STRATEGIC FINANCIAL

MANAGEMENT

EQUITY VALUATION

ADDITIONAL PRACTICE QUESTIONS

 Strategic Financial Management

PROBLEM - 1
The following data has been extracted from a popular stock index.

Day Value of index

1/3/2000 4100
2/3/2000 4200
3/3/2000 4350
4/3/2000 4100
5/3/2000 3850

The 100 day simple moving average as on 29/2/2000 is 4000. You are required
to calculate the 100 day exponential moving average starting from 1/3/2000.
(The value of exponent for 100 days may be taken as 0.02.)

Solution :
Col (D)
EMA for the day
Day At Ft-1 et Multiplied by
(F)
(A) (B) (C) (D) Exponent (E)
Ft=C + D
 et
1 4100 4000.00 100.00 2.00 4002.50
2 4200 4002.00 198.00 3.96 4005.96
3 4350 4005.96 344.04 6.88 4012.84
4 4100 4012.84 87.16 1.74 4014.58
5 3850 4014.58 -164.58 -3.29 4011.29

Assume : The EMA of previous day is assumed to be 4000.

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PROBLEM - 2
Given below is the daily price information of Larsen & Toubro for the last 6
trading session in March, 1999.

Day Price of L & T (Rs.)

1 575.50
2 545.40
3 535.35
4 540.80
5 542.50
6 550.60

You are required to

i. Calculate the 50-day. Exponential Moving Average (EMA) for Larsen &
Toubro. You can assume that the 50-day Simple Moving Average (SMA)
for the first day is Rs. 532.25.

ii. Compare EMA with price and interpret the results.

Solution :

i. The exponential moving average of L & T is calculated as follows :

The suitable exponent for 50 days period is 0.04

Day Price (Rs) Previous day Difference (IV) × EMA

(I) (II) EMA (Rs) (III) (IV) exponent (V) III+V
At Ft-1 et  et Ft
1 575.50 532.25 43.25 1.73 533.98
2 545.40 533.98 11.42 0.46 534.44
3 535.35 534.44 0.91 0.04 534.47
4 540.80 534.47 6.33 0.25 534.73
5 542.45 534.73 7.72 0.31 535.04
6 550.60 535.04 15.56 0.52 535.56

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ii. It is observed that the price line is above EMA line.

The price line has come down to the EMA line. The same does not give any
signal at the moment. However, if price line crosses the EMA line and goes
down, it will be a 'sell' signal. An investor should carefully watch the prices
in the coming days.

PROBLEM - 3
EC Limited, a manufacturer of electronic cards, is a listed company. The
current stock price of the company’s stock is Rs.160 per share. The earnings
and dividend growth prospects of the company are disputed by different
analysts. Mr. R. Ramamurthy is forecasting a growth of 7.50% for ever.
However, Mr. S. Prabhu is predicting a 25% growth in dividends for the next
three years after which the growth is to decline to a level of 5% p.a. forever.
The current dividend per share is Rs.11 and stocks of company’s of similar
risk are currently priced to provide 14% expected return.

You are required to calculate

i. The intrinsic value of EC Limited’s share based on the projections of Mr. R.

Ramamurthy.

ii. The intrinsic value of EC Limited’s share based on the projections of Mr. S.
Prabhu.

iii. The implied perpetual growth rate assuming that the stock is correctly
priced.

Solution :

i. The intrinsic value of EC Limited’s share according to Mr. R. Ramamurthy

is calculated as follows:
D0  1  g  11  1.075  11.825
V0    = Rs.181.92
Ke  g 0.14  0.075 0.065

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ii. The intrinsic value of EC Limited’s share according to Mr. S.Prabhu is

calculated as follows:

Year Dividends PV @ 14% PV of dividends

1 13.75 0.877 12.06
2 17.18 0.769 13.21
3 21.48 0.674 14.48
39.75

D3  1  g  21.48  1.05 
Price at the end of year 3, P3    250.60
0.14  0.05 0.09

PV of P3 = 250.6  0.674 = 168.90

V0 = 168.90 + 39.75 = Rs.208.65

iii. If we assume that the stock is currently correctly priced, the implied
perpetual growth rate is calculated as follows:

11  1  g 
160 
0.14  g
= 160 (0.14 - g) = 11 + 11g
= 22.4 - 160g = 11 + 11g
or, + 171g = +11.4
11.4
or, g  6.67%
171

PROBLEM - 4
Aksh Optima, is a company operating in a mature industry. Presently, its EPS
is Rs. 6.75. Aksh's dividend pay-out ratio is 60% and ROE is 10% and both of
these are expected to be the same in the near future. The beta of the company
is 0.86. The treasury bill rate is 9.86% and the average return from the market
is 15.26%.

