Problem 1.

We are going to explore the difference between two different companies, both from the same sector, firms A and B. They differ in their reinvestment abilities. Firm A and Firm B are both financed with equity only.

At the end of their business year, both firms report $1,000m in revenue. The net income is $100m for both firms. Assume that management is able to maintain a constant net profit margin of 10%.

• Firm A is capable of achieving 5% revenue growth annually by investing 25% of their net income.

• Firm B is capable of achieving 5% revenue growth annually by investing 50% of their net income.

Assume that this difference persists into the future.

a) Find the value of firms A and B. Use a discount rate of 10% for both firms.

Note: This value is the sum of the value of assets already in place plus the PV of future growth opportunities.

b) The forward P/E ratio of a company is the price of a share divided by next year’s earnings per share, or its value divided by next year’s earnings. What is the forward P/E ratio of firms A and B?

c) Comment on your result. Why is the forward P/E ratio higher for firm A? Or said differently: Why would shares of firm A be more expensive?

Problem 2.

One challenge in the creation of DCF models is the estimation of growth rates and tying them into the model. How is growth in the operating income (and eventually, free cash flow to the firm) generated?

Overly simplified, firms can increase their revenue while maintaining their margins (sell more of a unit without incurring additional costs), or firms can improve their margins while maintaining their revenue (sell the same number of units while making more profit on each), or both.