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Beta
1.1
1.5
2.0
1.0
1.275
a. Estimate the beta for Hewlett Packard as a company. Is this beta going to be equal to the
beta estimated by regressing past returns on HP stock against a market index. Why or
Why not?
We need to compute the weighted average of betas. Where, the weights are determined by the
market value of equity of each division.
Beta = (2/8)1.1 + (2/8)1.5 + (1/8)2 + (3/8)1 = 1.275
b. If the Treasury bond rate is 7.5% and market risk premium is 5.5%, estimate the cost of
equity for Hewlett Packard. Estimate the cost of equity for each division. Which cost of
equity would you use to value the printer division?
Business Group
Mainframes
PC
Software
Printers
Total
MV of Equity
$2.0 billion
$2.0
$1.0
$3.0
$8.0
Beta
1.1
1.5
2.0
1.0
1.275
Unlevered beta
1.1/(1+(1-.36)*(1/8))
1.5/(1+(1-.36)*(1/8)
2.0/(1+(1-.36)*(1/8)
1.0/(1+(1-.36)*(1/8)
1.275/(1+(1-.36)*(1/8)
COE
13.10%
15.13%
17.68%
12.59%
14%
(Disclaimer: this is my answer and may be different than the one suggested by the original
author).
Note: We need to unlevered the beta and than calculate the COE. The total value of the firm is
MV Equity + MV Debt = $8B +$1B = $9 Billions
It depends. If HP is interested to spawn-off the printers division, than we would have used the
COE relevant to the printers division. Otherwise, we would have used the COE applicable to all
of HP business. The reason is that the printers division has a share in the FCFE of the firm that is
not given here. Moreover, There are some returns to scales that can be considered (e.g.: lower
CAPEX in the combined firm compared to the stand alone firm).
c. Assume that HP divests itself of the mainframe business and pays the cash out as a
dividend. Estimate the beta for HP after the divestiture. (HP had $1 billion in debt
outstanding).
The betas computed in (a) were levered betas. We now need to account for firm value as a
whole (MV D and MV E).
o Total firm value = MV Equity+MV Debt = $8 + $1 = $9
o Assume a tax rate 36%
What will the company receive from selling its mainframe business?
o A simple answer is 2 billions. However, this is not a standalone value. As it must also
include the portion of debt used to finance its operations.
o The mainframe business is 25% of MV of equity and assumes it is also 25% of MV
of debt. Therefore, it will be sold at $2.25 billions. Thus the total enterprise value is
9-2.25 = $6.75 billions.
Total MV Equity = $6 B
Total MV Debt = $0.75B
o To calculate beta of HP we need to repeat (a) and (b) with new weights
Levered beta =
Business Group
PC
Software
Printers
Total
MV of Equity
$2.0
$1.0
$3.0
$6
Beta
1.5
2.0
1.0
1.333
Unlevered beta
1.5/(1+(1-.36)*(0.75/6.75)
2.0/(1+(1-.36)*(0.75/6.75)
1.0/(1+(1-.36)*(0.75/6.75)
1.333/(1+(1-.36)*(0.75/6.75)
2. The following table summarizes the percentage changes in operating income, percentage
changes in revenue and betas for four pharmaceutical firms.
Firm
PharmaCorp
SynerCorp
BioMed
Safemed
% Change in revenue
27%
25%
23%
21%
Beta
1.00
1.15
1.30
1.40
% Change in
revenue
27%
25%
23%
21%
% Change in operating
income
25%
32%
36%
40%
Beta
1.00
1.15
1.30
1.40
0.92
1.15
1.3
1.4
b. Use the operating leverage to explain why these firms have different betas.
- There is a clear relationship between the degree of operating leverage and the beta.
The greater the degree of operating leverage, the more responsive income (and
presumably stock returns) will be to changes in revenue which are correlated with
changes in market movements.
3. Battle Mountain is a mining company, which mines gold, silver and copper in mines in
South America, Africa and Australia. The beta for the stock is estimated to be 0.30. Given
the volatility in commodity prices, how would you explain the low beta?
- Recall that the company can hedge its exposures to these commodities by entering a
forward (or buying a future) contracts. That is, if commodity prices affect the
overall market, than hedging practices will mitigate the correlation between returns
and market fluctuations.
If commodities do not affect the market, than the low beta is explained in the sense
that commodity prices will not reflect on the market risk component of overall firm
risk but on the individual risk component (which in theory can be diversified away).
1. Zif Software is a firm with significant research and development expenses. In the most
recent year, the firm had $100 million in research and development expenses. R&D
expenses are amortizable over 5 years and the R& D expenses over the last 5 years are as
follows:
Year
Current
-1
-2
-3
-4
-5
R&D Expenses
$ 100 Million
$ 90
$ 80
$ 70
$ 60
$ 50
Year
Current
-1
-2
-3
-4
-5
R&D
Expenses
$ 100
$ 90
$ 80
$ 70
$ 60
$ 50
Current year
amortization
0
18
16
14
12
10
Unamortized
Amount
100
72 = 90*0.8
48=80*0.6
28 = 70*0.4
12 = 12*0.2
0
% of original
expense
100%
80%
60%
40%
20%
0
Total
70
260
Estimate the value per share, using the Dividend Discount Model.
Estimate the value per share, using the FCFE Model.
