week 9

Question 1

PORTER’S FIVE FORCES FRAMEWORK:

Answer 1

i.) Rivalry amongst existing firms
o Industry growth, differentiation, switching costs, fixed/variable costs, excess capacity, exit barriers
ii.) Threat of new entrants
o Scale of economies, first mover advantage, distribution access, switching costs, relationships, legal barriers
iii.) Threat of substitutes
o Relative prices & performance, buyers willingness to switch
iv.) Bargaining power of buyers
o Switching costs, differentiation, important of product for cost & quality, number of buyers, volume per buyer
v.) Bargaining power of suppliers
o Switching costs, differentiation, important of product for cost & quality, number of suppliers, volume per supplier

Question 2

 Framework for relating DCF method to analysis of company value

Answer 2

o Usefulness of DCF is a function of accuracy to estimates of cash flows
o Cash flows are a function of the company’s economic environment, difficult to predict but it is where we must start
o DCF does not work well in valuing growth options -> real options approach is better

Question 3

 Three principal steps in DCF: step 1

Answer 3

o Estimate FCF over life of investment
 Source: your own data or annual reports
 Need to make assumptions about growth rates
 Usually FCF calculated on an after-tax basis
o Two categories of FCF
 Predictable flows over identifiable periods
 Terminal Flows
• Cash flows expected beyond the last period, so we can forecast
o Terminal flows usually have least information to support them but can comprise of a major part of value of investment
o E.g. Amazon
 History will not help, have to make up predictions about its future value

Question 4

 Three principal steps in DCF: Step 2

Answer 4

o Estimate required ROR and discount FCFs by ROR to get present value
o ROR = Risk free rate + risk premium
 How much of a risk premium is required?
o In principle, CAPM is used to estimate ROR
o In principle, many sensible people use a nice round number as the discount rate
 Reasons for what discount rate you use
o Higher the discount rate -> shorter the period you need to discount the company
 Due to revenue generating becoming NIL
o Changes in discount rate has bigger changes in FCF of a company

Question 5

 Three principal steps in DCF: Step 3

Answer 5

o Sum of PV of all FCF to get total investment value

o If investment is a company, subtract value of debt to get equity holders’ portion of enterprise value