MGMT 310 Exam 2 Review

Depreciation

- Non-cash expense - Add back when computing operating cash flow - Does impact taxes, relevant for capital budgeting

Constant dividend growth

A (risky) growing perpetuity

Price = Benchmark PE * EPS = 2.08 * 12.7 = $26.42

A tech company has an earnings per share of $2.08. The tech industry as a whole has a price-to-earnings ratio of 12.7. Based on this information, what do you estimate the price of the company's shares should be?

NPV = -500,000 + 200,000/1.12 + 200,000/1.12^2 + 200,000/1.12^3 = -19,634

An investment project has the following cash flows: CF0 = -500,000; CF1, CF2, CF3 = 200,000 (e.g., upfront cost of -500,000 and cash flows of $200,000 in years 1, 2, and 3). If the required rate of return is 12%, what decision should be made using NPV?

Coupon

Ana just received the semiannual payment of $35 on a bond sheowns. This is called the ______ payment. - Coupon - Face value - Discount - Call premium - Yield

Annuities are investments that make payments for a set duration of time. Perpetuities are investments that make payments indefinitely

Annuity vs perpetuity

Constant dividend growth: Pt = D1 / (R - g) = $12.5 billion / (10% - 5%) = $250 billion

Apple is expected to pay a dividend of $12.5 billion next year. Furthermore, its dividends are forecasted to grow at 5% per year for the foreseeable future. Assuming a constant expected return of 10% per year, what should Apple be worth today?

Standalone principle

Assumption that evaluation of a project is based on the project's incremental cash flows

A decrease in all stock values

Based on the Gordon Growth model: if you expect the market rate of return to increase across the board for all equity securities, you should also expect: • An increase in all stock values • All stock values to remain constant • A decrease in all stock values

fall

Bond prices ____ when interest rates rise

rise

Bond prices fall when interest rates ____

OCF - NCS - Change in NWC

CFFA formula

New equipment cash flow - counterfactual cash flow

Calculate incremental cash flow

Irrelevant cash flows

Cash flows that would occur regardless of standalone principle

No, it is a sunk cost

Cerda Diagnostics spent $5,000 last week repairing equipment. This week the company is trying to decide whether the equipment could be better utilized by assigning it to a proposed project. Should the $5,000 be included in the cash flows for the project?

Incremental cash flows

Change in cash flows that result from decision

Effective Annual Rate

Compounded annual interest rate

Expected cash flow = 0.60*$200 + 0.40*$50 = $140 NPV = -100 + $140/(1+R)^5 IRR: 0 = -100 + $140/(1+R)^5 R = (140/100)^(1/5) -1 = 6.9%

Consider a project that you pay $100 to start today. In 5 years, the project will pay you $1000 with 60% probability and $50 with 40 percent probability, with no intermediate cash flows. What is the IRR of the project?

Present value = sum of expected cash flows discounted at constant rate

DCF approach to valuation

interest rate; risk

Discount rates reflect the _______ as well as the ______ associated with cash flows

P(t+5) = D6 / (R - g) = $2 / 14% - 4% = $20 Pt = P(t+5) / (1 + R)^5 = $20 / (1 + 0.14)^5 = $10.39

Drogon Corp. currently pays no dividend. But you think the CEO will initiate a dividend of $2 per share in 6 years. You expect a growth rate of 4% on this dividend, and the required return on this stock is 14%. What is the value?

Salvage value

Estimated value of an asset at the end of its life

Annuity

Finite series of equal payments that occur at regular intervals

Capital budgeting

Firm must make decisions on how to allocate capital as it is a scarce resource - Major long-term investment decisions which can have a significant impact on the value of the firm's assets

Annuity due

First payment occurs at the beginning of the time period

Ordinary annuity

First payment occurs at the end of the time period

less

For Gordon growth formula to make sense, need expected growth rate g to be ____ than expected return/discount rate R

better; higher

For depositing, a greater effective annual rate (EAR) means a (better/worse) and (higher/lower) rate of return. For borrowing, a lower EAR means a lower (better, cheaper) cost of borrowing.

future prices

For non-constant growth questions (e.g., Q9 on the practice exam), helpful to think of cash flow in terms of ________

stock price should be proportional; (1 + g) / (R - g); expected dividend growth rate g

