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Continued
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23
Chapter 14



Note 3: The decrease in long-
term debt represents an Positive
unscheduled principal repay-
Negative $
ment; there was no new
borrowing during the year. No Adustment




Note 4: On January 1, 2002, Positive
the company received cash
$
Negative
from issuing 400,000 shares of
common equity at a price of
No Adustment
$25.00 per share.




Note 5: A new appraisal
Positive
during the year increased
the estimated market value Negative $
of land held for investment by
No Adustment
$2 million, which was not
recognized in 2002 income.


Note: The five supplemental notes given in Exhibit 14-6 are reproduced in the Template.


Note: Question 16 has two parts (A, B) for a total of 8 minutes.

16. In the process of gathering data to value the equity of Rio National Corp. using a price-multiple ap-
proach, one of Katrina Shaar™s associates has suggested that the earnings per share (EPS) reported
by Rio National may need to be converted to normalized (underlying) earnings.
A. Determine, for each of the supplemental notes 2 through 5 given in Exhibit 14.6, the dollar
amount of the adjustment, if any, that should be made to pretax income to calculate Rio Na-
tional™s normalized (underlying) net income for the year 2002.
Note: The five supplemental notes given in Exhibit 14.6 are reproduced in the Template for
Question 16-A. Note 1 in the Template for Question 16-A is completed as an example.
Answer Question 16-A in the Template provided on page 24. [4 minutes]
Shaar has revised slightly her estimated earnings growth rate for Rio National and, using normal-
ized (underlying) EPS, now wants to compare the current value of Rio National™s equity to that of
the industry, on a growth-adjusted basis. Selected information about Rio National and the industry
is given in Exhibit 14.9.
B. State whether, compared to the industry, Rio National™s equity is overvalued or undervalued on a
P/E-to-growth (PEG) basis, using normalized (underlying) earnings per share. Justify your
response with one reason. Show your calculations.
Note: Your response should assume that the risk of Rio National is similar to the risk of the
industry. [4 minutes]
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24 Web Problems




Exhibit 14.9 Selected Information Rio National Corp. and Industry


Rio National

Estimated Earnings Growth Rate 11.00%
Current Share Price $25.00
Normalized (underlying) EPS for 2002 $1.71
Weighted Average Shares Outstanding during 2002 16,000,000

Industry

Estimated Earnings Growth Rate 12.00%
Median Price/Earnings (P/E) Ratio 19.90




TEMPLATE FOR QUESTION 16-A
Determine, for each of the supple-
mental notes 2 through 5 given in
Exhibit 14.6, the dollar amount of the
adjustment, if any, that should be
made to pretax income to calculate
Five supplemental notes given in Rio National™s normalized (underlying)
Exhibit 14.6 net income for the year 2002

Example: Example:
Note 1: Ratio National had $75 million in capital $ No adjustment
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
common 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.

Note: The five supplemental notes given in Exhibit 16-6 are reproduced in the Template. Note 1 in the Template is
completed as an example.


Note: Question 17 has two parts (A, B) for a total of 12 minutes.
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25
Chapter 14



17. As part of her valuation process, Katrina Shaar has collected the following comparative information
about Rio National Corp. and its primary competitor.
1. Rio National™s gross margin is 57 percent, up from 55 percent a year ago. Management
attributes this improvement to cost reductions from continuous efforts to achieve manufactur-
ing efficiencies.
2. Rio National is the largest company in the industry. The next largest competitor is
Gracemoor Inc., which has positioned itself as having high quality products and excellent
customer service. Gracemoor™s gross margin is 62 percent, which is the highest gross margin
in the industry.
3. Rio National™s customer base is:
Large volume retailers 45%
Ready to assemble product manufacturers 32%
Other 23%
Although Rio National is the largest company in the industry, it has relatively few customers.
Gracemoor is a substantially smaller company than Rio National but has several times the
number of customers.
4. Rio National™s management noted that most of Rio™s customers are highly price sensitive, so
Rio has found it quite difficult to increase prices. These customers, however, have consis-
tently purchased in large volumes. Rio™s management believes the Rio™s average selling price
is 20 percent below Gracemoor™s average selling price.
A. Identify the competitive strategy being employed by Rio National and Gracemoor, respectively.
Cite two facts about each company that are consistent with that company™s identified strategy.
Answer Question 17-A in the Template provided below. [8 minutes]



