week 9 - Cost of capital Flashcards
Where does valuation play an important role?
+ It plays an important role in today’s market economy
Give me situations where valuation is key?
1) A merger decision relies on the estimated fair value of a company and we need to do valuation in the process
2) We use valuation process when we need to find the share price of a business when an IPO is happening for a company
3) Valuation is also useful when identifying if stocks or bonds are undervalued or over valued
What are some important components of the ‘valuation model’?
+ Cost of capital
+ Forecast of future payoffs
What is cost of capital?
This is the discount rate we use to value the future payoffs and reflects the return the investor expects based on the perceived level of risk associated with that investment.
What are future payoffs?
+ Dividends - forecasted payoffs in the DDM model
+ Free cash flows - forecasted future payoffs in the DCF model
+ residual earnings - Forecasted future payoffs for the residual operating income model
What are some scenarios where valuation techniques will be useful?
1) Valuation is useful when we are trying to compare the stock-price estimate we come up with to the observing trading price and then decide whether to buy, sell or hold the stock.
2) Valuation is useful when we want to determine the current price of a bond or other financial instruments.
3) Valuation is also useful when we want to set the share price in an IPO
How do we apply valuation methods more broadly than simply in securities markets?
1) Companies use valuation to decide if a specific plant or division is profitable enough to continue operating. –> If not, it may be closed or downsized.
2) Valuation can be used broadly as it can help determine the appropriate amount to pay for another company or asset during a merger or acquisition.
3) If a company receives an acquisition offer, valuation helps assess whether the offer reflects the company’s true value or if it’s being undervalued.
What is the benefit from owning a stock or a bond?
+ Its the cash that we will recieve in the future
What is a bondholder entitled to recieve from a company?
+ Their entitled to recieve interest payments and the repayment of principal when the bond matures.
For stockholders what is the future cash flows they shall recieve?
+ Dividends
+ cash from selling stock in the future
What does both bondholders and stockholders have in one thing in common on their cash flows?
+ They occur in the future
How do we compute our valuation?
V₀ = Σ (Projected Future Payoffsₜ) / (1 + Discount Rate)ᵗ
+ Computing the present value of projected future cash flows
What is the cost of debt capital?
+ Used for payoffs to debt-holders
+ This is the discount rate when calculating the projected future payoffs to debt-holders
What is the cost of equity capital?
This is the discount rate we use for payoffs to equity holders
What is the weight average cost of capital?
+ this is the discount rate we used for payoffs to the entire firm
