Valuation

Question 1

You use dividends as returns when… (3)

Answer 1

The company is dividend paying
There is a dividend policy
Investor takes a non-control perspective

Question 2

4 basic steps in valuation

Answer 2

1. Selecting a specific definition of returns
2. Forecasting the cash flow
3. Choosing the discount rate
4. Discounting the cash flows to the present

Question 3

Gordon Growth Model assumption

Answer 3

dividends grow indefinitely at a constant rate, model is only valid when r > g, market’s implied growth rate can be calculated by substituting the values of V0, D0 and r

Question 4

Two-stage dividend discount model stages (2)

Answer 4

Stage 1 - presents a period of abnormal growth at a constant rate
Stage 2 - assumes a constant growth rate

Question 5

H Model assumptions (2)

Answer 5

growth rate is assumed to decline from an abnormal rate to the mature growth rate during stage 1, stage 2 assumes a constant growth rate

Question 6

CAPM assumptions (3)

Answer 6

Investors are risk averse
Investment is based on a mean return and variance of total portfolio
Relevant risk is systematic risk

Question 7

Dividend models are most appropriate for…

Answer 7

mature, profitable, dividend paying firms

Question 8

Gordon Growth model applicable for…

Answer 8

mature, stable firms

Question 9

Use free cash flow as return when… (4)

Answer 9

company is not dividend paying
company is paying dividend but differs significantly from FCFE
FCF and profitability are aligned
investor takes a control perspective

Question 10

FCFF is…

Answer 10

cash flow available to all firm capital providers

Question 11

FCFE is…

Answer 11

cash flow available to common equity holders

Question 12

FCFF is preferred when…

Answer 12

FCFE is negative or there is an unstable capital structure

Question 13

Discount FCFF with…

Answer 13

WACC

Question 14

Discount FCFE with…

Answer 14

required return on equity

Question 15

Equity Value =

Answer 15

PV(FCFF) - debt value

Question 16

Adjustments need to be made to FCFF and FCFE for…

Answer 16

non cash events

Question 17

Use residual income as a return when… (2)

Answer 17

company is not dividend paying
Expected FCFs are negative within the forecast horizon

Question 18

Strengths of the RI model (6)

Answer 18

less weighting on TV
uses available accounting data
useful for non-dividend paying firms
useful for firms without FCF
useful when cash flows are unpredictable
based on economic value

Question 19

Weaknesses of the RI model (4)

Answer 19

relies on accounting data
may require adjustments to accounting data
relies on clean surplus relation
assumes that cost of debt (Rd) = interest expense