Problem Set 2 Flashcards
If asked to compare firms based on the valuation multiple, how do you choose the firm?
You need to choose the firm with the lowest multiples, as this could mean that it is undervalued. However, this is an oversimplification.
What are the steps to solving this?
In this sort of question you need to use a valuation model. Notice how you are given the earnings per share and the book value per share. You can use the abnormal earnings model.
First you need to calculate the abnormal earnings, which is the earnings per share times the book value per share of the previous period times the equity cost of capital. You also need to calculate the terminal value, which is the abnormal earnings of the last year divided by the equity cost of capital minus the growth.
From that you can calculate the discount factor for each year (missing numerator). Then you calculate the discounted abnormal earnings per share by multiplying abnormal earnings per share by discount factor.
Also calculate the discounted terminal value, which is the discount factor times the terminal value.
Then sum these values to get the premium. The value of equity is the book value per share plus this premium.
What do you need to do to solve the DDM and AEM?
For the DDM you need to calculate the revenue, which in this case is just the cash flow and then calculate the interest earned on the retained cash of the previous period and add that to the current period. Once you have calculated this for all the years you sum up all the values and that you should give you the DDM.
For AEM you calculate the abnormal earnings by minusing the shareholder equity times equity cost of capital from the net income (which in this case is just the cash flow + any interest for that period). From that you can calculate the discounted abnormal earnings, which you sum to get the premium.
How do you solve these questions?
Note that the equity cost of capital used is
For the first one, the investment is expensed at t=0 and then the AE are calculated.
For the second one they are amortized over the 3 years. Each year there is a depreciation of 30 which is expensed from the net income. Interest is still calculated as if the investment was expensed from t=0.
For the held-for-trading security, the held-for-trading security at fair value is calculated at every period. Accretion of discount is calculated. (values don’t show up in excel solutions, so not entirely sure what happens next).
