BM08FI

Model answers (Resit)

1. Imagine two companies that are highly similar in terms of the factors that affect
their EV/EBITDA ratio: their cash flows, long-run growth prospects, their
riskiness and so on. A hurricane strikes one of the companies, lowering EBITDA
and raising reinvestment for the next year – other than that, the damage is
temporary and the firm will return to its growth path. Which company should
temporarily trade at a higher EV/EBITDA ratio or will they be the same? Y9ou
don't need to know or mention any formulas to answer this question; it can be
answered purely based on common sense. (4 points)

Answer: The hurricane strike causes temporary damage to the company. This is
likely to affect EBITDA, short-run reinvestment and EV and lower all of these three.
Crucially however, since we expect the firm to return to its pre-hurricane growth
path, the impact on EV should be lower than the impact on EBITDA and long-run
reinvestment rates should be the same. After this, it becomes a simple mechanical
exercise: EBITDA falls and EV falls, but the fall in current EBITDA will be much larger,
so therefore the EV/EBITDA ratio (based on current year EBITDA) of the affected firm
will rise. Once the firm recovers, the two firms should trade at the same ratio.

Note: Partial credit was given to answers that said both EV and EBITDA fall but the
ratio remains the same (not true, but reasoning is okay).

2. Explain the steps and inputs involved in calculating the implied equity risk
premium for a stock market index and the assumptions required for the
methodology to be valid. You do not need to state assumptions about the
investor being diversified etc. Instead, discuss the assumptions underlying the
inputs of the implied ERP model. (6 points)

Answer: The implied ERP is calculated by “reverse-engineering” the valuation of the

index by using a DCF. That is, decide on an appropriate forecast horizon, find out
expected cash flows from the index (from for instance analyst reports) and the
discount rate for each period. The current level of the index is the valuation of the
index and you have information on cash flows as well as the risk-free part of the
discount rate. If we assume that CAPM is the appropriate risk model, we are left with
one unknown – the ERP. We work backwards from the valuation to determine the
one missing input into the valuation and hence get a forward-looking measure of
risk.

For this to work, we have to assume we are using a similar model the marginal
market participant – that is, we have to assume that our choice of forecast horizon
is correct and that analyst estimates accurately proxy for the market’s growth
expectations and cash flows. We also have to assume that the CAPM is indeed the
correct measure of risk.

Note: People generally performed very poorly on this question. I was generous with
the grading even if the assumptions were not 100%.

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Model answers (Resit)

3. You are an analyst at a hedge fund. Your boss suggests that Fujiba, a Japanese
conglomerate with two divisions, computing equipment and nuclear power,
would unlock value if it were split into two separate companies (one focusing on
computing equipment and the other on nuclear power). Your boss asks you to
value the nuclear power operations as a standalone company. How would you
estimate the CAPM beta of the nuclear operations? Explain the process step-by-
step. You may assume that the marginal investor in Fujiba is Japanese.
(5 points)

Answer: We cannot determine a regression beta since we do not have a price

history for the nuclear arm, only for the entire company. Therefore we have to use
the bottom-up beta method. The steps involved are:
(i) Determine a group of peer firms (same industry, ideally same country, so nuclear
firms in Japan. You can use nuclear firms in other countries if necessary – the exact
peer specification were not the important thing here).
(ii) Calculate regression betas for these firms for an appropriate time horizon (e.g. daily
data, one year).
(iii) Calculate the asset beta (industry beta) by unlevering these betas – that is, adjust for
the capital structures of the peer firms.
(iv) Take the unlevered beta and re-lever it for the expected capital structure of the
standalone nuclear firm (either from current financial statements if available, though
we do not know the value of equity, or based on some sort of target)

Note 1: The principle of right answer + wrong answer applies here, except for some
students who came up with clever-but-flawed ways of trying to calculate a
regression beta for a company with no trading history as well as describing the steps
involved in bottom-up beta

Note 2: Saying take the “average peer beta” is not enough – we need to account for
differences in cap structure

4. A student is calculating the return on invested capital (ROIC) of European airline

firms and observes that there is a significant decrease in ROIC between 2018 and
2019. However, she does not observe any significant decline in revenues or other
costs. Explain to her what might be causing this decline and how she can make
the ROIC figures across years comparable. (5 points)

The decline in ROIC is due to the fact that under IFRS operating leases were capitalized
starting 2019. This means that lease expenses which were previously classified as
operating expenses are no longer treated as such but are capitalized in the balance
sheet and recognized as long-term debt on the liabilities side (tangible asset in the asset
side). This increases the invested capital, which is the denominator in the ROIC
calculation causing the decline in ROIC in 2019. To make the figures comparable across
years, the student should capitalize the operating leases in 2018.

Note 1: some of you mentioned R&D capitalization rather that capitalization of

operating leases. This is incorrect. Under IFRS development expenses are always
capitalized and there was no change in this regard between 2018 and 2019. So this
cannot explain the decline in ROIC between these two years.

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Model answers (Resit)

Note 2: even if the correct reason – capitalization of operating leases was given, full
points have been awarded only when students also mentioned how the capitalization
impacts the invested capital (i.e., tangible assets on the asset side; long-term debt on
the liabilities side).