You are required to:

i. Calculate the intrinsic value of Aksh Optims shares using Dividend

Discount Model (DDM).

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ii. Calculate the intrinsic value of Aksh Optima shares using DDM while
considering that the company acquires another company and as a result
dividends grow at 20% for the next three years and return to the constant
historical growth rate from 4th year.

Solution :

Required rate of return for Akash optima

= R f  i  R m  R f 
= 9.86 + 0.86 (15.26-9.86)
= 9.86 + 4.64 = 14.5%
D 0 1  g 
i. V0 
Ke  g
g = ROE (1 - d)
= 0.1 (1 - 0.60)
(Where d is the dividend pay-out ratio)
= 0.1 (0.4) = 0.04 = 4%
D0 = 6.75 × 0.6 = 4.05
4.05 1.04  4.212
V0  
0.145  0.04 0.105
= Rs. 40.11

ii. D0 = 4.05

Year Div PV@14.5% PV (Div)

1 4.05 × 1.2 = 4.86 0.873 4.24
2 4.86 × 1.2 = 5.83 0.763 4.45
3 5.83 × 1.2 = 7.00 0.666 4.66
13.35

7.00 1.04  7.28

P3    69.33
0.145  0.04 0.105

Present value of P3 = 69.33 × PVIF(14.5, 3)

= 69.33 × 0.666 = 46.17

Intrinsic Value = 46.17 + 13.35 = Rs. 59.52

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 EQUITY-Additional Practice Questions

PROBLEM - 5
The Beta Coefficient of Target Ltd. is 1.4. The company has been maintaining
8% rate of growth in dividends and earnings. The last dividend paid was `4
per share. Return on government securities is 10%. Return on market portfolio
is 15%. The current market price of one share of Target Ltd. is `36.

i. What will be the equilibrium price per share of Target Ltd. ?

ii. Would you advise purchasing the share?

Solution :

i. Expected rate of return on Equity Share of Target Ltd.

E(R P )  R f  i [E(R m )  R f ]
= 10 + 1.4(15% - 10%) = 17%

Computation of share price based on dividend growth model.

D1
Dividend growth model = g
P0
Where D1 = Dividend per share in year 1
g = Growth rate of dividends
P0 =Market price/share in year 0.

4(1.08)
0.17   0.08
P0
4(1.08)
0.09 
P0
4(1.08)
P0   `48
0.9

ii. The target Ltd’s equity share is valued at an equilibrium price of `48 and its
present market value is at `36. Hence it is recommended to purchase at
market price.

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PROBLEM - 6
Consider a firm which is present in 3 industries –X, Y and Z. The firm has
20 crores shares outstanding. The following details are given :

Particulars X Y Z
Industry sales projected 5000 cr 15000 cr 20000 cr
Market share of the firm 20% 10% 15%
Net profit margin of the firm 18% 15% 25%

Use Re = 16.24%

i. Calculate the intrinsic value of the share if the firm has a 100% payout ratio.

ii. The firm follows a constant payout ratio of 70%. Its return on equity (ROE)
is expected to be Case I - 20%, Case II - 16.24%, Case III - 12%.Find the
intrinsic value of the share and comment.

Solution :

i. PAT1 = 18% × 20% × 5000 + 15% × 10% × 15000 + 25% × 15% × 20000
= 180 + 225 + 750
= 1155 cr.

1155
 E1   57.75
20
 There is 100% payout ratio D1 = E1 = 57.57 a perpetuity
A 57.75
 N0    355.60
i .
01624

ii.
Particulars V = 20% V = 16.24% V = 12%
E1 57.75 57.75 57.75
D1 (70% × E1) 40.425 40.425 40.425
g 6% 4.872% 3.6%
Re 16.24% 16.24% 16.24%
PV0 D1 D1 D1
Re  g Re  g Re  g

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 EQUITY-Additional Practice Questions

40.425 40.425 40.425

=394.75 = 355.60 =319.82
10.24% 11.368% 12.64%
Comment : Since ROE > Re, Since ROE = RE Since ROE < Re,
retention is dividend policy is retention is bad
good & such irrelevant growth destroys
growth creates value.
value.

