Exercise 1

You are looking at two firms, A and B, with the same operating risks and capital structure. Both firms are expected to earn net operating profits after taxes of $100 in year 1. If the firms do not invest in new assets, they will continue to earn $100 per year forever. The WACC for both firms is 10%. Firm A reinvests at a rate of 30% per year and Firm B reinvests at a rate of 15% per year.

a. Suppose that both firms have a 15% return on new investments. Compute the value of each firm. Which firm is worth more? Can you explain why (in economic terms)?

b. Suppose now that both firms have a 10% return on new investments. Compute the value of each firm. Which firm is worth more? Can you explain why (in economic terms)?

c. Suppose now that both firms have an 8% return on new investments. Compute the value of each firm. Which firm is worth more? Can you explain why (in economic terms)?

Exercise 2

You are valuing a firm using a two-stage DCF valuation model. The WACC for the firm is 15%. The current (year 0) NOPAT is $100,000 and the current invested capital is $700,000. The firm is currently reinvesting 30% of its NOPAT.

The high growth stage is expected to last one year (year 1). Starting in year 2, the firm will enter a steady state (there is no transition stage).

In the high growth stage (ie, in year 1), NOPAT grows by 20% and the firm reinvests 30%. Starting in year 2, the firm enters the steady state, NOPAT grows by 9% per year and the firm reinvests 60%.

Compute the total enterprise value using both the FCFF model and the discounted EVA model. Do you get the same estimate of value using both approaches? If not, can you explain the difference?