Question 1

You are the financial manager of Caterpillar Inc. (symbol: CAT). You are considering the purchase of a heavy machinery company on the west coast. CAT will benefit from not only receiving the net cash flows generated by this company, but also from synergies produced by having the companies combine forces. You want to figure out the maximum you are willing to pay for this heavy machinery company.

CAT has determined that the hypothetical cash flows generated by this purchase would be of similar riskiness to its own total asset cash flows. Therefore, CAT will use its asset expected return to discount the future net cash flows it expects to receive from this target company. Your challenge is to calculate CATs asset expected return, which will then be used as the target heavy machinery companys discount rate.

a) First, calculate CATs equity beta. Go to Yahoo! Finance and click on Historical Data for CAT. Click on Historical Prices and download monthly CAT price data from December 31, 2017 to December 31, 2020. Do the same for the S&P500 (symbol: ^GSPC), our underlying proxy for the market portfolio.

Next, calculate monthly returns for CAT and the S&P500 using the equation: = ( 1)1, where is the return in month t, and is the adjusted closing price in month t. Convert all of your returns into excess returns ( ) by subtracting the monthly riskfree rate, which we will assume as 0.0184/12. You will not have a return observation for the first month of your time series.

Then, run a linear regression of CAT excess returns (your Y variable) on S&P500 excess returns (your X variable). You can find Regression in Microsoft Excel in Data Analysis under the Data tab.1

If the X-variable coefficient is positive and statistically significant (t-statistic greater than 1.95), then we conclude (with 95% confidence) that if S&P500 returns are 1 percent higher (lower), then CAT returns are (Coefficient multiplied by 1 percent) higher (lower).

Report the X-variable coefficient along with its t-statistic. The X-variable coefficient is the equity beta for CAT. This was derived by fitting data to the CAPM.

b) Next, we need CATs market values of debt and equity. Go back to the CAT page on Yahoo! Finance. The market value of equity is also known as market capitalization and can be found on the Summary page.

To find the market value of debt, click on Financials and then Balance Sheet to obtain CATs Total Liabilities Net Minority Interest from the 12/31/2019 column of the balance sheet. Keep in mind that all financial statement items are reports in thousands of dollars, so you will need to add three zeros to the reported number. Because CATs debt is fairly stable, it is safe to assume that the book value of debt equals the market value of debt. Because CATs debt is considered very low risk, we will assume CATs debt beta equals 0.05.

Report the market value of equity and the market value of debt for CAT.

c) Using the information from parts (a) and (b), calculate the asset beta for CAT. Show your workings.

d) Using the CAPM, calculate and report the expected return for CATs assets. Assume a market risk premium of 5.0% and a risk-free rate of 1.84% (the approximate yield on 30-year U.S. treasury securities). Show your workings.

You expect this acquisition to generate its first cash flow next year, and that the cash flow will equal 0.50 percent of your firms cash flows provided by operating activities from the 12/31/2019 column of the cash flow statement (the cash flow statement can be found by clicking on Financials and then Cash Flow; the numbers on this statement are also reported in thousands of dollars). Forecasts inform you that the cash flows generated by this acquisition will grow by 0.40 percent per year thereafter, and that you will receive the cash flows in perpetuity.

e) What is the maximum you would be willing to pay for this heavy machinery company? That is, what is the fair value of this company, according to your calculations?