PROBLEM - 7

Megatron Ltd paid a dividend of `2.60 during the last year and the growth
rate in the dividends are expected to be 8%. The current market price of the
stock is `30.00. The beta of the stock is 1.60 and the return on the market index
is 13%. If the risk free rate of return is 8%, by how much should the price of
the stock be raised in percentage terms so that it is at equilibrium?

Solution :
Using CAPM, Re = Rf + (Rm - Rf)Beta
or, Re = 8 + (13 - 8) 1.6 = 16%
IVo = D1/(Re-g)
= 2.6(1.08)/(.16-.08) = 35.1
Po = 30
To reach at equilibrium level, Po = IVo.
so the stock should go from `30 to `35.1
i.e. (35.1 - 30)/30 100 = 17%

PROBLEM - 8
Yield on Govt. Securities = 7%
Market Risk Premium = 6%
It has been found that when the market return charges by 7.5%, the return in
stock changes by 15%
Calculate required rate of return on the stock?

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Solution :
When the market changes by 7.5%, the stock return changes by 15%,
so the beta of the stock = 15/7.5 = 2.
As per CAPM, Re = Rf+(Rm-Rf)beta
= 7+6  2 = 19%.

PROBLEM - 9

Consider a no growth firm with 100% payout ratio. It is trading in the market
at a PE multiple of 12. If systematic risk fall by 25%. Calculate revised P/E
Ratio. Use Rf = 4%, and market risk premium = 6%.

Solution :
1
For a no growth firm Re 
P E ratio
1
  8.33%
12
CAPM : Re = Rf + (Rm - Rf)
8.33 = 4 + 6
 = 0.72
New  = 0.72 - 0.72 × 25% = 0.54
 New Re = 4 + 6 × 
= 4 + 6 × 0.54
= 7.24%
Revised P/E ratio
1
  13.81 times
0.724

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 EQUITY-Additional Practice Questions

PROBLEM - 10

Mr. Jain, an analyst is evaluating Tedat Industries Ltd. (TIL). The company has
maintained high growth rates in the face of strong competition in the last few
years; it has done so while maintaining high returns on capital. The
fundamentals suggest that growth will continue to be high and given the size
of the market and potential growth (as well as the strong brand name
identification), growth seems sustainable for a longer period.

Earnings per share of TIL in 2006-07 is ` 32

The following are the assumptions made by Mr. Jain
Assumptions for the High Growth Period
 Length of the high growth Period
 Expected growth rate in earnings is 25% (Based upon analyst projections)
 Beta during high growth period is 1.40
 Risk free rate is 6.5%
 Market rate of return is 20%
 Dividend payout Ratio is 20% (based on existing payout ratio)
Assumptions for the Transition Period
 Length of the transition period is 5 years.
 Growth rate in earnings will decline from 25% in year 5 to 10% in year 10 in
linear increments.
 Payout ratio will increase from 20% to 60% over the same period in linear
increments.
 Beta will drop from 1.40 to 1.00 over the same period in linear increments.
 Risk free rate is 6%
 Market rate of return is 15%
You are require to
i. Estimate the share price of TIL as on March 31, 2007 as per the assumptions
made by Mr. Jain.
ii. If the shares of the top five companies of the industry to which TIL belongs
to are trading at the average P/E of 45, what should be done by Mr. Jain, if
the current price reflects the intrinsic value calculated in (i) above.

