Equity Valuation Level 2

The strengths/weaknesses of the residual income approach include the following: •

-Terminal value does not dominate the valuation equation (as with DDM and FCFE approaches). -Residual income uses available accounting data. -Residual income is applicable to non-dividend-paying firms. -Residual income focuses on economic profits. The limitations of the residual income approach are as follows: • The accounting data may be manipulated by management. • The accounting data may require significant adjustment. • The model assumes a clean surplus relationship (i.e., ending BV = beginning BV + earnings - dividends). Economic Profit is the value that management adds above what is required by both debt and equity holders. Hence it measures profit to all capital holders both debt and equity since they discount WACC

(2) Compared to the industry Mean. A company will be underpriced if the P/S ratio is over/under the industry mean?

A company will be underpriced if the P/S ratio is under the industry mean. Since for the level of sales its receiving a lower price per share than competitors.

(3) When calculating WACC how would your approach be different if given debt to equity ratio of 30% vs given a debt financing ratio of 30%

A debt to equity ratio of 30% means 30debt : 100 equity. Thus, debt/debt+equity= 30/130 and the equity/debt+equity=100/130 A debt financing ratio is simple. Debt/debt+equity=30% and Equity/debt+equity=70%

(2) What is the PVGO model and how to calculate?

Basically a way to value a company by splitting up the constant growth dividend model into two parts. The first part is just the value if the company had no growth and paid out its earnings. The second part accounts for the growth opportunities that company could have.

(1) What is confidence risk and what is business cycle risk. In essence, how would you determine when there is confidence risk and when there is business cycle risk?

Business cycle risk: the unexpected change in the level of real business activity. A positive surprise or unanticipated change indicates that the expected growth rate of the economy, measured in constant dollars, has increased. Confidence risk: the unanticipated change in the return difference between risky corporate bonds and government bonds, both with maturities of 20 years. To explain the factor's name, when their confidence is high, investors are willing to accept a smaller reward for bearing the added risk of corporate bonds.

(2) How do you find single stage residual income?

Bv0+(ROE-r)BVo/ r-g.

(*0) FLIP FLIP FLIP EVA=EBIT(1-tax)-WACC(invested capital). Where invested capital= beginning book value of long term debt + beginning book value of equity. Invested Capital also equals: fixed assets +Net Working Capital MVA= Total Market Value- Ending total capital. Which is the same as the following: MVA= MV of Equity+MV of Debt-(Ending invested capital) MVA= MV of Equity+MV of Debt-(Ending Long Term Debt+ Ending Equity) EVA= 1,307,600-.119(6,200,000+3,281,000)=179,361 MVA= (.95*6,211,000)+130,000*36)=10,580,450 10,580,450-(6,211,000+2,100,000+2,081,000)=188,450

Calculate EVA and MVA. EBIT(1-t)=1,307,600. Long term debt is currently trading at 95% of book value. EVA and MVA A)179,361 and 188,450 B) 23,455 and 369,500 C)(70,900) and 369,500

(1) If given an income statement how do you find EPS?

EPS must be adjusted. Thus, find net income before tax and add back nonrecurring extraordinary items such as restructuring costs and write downs. Then multiply by (1-tax). Finally divide by # Shares.

(1) Energy's EV/EBITDA ratio are as follows: Stock price: $30.00 Shares outstanding: 45.0 Market value of debt: $120.0 EBITDA: $320.0 Cash and marketable securities: $42.0 Investments: $275.0 What is EV/EBITDA

EV = market value of common stock + market value of debt - cash and investments EV = ($30 × 45) + $120 - $42 - $275 = $1,153 million The EV/EBITDA ratio is then: 1,153 / 320 = 3.60.

(1) FLIP FLIP FLIP Beginning Book Value= Assets-total liabilities or common shares plus retained earning =4181000 Book Value per Share= 4181000/130000=32.16 Earnings Forecast: 4.50*130,000=585,000 Residual Income: NI-(Cost of Equity*Beginning book value) Residual Income: (585,000-.128(4181000)) divide by shares=.38

Find Book Value per Share for 2009 and Residual Income A) 32.16 and RI .38 B) 38 and RI 2.32 C) 36.4 and RI 2.32

(2) How can DLOM be estimated?

If an interest in a firm cannot be easily sold, a DLOM is applied. The DLOM can be estimated using restricted share versus publicly traded share prices, pre-IPO versus post-IPO prices, and put prices. The advantage of using put prices over the other two DLOM estimation methods is that the estimated risk of the firm can be factored into the option price. Discounts for lack of marketability (DLOM) are applied when the comparables are based on highly marketable securities, such as public shares, and the interest in the target company is less marketable, as in the case of a minority interest in a private firm. The DLOM can be estimated using restricted share versus publicly traded share prices, pre-IPO versus post-IPO prices, and put prices. It can be challenging to implement these methods.

(2) How do you calculate a P/E ratio based on normalized EPS?

Instead of doing Price/Earnings it is preferred to do Price/average earnings per share. Ideally you will use "normalized" earnings per share. To Find Normalized EPS: Find the simple average of ROE per share over a few periods. Then take Average ROE per share * Book Value per share.

(2) Market price per share kr 132 Shares outstanding 12 million Book value per share kr 120 Book value of debt kr 1,500 million If Halldorsson calculates the intrinsic value of Lagerback as kr 132, then it is most likely that Halldorsson has estimated Lagerback's cost of equity to be: A)equal to its ROE. B)greater than its ROE. C)lower than its ROE.

Lagerback's book value is given as kr 120. The higher intrinsic value (of kr 132) implies positive residual income and hence an ROE greater than the cost of equity.

(2) Run down the major items of an income statement

Note that operating Income is the same as EBIT.

(3) Sue determines that the expected return on the stock, given ValueFoods risks is 10%. In applying the CAPM model the result is 12% rate of return. Is the stock most likely overvalued, undervalued, correctly valued

Overvalued. The CAPM is the required rate of return which is higher than what the expected return of the stock is. Therefore the stock is overvalued.

(3) What is projection risk?

Projection risk refers to the risk of misestimating future cash flows. Given the lower availability of information from private firms, the uncertainty of projected cash flows may increase. Additionally, management may not be experienced with projections and may underestimate or overestimate future prospects. The discount rate would then be decreased or increased accordingly. So management is not always overly optimistic and projection risk does not always result in higher discount rates.

(1) An analyst gathers the following information regarding a company: Risk‐free rate of return = 5.5% Equity market risk premium = 4.0% Beta = 1.20 Use the CAPM to calculate the company's required return on equity using (1) raw beta and (2) adjusted beta via Blume adjustment

Solution: Required return (based on raw beta) = 0.055 + (1.20 × 0.04) = 10.30% Adjusted beta = (2/3*B)+(1/3) Adjusted beta = (2/3 × 1.20) + (1/3 × 1.0) = 1.13 Required return (based on adjusted beta) = 0.055 + (1.13 × 0.04) = 10.02% The value of beta obtained through OLS regression is known as raw or unadjusted beta. Betas have exhibited a tendency to revert towards 1.0 over time, and since valuation is forward looking, raw betas are adjusted (via the Blume adjustment) so that they more accurately reflect future betas (closer to 1.0).

(2) Explain the following methods to valuing a private company: -Guideline Public Company Method -Guideline Transactions Method -Prior Transactions Method

The guideline public company method (GPCM) approach to private company valuation uses price multiples from traded public companies with adjustments for risk differences. The guideline transactions method (GTM) uses the price multiples from the sale of whole public and private companies, again with adjustments for risk differences. The prior transaction method (PTM) uses historical stock sales of the subject company; it works best when using recent, arm's-length data of the same motivation.

(2) What is the capitalized cash flow method and how do you calculate?

There are three main ways to value a private company: income approach, market comparable, and asset based approach. Within the income approach you have: Free cash flow method: discounts a series of discrete cash flows plus a terminal value. It is a 2-stage model. Capitalized cash flow method: discounts a single cash flow by the capitalization rate. It is a single-stage model. Excess earnings method: values tangible and intangible assets separately and is useful for small firms and when there are intangible assets to value.

(4) When using the bond-yield plus risk premium method to calculate required returns do you use a short term or long term bonds? Required return = yield to maturity on ______-term bonds + risk premium.

long term bonds of the company.

(2) How do you calculate expanded CAPM?

*calculate regular CAPM but add company specific risk premium and size risk premium*. For example: Income return on bonds 6.0% Capital return on bonds 2.0% Long-term Treasury yield 3.5% Beta 1.4 Equity risk premium 6.0% Small stock premium 4.0% Company-specific risk premium 3.0% Industry risk-premium 2.0% The required return on equity using the CAPM is: 3.5% + 1.4(6%) = 11.9%. Using the expanded CAPM, a small stock premium and company-specific risk premium are added: 11.9% + 4% + 3% = 18.9%.

(0) ROE = 20% WACC = 7.5% Cost of debt (kd) = 9% Cost of equity (ke) = 12% Ending book value = $10 Dividend payout ratio = 0.75 Redding estimates the value of Overton using two different assumptions about future residual income: Assumption 2: ROE will be 20% next year but will decline over time so that Overton's residual income will decrease by 20% each year after next year. The residual income model value of Overton shares under Redding's second set of assumptions is closest to: A)$12.50. B)$13.21. C)$14.84.

