Lecture 2

Question 1

Please explain the difference between forecasting period and terminal value. Provide the general formula as well.

Answer 1

Question 2

Please explain and provide the formula for the DDM

Answer 2

Question 3

Nike Inc. just paid a dividend per share of $0.74 at the end of 2024. Dividends are expected to grow 7% per year during 2025-2029. After 2029, dividends are expected to
drop to a stable 5%. Investors’ required rate of return (𝑟𝑒) is 10%.

Answer 3

Question 4

What are the advantages/disadvantages with the DDM?

Answer 4

Advantages
* Easy concept: Dividends are what shareholders get
* Predictability: Dividends are usually fair stable in the short run

Disadvantages
* Irrelevance: Distribution, which typically happens later than the
actual creation of value.

When it works best
* When payout is permanently tied to the value generation in the
firm (dividends/earnings).

Question 5

Please explain what residual earnings are and provide the formula

Answer 5

RE is the excess income generated by the company above the expected return on equity.

Question 6

What are the advantages/disadvantages with the RE model?

Answer 6

Advantages:
* Focuses on value drivers: 1) profitability and 2) growth in investment
* Describes a firm’s value using accounting variables that are subjects of
financial analysis and forecasting.
* Uses the properties of accrual accounting that
* recognizes value added ahead of cash flows
* treats investment as an asset rather than a loss of value
* Incorporates the value already recognized in the balance sheet
(through book value of equity).
* Reduces reliance on speculation

Disadvantages:
* Accounting complexity
* Accounting distortions

Question 7

Please describe the free cash flow model

Answer 7

• Value of the operations: Present value of future free cash flows to firm
• Free Cash Flows to firm (FCF) = Operating Cash Flows – Capital
  Expenditures
• FCF (reformulated approach) = Net Operating Income (after taxes) –
  Changes in Net Operating Assets
• The intuition is that FCF is cash “left” in the firm after capital investments.
  Such cash is likely to be paid as interest (debtholders) and dividends
  (shareholders).

Question 8

Provide the formula for the DCF model

Answer 8

Question 9

What are the advantages/disadvantages to a DCF?

Answer 9

• Advantages
• Easy concept: cash flows are real and easy to think about.
• Familiarity: straightforward application of familiar PV techniques.
• Disadvantages
• Relevance:
• FCF fails to recognise value generated that does not involve cash flows.
• Firms can increase FCF by cutting back on investments, causing
  investment to be treated as a loss of value.
• Not aligned with what people forecast.
• When it works best
• When the investment pattern produces positive constant free cash flow or
  free cash flow growing at a constant rate; a “cash cow” business.

Question 10

What i the residual operating income model (REOI)? Please describe and provide formula

Answer 10

• Similar intuition with the residual earnings model; but REOI focuses
  on abnormal operating profitability.
• It measures the incremental operating income generated after
  meeting the firm’s cost of capital.

Question 11

What is relative valuation and what are the steps in finding it?

Answer 11

• The value of an asset is compared to the market value of other comparable
  assets.
• Example of multiples: Price-Earnings ratio (P/E)
• Three steps in relative valuation
• Step1: Select a set of comparable companies
• Step2: Compute average P/E-ratio of these comparables
• Step3: Multiply earnings of company to be valued with average P/E of comparables
• Done!