Chapter 9 Flashcards
Equity Cost of Capital
The expected total return of a stock is equal to the firm’s Equity Cost of Capital. And the equity cost of capital for a corporation is equal to the expected return of other securities in the market with equivalent risk and term to owning the firms shares.
Dividend Discount Model
Dividend discount model asserts that the stock price equals the present value of all future dividends (forever) discounted at the equity cost of capital, RE.
Total Payout Model
The total payout model asserts that if the firm buys back shares in addition to paying dividends, then you must modify the dividend discount model. The total market capitalization will be:
The Value of Equity = PV of all future dividends and share repurchases
The per share price, of course, takes this total value and divides it by the number of shares outstanding
WACC
The weighted average cost of capital (WACC) is the rate that reflects the overall business – that is the combined risks of the firm’s equity and debt. So it is a weighted average of the firm’s debt cost of capital
Enterprise Value
Enterprise Value equals the PV of all future free cash flows.
Discounted Free Cash Flow
If the firm has debt, a better model to use to value it is the discounted cash flow model. It states that:
Enterprise Value = PV of all future free cash flows at the Weighted Average Cost of Capital (WACC)
Comparables
A 4th valuation method is to look at the enterprise value of the firms in the same business. Adjusting for size, their enterprise value should also be comparable. So, if firms ABC and XYZ are in the same business, and the revenues of firm ABC are twice as large as firm XYZ, we would expect the enterprise value to be about twice as large.
Under the dividend discount model, would it ever make sense for a firm to lower its dividend?
Based on this, it would make sense for a firm to lower their dividend if and only if the firm can reinvest those proceeds into projects which would result in future dividends whose present value exceeds the value of the dividend it would otherwise pay today. For firms with no debt, that would mean reinvesting in projects whose returns exceed the equity cost of capital. For firms with debt, it would mean reinvesting the proceeds into projects whose returns exceed the weighted average cost of capital.
Are comparables a good stand alone model? How is the model best used?
This is not a very good stand-alone method. It is best used as a reasonability test on your model. If your model produces a much different result, you must ask yourself why. Are you missing something? Can you explain the difference in valuation.
Debt Cost of Capital
The effective rate that a company pays on its borrowed funds. It represents the return required by debt holders and is usually expressed as an annual percentage.
