4120 Test 1

Would you expect the financial characteristics of the firm to change once it reaches a steady state? What form do you expect the change to take?

-ROC will decline as the firm gets larger and the marring projects are no longer as lucrative -Dividend payout will increase -Debt/Equity ratio will increase as the firm gets larger and safer -The interest rate on debt will decline for the same reasons

Real Discount Rate

(1+ market rate/1+ Expected inflation) -1

T/F The dividend discount model will find more undervalued stocks, when the overall stock market is depressed.

False this will be true only if the stock market falls more than merited by changes the fundamentals (such as growth and cash flows)

T/F Discounting nominal cash flows at the real discount rate will result in too low an estimate of value.

False. It will result in too high a value

T/F The free cash flow to equity will always be higher than the net income of the firm, because depreciation is added back.

False: Capital expenditures may be greater than depreciation

T/F As the uncertainty about the expected cash flows increases, the value of an asset increases.

False: Generally, the greater the uncertainty, the lower is the value of an asset

T/F The dividend discount model will undervalue stocks, because it is too conservative.

False: It depends upon the assumptions made about expected future growth and risk

T/F A. The dividend discount model cannot be used to value a high growth company that pays no dividends.

False: The dividends discount model can still be used to value the dividends that the company will

T/F The entire free cash flow to equity cannot be paid out as a dividend because some of it has to be invested in new projects.

False: The free cash flow to equity is after capital expenditures

T/F An asset with an infinite life (i.e., it is expected to last forever) will have an infinite value.

False: The present value effect will translate the vale of an asset from infinite to finite terms

T/F As the discount rate increases, the value of an asset increases.

False: The reverse is generally true

T/F The free cash flow to equity will always be higher than cash flow to the firm, because the latter is a pre-debt cash flow.

False: the FCFF is a pre-debt cash flow. In the long term, it can be equal to, but it cannot be lower than FCFE> In any one year, however the FCFE can exceed the FCFF is there are substantial new debt issues

T/F The free cash flow to equity will always be higher than the dividend.

False: the dividends can exceed the free cash flow to equity

DCF firm vs equity

Firm: Value the entire business Equity: Value just the equity claim in the business -If the cash flows being discounted are cash flows to equity, the appropriate discount rate is a cost of equity -If the cash flows are cash flows to the firm, the appropriate discount rate is the cost of capital.

best description of the free cash flow to equity

It is the cash that equity investors can take out of the firm after financing investment needed to sustain future growth.

No firm raises dividends by a fixed percent every year. The model's assumption is unrealistic and the values obtained from it will not hold.

It is true that the model smooths out growth rates in dividends. In present value terms, though, this smoothing effect cannot have a large effect on the value estimate obtained from the model.

What does the intercept of this regression measure?

It measures the riskless rate during the period of the analysis

What does premium measure

It measures, on average, the premium earned by stocks over government securities. It is used as a measure of the expected risk premium in the future.

T/F Stocks that are undervalued using the dividend discount model have generally made significant positive excess returns over long periods (five years or more).

True. Portfolios of stocks that are undervalued using the dividend discount model seem to earn excess returns over long time periods.

T/F Stocks which pay high dividends and have low price/earnings ratios are more likely to come out as undervalued using the dividend discount model.

True. The model is biased towards these stocks because of its emphasis on dividends

T/F As the life of an asset is lengthened, the value of that asset increases.

True: The value of an asset is an increasing function of its life

T/F As the expected growth rate in cash flows increases, the value of an asset increases.

True: the value of an asset is an increasing function of its cash flows

Problem With DCF A firm, which owns a lot of valuable land that is currently unutilized.

Unutilized assets do not produce cash flows and hence do not show up in discounted cash flow valuation, unless they are considered separately.

A firm, which has a long and fairly reliable history of earnings growth, but which has just sold off three divisions (comprising almost half of the market value of the firm). Analysts follow the stock, but base forecasts primarily on historical growth.

