 6.0%
Beta = 1.2
Beginning Book Value of Equity = $15 billion
Current stock price = $106 per share
Dividends (current year) = $1.48 per share per year
Dividend growth rate = 5%
Earnings per Share = $3.24/share
Equity Rist Premium = 7.5%
Market Cap = $164.3 billion
Net Debt to Capital = 20%
NOPAT Margin = 8%
Risk Free Rate = 4.4%
Sales / Beginning Long-term assets = 20
Sales / Beginning Net Operating Working Capital = 10
1a. Compute Nike’s cost of equity, using the Capital Asset Pricing Model. Show your computations. (5 points)
| Nike’s Cost of Equity: | Computations: |
1b. If Nike pays dividends at the end of each year, compute the value of one share of Nike stock using the discounted dividend approach. Show your computations (5 points)
| Nike’s value per share: | Computations: |
1c. Briefly (one sentence should suffice) why the dividend discount model is rarely used for valuation – that is, what is the biggest problem with this approach. While being brief, be as specific as possible. (5 points)
2a. Compute Nike’s P/E ratio. Show your computations. (5 points)
| Nike’s P/E Ratio: | Computations: |
2b. If Adidas has a higher beta than Nike, which company would you expect to have a higher P/E ratio? Briefly (one sentence should be sufficient) explain. (5 points)
| ____ will have the higher PE ratio: (Choose one) NIKE ADIDAS There is not enough information to determine |
| Explanation: |
3a. Following the assumptions of our Kroger Model, compute the impact of $10,000 of additional sales next year at Nike on Nike’s free cash flow to equity next year. Be clear to indicate a direction as well as an amount (i.e., “+$5,000” or “-$1,000”, not just “6000”. Round to the nearest $1. Show your computations. (10 points)
| Effect on free cash flow to equity: | Computations: |
3b. Assuming that the $1 increase in sales lasts “forever”, but that the additional investment is only necessary one time, compute the impact of the $1 of additional sales on Nike’s current valuation. Again, be sure to indicate a direction as well as an amount. Show your computations. (5 points)
| Effect on valuation: | Computations: |
4a. Compute Nike’s residual income (for the whole firm, not per share)? Show your computations. (5 points)
| Residual Income: | Computations: |
4b. Why might we expect, theoretically, that abnormal or residual income will trend towards zero in the long run? Be brief (one sentence should be sufficient) (5 points)
4c. Why, in practice, does this not actually occur (residual income tends to be positive in the long run)? Be brief (one sentence should be sufficient) (5 points)
5. Assume that one year from now, ABC company stock will have a price of $48 (30% chance), $46 (40% chance) or $24 (30% chance). The current price of ABC company stock is $40. Consider an option with an exercise price of $38.
5a. Compute the intrinsic value of the option (i.e., the value of the option if it had to be exercised currently). Show your computations? (5 points)
| Intrinsic Value: | Computations: |
5b. Compute the market value of the option if it allows the share to be purchased one year from now (note that in this simple example, you don’t need the Black-Scholes formula). Show your computations (5 points)
| Market Value: | Computations: |
5c. Assume that due to rapid market changes the future price of ABC becomes “more volatile” – for example, the high prices become higher and the low prices become lower, while the expected future value remains the same. Would you expect that the market value of the option would increase, decrease, or remain the same. Briefly (one sentence should suffice) explain. Note that no math is necessary to answer this part of the question. (5 points)
| The market value of the option will _____ (Choose one) Increase Decrease Remain the same |
| Explanation: |
6a. What is the fundamental reason why the interests of bondholders and stockholders do not align? Be brief (one sentence should be sufficient). (5 points)
6b. Give two legal ways in which stockholders can transfer wealth from the bondholders to themselves, in a solvent (i.e., not bankrupt) company. Be brief (one sentence or even just a few words each should be sufficient) but be as specific as possible. (5 points)
| Method 1: |
| Method 2: |
7. Assume that P company purchases 60% of the outstanding shares of S company for $300 cash and that all of S company’s assets and liabilities are carried on S’s books at market value. Below find the balance sheets for the two companies, immediately before the purchase occurs.
P Company S Company
Assets $3,000 $2,000
Liabilities $1,000 $1,500
Shareholders’ Equity $2,000 $ 500
7a. Compute non-controlling interest that will appear on P Company’s consolidated balance sheet immediately after the merger. Show your computations? (5 points)
| Non-controlling interest: | Computations: |
In the quarter following the purchase, P company’s consolidated income statement ends in the following way:
Net Income: $200
Net Income Attributable to noncontrolling interests: +10
Net Income Attributable to P Company: $210
7b. What was the total profit or loss of S company for the quarter? Show your computations? (5 points)
| Circle One: Profit Loss Amount: | Computations: |
7c. How much of S’s income is included in the $210 “Net Income Attributable to P Company”? Show your computations. (5 points)
| Circle One: Profit Loss Amount: | Computations: |