5. Explain with the help of a numerical example why a firm’s growth rate in the long-
run cannot exceed the growth rate in its industry. For the purposes of illustration
you may assume that there are only two firms in the industry. (10 points)

Answer: Consider an industry for whose products there is an aggregate demand of

$100. Assume there are two firms an industry A and B which have revenues of $60 and
$40. Suppose the demand for the products of the industry grows by 10% each year but
firm A grew by 20% then:

Revenues cannot be negative!  firm B goes out of business; firm A cannot have
revenues higher than $177  in the long-run firm A can at most grow at the industry
growth rate.

Note: some of you answered that the long-run growth rate of a firm cannot exceed the
industry growth rate because that would imply negative revenues for the other firm or
that other firm would go out of business. This is however not the full answer. The
correct reasoning is that the firm with larger growth rate than that of the industry will
over time come to constitute the entire industry (as a result of the other firm going out
of business). It cannot however have revenues outpacing the demand for the industry’s
output which means that the firm’s long-run growth rate is bounded by the industry
growth rate. Full points have been awarded only when you mentioned the above.

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Model answers (Resit)

6. Solution to Excel-based exercise

(in EUR million) 21 May 2021 (A) 31 May 2022 (F) 31 May 2023 (F) 31 May 2024 (F) 31 May 2025 (F)
EBITDA 23.659 23.986 24.295 24.398
NOPAT 5.542 5.671 5.755 5.836
FCFF 3.670 3.787 3.883

RONIC (Nominal) 4,33%

Reinvestment rate 32,53%

3 year forward rate on a 17 year bond (nominal) 2,02%

3 year forward rate on a 17 year bond (real) -0,48%

Exp. Inflation 2,51%

RONIC (Real) 1,77%

Implied stable growth rate (real) 0,58%

Implied stable growth rate (nominal) 3,10% Ans (i)

Unlevered cost of capital 5,12% 5,12% 5,12%

Time to cashflow in months 5,00 17,00 29,00
Time to cashflow in years 0,42 1,42 2,42
Cumulative discount factor 0,979 0,932 0,886

Continuing value (using unlevered cost of capital) 133.331

PV of FCF (using unlevered cost of capital) 3.595 3.529 121.630
Value of unlevered firm 128.753 Ans (ii)

Value effects of financing

Projected debt/EBITDA 5,5 5,2 5
Projected debt level 130.400 130.125 124.727 121.475
Projected cost of debt 2,5% 2,5% 2,5%
Proejcted statutory tax rate 30,00% 30,00% 30,00%
Tax shield 978 976 935
Tax shield in continuing period 32121
PV of tax shield 958 909 29302
Distress costs 0
Net value effect of financing of 31 Dec '21 (= total PV of tax shield) 31.169 Ans (iii)

Market-value
Levered debt-to-equity
Industry peer equity beta ratio Statutory tax rate Asset beta
A 1,5 1,1 30,00% 0,847
B 1,7 1,4 30,00% 0,859
Average 0,853

Average asset Equity market Unlevered cost of

beta Risk-free rate risk premium capital
Projection period 0,853 0,85% 5% 5,12%
Stable growth phase 0,853 1,84% 5% 6,11%

Debt-to- Levered equity Equity market Levered cost of

equity ratio Statutory tax rate beta Risk-free rate risk premium equity
Projection period 1,273 30,00% 1,61 0,85% 5% 8,91%
Stable growth phase 1,273 30,00% 1,61 1,84% 5% 9,90%

Debt-to- Statutory tax Equity-to-value Levered cost

value ratio Cost of debt rate ratio of equity WACC
Projection period 0,56 2,5% 30,00% 0,44 8,91% 4,90% Ans (iv)
Stable growth phase 0,56 2,5% 30,00% 0,44 9,90% 5,34% Ans (iv)

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Model answers (Resit)

21 May 2021 (A) 31 May 2022 (F) 31 May 2023 (F) 31 May 2024 (F)
FCFF 3.670 3.787 3.883
Weighted average cost of capital 4,90% 4,90% 4,90%
Time to cashflow as of 31 Dec '21 0,42 1,42 2,42
Cumulative discount factor 0,980 0,934 0,891
Continuing value 179.069
PV of discounted CF 3.598 3.539 162.969
Value of firm's operating assets as of 31 Dec '21 (= total PV of discounted CF) 170.105
- Operating liabilities
Deferred tax liabilities 114.750
+ Non-operating assets
Investments in associates and joint ventures (market value estimate) 200.000
Other financial fixed assets 33.150
Deferred tax assets 0
Excess Cash 19.938
Assets held for sale 29.225
- Non-operating liabilities
Pensions and other post employement benefits 37.750
Liabilities associated with assets held for sale 14.475
- Debt 130.400
- Minority interest (market value estimate) 41.014
- Value of preferred equity 0
- Value of share-based compensation 0
Value of ordinary shares 114.029
- Illiquidity discount 0
- Minority discount 0
Number of shares outstanding 5.000
Value per share (in EUR) 22,81 Ans (v)

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