Ch.5.2
When performing a discounted cash flow analysis, a banker uses which of the following to capture the value of a company beyond the projection period?
Terminal value The DCF approach to valuation is based on determining the present value of all future free cash flows produced by a company. As it is infeasible to project a company's FCF indefinitely, the banker uses a terminal value to capture the value of the company beyond the projection period. As its name suggests, terminal value is typically calculated on the basis of the company's FCF (or a proxy such as EBITDA) in the final year of the projection period. The terminal value typically accounts for a substantial portion of a company's value in a DCF, sometimes as much as three-quarters or more.
Consider Exhibit 18. Assuming a terminal growth rate of 2%, what is the present value of the full stream of cashflows?
Terminal value = FCFn × (1 + g)/(r - g) = 98.1 × (1 + 0.02)/(0.11 - 0.02) = 1,111.8. Discounting that back to time 0 gives 1,111.8 × 0.63 = 700.434. The value of the full stream is then Sum of Present Value of FCF + Terminal Value = 346.3 + 700.434 = 1,046.7
The premise that equity investors need to be compensated for their assumption of systemic risk in the form of a risk premium is the basis for the
The capital asset pricing model (CAPM) is based on the premise that equity investors need to be compensated for their assumption of systemic risk in the form of a risk premium, or the amount of market return in excess of a stated risk-free rate. Systematic risk is the risk related to the overall market, which is also known as non-diversifiable risk. A company's level of systemic risk depends on the covariance of its share price with movements in the overall market, as measured by its beta.
For publicly traded bonds, cost of debt for the WACC calculation is determined on the basis of the
current yield For publicly traded bonds, cost of debt is determined on the basis of the current yield on all outstanding issues. Market-based approaches such as these are generally preferred as the current yield on a company's outstanding debt serves as the best indicator of its expected cost of debt and reflects the risk of default.
The lower a company's DSO, the faster it
receives cash from credit sales DSO provides a gauge of how well a company is managing the collection of its A/R by measuring the number of days it takes to collect payment after the sale of a product or service. For example, a DSO of 30 implies that the company, on average, receives payment 30 days after an initial sale is made. The lower a company's DSO, the faster it receives cash from credit sales.
A proposed plant expansion by a manufacturing company will cost $70 million. To evaluate the project, an analyst runs two net present value (NPV) scenarios, each of which assumes the same 10-year series of cash flows to be produced by the project. In one scenario, the company uses a "hurdle rate" of 7%. In the other, it uses a hurdle rate of 8.5%. Which scenario will produce the higher net present value?
7% The hurdle rate in NPV analysis may represent the company's required rate of return on investment, or it may represent a cost of capital (e.g., discount rate). In either case, it works the same as a discount rate in discounted cash flow analysis. In NPV, the investment is input as a current cost, a negative number. Cash flows returned are a stream of positive numbers discounted by the hurdle rate. If the sum of all numbers input is positive, the project "clears the hurdle rate" on an NPV basis and is viable. The lower the hurdle (discount) rate is, the more valuable the present value of future cash flows and the higher the NPV will be.
What is the best statement describing the relationship to the valuations performed using multiples compared to valuations using a DCF approach?
A DCF is very sensitive to cash flow estimates, including the firm's working capital. Therefore, two similar firms might have similar valuations based on their multiples, but very different valuations using a DCF if their working capital projections are different. A firm's dividends paid or its interest expense have no impact on the DCF number. The measurement of DCF starts with EBIAT which is pre-interest. It is an unlevered cash flow calculation.
Bass Hospital Group has a debt to equity ratio of 25%, an effective tax rate of 15%, and operates in an industry that has an average unlevered beta of .44. What is Bass Hospital Group's levered beta?
Levered beta = Unlevered beta x (1 + (1-tax rate) x debt / equity ratio). Here, the levered beta is 0.44 x (1 + (1 - .15) x .25) = 0.53
General Aero has a debt to equity ratio of 27%, an effective tax rate of 30%, and operates in an industry that has an average unlevered beta of 0.8. What is General Aero's levered beta?
