[SOLVED] BANK3014 INVESTMENT AND PRIVATE BANKING

BANK3014 INVESTMENT AND PRIVATE BANKING
WEEKS 3 AND 4 ADDITIONAL VALUATION
PRACTICE QUESTIONS SUGGESTED SOLUTIONS (Note: Questions adapted from CFA)
Question 1 FCFF:

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Inc., incorporated on 31 December 2009 with initial capital infusions of $224,000 of debt and $336,000 of common stock, acts as a distributor of industrial goods. The company managers immediately invested the initial capital in fixed capital of $500,000 and working capital of $60,000. Working capital initially consisted solely of inventory. The fixed capital consisted of non-depreciable property of $50,000 and depreciable property of $450,000. The depreciable property has a 10-year useful like with no salvage value. Exhibits 1,2 and 3 provide Canes financial statements for the three years following incorporation. Starting with net income, calculate Canes FCFF for each year.
Exhibit 1, Inc. Income Statement (in Thousands)
Years Ending 31 December
Depreciation Expense Operating Income
Interest expense (at 7 percent) Income before taxers
Income taxes (at 30 percent) Net Income
2010 2011 $ 200.00 $ 220.00
2012 242.00
54.45 187.55 18.97 168.58 50.58
45.00 49.50 155.00 170.50 15.68 17.25 139.32 153.25 41.80 45.97
97.52 $ 107.28
Exhibit 2, Inc. Balance Sheet (in Thousands)
Years Ending 31 December
2009 Cash $
$ 108.92 $ 228.74
100.00 110.00 66.00 72.60 274.92 411.34 500.00 550.00 45.00 94.50
$ 729.92 $ 866.84
$ 50.00 $ 55.00
50.00 55.00 246.40 271.04 336.00 336.00
97.52 204.80 $ 729.92 $ 866.84
121.00 79.86 561.40 605.00 148.95
$ 1,017.45
60.50 298.14 336.00 332.80
$ 1,027.44
Accounts receivable
Inventory 60.00
Current Assets Fixed assets
less: Accumulated depreciation Total Assets
Accounts payable
Current portion of long-term debt
Current Liabilities Long-term debt Common stock Retained earnings
Total Liabilities and equity
60.00 500.00
224.00 336.00

Exhibit 3, Inc. Working Capital (in Thousands)
Years Ending 31 December
Current assets excluding cash
Accounts receivable Inventory
Total Current Assets excluding cash
Current liabilities excluding short-term debt
Accounts payable
Working Capital
Increase in working capital
2009 2010 2011
$ $ 100.00 $ 110.00 60.00 66.00 72.60 60.00 166.00 182.60
50.00 55.00 $ 60.00 $ 116.00 $ 127.60
121.00 79.86 200.86
60.50 140.36 $ 11.60 $ 12.76
We can write the expression for FCFF as follows:
FCFF = Net income available to common shareholders (NI)
Plus: Net noncash charges (NCC)
Plus: Interest expense x (1- Tax Rate)
Less: Investment in fixed capital (FCInv) Less: Investment in working capital (WCInv)
We can re-rewrite this expression more compactly as:
!!! = $% + $ + %'( *1 -./ 0.(12 !%3 4%3
We calculate FCFF from net income as follows: We add non-cash charges (here, depreciation) and after-tax interest expense to net income, then subtract the investment in fixed capital and the investment in working capital. The format for presenting the solution follows the convention that parentheses around a number indicate subtraction. The calculation follows (in thousands):
Years Ending 31 December
Net Income
Noncash charges Depreciation Interest expense * (1- Tax Rate) Investment in fixed capital Investment in working capital
Question 2 Multiples:
2010 97.52
45.00 10.98 (56.00)
12.08 (50.00) (11.60)
13.28 (55.00) (12.76)
As a telecommunication industry analyst at an investment bank, you are valuing Verizon Communications, Inc (NYSE: VZ), one of the worlds largest leading telecommunications companies. The valuation metric that you have selected is the trailing P/E. You are evaluating the P/E using the median trailing P/E of peer-group companies as the benchmark value. According to GICS, VZ is in the telecommunications services sector and, within it, the integrated telecommunications services subindustry. Exhibit 1 presents the relevant data. (Note that although BCE Inc. is a Canadian company, it is classified in this peer group.)