Answer A

(3) A decrease in the earnings retention rate will cause a price-to-sales (P/S) multiple to: A)increase. B)decrease. C)remain the same.

Answer A A decrease in the earnings retention rate will increase the following expression for P/S due to the implied increase in the payout ratio, which is (1 - b): P0 / S0 = [(E0 / S0)(1 - b)(1 + g)] / (r - g) Note that the topic review does not allow for any interactive relationship between retention and growth. Thus, no explicit consideration is given to whether the increase in the payout ratio will cause an offsetting decrease in growth.

(1) A justified price multiple is the: A)warranted or intrinsic price multiple. B)multiple implied by historical growth. C)multiple implied by the market price.

Answer A A justified price multiple is the warranted or intrinsic price multiple. It is the estimated fair value of that multiple.

(1) An analyst is considering the purchase of Rylinks, Inc., which has a price to book value (P/B) ratio of 6.00. Return on equity (ROE) is expected to be 13%, current book value per share is $13.00, and the cost of equity is 11%. What growth rate is implied by the current P/B rate? Use residual model to find growth rate. A)10.60%. B)11.00%. C)0.40%.

Answer A Basically use the single stage residual income model and solve for G after you figure out that that the price is $78 The P/B ratio of 6.00 and the current book value per share of $13.00 imply a current market price of $78.00. This implies a growth rate of: 78= 13 +([13.00(0.13 - 0.11} / .11-g)

(2) Continuing residual income is defined as the: A)residual income that is expected beyond the initial forecast time horizon. B)residual income that forces the net present value to zero. C)permanent as opposed to the transitory part of residual income.

Answer A Continuing residual income is defined as the residual income that is expected beyond the initial forecast time horizon. It comes into play when RI is forecast for a defined time horizon and a terminal value based on continuing RI is estimated at the end of that time frame. Approach 1: RIt-1= RI/r if RI is continuing forever Approach 2 Rit-1= RI/1+R if RI is dropping to zero Approach 3 RIt-1=RI/R-w if RI is declining over time where W is the persistence factor. Approach 4 RIt-1= RI+Price-BookValue/1+RI

(2) Precision Tools is expected to have earnings per share (EPS) of $5.00 per share in five years, a dividend per share of $2.00, a cost of equity of 12%, and a long-term expected growth rate of 5%. What is the terminal trailing price-to-earnings (P/E) ratio in five years? A)6.00. B)7.14. C)9.00.

Answer A Trailing P/E= Payout(1+G)/(R-G) P5/E5 = (0.40 × 1.05) / (0.12 - 0.05) = 6.00

Find FCFF from NI, EBIT, EBITDA, CFO

FCFF=NI+Interest(1-tax)+Depreciation-WC-Cap EX FCFF=(EBIT*(1-tax))+Depreciation-WC-Capex FCFF=(EBITDA-Depreciation)*(1-tax)+Depreciation-WC-CapEx or FCFF = (EBITDA x (1-tax rate)) + (Depreciation x tax rate) - FCInv - WCInv. use depreciation x tax rate to determine tax benefit of depreciation FCFF=CFO+ Interest(1-tax)-Cap Ex. As a refresher of CFO see pic. CFO takes Net Income adds back changes in NWC and adds back Non cash expenses.

(0)What are two ways to calculate justified trailing P/S ratio? How about the leading P/S ratio

(Profit Margin)*(Payout)*(1+G)/r-g or Net Margin*Trailing P/E For Leading= (Profit Margin)*(Payout)/r-g essentially you don't multiply by the growth rate.

(3) A valuation of a firm based on the intrinsic value of the firm's investment characteristics is known as an: A)absolute valuation. B)asset based valuation. C)relative valuation.

Answer A An absolute valuation approach attempts to determine the value of the firm based on its specific characteristics without regard to the market prices of other firms.

(2) Yolanda Resham is currently developing a forecast horizon for several companies that she covers in her role as an equity analyst. The equities under consideration are part of a portfolio with an average annual turnover of 25%. Which of the following statements is least accurate regarding the choice of time horizon? A)Cyclicality should be considered when developing the timeframe. B)The time horizon should be independent of the average holding period for a stock. C)A time horizon of 4 years would be consistent with the portfolio turnover.

Answer C

(2) Which of the following is NOT a use of asset valuation? A)Projecting the value of corporate actions. B)Issuing fairness opinions. C)Estimating inflation rates.

Answer C Asset valuation has many uses including stock selection, reading the market, projecting the value of corporate actions, issuing fairness opinions, and valuing private businesses. Asset valuation is not used to project inflation rates.

(2) Currently the market index stands at 1,190.45. Firms in the index are expected to pay cumulative dividends of 35.71 over the coming year. The consensus 5-year earnings growth forecast for these firms is expected to increase to 6.2% up from last year's forecast of 4.5%. The long-term government bond is yielding 5.0%. According to the Gordon growth model, what is the equity risk premium? A)1.2%. B)2.5%. C)4.2%.

Answer C Equity risk premium = (35.71 / 1,190.45) + (6.2%) - 5.0% = 4.2%

(2) When using the two-stage FCFE model, if increases in working capital appear too high the analyst should: A)normalize them to be equal to zero. B)switch to a three-stage model. C)use changes that are based upon a working capital ratio that is closer to the industry average.

Answer C The best solution is to use changes that are based upon a working capital ratio that approximates the industry average. The problem will not be eliminated by switching to a three-stage FCFE model.

(3) Analyst Charlie Howell, CFA, is trying to calculate the required return on equity for Yazz Jazz, a maker of saxophones. However, Yazz Jazz operates in a country with rapidly changing inflation rates. Which method should Howell use? A)Bond-yield plus risk premium. B)Build-up. C)A multifactor model.

Answer C The build-up method assigns premiums based on company size and other company-specific factors. It is designed for use on closely held companies and does not take inflation changes into account. The bond-yield method adds a risk premium to the yield on the company's publicly traded debt. The bond yields will reflect inflation indirectly, but the model does not easily adjust for inflation changes. For taking rapid inflation changes into account, a multifactor model works the best.

(3) Which of the following free cash flow to the firm (FCFF) models is most suited to analyze firms that are growing at a faster rate than the overall economy? A)No growth FCFF model. B)High growth FCFF model. C)Two-stage FCFF model.

Answer C The two-stage FCFF model is most suited for analyzing firms growing at a rate faster than the overall economy. The two-stage model assumes a high rate of growth for an initial period, followed by an immediate jump to a constant, stable growth rate.

(2) The value per share for Burton, Inc. is $32.00 using the Gordon Growth model. The company paid a dividend of $2.00 last year. The estimates used to calculate the value have changed. If the new required rate of return is 12.00% and expected growth rate in dividends is 6%, the value per share will increase by: A)9.51%. B)4.17%. C)10.42%.

Answer C The value per share using the new estimates is $35.33 = [$2.0(1.06) / 0.12 - 0.06)] and the percentage increase in the value per share will be 10.42% = [(35.33 - 32.00) / 32.00] × 100%.

(3) Ben Jacobs, CFA, is attempting to calculate a historical equity risk premium. His first estimate uses geometric mean equity returns and long-term bond yields. His second estimate uses arithmetic mean returns and short-term bond yields. The effect of the changes in methodology in the second estimate, relative to the first, will: A)have offsetting effects. B)both increase the size of the risk premium. C)both decrease the size of the risk premium.

Answer: B Switching from a geometric mean to an arithmetic mean will increase the mean equity return. All else being equal, that will increase the estimated risk premium. When the yield curve slopes upward, short-term bonds yield less than long-term bonds. Thus, the equity risk premium estimate will be larger when short-term bond rates are used. Remember that for most methods of figuring out the equity premium you end up subtracting Return of market-Return of risk free. This is especially the case when using CAPM.

(2) Difference between fair market value and investment value? Difference between fair market value and intrinsic value?

Investment value is the most relevant definition of value to use in an agreement between the owners of a private business regarding the price at which the owners can sell their ownership interest. Basically Fair Market Value is the price that will agreed upon when there's one buyer and seller. Intrinsic value: is the true underlying value of a security given complete understanding.

What is the gordon growth model and how do you calculate?

It is a forward looking way to calculate Equity risk premiums. There are four types of estimates of the equity risk premium: historical estimates, forward-looking (ex-ante) estimates, macroeconomic model estimates, and survey estimates.

(2) An analyst has forecasted dividend growth for Triple Crown, Inc., to be 8% for the next two years, declining to 5% over the following three years, and then remaining at 5% thereafter. If the current dividend is $4.00, and the required return is 10%, what is the current value of Triple Crown shares based on a three-stage model? A)$92.23. B)$91.11. C)$73.68.

Note: The H model is like perpetuity. Use the H model in year that decline will first occur in this case year 3. Your ending value is discounted back to year before decline. Hence if the decline begins at year 1 then H-Model will take you to Vt=0. Answer A Vt1=$4(1.08) / 1.10 =4.32/1.10 Vt2=$4(1.08)^2 / (1.10)^2= 4.6656/(1.10)^2 Vt2= 4.6656(1.05)+4.6656(3/2)(.08-.05)/(.10-.05)=102.17664 @Vt2 Thus you can combine both the cash flows at time 2 and ultimately you are left with 4.6656+102.17664/(1.10)^2 + 4.32/1.10= 92.23

(2) Sum of the parts valuation can also be called what two things?

private market value and breakup value. Sum-of-the-parts valuation totals the estimated values of each of the company's business divisions as independent going concerns. The value derived using a sum-of-the-parts valuation is also sometimes called the private market value or the breakup value, even when such a restructuring is not necessarily expected.