Gordon Growth Model: • Dividend growth model implies that ____________ to current period dividend • Price-dividend ratio should be constant and given by: _________ • This means that the expected growth rate of the stock price should be equal to the ___________

Pay zero dividends today

Gordon growth formula does not make sense for stocks that:

increasing

Gordon growth formula, all else equal: • Stock price should be _______ in dividend growth rate g (so long as g < R)

decreasing

Gordon growth formula, all else equal: • Stock price should be ________ in expected return R (so long as R > g)

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Gordon growth formula, all else equal: • Stock price should be decreasing in expected return R (so long as R >,<,= g)

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Gordon growth formula, all else equal: • Stock price should be increasing in dividend growth rate g (so long as g >,<,= R)

expected cash flows

In valuation, we use _________ for risk

Spillovers/externalities

Indirect effects of the project that may affect the profits of other business activities of the firm

Perpetuity

Infinite sum of constant payments each period PV = C/r Growing: PV = C / (r-g)

rise

Inflation generally causes interest rates to _____

Annual Percentage Rate

Interest rate per time period multiplied by number of periods per year

Sunk costs, financing costs

Irrelevant cash flows

Incremental sales = $24,000 Erosion = 25% * $24,000 = $6,000 CF = $24,000 - $6,000 = $18,000

Linksys plans to introduce a new wireless router namedHomeNet, whose sales are expected to increase the firm's cashflows by $24,000 per year. If 25% of these sales come from customers who would have purchased an existing Linksys wireless router if Home Net were not available, how much are the actual annual incremental cash flows for the HomeNet project?

Pt = Dt * (1 + g))/(R - g) P9 = D10 / (R - g) P9 = $11 / (0.12 - 0.04) = $137.50 P0 = $137.50 / 1.12^9 = $49.58

Metallica Bearings, Inc., is a young start-up company. No dividends will be paid on the stock over the next nine years. The company will pay a $11 per share dividend 10 years from today and will increase the dividend by 4% per year there after. If the required return on this stock is 12%, what is the current share price?

Common stock

No fixed dividend amount, voting rights

Discounted value of dividends + the stock price you will receive in the future

Non-constant growth: Stock price today should reflect ___________ + ___________

Market price of the bond will decrease

Olivares, Incorporated, bonds mature in 17 years and have acoupon rate of 5.4 percent. If the market rate of interest increases, then the: Coupon rate will also increase Current yield will decrease Market price of the bond will decrease Coupon payment will increase

Net present value

Present value of all present and future net cash flows produced by an investment decision

Interest rate risk

Price of _______ is reflected in bond yields

Bond yields

Price of interest rate risk is reflected in _________

Discount rates

Reflect the interest rate as well as the risk associated with cash flows

--

Relationship between discount rates, dividend growth, and stock prices

Incremental cash flows

Relevant cash flows

Opportunity costs, side effects/spillovers, change to net working capital, changes in taxes paid

Relevant cash flows

Yield/Yield-to-maturity

Required return / market rate / discount rate for the bond. For many bonds, this will be different than the interest rate.

Constant dividends

Risky perpetuity

$439,500 - 14,200 = $425,300

Seven years ago, you paid $324,800 to purchase a rental house. The maintenance expenses average $200 a month and property taxes are $4,800 annually. The house was recently appraised at $439,500. If you sell the house you will incur $14,200 in selling costs. If you decide to use the house as your office, what salvage value should you assign it?

expected return

Since expected future cash flows are discounted at the rate R, the terms ____________ and discount rate are used synonymously

discounted cash flow approach

Standard approach to evaluate NPV

Preferred stock

Stated dividend amount paid before common stockholders, no voting rights

Coupon

Stated dollar interest payment on the bond

𝑃𝑡 = 𝔼(𝐷𝑡+1) / (1 + 𝑅) + 𝔼(𝐷𝑡+2) / (1 + 𝑅)^2 + 𝔼(𝑃𝑡+2) / (1 + 𝑅)^2 = ($2 * 1.25)/(1+0.20) + ($2*1.25*1.20)/(1+0.20)^2 + ($2*1.25*1.20*1.05)/(0.20-0.05)/(1+0.20)^2 = $18.75

Suppose a company is expected to increase dividends by 25% next year and 20% the following year. After that, the dividends will increase at 5% indefinitely. If the most recent dividend was $2 and the required return is 20%, what is the value of the stock?

