Hello,

Please see the attached file. I downloaded this file from www.coursehero.com website. There are some indications how to answer to the asked questions, however, I still have difficulties getting those questions. Could you please help me out with that?

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Student

Problem 1: VALUE DRIVERS, STRATEGY AND THE DCF-FRAMEWORK Suppose you started a new company, which is expected to generate a Return on Invested Capital ROIC (ROE) of 15% per year. The company is all-equity financed and the book value of the invested capital (equity) equals $5 million. The cost of capital for the firm is 10% and you expect the firm to grow at a constant rate of 5% forever with a corresponding reinvestment rate of 33.33%. With this information, please answer the following three questions. (i) What is the intrinsic value of the company and what is its value to book ratio? Show your calculations. The intrinsic value is the underlying or \"fair\" value of a company calculated by discounting a set of future cash flows or income expected to be generated by a company back to its present value. Intrinsic Value= Present value of future cash flow + excess cash or Intrinsic Value= DCF +(Total Cash-MAX (0, current liabilities-current assets)) Book value refers to the total amount a company would be worth if it liquidated its assets and paid back all its liabilities. Book value can also represent the value of a particular asset on the company's balance sheet after taking accumulated depreciation into account. Book value is calculated by taking a company's physical assets (including land, buildings, computers, etc.) and subtracting out intangible assets (such as patents) and liabilities -including preferred stock, debt, and accounts payable. The value left after this calculation represents what the company is intrinsically worth. Thus, book value is calculated: Book value = total assets - intangible assets - liabilities (ii) What drives the difference between the book value and the intrinsic value of the firm, and what are the levers the firm can use to enhance its value? Clearly motivate your answer. The intrinsic value of the firm can be greater than the book value for many reasons some of the common drivers are things like superior competitive positioning, a strong management team, an early mover advantage, etc. (iii) Suppose you are considering two strategies to increase the value of the firm. The first strategy is a fast expansion strategy, which doubles the firm's growth rate to 10% at a ROIC of 15%, but increases the firm's risk and results in a cost of capital of 12%. The second strategy is a risk reduction strategy, which results in a cost of capital of 7% and a lower growth rate of 3% at a ROIC of 15%. Using the DCF-framework, determine the value of the firm under each of these strategies. Is the firm better off with a focus on fast growth or on risk reduction? Motivate your approach and show all your calculations. Set up a basic DCF to answer this question. (Note assumptions about terminal value assume DCF analysis.) Expansion Strategy: Risk Reduction Strategy: Problem 2: LEVERAGE, RISK AND COST OF CAPITAL Pharma-C is a pharmaceutical firm, which manufactures and sells a portfolio of blockbuster drugs at steady margins. The firm is currently all-equity financed. Its annual pre-tax operating profit (EBIT) equals $100 million and is expected to remain constant in the future. Pharma-C's current cost of capital is 8% and there are 50 million shares outstanding. Since the firm expects to generate stable cash flows in the future, management is considering to buy back $200 million in shares in the open market and finance the repurchase by issuing bonds. Pharma-C is expected to maintain the new capital structure indefinitely. At this level of debt, the bonds would be A-rated, and the firm would pay an interest rate of 4.05%. The risk free interest rate is 3%, the market risk premium is 5% and the firm's marginal corporate tax rate is 40%. With this information answer the following four questions. (i) Calculate the value of Pharma-C's operating assets (or the value of the unlevered firm) prior to the announcement of the repurchase. Show your calculations. Calculate the value of the firm as it is before any change to the capital structure (i.e. before taking on debt). (ii) Calculate the stock price of Pharma-C when the debt-financed repurchase plan is announced to the market, and determine how many shares the firm needs to repurchase. Motivate your approach and show your calculations. Determine the optimal capital structure of the company using a mix of debt and equity. Note that the number of shares repurchased will depend on the valuation developed in the first part of the question. (iii) Determine Pharma-C's cost of equity and its cost of capital after the share repurchase and also explain the directional change for both. Show all your calculations. Calculate the components of WACC. May need to make some assumptions in order to calculate the cost of equity. (iv) Now suppose that the firm announces instead that it plans to issue $400 million of debt to repurchase shares, and the stock price upon announcement equals $17.30. If we assume the marginal tax rate for the firm is unchanged, what is the market's estimate of the firm's risk and expected costs of financial distress at this debt level? Clearly motivate your answer. This uses the same formula as discussed in part two of the question. Solve for different parts of the equation (namely the revised cost of debt, which impacts the WACC, since the company is now riskier than it was with less debt). Problem 3: VALUATION, COUNTRY RISK AND COST OF CAPITAL Vale, a Brazilian-based international mining and shipping conglomerate, is considering the acquisition of several copper mines in Indonesia. The firm is trading on the New York Stock Exchange and an equity analyst following the firm wants to assess the risk of the acquisition and value the copper mines in US dollars. The projected free cash flows for the next 5 years (including a terminal value estimate as of the end of year 5) are summarized below (in $ millions): The analyst collected the following information in order to estimate the cost of capital for the acquisition: Vale currently has no operations in Indonesia. The marginal corporate tax rate for the mining operations equals 30%, and the target debt ratio (D/V) for the acquisition equals 20% in market value terms. The corresponding bond rating for the debt would be A3. With this information, please answer the following three questions: (i) Estimate the dollar-based cost of capital for the acquisition using only information for the U.S. Clearly describe which financial market information you would use, and why. Calculate the WACC you would use to determine the valuation of the free cash flows from the acquisition. a. First, determine the cost of equity. Note provided a couple of choices for Beta and Market risk premiums. b. Second, determine the cost of debt. Given all the information needed, pick which data to use and support why. (ii) If we assume that the cash flows from the mines predominantly depend on global economic conditions, but that there is a 7.5% probability that the mines will be fully expropriated by the Indonesian government shortly after the end of year 4, how should the analyst proceed in valuing the mining operations, and what is the resulting value of the mines based on this new information? Motivate your approach and show your calculations. Run two DCFs: a. First one is a valuation assuming that the mines are not appropriated by the Government. b. Second one is a valuation assuming that the mines are appropriated by the Government so that no value is realized after year four. c. Then, develop a weighted average of both scenarios to determine the value for the acquisition: 7.5% (value in scenario two) + 92.5% (value in scenario one) (iii) Suppose that a colleague proposes to adjust the discount rate for the acquisition in order to take the risk of expropriation into account by adding the sovereign spread for Indonesia to the cost of debt, and an equity risk premium for Indonesia to the cost of equity. What would be value of the acquisition based on this approach, and what is the value loss due to expropriation implied by the use of a higher discount rate? What do you conclude from this and how does this inform your perspective on incorporating risk in the valuation framework in general? Show all your calculations