(3) The equity risk premium is the difference between:

the required equity return and the risk-free return. The equity risk premium reflects the return in excess of the risk-free rate that investors require for holding stocks. It is derived by subtracting the risk-free return from the required return.

(*2) What is the formula for figuring out the H-Model method of finding the value of a dividend paying stock?

{D0*(1+gl) + D0(#years/2)*(gs-gl)} / R-gl D0= dividend at heart 0 Gl= growth in long therm #years= # of years to linearly decrease to terminal value R= Required rate of return

(2) How do you find FCFF from Net Income and how about FCFE?

NICETIPGLAD N=Net Income I= Interest(1-tax) (C)= Working Capital (E)= Cap Expenditure T= Deferred Tax Liability I= Impairment (P)= Premium discount (G)=Gain L= Losses D= Depreciation For FCFE its NEWBTIPGLAD the only change is the beginning part thus, N= Net Income (E)= Cap Ex (W)= Working Capital B= Net New Borrowings

(1) Which of the following best describes the estimation of discounts for lack of marketability (DLOM) in private company valuations? The primary advantage of using put prices to estimate the DLOM over the other two methods is: A)the volatility of the firm can be incorporated into the analysis. B)exchange traded put prices are readily available. C)the Black-Scholes model has been shown to be valid for private firms.

Answer A If an interest in a firm cannot be easily sold, a DLOM is applied. The DLOM can be estimated using restricted share versus publicly traded share prices, pre-IPO versus post-IPO prices, and put prices. The advantage of using put prices over the other two DLOM estimation methods is that the estimated risk of the firm can be factored into the option price. Discounts for lack of marketability (DLOM) are applied when the comparables are based on highly marketable securities, such as public shares, and the interest in the target company is less marketable, as in the case of a minority interest in a private firm. The DLOM can be estimated using restricted share versus publicly traded share prices, pre-IPO versus post-IPO prices, and put prices. It can be challenging to implement these methods.

(2) Which of the following statements related to the role of valuation standards in valuing private companies is most accurate: A)Business appraisers in the U.S. and most other countries are not required to adhere to government-authorized valuation standards. B)No international valuation standards exist; countries generally each have their own standards for valuation. C)Standards organizations provide technical guidance that ensures homogeneous valuations by those that use their standards.

Answer A In the United States, the Appraisal Foundation is a congressionally authorized provider of standards, however business appraisers are not required to adhere to the standards. Other challenges involved with valuation standards are: there are many different valuation standards; technical guidance on the use of standards is limited; it is difficult to ensure compliance to the standards; and valuation will depend on the definition of value used.

(3) Which of the following best describes the guidance on the use of private company valuation standards provided by appraisal organizations? A)Guidance on the use of standards is necessarily limited due to the heterogeneity of valuations. B)Technical guidance on the use of standards is widespread, as it is provided by both industry and consumer groups. C)Guidance on the use of standards is not provided.

Answer A One of the challenges involved with the implementation of appraisal standards is that although the organizations provide technical guidance on the use of their standards, it is necessarily limited due to the heterogeneity of valuations.

(2) (Retention Rate) (Margin) (Sales/Book Value of Equity) CVR, Inc: High Margin / Low Volume 20% 8% 1.25 CVR, Inc: Low Margin / High Volume 20% 2% 4.00 Home Co: High Margin / Low Volume 40% 9% 2.00 Home Co: Low Margin / High Volume 40% 1% 20.0 Note: CVR, Inc., has a book value of equity of $80 and a required rate of return of 10%. Home, Inc., has a book value of equity of $100 and a required rate of return of 11%. If Home, Inc., has a required return for shareholders of 11%, what is its appropriate leading price-to-sales multiple (Po / S1) if the firm undertakes the low margin/high volume strategy? A)0.20. B)1.00. C)0.80.

Answer A P/S Leading Ratio: Margin(payout)/R-G. You know to do leading because (Po / S1) thus sales at time period 1. g = Retention Rate × Profit Margin × SBV of equity = 0.40 × 0.01 × 20.0 = 0.08. If profit margin is based on the expected earnings next period, P/S = (profit margin × payout ratio) / (r − g) = (0.01 × 0.60) / (0.11 − 0.08) = 0.20.

(2) An argument against using the price-to-sales (P/S) valuation approach is that: A)P/S ratios do not express differences in cost structures across companies. B)P/S ratios are not as volatile as price-to-earnings (P/E) multiples. C)sales figures are not as easy to manipulate or distort as earnings per share (EPS) and book value.

Answer A P/S ratios do not express differences in cost structures across companies. Both remaining responses are advantages of the P/S ratios, not disadvantages.

(2) Firm 2, a software manufacturer, has a consistent track record of paying dividends that is related to its earnings. The firm is projected to have a growth rate of 25% for the next five years and has an estimated required rate of return of 14%. The valuation of Firm 2 will be included in a ValueSegment research report targeted toward common investors. Would it be appropriate for Porter to use a dividend discount model (DDM) to value Firm 2? A)Yes. B)No, the DDM should only be used when an investor takes the perspective of a majority shareholder. C)No, the dividend growth rate is higher than the required rate of return.

Answer A The fact that the current growth rate is higher than the required rate of return means that the single-stage Gordon growth model could not be applied, but a multiple stage dividend discount model may be appropriate. The dividend discount model (DDM) is an appropriate valuation methodology to use when: The company has a history of dividend payments.The dividend policy is clear and related to the earnings of the firm.The perspective is that of a minority shareholder.

(2) An analyst values a private firm by using price multiples from the sale of whole companies, with adjustments for risk differences. Which of the following best describes the valuation method that the analyst is using? A)The guideline transactions method. B)The prior transaction method. C)The guideline public company method.

Answer A The guideline transactions method (GTM) generates a value estimate based on pricing multiples associated with the acquisition of control of entire companies. The guideline public company method (GPCM) generates an estimate of value based on the multiples from trading activity in the shares of public companies that are similar to the private company in question. The prior transaction method (PTM) uses actual transactions in the stock of the subject private company.

(2) Proprietary Technologies, Inc., (PTI) has a leading price-to-earnings (P/E) ratio of 38 while the median leading P/E of a peer group of companies within the industry is 28. Based on the method of comparables, an analyst would most likely conclude that PTI should be: A)sold or sold short as an overvalued stock. B)bought as an undervalued stock. C)viewed as a properly valued stock.

Answer A The price per dollar of earnings is considerably higher than that for the median of the peer group, which implies that it may well be overvalued.

(1) Aims's associate likes to use the price-earnings-to-growth (PEG) ratio because it appears to address the effect of growth on the P/E ratio. For example, if a firm's P/E ratio is 20 and its forecasted 5-year growth rate is 10%, the PEG ratio is 2.0. The associate likes to invest in firms that have an above-industry-average PEG ratio. The associate also says that he likes to invest in firms whose leading P/E is greater than its trailing P/E. Aims tells the associate that he would like to further investigate these two investment criteria. When Aims further investigates the two investment criteria (the PEG ratio and the comparison between the trailing and leading P/E ratio), should he find his colleague's use of them to be appropriate? A)No. B)The PEG ratio criterion is appropriate, but the P/E ratio criterion is not. C)The P/E ratio criterion is appropriate, but the PEG ratio criterion is not.

Answer A Both criteria are poorly applied by the associate. Generally, a lower PEG ratio is considered desirable, not a higher one. The difference in the trailing and leading P/E ratios could be due to transitory elements in the current year's income in the denominator of the trailing P/E. In a constant growth model (admittedly a strong assumption), the leading P/E will naturally be smaller than the trailing P/E because earnings are growing by g.

(2) Which of the following scenarios represents a violation of the clean surplus relationship? A)The market value of securities held for sale changes. B)Unusual charges against income are not charged against equity. C)A company stops paying dividends suddenly.

Answer A Essentially your are looking for things that impact other comprehensive income (Cap-F) The clean surplus relationship holds that ending book value equals the beginning book value plus earnings minus dividends, excluding ownership transactions. The relationship is violated when charges skip the income statement and go directly to equity. Changes in the market value of debt and equity classified as available for sale can affect equity without affecting earnings. Unusual charges should not be included in residual-value calculations because they are not expected to recur. Charges that do not affect equity will not violate the relationship. Cessation of dividends also does not violate the relationship.

(3) In general, firms making aggressive accounting decisions will report book values that are: A)higher. B)consistent with fair market value. C)lower.

Answer A In general, firms making aggressive (conservative) accounting decisions will report higher (lower) book values and lower (higher) future earnings.

(0) In preparing to estimate a suitable required rate of return on equity for Trailblazer, Valentine notes that the current T-bill rate is 3.5% and that the yield on the company's 10-year bonds is 7.25% while the yield on a 10-year Treasury bond is 4.4%. Additionally, Valentine estimates that the appropriate equity risk premium in excess of the company's cost of debt is 3%. Valentine estimates that average dividend yield for the S&P 500 (the market proxy) is 2.1% and a consensus long-term EPS growth rate of 3.5% is forecast for S&P 500 index. The forward-looking estimate of average equity risk premium (based on the S&P 500 index as market proxy) is closest to: A)1.2%. B)2.1%. C)5.6%.

