Week 2 Dam 1,2

Question 1

w2e1. Two firms in the same business can arrive at similar returns on equity (ROE), one by taking great projects (high return on asset, ROA) and the other by taking high leverage on average projects. Is there a qualitative difference between the two firms? Which ROE is of higher quality? Why?

Answer 1

Yes, the firm that earns a higher return on equity using debt will be riskier than the firm that earns a high return on equity by investing in great projects. The second firm will be worth more than the first firm and can be viewed as having a higher quality return on equity.

Question 2

how much did a firm obtain in equity capital when it originally issued stock to the market?

Answer 2

Common stock issued + capital surplus

Question 3

When we are making the growth rate endogenous (fundomental) that means…

Answer 3

…to make it a function of how much a firm reinvests for future growth and the quality of its reinvestment.

Question 4

Net income is …

Answer 4

…the profit that remains after all expenses and costs and taxes, have been subtracted from revenue.

Question 5

Gross profit is…

Answer 5

…the income or profit remaining after production costs have been subtracted from revenue

Question 6

Equity reinvested in business =

Answer 6

(Capital expenditures – Depreciation) + Change in working capital –
(New debt issued – Debt repaid)

Question 7

Equity reinvestment rate =

Answer 7

Equity reinvested / Net Income

Question 8

Claim: Levered Beta is inclusive of Capital Structure (D/E) Effects.

Answer 8

True

Question 9

Claim: Levered Beta is not inclusive of Capital Structure (D/E) Effects.

Answer 9

False: Levered Beta is inclusive of Capital Structure (D/E) Effects

Question 10

Claim: Unlevered Beta is removing the Capital Structure (D/E) Effects

Answer 10

True

Question 11

Claim: Unlevered Beta includes the Capital Structure (D/E) Effects

Answer 11

False: Unlevered Beta is removing the Capital Structure (D/E) Effects

Question 12

Typically, money that is received somewhere in the future is valued … than money received today.

Answer 12

less

Question 13

What is a Perpetuity?

Answer 13

Perpetuity: An asset that pays out a certain (constantly growing) cash
flow from next period on forever

𝑃𝑉 𝑃𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦 =𝐶𝐹 / 𝑟 − 𝑔

Question 14

Advantages DCF

Answer 14

Less exposed to market moods and perceptions.

If investors buy businesses rather than stocks (the Warren Buffet philosophy), discounted cash flow valuation is the
right way to think about what you are getting when you buy an asset

DCF valuation forces you to think about the underlying characteristics of the firm and understand its business.

Question 15

Disadvantages of DCF

Answer 15

Requires far more inputs and information than other valuation approaches

Inputs are noisy, difficult to estimate and can be manipulated

No guarantee that anything will emerge as under or over valued.