CFAI Sample Question - Equity - Mendosa

CFA Level II
#1

Statement 3 is accurate; Statements 1 and 2 are not. Any ideas why 1 and 2 are no go? Thanks.

Statement 1—Raman : Because PRBI’s management is actively seeking opportunities to be acquired, the guideline transactions method (GPCM) would be most appropriate. It establishes a value estimate based on pricing multiples derived from the acquisition of control of entire public or private companies. Specifically, it uses a multiple that relates to the sale of entire companies.

Statement 2—Mendosa : We could also value PRBI using the free cash flow to equity (FCFE) model. But in order to support its rapid growth, the company is expected to significantly increase its net borrowing every year for the next three to five years, and during those years, it could have a significant dampening effect on the company’s FCFE and thus a lower value for its equity.

Statement 3—Raman : I agree. The residual income (RI) model, also called the “excess earnings method,” does not have the same weakness as the FCFE approach because residual income is an estimate of the profit of the company after deducting the cost of all capital: debt and equity. Furthermore, it makes no assumptions about future earnings and the justified P/B is directly related to expected future residual income.

#2

My guess - 1 is valid only for M&A, not if you buy a small equity stake. 2 may be because you should consider FCFF if the capital structure is changing?

#3

#2 is wrong because increasing borrowing increases FCFE.

#3 is wrong because RI considers the cost of equity, not WACC

#4

#1 is incorrect because the Guideline Transactions Method is (GTM) not (GPCM i.e. guideline public company method)

#2 is incorrect, because as a company increases net borrowing significantly, FCFE will also increase, increasing the value of the equity when doing a discounted FCFE model, not decrease

#5

the cost of all capital is taken into consideration since you use net income… hence, interest expense, or the cost of debt, has already been taken out

#6

good perspective! Thanks!

#7

But isn’t the formula for residual income: net income less equity charge? I"m confused as to how “cost of all capital” got involved?

#8

It’s beyond the what the specific inputs are. Net income is after interest, obviously. What is interest? Interest is the cost of debt, a source of capital. What’s the formual for residual income? (ROE - r)(Beg BV). ROE is calculated by taking net income / equity… Interest being a reduction to net income (cost of debt) and the equity charge (the cost of equity) comes by the way of (ROE - r)(BV). Hence, RI takes into consideration, the cost of ALL capital.