Lecture 4

Question 1

What is the dividend discount model

Answer 1

1. Looks at the value of a company’s equity is at the PV of all expected dividends
2. Companies can increase value by delaying dividends and investing in positive NPV projects which will lead to bigger dividends in the future

Question 2

What does the dividend discount model yield

Answer 2

The intrinsic value or the fundamental value of the firm

Question 3

What is the General DDM model

Answer 3

1. Value of stock
2. Expected dividend at time t
3. Required return or discount rate or cost of equity

Question 4

When is the DDM suitable

Answer 4

1. Company is paying dividends
   
   2. Have established a dividend policy that is consistent with companys profitability
   3. Investor takes a non control perspective

Question 5

What is the DDM Constant Growth Model (Gordon Model)

Answer 5

1. The firms value at time zero
2. The dividend at time one
3. The cost of equity
4. The perpetual dividend growth rate

Question 6

What does the constant growth model do

Answer 6

1. Determines the companys growth rate and estimate of the economy nominal growth rate
2. Nominal growth rate is usually measured by the growth in GDP → (SUM: of estimated real growth rate GDP + expected long run inflation rate)

Question 7

What are the functions of growth rates

Answer 7

1. Return on Equity (Return from investing)
2. Reinvestment (How much to invest)

Question 8

What is b

Answer 8

Reinvestment rate

Question 9

What is d

Answer 9

Dividend payout ratio = 1-b

Question 10

What is g

Answer 10

Rate of dividend growth

Question 11

How do you estimate g

Answer 11

1. Assume that growth rates are a function of two factors
   
   1. ROE (Return from investing)
   2. Reinvestment (How much you invest)
2. b= reinvestment rate, plowback ratio or earnings retention ratio
3. D = dividend pay out ratio = 1b
4. ROE
5. g = growth of dividend

Question 12

How do you value a firms growth opportunity

Answer 12

1. Chosen investment and dividend rates
2. Decompose the firms equity into:
   
   1. No growth component
   2. Growth opportunities component (expected value of opportunities today to profitably reinvest future earnings)

Question 13

How do you partition value

Answer 13

1. = Present value of growth opportunities
2. = Earnings per share for period 1

Question 14

What happens in a no growth model

Answer 14

1. Same as constant growth with g = 0
2. This is when a company doesn’t have positive expected NPV projects
3. Earnings are all distributed in dividends

Question 15

How to partition value

Answer 15

1. Look for PV of growth rates
2. Earnings per share for period 1

Question 16

What is the Free Cash Flow valuation

Answer 16

1. This is useful for companies that are not paying dividends yet
2. This aligns with profitability within a reasonable forecast period
3. The investor takes a control perspective

Question 17

What is Free Cash Flow to the Firm

Answer 17

Valuing the entire firm. The cash flow available to the company’s suppliers of capital after all operating expenses have been paid and necessary investments in working capital and fixed capital have been made

Question 18

What happens during growth opportunities

Answer 18

1. Companies do not pay their entire earnings as dividends
2. Current earnings is invested back into the same
3. ROE>K, shareholders gain

Question 19

Why would a firm with negative PVGO represent a good takeover target?

Answer 19

Bc another firm could buy the firm for the market price

Question 20

What does it mean to have a negative PVGO

Answer 20

Negative present value of growth opportunities means by reinvesting earnings, a company is eroding value rather than creating it. Company should distribute more of its net earnings to shareholders

Question 21

What happens if you the value from the gordon model is different from mp

Answer 21

1. Valuation is right and market is wrong or vice versa
2. Do a sensitivity analysis on k and g
   
   1. Implied growth ate
   2. Implied ROE = implied growth rate/retention ration

Question 22

What is FCFE (Free cash flow to equity)

Answer 22

Cash flow available to the companys suppliers of capital after all operating expenses, interest and principal payment have been paid and necessary investments in working capital and fixed capital have been made

Question 23

How do you compute free cash flow

Answer 23

1. Find cap ex
2. Find change NWC
3. Find Net debt

Question 24

What is cap ex

Answer 24

Capital expenditures for long term assets (property, plant and equipment)

Question 25

What is Change in NWC

Answer 25

Current assets - current liabilities

Question 26

What is change in Net Debt

Answer 26

New debt borrowing minus debt repayment

Question 27

What is change of net debt

Answer 27

New debt borrowing minus debt repayment

Question 28

What are the advantages and disadvantages of Free Cash Flow Valuation

Answer 28

1. Financial methods commonly accepted
2. May require number of inputs each requiring estimates that require professional judgement
3. May adjust financial statements
4. Requires significant amount of effort
5. Sensitivity Analysis is important

Question 29

What is the value of the financial asset

Answer 29

Present value of all expected cash flows

Question 30

What is cashflow that equities produce

Answer 30

Dividends

Question 31

What happens when a company delays its dividends

Answer 31

Invest in positive NPV projects

Question 32

When is the Gordon Growth Model best suited

Answer 32

For firms growing at a rate comparable to or lower than the nominal growth of the economy

Question 33

What is the discount rate for asset pricing

Answer 33

Risk Free rate

Question 34

What happens if the cashflow or earnings are uncertain

Answer 34

Same earnings, risk will be higher, price of the asset will be lower to induce you to invest, discount rate will be higher

Question 35

What determines risk premium

Answer 35

Risk aversion and risk characteristics such as volatility

Question 36

What happens when risk security goes up

Answer 36

Price comes down