In Problem 10.16, we projected financial statements for Walmart Stores for Years +1 through +5. The data in Chapter 12 Exhibits 12.17-12.19 include the actual amounts for 2012 and the projected amounts for Year +1 to Year þ5 for the income statements, balance sheets, and statements of cash flows for Walmart (in millions).
The market equity beta for Walmart at the end of 2012 was 1.00. Assume that the risk-free interest rate was 3.0% and the market risk premium was 6.0%. Walmart had 3,314 million shares outstanding at the end of 2012, and the share price was $69.09.
REQUIRED
Part I-Computing Walmart's Value-to-Book Ratio Using the Value-to-Book Valuation
Approach
a. Use the CAPM to compute the required rate of return on common equity capital for
Walmart.
b. Using the projected financial statements in Chapter 12 Exhibits 12.17-12.19, derive the projected residual ROCE (return on common shareholders' equity) for Walmart for Years +1 through +5.
c. Assume that the steady-state, long-run growth rate will be 3% in Year +6 and beyond. Project that the Year þ5 income statement and balance sheet amounts will grow by 3% in Year þ6; then derive the projected residual ROCE for Year +6 for Walmart.
d. Using the required rate of return on common equity from Requirement a as a discount rate, compute the sum of the present value of residual ROCE for Walmart for Years +1 through +5.
e. Using the required rate of return on common equity from Requirement a as a discount rate and the long-run growth rate from Requirement c, compute the continuing value of Walmart as of the start of Year +6 based on Walmart's continuing residual ROCE in Year +6 and beyond. After computing continuing value as of the start of Year þ6, discount it to present value at the start of Year +1.
f. Compute Walmart's value-to-book ratio as of the end of 2012 with the following three steps: (1) Compute the total sum of the present value of all future residual ROCE (from Requirements d and e).
(2) To the total from Requirement f (1), add 1 (representing the book value of equity as of the beginning of the valuation as of the end of 2012).
(3) Adjust the total sum from Requirement f (2) using the midyear discounting adjustment factor.
g. Compute Walmart's market-to-book ratio as of the end of 2012. Compare the value-tobook ratio to the market-to-book ratio. What investment decision does the comparison suggest? What does the comparison suggest regarding the pricing of Walmart shares in the market: underpriced, overpriced, or fairly priced?
h. Use the value-to-book ratio to project Walmart's share value.
i. If you computed Walmart's common equity share value using the dividends valuation approach in Problem 11.14 in Chapter 11, and/or the free cash flows to common equity valuation approach in Problem 12.17 in Chapter 12, and/or the residual income valuation approach in Problem 13.20 in Chapter 13, compare the value estimate you obtained in those problems with the estimate you obtained in this case. You should obtain the same value estimates under all four approaches. If you have not yet worked those problems, you would benefit from doing so now.
j. Use the forecast data for Year +1 to project Year +1 earnings per share. To do so, divide Walmart's projected comprehensive income available for common shareholders in Year +1 by the number of common shares outstanding at the end of 2012. Using this Year +1 earnings-per-share forecast and the share value computed in Requirement h, compute Walmart's value-earnings ratio.
k. Using the Year þ1 earnings-per-share forecast from Requirement j and using the share price of $69.09 at the end of 2012, compute Walmart's price-earnings ratio. Compare Walmart's value-earnings ratio with its price-earnings ratio. What does the comparison suggest regarding the pricing of Walmart shares in the market: underpriced, overpriced, or fairly priced? What investment decision does the comparison suggest? Does this comparison lead to the same conclusions you reached when comparing value-to-book ratios with market-to-book ratios in Requirement g?
l. Note: For this part only, assume Walmart's long-run growth beginning in Year þ6 will be 1% rather than 3%. With a 1% growth rate, Year þ6 comprehensive income will be $21,059 million. Compute Walmart's price differential at the end of 2012. Compute Walmart's price differential as a percentage of Walmart's risk-neutral value. What dollar amount and what percentage amount has the market discounted Walmart shares for risk?
m. Reverse engineer Walmart's share price at the end of 2012 to solve for the implied expected rate of return. First, assume that value equals price and that the earnings and 3% long-run growth forecasts in Year +6 and beyond are reliable proxies for the market's expectations for Walmart. Then solve for the implied expected rate of return (the discount rate) the market has impounded in Walmart's share price.
n. Reverse engineer Walmart's share price at the end of 2012 to solve for the implied expected long-run growth. First, assume that value equals price and that the earnings forecasts through Year þ5 are reliable proxies for the market's expectations for Walmart. Also assume that the discount rate implied by the CAPM (computed in Requirement a) is a reliable proxy for the market's expected rate of return. Then solve for the implied expected long-run growth rate the market has impounded in Walmart's share price. (Hint: Begin with the forecast and valuation spreadsheet you developed to value Walmart shares and use the CAPM discount rate. Set the long-run growth parameter initially to zero. Increase the long-run growth rate until you solve for the growth rate that makes your value estimate exactly equal the end-of-2012 market price of $69.09 per share.)