Sample Paper 4

SP Jain Center of Management – Dubai/Singapore

Q1. Wizcraft Entertainment operates in a wide variety of entertainment businesses. In the current year, the firm reported $300 million in operating income (EBIT) on capital invested of $1500 million. A portion of the operating income ($100 million), capital invested ($400 million), and debt outstanding ($150 million) represent Wizcraft’s holdings in Mermaid Television, a television station owner. Wizcraft owns only 51% of Mermaid, but Wizcraft’s financials are consolidated with those of Mermaid. You are required to:

(a) Value the equity in the operating assets of Wizcraft without counting its holding in Mermaid.

(b) Value the 51% equity in Mermaid Television.

You may make the following assumptions:

i. The cost of capital for Wizcraft Entertainment is 10%. The firm is in stable growth, with operating income (again not counting the holdings) growing 5% a year in perpetuity.

ii. Mermaid Television has a cost of capital of 9% and is in stable growth, with operating income growing 5% a year in perpetuity.

iii. None of the firms has a significant balance of cash and marketable securities.

iv. The tax rate for both the firms is 40%.

(10 marks)

Q2. Spicy Foods is a specialty food retailer. In its balance sheet, the firm reports $1 billion in book value of equity and no debt, but it has operating leases on all its stores. In the most recent year, the firm made $85 million in operating lease payments, and its commitments to make lease payments for the next 5 years and beyond are:

Year	Operating Lease Expense
1	$90 million
2	$90 million
3	$85 million
4	$80 million
5	$80 million
6-10	$75 million annually

1. If the firm’s current cost of borrowing is 7%, estimate the debt value of operating leases. Estimate the book value debt-to-equity ratio.

2. Assume that Spicy Foods, reported earnings before interest and taxes (with operating leases expensed) of $200 million. Estimate the adjusted operating income, assuming that operating leases are capitalized.

(10 marks)

Q3. The profit and loss account and balance sheet of Zenith Corporation for two years (year 1, year 2) are given below:

Profit and Loss Account

YEAR	1		2
NET SALES	5600		6440
INCOME FROM MARKETABLE SECURITIES	140		210
NON-OPERATING INCOME	70		140
TOTAL INCOME	5810		6790
COST OF GOODS SOLD	3220		3780
SELLING AND ADMINISTRATIVE EXPENSES	700		770
DEPRECIATION	350		420
INTEREST EXPENSES	336		392
TOTAL COSTS AND EXPENSES	4606		5362
PBT	1204		1428
TAX PROVISION	364		448
PAT	840		980
DIVIDEND	420		560
RETAINED EARNINGS	420		420

Balance Sheet

	YEAR 1		YEAR 2
EQUITY CAPITAL	2100		2100
RESERVES AND SURPLUS	1680		2100
DEBT	2520		2940
	6300		7140
FIXED ASSETS	4200		4550
INVESTMENTS	1260		1400
NET CURRENT ASSETS	840		1190
	6300		7140

(i) What is the EBIT for year 2?

(ii) What is the tax on EBIT for year 2?

(iii) What is the NOPLAT for year 2?

(iv) What is the free cash flow to the firm (FCFF) for year 2?

(v) Give a break up of the financing flow for year 2.

(2 x 5 = 10 marks)

Q4. Everlast Batteries Inc. has hired you as a consultant. The firm had after-tax operating earnings in 1998 of $180 million and net income of $100 million, and it paid a dividend of $50 million. The book value of equity at the end of 1998 was $1.25 billion, and the book value of debt was $350 million. The firm raised $50 million of new debt during 1998. The market value of equity at the end of 1998 was twice the book value of equity, and the market value of debt was the same as the book value of debt. The firm has a cost of equity of 12% and an after-tax cost of debt of 5%.

1. Estimate the return on capital earned by Everlast Batteries.
2. Estimate the cost of capital earned by Everlast Batteries.
3. Estimate the economic value added by Everlast Batteries.
4. Assume that Everlast Batteries is in stable growth, and that it expects its economic value added to grow at 5% a year forever. Estimate the value of the firm.

