Week 5

Question 1

What are the basic forecasting approaches?

Answer 1

Quantitative and qualitative

Question 2

What is quantitative forecasting approach?

Answer 2

historical data from time-series or correlation information

Question 3

What is qualitative forecasting approach?

Answer 3

opinions from experts, decision makers, or customers

Question 4

What are the quantitative forecasting methods?

Answer 4

• Naïve approach (what happened in previous period is going to happen in the future)
• Moving averages (exponential smoothing)
• Trend projection

Question 5

What are the qualitative forecasting methods?

Answer 5

• Executive opinion (executives making decisions/opinions)
• Delphi method (consumers/trusted advisors giving opinions)
• Sales force estimates (individuals from sales giving estimates of what will happen)
• Consumer surveys (would you purchase this?)

Question 6

What is dividend discount model (DDM)?

Answer 6

• valuing a firm based on dividends that we’re expecting to occur
• Basic tool in valuing common stock

Question 7

Formula for gordon growth model

Answer 7

P = D1 / (re – g)

• P – share price
• D1 – next year’s annual dividend per share
• re – cost of equity
• g – constant growth rate of dividends
• P = dividends per share in next period / cost of equity – growth rate expected for dividends

Question 8

When are DDMs most appropriate?

Answer 8

• Firm has a history of dividend payments (Provides an analyst with a history from which to extrapolate future dividends) (It is difficult to forecast when a non-dividend-paying firm will start paying dividends and how much they will eventually be)
• Firm’s dividends have a consistent relationship with the firm’s earnings (Dividends should be related to firm earnings if they are to be a good indicator of future firm and shareholder wealth)
• Valuation perspective is that of a non-controlling shareholder (If the perspective is that of a controlling shareholder where firm cash flows can be controlled, a free cash flow model would be more appropriate)

Question 9

Formula for gordon growth model

Answer 9

Value of common stock at Time 0 (V0) = dividend next period (D1) / (required return on common equity (r) - the constant growth rate for dividends (g))

Question 10

Formula for CAPM

Answer 10

Required return on equity is the risk-free rate + beta x equity risk premiums

Question 11

Issues with gordon growth method

Answer 11

Strengths:
- Simple and applicable to stable, mature firms (constant growth in dividends)
- Can be applied to entire markets
- g can be estimated using macro data (GDP growth)
- Can be applied to firms that pay dividends and repurchase stock
Limitations:
- Not applicable to non-dividend-paying firms (can’t forecast the future, should have a consistent relationship with firms’ earnings)
- g must be constant (cannot be applied with different future rates in dividends, r>g)
- Stock value is very sensitive to r-g
- Most firms have nonconstant growth in dividends

Question 12

What is statutory tax rate?

Answer 12

imposed by law on taxable income that falls within a given tax bracket