Lecture 6 Valuation

Question 1

What is a levered valuation?

Answer 1

• Value the equity of the company directly
• Use ROE to discount

Question 2

What is unlevered valuation?

Answer 2

• Recognise that the firm can be funded by debt or equity
• Value firm as a whole à take way value of debt = equity
• Use WACC to discount

Question 3

What is the dividend discount model?

What is the rational for it?

Answer 3

Rational for DDM: over the life of the firm cash=earnings=dividends.

• Value of any company is determined by its dividends + terminal dividend (liquidated dividends) when the company is wound up.

Question 4

Outline 3 problems with DDM

Answer 4

1. The measure the distribution of earnings not the creation of value.
   
   1. The future payoffs to shareholders reflect economic value added (created) by the firm.
   2. Therefore, in the short run, distribution will not accurately measure value.
      
      1. Dividends will only be distributed under the condition that the firm has surplus cash and does not have any positive NPV projects.
2. Large number of firms do not declare or disclose dividends.
   
   1. E.g. those firms who have positive NPV projects will likely not declare dividends.
3. Engage in share buy backs
   
   1. Dividend policy is ‘sicky’ à becomes an obligation and expectation, as declaring lower would signal the firm is not performing well.
   2. Debt is cheaper
   3. Can create perception that EPS is better.

Question 5

Residual Income Model

Answer 5

Write it

Question 6

What is the clean surplus relation?

Answer 6

Book value of the present is comprised of book value in the past

+ earnings

• dividends

Question 7

3 types of terminal values

Answer 7

1. Zero residual earnings, thus Continuing value (CV)=0
   
   1. Still making projects just at normal/expected rates
2. Constant residual earnings
   
3. Growth in residual earnings
   
   1. Perpetuity =

Question 8

What is the discount value?

Answer 8

Levered - Cost of equity

Unlevered - WACC

Question 9

How do we measure risk?

Answer 9

CAPM model

Question 10

4 advantages of the RI model

Answer 10

1. Focuses on value drivers
   
   1. Economic value added (RIà abnormal earnings)
2. Uses information sets we know
   
   1. E.g. upfront capital investment
3. Accrual Accounting:
   
   1. economic value added not always cash
   2. Can be more accurate
4. Analysts typically forecast earnings.

Question 11

2 disadvantages of the RI model

Answer 11

1. Cash can be understood (no suspect accounting)
2. Accruals are complex.

Question 12

What is the free cash flow model?

Question 13

Clear surplus model, when does it fail

Answer 13

Any adjustements to equity.

e.g. stock options, or unrealised gains.