chapter 9

Question 1

the Law of One Price

Answer 1

implies that to value any security, we must determine the expected cash flows an investor will receive from owning it.

Question 2

P0

Answer 2

the current market price for a share.

Question 3

Div1

Answer 3

the total dividends paid per share at P1.

Question 4

P1

Answer 4

the new market price.

Question 5

equity cost of capital (rE)

Answer 5

the expected return of other investments available in the market with equivalent risk to the firm’s shares. this is used to discount risky cash flows of stocks.

Question 6

dividend yield

Answer 6

the percentage return the investor expects to earn from the dividend paid by the stock.

Question 7

capital gain

Answer 7

what the investor will earn on the stock, which is the difference between the expected sale price and the purchase price of the stock.

Question 8

capital gain rate

Answer 8

the capital gain as a percentage return. it is the capital gain divided by the current stock price.

Question 9

total return

Answer 9

the expected return that the investor will earn for a one-year investment in the stock. the expected total return should equal the expected return of other investments available in the market with equivalent risk.

Question 10

constant dividend growth model

Answer 10

the simplest forecast for the firm’s future dividends. it states that dividends will grow at a constant rate (g) forever. we expect the dividends to be a constant growth perpetuity.

Question 11

dividend pay-out rate

Answer 11

the fraction of earnings that the firm pays as dividends each year.

Question 12

retention rate

Answer 12

the fraction of current earnings that the firm retains.

Question 13

sustainable growth rate

Answer 13

the growth rate in dividends if the firm chooses to keep its dividend pay-out rate constant. so, the rate at which it can grow using only retained earnings.it is g = retention rate * return on new investment.

Question 14

share repurchases

Answer 14

occur when the firm uses excess cash to buy back its own stock. it decreases the number of shares outstanding, increases EPS and therefore increases dividends per share in the long run.

Question 15

total pay-out model

Answer 15

an alternative approach to value a firm’s shares. it allows us to ignore the choice between dividends and share repurchases. it values the total firm equity, rather than a single share. the key benefit is that it assumes that any cash paid out to shareholders takes the form of a dividend.

Question 16

discounted free cash flow model

Answer 16

focuses on the cash flows to all of the firm’s investors, both debt and equity holders, allowing us to avoid estimating the impact of the firm’s borrowing decisions on earnings.

Question 17

weighted average cost of capital (WACC/rwacc)

Answer 17

the average cost of capital the firm must pay to all of its investors, both debt and equity holders. it is used for the discounted free cash flow model.

Question 18

method of comparables

Answer 18

estimates the value of the firm based on the value of other comparable firms or investments that we expect will generate very similar cash flows in the future rather than the value of the firm’s cash flows directly. it is an application of the law of one price.

Question 19

valuation multiple

Answer 19

a ratio of the value to some measure of the firm’s scale. it adjusts for differences in scale between firms.

Question 20

forward P/E

Answer 20

the P/E multiple computed based on its forward earnings, which are the expected earnings over the next twelve months.

Question 21

trailing P/E

Answer 21

a ratio using trailing earnings, which are earnings over the previous twelve months.

Question 22

value of a share

Answer 22

the present value of all future cash flows to equity holders at the opportunity cost of capital of the equity holder (rE).

Question 23

value of equity

Answer 23

according to the Dividend Discount Model (DDM), the value of equity is the PV of all future dividends.

Question 24

terminal value

Answer 24

the future share price of the stock once the expected growth rate stabilises when a stock has non-constant growth rates. it is the value of the remaining cash flows after growth stabilises.

Question 25

free cash flow

Answer 25

the cash flow available to pay both debt holders and equity holders.

Question 26

Comparable Company Analysis

Answer 26

estimates the value of the firm based on the value of other, comparable firms or investments that we expect will generate very similar cash flows in the future.

Question 27

Precedent Transaction Analysis

Answer 27

estimates the value of the firm based on the value in other preceding transactions of other, comparable firms or investments that we expect will generate very similar cash flows in the future.

Question 28

Payout policy/dividend policy decision

Answer 28

the decision made by the firm regarding whether to pay out cash to shareholders or invest in new projects. So, it includes weighing dividend pay out rate, return on a potential new investment, and the growth rate in dividends. it is set by the board of directors.

Question 29

Present Value of Growth Opportunities (PVGO)

Answer 29

compares the share price with growth and the share price without growth.

Question 30

valuation model

Answer 30

determines the relationship among the firm’s future cash flows, cost of capital, and share value. it allows us to make inferences about the third variable if given information about two of them. the way we use it depends on the quality of the information.

Question 31

efficient market hypothesis

Answer 31

the idea that competition among investors works to eliminate all positive-NPV trading opportunities. it implies that securities will be fairly priced, based on their future cash flows, given all information available to investors. it is best viewed as an idealised approximation for highly competitive markets.

Question 32

arbitrage opportunity

Answer 32

a situation in which two securities or portfolios with identical cash flows have different prices. we expect that investors will immediately exploit and eliminate these opportunities.