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Total noncurrent liabilities $100,000
Total liabilities $170,000
Shareholders™ Equity
Common equity $ 40,000
Retained earnings 110,000
Total equity $150,000
Total liabilities and equity $320,000




Table 14.16 Mackinac Inc. Cash Flow Statement for the Year Ended June 30, 2001
(In Thousands)


Cash Flow from Operating Activities
Net income $37,450
Depreciation and amortization 10,500
Change in Working Capital
(Increase) decrease in receivables ($ 5,000)
(Increase) decrease in inventories (8,000)
Continued
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19
Chapter 14



Change in Working Capital
Increase (decrease) in payables 6,000
Increase (decrease) in other current liabilities 1,500
Net change in working capital ($ 5,500)
Net cash from operating activities $42,450

Cash Flow from Investing Activities
Purchase of property, plant, and equipment ($15,000)
Net cash from investing activities ($15,000)

Cash Flow from Financing Activities
Change in debt outstanding $ 4,000
Payment of cash dividends (22,470)
Net cash from financing activities ($18,470)

Net change in cash and cash equivalents $ 8,980
Cash at beginning of period 11,020
Cash at end of period $20,000



13. CFA Examination Level II
CFA
®
Mackinac has announced that it has finalized an agreement to handle North American production of
a successful product currently marketed by a foreign company. Jones decides to value Mackinac us-
ing the dividend discount model (DDM) and the free cash flow to equity (FCFE) model. After re-
viewing Mackinac™s financial statements in Tables 14.14, 14.15, and 14.16 and forecasts related to
the new production agreement, Jones concludes the following:
• Mackinac™s earnings and FCFE are expected to grow 17 percent per year over the next three
years before stabilizing at an annual growth rate of 9 percent.
• Mackinac will maintain the current payout ratio.
• Mackinac™s beta is 1.25.
• The government bond yield is 6 percent and the market equity risk premium is 5 percent.
a. Calculate the value of a share of Mackinac™s common stock using the two-stage DDM. Show
your calculations. [8 minutes]
b. Calculate the value of a share of Mackinac™s common stock using the two-stage FCFE model.
Show your calculations. [8 minutes]
Jones is discussing with a corporate client the possibility of that client acquiring a 70 percent interest
in Mackinac.
c. Discuss whether the dividend discount model (DDM) or free cash flow to equity (FCFE) model
is more appropriate for this client™s valuation purposes. [3 minutes]



Note: Questions 14 through 18 relate to Rio National Corp. A total of 72 minutes is
allocated to these questions. Candidates should answer these questions in the
order presented. Exhibits 14.4 through 14.8 relate to Rio National.



14. Rio National Corp. is a U.S.-based company and the largest competitor in its industry. Exhibits 14.4
through 14.7 present the financial statements, which are prepared according to U.S. Generally
Accepted Accounting Principles (U.S. GAAP), and related information for the company. Exhibit 14.8
presents relevant industry and market data.
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20 Web Problems




Exhibit 14.4 Rio National Corp. Summary Balance Sheets on 31 December (U.S. $ Millions)

2002 2001

Cash $ 13.00 $5.87
Accounts Receivable 30.00 27.00
Inventory 209.06 189.06
Current Assets $252.06 $221.93
Gross Fixed Assets 474.47 409.47
Accumulated Depreciation (154.17) (90.00)
Net Fixed Assets 320.30 319.47
Total Assets $572.36 $541.40

Accounts Payable $ 25.05 $ 26.05
Notes Payable 0.00 0.00
Current Portion of Long-term Debt 0.00 0.00
Current Liabilities $ 25.05 $ 26.05
Long-term Debt 240.00 245.00
Total Liabilities $265.05 $271.05
Common Stock 160.00 150.00
Retained Earnings 147.31 120.35
Total Shareholders™ Equity $307.31 $270.35
Total Liabilities and Shareholders™ Equity $572.36 $541.40




Exhibit 14.5 Rio National Corp. Summary Income Statement for the
Year Ended 31 December 2002 (U.S. $ Millions)

Revenue $300.80
Total Operating Expenses (173.74)
Operating Profit 127.06
Gain on Sale 4.00
Earnings before Interest, Taxes, 131.06
Depreciation and Amortization (EBITDA)
Depreciation and Amortization (71.17)
Earnings Before Interest and Taxes (EBIT) 59.89
Interest (16.80)
Income Tax Expense (12.93)
Net Income $ 30.16
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21
Chapter 14




