QUESTION: 4 Exam Topic: 2, Equity Investment

Carl Warner, CFA, has been asked to review the financial information of Global Drug World (GDW) in preparation for a possible takeover bid by rival competitor Consolidated Drugstores International (Consolidated). GDW has produced impressive results since going public via an initial public offering in 1998. Through a program of aggressive growth by acquisition, GDW is currently seen as a major player and a threat to Consolidated^ own plans for growth and profitability. In preparation for his analysis, Warner has gathered the following financial data from GDW's year-end statements:

Partial GDW Balance Sheet on May 31, 2008

As part of his analysis, Warner needs to forecast the free cash flow to the firm (FCFF) for 2009. The best information he has points to an increase in sales of 6%. The earnings before interest and tax (EBIT) margin is not expected to change from the rate of 6.4% achieved in 2008. Additional fixed capital spending is expected to be $36,470. Investment in net working capital is expected to be $24,313. Moreover, Warner notes that the only noncash charge is depreciation, which he estimates will be $60,000.

Warner has been asked to analyze the effect each of the following corporate events, if taken during 2009, would have on GDW's free cash flow to equity (FCFE):
• 20% increase in dividends per share.
• Repurchase of 25% of the firm's outstanding shares using cash.
• New common share offering that would increase shares outstanding by 30%.
• New issue of convertible bonds that are not callable for fi\e years and would increase the level of debt by 10%.

The 2009 estimate of FCFF is closest to:

$191,646.
$210,329.
$215,329.

Answer(s): A

Explanation:

When depreciation is the only noncash charge, FCFF can be estimated from:

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QUESTION: 5 Exam Topic: 2, Equity Investment

$4.37.
$7.15.
$13.49.

Answer(s): A

Explanation:

This is a two-siage FCFE model. The required return on equity is 10% (from problem 21), and the long-term growth rate after 2 years is 5%.

Financial calculators can perform this calculation more quickly and accurately. The appropriate keystrokes are:
CFO = 0; C01 = $0.21; C02 = $0.23 4 $4.83 = $5.06; I = 10.0; CPT -> NPV = $4.37

Notice that the second cash flow combines the FCFE for the second year with the present value of the series of constantly growing FCFE terms that begin at the end of the third year. This approach is valid since the timing of these two cash flows is the same (i.e., the end of the second year). (Study Session 12, LOS 41.k)

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QUESTION: 6 Exam Topic: 2, Equity Investment

Share repurchase.
Share offering.
Convertible bond issue.

Answer(s): C

Explanation:

Dividends, share repurchases, and changes in the number of shares outstanding do not have an effect on either FCFE or FCFF. Therefore, only the new convertible debt offering will have a significant influence on the current level of FCFE because net borrowing changes FCFE. (Study Session 12, LOS 41.h)

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QUESTION: 7 Exam Topic: 2, Equity Investment

Matthew Emery, CFA, is responsible for analyzing companies in the retail industry. He is currently reviewing the status of Ferguson Department Stores, Inc. (FDS). FDS has recently gone through extensive restructuring in the wake of a slowdown in the economy that has made retailing particularly challenging. As part of his analysis, Emery has gathered information from a number of sources.

Ferguson Department Stores, Inc.
FDS went public in 1969 following a major acquisition, and the Ferguson name quickly became one of the most recognized in retailing. Ferguson had been successful through most of its first 30 years in business and has prided itself on being the one-stop shopping destination for consumers living on the West Coast of the United States. Recently, FDS began to experience both top and bottom line difficulties due to increased competition from specialty retailers who could operate more efficiently and offer a wider range of products in a focused retailing sector. When the company's main bank reduced FDS's line of credit, a serious working capital crisis ensued, and the company was forced to issue additional equity in an effort to overcome the problem. FDS has a cost of capital of 10% and a required rate of return on equity of 12%. Dividends are growing at a rate of 8%, but the growth rate is expected to decline linearly over the next six years to a long-term growth rate of 4%. The company recently paid an annual dividend of $1.

At the end of 2008, FDS announced that it would be expanding its retail operations, moving to a warehouse concept, and opening new stores around the country. FDS also announced it would close some existing stores, write-down assets, and take a large restructuring charge. Upon reviewing the prospects of the firm, Emery issued an earnings per share forecast for 2009 of $0.90. He set a 12- month share price target of $22.50. Immediately following the expansion announcement, the share price of FDS jumped from $14 to $18.

In 2008, FDS also reported an unusual expense of $189.1 million related to restructuring costs and asset write downs.

In response to questions from a colleague, Emery makes the following statements regarding the merits of earnings yield compared to the P/E ratio:
Statement 1: For ranking purposes, earnings yield may be useful whenever earnings are either negative or close to zero.
Statement 2: A high E/P implies the security is overpriced.

The value of one share of FDS using the H-model is closest to: