6.0 Valuation Methods /Cost of Capital

Question 1

Constant Dividend Growth Model (single period)
Stock Valuation
Common Stock

Answer 1

Expected Dividend per share/
Discount Rate - Growth Rate

• Expected Dividend= Last Dividend * (1 + Growth Rate)

Question 2

Constant Dividend Growth Model (multiple years)

Stock Valuation

Answer 2

Last Dividend + (1 + (Growth percent) t power))/
Discount Rate - Growth

eg. 10 * (1.05)4th power = 12.16/
.12-.05

Question 3

Variable Dividend (growth then stable) Stock Valuation

2 Stage/3 Steps

12% Return
5% Growth

Answer 3

End of Yr Dividend PV factor PV of Dividend
1 = 5.00 .893 4.47
2 5.00 * 1.05 = 6.00 .797 4.78
3 6.00 * 1.05 = 7.20 .712 5.13

sum 14.38

Step 2
calculate the present value based on steady growth (8%)
a. calculate the next dividend 7.20 * 1.08 = 7.78
b. use standard dividend growth formula
7.78/
.12-.08 = 194.50 x .712 (last pv factor) = 138.48

Step 3
sum the two : 14.38 + 138.48 = 152.86

Question 4

Preferred Stock Valuation

Answer 4

Preferred Dividend Per Share/
Cost of Capital (Rs)

$12/
.15

Question 5

Component Cost of Capital - Debt (Existing)

Answer 5

Effective Rate * (1-tax rate)

Question 6

Component Cost of Capital - Preferred Stock (Existing)

Answer 6

Dividend Yield

Dividend /
Market Price

Question 7

Component Cost of Capital - Common Stock (Existing)

Answer 7

Dividend Yield

Dividend/
Market Price

Question 8

Component Cost of Retained Earnings

Answer 8

Normally lower than the cost of Common Stock due to no Issuance costs. (sometimes set equal without flotation costs. )

Question 9

WACC

Weighted Average Cost of Capital

Answer 9

Is based on the MARKET value, not BOOK

1. Calculate each Component Cost
2. Calculate each components weight based on Market Value

Component Percent x Component Costs = Value
10% (Debt) 7.41% .741 %
20.91% (Preferred) 11.5% 2.404%
63.64% (Common) 16.00% 10.1824%
1.45% (Retained Earnings) 16.00% .872%

SUM = WACC 14.20%

Question 10

WACC formula with no preferred stock

Answer 10

Equity/ x Rs Equity x Debt/ x Rd (1 - Tax Rate)
Total Total

Rs = Cost of Equity
Rd = Cost of Debt

Question 11

Effect of Taxes

Capital Gains
Dividends
Interest on Debt

Answer 11

Capital Gains

a. Corporate received Capital Gains=Normal Tax Rate
b. Individual received Capital Gains = 16%

Dividends Received

a. Corp to Corp = 70%-100% tax free
b. Corp to Individual = normal tax rate

Interest on Debt

a. Corp to Individual = Tax Deductible (so Corp prefers debt to Debt
b. Corp to Individual CAPITAL GAINS = INDIVIDUAL investor prefers to CAPITAL GAIN because partially non taxable (This is not debt to dividends but Interest to capital gains

Question 12

MCC - Marginal Cost of Capital

Answer 12

The cost of NEW capital = the WEIGHTED Average of the NEXT dollar. Not the cost of the specific component

Question 13

Cost of NEW Debt

Answer 13

Annual Interest Expense/

Net Proceeds

Question 14

Cost of NEW Preferred Stock

Answer 14

Next Dividend/

Net Proceeds

Question 15

Cost of NEW Common Stock

Cost of NEW Retained Earnings

Answer 15

Next Dividend/
Net Proceeds + Growth Rate

$8/
$55-3 + 2%

Retained Earnings does not include the $3 Flotation cost

Question 16

WACC of New Capital

Answer 16

Same as WACC for existing except percentages can be
using the same weight if the company has achieved optimal x each components cost. Or can be adjusted such as using retained earnings first

Question 17

Long COLLERUP

Answer 17

A long position: the investor hopes to gain with a rise in price in the future

Question 18

Cash Flow Hedge

Answer 18

A hedge were intent is to protect future cash flows

Question 19

SHORT HEDGE

Answer 19

person Borrows and then Sells NOW. Then replaces the stock borrowed with lower priced stock later (hopefully)

Question 20

FAIR VALUE HEDGE

Answer 20

Hedges against the change in Fair Value

Question 21

NATURAL HEDGE

Answer 21

Does not rely on sophisticated financial instruments

ie financing a piece of equipment over its natural life

Question 22

Exercise Price  (Strike Price)
Option Price (Option Premium)

Answer 22

Exercise or Strike Price is the price at which the Option can be acted on

Option Price (Option Premium) the thing that you buy at the specified price for the RIGHT to exercise the option.

Question 23

Covered Option v

Naked Option

Answer 23

Covered: The SELLER has possession of the underlying
Naked: The SELLER does not yet own the underlying which they may have to perform on

Question 24

Types of Options

Answer 24

Stock Option: Underlying is a traded stock
Index Option: Underlying is an INDEX. Settlement in Cash delivering underlying is impossible.
LEAPS (Long Term Index Option): up to three years away
Foreign Currency Options: Right to buy a specific currency at a designated EXCHANGE RATE

Question 25

Call Option

Answer 25

Right to Buy (Call) at a specific price Intrinsic Value is : Price of Underlying LESS Exercise Price Out of the Money: Underlying is less than the Exercise Price In the Money: Underlying exceeds the Exercise Price At The Money: Underlying equals the Exercise Price

Question 26

Call Option Gain/Loss Calculation

Answer 26

In The Money Buyer: (Underlying over Exercise Price) - Option Price) x Units Seller Option Price - (Underlying over Exercise Price) x Units Out of The Money Since nothing will be exercised> Buyer > Option Price paid is the loss Seller > Option Price received is the gain

Question 27

Put Option

Answer 27

Right to SELL at a fixed price (Right to Put on the Market) Intrinsic Value = Exercise Price less the value of underlying In the Money: Price of underlying is less than exercise Out of the Money: Price is higher than exercise price At The Money: Price is at the exercise price

Question 28

Put Option

Answer 28

Right to SELL at a fixed price (Right to Put on the Market) . A SHORT position. Intrinsic Value = Exercise Price less the value of underlying In the Money: Price of underlying is less than exercise Out of the Money: Price is higher than exercise price At The Money: Price is at the exercise price

Question 29

Put Option Gain/Loss Calculation

Answer 29

In The Money: Buyer Exercise over Underlying - Option Price x Units Seller Option Price - Exercise Price over Underlying x Units ``` Out of the Money: Buyer Option Price Paid Seller Option Price Received ```

Question 30

Put Call Parity Theorem

Answer 30

Value of Call + PV of exercise = Value of Put + Value of Underlying PV of exercise is at Rf rate Restated: PV of Exercise = Value of Put + Value of Underlying - Value of Call ie Value of buying a Put + Value of Underlying - Buying a Call = PV of Exercise at risk free rate

Question 31

Valuing an Option What happens when underlying changes, exercise changes, Interest rates Change Volitility, Term

Answer 31

Exercise Price: INCREASE in exercise of a Call, reduces the value DECREASE in the exercise of a Put, reduces the value Price of Underlying: Call underlying increase = Increase in Call Value Put Underlying decreases = Increase in Put Value Interest Rates: In Inflation, using inflated dollar to pay, thus to pay a Call using inflated dollar so value increase. Put decreases because you are paying the decrease with inflated dollar. Time to Maturity: Increase Call and Put Volatility: Increases Call and Put

Question 32

Forward Contract

Answer 32

A simple hedge: Buyer is locking future delivery at specific price; Buyer is long because he is guarding against higher future. Seller is Short because guarding against lower future. Different than option because buyer and seller MUST deliver. It is not an option to be exercised

Question 33

Futures Contract

Answer 33

Rather than specific things to be delivered as in Forward Contract> Undifferentiated Commodities: Currency, Grain To be delivered in a Month (not a day) Also, profit or loss is marked daily and settled. Less risk of default Also Forward delivers actual product. Futures only deliver difference between prices.

Question 34

Swaps

Answer 34

Interest Rate Swaps: Firm exchanges payments at one interest rate for another that matches better Currency Swaps: Company A need Euros, Company B need USD. Agree to exchange at a specific rate Credit Default Swaps: One bank basically insures against to non-pmt to a second bank buy a third party most swaps are at the money. As interest, exchange rates and credit risks change the swap changes