Levered beta = Unlevered beta x (1 + (1-tax rate) x debt / equity ratio). Here, the levered beta is 0.8 x (1 + (1 - .30) x .27) = 0.95
Jordan is an investment banker evaluating ABC Securities, a privately held company. He wishes to determine a reasonable price to offer for ABC's stock using a trading comps analysis. He has identified four companies with business profiles similar to ABC's - three public and one private. All four companies operate in ABC's industry. In which case might it be more advisable to execute a discounted cash flow analysis instead?
the four comps have substantially different net working capital than ABC In order to capture a significant difference in net working capital in a valuation analysis, a discounted cash flow would be a better choice. A company with lower working capital (i.e. source of cash) would have a higher valuation when utilizing a DCF.
A $50 million increase in capital expenditures during 2010 would result in a
$50 million increase in non-current assets A $50 million increase in capex would result in an increase in property, plant, and equipment (PP&E). As PP&E is a component of non-current assets, an increase in capex of $50 million results in an increase in non-current assets of $50 million. In addition, net income would ultimately decrease by the amount of incremental depreciation associated with the increase in capex.
Using the information provided in Exhibit 21, what is the company's change in net working capital from 2008 to 2009?
$8 million increase The first step in determining the change in the company's net working capital is to determine the net working capital for 2008 and 2009. Net working capital is determined as total current assets minus total current liabilities. As such, net working capital in 2008 and 2009 is $100 million and $108 million, respectively. To determine the year-over-year change, 2009 NWC of $108 million is subtracted from 2008 NWC of $100 million to provide an increase of $8 million. Also, the $8 million increase is a use of cash and, therefore, subtracted from free cash flow.
$100 million of free cash flow to be received at the end of the first year of a company's projection period given a WACC of 10% would be worth what amount today?
$91 million The present value of $100 million assumed to be received at the end of year 1 of a company's projection period would be determined as $100 million / (1+10%) = $91 million. Alternatively, a discount factor can be multiplied by $100 million to determine the appropriate value. This calculation would be performed as follows: $1.00 / (1 + 10%) = 0.91 and 0.91 multiplied by $100 million = $91 million. The discount factor is the fractional value representing the present value of one dollar received at a future date given an assumed discount rate.
A company has an unlevered beta of 0.94, a levered beta of 1.16 and a marginal tax rate of 35%. The risk free rate is 3.4% and the market risk premium is 6.2%. What is the company's cost of equity?
10.60% The company's cost of equity is the risk-free rate plus the company's levered beta times the market risk premium (10.6% = 3.4% + 1.16 × 6.2%). The unlevered beta and the tax rate are not required.
A company expects $100,000,000 in cash flow in its next fiscal year. It expects annual cash flow to increase by 6.5% in perpetuity. Assuming a 10.0% discount rate, what is the company's valuation?
A company's valuation under the perpetuity growth method can be calculated as Annual Cash Flow / (Discount Rate - Growth Rate). In this case, $100,000,000 / (10.0% - 6.5%) = $2,857,142,857. Note that if the growth rate had been zero, the correct answer would have been calculated as Cash Flow / Discount Rate = $100,000,000 / 10.0% = $1,000,000,000.
Which statement is true with regard to calculating and using WACC when valuing a firm?
A size premium needs to be added to a small company's WACC in order to address concerns of less liquidity causing limited trading volumes in the stock. This leads to concerns that it results in an inaccurate beta. Increasing the beta will serve to lower the company's valuation.
An increase in accounts payable would result in which of the following?
An increase in any current liability account is a source of cash for the company. Companies aspire to maximize or "push out" (within reason) their payables so as to increase short-term liquidity. Accounts payable are a current liability and refer to amounts owed by a company for products and services already purchased.
Consider Exhibits 56 - 59. What is Goodperson Inc's Accounts Payable Turnover for 2009?
Average Accounts Payable = (5,375 + 3,555)/2 = 4,465 Accounts Payable Turnover = COGS/Average Accounts Payable = 21,076/4,465 = 4.72×
Consider Exhibits 50-53. What is GoodPancakeHouse Inc's Days Sales Outstanding?
Average Accounts Receivable = (18,106 + 15,146)/2 = 16,626 Days Sales Outstanding = 365 × Average Accounts Receivable/Sales = 16,626/608,103 = 10.0 days
Which formula best describes the calculation of Free Cash Flow?
B) EBIT - Taxes on EBIT + Depreciation + Amortization - Capex +/- Changes in Net Working Capital Items. Free Cash Flow is attempting to calculate the amount of cash flow available to all constituencies. It is used to calculate the Enterprise Value of the Firm. It would not subtract out dividends, because those payments only go to shareholders. It is calculated before interest expense because only debtholders receive those payments.