How would you explain the difference between the two models and which one
would you use as your benchmark for comparison to the market price?
of $2.02 in 1993 and paid no dividends. These earnings are expected to grow 14% a year
for five years (1994 to 1998) and 7% a year after that. The firm reported depreciation of
$2 million in 1993 and capital spending of $4.20 million, and had 7 million shares
outstanding. The working capital is expected to remain at 50% of revenues, which were
$106 million in 1993, and are expected to grow 6% a year from 1994 to 1998 and 4% a
year after that. The firm is expected to finance 10% of its capital expenditures and
working capital needs with debt. Dionex had a beta of 1.20 in 1993, and this beta is
expected to drop to 1.10 after 1998. (The treasury bond rate is 7%)
Estimate the expected free cash flow to equity from 1994 to 1998, assuming that
capital expenditures and depreciation grow at the same rate as earnings.
b. Estimate the terminal price per share (at the end of 1998). Stable firms in this
industry have capital expenditures that are 150% of revenues and maintain
working capital at 25% of revenues.
c. Estimate the value per share today, based upon the FCFE model.
a.
1993
1994
1995
1996
1997
1998
1999
$2,02
$2,30
$2,63
$2,99
$3,41
$3,89
$4,16
CAPEX/Share
$0,60
$0,68
$0,78
$0,89
$1,01
$1,16
$0,88
Depreciation/share
$0,29
$0,33
$0,37
$0,42
$0,48
$0,55
$0,59
Net Capex/Share
$0,31
$0,36
$0,41
$0,47
$0,53
$0,61
$0,29
Revenues/share
$15,14
$16,05
$17,01
$18,04
$19,12
$20,26
$21,08
$7,57
$8,03
$8,51
$9,02
$9,56
$10,13
$5,27
$0,45
$0,48
$0,51
$0,54
$0,57
$(4,86)
10,0%
10,0%
10,0%
10,0%
10,0%
10,0%
$1,28
$1,49
$1,73
$2,01
$2,33
$7,75
EPS
WC
Change in WC
D/(D+E)
FCFE/Share
10,0%
Beta
120,0%
120,0%
120,0%
120,0%
120,0%
120,0%
110,0%
Market premium
5,5%
5,5%
5,5%
5,5%
5,5%
5,5%
5,5%
Rf
7,0%
7,0%
7,0%
7,0%
7,0%
7,0%
7,0%
13,60%
13,60%
13,60%
13,60%
13,60%
13,60%
13,05%
COE
Terminal Price
PV
128,0452193
1,125301811
1,154609878
1,182325476
1,208556442
1,2334034
59,57902339
$65,48
Value
3. Biomet Inc. designs, manufactures and markets reconstructive and trauma devices and
reported earnings per share of $0.56 in 1993, on which it paid no dividends (It had
revenues per share in 1993 of $2.91). It had capital expenditures of $0.13 per share in
1993 and depreciation in the same year of $0.08 per share. The working capital was 60%
of revenues in 1993 and will remain at that level from 1994 to 1998, while earnings and
revenues are expected to grow 17% a year. The earnings growth rate is expected to
decline linearly over the following five years to a rate of 5% in 2003. During the high
growth and transition periods, capital spending and depreciation are expected to grow at
the same rate as earnings, but are expected to offset each other when the firm reaches
steady state. Working capital is expected to drop from 60% of revenues during the 19941998 period to 30% of revenues after 2003. The firm has no debt currently, but plans to
finance 10% of its net capital investment and working capital requirements with debt.
The stock is expected to have a beta of 1.45 for the high growth period (1994- 1998) and
it is expected to decline to 1.10 by the time the firm goes into steady state (in 2003). The
treasury bond rate is 7%.
Estimate the value per share, using the FCFE model.
Estimate the value per share, assuming that working capital stays at 60% of
revenues forever.
c. Estimate the value per share, assuming that the beta remains unchanged at 1.45
forever.
a.
b.
10
11
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
EPS
0,56
0,66
0,77
0,90
1,05
1,23
1,41
1,58
1,73
1,86
1,95
2,05
Rev/Share
2,91
3,40
3,98
4,66
5,45
6,38
7,31
8,20
9,01
9,67
10,16
10,67
5%
Growth
17%
17%
17%
17%
17%
17%
15%
12%
10%
7%
5%
CAPEX/Share
0,13
0,15
0,18
0,21
0,24
0,29
0,33
0,37
0,40
0,43
0,45
Dep/Share
0,08
0,09
0,11
0,13
0,16
0,21
0,28
0,38
0,53
0,76
1,11
Net Capex
0,05
0,06
0,07
0,08
0,08
0,08
0,05
(0,01)
(0,13)
(0,33)
(0,66)
WC
1,75
2,04
2,39
2,80
3,27
3,83
4,39
4,92
5,40
5,80
6,09
3,20
0,30
0,35
0,41
0,48
0,56
0,56
0,54
0,48
0,40
0,29
(2,89)
dWC
D portion
10%
10%
10%
10%
10%
10%
10%
10%
10%
10%
10%
10%
beta
1,45
1,45
1,45
1,45
1,45
1,45
1,45
1,45
1,45
1,45
1,1
1,1
0,33
0,39
0,46
0,55
0,66
0,86
1,11
1,42
1,80
2,28
4,66
14,98%
14,98%
14,98%
14,98%
14,98%
14,98%
14,98%
14,98%
14,98%
13,05%
13,05%
0,29
0,30
0,30
0,31
0,33
0,37
0,42
0,46
0,51
0,67
Rf
Market
premium
7%
5,50%
FCFE
COE
PV
PV(Terminal)
16,97
Value
20,94