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Solution :

Stage I + Stage II  Explicit forecast period (1st 10 yrs)

E0 = 32

i.
Yrs Growth EPS Payout DPS  Re PV
Rate of EPS Ratio
1 25% 40 20% 8 1.4 25.4% 6.38
2 25% 50 20% 10 1.4 25.4% 6.36
3 25% 62.5 20% 12.5 1.4 25.4% 6.34
4 25% 78.13 20% 15.63 1.4 25.4% 6.32
5 25% 97.66 20% 19.53 1.4 25.4% 6.30
6 22% 119.14 28% 33.36 1.32 17.88 9.13
7 19% 141.78 36% 51.04 1.24 17.16 11.92
8 16% 164.46 44% 72.36 1.16 16.44% 14.52
9 13% 185.84 52% 96.64 1.08 15.72% 16.76
10 10% 204.43 60% 122.66 1 15% 18.49
102.5

Stage 3
Horizon Period (Beyond 10 yrs)
D11 = 122.66 × 1.1 = 134.93
D11 134.93
P10    2698.6
Re  g 015
.  010
.
18.49
PV of P10  P10 
122.66
18.49
 2698.6  = 406.79
122.66
Share price today = 406.79 +102.5
= 509.29

Pr ice 509.29
ii. P/E ratio of TIL    15.92 .
EPS 32
This is significantly less than P/E ratio of top 5 firms in the industry.
So, TIL is relatively underpriced - Mr. Jain is advised to buy the stock.

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 EQUITY-Additional Practice Questions

PROBLEM - 11

Consider the following data for the year just ended -

Revenue 7500 crores

Operating exp including depreciation 4500 crores.
Capital spending - Depreciation 600 crores.
Working Capital 1200 crores
Tax rate 30%

All components of FCFF are expected to grow by 12%

If Kc = 15% and market value of Debt is 7000 crores calculate intrinsic value of
shares No, of shares = 250 crore

Solution :
Step 1 : NOPAT for the next yr.

For the year just ended 

Revenue 7500
(-) Operating Expenses Including dep 4500
EBIT 3000
NOPAT @ 70% (3000 × 70%) = 2100
Growth 12%
NOPAT1 2100 × 1.12 = 2352

Step 2 : Calculation of net investment for the next yr.

Capital spending - dep = 600 × 1.12  672

 wc = 1200 × 0.12  144
Net Investment  816

Step 3 : FCFF = NOPAT - Net investment

= 2352 - 816 = 1536

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FCFF1
Value of the firm 
Re  g
1536
  51, 200 cr
0.15  0.12
Less : Value of debt = (7000 cr)
Value of Equity = 44200 cr
No. of Shares = 250 cr

44200
PV0   176.8
250

PROBLEM - 12

Karan Rajouri Limited (KBL), a household product manufacturer, reported

earnings per share of ` 3.20 during last year and paid dividends per share of
`1.7. The firm reported depreciation of ` 315 lakh and capital expenditures of
`475 lakh. There were 160 lakh shares outstanding trading at ` 51 per share.
The net capital expenditures is expected to grow same as the earnings. The
working capital needs are negligible, KRL had debt outstanding of ` 16 crore
and intends to maintain its current financing mix to finance future investment
needs. The firm is in a steady state, and earnings are expected to grow 7% a
year. The stock has a beta of 1.05 and treasury bond rate is 6.25%. The risk
premium expected from the market portfolio is 5.5%.
You are required to
i. Estimate the value per share, using the dividend discount model
ii. Estimate the value per share using FCFE model.
iii.Explain why the estimates of the value per share are different in (i) and (ii).
iv. Explain which one you would suggest to use as benchmark for comparison
to the market price.

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Solution :
i. Rf + (Rm - Rf)
= 6.25 + 5.5 × 1.05
= 12.025%
D0 = 1.7; g = 7% D1 = 1.7 × 107% = 1.819
D1 1.819
PV0    36.20
Re  g 012025
.  0.07

ii. Market Value of Equity = 160 × 51 = 8160 lacs

Debt = 160 × 100 = 1600 lacs
= 9760 lacs.
Equity Financing Ratio = We  83.61%
= Wd = 16.39%
Capital Spending  Dep WC
Net investment 1 share 
no of shares
475  315  0
 ` 1 / share
160
Equity Investment / share = 83.61% × 1
= 0.8361
 FCFE0  EPS - Equity Investment/share
= 3.2 - 0.836
= 2.3639
g = 7%

 FCFE1 = 2.3639 × 107%

= 2.5294

FCFE1 2.5294
 PV0    50.34
Re  g 012025
.  0.07

iii.The value estimates as per DDM & FCFE ave different because of difference
in the estimate of D & FCFE - D is 1.819 & where as FCFE, is 2.5294

