Unit 4: Valuation Methods and Cost of Capital

Question 1

Constant Growth Dividend Model

Answer 1

(only if dividends are expected to growth at constant rate)

• Expected dividend per share / (discount rate – dividend growth rate)
• Expected dividend = last annual dividend paid * (1+growth rate)^t
• If result from formula above is higher than current market price, then the stock is undervalued (buying opportunity)

Question 2

Common stock with variable dividend growth

Answer 2

• STEPS
  
  • 1.Calculate the sum of present value of dividends of high growth.
  • 2.Calculate the present value of the stock based on the period of steady growth, discounting the value back to year 1.
  • 3.Sum the totals from 1 and 2.

Question 3

Preferred stock valuation (with fixed dividend)

Answer 3

Dividend per share / cost of capital

Question 4

P/EBITDA

Answer 4

• Advantage: operational comparability between company and proxy for cashflow since D&A is excluded
• Disadvantages of EBITDA (outweighs advantages)
  
  • Overstates income
  • Neglects WC requirements
  • Is not effective for valuation cause it does not show the debt component that should lower valuations.

Question 5

Book value / share

Answer 5

• Measures the amount of net assets to the COMMON shareholder.
• (Total stockholder’s equity – preferred equity)/nr of common shares outstanding
  
  • Disadvantages of book value:
    
    • Does not consider future earnings potential.
    • Recorded value of assets on books are subject to accounting estimates (depreciation method for example)
    • Assets might be pledged as collateral on a loan
    • A well-managed firms stock should sell at high multiples of its book value.

Question 6

P/E

Answer 6

• Growth companies are likely to have high P/E ratios (positive assessment of the firms earnings quality and prospects.
• Can lead to “earnings management”:
  
  • Decrease of required rate of return will cause share prices to go up, which will result in a higher P/E ratio.
  • A decline in the rate of dividend growth will cause the share price to decline.
  • Increasing dividend yield indicates that share price is declining, which will result in lower P/E ratio.

Question 7

Market-to-book ratio

Answer 7

• Market price per share / book value per share

Book value = net assets (equity) / divided by common shares outstanding at par price

Question 8

P/Sales

Answer 8

• Market price per share / sales per share (rationale = sales is least exposed to manipulation)

Question 9

EPS (Very Important to Common Shareholders):

Calculation and Simple Capital Structure

Answer 9

• EPS
  
  • Net income available to COMMON shareholders (excludes dividends) / weighted average of common shares outstanding

IMPORTANT THAT IS WEIGHTED SHARES OF STOCKS, AND HAVE TO BE WEIGHTED BY THE TIME OF ISSUANCE/AVAILABILITY. BE AWARE THAT STOCK *DIVIDEND* AND STOCK SPLITS ARE ASSUMED TO BE OUTSTANDING AS OF THE BEGINNING OF THE EARLIEST ACCOUNT PERIOD.

• Most heavily relied-upon performance measure used by investors.
• Only calculated for common stocks because common shareholders are the residual owners of the corporation (preferred stock amounts have to be removed)
• A corporation is said to have a simple capital structure if:
  
  • The firm has only common stock.
  • The firm has no dilutive potential common stock (convertible securities, options, warrants) that can reduce EPS.
• A firm with a simple capital structure only has to report a single category of EPS, called Basic EPS (BEPS).
  
  • Otherwise, show also DEPS – dilutive EPS.

Question 10

Other Market Based Measures

(Earning Yield

&

Dividend Payout Ratio)

Answer 10

• Earnings yield (reciprocal of PE)
  
  • Earnings per share / market price per share
• Dividend payout ratio
  
  • Dividends to common shareholders/ income available for common shareholders.
  • Growth companies have usually lower payout to focus on growth.

Question 11

Types of Options

Answer 11

• European option can only be exercised on the expiration date.
• American option can be exercised at any time before expiration.
• Exercise price = strike price
• Covered option is the one on which the seller has possession of underlying.
• A naked option is a speculative instrument since writer does not hold the underlying: he might have to acquire it at an unknown price in the future.
• Types:
  
  • Stock option (underlying asset is a traded stock)
  • Index option
  • Long-term equity anticipation securities (LEAPS)
  • Fx OPTIONS.

Question 12

Call and Put Option

Answer 12

CALL

• Intrinsic value = price of underlying asset minus exercise and cannot be less than zero. When positive means that the option is “in-the-money”.