Company A has a very young workforce. Company B has a relatively old workforce. Both companies have pension plan funding ratios of .85. If interest rates decline, which company's funding ratio is more vulnerable?
Company A For companies, pension liabilities are similar to debts. The younger the workforce, the longer into the future the promise to pay benefits extends. A promise to a 30-year old worker (who will begin collecting benefits at around age 60) is similar to a bond with a 30-year maturity. If interest rates decline, the discounted value of a 30-year obligation increases, and this will impact the pension funding ratio negatively. A company with an older workforce also will be negatively affected by declining rates, but the impact will be less because the "time horizon" until pension payout is shorter.
A banker is asked to calculate the cost of equity for a company with a beta of 1.35. Assuming the risk-free rate is 3.2% and an S&P 500 expected return of 10.2%, what is the company's cost of equity calculated in accordance with the Capital Asset Pricing Model (CAPM)?
Cost of Equity = risk-free rate + (beta x market risk premium). Market risk premium (MRP) = S&P 500 expected return - risk-free rate = 10.2% - 3.2% = 7.0%. Therefore, the cost of equity = 3.2% + (1.35 x 7.0%) = 12.65%
A company's outstanding debentures are currently trading at 91, and have a nominal yield of 5.9%. The risk free rate is 3.7%, the expected return on the S&P 500 is 8.5% and the tax rate is 35%. What post-tax cost of debt would you use in a WACC calculation?
Current yield on the debentures is 5.9%/91 = 6.5%. The post-tax cost of debt is then 6.5% × (1 - 35%) = 4.2%. The risk free rate and expected return on the S&P 500 were not required.
ERT Corp. expects to receive $100 million free cash flow each year in perpetuity. Additional facts: 1) T-Bill Rate - 2% 2) WACC - 12% 3) Market Risk Premium - 4% 4) Cost of Debt - 5% What is the best estimate of ERT Corp's enterprise value, based on these facts?
Enterprise Value can be calculated as: free cash flow number / (discount rate - growth rate). Absent other information we assume we use a discount rate of WACC. Since this is a payment in perpetuity the growth rate is zero. Accordingly: $100 million / 12% = $833.33 million.
A company has debt of $9,000m and equity of $32,000m. Its outstanding debentures are currently trading at 94, and have a nominal yield of 8.0%. It has an unlevered beta of 1.17, a levered beta of 1.33 and a marginal tax rate of 35%. The risk free rate is 5.6% and expected return on the S&P 500 is 10.5%. What is the company's WACC?
Current yield on the debentures is 8.0%/94 = 8.5%. The post-tax cost of debt is then 8.5% × (1 - 35%) = 5.5%. The market risk premium is calculated as the expected return on the S&P 500 minus the risk-free rate (4.9% = 10.5% - 5.6%). The company's cost of equity is the risk-free rate plus the company's levered beta times the market risk premium (12.1% = 5.6% + 1.33 × 4.9%). Finally, the WACC is 5.5% × 9,000/(9,000 + 32,000) + 12.1% × 32,000/(9,000 + 32,000) = 10.7%
Tobin wants to value a private company using discounted cash flow (DCF) analysis. He has projected the company's cash flows for a series of future years. What tool should he use to discount projected future cash flows to a present value?
DCF analysis, projected cash flows are discounted to present value using the company's weighted average cost of capital (WACC). This combines the market value (cost) of both debt and equity, in proportion to their weights in the capital structure. The higher the WACC, the lower the present value for a given stream of cash flows. WACC explains why companies that qualify for low-cost capital are generally more valuable than companies that pay dearly for capital.
A company with inventory of $150 million, COGS of $750 million, and sales of $1.0 billion in a given year would have a DIH of
Days inventory held (DIH) measures the number of days it takes a company to sell its inventory. It is calculated as inventory divided by cost of goods sold multiplied by 365. Hence, a company with a company with $150 million in inventory and $750 million in COGS would have a DIH of 73.00 ($150 million/$750 million x 365). Sales are not factored into the calculation of DIH.
