Mark Miller, CFA is an analyst for Rust Belt Partners, an investment fund specializing in industrial product companies based in the Midwest. His boss, Larry Steele, asked him to investigate the value of the stock of Precision Valves, a mature industrial valves company that had emerged from bankruptcy five years before. Miller was asked to value Precision Valves considering both the Free Cash Flow to Equity (FCFE) and Dividend Discount Model (DDM) approaches. The following is a summary of relevant financial data for Precision Valves, for its fiscal year ended December 31, 2005: Exhibit 6-1
Relevant Financial Data
As of December 13, 2005
DOLLAR AMOUNTS IN THOUSANDS
Revenue 850,000
Gross Margin 238,000
Selling, General & Administrative Expense 170,000
Operating Income 68,000
Interest Expense 6,000
Profit Before Taxes 62,000
Income Tax Expense @ 35% 21,700
Net Income After Taxes 40,300
Depreciation Expense 32,000
Capital Expenditures 38,000
Amortization Expense 2,750
Precision Valves also reported its balance sheet for the years ended December 31, 2004 and 2005 as follows: Exhibit 6-2
Precision Valves
Balance Sheets
DOLLAR AMOUNTS IN THOUSANDS December 31, 2004 December 31, 2005
Cash 25,000 30,000
Current Assets (Non-Cash) 60,000 68,050
Property, Plant & Equipment, Net 275,000 281,000
Intangible Assets, Net 55,000 52,250
Goodwill 180,000 180,000
Total Assets 595,000 611,300
Current Liabilities (Debt-Free) 60,000 62,000
Long-Term Debt 105,000 95,000
Other Long Term Liabilities 40,000 40,000
Stockholders’ Equity 390,000 414,300
Total Liabilities & Stockholders’ Equity 595,000 611,300
The following is additionalinformation on Precision Valves and on Capital Markets as of January 31, 2006: Exhibit 6-3
Additional Information
Dividends for fiscal year 2005 (in thousands) 16,000
Common shares outstanding 8,000
Risk-free rate 4.5%
Precision Valves Beta 1.3
Equity Risk Premium 5.0%
36. When deciding whether the single stage DDM method or the single state FCFE method is more appropriate when valuing the per share value of Precision Valves, Miller concludes that:
A. it doesn’t make a difference, since both methodologies result in the same value per share.
B. the FCFE approach is better, because it more accurately reflects the dividend “potential” of Precision Valves.
C. since Precision Valves’ return on equity exceeds its cost of equity capital, he should be using a residual income method instead.
D. the DDM approach is better, because, as a potential minority shareholder of Precision Valves, Rust Belt is not in a position to compel the company to change its dividend policy.
Relevant Financial Data
As of December 13, 2005
DOLLAR AMOUNTS IN THOUSANDS
Revenue 850,000
Gross Margin 238,000
Selling, General & Administrative Expense 170,000
Operating Income 68,000
Interest Expense 6,000
Profit Before Taxes 62,000
Income Tax Expense @ 35% 21,700
Net Income After Taxes 40,300
Depreciation Expense 32,000
Capital Expenditures 38,000
Amortization Expense 2,750
Precision Valves also reported its balance sheet for the years ended December 31, 2004 and 2005 as follows: Exhibit 6-2
Precision Valves
Balance Sheets
DOLLAR AMOUNTS IN THOUSANDS December 31, 2004 December 31, 2005
Cash 25,000 30,000
Current Assets (Non-Cash) 60,000 68,050
Property, Plant & Equipment, Net 275,000 281,000
Intangible Assets, Net 55,000 52,250
Goodwill 180,000 180,000
Total Assets 595,000 611,300
Current Liabilities (Debt-Free) 60,000 62,000
Long-Term Debt 105,000 95,000
Other Long Term Liabilities 40,000 40,000
Stockholders’ Equity 390,000 414,300
Total Liabilities & Stockholders’ Equity 595,000 611,300
The following is additionalinformation on Precision Valves and on Capital Markets as of January 31, 2006: Exhibit 6-3
Additional Information
Dividends for fiscal year 2005 (in thousands) 16,000
Common shares outstanding 8,000
Risk-free rate 4.5%
Precision Valves Beta 1.3
Equity Risk Premium 5.0%
36. When deciding whether the single stage DDM method or the single state FCFE method is more appropriate when valuing the per share value of Precision Valves, Miller concludes that:
A. it doesn’t make a difference, since both methodologies result in the same value per share.
B. the FCFE approach is better, because it more accurately reflects the dividend “potential” of Precision Valves.
C. since Precision Valves’ return on equity exceeds its cost of equity capital, he should be using a residual income method instead.
D. the DDM approach is better, because, as a potential minority shareholder of Precision Valves, Rust Belt is not in a position to compel the company to change its dividend policy.