## Learning Module 3 Due April 17

Objective

Question 1 of this learning module begins with the "rule of thumb" dividend discount model applied to a particular stock. You will explore the implications of changing growth rates and discount rates on value. Note that we can write the model in terms of price to expected earnings ratios.Substitute the payout, in terms of earnings, for the dividend, and divide both sides by the earnings. You are given a discussion question for the main bulletin board.

The next three questions apply to our knowledge of discounting to evaluate projects. There is some additional complexity added here by calculating after tax cash flows. We need to be careful to deduct depreciation expenses before calculating taxes. I usually use two spreadsheet pages. The first calculates the taxes, and the second uses the first to recalculate the cash flows for discounting. However, you can respond to the question in any appropriate way.

There is a Main Bulletin Board discussion question in question 3.

Question 4 introduces the concept of Real Options. In part a, you are asked to do the calculation in the "traditional" incorrect way. In part b, you are asked to identify the minimum value of the option that would make you indifferent between the projects. A Main Bulletin Board discussion question is included.

1. Stock Valuation

Campbell Soup Co. had earnings of \$2.70 in the year ending October 31 1996 (four quarters) and paid 50.4% of earnings as dividends. Assume that an investor's required rate of return on equity is 14%. For simplicity, assume that dividends are paid once a year and that the next dividend payment is exactly one year away.

a) Value the stock assuming earnings and dividends remain constant into the future.

b) Now, value the stock as of January 1 1997 assuming this year's earnings are going to be \$3.00 per share and that earnings grow by 11% per annum and the percentage of earnings paid out as dividends remains constant. Assume that this year's earnings will be realized exactly one year from today, 1/1/97.

c) Given that Campbell Soup's price is currently at \$83.25 what is the growth rate you need to assume so that your valuation coincides with this price? How would your estimate change if the required rate of return on Campbell's stock would be 10% (use the data under (b) above).

d) The Wall Street Journal reports that Campbell's P/E ratio is about 5% below that of the industry. What is the growth rate of the industry if Campbell has the same required rate of return (14%) and the same payout policy (50.4%) as the rest of the industry?

Main Bulletin Board Discussion Question:

The stock's P/E ratio is about 5% below the industry average. Discuss the potential reasons why the P/E could be lower.

2. Project Evaluation

Transland Trucking Corp. (TTC) has decided to enter into a series of 5 year lease agreements with GE Corp. to provide and maintain equipment for its global transport needs. These agreements will be rolled over every five years ad infinitum. TTC has not yet decided when to initiate the first of these leasing agreements. TTC currently has a fleet of existing trucks which have 3 years of useful life remaining.

At present, TTC's truck fleet could be sold for \$2,900,000. In 3 years time, the fleet salvage value will be \$550,000. Current book value for the truck fleet is \$2,400,000 and the fleet is being depreciated on a straight-line basis. Maintaining the truck fleet involves \$160,000 worth of expenses per year. Under the leasing agreement, GE provides and maintains the equipment for a fee of \$1,050,000 per annum. Regardless of the timing of the leasing decision, the firm will generate \$2,025,000 in revenue and \$410,000 in expenses (apart from truck fleet related expenses) this year and each following year.

The company's cost of capital is 15% (required rate of return). Assume that this project has a level of risk which is identical to the risk of the firm as a whole. Also assume that their tax rate is 34%.

Should TTC immediately initiate the leasing agreement and sell their current fleet of trucks
or should TTC continue using their existing fleet for 3 more years and then initiate the leasing agreement?

3. Project Evaluation

Gadgets, Inc. needs to allocate this year's capital expenditure budget to either construction of a new retail outlet or investment in product enhancement. The marketing department has prepared estimates of the predicted increase in sales resulting from each project. The required investment for each project is known and will be depreciated over five years. The required rate of return for both projects is is identical to the firm's cost of capital of12%. Their tax rate is 34%.

New Retail Outlet

 Year 0 1 2 3 4 5 Investment \$1,000.00 Revenue \$900.00 \$945.00 \$992.25 \$1,041.86 \$1,093.96 Expenses \$500.00 \$525.00 \$471.25 \$578.81 \$607.75

All figures in thousands

Product Enhancement

 Year 0 1 2 3 4 5 Investment \$800.00 Revenue \$850.00 \$892.50 \$937.13 \$983.98 \$1,093.96 Expenses \$400.00 \$420.00 \$441.00 \$463.05 \$506.20

All figures in thousands

a) Calculate net cash flows for each project

b) Calculate the NPV of each project. Which project should you choose?

c) Graph the NPV of project 1 and project 2 (y-axis) against a range of discount rates from
0% to 40% in 5% increments (x-axis).

d) Calculate the IRR of each project.

Main Bulletin Board Discussion Question:

We assumed here that the projects have identical risk. Suppose project enhancement is riskier. What is the discount rate that is necessary to change your choice in part b? (For purposes of the discussion, you can just look at the growth and estimate).

4. Project Evaluation

Microprocessor Inc. (MI) has decided to build a new plant in order to take advantage of overwhelming demand for their current microprocessor product. MI needs to decide whether to build the plant (1) solely to produce their current product or if they should engineer the plant so that (2) it will also be able to produce the next generation of their product if it becomes profitable to do so. That is, there is some uncertainty about whether this type of technology will be popular in the marketplace. If it does become popular, a second generation of the product will be profitable. This uncertainty will be resolved over the next five years.

Under (2) the plant costs more, but produces the current product more efficiently for a longer period of time. Since the firm hasn't used this type of plant before there are extra training and teething costs expected in the early years of its life. Moreover, under (2), the firm will be able to produce the second generation of the product if it should be profitable to do so. Production of the second generation product would require some minor additional capital expenditures in the plant from (2) in five years. Under (1), the firm will be unable to enter the market for the second generation of the product because the costs of completely reengineering the plant to enter the second generation market will be prohibitively high.

The expected net cash flows generated by each plant option are listed below. The company's cost of capital for this type of project is 15%. Note that neither the potential investment in a plant upgrade for the second generation product nor the potential revenues from this product have been included in the earnings estimates for plant (2). That is, for both plant options, the cash flows below relate solely to production of the current product. The competitive situation surrounding technology advances over the five year period is highly uncertain, thereby making reliable estimation extremely difficult.

(a) Should MI prefer plant (1) or plant (2) or is it indifferent if they only pay attention to the cash flows from the first generation product?

(b) Suppose the value of the opportunity to invest in the second generatio product at a later stage is some value X. How large/small would X have to be so that your answer to the first question would change?