A company with accounts payable of $100 million, COGS of $750 million, and sales of $1.0 billion in a given year would have a DPO of
Days payable outstanding (DPO) measures the number of days it takes for a company to make payment on its outstanding purchases of goods and services. It is calculated as (accounts payable / cost of goods sold) x 365. Hence, a company with $100 million in accounts payable and $750 million in COGS would have a DPO of 48.67 ($100 million/$750 million x 365). Sales are not factored into the calculation of DPO.
A company's cash flow from operations would increase under which of the following scenarios?
Decrease in accounts receivable III.Increase in accounts payable decrease in accounts receivable represents a source of cash. Hence, companies strive to minimize their receivables so as to speed up their collection of cash. This increase in the cash cycle decreases short-term liquidity as the company has less cash on hand to fund short-term business operations and meet current debt obligations. An increase in accounts payable is also a source of cash for the company. Companies aspire to maximize or "push out" (within reason) their payables so as to increase short-term liquidity. Accounts payable are a current liability and refer to amounts owed by a company for products and services already purchased.
Which of the following valuation methodologies is premised on the principle that the value of a company, division, business, or collection of assets can be derived from the present value of its projected free cash flow?
Discounted cash flow analysis is a fundamental valuation methodology broadly used by investment bankers, corporate officers, university professors, investors, and other finance professionals. It is premised on the principle that the value of a company, division, business, or collection of assets can be derived from the present value of its projected free cash flow.
XCV Corp. purchased ABC Corp for $1,000,000. ABC recently earned $200,000 of EBIT, including $40,000 of depreciation. The investment has a 10% discount rate and XCV has a 40% marginal tax rate. From the above information please determine the Economic Value Added (EVA), created by this acquisition.
EVA = EBIAT - (WACC x Investment) EBIAT = EBIT of $200,000 x 60% = $120,000. WACC 10% x $1,000,000 investment = $100,000. EVA $120,000-$100,000 = $20,000 The information about depreciation and amortization is not necessary for this calculation.
Which of the following are two widely accepted methods used to calculate a company's terminal value?
Exit multiple method III. Perpetuity growth method There are two widely accepted methods used to calculate a company's terminal value—the exit multiple method and the perpetuity growth method. Depending on the situation and company being valued, the banker may use one or both methods, with each serving as a check on the other. The exit multiple method (EMM) calculates the remaining value of a company's FCF produced after the projection period on the basis of a multiple of its terminal year EBITDA (or EBIT). This multiple is typically based on the current LTM trading multiples for comparable companies. The perpetuity growth method (PGM) calculates terminal value by treating a company's terminal year FCF as a perpetuity growing at an assumed rate.
A small company has a cost of equity of 12.5%. The risk-free rate is 4.2%, the market risk premium is 5.0%, and the company's stock has a beta of 1.2. Has any small company "size premium" been assigned?
For small companies, the cost of equity = risk-free rate + (beta x market risk premium) + size premium. The size premium, if assigned, is always positive to compensate for the extra risk of small companies. Without a size premium, the cost of equity would be 4.2% + (1.2 x 5.0%) = 10.2%. But we know the cost of equity is 12.5%, so the difference (12.5% - 10.2% = 2.30%) must be caused by the size premium
ABC Corporation reports annual EBIT of $130 million, depreciation and amortization of $21 million, and capital expenditures of $13 million. There is no change in net working capital. If the current market price is $40 and there are 50 million total shares, what is the free cash flow yield, excluding any provision for income taxes?
Free cash flow = EBIT + D&A + decrease in net working capital - capex = $130 million + $21 million - $13 million = $138 million, or $2.76 per share ($138mm/50mm shares). Free cash flow yield = free cash flow/stock price = $2.76/$40 = 6.9%.
Toys & Things, Inc. has 2009 sales of $500 million and a net income margin of 10%. Given this information as well as that provided in Exhibit 7, calculate the company's 2009 cash flow from operations.
Given a net income margin of 10% and sales of $500 million, net income is $50 million. That amount added to D&A (because it is a non-cash expense) of $20 million and ($10.9) million of changes in working capital (sum of changes in current assets and current liabilities) provides a cash flow from operating activities amount of $59.1 million.
Using the information provided in Exhibit 22, what is the company's unlevered beta?