PUT

• Intrinsic value = price of exercise minus price of underlying and cannot be less than zero. When positive means that the option is “in-the-money”.

FOR BOTH (WHEN YOU ARE THE HOLDER)

• Gain/loss for holder – which is always symmetrical to the seller:
  
  • (Intrinsic Value – option price) * units of asset

Question 13

Put Call Parity

(C maix X presente IGUALA SoP)

Answer 13

• C + X/(1+r)^t = So + P
• X/(1+r)t = P + So – C

Where

1.C is the value of call,

2. X is exercise/strike price

3. So value of underlying

4. Value of put

Question 14

Option Determinants/Drivers (from BS model implications)

Answer 14

• BS general statements (look from standpoint of value to holder and price incentive) - Pior mais barata, melhor mais cara
  
  • Higher the strike price, cheaper the call option.
  • Higher the price of underlying, more expensive the call option.
  • Higher the interest rates (more inflated the dollar value), higher the price of call option.
  • The more the time passes the riskier an investment, so both call and puts earn value. (BOTH CALLS AND PUTS)
  • Increase in volatility increases price of both calls and puts. (BOTH CALLS AND PUTS)
  • ONLY EXERCISE PRICE IS INVERSELY CORRELATED FOR CALLS.

Question 15

Forward vs Future Contract

Answer 15

• Forward contracts are different from options because both parties must meet their contractual obligations. It is set to a specific date and is more appropriate for a retailer and a wholesaler who are changing very specific merchandise compared to futures. In Forward there is actual delivery.
• Future contracts is similar to forward but the counterparty is unknown since it is actively traded on future exchanges (more liquid and flexible also because delivery can be set for a given month). More used for undifferentiated commodities like grains, metal , fossil fuels and currencies.
  
  • Future contracts are also marked to market every day to minimize defaults as profits and losses are cleared daily.

Question 16

Swaps and Types

(Interest Rate + Currency + Credit Default)

Answer 16

• Swaps are contracts by which the parties exchange cash flows.
  
  • Interest rate swaps (fixed vs variable)
    
    • Highly customized.
  • Currency swaps (one vs other currency).
  • Credit default swaps (one party indemnifies the other against default by a third party).
    
    • As opposed to interest rate swaps, is bundled into large portfolio. Works like a loan default insurance.

Question 17

Cost of Capital Current

(Cost of debt, cost of stocks, cost of retained earning, and WACC)

Answer 17

• Components Cost of Capital
  
  • Cost of debt = Effective Rate * (1-t)
  • Cost of preferred stock (dividend yield ratio) =
    
    • Cash dividend preferred stock / market price of preferred stock
  • Common stock (dividend yield)
    
    • Cash dividend of common stock / market price of common stock
  • For practical purposes, cost of retained earnings is the same as that for common stock, however in practice is usually lower due to absence of issuance costs.
• WACC
  
  • WACC = E/V *Re + D/V *Rd * (1-T)
• Some trade-offs on Capital structure decisions

Question 18

Trade off on Capital Structure Decision

Debt vs Stock: From Investor and Company Perspective

Answer 18

• Some trade-offs on Capital structure decisions
  
  • Companies prefer to issue debt than stocks because dividends are not tax deductible (interest expense is). Investors prefer the issue of stock since return on stock is only partially taxable or taxable at special low rates, while debt interest is fully taxable.

Question 19

Marginal cost of capital

Answer 19

• Retained earnings alone are rarely sufficient to fund all of a corporation’s long term needs.
• Maintaining the firm’s optimal capital structure may require the issuance of new capital raised after existing internal sources are exhausted.
• The marginal cost of capital is the weighted average cost to the firm of the next dollar of new capital raised after existing internal resources are exhausted.
  
  • Each additional dollar raised becomes increasingly expensive as investors demand higher returns to compensate for increased risk (so probably higher than current WACC)

Question 20

Cost of New Capital (external)

Answer 20

• Cost of new debt: Annual interest / net issue proceeds
  
  • ​Net issue proceeds: annual interest times value - value * flotation costs
• Cost of new preferred stock: Next dividend / net issue proceeds
• Cost of new common stock:
  
  • Next dividend/net issue proceeds + dividend growth rate
  • Net issue = X value minus flotation costs
• NEXT DIVIDEND ALWAYS BASED ON CARRYING VALUE OF BALANCE SHEET (OR PAR VALUE), ISSUE PROCEEDS IS MARKET VALUE.