Advanced Financial Analysis: CAPM, Free Cash Flows, and Corporate Valuation

Assignment Task

1. True/False- Short Explanation Questions

Indicate whether the statements below are true or false. If the answer is true, explain why it is true. If the answer is false, explain why it is false. Feel free to give examples or counter examples. Although there may be a variety of reasons answers are true or false, I am looking specifically for reasons discussed in the lectures, readings, and cases of this course.

• Two firms have the exact same cash flows from the project on the asset side and those cash flows have identical covariance with the market. These firms have the same NPV
• Does Not Exist Corp (DNEC) is a firm with operating assets. As DNEC’s leverage increases, the empirical data show that both its required return on equity (rE) and required return on debt (rD) increase. Therefore, as leverage increases, DNEC’s value
• Under CAPM, the higher the volatility of stock returns the higher the expected returns demanded by investors
• You are trying to estimate cost of capital for a project taken by Firm X. There are no taxes. Based on business risk of Firm X's project you identify three comparables -- Firm a, Firm b and Firm c. The data tells you that the equity beta βE_a = 0.90, βE_b = 1.00 and βE_c = 1.10 and the market value of Debt/(Debt+Equity) ratio of the three firms are 25%, 35% and 50% for firms a, b and c respectively. If the βD_a = βD_b =βD_c=0, the asset beta for Firm X's project is 1.00.

2. Diving right into Free Cash Flows

You are given the information below from the projected balance sheet and income statement of the Last Gasp Scuba Diving School. The firm’s cost of capital (rA) is 10%, and the corporate tax rate is 40%.

Find the firm’s expected free cash flows for 2006-2010, excluding any terminal value. Assume that current assets and current liabilities had the same values in 2005 as they do in the 2006 projections. Assume no new capital expenditures. Space is provided in the table for your calculations and answers.

• Suppose that the firm’s free cash flows are constant from 2010 to eternity. Calculate the discounted value of the firm’s cash flows from 2011 to eternity as of the end of the year 2010.

3. Can you dance like CAPM?

Your uncle, Ryan-with-a-Secret, who produces the show “Dancing with the Stars” has asked you for some financial advice. His retirement savings are currently invested as follows: $30,000 in the risk-free asset and $70,000 in GM stock. He wants to know if this is a sensible portfolio. You decide to analyze it based on the CAPM model.

You look in a Beta Book and find that GM stock has a Beta 1.20 and the R2 of the regression is 0.30.

a. If rf is 7% and the expected excess return on the market (rm – rf) is 8%, what is the expected return on his portfolio?

b. Suggest a different portfolio for your uncle that has the same expected return as the old portfolio but is efficient (i.e., has the smallest variance possible for that level of expected return).

c. If the market return has a standard deviation of 22%, compute the variance and standard deviation of his current portfolio (using information provided by the R2 value) and compare it to the variance and standard deviation of the portfolio you are suggesting in part (b). 

4. Mining to Extract Betas 

Gold et al, a mining conglomerate, is considering an $100 million investment in a new copper mine that will create cash flows of $100 million in year 1 and grow at 10% until the end of time. The main competitor of Gold et al is Silver. Both of these companies mine a similarly broad range of minerals, including copper and gold.

In determining the relevant discount rate at which to discount the cash flows for the new copper factory, Gold has researched several other corporations, including the Mine-it-all (a company mining both copper and gold) and the Copper Corp., which mines only copper. The CEO of Gold et al compiled the following historical information.

What is the proper comparable company for valuing the new copper mine? Why are others that you rejected not good comparables?

Compute for the comparable company in part (a) by unlevering the equity beta and debt beta. Calculate the proper discount rate for valuing the copper mine project and NPV of the investment

5. A Problem of Acquisition

In 1989, General Motors (GM) was evaluating the acquisition of Hughes Aircraft Corporation. GM assumed that Hughes was of approximately the same risk as Lockheed or Northrop which had low-risk defense contracts and products that were similar to those of Hughes. Specifically, assume:

• GM's target D/E after acquisition of Hughes is 1
• Hughes’s expected after-tax real asset cash flow next year = $300 million each year in perpetuity
• r_m = 11.7% and r_f = 4%
• Debt is riskless, so that the appropriate r_D = r_f, and β_D = 0.

 Analyze the Hughes acquisition (which never took place) by first computing the betas of the comparison firms, Lockheed and Northrop, as if they were all equity financed (i.e. by unlevering the betas). 

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