Use fundamentals on the remaining devisions to predict growth

When to use Arithmetic vs Geometric mean

-arithmetic mean if you are using the Treasury bill rate as your riskfree rate, have a short time horizon and want to estimate expected returns over that horizon. -Geometric if you are using the Treasury bond rate as your riskfree rate, have a long time horizon and want to estimate the expected return over that long time horizon.

The terminal value in a capital budgeting project is generally much lower than the initial investment. The terminal price in a stock valuation is generally much higher than the initial investment. How would you explain the difference?

A capital Budgeting project generally has a finite life. Consequently it loses value over time. A stock has an infinite life. It generally increases in value over time, both as a consequence of inflation and real growth

The model sometimes yields negative values for stocks, when growth rates exceed the discount rate.

A stable stock cannot have a growth rate greater than the discount rate, because no company can grow much faster than the economy in which it operates in the Gordon Growth Model. This upper limit on how high growth rates can go operates as a constraint in the model.

The model yields absurdly high values for other stocks, where the discount rate is very close to the growth rate.

A stable stock cannot have a growth rate greater than the discount rate, because no company can grow much faster than the economy in which it operates in the Gordon Growth Model. This upper limit on how high growth rates can go operates as a constraint in the model. This should not happen for a stable stock, for the same reasons stated above.

The model values stocks which do not pay dividends at zero.

A stock that pays no dividends is not a stable stock. The Gordon Growth model is not designed to value such a stock. If a company with stable growth insists on not paying dividends, but retains the FCFE, this FCFE can be used in the Gordon Growth model as the dividend.

T/F A. The free cash flow to the firm is always higher than the free cash flow to equity.

A. False. It can be equal to the FCFE if the firm has no debt.

T/F A. The free cash flow to equity will generally be more volatile than dividends.

A. True. Dividends are generally smoothed out. Free cash flows to equity reflect the variability of the underlying earnings as well as the variability in capital expenditures.

CAPM?

Assumes that the market factor captures all systematic risk

Gordon Growth Model, considerations in estimating growth The economy in which the firm operates is growing very rapidly.

B. This should affect the estimation of a stable growth rate. A much higher stable growth rate can be used for firms in economies which are growing rapidly.

T/F B. The free cash flow to equity will always be higher than the dividends.

B. False. Firms can have negative free cash flows to equity. Dividends cannot be less than zero.

Gordon Growth Model, considerations in estimating growth The current management of the firm is of very high quality

C. An analyst has very limited flexibility when it comes to using the Gordon Growth model in estimating growth. If the growth potential of the industry in which the firm operates is very high, a growth rate slightly higher (1 to 2%) than the growth rate in the economy can be used as a stable growth rate. Alternatively, a two-stage or three-stage growth model can be used to value the stock.

Gordon Growth Model, considerations in estimating growth The growth potential of the industry in which the firm operates is very high.

C. An analyst has very limited flexibility when it comes to using the Gordon Growth model in estimating growth. If the growth potential of the industry in which the firm operates is very high, a growth rate slightly higher (1 to 2%) than the growth rate in the economy can be used as a stable growth rate. Alternatively, a two-stage or three-stage growth model can be used to value the stock.

T/F C. The free cash flow to equity will always be higher than net income.

C. False. Firms with high capital expenditures, relative to depreciation, may have lower FCFE than net income.

T/F C. The free cash flow to the firm is a pre-debt, pre-tax cash flow.

C. False. It is pre-debt, but after-tax

T/F D. The free cash flow to the firm is an after-debt, after-tax cash flow.

D. False. It is after-tax, but pre-debt.

T/F D. The free cash flow to equity can never be negative.

D. False. The free cash flow to equity can be negative for companies, which either have negative net income and/or high capital expenditures, relative to depreciation. This implies that new stock has to be issued.

T/F D. If companies can raise prices at the same rate as inflation, their value should not be affected by changes in the inflation rate.

D: False. There might be lost of value due to loss of depreciation tax benefits

T/F E. The free cash flow to the firm cannot be estimated without knowing interest and principal payments, for a firm with debt.

