2015 Midterm Review Problems Solutions Essay

Submitted By Malcolm-Lu
Words: 2143
Pages: 9

Financial Analysis and Valuation:
Practice Midterm Questions
SOLUTION GUIDELINES
Question 1: The figure below illustrates the fluctuations in the stock market price of Starbucks Coffee between June 1997 and May 2007. In principle, explain what factors can justify such fluctuations in the intrinsic value of the stock.
Recall that intrinsic value is computed as the discounted expected cash flows of the company.
Therefore, changes in intrinsic value can only come from changes in expected cash flows (the numerator of the DCF) and/or changes in the market discount rate (the denominator of the
DCF). Investors get more or less patient (or risk-averse), and therefore market discount rates change. Alternatively, there is new information about the company and expected cash flows change. Question 2: In 1999, a Silicon Valley technology company called 3Com decided to spin off one of its divisions (Palm), maker of the hot new handheld computers. In other words, 3Com decided to make Palm a new independent company that would be traded in the stock market. In a first step, 3Com sold 5% of
Palm’s shares in an IPO. After the IPO, the remaining 95% of the shares would be distributed to 3Com investors. The shareholders from 3Com would receive 1.5 shares in Palm for each share that they owned in 3Com. Suppose Palm’s shares were trading for $95/ share in the period between the IPO and the date
3Com shareholders received Palm’s shares.
(a) If the market values of Palm and 3Com reflect their intrinsic value, what is the minimum value that 3Com shares should be trading for during this period (between the IPO and the date 3Com shareholders received Palm’s shares)?
Price(3Com) = 1.5*Price(Palm) + Price(Non-Palm divisions of 3Com) ≥ 1.5*Price(Palm)
 Price(3Com) ≥ 1.5*(95) = 142.5
(b) Suppose now that the value of 3Com shares during this period was equal to $200/share. If the prices of both 3Com and Palm reflected their intrinsic value, what is the intrinsic value per share of the Non-Palm divisions of 3Com?
Price(3Com) = 1.5*Price(Palm) + Price(Non-Palm divisions of 3Com)
 200 = 1.5*(95) + Price (Non-Palm divisions of 3Com)
 Price (Non-Palm divisions of 3Com) = 200 - 1.5*(95) = 57.5

Question 3: In the presence of market efficiency, explain two possible reasons for discounts on closedend funds, i.e. for the market value of the fund’s shares to trade below its net asset value per share.
A first potential factor leading to discounts is the existence of fees charged by the fund. These fees are necessary to cover the fund’s costs such as the compensations of its managers. A second potential factor leading to discounts is the trading behavior of funds. If funds actively buy and sell stocks, to the extent that they are expected to lose money in this process, this could lead to a discount.
Question 4: Consider two companies (A and B) with identical operations. Company A has $30 Million in cash, $10 Million debt and $20 Million in other non-operating assets. Company B has $10 Million in cash, $40 Million debt and $5 Million in other non-operating assets.
(a) What is the difference (if any) between the enterprise values of the two companies?
Enterprise Value is the value of firms’ operations. This value should be the same since their operations are identical.
(b) What is the difference (if any) between the total firm values of the two companies?
Total Firm Value = Enterprise Value + Non-Operating Assets
The enterprise value of the firms is the same so the difference between their total firm values must be given by:
Total Firm Value (A) - Total Firm Value (B) = Non-Operating Assets (A) – NonOperating Assets (B) = ($30M + $20M) – ($10M + $5M) = $35 Million

(c) What is the difference (if any) between the equity values of the two companies?
Equity Value = Enterprise Value + Non-Operating Assets - Debt
The enterprise value of the firms is the same so the difference between their equity values must be given by:
Equity Value (A) - Equity Value (B) = Non-Operating