Alahtab Inc.

Cuyahoga River Navigators, Inc. (CRN), based in Cleveland, Ohio, has a fleet of 30 watercraft, consisting of riverboats, yachts, barges, and ships, navigating the Cuyahoga River and Lake Erie. CRN is a high beta stock and its market liquidity is quite low. Insiders own more than 50% and institutions own less than 30% of the firms common stock. The companys pays dividends and follows a constant payout ratio policy. The companys management is confident of a huge increase in revenue growth over the next four to five years. To meet the capital needs for growth opportunities, CRNs management is contemplating the issuance of debt or common stock.

Abhishek Alahtab is a junior equity analyst at Cleveland Investment Research, LLC, and follows regional small-cap stocks trading in the over-the-counter market. Amit Jatin, a senior equity analyst at Cleveland Investment Research, asks Alahtab to evaluate CRN and prepare a research report for updating the firms recommendation about the stock. He gives Alahtab CRNs financial data, which is shown in Exhibits 1 and 2.

Exhibit 1: Income Statement Excerpts, Years Ending 31 December

($ millions)	2013	2012
EBITDA	275	250
Depreciation expense	82.5	75
Operating income	192.5	175
Interest expense	16	14.9
Income expense	176.5	160.2
Income taxes	56.5	48
Net income	120	112.1
Common dividend	48	44.8

Exhibit 2: Selected Balance Sheet Data Years Ending 31 December

($ millions)
Net Investment in fixed capital	165.3
Net Increase in working capital	-1.80
	2013	2012
Current Assets	354.2	322
Accumulated depreciation	257.5	175
Notes payable	20	15
Long-term debt	157.5	150
Common Stock (50million shares outstanding)	800	800
Retained earnings	159.3	87.3
Total liabilities and equity	1,265.00	1,150.00

Ratios are calculated using year-end values

Alahtab uses the Gordon growth model to estimate CRNs intrinsic value. He uses the firms sustainable growth rate for 2013 as a measure of dividend growth. Using the capital asset pricing model (CAPM), he arrives at 11% as the required rate of return on the stock.

Jatin disagrees with Alahtabs preference for the Gordon growth model. He thinks that CRNs stock should be valued using sophisticated techniques that correctly account for the huge increase in revenues expected over the next four to five years. In particular, he suggest a couple of two-stage valuation models- the H-model and the free cash flow to equity (FCFE) model. Upon a closer examination of the data and expectation of the data and expectations of high growth from the increased tourism and transportation on the revitalized Cuyahoga River, Jatin suggests that Alahtab incorporate the following as inputs into his H-model and FCFE model computations:

• A growth rate of 20% per year over the next four years (2014 through 2017) and a 6% constant growth rate beyond 2017
• An estimate of FCFE of $0.96 per share for 2014
• The addition of a small- firm risk premium of 2% to the rate of return on the stock
• A tax rate of 35%

Additionally, Jatin makes the following statements concerning the valuation models that he prefers:

The H-model assumes that the dividend growth begins at a high rate and declines linearly throughout the super-normal growth period until it reaches a normal growth rate at the end. A smoother transition to the mature phase growth rate would be more realistic than the erratic growth rate in dividends displayed by the data.

The FCFE model ignores a companys investment and financing policies as well as the dividend policy. This model would be appropriate because free cash flow is not affected by the firms dividend payout policy, but any stock issuance in the future can have a significant impact on cash flow available to common stockholders.

An increase in leverage will lead to a decrease in FCFE in the year the debt is issued, thereby potentially reducing the value per share.

Alahtab reevaluates the stock following Jatins suggestions, but prior to issuing the new price target and recommendation on CRN, Jatin and Alahtab meet with Julia Lederman, the chief investment officer at Cleveland Investment Research, for her approval. After taking a close look at the data and analyses, Lederman makes the following statements:

I suggest we use a forward-looking beta by making the Blume adjustment to CRNs raw beta. The adjustment increases the required return on CRNs stock as well as its intrinsic value.

It is good to see an adjustment for small-firm risk premium, but the Pastor-Stambaugh model should be used for estimating the required return on CRNs stock in order to capture the liquidity premium given the stocks low liquidity.

I also suggest using a residual income model because, unlike free cash flows, the accounting data used in residual income models may not require significant adjustments.

The meeting concludes with the understanding that Alahtab will redo the analyses per Lendermens suggestions and bring the results back for her approval.

ANSWER THE FOLLOWING QUESTIONS ONLY BY WRITING THE LETTER OF THE CORRECT ANSWER.

Question 1 of 6

According to the Gordon growth model and the inputs used by Alahtab, CRNs intrinsic value per share as of 2013 is closest to:

A. $27.43

B. $29.49

C. $16.80

Question 2 of 6

Using the H-model, the information in Exhibit 1 and Exhibit 2, and Jatins estimates for growth and required return on the stock, the intrinsic value of CRNs stock as of 2013 is closest to:

A. $22.22

B. $17.55

C. $18.38

Question 3 of 6

Using the data in Exhibits 1 and 2 and the tax rate suggested by Jatin, CRNs FCFE per share for 2013 is closest to:

A. $0.82

B. $0.92

C. $0.85

Question 4 of 6

Using Jatins 2014 estimate for FCFE per share and his other suggested inputs for growth and required return on the stock, the intrinsic value of CRNs stock as of 2013 is closest to:

A. $17.37

B. $21.27

C. $19.15

Question 5 of 6

In regard to Jatins three statements concerning valuation models, he is most accurate with respect to statement:

A. 3

B. 1

C. 2

Question 6 of 6

In regard to her three statements, Lederman is most accurate with respect to statement:

A. 3

B. 1

C. 2