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PROBLEM - 13
Zanskar Advisors (ZA) announced that the current financial year's income
statement reports its net income to be ` 15,00,000. Zanskar marginal tax rate is
30 percent, and its interest expense for the year was ` 10,00,000. The company
has ` 60,00,000 of invested capital, of which 60 percent is debt. In addition,
AAA tries to maintain a weighted average cost of capital (WACC) near 10
percent.

i. Compute the operating income, or EBIT, Zanskar earned in the current

year.
ii. What is Zanakar Economic Value Added (EVA) for the current year?
iii.Zanskar has 4,00,000 equity share outstanding. According to the EVA value
you computed in part b, how much Zanakar can pay in dividends per share
before the value of the firm would start to de-crease? It Zanaskar does not
pay any dividends, what would you expect to happen to the value of the
firm?

Solution :

i. PAT = 15,00,000
tax rate = 30%
PBT = 21,42,857
Add : interest expense = 10,00,000
31,42,857  EBIT
ii. NOPAT = EBIT (1 - t) = 22,00,000
(- ) Capital Charge = 6000000 × 10% = 600000
 EVA = Nopat - Capital Charge
= 22,00,000 - 6,00,000 = 16,00,000
iii.Maximum DPS = EVA/share
= 16,00,000/4,00,000 = ` 4
In fact, if big basket does not pay dividend, retained earnings will be higher
resulting in higher capital employee i.e higher EVA & therefore higher value
of the firm.

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PROBLEM - 14

Splash is a small but profitable produced of beauty cosmetics using the plant
Aloe Vera. This is not a high-tech business, but Splash earnings have average
around `16 lakh after tax, largely on the strength of its patented beauty cream
for removing the pimples.
The patent has eight years to run, and Herbal has been offered ` 60 lakhs for
the patent rights. Splash assets include ` 25 lakhs of working capital and
` 90 lakhs of property, plant, and equipment. The pat-ent is not shown on
Splash books. Suppose Splash cost of capital is 12 percent. What is its
Economic Value Added (EVA)?

Solution :
In the absence of interest information, NOPAT = PAT = 16
Capital employed including patent = 60 + 25 + 90 = 175
 Capital Charge = 12% × 175 = 21
 EVA = 16 - 21 = (5) lakhs.

PROBLEM - 15

Using the SOPV approach(or Break-up value approach), assign a value for ITC
Ltd. Whose stock is currently trading at a total market price of `8 million. For
ITC, the accounting data set forth three business segments : Cigarettes, FMCG,
and paper. Data for the firm's three segments are as follows:
` in lakhs
Business segment Segment sales Segment assets Segment income
Cigarettes 30 15 2
FMCG 16 14 3
Paper 40 60 12

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Industry data for 'pure play' firms have been compiled and summarized as
follows:

Business Capitalization / Capitalization / Capitalization/

Segment Sales Assets operating Income
Cigarettes 1.5 1.2 20
FMCG 2.20 1.8 14
Paper 2 1.2 12

Solution :
I. Valuation of Cig Division
 Using sales = P/S × Sales
= 1.5 ×30 = 45
 Using Assets = 15 × 1.2 = 18

 Using Operating Income = P/E × operating Income = 2 × 20 = 40

45  18  40
Average Value of the Cigarette division =  34.33
3

II. Valuation of FMCG division

 Using sales = 16 × 2.2 = 35.2
 Using Assets = 14 × 1.8 = 25.2
 Using Operating Income = 3 × 14 = 42
Average = 34.13

III. Valuation of Paper

 Using Sales = 40 × 2 = 80
 Using Assets = 60 × 1.2 = 72
 Using Operating Income = 12 × 12 = 144
Average = 98.67

As per the Sum of Parts Approach , value of ITC = 34.13 + 34.33 + 98.67
= 167.13 Lacs
Given the current market value of ITC i.e. 80 Lacs it seems to be trading cheap
& a long position is advisable.

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PROBLEM - 16
The market price of Axis Ltd. Is Rs. 80. The current EPS is Rs. 7 and is
expected to grow at the rate of 3% per year. The present dividend retention
ratio is 40% and is expected to stay at this level in the future. If the investor
decides to buy and hold it for four years, what should be the ending P/E ratio,
if the investor's required return is 13% during the holding period?

