### Calculate expected abnormal price-earnings ratio for stock

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##### Reference no: EM13911732

The book is: Aswath Damodaran, Investment Valuation, Tools and Techniques for Determining the Value of Any Asset, Second University Edition, John Wiley & Sons, 2002 [ISBN 0-471-4190-5 (paper)]

1. Magid's operating income after taxes last year was \$55 million, while net income was \$30 million. Magid paid normal cash dividends of \$10 million. The ending book value of equity was \$750 million while the book value of debt was \$250 million. Magid borrowed an additional \$40 million last year. The market value of the equity was 1.5 times book value while the market value of the debt was 80% of book value. Magid's stock beta is 1.20. The yield on 10-year treasuries is 4.5%. The market risk premium is 6%.

a. Estimate the return on capital.

b. Estimate the cost of capital.

c. Estimate the economic value added.

2. Explain how one can calculate a growth rate using financial statements for one year.

3. Plantics, Inc. has created a fast-growing plant whose fibrous molecular structure is similar to plastic. Plantics plant "invention" promises to supplant petro-chemicals as the molecular source for plastics. This promises to create extra-ordinary cash flows for the next 8 years. It has unleveraged assets-per-share in place of \$2.50. Its cost of equity capital is estimated at 13%, typical of the normal competitive firms in its industry. The normalized earnings-per-share next year is expected to be \$0.80. This firm does not expect to pay dividends while its patents earn extra-ordinary returns.

a. Using the franchise factor model, estimate the "normal" industry price-earnings ratio.

b. Calculate the expected abnormal price-earnings ratio for this stock, and nominal total P/E ratio.

c. If this firm's common equity has a market price of \$43 per share, what is the indicated stock transaction?

4. Magic Kelly Productions is a circus firm. The firm's book value of assets is \$250 million. The assets are 6 years old and have been depreciated \$100 million. The inflation rate over the last 6 years has averaged 3% annually. The firm has \$45 million in aftertax operating income from the use of the assets. The assets have a remaining life of 6 more years. Depreciation is expected to be \$12 million for the remaining life of the assets, which have a salvage value of \$78 million. Magic's nominal cost of capital is 12%. Estimate CFROI using the conventional approach.

5. Magid's chief financial officer has recommended a permanent change in its target debt/equity ratio from 30% to 45%. A member of the board of directors has asked whether the cost of capital would change if Magid borrowed up to the recommended ratio. Magid's stock beta is 1.20 and its tax rate is 34%. The additional borrowings would increase the pretax cost of debt from 7% to 8.5%. As the chief financial officer of Magid, answer the board member's question. Assume the yield on 10-year treasuries is 4.5% and the market risk premium is 5.25%.

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