Answer A. The method is called the gordon growth model equity risk premium on the quick sheet. Equity risk premium = dividend yield + LT EPS growth rate - LT government bond yield = 2.1% + 3.5% - 4.4% = 1.2%

(1) Risk-free rate: 4.0% Market risk premium: 5.0% Size premium: 2.0% Value premium: 4.0% Liquidity premium: 4.5% Sunil Gurpreet Company (SGC) is a small company focusing on new high-density paper, which has found application in the aerospace industry. SGC's earnings and revenues are expected to grow at 30% for eight years, after which time the technology will lose patent protection and SGC's growth rate will revert to the industry's overall growth rate. Last year's reported earnings were $160 million but these earnings are believed to be of poor quality. SGC has never paid dividends. SGC's earnings can be volatile, but cash flows have been positive and stable. Rojas obtains inputs to estimate SGC's cost of equity as shown in Exhibit 3. Exhibit 3: SGC's Cost of Equity Factor Exposures SGC ................β Market β Size β Value β Liquidity Factor sensitivities 1.20 0.50 −0.20 0.20 SGC current share price$28.45 Stock outstanding in millions: 100 The fraction of SGC's market price that is attributable to the value of growth is closest to: A)21%. B)34%. C)50%.

Answer B

(3) Which of the following definitions of value refers to the value of an asset given a hypothetically complete understanding of the asset's investment characteristics? A)Investment value. B)Fair value. C)Intrinsic value.

Answer C Intrinsic value is derived from investment analysis and is the "true" value independent of short-term mispricing that may occur. Fair value is a concept used in financial reporting or litigation matters. Investment value is the value to a particular buyer.

(2) Suppose the equity required rate of return is 10%, the dividend just paid is $1.00 and dividends are expected to grow at an annual rate of 6% forever. What is the expected price at the end of year 2? A)$27.07. B)$29.78. C)$28.09.

Answer B

(3) A firm has a payout ratio of 35%, a return on equity (ROE) of 18%, an estimated growth rate of 13%, and its shareholders require a return of 17% on their investment. Based on these fundamentals, a reasonable estimate of the appropriate price-to-book value ratio for the firm is: A)1.58. B)1.25. C)2.42.

Answer B

(2) A use of the residual income (RI) valuation approach is: A)deferring value more than in competing valuation approaches. B)providing a check of consistency between competing approaches like free cash flow of equity (FCFE) and dividend discount model (DDM) . C)providing more reliable estimates of terminal value.

Answer B A RI model can be used along with other models to assess the consistency of results. FCFE and DDM models forecast future cash flows while RI models start with a balance sheet measure of equity and add the present value of expected future RI.

(3) All other variables held constant, the justified price-to-book multiple will decrease with a decrease in: A)payout ratio. B)expected growth rate. C)required rate of return.

Answer B All other variables held constant, a decrease in expected growth rate will result in a decrease in the justified price-to-book multiple. P/B=(ROE-G)/(R-G)

(2) Which of the following is a disadvantage of using price-to-sales (P/S) multiples in stock valuations? A)It is difficult to capture the effects of changes in pricing policies using P/S ratios. B)The use of P/S multiples can miss problems associated with cost control. C)P/S multiples are more volatile than price-to-earnings (P/E) multiples.

Answer B Due to the stability of using sales relative to earnings in the P/S multiple, an analyst may miss problems of troubled firms concerning its cost control. P/S multiples are actually less volatile than P/E ratios, which is an advantage in using the P/S multiple. Also, P/S ratios provide a useful framework for evaluating effects of pricing changes on firm value.

(3) Finally, Gunnarsdottir needs to revise his projections for Havlett hf, a firm in the passenger transportation industry. In his previous analysis of Havlett, Gunnarsdottir had underestimated the interest cost for next year by kr 78,000 and overestimated operating expenses by kr 12,000. Havlett's marginal tax rate is 20%. . What would be the impact on Havlett's estimated free cash flow to equity and free cash flow to the firm due to the adjustments made by Gunnarsdottir? A)FCFE would decrease by kr 66,000 while FCFF would increase by kr 12,000. B)FCFE would decrease by kr 52,800 while FCFF would increase by kr 9,600. C)FCFE would increase by kr 9,600 while FCFF would increase by kr 12,000.

Answer B For FCFF you increase expenses by the after tax cost of debt but then you subtract by the after tax cost of debt. Therefore you get 0 for the increase in debt. A decrease in expenses increases income by 12,000*(1-tax). For FCFE you increase expenses by the after tax cost of debt of 62,400. The decrease in expenses is like extra NI so you tax it. So 12,000*.80= $9,600. So ultimately $9,600-62,400= $52,800 It seems that the rule of thumb for calculating Net Income is to just tax any changes to NI and then figure out if its a positive or negative change.

(2) In a single-stage residual income model for a firm with return on equity (ROE) greater than the required rate of return, which statement is least accurate? A)Market value will be greater than book value. B)Free cash flow to equity will be positive. C)The justified price-to-book value (P/B) ratio will be greater than one.

Answer B In a single-stage residual income model with ROE greater than the required rate of return, justified P/B will be greater than one and market value will be greater than book. There is no clear relationship with free cash flow to equity.

Income Statement 20X2 Revenue $20,000.0 million EBITDA $3,750.0 million Operating income $3,290.0 million Interest expense $600.0 million Income tax rate 30.0% Payout ratio 72.0% Stock Price: $26.5 Shares outstanding: 1000million Industry Growth: 3.4% If the justified leading P/E for BMC stock is 14.1X, then BMC stock is best described as: A)overvalued. B)undervalued. C)fairly valued.

Answer B Leading P/E= Current Price/EarningsT=1 EarningsT@1= (3290-600).7=1883*1.034=1,947 EPS@1=1,947/1000=1.947 Implied Stock Price=1.947*14.1=$27.45 which is more than the current stock price. So the current stock price is undervalued.

(2) Market value added is calculated as: A)net operating profit after taxes minus a charge for total capital. B)market value of the company minus total capital. C)market value of the company minus a charge for equity capital.

Answer B Market value added is the market value of the company minus total capital. It is used to measure the effect on value of management's decisions since the firm's inception.

(2) The following data was available for Morris, Inc., for the year ending December 31, 2001: Sales per share = $150. Earnings per share = $1.75. Return on Equity (ROE) = 16%. Required rate of return = 12%. If the expected growth rate in dividends and earning is 4%, what will the appropriate price-to-sales (P/S) multiple be for Morris? A)0.037. B)0.114. C)0.109.

Answer B Profit Margin = EPS / Sales per share = 1.75 / 150 = 0.01167 or 1.167%. Payout ratio = 1 − (g / ROE) = 1 − (0.04 / 0.16) = 0.75 or 75%. Remember G=ROE(1-Payout Ratio) so you can solve backwards which is what the example does. Remember P/S and P/E both have Payout Ratio on top. B/P is the only one with ROE on numerator. P0 / S0 = [profit margin × payout ratio × (1 + g)] / (r − g) = [0.01167 × 0.75 × 1.04] / (0.12 − 0.04) = 0.11375.

(3) Travel Advisors has earnings before interest and taxes (EBIT) of $200 million, interest expense of $83 million, taxes of $46.8 million, and total debt of $125 million. It is also financed with total equity of $850 million, which has a required rate of return of 12%. What is Travel Advisors' residual income? A)A profit of $70.2 million. B)A loss of $31.8 million. C)A profit of $31.8 million.

Answer B Residual Income= NI-(Re*Beginning Equity) Net income = 200,000,000 - 83,000,000 - 46,800,000 = $70,200,000. The equity capital charge is 850,000,000 × 0.12 = $102,000,000. Thus, residual income = 70,200,000 - 102,000,000 = -$31,800,000.

(3) Among the various price multiples, the residual income model is most closely linked to which of the following? A)Price to free cash flow (P/FCF). B)Price to book value (P/B). C)Price to earnings (P/E).

Answer B The residual income model is most closely linked to P/B because justified P/B is directly linked to expected residual future income. If there is residual income then P/B will be positive (i.e. the market price of the company will be greater than its book value). Remember residual income= Net Income- Equity Cost(invested Capital) or Net Income-Equity Cost(beginning book value of equity) But when talking about residual income model look at the picture

(3) Leslie Singer comments to Robert Chan that Dreamtime Industries' expected dividend growth rate is 5.0%, ROE is 14%, and required return on equity (r) is 10%. Based on a justified P/B ratio compared to a P/B ratio (based on market price per share) of 1.60, Dreamtime Industries is most likely: A)overvalued. B)correctly valued. C)undervalued.

Answer C Justified P/B = (ROE − g) / (r − g). When the expected dividend growth is 5.0%, the justified P/B = (0.14 − 0.05) / (0.10 − 0.05) = 1.80. This is greater than the market P/B of 1.60.

(2) Which description of the relationship among residual income, dividend discount (DDM) and free cash flow to equity (FCFE) models is least accurate? A)Residual income differs from DDM and FCFE in that it discounts income rather than cash. B)The different models should result in different intrinsic values because of the theoretical differences in the models. C)Residual income differs from DDM and FCFE in that residual income starts with book value.

