Analysis for Financial Management, 10e

SUGGESTED ANSWERS TO EVEN-NUMBERED PROBLEMS

CHAPTER 9
2. The value of the bid to Newscorps shareholders is the value of the
assets acquired in the merger. This includes the value of the
equity acquired plus the liabilities assumed by the buyer. The
estimat4ed cost of the acquisition was thus ($60 x 82 million
shares) + $1.46 billion = 6.38 billion. This is an estimate because
the book value of Dow Joness debt only approximates the
preferred market value, although the approximation is probably
reasonably close.
4. a. The terminal value = 700*(1+.04)/(.08-.04) = $18,200.
Discounting the annual free cash flows plus the terminal value at
8 percent, the MAP = $11,926.
b. The terminal value = 700*(1+.05)/(.07-.05) = $36,750.
Discounting the annual free cash flow plus the terminal value at
7 percent, the MAP = $25,757.
c. The MAP increases 116 percent when the discount rate falls one
percentage point and the perpetual growth rate rises by the
same amount. Plausible changes in the discount rate and the
perpetual growth rate can cause large changes in estimated
firm value. This is especially true when the initial rates are
similar.
6. a. EBIT = $50 million. As a stand-alone company, typical debt
would be .40 x $250 million = $100 million. At a 10% interest
rate, interest expense would be $10 million. Therefore, profit
before tax = $50 10 = $40 million. Profit after tax = $40(1-.34)
= $26.4 million. Therefore the value of the division's equity
relative to comparable firms is $26.4 x 12 = $316.8 million.
Adding liabilities, Value of division = $316.8 + $100 = $416.8
million. This should be the owner's minimum acceptable price.
b. From the acquirer's perspective, this is essentially a "make-orbuy" decision. Because the acquirer can "make" a like operation
for a present value cost of $450 million, he should not pay more
than this to "buy" the division. (This assumes the opportunity
costs of being slower to market are included in the $450 million
price.)
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whole or part.

c. An acquisition appears feasible; the owner's minimum price is

less than the buyer's maximum.
d. Redoing the answer to (a) at a 15 price-to-earnings ratio, the
value of the division's equity = $26.4 x 15 = $396, and adding
liabilities, the value of the division is now $396 + 100 = $496.
Because the owner's minimum price is now more than the buyer's
maximum, an acquisition does not make economic sense.
e. The answer to (d) suggests that acquisition activity will decrease
when market value rises above replacement value. In this
situation, companies find it more expensive to "buy" assets than
to "make" them. This is why economists are interested in James
Tobin's q-ratio, defined as the market value of a
company/replacement value of its assets. When q rises,
acquisition activity should fall, and vice versa.
8. a. Negative free cash flow simply means that the company will not
be able to fund all worthwhile activities in that year out of
operating cash flows and needs to raise capital from outside
sources. Negative free cash flows are usually associated with
growing companies.
b. Negative free cash flows do not compromise or invalidate the
notion that the value of the firm equals the present value of free
cash flows, provided the securities sold to make up the shortfall
are fairly priced. They do mean that existing capital suppliers will
have to inject added capital into the business or share future free
cash flows with new investors. In the latter case, this does not
change the value of the business to existing capital suppliers
provided the present value of the free cash flows sacrificed
equals the value of the capital raised from new investors.
c. The going-concern value of a company with negative expected
free cash flows in all future periods is negative. Nonetheless, an
equity investor might buy shares in such a company for at least
two reasons: the expected liquidation value of equity might be
positive, and there might be a small but positive chance the
present value of future free cash flows will be positive.
(Remember, negative expected free cash flows does not rule out
the chance that actual cash flows might be positive.) In this
latter case, the stock can be viewed as an out-of-the-money
option, which is valuable. Heres a numerical example. An allequity, one-period company has a 90% chance of generating a
FCF next year of -$100 and a 10% chance of generating +$50.
The expected FCF is -$85, but due to limited liability, the payoff to

2012 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.

shareholders is a 90% chance at $0 and a 10% chance at $50,

which has an expected value of $5.
10. The median and mean values for Scottss peers appear below.
Values excluding Scotts
Median
Mean
8.5
7.0
5.1
3.7
9.2
9.8
5.8
6.1
0.7
0.7
6,591
9,034

5-year growth rate in sales (%)

5-year growth rate in eps (%)
Analysts projected growth (%)
Interest coverage ratio (X)
Total liabilities to assets (X)
Total assets ($ millions)
Price/earnings (X)
MV firm/EBIT(1-Tax rate (X)
MV equity/sales (X)
MV firm/sales (X)
MV equity/BV equity (X)
MV firm/BV firm (X)

16.9
17.8
1.6
2.0
3.6
1.5

17.9
18.0
1.3
1.8
4.4
1.5

Here are my indicators of value for Scotts. In coming to these numbers, I believe
that Scottss somewhat higher historical and projected growth rates, combined with
dominant positions in its chosen markets,warrant numbers that are in the upper half
of the indicated valuation ranges. However, the companys somewhat smaller size
suggests some caution. I have selected multiples for the first two ratios roughly 10
percent above the sample median and 5 percent above the mean. Scottss mediocre
gross margins, especially for a company that dominates its markets, suggest that
investors will pay less per dollar of sales for Scotts than for peers, resulting in lower
than average multiples for the next two ratios. I have chosen representative
multiples for the last two ratios.
Price/earnings (X)
MV firm/EBIT(1-Tax rate (X)
MV equity/sales (X)
MV firm/sales (X)
MV equity/BV equity (X)
MV firm/BV firm (X)

18.7
19.4
1.1
1.5
4.0
1.5

The implied value of Scottss common stock for each indicator is:

2012 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.

Looking at these numbers,my best guess of a fair price for Scottss shares on
November 1, 2007 is$33.00. I think $29.88 is the best single estimate, but because
all of the other estimated values are above this figure, I have raised my best guess by
about 10 percent. $33.00 compares to an actual price on the valuation date of
$38.69, so my estimate is about 17 percent low, within my notion of the tolerances
inherent in business valuation. Many other estimates are, of course, possible.
12. Price per share = $5 million/400,000 shares = $12.50 per share. Pre-money value =
1.6 million shares X $12.50 = $20 million. Post-money value = 2 million shares X
$12.50 = $25 million. Alternatively, post-money value = pre-money value +
$5million = $25 million.

2012 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.

14.

16. See C9_Problem-16_Answer.xlsx on this Web site.

2012 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.