Goldfarb

Question 1

Insurance company valuation methods (5)

Answer 1

1. dividend discount model
2. discounted cash flows (FCFF and FCFE)
3. abnormal earnings
4. relative valuation using multiples
5. option pricing methods

Question 2

Present value of dividends with growth into perpetuity

Answer 2

E[next div] / (k - g)

*remember to also discount back to time 0 if terminal value

Question 3

Formula for growth rate beyond forecast horizon and alternative method for DDM

Answer 3

g = plowback ratio * ROE

alternative = extrapolate growth rate during the forecast horizon

Question 4

CAPM required return (aka risk-adjusted discount rate, or cost of capital)

Answer 4

k = risk free rate + beta * (expected market return - risk free rate)

expected market return - risk free rate = market risk premium

Question 5

Beta in CAPM represents

Answer 5

firm’s systemic/non-diversifiable risk (high beta = high risk)

Question 6

Primary considerations in beta selection (2)

Answer 6

1. mix of business

2. financial leverage

Question 7

Options for basis of risk free rate (3)

Answer 7

1. 90-day T-bills
2. maturity matched T-notes
3. T-bonds&raquo_space; *must be net of liquidity premium

Question 8

ROE formula

Answer 8

net income after tax / beginning equity

Question 9

Ending equity formula

Answer 9

= beginning equity + net income after tax - dividends paid

Question 10

Limitations of DDM (2)

Answer 10

1. dividend payments are discretionary and difficult to forecast
2. may need to re-define dividend with increased use of stock buybacks

Question 11

Implicit assumption of FCF methods

Answer 11

any FCF not paid as dividends are invested to earn an appropriate risk-adjusted return

Question 12

Free cash flow to the firm (FCFF) method

Answer 12

equity = firm value - market value of debt

Question 13

Reasons FCFF method is difficult to apply to P and C companies (2)

Answer 13

1. arbitrary difference b/w PH liabilities and debt

2. distinction b/w PH liabilities and debt makes it difficult to determine WACC or APV discount rate

Question 14

Distinction b/w FCFF and FCFE

Answer 14

FCFF - reflects CFs/risk to equity and debt-holders

FCFE - reflects only CFs/risk to equity holders

Question 15

FCFE formula

Answer 15

FCFE = net income after tax
+ non-cash charges (x change in reserves)
- net working capital investment
- increase in required capital (aka capital expenditures)
+ net borrowing

Question 16

Reason change in reserves is excluded from non-cash charges in FCFE equation

Answer 16

added as a non-cash charge, but also subtracted as a capital expenditure, so the net effect cancels out

Question 17

Examples of net working capital expense (2)

Answer 17

1. inventory

2. accounts receivable

Question 18

Examples of capital expenditures (3)

Answer 18

investments in:

1. property
2. plant
3. equipment

in addition to changes in regulatory, rating agency, or management requirements

Question 19

Differences b/w DDM and FCFE methods (2)

Answer 19

1. growth rates - difficult to define reinvestment under FCFE method
2. discount rates - theoretically should reflect riskiness to shareholders, but in practice same rate used

Question 20

Reinvestment rate for FCFE growth rate

Answer 20

reinvestment rate = change in capital / net income after tax

Question 21

Horizon growth rate for FCFE method

Answer 21

g = selected reinvestment rate * selected ROE

Question 22

Weaknesses of the DCF methods (3)

Answer 22

1. financial statements must be forecast using specific accounting standards
2. variety of adjustments are made to estimate FCFs from forecasted net income
3. resulting CFs may not necessarily = plan

Question 23

Book value for AE method

Answer 23

book value = beginning capital

Question 24

AE formula

Answer 24

= (ROE - k) * book value

OR = net income - required earnings where
required earnings = k * book value

Question 25

Value of firm under AE method

Answer 25

value = book value + PV (AE)

Question 26

Key difference b/w AE and other methods

Answer 26

AE does not assume constant growth in perpetuity | *instead, AE decline linearly to 0 as new competition enters the market to capture AE decrease by 1/(n + 1) per year

Question 27

Benefits of the AE method (2)

Answer 27

1. uses assumptions more directly tied to the source of value creation vs. effect (dividends and FCFs) 2. de-emphasizes terminal value (more of value reflected w/in forecast horizon)

Question 28

Reasons to use relative valuation instead of other methods (3)

Answer 28

1. insufficient data available 2. difficult to obtain growth and rate adequacy estimates w/o market knowledge and planning data 3. horizon used may stretch limits of forecasting ability

Question 29

Use cases for relative valuation using multiples (3)

Answer 29

1. reasonability check/validation of assumptions 2. shortcut to valuation 3. method to estimate terminal value

Question 30

Price-earnings ratio for relative valuation

Answer 30

price @ time 0 / EPS @ time 1 = dividend payout rate / (k - g)

Question 31

Price-book value ratio for relative valuation | >> assuming growth and AE continue into perpetuity

Answer 31

price @ time 0 / book value @ time 0 = 1 + [(ROE - k) / (k - g)]

Question 32

Total firm value under relative valuation using multiples

Answer 32

= weighted average of segment values often average multiples to avoid relying on a single one

Question 33

Multiple in relative valuation reflects (3)

Answer 33

combined effect of: 1. dividend payout ratio 2. growth rate 3. discount rate

Question 34

Price-book value ratio for relative valuation | >> assuming ROE declines to cost of capital after n yrs

Answer 34

price @ time 0 / book value @ time 0 = 1 + [(ROE - k) / (k - g)] * [ 1 - ((1 + g) / (1 + k)) ^ n]

Question 35

Advantage of using transaction multiples

Answer 35

often based on a complex negotiation w/sophisticated calculations on both sides

Question 36

Reasons to exercise caution when using transaction multiples (4)

Answer 36

1. control premiums to gain control of ops 2. overpricing in M and A due to increased shareholder value 3. trend for underpricing in IPOs 4. appropriateness of assumptions underlying reported financial variables or economic conditions

Question 37

General rule for calls/puts in real option pricing

Answer 37

call - options to expand/postpone | put - options to contract/abandon