Answer B The three models should all produce the same intrinsic value as long as the underlying assumptions are the same. The differences in intrinsic values arise from difficulty in estimating the inputs, not from theoretical differences in the models. Since they should produce the same results, they can be used to assess consistency. Residual income differs from DDM and FCFE in the use of accounting assumptions, including book value and discounting income.

(DELETE)An analyst is calculating the weighted harmonic mean P/E ratio of a 2-stock portfolio. Stocks AAA and BBB have prices of $12 and $15, respectively, and EPS of $1 and $2, respectively. Which of the following is the weighted harmonic mean P/E of the portfolio closest to? A)9.75 B)9.00 C)9.23

Answer B The weighted harmonic mean is 1/[(12/27)(1/12) + (15/27)(2/15)] = 27/3 = 9.00 The weighted harmonic mean of the individual stocks P/Es is the best measure of the P/E for a portfolio of stocks.

Which of the following statements best identifies and explains which bond is used as the expected return for a bond segment? A)A coupon bond, because of the reinvestment rate assumption. B)A zero coupon bond, because of the reinvestment rate assumption. C)A zero coupon bond, because of the maturity assumption.

Answer B The yield to maturity on a reference bond in a segment is used as the expected return. The drawback to this approach is that the yield to maturity assumes that intermediate cash flows are reinvested at the yield to maturity, which may be implausible if the yield to maturity is quite high. A zero coupon bond has no intermediate cash flows so it is not susceptible to the reinvestment rate assumption of the yield to maturity in a coupon bond. A zero coupon bond's yield to maturity would be preferable to that of a coupon bond.

(2) Using the following figures, calculate the value of the equity using the capitalized cash flow method (CCM), assuming the firm will be acquired. Normalized FCFE in current year $3,000,000 Reported FCFE in current year $2,400,000 Growth rate of FCFE 7.0% Equity discount rate 16.0% WACC 13.0% Risk-free rate 3.5% Cost of debt 10.5% Market value of debt $3,000,000 The value of the equity is: A)$28,533,333. B)$35,666,667. C)$32,666,667.

Answer B To arrive at the value of the equity using the CCM, it can be estimated using the free cash flows to equity and the required return on equity (r): CCM= FCFEt=1/Re-g thus 3,000,000*1.07/(.16-.07)= 35,666,667 Note that we grow the FCFE at the growth rate because the current year FCFE is provided in the problem (not next year"s FCFE). We use normalized earnings, not reported earnings, given that normalized earnings are most relevant for the acquirers of the firm. The relevant required return for FCFE is the equity discount rate, not the WACC. An alternative approach to calculate the value of the equity would be to subtract the market value of the firm"s debt from total firm value. However, the FCFF are not provided so a total firm value cannot be calculated. If it were you would do (FCFF*FCFF Growth/WACC-G)-debt=Value of firms equity

(2) The Lewis Corp. had revenue per share of $300 in 2001, earnings per share of $4.50, and paid out 60% of its earnings as dividends. If the return on equity (ROE) and required rate of return of Lewis are 20% and 13% respectively, what is the appropriate price/sales (P/S) multiple for Lewis? A)0.12. B)0.19. C)0.18.

Answer B Trailing P/S= Margin(Payout Ratio)(1+G)/(R-G) Notice that since this problem doesn't say anything about projecting next years sales and you are given the sales for this year, the problem becomes a trailing P/S instead of leading. Profit Margin = EPS / Sales per share = 4.50 / 300 = 0.015 or 1.5%. Expected growth in dividends and earnings = ROE × (1 − payout ratio) = 0.20 × 0.40 = 0.08 or 8%. P0/S0 = [profit margin × payout ratio × (1 + g)] / (r − g) = [0.015 × 0.60 × (1.08)] / (0.13 − 0.08) = 0.1944.

(-1) Given the following figures, calculate the FCFF. Assume the earnings and expenses are normalized and that capital expenditures will cover depreciation plus 3 percent of the firm's incremental revenues. Current Revenues $30,000,000 Revenue growth 6% Gross profit margin 20% Depreciation expense as a percent of sales 1% Working capital as a percent of sales 15% SG&A expenses $3,800,000 Tax rate 30% A)$927,400. B)$1,245,400. C)$1,785,400.

Answer B Whenever you are given a growth rate or see the words incremental go ahead and assume you will fine FCFF for the next period. Cap Ex ends up being: ((30,000,000*1.06)-30,000,000)*1.03 And working capital is not just revenues times 15% but the incremental working capital of last years rev and the upcoming years rev times 15%.

(3) Travel Advisors has earnings before interest and taxes (EBIT) of $200 million, interest expense of $83 million, taxes of $46.8 million, and total debt of $125 million. It is also financed with total equity of $650 million, which has a required rate of return of 12 percent. What is Travel Advisors' residual income? A: A)loss of $70.2 million. B)profit of $70.2 million. C)loss of $7.8 million.

Answer C Net income = 200,000,000 - 83,000,000 - 46,800,000 = $70,200,000. The equity capital charge is 650,000,000 × 0.12 = $78,000,000. Thus, residual income = 70,200,000 - 78,000,000 = -$7,800,000. Residual Income= NI-(cost of equity*beginning equity)

(2)What is the justified trailing price-to-earnings (P/E) multiple of a stock that has a payout ratio of 40% if the shareholders require a return of 16% on their investment and the expected growth rate in dividends is 6%? A)6.36. B)4.24. C)4.00.

Answer B Trailing P/E= Payout(1+g)/(r-g) P0/E0 = (0.40 × 1.06) / (0.16 - 0.06) = 4.24

(2) Patterns of persistence or reversals in returns provide the most appropriate rationale for valuation using? A) Unexpected Earnings B) Relative Strength Indicators C) Standardized unexpected Earnings

Answer B.

(2) Midland Semiconductor has a book value of $10.50 per share. The company's return on equity is 20%, and its required return on equity is 17%. The dividend payout ratio is 30%. What is the value of the shares using a single-stage residual income model? A)$10.50. B)$31.50. C)$21.00.

Answer C

(3) A private pharmaceutical firm is under consideration for acquisition where the financial buyer will pay with equity. Part of the payment to the sellers is based on FDA approval of the firm's drug. If the analyst uses a market approach and comparable data from public firms, which of the following would most likely result in a price-multiple that is too high? The comparable data is: A)from transactions where the buyer used cash. B)for transactions where the consideration was non-contingent. C)for strategic buyers.

Answer C In market approaches, the analyst values the subject private firm using price multiples from previous public and private transactions. A strategic buyer is one who will have synergies with the target whereas a financial buyer does not. A financial transaction typically has a smaller price premium. So in this case, the comparable price-multiple will be too high. If the acquisition involves the acquirer's stock, the acquirer may be using overvalued shares to buy their target. Using comparables where cash is the consideration would result in lower price multiples. Contingent consideration is payment to the sellers based on the achievement of specific goals such as FDA approval. Contingent consideration increases the risk to the seller and ceteris paribus, they would demand a higher price. Using comparables where the consideration was non-contingent would result in lower price multiples.

(3) What is the appropriate price-to-sales (P/S) multiple of a stock that has a retention ratio of 45%, a return on equity (ROE) of 14%, an earnings per share (EPS) of $5.25, sales per share of $245.54, an expected growth rate in dividends and earnings of 6.5%, and shareholders require a return of 11% on their investment? A)0.227. B)0.158. C)0.278.

Answer C Recall that profit margin is measured as E0 / S0. In this example, the profit margin is (5.25 / 245.54) = 0.0214. Thus: P0 / S0 = [(E0 / S0)(1 − b)(1 + g)] / (r − g) = [0.0214(0.55)(1.065)] / (0.11 − 0.065) = 0.278

(2) Proprietary Technologies, Inc., (PTI) has a leading price-to-earnings (P/E) ratio of 38 while the median leading P/E of a peer group of companies within the industry is 28. Based on the method of comparables, an analyst would most likely conclude that PTI should be: A)viewed as a properly valued stock. B)bought as an undervalued stock. C)sold or sold short as an overvalued stock.

Answer C The price per dollar of earnings is considerably higher than that for the median of the peer group, which implies that it may well be overvalued.

(1) One disadvantage of using the price/sales (P/S) multiple for stock valuation is that: A)P/S multiple does not provide a framework to evaluate the effects of corporate policy decisions and price changes. B)profit margins are not consistent across firms within an industry. C)sales are relatively stable and might not change even though earnings and value might change significantly.

Answer C The stability of sales (relative to earnings and book value) can be a disadvantage. For example, revenues may remain stable but earnings and book values can drop significantly due to a sharp increase in expenses.

(2) The present value of GB Industries' projected residual income (RI) for the next five years is 70 per share. Beyond that time horizon, a key analyst projects that the firm will sustain a RI of 15 per share, which is the RI for year 5. Given a cost of equity of 12%, what is the terminal value of the stock as of year 5? A)£500.00. B)£560.00. C)£125.00.

Answer C The stock's terminal value as of year 5 is: TV = 15.00/0.12 = 125.00

(1) Midland Semiconductor has a book value of $10.50 per share. The company's return on equity is 20%, and its required return on equity is 17%. The dividend payout ratio is 30%. The current share price is $21.00 per share. The shares (relative to a single-stage residual income model) are most likely: A)undervalued. B)overvalued. C)correctly valued.

