13. (Adapted from CFA Level II exam, 2000) The management of Telluride, an international diversified conglomerate based in the United States, believes that the recent strong perfor- mance of its wholly owned medical supply subsidiary, Sundanci, has gone unnoticed. To realize Sundancis full value, Telluride announced that it will divest Sundanci in a tax-free spinoff. Sue Carroll, CFA, is Director of Research at Kesson and Associates. In developing an investment recommendation for Sundanci, Carroll has gathered the information shown in Tables 3-16 and 3-17 below. Abbey Naylor, CFA, has been directed by Carroll to determine the value of Sun- dancis stock using the FCFE model. Naylor believes that Sundancis FCFE will grow at 27 percent for two years, and 13 percent thereafter. Capital expenditures, depreciation, and working capital are all expected to increase proportionately with FCFE.

A. Calculate the amount of FCFE per share for 2000 using the data from Table 3-16. Show your work. B. Calculate the current value of a share of Sundanci stock based on the two-stage FCFE model. Show your work. C. Describe limitations that the two-stage DDM and FCFE models have in com- mon.

160 Equity Asset Valuation

TABLE 3-16 Sundanci Actual 1999 and 2000 Financial Statements for Fiscal Years Ending 31 May (in millions, except per-share data)

Income Statement 1999 2000

Revenue $474 $598 Depreciation 20 23 Other operating costs 368 460 Income before taxes 86 115

Taxes 26 35 Net income 60 80 Dividends 18 24

Earnings per share $0.714 $0.952 Dividends per share $0.214 $0.286

Common shares outstanding 84.0 84.0

Balance Sheet 1999 2000

Current assets (includes $5 cash in 1999 and 2000) $201 $326 Net property, plant, and equipment 474 489 Total assets 675 815

Current liabilities (all non-interest bearing) 57 141 Long-term debt 0 0 Total liabilities

Shareholders equity 618 674 Total liabilities and equity 675 815

Capital expenditures 34 38

TABLE 3-17 Selected Financial Information

Required rate of return on equity 14%

Industry growth rate 13% Industry P/E 26