Deck 12: Allocating Capital and Corporate Strategy

Question 1

Explain the Brennan-Schwartz method for valuing mines.

Answer 1

Brennan and Schwartz developed a method for valuing mines that takes into account the owner's options to reduce and increase production,but does not require the observation of the market price of an option to purchase the mineral being mined.The inputs used in their valuation method are the current forward price of the mineral,the volatility of the price of the mineral,and the risk-free rate of interest.Although the Brennan and Schwartz method is complex,it can be approximated with the binomial approach.This technique,used in valuing derivative assets,assumes that the future price movements of the underlying asset follow a binomial process in which the price of the asset takes on one of only two possible values after one time period: a high value or a low value.The derivative asset also takes on only one of two possible values at the end of the time period.Thus,the future value of the mine can be tracked by a portfolio of two traded investments,which,according to the no-arbitrage assumption,implies that the value of the mine is simply the cost of the tracking portfolio.

Question 2

Which of the following is true of the competitive analysis approach?

A)Firms in a competitive market can achieve a positive NPV from a project only if their price/earnings ratio is greater than their competitors.
B)Firms in a competitive market can achieve a positive NPV from a project only if they have some advantage over their competitors.
C)Firms in a competitive market can achieve a positive NPV from a project only if they have a net income higher than their competitors.
D)When other firms have competitive advantages,the project's NPV will be zero.

Answer 2

B

Question 3

Zeta Corporation plans to invest in a project.The initial investment is €200 million and the next year's cash flow will be €20 million.There will be a perpetual annual cash flow stream of either €15 million or €4 million will occur each year thereafter,depending on whether the economy is good or bad one year from now.Assuming that the risk-free interest rate is 5 per cent per year,and that €1.00 invested in the market portfolio today will be worth either €1.30 (if the economy does well)or €0.80 (if the economy does poorly).What is the value of the project in the year 1 when the economy is bad?

A)€100 million
B)€320 million
C)€210 million
D)€310 million

Answer 3

A

Question 4

Vacant land can be viewed as an option:

A)to purchase developed land where the exercise price is less than the cost of developing a building on the land.
B)that is increasing in the degree of uncertainty about the value of development.
C)to purchase developed land where the exercise price is greater than the cost of developing a building on the land.
D)that is unaffected by the degree of uncertainty of the value of development.

Question 5

Which of the following is true of the Brennan-Schwartz method for valuing mines?

A)It requires the observation of the market price of an option to purchase the mineral being mined.
B)The inputs used in the valuation are the current market price of the mineral,the historical price of the mineral,and the risk-free rate of interest.
C)The inputs used in the valuation are the current market price of the mineral,the historical price of the mineral,and the market risk premium.
D)It assumes that the future price movements of the underlying asset follow a binomial process.

Question 6

Explain the ratio comparison approach.

Question 7

As per the price/earnings ratio method,a company should adopt a project when:

A)the ratio of its initial cost-to-earnings is lower than the price to earnings ratio of the comparison investment.
B)the ratio of breakeven value to earnings is lower than the price to earnings ratio of the comparison investment.
C)the ratio of its initial current ratio is lower than the price to earnings ratio of the comparison investment.
D)the ratio of its initial net income-to-earnings is higher than the price to earnings ratio of the comparison investment.

Question 8

A mine can be viewed as an option to extract minerals:

A)at a strike price equal to the cost of extraction less risk free cost of capital.
B)at a strike price equal to the cost of extraction.
C)at a strike price greater than the cost of extraction plus the premium.
D)at a strike price less than the cost of extraction.

Question 9

Which of the following is a criticism of the traditional discounted cash flow method?

A)It is biased against short-term projects.
B)It tends to ignore the direct cash flows.
C)It tends to focus on what can easily be quantified.
D)It cannot be applied to value securities which have an expected rate of return greater than their dividend growth rate.

Question 10

Which of the following is an assumption of the competitive analysis approach?

