Exam 7: Merger and Acquisition Cash Flow Valuation Basics

Intuition suggests that the length of the high-growth period when applying the variable growth model should be shorter the greater the current growth rate of the firm's cash flow.

A risk-free rate of return is one for which the expected return is certain.

Growth rates can be calculated based on the historical experience of the firm or industry.

ABC Incorporated shares are currently trading for $32 per share. The firm has 1.13 billion shares outstanding. In addition, the market value of the firm's outstanding debt is $2 billion. The 10-year Treasury bond rate is 6.25%. ABC has an outstanding credit record and has earned an AAA rating from the major credit rating agencies. The current interest rate on AAA corporate bonds is 6.45%. The historical risk premium for stocks over the risk-free rate of return is 5.5 percentage points. The firm's beta is estimated to be 1.1 and its marginal tax rate, including federal, state, and local taxes is 40%. a. What is the cost of equity? b. What is the after-tax cost of debt? c. What is the cost of capital?

The following information is available for two different common stocks: company A and Company B. Company A Company B Free frsh flow per share in the curent year \ 1.00 \ 5.00 Grawthrate in cath flow per share 8\% 4\% Beta 1.3 .8 Risk-free return 7\% 7\% Expected return on all stacks 13.5\% 13.5\% a. Estimate the cost of equity for each firm. b. Assume that the companies' growth rates will continue at the same rate indefinitely. Estimate the per share value of each companies common stock.

The zero growth model is a special case of what valuation model?

Which of the following is not true about the constant growth valuation model?

A firm's credit rating is a poor measure of a firm's default risk.

The weighted average cost of capital consists only of debt and equity.

The levered beta reflects the firm's degree of cyclicality, operating and financial leverage.

When cash flow is temporarily depressed due to strikes, litigation, warranty claims, or other one-time events, it is generally safe to assume that cash flow will recover in the near term.

In calculating the weighted average cost of capital, the weights should be estimated using the market value of the target firm's debt and equity.

Free cash flow to the firm is also called enterprise cash flow.

Which of the following is not true about the variable growth valuation model?

What does a firm's $\beta$ measure? What is the difference between an unlevered and levered $\beta$ ? Why is this distinction significant?

The cost of equity can also be viewed as an opportunity cost.

HiFlyer Corporation does not currently have any debt. Its tax rate is .4 and its unlevered beta is estimated by examining comparable companies to be 2.0. The 10-year Treasury bond rate is 6.25% and the historical risk premium over the risk free rate is 5.5%. Next year, HiFlyer expects to borrow up to 75% of its equity value to fund future growth. a. Calculate the firm's current cost of equity. b. Estimate the firm's cost of equity after it increases its leverage to 75% of equity?

Studies show that it is generally unnecessary to adjust the capital asset pricing model for the size of the firm .

Whatever the analyst chooses to do with respect to the selection of a tax rate, it is critical to use the marginal rate in calculating after-tax operating income in perpetuity. Otherwise, the implicit assumption is that taxes can be deferred indefinitely.

The market risk or equity premium refers to the additional rate of return in excess of the weighted average cost of capital that investors require to purchase a firm's equity.