TEMPLATE FOR QUESTION 17-A
Identify the competitive Cite two facts about each company
strategy being employed by that are consistent with that
Rio National and Gracemore, company™s identified strategy
respectively (circle one for each
company)

1.
Cost Leadership

Cost Focus

Rio National Differentiation
2.
Differentiation Focus

Buyer Bargaining Power


1.
Cost Leadership

Cost Focus

Gracemoor Differentiation
2.
Differentiation Focus

Buyer Bargaining Power
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26 Web Problems



A few weeks later, Shaar is reviewing several current e-mail newsletters that focus on this industry.
One of the newsletters contains a press release entitled “Gracemoor Inc. Announces Merger with
Remalco Corporation.” An extract from this press release is shown below.

Extract from Gracemoor Inc. Press Release

“Gracemoor Inc. Announces Merger with Remalco Corporation”
Jeff Fedor, President of Gracemoor Inc., and John Rutt, President of Remalco Corporation, are
pleased to announce that the firms have reached an agreement to merge operations. The combined
entity, GraceMalco, will have over $250 million in annual revenues and will employ 1,500 people in
three locations.
“The merger of the operations will allow us to reorganize and update manufacturing operations, result-
ing in substantial manufacturing cost reductions. GraceMalco will continue the high level of customer
and technical support that has been integral to Gracemoor™s prior success but the new company will
also be able to expand the lower margin, high volume consumer markets that have been Remalco™s
focus over the last three years,” said Fedor, the new president of GraceMalco.

After reading the press release, Shaar calls both Rio National and GraceMalco for more details and
obtains the following comments:
• From Rio National™s Vice President of Investor Relations:
“We believe that the market is large and there is room for more than one company to pursue
the strategy that we have chosen.”
• From the new President of GraceMalco:
“Our merged firm will be able to pursue multiple strategies and compete more effectively
against Rio National.”
B. Discuss one threat each that the merger may pose to the sustainability of the competitive strate-
gies of the following two companies: [4 minutes]
i. Rio National
ii. GraceMalco

Note: Question 18 has two parts (A, B) for a total of 10 minutes.

18. The management of Rio National Corp. has now announced the signing of a new marketing agree-
ment that will allow the company to sell its products in Southeast Asia. Sophie Delourme, an ana-
lyst at Euro-International Co., is analyzing the effect of this announcement on her estimated value of
Rio National™s equity. She uses the H-model in her valuation process and has identified the follow-
ing inputs:
• Rio National™s earnings growth rate is expected to be 30.0 percent in 2003, declining over a five-
year period to a constant growth rate of 12.0 percent in 2008 and thereafter.
• Because of the change in risk, the required rate of return (cost of equity) for Rio National is ex-
pected to be 13.5 percent.
• The dividend per share for 2002 was $0.20.
• The dividend payout ratio is expected to be constant.
A. Calculate the estimated value of a share of Rio National™s equity on 31 December 2002, using
the H-model. Show your calculations. [6 minutes]
Delourme presents her analysis to her supervisor and concludes:
“Except in rare circumstances, the H-model™s estimated value will be a close approximation to
estimated values generated by multi-stage dividend growth models that explicitly forecast divi-
dends each year.”
B. State whether Delourme™s conclusion is correct or incorrect. Justify your response with one
reason. [4 minutes]
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27
Chapter 16




Note: Question 19 has one part for a total of 6 minutes.

19. After Rio National Corp. announced the new marketing agreement to sell its products in Southeast
Asia, several analysts revised their 2003 outlook for Rio National. Reflecting the new marketing
agreement, the current consensus 2003 earnings per share is $2.19 and the current consensus
12-month target share price is $50.00.
Sophie Delourme observes that Rio National™s share price rose from $25.00 to $37.00 after the

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