January Examination Period 2020-21

ECOM118 Practical Valuation Duration: 3 hours

Answer ALL questions

THIS IS AN OPEN BOOK EXAMINATION TO BE CONDUCTED ONLINE. YOU MAY

REFER TO ANY OF THE COURSE MATERIALS, OR ANY OTHER SOURCE OF
INFORMATION. YOU MAY ALSO USE A SPREADSHEET OR CALCULATOR.

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ANSWERS ARE TO BE TYPED AND SUBMITTED TO BOTH QMPLUS & EMAILED TO:
ecom118-exam@qmul.ac.uk

PLEASE ENSURE THAT YOUR WORKING IS CLEARLY SHOWN WITH ALL STEPS
OF YOUR CALCULATION INCLUDED IN YOUR ANSWER DOCUMENT, INCLUDING
ANY FORMULA USED.

When writing formulas, please note the following:

• It is acceptable to use the standard alphabet rather than greek letters. The following
are recommended: m for μ, s for σ, w for ω, r for ρ, d for Δ, b for β.
• For mathematical operators: add +, subtract -, multiply *, and divide /.

• Where appropriate, use an underscore to indicate a subscript, Eg r_f for rf.

• Use the ^ character for power, eg x^2 for x2, x^0.5 for √x.

• As an alternative to x^.5 you may type sqrt(x).

• Use brackets as necessary. To make your answer clearer use different brackets
where appropriate, eg [] {} ().

Examiner: Gonçalo Faria

© Queen Mary University of London, 2021

Page 2 ECOM118 (2021)

Question 1

A hedge fund manager is valuing a company that is expected to generate sales from year
1 onwards as given in Table 1.
Table 1
Year 1 Year 2 Year 3 Year 4 Year 5
€70000 €72000 €68500 €71000 €73000

Expected EBIT margin (% sales) in year 1 is 8%. Additional assumptions are:

• EBIT margin (% sales): increases 35 basis points (0.35%) per year until year 3,
including year 3, and decreases 15 basis points (0.15%) per year in years 4 and 5
• Depreciation: 5% of sales, each year
• Recurrent Capex: 7% of sales for year 1, with this percentage decreasing 55 basis
points (0.55%) per year until year 4 (e.g., 6.45% of sales for year 2)
• Change in working capital: 14% of yearly change of sales
• Tax rate: 25%
• Target capital structure: debt/(debt + equity) ratio of 55%
• Asset beta: 1.25
• Risk-free rate: 2%
• Equity risk premium: 6%
• Debt spread: 4%

To answer the following questions make plausible assumptions if necessary. In case you
prefer, standard characters can be used (e.g b rather than β, capital_sigma rather than ∑).

a. Compute the Free Cash Flows to the Firm (FCF) for the period from year 1 until
year 5, including year 5. Explain your answer.
[10 marks]

b. The way taxes are estimated when computing the FCF reveals an important
characteristic of the FCF model. Which one? Explain your answer.
[10 marks]

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© Queen Mary University of London 2021

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Page 3 ECOM118 (2021)

c. Why is equity beta different from asset beta in case the company makes use of
debt? Explain your answer.
[10 marks]

d. Given the target capital structure and the set of assumptions reported below Table
1, what is the discount rate to be used in this valuation exercise? Explain your
answer.
[10 marks]

e. The expected nominal growth rate of FCF in perpetuity is 1.5%. What is the
expected value of the company at the end of year 1? Explain your answer.
[10 marks]

Question 2

An investor is valuing the Company OUT which has 5000 equity shares and the following
expected key financial measures for year-end 2021 (Table 2):
Table 2
Enterprise value €70000
Level of cash €8000
Level of interest bearing debt €22000
Minority interest €3750
Financial Investments €2300
2021 Book Value Per Share (BVS) €5.25

Additionally, the investor has collected the following information about a set of comparable
listed companies with similar leverage and other relevant fundamentals (Table 3):
Table 3
Company Current market price per share (€) BVS 2021 (€)
B 9.0 7.50
C 10.7 8.50
D 8.3 9.20

Round your computations to one decimal place (e.g. present 1.56 as 1.6).
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© Queen Mary University of London 2021

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Page 4 ECOM118 (2021)

a. What is the expected 2021 price-to-book (PBV) multiple of company OUT implied
in investor’s expectations? Explain your answer.
[10 marks]

b. Considering the information of the expected 2021 PBV multiple of the set of
comparable companies, what is your conclusion about the relative valuation of
company OUT? Explain your answer.
[10 marks]

c. Some fundamental variables impact on the PBV multiple and should be taken into
account when carrying out a relative valuation exercise based on this multiple.
Give two examples of such variables, explaining your answer (no need for
computations).
[10 marks]

Question 3

A company is building a distribution centre, with investment cost (year zero) of €200 million
and present value (year zero) of cash flows of €180 million. However, the company has
the option to sell this distribution centre at the end of next year. The company estimates
that the market value of the distribution centre, within 1 year, will be €240 million if the
market evolves favourably, and €120 million if the market evolves unfavourably. The risk-
free interest rate is 2% per year and the project gross value is assumed to follow a
multiplicative binomial process. The market value of the shadow asset is given by S.
Currently S = 12 and the estimation is that, within 1 year, S = 19 and S = 7 for the
scenarios of favourable and unfavourable market evolution, respectively.
Present your answers rounded to the first two decimal places (e.g. 1.555 is rounded to
1.56) and in order to compute relevant inputs assume compound annual growth.
To answer the following questions make plausible assumptions if necessary. In case you
prefer, standard characters can be used (e.g b rather than β, capital_sigma rather than ∑).

“Continues on next page…”

© Queen Mary University of London 2021

Turn over
 a. What is the real option in this project? Explain your answer.

[2.5 marks]

b. What is the expanded NPV of the project? Explain your answer.

[10 marks]

c. What should be the investment decision for this project? Explain your answer.

[2.5 marks]

d. Consider the following statement “If an analyst decides to use real options
methodology to value a project, estimating a standard Discounted Cash Flow
model is useless”. Do you agree with this statement? Explain your answer.

[5 marks]

End of Paper

End of Examination / Gonçalo Faria

© Queen Mary University of London, 2021