Given that the cost of equity, market risk premium, and risk-free rate is provided, levered beta is calculated in accordance with the CAPM formula below. Cost of Equity = Risk-free rate + Levered Beta x Market Risk Premium. Therefore, Levered Beta = (Cost of Equity - Risk-free rate) / Market Risk Premium = (11% - 4%) / 7% = 1.0 Given that the marginal tax rate of 38% and debt/equity ratio of 50% is known, unlevered beta can be calculated using the formula below: Unlevered Beta = Levered Beta / (1 + D/E x (1-tax rate)) = 1 / (1 + 50% x (1-.38%)) = ,76 Note that while calculating unlevered beta is a testable concept, knowing the CAPM formula to calculate cost of equity is more important on the exam.
A company's financial statements show the data provided in Exhibit 95. Furthermore, the company recently issued debt at 5.45% which is currently trading at 104. An investment banking analyst estimates a beta of 1.8, risk-free rate of 2.50% and expected market return of 9.00%. Also, the analyst expects cash flow to grow by 5.0% annually. What is the company's estimated enterprise value?
Given the data provided here, the enterprise value is best calculated using the perpetuity calculation: Cash Flow / (WACC - Growth Rate). The most challenging part of this question is calculating WACC. Cost of Debt = Current Yield x (1 - tax rate) = 5.45%/104 x (1 - 38%) = 3.25%. Also, the company's debt / equity ratio (which uses market cap) = $60,000,000 debt / ($60,000,000 debt + $150,000,000 market cap) = 28.57%. Therefore, the % of debt is 28.57% and the percentage of equity = 1 - 28.57% = 71.43%. Cost of Equity = Risk-free rate + beta x (market return - risk free) = 2.50% + 1.8 x (9.00% - 2.50%) = 14.20%. Therefore, WACC = (14.20% cost of equity x 71.43% % of equity) + (3.25% cost of debt x 28.57% % of debt) = 11.07%. Now, enterprise value can be calculated as $33,000,000 cash flow / (11.07% WACC - 5.0% growth rate) = $543,554,007. Note that it is common practice for the perpetuity calculation to include (1+g) in the numerator, resulting in the formula as follows: enterprise value = (cash flow x (1+g)) / (WACC - g). However, the exam will not always include the (1+g). If you try the calculation using (1+g) and the result does not show up as an answer choice, eliminate the (1+g) and see if that result "fits."
n 2017 VBN Corp. paid annual dividends of $50,000,000 million on 100,000,000 outstanding shares. On December 31, 2017 VBN announces a 30% per share increase in future dividends. On January 1, 2018 VBN buys back 10,000,000 shares, using 5,000,000 of them to acquire SDF Corp. VBN declares and pays its dividend quarterly in late February, May, August and November. What total dividends will VBN pay in 2018?
In 2017, the company paid a $50,000,000 dividend on 100,000,000 shares which is $.50 per share. If they increase the dividend on a per share basis by 30% it will now be $.65 per share. The new share count in millions is 100-10 buy back +5 reissued = 95 million shares. 95 million x $.65 results in a 2018 dividend of $61,750,000. The key was to calculate dividends on a per share basis. Take care to address whether a dividend growth rate is the total dividend or on a per share basis.
A company with inventory of $250 million, COGS of $1.0 billion, and sales of $1.5 billion in a given year would have inventory turns of
Inventory turns measures the number of times a company turns over its inventory in a given year. As with DIH, inventory turns is used together with COGS to determine inventory management efficiency. Inventory turns is calculated as COGS/inventory. As such, COGS of $1.0 billion divided by inventory of $250 million equals inventory turns of 4.0x.
A company has an inventory turns multiple of 4.0x and COGS of $750 million. What is the inventory balance?
Inventory turns measures the number of times a company turns over its inventory in a given year. Inventory turns is calculated as COGS/inventory. Hence, if the inventory turns multiple and COGS are known, then the inventory balance equals COGS/inventory turns. As such, COGS of $750 million divided by inventory turns of 4.0x equals inventory of $187.5 million.
ABC Corporation has experienced a decline in working capital over the past year. Its current liabilities are the same as a year ago. Which of the following must be true?
Net working capital = current assets - current liabilities. If current liabilities have stayed the same while working capital declined, it means current assets have declined.
Net working capital is represented by which of the following
Net working capital is defined as current assets less current liabilities. It serves as a measure of how much cash a company needs to fund its operations on an ongoing basis. An increase in NWC over a given period (i.e., when current assets increase by more than current liabilities) is a use of cash. This is typical for a growing company, which tends to increase its spending on inventory to support sales growth.