E. False. The free cash flow to firm can be estimated directly from the earnings before interest and taxes.

T/F E. Inflation should increase the value of stocks because it increases expected future cash flows

E: False. The discount rate also goes up

An analyst tells you that he uses price/earnings multiples, rather than discounted cash flow valuation, to value stocks, because he does not like making assumptions about fundamentals - growth, risk, and payout ratios. Is his reasoning correct?

No. Any time a multiple is used, there is implicit, in that multiple, assumptions about growth, risk and payout. In fact, any multiple can be stated as an explicit function of these variables.

Real Cash Flow

Nominal Cash flow/ (1+ expected Inflation)t

Problem With DCF A firm, which is in the process of restructuring, where it is selling some of its assets and changing its financial mix.

Restructuring alters the asset and liability mix of the firm, making it difficult to use historical data on earnings growth and cash flows on the firm.

Problem With DCF A troubled firm, which has made significant losses and is not expected to get out of trouble for a few years.

Since discounted cash flow valuation requires positive cash flows some time in the near term, valuing troubled firms, which are likely to have negative cash flows in the foreseeable future, is likely to be difficult.

Problem with DCF A biotechnology firm, with no current products or sales, but with several promising product patents in the pipeline.

Since the firm has no history of earnings and cash flow growth and, in fact, no potential for either in the near future, estimating near term cash flows may be impossible.

difference between the FCFE and Dividend Discount model and which one would you use as your benchmark for comparison to the market price

The FCFE is greater than the dividends paid. The higher value from the model reflects the additional value from cash accumulated in the firm. The FCFE vale is more likely to reflect the true value.

What do the factor coefficients and betas measure

The factor coefficients measure the risk premium relative to each factor, and the betas measure sensitivity to the factor

Problem With DCF A cyclical firm, during a recession.

The firm's current earnings and cash flows may be depressed due to the recession. Other measures, such as debt-equity ratios and return on assets may also be affected.

Geometric Mean vs Arithmetic Mean

The geometric mean allows for compounding, while the arithmetic mean does not. The compounding effect, in conjunction with the variability of returns, will lower the geometric mean relative to the arithmetic mean.

Which one of these estimates would you use in valuation? Why

The long-term bond rate should be used as the risk-free rate, because valuation is based upon a long time horizon.

Since cyclical firms have earnings which go up and down, based upon economic conditions, the model can never be used to value a cyclical firm

The model requires that, in the long term, the growth rate for a firm is stable (close to the growth rate in the economy). Thus, cyclical firms, which maintain an average growth rate close to a stable rate, cyclical ups and downs notwithstanding, can be valued using this mod

Gordon Growth Model, considerations in estimating growth There is an increase in the inflation rate.

This should increase both the cost of equity (by raising interest rates) and the nominal growth rate. Whether the increase will be the same in both variables will depend in large part on whether an increase in inflation will adversely impact real economic growth.

T/F Dicounting real cash flows at the nominal discount rate will result in too low an estimate of value.

True

T/F If done right, the value estimated should be the same if either real cash flows are discounted at the real discount rate or nominal cash flows are discounted at the nominal discount rate.

True

T/F B. The free cash flow to the firm is the cumulated cash flow to all investors in the firm, though the form of their claims may be different.

True

A troubled firm, whose earnings have dropped significantly because of a combination of bad luck and bad management, but which is now restructuring. You have fairly good information on the form the restructuring will take and its expected impact. Analysts follow the firm, but their track record is spotty.

Use growth rates from fundamentals, and reflect the expected changes from the restructuring in these fundamentals

A healthy firm, where the estimates of growth from history, analysts, and fundamentals are fairly close.

Weight all three growth rates equally

A cyclical firm, whose earnings have dropped significantly (historical growth rate is negative) as a consequence of a recession, but which you believe has bottomed out and is in the process of recovering. The firm is heavily followed by analysts, who have a good track record in forecasting earnings growth.

Weight analysts' forecast the most, and historical growth rates the least (or not at al). instigating growth rates from fundamentals, use predicted values for the fundamentals, rather than current values

Unlevered beta

measure the business and operating leverage risk associated with each of these firms