Solution :
Given,
Current market price = Rs. 80
Current EPS = Rs. 7
Growth rate in earnings = 3%
Retention ratio = 40%
Holding period = 4 years
Required rate of return = 13%
The price of the share, P0 is equal to the PV of the dividend stream for four
years and the PV of the market price at the end of the fourth year. The market
price at the end of the fourth year

  EPS  4   P / E   E 0 1  g    P / E  4
4

Mathematically we express it as shown below.

E0 1  g   Payout ratio  E0 1  g   P /E 4
t 4
4
P0   
1  k  1  k 
t 4
t 1

Substituting the respective value we have

7 1  0.03  P / E 4
4
7 1  0.03 0.60  7 1  0.03  0.06  7 1  0.03  0.60  7 1  0.03  0.06 
2 3 4

80     
1  0.13 1  0.13
2
1  0.13
3
1  0.13
4
1  0.13
4

80  3.828  3.489  3.180  2.899  4.832  P /E 4

80  13.396  4.832  P /E 4
 P /E 4  66.604 / 4.832  13.78
That is, the PE ratio at the end of the fourth year should be 13.78 so that the
investor could earn a return of 13%.

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PROBLEM - 17
Calculate the value of share of Avenger Ltd. from the following information:

Equity capital of company ` 1,200 crores

Profit of the company ` 300 crores
Par value of share ` 40 each
Debt ratio of company 25
Long run growth rate of the company 8%
Beta 0.1; risk free interest rate 8.7%
Market returns 10.3%
Change in working capital per share `4
Depreciation per share ` 40
Capital expenditure per share ` 48

Solution :
` 1200 crore
No. of Shares   30 Crores
` 40
PAT
EPS 
No. of shares
` 300 crore
EPS   ` 10.00
30 crore

FCFE = Net income – [(1-b) (capex – dep) + (1-b) (ΔWC)]

FCFE = 10.00 – [(1- 0.25) (48 - 40) + (1 - 0.25) (4)]
= 10.00 – [6.00 + 3.00] = 1.00

Cost of Equity = Rf + β (Rm – Rf)

= 8.7 + 0.1 (10.3 – 8.7) = 8.86%

FCFE 1  g  1.00 1.08  1.08

P0     ` 125.58
Ke  g 0.0886  0.08 0.0086

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SANJAY SARAF SIR
 EQUITY-Additional Practice Questions

PROBLEM - 18
XN Ltd. reported a profit of ` 100.32 lakhs after 34% tax for the
financial Year 2015- 2016. An analysis of the accounts reveals that the income
included extraordinary items of ` 14 lakhs and an extraordinary loss of
` 5 lakhs. The existing operations, except for the extraordinary items, are
expected to continue in future. Further, a new product is launched and
the expectations are as under:

Particulars Amount ` in lakhs

Sales 70
Material Costs 20
Labour Costs 16
Fixed Costs 10

The company has 50,00,000 Equity Shares of ` 10 each and 80,000, 9%

Preference Shares of ` 100 each with P/E Ratio being 6 times.

You are required to:

i. compute the value of the business. Assume cost of capital to be 12% (after
tax) and
ii. determine the market price per equity share.

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SANJAY SARAF SIR
 Strategic Financial Management

Solution :
i. Computation of Business Value
(` Lakhs)
100.32 152
Profit before tax
1  0.34
Less: Extraordinary income (14)
Add: Extraordinary losses 5
Profit from new product 143
(` Lakhs)
Sales 70
Less: Material costs 20
Labour costs 16
Fixed costs 10
(46) 24
167.00
Less: Taxes @34% 56.78
Future Maintainable Profit after taxes 110.22
Relevant Capitalisation Factor 0.12
Value of Business (`110.22/0.12) 918.50

ii. Determination of Market Price of Equity Share

Future maintainable profits (After Tax) ` 1,10,22,000

Less: Preference share dividends 80,000 shares of ` 100 @ 9% ` 7,20,000
Earnings available for Equity Shareholders ` 1,03,02,000
No. of Equity Shares 50,00,000
` 1,03,02,000
Earning per share  ` 2.06
50,00,000
PE ratio 6
Market price per share ` 12.36

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SANJAY SARAF SIR