(2+2+2+4 =10 marks)

Q5A. Answer the following questions in brief. Each question carries 1 mark.

(a) What is non-cash ROE? (Mention the formula)

(b) EBITDA = Market value of ……….. + Market value of ………. - ..........

(c)Answer true or false to the following statements, with a short explanation.

(i) A stock that sells for less than book value is undervalued.

(ii) Increasing the debt ratio increase free cash flow to equity.

(iii) If a company’s return on equity drops, its price/book value ratio will generally drop more than proportionately (i.e., if the return on equity drops by half, the price/book value ratio will drop by more than half).

(5 marks)

Q5B. The following table summarises the percentage changes in operating income, percentage changes in revenue, and betas for four pharmaceutical firms.

Firm	% Change in revenue	% Change in operating income	Beta
Pharma Corp	27%	25%	1.00
Syner Corp	25%	32%	1.15
Bio Med	23%	36%	1.30
Safe Med	21%	40%	1.40

(a) Calculate the degree of operating leverage for each of these firms.

(b) Use the operating leverage to explain why these firms have different betas.

(2 marks)

Q5C. The table shown below provides a summary of the median ratios from 1997 to 1999 for different S&P ratings classes for manufacturing classes.

	AAA	AA	A	BBB	BB	B	CCC
EBIT interest coverage	17.5	10.8	6.8	3.9	2.3	1.0	0.2
EBITDA interest coverage	21.8	14.6	9.6	6.1	3.8	2.0	1.4
Funds flow % total debt	105.8	55.8	46.1	30.5	19.2	9.4	5.8
Free oper. cashflow/total debt (%)	55.4	24.6	15.6	6.6	1.9	(4.5)	(14.0)
Return on capital (%)	28.2	22.9	19.9	14.0	11.7	7.2	0.5
Operating income. % sales	29.2	21.3	18.3	15.3	15.4	11.2	13.6
Long term debt/cap. (%)	15.2	26.4	32.5	41	55.8	70.7	80.3
Total debt % cap.	26.9	35.6	40.1	47.4	61.3	74.6	89.4
Companies	10	34	150	234	276	240	23

Evaluate the above table on credit risk.

(3 marks)

Q6A. From the following financial statements of XYZ Ltd. and PQR Ltd., indicate in which company is it advisable to invest. Both companies are manufacturing the same product.

In order to facilitate your analysis, you may calculate the following ratios:

(a) Gross profit ratio (for comparing profitability)

(b) Operating net profit ratio (for comparing profitability)

(c) Return on capital employed (for comparing efficiency)

(d) Earning per share (for comparing returns to equity shareholders)

(e) Price earning ratio (for comparing possibility of future rise in market price)

Income Statement (Rs. in ’000s)

	XYZ LTD.		PQR LTD.
	Rs.		Rs.
SALES		500		750
LESS: COST OF SALES		300		500
GROSS MARGIN		200		250
LESS: OPERATING EXPENSES:
ADMINISTRATIVE EXPENSES	40		50
INTEREST	30		60
SELLING EXPENSES	50	120	50	160
OPERATING NET PROFIT		80		90
ADD: NON-OPERATING INCOME		100		10
NET PROFIT BEFORE TAX		180		100
TAXATION		40		40
NET PROFIT AFTER TAX		140		60

Note: XYZ Ltd. had during the year received Rs. 100000 as compensation for withdrawing a legal suit against a supplier for non-performance of contract.

Balance Sheet (Rs. in ’000s)

	XYZ LTD.		PQR LTD.
	Rs.		Rs.
FUNDS EMPLOYED:
PROPRIETORS' FUNDS
EQUITY CAPITAL (Rs. 10 EACH)	300		300
RESERVES	100		200
		400		500
LOAN FUNDS
TERM LOAN FROM BANK		200		400
TOTAL		600		900
EMPLOYED AS UNDER:
FIXED ASSETS		450		600
CURRENT ASSETS
STOCK	300		600
DEBTORS	100		300
BANK	50		100
	450		1000
CURRENT LIABILITIES
CREDITORS AND PROVISIONS	300		700
		150		300
		600		900

(5 marks)