A)When the competing firms have competitive advantages,the project has a zero NPV.
B)All competitors can borrow and lend at risk-free rates.
C)All competitors are value-maximizing competitors.
D)The market is frictionless and tax-free.

Question 11

Which of the following is an assumption of the price/earnings ratio method?

A)The comparison investment on which the price/earnings multiple is based has the discount rate less than the earnings growth as the project being valued.
B)The comparison investment on which the price/earnings multiple is based has the discount rate equal to the risk-free rate as used for the project being valued.
C)The comparison investment on which the price/earnings multiple is based has the discount rate less than the risk-free rate as the project being valued.
D)The comparison investment on which the price/earnings multiple is based has the same discount rate and earnings growth as the project being valued.

Question 12

Explain the valuation of vacant land.

Question 13

AU Gold Mine,a European mining firm,owns a gold mine in Africa.The mine has a total 25.6 million ounces of gold.The firm extracts 12 million ounces in year 1 and the rest of the gold is extracted in year 2.The extraction cost for the year 1 and year 2 are £172/oz and £180/oz respectively.The current forward prices are £531.25/oz for a one-year contract and $562.5/oz for a two-year contract.The annually compounded risk-free rates are 3.75% for one-year zero-coupon bonds and 4% for two-year zero-coupon bonds.What is the present value of the cash flows from the mine,assuming that payments for the mined gold are received at the end of each year?

A)£8.96 billion
B)£4.48 billion
C)£7.34 billion
D)£5.28 billion

Question 14

Real estate investment trusts (REITs)are:

A)financial intermediaries which take deposits from individuals and corporations,and lend these funds to real estate investors.
B)fund management companies that pool money from real estate investors and other financial intermediaries to fund relatively small,new businesses,generally with private equity financing.
C)property portfolios that list and trade like shares of equity on an exchange,as a percentage of the book values of their assets.
D)investment bankers which raise money for corporations by marketing and selling securities.

Question 15

Zeta Corporation plans to invest in a project.The initial investment is €200 million and the next year's cash flow will be €20 million.There will be a perpetual annual cash flow stream of either €15 million or €4 million will occur each year thereafter,depending on whether the economy is good or bad one year from now.Assuming that the risk-free interest rate is 5 per cent per year,and that €1.00 invested in the market portfolio today will be worth either €1.30 (if the economy does well)or €0.80 (if the economy does poorly).Calculate the risk-neutral probability ( $\pi$ )associated with the valuation of the market portfolio.

A)0.8
B)0.25
C)1
D)0.5

Question 16

Zeta Corporation plans to invest in a project.The initial investment is €200 million and the next year's cash flow will be €20 million.There will be a perpetual annual cash flow stream of either €15 million or €4 million will occur each year thereafter,depending on whether the economy is good or bad one year from now.Assuming that the risk-free interest rate is 5 per cent per year,and that €1.00 invested in the market portfolio today will be worth either €1.30 (if the economy does well)or €0.80 (if the economy does poorly).Find the NPV of the project.

A)€200 million
B)€320 million
C)€210 million
D)€100 million

Question 17

Explain the effect of earnings growth and accounting methodology on price/earnings ratios.

Question 18

Zeta Corporation plans to invest in a project.The initial investment is €200 million and the next year's cash flow will be €20 million.There will be a perpetual annual cash flow stream of either €15 million or €4 million will occur each year thereafter,depending on whether the economy is good or bad one year from now.Assuming that the risk-free interest rate is 5 per cent per year,and that €1.00 invested in the market portfolio today will be worth either €1.30 (if the economy does well)or €0.80 (if the economy does poorly).What is the value of the project in the year 1 when the economy is good?

A)€100 million
B)€210 million
C)€320 million
D)€290 million

Question 19

In the valuation of initial public offering,which of the following is a better proxy in determining the tracking portfolio?

A)Fixed assets
B)Earnings
C)Current cash flow
D)Depreciation