ECOM118 Practical Valuation - Queen Mary University of London

Question 1

An equity analyst is valuing a listed company that is expected to generate EBIT from year 1 onwards as given in Table 1.

Table 1

The EBIT margin is expected to be stable at 10.2% of sales from year 2 until year 5. The expected level of sales for year 1 is €130000. Additional assumptions are:

• Depreciation: 5% of sales, all years
• Recurrent Capex: 7% of sales for year 1, with percentage decreasing 55 basis points (0.55%) per year until year 4
• Change in working capital: 10% of yearly changes of EBIT
• Tax rate: 20%
• Target capital structure: debt/(debt + equity) ratio of 40%
• Asset beta: 1.25
• Risk-free rate: 2.5%
• Equity risk premium: 6%
• Debt spread: 3%
• Expected level of interest bearing debt at end of year 1: €20000
• Expected level of cash at the end of year 1: €7500

a) Compute the Free Cash Flows to the Firm (FCF) for the period from year 1 until year 5, including year 5. Explain your answer.

b) It is often recognised that there exists an optimal capital structure (debt versus equity), that maximises the value of the company. Explain why, up until a certain level of debt, more debt increases the value of the company and, above that level, increases in debt destroys value (everything else being constant).

c) Given the target capital structure and the set of assumptions reported in Table 1, what is the discount rate to be used in this valuation exercise? Explain your answer.

d) The expected nominal growth rate of FCF in perpetuity is 1.25%. What is the expected value of the company at the end of year 1? Explain your answer.

e) The current market capitalization of the company under analysis is €105000. What would be the equity analyst investment recommendation? Explain your answer.

Question 2

Consider the following information in Table 2 about two companies, SU and STA:

where EPS 2020 and EPS 2021 stands for expected earnings per share for the year 2020 and 2021, respectively. Present results with one decimal (example: 1.45 rounded to 1.5).

a) What is the total equity value and the equity value per share of each company? Explain your answer.

b) The market prices per share of company SU and STA are €14.8 and €14.2, respectively. What is your investment recommendation for SU and STA based on the fundamental valuation done in Question 2a? Explain your answer.

c) Using market prices of each company, what is the Price Earnings multiple for 2020 and 2021 (PE 2020 and PE 2021) for each company? Explain your answer.

d) Assume that nominal growth rates (g) of dividends of company SU and STA are 4% and 0.8%, respectively. What is the 2020 and 2021 Price earnings expected growth (PEG) ratio for each company? Explain your answer.

e) Considering information from Questions 2c and 2d what can you conclude about the relative valuation of companies SU and STA? Explain your answer.

f) Is your investment recommendation based on the relative valuation in line with the one based on the fundamental valuation done in Question 2b? Explain your answer.

Question 3

Consider the information in Table 3 about an investment opportunity that a private equity fund is considering. This investment opportunity can be deferred for one year.

a) What is the "static" Net Present Value of this investment opportunity? Explain your answer and present the result rounded to one decimal place (example 1.75 to 1.8).

b) What is the value of this investment opportunity using the Dixit and Pindyck (D&P) model? Explain your answer (use the input β = 3.79 in the D&P model). Present your result rounded to one decimal place.

c) Should this investment opportunity be accepted by the private equity fund? Explain your answer.