INDIAN INSTITUTE OF MANAGEMENT LUCKNOW PGP TERM IV (JULY 2009) MID TERM EXAMINATION CORPORATE VALUATION AND RESTRUCTURING

Time Allowed: 2 hours MM: 25 Marks

Instructions 1. Answer all the five questions. 2. Ideally I would prefer if the questions are answered in the same sequence as they appear in the question paper. In any case attempt all parts of a question at one place. 3. Make assumptions that you find absolutely necessary and state them clearly. Unreasonable assumptions will be penalized. 4. Make sure you don't waste time on questions that you are not confident of tackling. Manage your time! 5. Brevity of expression is an asset. Capitalize it! 6. No queries will be entertained during the exam. Question 1: Ambani Ltd is considering the question of whether it has any excess debt capacity. The firm has Rs. 660 million in market value of debt outstanding and 1.74 billion in market value of equity. The firm has Earnings Before Interest and Tax of Rs. 131 million and faces a current corporate tax rate of 40%. The companys bonds are rated BBB and the cost of debt is 8%. At this rating the firm has a probability of default of 2.7% and the cost of bankruptcy is expected to be 35% of the firm value. a. Estimate the unlevered value of the firm from the current market value of the firm. b. Estimate the levered value of the firm using the adjusted present value approach at a debt ratio of 50%. At that ratio the firms bond ratings will be CCC and the probability of default will increase to 36.78% of unlevered firm. The cost of bankruptcy will remain the same. (2 + 3 = 5 Marks) Question 2: Assume that you are in U.S and you are reviewing the cost of equity computation that an analyst has made for Luo Tang, a Vientamese company. The analyst has estimated a cost of equity of 18% for the company in Vienamese Dong (VND). In making this estimate, the analyst used the following information: The ten-year Vietnamese government bond rate, in VND, is 9%, and was used by the analyst as the riskfree rate. However Vietnam has a local currency rating of Baa3 and the default spread for Baa3 rated bonds is 3%. The analyst used a total equity risk premium of 7.5% for Vietnam (obtained by adding 3% to the US risk premium of 4.5%) and a beta of 1.2 for the company. a. Assuming that you were trying to estimate the cost of equity in VND, what risk free rate would you use in your estimate? b. If you were told that the volatility in the Vietnamese equity index is twice the volatility in the Vietnamese government bond, what country risk premium would you attach to Vietnam (over and above the US premium)? c. If you are now told that only 30% of Luo Tangs revenues come from Vietnam and that the rest come from mature markets, estimate the lambda for Luo Tang. (You can assume that the average Vietnamese company gets 90% of its revenues from Vietnam).

d. Using your estimates of the risk free rate, risk premium and lambda, estimate the cost of equity in VDG for Luo Tang. (You can assume that the analysts estimates of beta and the US risk premium are correct). (1+1+1+2 = 5 Marks) Question 3 You have been asked to estimate the expected free cash flow to the firm next year of Adani Enterprises, a beverage company. The firm has reported the following: The earnings before interest and taxes in the most recent year amounted to Rs 150 million. The tax rate of the firm is 40%. The firm had operating lease payments of Rs 50 million in the most recent year, and has commitments to make similar payments each year for the next 10 years. The pre-tax cost of debt for the firm is 8%. The book value of equity is Rs 400 million and the book value of debt (not including operating leases) is Rs 100 million. The expected growth rate in the earnings before interest and taxes next year is 10% and the return on capital will remain unchanged from this years level. a. Estimate the adjusted (for operating leases) return on capital for the firm. b. Estimate the expected free cash flow to the firm next year. (Assume no depreciation) (4 Marks) Question 4 a. Tata McGrawHill is considering a sale of its publishing division. The division had earnings before interest, taxes and depreciation of Rs. 550 million in the most recent year (depreciation was Rs. 150 million), growing at an estimated 5% a year (You can assume that depreciation grows at the same rate). The return on capital in the division is 15%, and the corporate tax rate is 40%. If the cost of capital for the division is 9%, estimate the following: i. the value/FCFF multiple based upon fundamentals ii. the value/EBIT multiple based upond fundamentals iii. the value/EBITDA multiple based upon fundamentals (5 Marks) Question 5 You are trying to value Ponds, a privately owned business in the business of manufacturing cosmetics for sale. You have collected the following information to do your valuation: The company earned an after-tax margin of 14% on revenues of Rs 2 billion in the most recent year. The income is expected to grow 4% a year in perpetuity. The book value of equity invested in the firm at the beginning of the year was Rs1.6 billion and the firm has no debt outstanding. The firm expects to maintain its policy of not borrowing money. The betas of three other publicly traded cosmetics firms are 1.3, 1.2 and 1.75 respectively and the market debt to equity ratio of these firms is 50%, 33.3 % and 125% respectively. The average R-squared across these companies is 16%. The tax rate for publicly traded companies is 40% but the tax rate for private business is only 30%. The riskfree rate is 5% and the market risk premium is 4%. a. If you were valuing Ponds for sale in a private transaction to an undiversified individual, estimate the value. b. If you were valuing Ponds for an initial public offering, estimate the value you would attach to the company. (3 + 3 = 6 Marks)