Answer C The strengths of the residual income approach include the following: • Terminal value does not dominate the valuation equation (as with DDM and FCFE approaches). Residual income uses available accounting data. Residual income is applicable to non-dividend-paying firms. Residual income focuses on economic profits. The limitations of the residual income approach are as follows: • The accounting data may be manipulated by management. • The accounting data may require significant adjustment. • The model assumes a clean surplus relationship (i.e., ending BV = beginning BV + earnings - dividends).

(2) P/E multiples are often computed using the average of the multiples of comparable firms, because: A)it provides the most accurate results. B)it is very easy to find comparable firms that have the same business mix and risk and growth profiles. C)it is conceptually very straightforward.

Answer C The use of comparable firms is quite common, because it is conceptually very straightforward. Also, it does not require the analyst to make specific assumptions regarding growth, risk, and other variables. However, it is often difficult to find comparable firms, since even within the same industry different firms can have different business mixes and risk and growth profiles.

(2) What is the value of a fixed-rate perpetual preferred share (par value $100) with a dividend rate of 11.0% and a required return of 7.5%? A)$138. B)$152. C)$147.

Answer C The value of the preferred is $147: V0 = ($100par × 11%) / 7.5% = $146.67

(2) Shares of TKR Construction (TKR) are selling for $50. Earnings for the last 12 months were $4.00 per share. The average trailing P/E ratio for firms in TKR's industry is 15. The appropriate WACC is 12%, and the risk-free rate is 8%. Assume a growth rate of 0%. Using the method of comparables, what price is indicated for TKR? A)$33.33. B)$50.00. C)$60.00.

Answer C Using the method of comparables, TKR should be priced as (15 × 4) = $60.00.

(2) When a company's ROE is the same as the return required by the market, the stock's justified market value is closest to the: A)book value plus residual income. B)actual market value plus residual income. C)book value.

Answer C When ROE is equal to the required return on equity, the justified market value of a share of stock is equal to its book value. In this case, there is no residual income.

(2) Which of the following methods of figuring out equity risk premium is most susceptible to survivorship bias? A) survey estimates B) Gordon model estimates C) historical estimates Will this skew equity risk premium up or down?

Answer C equity risk premium B(RM-RF) it will be too high since the actual RM will be too high since it excludes companies that failed and would have lowered this return.

(0) Using the following figures, calculate the value of the firm using the excess earnings method (EEM). Working capital $600,000 Fixed assets $2,300,000 Normalized earnings $340,000 Required return for working capital 5% Required return for fixed assets 13% Growth rate of residual income 4% Discount rate for intangible assets 18% A)$3,073,199. B)$3,027,111. C)$2,981,714.

Answer C Excess earnings method: values tangible and intangible assets separately and is useful for small firms and when there are intangible assets to value. 340,000-(.13*2,300,000-.05*600,000)=11,000 11000*1.04/.18-.04=81,714 81,714+600,000+2,300,000=2,981,714 Residual Income=Normalized Income-WC*%WC-FixedAssets*%Fixed Assets Intangible Asset Value=RI*Growth/(Rate for Intangibles-Growth Rate) WC+Fixed Assets+Intangibles=Value of Private firm using EEM.

(-1) Dien Thoai's dividend yield based on the most recent dividend paid is 5%. Dividends and earnings are expected to grow 12% next year, but that rate is expected to decrease linearly over the next six years to a long-term rate of 3% per year. The required rate of return on Dien Thoai stock implied in its current market price is closest to: A)9.5% B)10.8%. C)11.3%.

Answer C Given: dividend yield = 5%, gs = 12%, gL = 3% and H = 6/2 = 3. r=[(0.05) × {(1.03) + 3(0.12 - 0.03)}] + 0.03 = 0.095 or 9.5%

(2) Which of the following will have the largest effect on FCFE? A) A share repurchase B) More Dividends C) Convertible bond issue

Answer C Issuing new stock does not count as new borrowing since its not new borrowing. you are issuing equity you don't have to pay back.

(2) Hamilton is following a firm that manufactures oil and gas drilling equipment, Rig Industries. Last year, Rig had reported earnings per share of $2.40, under International Financial Reporting Standards (IFRS). Hamilton is estimating the firm's underlying and normalized earnings. The economy and the industry have been in an expansion for three years. The firm reported expenses for environmental remediation of $0.29 per share last year and a gain on sales of surplus assets of $0.17 per share. The highest trailing price-to-earnings ratio for Rig Industries would be one based on: A)reported earnings. B)underlying earnings. C)normalized earnings.

Answer C Rig has reported earnings per share of $2.40 and the economy and industry are three years into an expansion. Normalized earnings average the company's earnings over a business cycle, so Rig's normalized earnings would, in all likelihood, be lower than the current reported earnings per share. Underlying earnings are adjusted for nonrecurring items such as environmental remediation costs and gains on asset sales. Underlying earnings (adjusted for nonrecurring items) are higher than the reported earnings per share in this case. As normalized earnings are the lowest, they will result in the highest price-to-earnings ratio.

(3) If a multistage residual income model incorporates a persistence factor of zero, the analyst is most likely assuming that residual income will: A)persist at the current level forever. B)decline to zero over time. C)fall to zero immediately.

Answer C Just like the DDM there's a few variations of the Residual Income Model. To find single stage residual income model then BV0+((ROE-r)*BVO/(r-g)). If you have different residual incomes over a few years then you can do BVO+(RI/(1+R))+(R12/(1+R)^2.) Just like DCF but add BVO to the answer. To find the terminal value is when the persistence factor comes into play. Thus at third period you would have RI3/(1+R-w)^t. Where R is the required return on equity. See the picture. Ultimately, a higher W means that your residual income will persist for a longer time (good). A persistence factor of zero is used when residual income is expected to drop immediately to zero. A persistence factor of one is used when residual income is expected to persist at the current level forever. A persistence factor between zero and one is used when residual income is expected to decline over time.

(1) Gunnarsdottir is also evaluating the common stocks of Arctic Home Builders (AHB) and Advani Specialty Components (ASC). AHB is in the highly cyclical residential construction industry that has experienced significant recovery in earnings following large losses incurred during the recent recession. ASC is a manufacturer of specialty components for the global telecommunications industry. ASC was recently awarded a patent that turned out to be an immediate game changer for a particular class of optoelectronic components. For the purpose of performing a relative valuation of Arctic Home Builders, the most appropriate price multiple is: A)price-to-book value. B)price-to-earnings using trailing earnings. C)price-to-earnings using normalized earnings. For the purpose of performing a relative valuation of Advani Specialty Components, the most appropriate price multiple is: A)price-to-book value. B)price-to-sales. C)price-to-earnings using leading earnings.

Answer C and C A relative valuation example: The airline in question generates annual EPS of €2.00. The investor finds that the average price-to-earnings multiple, or P/E, for the industry is 9. Using relative valuation, the investor estimates that the value of the airline's stock, on a per share basis, is €18.00 (= €2.00 x 9). Thus when performing relative valuation on AHB, find the metric that makes the most sense for the company you are valuing. AHB is in a cyclical industry, and hence normalized earnings would be the best metric to use in relative valuation. Due to a major event (i.e. the granting of a patent), forward-looking metrics (such as leading earnings) would be the most appropriate to use for valuing ASC. Highly cyclical companies present difficulties when choosing a forecast horizon. The horizon should be long enough that the effects of the current phase of the economic cycle are not driving above-trend or below-trend earnings effects. The forecast horizon should be long enough to include the middle of a business cycle so the analyst's forecast includes mid-cycle level of sales and profits. Normalized earnings are expected mid-cycle earnings or, alternatively, expected earnings when the current (temporary) effects of events or cyclicality are no longer affecting earnings.

(1) Brown Manufacturing's recent financial statements reported a book value of $9.50 per share; its required rate of return is 10%. Analyst Tony Giancola, CFA, wants to calculate the company's intrinsic value using a multistage residual income with a high-growth RI for the next 5 years. Giancola creates the following estimates: PV of interim high-growth RI for the next 5 years is $3.10 At the end of year 5, the PV of continuing RI is $10.00 Estimated Book Value in 5 years is $25.00 Which of the following is closest to the current intrinsic value of Brown Manufacturing? A)$22.60. B)$13.10. C)$18.81.

Answer C: Applying the multistage residual income model: V0 = B0 + PV of interim high-growth RI + PV of continuing RI = 9.50 + 3.10 + [(10.00) / (1.10)5] = $18.81 This one is easy because you don't even need to calculate Residual income or the Continuing residual income using one of the four methods it already gives you everything.

(3) Earnings before interest, taxes, depreciation, and amortization (EBITDA) is best suited for a multiple measure of: A)debt capacity. B)total company value. C)equity value.

Answer: B EBITDA is a pre-tax, pre-interest measure, which represents a flow to both equity and debt. Thus, it is better suited as an indicator of total company value than just equity value. The common multiple for this is EV/EBITDA. In other words EBITDA is a proxy for cash flow for both equity and debt holders since it doesn't include dividends or interest payments. Thus in the numerator the corresponding value is EV = MV debt + MV equity + preferred equity + minority interest - cash and cash equivalents. *Cash equivalents include investments* Notice that EV encompasses both debt and equity thus it's the total company value to both debt and equity holders. EV is the value that someone buying an entire company would have to pay.