Prepaid expenses are considered a current asset for which of the following reasons?
Prepaid expenses refers to payments made for services, such as insurance, that will benefit the company for a period of one year or less. As the cash has been spent for a service that will be provided within a year, prepaid expenses are current. Prepaid expenses represent cash already paid, and hence, they cannot be converted back into cash, under most circumstances.
A company has a debt-to-capitalization ratio of 31.8%. Its pre-tax cost of debt is 7.4%. It has an unlevered beta of 1.05, a levered beta of 1.37 and a marginal tax rate of 35%. The risk free rate is 5.2% and the market risk premium is 6.2%. What is the company's WACC?
The company's after-tax cost of debt is the pre-tax cost of debt times one minus the tax rate (4.8% = 7.4% × (1 - 0.35)). The company's cost of equity is the risk-free rate plus the company's levered beta times the market risk premium (13.7% = 5.2% + 1.37 × 6.2%). The weighting on the after-tax cost of debt is the debt-to-cap ratio and the weighting on the cost of equity is one minus that ratio. So WACC = 0.318 × 4.8% + (1 - 0.318) × 13.7% = 10.9%
A company has an unlevered beta of 1.24, a levered beta of 1.56 and a marginal tax rate of 35%. The risk free rate is 2.9% and the market risk premium is 5.8%. What is the company's cost of equity?
The company's cost of equity is the risk-free rate plus the company's levered beta times the market risk premium (11.9% = 2.9% + 1.56 × 5.8%). The unlevered beta and the tax rate are not required.
Two companies are each projected to generate $40 million of free cash flow over the next 10 years and then have similar terminal values. Company A is profitable now. Company B is only marginally profitable now but is growing faster and is expected to exceed Company A's cash flow in year 3. Company A's weighted average cost of capital is 5.5%. Company B's weighted average cost of capital is 7.1%. Which company would likely have the higher valuation under a DCF analysis.
The key points to remember about DCF are: 1) profits in the early years create greater value than profits in later years due to discounting (time value of money); and 2) companies with lower weighted average cost of capital (WACC) are more valuable than companies with higher WACC because WACC is the discount rate. The higher the discount rate, the lower the value. Company A is generating cash flow faster than Company B and also has a lower WACC. As Company B becomes more profitable, it's possible its WACC will decline, in which case a new DCF analysis should be performed.
A company has an unlevered beta of 1.17, a levered beta of 1.33 and a marginal tax rate of 35%. The risk free rate is 5.6% and expected return on the S&P 500 is 10.5%. What is the company's cost of equity?
The market risk premium is calculated as the expected return on the S&P 500 minus the risk-free rate (4.9% = 10.5% - 5.6%). The company's cost of equity is the risk-free rate plus the company's levered beta times the market risk premium (12.1% = 5.6% + 1.33 × 4.9%). The unlevered beta and the tax rate are not required.
$100 million of free cash flow to be received at the end of the first year of a company's projection period the given a WACC of 10% would be worth what amount today?
The present value of $100 million assumed to be received at the end of year 1 of a company's projection period would be determined as $100 million / (1 + 10%)^1. Alternatively, a discount factor can be multiplied by $100 million to determine the appropriate value. This calculation would be performed as follows: $1.00 / (1 + 10%)^1 = 0.91 and 0.91 multiplied by $100 million = $91 million. The discount factor is the fractional value representing the present value of one dollar received at a future date given an assumed discount rate.
Which of the following would be captured under the investing activities section of a company's cash flow statement?
The purchase of new equipment (i.e., capital expenditures) is classified as an investing activity. Investing activities capture cash outflows or inflows from the purchase or sale of assets or equipment. An increase in accounts receivable, which is a use of cash, would be displayed under the operating activities section of the cash flow statement. The issuance of debt or equity is classified as a financing activity.
A small company's stock price is 25% more volatile than the stock market as a whole, as represented by the S&P 500 Index. If the stock's price is $20 per share, what will its Beta be?
The stock market as a whole (usually represented by the S&P 500) has a beta of 1.00. A stock that is 25% more volatile than the market as a whole has a beta of 1.25. Beta is calculated without regard to any size premium assigned to small companies.