Exhibit 14.6 Rio National Corp. Supplemental Notes for 2002


Note 1: Rio National had $75 million in capital expenditures during the year.
Note 2: A piece of equipment that was originally purchased for $10 million was sold for
$7 million at year-end, when it had a net book value of $3 million. Equipment sales
are unusual for Rio National.
Note 3: The decrease in long-term debt represents an unscheduled principal repayment;
there was no new borrowing during the year.
Note 4: On 1 January 2002, the company received cash from issuing 400,000 shares of com-
mon equity at a price of $25.00 per share.
Note 5: A new appraisal during the year increased the estimated market value of land held
for investment by $2 million, which was not recognized in 2002 income.




Exhibit 14.7 Rio National Corp. Common Equity Data for 2002


Dividends Paid (U.S. $ millions) $3.20
Weighted Average Shares Outstanding during 2002 16,000,000
Dividend per Share $0.20
Earnings per Share $1.89
Beta 1.80

Note: The dividend payout ratio is expected to be constant.




Exhibit 14.8 Industry and Market Data 31 December 2002


Risk-free Rate of Return 4.00%
Expected Rate of Return on Market Index 9.00%
Median Industry Price/Earnings (P/E) Ratio 19.90
Expected Industry Earnings Growth Rate 12.00%



Note: Question 14 has three parts (A, B, C) for a total of 16 minutes.


The portfolio manager of a large mutual fund comments to one of the fund™s analysts, Katrina Shaar:
“We have been considering the purchase of Rio National Corp. equity shares, so I would like you to analyze
the value of the company. To begin, based on Rio National™s past performance, you can assume that the
company will grow at the same rate as the industry.”

A. Calculate the value of a share of Rio National equity on 31 December 2002, using the Gordon
growth model and the capital asset pricing model. Show your calculations. [6 minutes]
B. Calculate the three components of Rio National™s return on equity for the year 2002, using the
DuPont model. Show your calculations.
Note: Your calculations should use 2002 beginning-of-year balance sheet values. [6 minutes]
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22 Web Problems



C. Calculate the sustainable growth rate of Rio National on 31 December 2002.
Note: Your calculations should use 2002 beginning-of-year balance sheet values. [4 minutes]

Note: Question 15 has three parts (A, B, C) for a total of 20 minutes.


15. While valuing the equity of Rio National Corp., Katrina Shaar is considering the use of either cash
flow from operations (CFO) or free cash flow to equity (FCFE) in her valuation process.
A. State two adjustments that Shaar should make to cash flow from operations to obtain free cash
flow to equity. Explain why it is necessary to make each of the two adjustments when valuing
the equity of a firm.
Note: No calculations are required. [4 minutes]
Shaar decides to calculate Rio National™s FCFE for the year 2002, starting with net income.
B. Determine, for each of the five supplemental notes given in Exhibit 14.6:
i. Whether a net positive adjustment, a net negative adjustment, or no adjustment should be
made to net income to calculate Rio National™s free cash flow to equity for the year 2002
ii. The dollar amount of the adjustment, if any
Note: The five supplemental notes given in Exhibit 14.6 are reproduced in the Template for
Question 15-B.
Answer Question 15-B in the Template below. [10 minutes]
C. Calculate Rio National™s free cash flow to equity for the year 2002. Show your calculations.
Note: Your calculations should start with net income. [6 minutes]



TEMPLATE FOR QUESTION 15-B
Determine, for each of the
five supplemental notes,
whether a net positive adjustment
a net negative adjustment, or
no adjustment should be made
to net income to calculate
Five supplemental Rio National™s free cash flow to Determine the dollar
notes given in equity for the year 2002 amount of the
Exhibit 5-3 (circle one for each note) adjustment, if any

Positive
Note 1: Rio National had $75
$
Negative
million in capital expenditures
during the year.
No Adustment



Note 2: A piece of equipment
that was originally purchased Positive
for $10 million was sold for
$
Negative
$7 million at year-end, when
it had a net book value of
No Adustment
$3 million. Equipment sales
are unusual for Rio National.


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