PV = 333,333.33[1 - 1/1.05^30] / 0.05 = $5,124,150.29

Suppose you win the Publishers Clearinghouse $10 million sweepstakes. The money is paid in equal annual installments of $333,333.33 over 30 years. If the appropriate discount rate is 5%, how much is the sweepstakes actually worth today?

Incremental cash flows

The amount by which the firm's cash flows are expected to change as a result of the investment decision

Coupon rate

The annual coupon divided by the face value of the bond

all dividends

The cash flow from purchasing a stock can be expressed in multiple equivalent ways: If you hold for forever, __________ (other stock pricing formulas)

Next period's dividend + price of stock next period

The cash flow from purchasing a stock can be expressed in multiple equivalent ways: If you hold for one period, then sell __________

Two dividends + price of the stock two periods from now

The cash flow from purchasing a stock can be expressed in multiple equivalent ways: If you hold for two periods, then sell __________

Face/par value

The principal amount of the bond that is repaid at the end of the term

Maturity

The specified date on which the principal amount of a bond is paid

Opportunity costs

The value a resource could have provided in its best alternative use

Company pays you a dividend or you sell the shares

Two ways to receive cash flows if you buy a share of stock

- Have to convert everything to semi-annual units (how often the payments happen), then can plug into the bond pricing equation. Semi-Annual yield: 7% 𝑎𝑛𝑛𝑢𝑎𝑙 𝑦𝑖𝑒𝑙𝑑 / 2 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 = 3.5% Semi-Annual Coupon payment: (5.5% 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑢𝑝𝑜𝑛 𝑟𝑎𝑡𝑒 / 2 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠) × $1000 = $27.50 Number of periods: 10 𝑦𝑒𝑎𝑟𝑠 × 2 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 = 20 𝑝𝑒𝑟𝑖𝑜𝑑s - Yield-to-maturity is always quoted as an APR Bond price = $27.50 * ((1-(1/(1.035^20))/0.035) + 1000/(1.035^20) = $893.41

Werden Drilling offers 5.5 percent coupon bonds with semiannual payments and a yield to maturity of 7 percent. The bonds mature in 10 years. What is the market price per bond if the face value is $1,000?

Assuming a company's goal is to maximize shareholder wealth, they should choose to invest in projects which increase the firm's value

What is the method that is closest to the goal of financial management?

stabilizes; stock price

When dividend growth _______ in the future, you can use the Gordon growth formula, but that will give you the _________ in the future

PV = $5000 / (1 + 0.10)^5 = $3104.61

You are considering a project that will pay $10,000 with 50% probability in five years and will pay you nothing with 50% probability. If your discount rate is 10%, what is the present value of the project?

$5000

You are considering a project that will pay $10,000 with 50% probability in five years and will pay you nothing with 50% probability. What is the expected cash flow from the project in five years?

PV1 = 1000 / (1.1)1 = $ 909.09 PV2 = 2000 / (1.1)2 = $1,652.89 PV3 = 3000 / (1.1)3 = $2,253.94 PV = 909.09 + 1,652.89 + 2,253.94 = $4,815.92

You are considering an investment that will pay you $1,000 in one year, $2,000 in two years and $3,000 in three years. If you want to earn 10% on your money, how much would you be willing to pay today?

Prefer the loan that makes payments every 6 months. Lower effective annual rate.

You are interested in borrowing money to buy a car and are comparing two loans for the same principal amount that havethe same APR. Loan A makes monthly payments and Loan B makes payments every 6 months. Which loan has a higher effective annual interest rate? Which loan would you prefer?

Sunk costs

costs that have not been or will be paid regardless of the decision whether or not the investment is undertaken

EAR

most effective for evaluating frequently compounding loans such as credit cards

APR

most useful for evaluating mortgage and auto loans

the present value of the future cash flows minus the initial cash outlay

project requires an initial cash outlay, and produces positive future cash flows, then NPV is:

APRs

yield-to-maturity / coupon payments are quoted as _____, but need to make appropriate conversions if payments are not annual

Two-stage growth

• Dividend growth not constant initially, but settles into a long-term growth rate eventually • Price is calculated using a multi-stage model

Constant dividend growth

• Firm will increase the dividend by a constant percent each time period • Price is calculated using the growing perpetuity formula

Constant dividend

• Firm will pay the same dividend forever • Preferred stocks usually fall into this category • Price is calculated using the perpetuity formula