(1) An increase in which of the following variables will least likley result in a corresponding increase in the price-to-book value (PBV) ratio for a high-growth firm? A)Payout ratios. B)Required rate of return C)Growth rates in earnings.

Answer: B The PBV ratio decreases as the required rate of return increases. PBV ratio is: ROE-g/r-g

(2) The sustainable growth rate, g, equals: A)pretax margin divided by working capital. B)earnings retention rate times the return on equity. C)dividend payout rate times the return on assets.

Answer: B The formula for sustainable growth is: g = b × ROE, where g = sustainable growth, b = the earnings retention rate, and ROE equals return on equity.

(2) An analyst has gathered the following data about Jackson, Inc.: Payout ratio = 60%. Expected growth rate in dividends = 6.7%. Required rate of return = 12.5%. What will be the appropriate price-to-book value (PBV) ratio for Jackson, based on fundamentals? A)0.58. B)1.38. C)1.73.

Answer: C P/Book Value: (ROE-g)/(r-g) Return on equity (ROE) = g / (1 − payout ratio) = 0.067 / 0.40 = 0.1675 or 16.75%. Based on fundamentals: PBV = (0.1675 − 0.067) / (0.125 − 0.067) = 1.73.

(0) Find EVA Invested capital $225 Market capitalization $231 Debt $130 Sales $90 Cost of goods sold (COGS) $26 Selling, general & administrative (SG&A) expense $10 Depreciation and amortization expense $25 Interest expense $6.5 Dividend expense $6 Tax rate 40.0% Pretax cost of equity 11.4% Pretax cost of debt 5%

Answer=$2.67million EVA = NOPAT − (WACC × invested capital). where invested capital can be also Equity-Debt NOPAT = (sales − COGS − SG&A expense − depreciation and amortization expense) × (1 − tax rate) = $17.40 million. To calculate the weighted average cost of capital (WACC), start by determining the percentage of equity and debt. $130 million in debt represented 57.78% of total capital. The remaining 42.22% is the equity portion. Don't forget to adjust the cost of debt for taxes. WACC = 57.78% × (5% × [1 − 40%]) + (42.22% × 11.4%) = 6.55%. EVA = $17.40 million − ($225 million × 6.55%) = $2.67 million. Note that in this problem residual income and EVA are the same. This is true in a "perfect world" but you should not assume this will always be true on exam problems.

(2) Q2. Which description of the relationship among residual income, dividend discount (DDM) and free cash flow to equity (FCFE) models is least accurate? A)Residual income differs from DDM and FCFE in that residual income starts with book value. B)Residual income differs from DDM and FCFE in that it discounts income rather than cash. C)The different models should result in different intrinsic values because of the theoretical differences in the models.

Correct answer is C) The three models should all produce the same intrinsic value as long as the underlying assumptions are the same. The differences in intrinsic values arise from difficulty in estimating the inputs, not from theoretical differences in the models. Since they should produce the same results, they can be used to assess consistency. Residual income differs from DDM and FCFE in the use of accounting assumptions, including book value and discounting income.

(*.1) If asked to find FCFE what are the different ways you can try to find it? Also what are net borrowings and how do you find the increase in Working capital?

Either by starting with NI, FCFF, or CFO FCFE=NI+Net Borrowings-Capital Expenditures-Working Capital+ Non Cash Expenses FCFE=FCFF+Net Borrowings-interest(1-tax) FCFE= CFO+Net Borrowings-Capital Ex Net Borrowings: change in long term debt and notes payable. (do not include accounts payable). So be careful and don't assume the increase in liabilities its automatically your increase in net borrowings because accounts payable is included in that figure. Alternatively Net borrowings: Long term debt+Short Term Debt Working Capital Investment: Current Assets-Current Liabilities. However be aware that if current assets and liabilities are broken out the use the specific formula of: (Current Assets-Cash)-(Current Liabilities-Debt). I.E (current assets-cash)-(current assets-short term debt). I.E (current assets-cash)-(current assets-current portion of long term debt).

(2) What is equity risk premium and two ways to calculate?

Equity risk premium is the return that investors require over a risk free asset (10-year treasury) Equity Risk Premium=Return Market-Return of risk free Equity Risk Premium=long term growth rate + dividend yield - risk free asset

(2) An appraiser must determine the value of an asset for tax purposes. Which of the following is the most likely standard of value the appraiser will use? How about if this is a real asset or real estate appraisal? -Fair value for financial reporting. -Fair market value. -Market value.

Fair market value is used for tax purposes in the U.S. and based on an arm's length transaction. Though similar to fair market value, fair value for financial reporting is used for financial not tax reporting. Market value is used in real estate and other real asset appraisals.

(1) T/F If Kirkham were to substitute a stock repurchase program for the dividends, free cash flow to equity would increase for the selling shareholders, but decrease for the long-term shareholders. Free cash flow to the firm, however, would be unaffected. Given Banstead's recent return to profitability and an increase in its EBIT, both free cash flow to equity and free cash flow to the firm will increase.

False, True substituting dividends with a stock repurchase does not change FCFE. It also doesn't change FCFF. Increasing CFO,EBIT, EBITDA, or NI increases both FCFE or FCFF.

(1) FLIP FLIP FLIP FCFE=CFO-Cap Ex+Net Borrow So 1042-648+((2070+644)-(2020+600))=488 FCFF= CFO+Interest(1-tax)-Cap Ex So 1042+150(1-.3)-648=499 Net Borrowings= Change in longer term debt and notes payable. (do not include accounts payable). So be careful and don't assume the increase in liabilities its automatically your increase in net borrowings because accounts payable is included in that figure. For the purposes of the test Cash Flow from investing activities counts as Capital Expenditures.

Find FCFE and FCFF

(1) What is the discount for lack of control, how do you calculate? How about calculating the total discount of both lack of control and lack of marketability? An analyst calculates a control premium of 15% and discount for lack of marketability (DLOM) of 20%. Which of the following is closest to the total discount for valuing minority equity interests in the private firm?

Formula: (1-(1/1+Control Premium))*(1-DLOM) The application of discounts and premiums to comparable company values depends on differences between the characteristics of the interest in the comparable company (companies) that serves as the benchmark value and the characteristics of the interest in the target company to be valued. A discount for lack of control (DLOC) is applied when the comparable values are for the sale of an entire company (public or private), and the valuation is being done for a minority interest in the target company. A control premium is added when the comparable company values are for public shares or other minority interests, and the target company valuation is for a controlling interest. A DLOC can be estimated using valuations based on reported earnings rather than normalized earnings or as: 1-(1/(1+Control Premium) Discounts for lack of marketability (DLOM) are applied when the comparables are based on highly marketable securities, such as public shares, and the interest in the target company is less marketable, as in the case of a minority interest in a private firm. The DLOM can be estimated using restricted share versus publicly traded share prices, pre-IPO versus post-IPO prices, and put prices. It can be challenging to implement these methods. The DLOC and DLOM are applied multiplicatively using: total discount = 1 − [(1 − DLOC)(1 − DLOM)]

(3) As a rule of thumb how can you determine if there are economies of scale when comparing one large company in the same industry as a smaller company?

If the larger company has more revenues and a higher gross profit margin then there are economies of scale. In sum, higher revenues and profit margin indicate economies of scale.

(-1) What main 4 things violate the clean surplus relationship?

If there is a violation of the clean surplus relationship, BV will still be correct but NI will be incorrect. Note that one of the downsides of using the Residual income model is that it assumes that the clean surplus relationship holds.

(1) What do dividends and non-reoccurring items indicate about the persistence factor?

Low dividends: High persistence factor (good) makes RI higher Low non-reoccurring items: High persistence factor. Low dividend payout indicates that management is spending money on capital projects which will increase returns in the future. eg Apple, their paying a dividend was seen as a signal there are no new revolutionary products upcoming. Low non-recurring items would indicate that high profits this quarter were not due to some unusual factor eg jump in income for a Japanese construction company after tsunami would be a non-recurring item, we would not expect this income to persist into the future. Just like the DDM there's a few variations of the Residual Income Model. To find single stage residual income model then BV0+((ROE-r)*BVO/(r-g)). If you have different residual incomes over a few years then you can do BVO+(RI/(1+R))+(R12/(1+R)^2.) Just like DCF but add BVO to the answer. To find the terminal value is when the persistence factor comes into play. Thus at third period you would have RI3/(1+R-w). Where R is the required return on equity. See the picture. Ultimately, a higher W means that your residual income will persist for a longer time (good).

(*2) How do you calculate EVA?

Measures how much value management is adding to shareholders. EVA is basically the same as Economic Profit= NOPAT-WACC(invested capital). EVA is used in the equity section and Economic Profit is introduced in the Econ section but both the same thing. Compared to Residual Income, EVA and Economic Profit is the value that management adds above what is required by both debt and equity holders. Hence it measures profit to all capital holders both debt and equity since they discount WACC. Total Capital= the beginning book value of long term debt+beginning book value of equity. Residual Income: Net income- Cost of Equity*beginning book value. Measures income to shareholders only above what is required based on the cost of equity. Not to be confused with Economic Income= After Tax Cash Flow − economic depreciation. Where: economic depreciation = (beginning market value − ending market value) Tip: Associate word Economic with all capital holders and WACC. Associate Residual with Equity holders and cost of equity.