Exhibit 1 Trailing P/Es of Telecommunication Services Companies Company
AT&T (NYSE: T)
BCE Inc. (NYSE: BCE; TSC: BCE)
Centurytel (NYSE: CTL)
Equinix (NASDAQ: EQIX)
Frontier Communications Corp. (NASDAQ: FTR) Verizon Communications (NYSE: VZ) Windstream Corp. (NYSE: WIN)
Trailing P/E 25.73 14.49 18.86 131.28 43.30 86.06 36.91 50.95 36.91
Based on the data in Exhibit 1(above), address the following:
1. Given the definition of the benchmark stated above, determine the most
appropriate benchmark value of the P/E for VZ.
2. State whether VZ is relatively fairly valued, relatively overvalued or relatively
undervalued, assuming no differences in fundamentals among the peer
group companies. Justify your answer.
3. Identify the stocks in this group of telecommunication companies that appear
to be relatively undervalued when the median trailing P/E is used as a benchmark. Explain what further analysis might be appropriate to confirm your answer.
1. The use of median values mitigates the effect of outliers on the valuation conclusion. In this instance, the P/E for EQIX is clearly an outlier. Therefore, the median trailing P/E for the group, 36.91, is more appropriate than the mean trailing P/E of 50.95 for use as the benchmark value of the P/E.
2. If you assume no differences in fundamentals among the peer group companies, VZ appears to be overvalued because its P/E is greater than the median P/E of 36.91.
3. T, BCE, and CTL appear to be undervalued relative to their peers because their trailing P/Es are lower than the median P/E. Win appears to be relatively fairly valued because its P/E equals the median P/E. VZ, FTR, and EQIX appear to be overvalued.
To confirm this valuation conclusion, you should look at other metrics. One issue for this particular industry is that the earnings may differ significantly from cash flow. These companies invest considerable amounts of money to build out their networks whether it be landlines or increasing bandwidth capacity for mobile users. Because telecommunication service providers are frequently required to take large non-cash charges on their infrastructure, reported earnings are typically very volatility and frequently much lower than cash flow.
Extension:
Continuing with the valuation of telecommunication service providers, you gather information on selected fundamentals related to risk (beta), profitability, (five-year earnings growth forecasts), and valuation (trailing and forward P/Es). These data are reported in Exhibit 2 (below), which lists companies in order of descending

earnings growth forecast. The use of forward P/Es recognizes that differences in trailing P/Es could be the result of transitory effects on earnings.
Exhibit 2 Valuation Data for Telecommunication Services Companies
Equinix (NASDAQ: EQIX)
Frontier Communications Corp. (NASDAQ: FTR) Verizon Communications (NYSE: VZ)
AT&T (NYSE: T)
BCE Inc. (NYSE: BCE; TSC: BCE)
Centurytel (NYSE: CTL)
Windstream Corp. (NYSE: WIN)
Trailing Forward P/E P/E 131.28 43.97 43.30 18.83 86.06 14.40 25.73 12.62 14.49 14.12 18.86 12.04 36.91 18.66 50.95 19.23 36.91 14.40
Five-year EPS Forward Beta Growth Forecast PEG
0.25 1.74 1.26 0.22 0.86 0.78 0.10 1.41 0.38 0.06 1.95 0.40 0.03 4.71 0.76 0.02 8.92 0.89
-0.12 NM 0.89 0.08 3.27 0.77 6.46 1.85 0.78
Note: NM = Not meaningful. The five-year EPS growth forecast for WIN is a negative number which would result in a negative PEG.
Based on the data in Exhibit 2 (above), answer the following questions:
1. T, BCE, and CTL were identified as possibly relatively undervalued compared with the peer group as a whole, and WIN was identified as relatively fairly valued., What does the additional information in Exhibit 2 relating to profitability and risk suggest about the relative valuation of these
2. T has a consensus year-ahead EPS forecast of $2,69. Suppose the median
P/E of 14.40 for the peer group is subjectively adjusted upwards to 15.00 to reflect Ts superior profitability and below-average risk. Estimate Ts intrinsic value.
3. Ts current market price is $33.99. State whether T appears to be fairly valued, overvalued, or undervalued when compared with the intrinsic value estimated in answer to Part 2 above.
Extension Solution:
1. According to the profitability data and PEG given in Exhibit 2, EQIX, FTR, and VZ appear to represent the greatest undervaluation. Of the three stocks, FTR has: (i) the second highest five-year consensus earnings growth forecast; and (ii) the lowest PEG based on forward P/E.
Of the three stocks, EQIX has the highest beta by far, which is consistent with studies that have shown that growth stocks tend to have higher beta values than those of value stocks. Based on the high trailing and forward P/E ratios, it appears that investors in EQIX have high expectations concerning the companys future earnings potential. However, the high beta value is likely reflective of the uncertainty surrounding the earnings forecast and the possibility that actual future earnings may be less than expected.
Some analysts consider a PEG ratio below 1 to be a signal of undervaluation implying that FTR is attractive when judged by this ratio. However, one limitation of the PEG ratio is that it does not account for the overall growth rate of an industry or the economy as a whole. Hence, it is typically a good idea for an investor to compare a stocks PEG ratio to an average or median PEG ratio for the industry, as well as the entire market, to get an accurate sense of how fairly valued a stock is. The PEG ratio of FTR is not only below 1,

but it is significantly lower than the PEG ratios for the other telecommunication companies further indicating that FTR is relatively undervalued.
2. $2.69 x15.0 = $40.35 is an estimation of intrinsic value.
Because of the estimated intrinsic value of $40.35 is greater than the current market price of $33.99, T appears to be undervalued by the market on an absolute basis.

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