A company's stock is trading at $4.50 and paid $0.15 per share in dividends last year, which are expected to grow by 5.0%. The company's discount rate is 9.0%. What is the company's implied stock price, calculated in accordance with the dividend discount model?
Under the dividend discount model, Stock Price = last year's dividend x (1 + growth rate) / (discount rate - growth rate) = $0.15 x (1 + 0.05) / (0.09 - 0.05) = $3.94.
A company's stock is trading at $18.00 and paid $0.40 per share in dividends last year, which are expected to grow by 3.0%. The company's discount rate is 5.0%. What is the company's implied stock price, calculated in accordance with the dividend discount model?
Under the dividend discount model, Stock Price = last year's dividend x (1 + growth rate) / (discount rate - growth rate) = $0.40 x (1 + 0.03) / (0.05 - 0.03) = $20.60.
n which of the following instances would it be advisable to use a "sum of the parts" analysis?
When valuing companies with diverse business segments Companies with diverse business segments may have different costs of capital for their various businesses. In these instances, it may be advisable to conduct a DCF using a "sum of the parts" approach in which a separate DCF analysis is performed for each distinct business segment, each with its own WACC. The values for each business segment are then summed to arrive at an implied enterprise valuation for the entire company.
As part of a discounted cash flow analysis, a banker uses two common methods for determining the company's terminal value. These methods are most likely to be
exit multiple and perpetuity growth Within a discounted cash flow valuation analysis, there are two widely accepted methods for calculating a company's terminal value. They are the exit multiple method, which applies a multiple to the final year's EBITDA (or EBIT), and the perpetuity growth model, which assigns a growth factor to perpetuity to the final year's cash flow. Depending on the situation and company, a combination of both methods can be advisable, with one serving as a check on the other.
Beverly, a financial consultant, wants to value a private streaming Internet entertainment company that is the subject of an acquisition offer. She wants to counsel her clients who own the stock on whether to accept or reject the offer. She has identified five comparable companies in the same industry that have merged or been acquired. What will determine whether a transaction comps analysis is useful for this purpose?
how long ago the comparable transactions occurred and the maturity of the industry A transaction comp analysis is useful when there have been a number of mergers or acquisitions in a sector. In particular, recent transactions are more useful than older transactions because older transactions may have occurred in a different stage of the industry life cycle - i.e., when the industry was more or less mature.
The valuation implied for a company by a discounted cash flow analysis is also known as its
intrinsic value The valuation implied for a target by a DCF is also known as its intrinsic value, as opposed to its market value, which is the value ascribed by the market at a given point in time. Intrinsic value refers to the perceived value of a company or asset based on an analysis of the fundamental aspects of a business. It is determined by projecting the cash flow or income to be produced by an entity and discounting that stream of cash flow or income to its present value. Book value is the carrying value of a company's assets on its balance sheet. It is typically calculated as total assets, less intangible assets, less total liabilities. Net asset value (NAV) refers to the value of an entity's assets less its liabilities.
n determining the weighted average cost of capital for a company as part of a discounted cash flow analysis, an investment banker adds a size premium to the CAPM formula. What type of company is this most likely to be?
maller companies generally are riskier and have higher cost of equity than large companies. At times, the risk of smaller companies is not totally captured in their betas, given their limited trading volumes. Size premiums can adjust for the higher risk of these stocks in the calculation of the cost of equity.
Karen wants to establish a valuation for a privately held software company. She has identified several other software companies with comparable business and financial profiles. However, all of the companies have far more net working capital than the subject company. Which valuation method should she use?
n order to capture a significant difference in net working capital in a valuation analysis, a discounted cash flow would be a better choice. A company with lower working capital (i.e. source of cash) would have a higher valuation when utilizing a DCF.
The financing mix that minimizes WACC, thereby maximizing a company's theoretical value is known as the company's
optimal capital structure The financing mix that minimizes WACC, thereby maximizing a company's theoretical value is known as the optimal capital structure. As the proportion of debt in the capital structure increases, WACC gradually decreases due to the tax deductibility of interest expense. WACC continues to decrease up to the point where the optimal capital structure is reached. Once this threshold is surpassed, the cost of potential financial distress (i.e., the negative effects of an over-leveraged capital structure, including the increased probability of insolvency) begins to override the tax advantages of debt.