(Delete) Hamilton and Fisher are concerned about the estimates of equity risk premium from their data provider. Fisher states that economic reports indicate that labor productivity will continue to increase at a 1.1% annual rate while inflation will be stable at 3.2%. Hamilton states that demographic trends indicate that the labor supply growth rate will moderate to an annual rate of 0.6%. Fisher indicates that broad equity market index will continue to provide a yield (including reinvestment) of 1.8%. Hamilton feels that the current valuation levels continue to be too low, and that a market correction will expand the average P/E multiple by 1.2%.

Required rate of return = Y + [(1 + E(I))(1 + G)(1 + PEG) - 1] Note that the question is asking for required return on equity and not equity risk premium; hence, don't subtract the risk-free rate. Y = dividend yield = 0.018 (given); E(I) = expected inflation = 0.032 (given); PEG = expansion/contraction in P/E = +0.012 G = real EPS growth rate = real GDP growth rate = growth in labor productivity + growth in labor supply = 0.011 + 0.006 = 0.017 Required rate of return = 0.018 + [(1.032)(1.017)(1.012) - 1] = 0.0801 or 8.01%.

(2) Compared to the P/E: For Ranking purposes earnings yields may be useful whenever earnings are either negative or close to zero. T/F A high E/P implies the security is overpriced. T/F

T and F Earnings yield is Earnings/Price. The opposite of P/E. As the earnings on P/E approach 0 you start getting absurd P/E ratios that are super high. When using earnings yield they simply approach 0 so E/P is better for ranking purposes. A high E/P usually means the security is underpriced.

(1) Lear is trying to determine the best method for estimating required return for Densmore, a closely held company. The company has not issued debt securities to the market and relies on bank financing. Which method should she choose? A)Build up B)Risk Premium C)Bond Yield plus risk premium method.

The build up method. The risk premium method is the same as CAPM method. Since the company does not have public debt, you can't use the bond yield plus risk premium method. See pic. In essence the market risk premium is RM-RF. The Equity risk premium is B(RM-RF). The risk premium (CAPM method) uses historical figures. You can use the gordon growth Stock Price= Div1/R-G to also calculate the required return on equity by backing into R using the current market price of the stock. The Gordon growth model to find required return is a forward looking estimate.

What are the three main ways to value a private company:

The three major approaches to private company valuation are the income approach, the market approach, and the asset-based approach. The valuation should consider the firm's operations, lifecycle stage, size, risk, and growth. The income approach values a firm as the present value of its future income. The asset-based approach values a firm as its assets minus liabilities. The market approach values a firm using the price-multiples from the sales of comparable assets.

(2) When should you use DDM, FCF, Residual Income, to value company

Use the DDM for valuation problems with the following characteristics: The firm has a dividend history. The dividend policy is consistent and related to earnings. The perspective is that of a minority shareholder. FCF valuation is appropriate when the following characteristics exist: The firm does not have a stable dividend policy. The firm has a dividend policy that is not related to earnings. The firm's FCF is related to profitability. The perspective is that of a controlling shareholder. The RI method can be difficult to apply because it requires an in-depth analysis of the firm's accounting accruals. The RI method is most appropriate under the following conditions: • • • The firm does not have a dividend history. The firm's FCF is negative. It is a firm with transparent and high quality accounting. either way you will have to calculate a required rate or return to use when discounting by either using CAPM, multi factor model, or build up model.

(0) What is the Ibbotson-Chen model and how do you find it?

Used to find the equity risk premium. It is a multi factor model, specifically, a macroeconomic model. Remember you can find the equity risk premium using CAPM, build up models, or multi factor models. Expected inflation (EINFL) can be calculated as the difference between the yields forlong term Treasury bonds and Treasury Inflation Protected Securities (TIPS) of a similar maturity. The expected growth rate in the P/E ratio (EGPE) has a baseline value of zero. However,it may be positive (negative) if the analyst views the market as currently undervalued (overvalued). For example in a problem it will say "Tang believes the markets are overvalued by 3%" The expected income component (EINC) can be based on the historical rate (e.g., 4.5% in the U.S.) and tweaked according to forward‐looking estimates. For example "the yield on the market index is 1.7%"

(0) How do you calculate EVA and how to calculate MVA?

Where Invested Capital for EVA is the beginning book value of debt+beginning book value of equity. Invested Capital also equals: fixed assets +Net Working Capital MVA= Total Market Value- Ending total capital. Which is the same as the following: MVA= MV of Equity+MV of Debt-(Ending invested capital) MVA= MV of Equity+MV of Debt-(Ending Long Term Debt+ Ending Equity)

(0*) Flip Flip Flip FCFE=NI+Net Borrowings-Capital Expenditures-Working Capital+ Non Cash Expenses Net Borrowings: change in long term debt and notes payable. (do not include accounts payable). So be careful and don't assume the increase in liabilities its automatically your increase in net borrowings because accounts payable is included in that figure. Alternatively Net borrowings: Long term debt+Short Term Debt. Short term debt includes notes payables just not accounts payables. Working Capital Investment: Current Assets-Current Liabilities. However be aware that if current assets and liabilities are broken out the use the specific formula of: (Current Assets-Cash)-(Current Liabilities-Debt). I.E (current assets-cash)-(Current Liabilities-short term debt). I.E (current assets-cash)-(Current Liabilities-current portion of long term debt). NI=81 Net Borrowings: 49 Cap Ex: 150 WC: (100-15-30)-(60-10-30)=35 Non Cash: 60 FCFE= 81+49-150-35+60=5

Which of the following is closest to the Tarrington Enterprises' FCFE for 20X1? A)−$55. B)−$32. C)$5.

(2) At the request of a client, Hudson is examining the prospects of Wickham Materials, a thinly traded, regional firm. The firm's FCFF has grown at a fairly constant rate of 4%. She uses the following figures to value the firm and to calculate its per share equity value. FCFF: $8,000,000 Target debt-to-equity ratio: 0.30 Par value of debt: $13,000,000 Market value of debt: $12,000,000 Shares outstanding: 2,500,000 Required return on equity: 18% Cost of debt: 10% Long-term growth in FCFF: 4% Tax rate: 30% Which of the following is closest to the per share equity value that Hudson should estimate for Wickham Materials? A)$24.24. B)$26.30. C)$29.04.

Wickham Materials' FCFF is expected to grow at a constant rate, so a single-stage model is appropriate. The FCFE is not provided, so we will calculate the value of the firm using FCFF and then subtract out the debt value. Note that the FCFF is discounted below by the firm's weighted average cost of capital (WACC). If the FCFE were provided, it would be discounted by the shareholder's required return.

(2) Why do you unlever and relever beta and how do you do it?

You do this to when trying to find the WACC or Return on Equity for a company that doesn't publicly trade to ultimately value the company. It helps isolate market risk by taking out leverage. You need a beta in both WACC and return on equity. 1) Unlevered Beta=Beta of public / (1+D/E) 2)Relevered Beta= Unlevered Beta *(1+D/E) Sometimes the question might throw tax on there so: 1) Unlevered Beta=Beta of public / (1+D/E)(1-tax) 2)Relevered Beta= Unlevered Beta *(1+D/E)(1-tax)

(1) What is residual income and what is economic profit?

residual income is different from net income in that it takes away the cost of equity to give you an amount that more truly reflects the companies income past the cost of the companies equity. Economic profit and residual income are both the same thing look at picture. Residual income is traditionally Net income-cost of equity(beginning equity) Economi profit is NOPAT-WACC(invested capital) Where invested capital is book value long term Debt+Equity. Note that use the book values at the beginning of the year.

(2) What are the differences (pros/cons) between using the CAPM, multi-factor model, or build up model, gordon growth model? At a real simplistic level.

-The CAPM is simple but may have low explanatory power. Only useful for public companies. -Multifactor models have more explanatory power but are more complex and costly. -Build-up models are simple and can apply to closely held companies, but they typically use historical values as estimates that may or may not be relevant to the current situation. -Gordon Growth Model can also be used Stock Price=Dv1/R-G. to calculate require return based on current stock price. This is called a forward looking estimate.

(2) What are the two methods for estimating the size of the premium for an emerging market?

*The country spread model* uses a corresponding developed market as a benchmark and adds a premium for the emerging market risk. The premium can be estimated by taking the difference between the yield on bonds in the emerging market minus the yield of corresponding bonds in the developed market. *The country risk rating model* estimates an equation for the equity risk premium for developed countries and then uses the equation and inputs associated with the emerging market to estimate the required return for the emerging market.

(2) When calculating intrinsic value, If the growth rate in dividends is too high, it should be replaced with: A)a growth rate closer to that of gross domestic product (GDP). B)the average growth rate of the industry. C)the growth rate in earnings per share.

Answer A A firm cannot, in the long term, grow at a rate significantly greater than the growth rate of the economy in which it operates. If the growth rate in dividends is too high, then it is best replaced by a growth rate closer to that of GDP.

(2) The H-model is more flexible than the two-stage dividend discount model (DDM) because: A)initial high growth rate declines linearly to the level of stable growth rate. B)terminal value is not sensitive to the estimates of growth rates. C)payout ratio changes to adjust the changes in growth estimates.

Answer A A sudden decline in high growth rate in two-stage DDM may not be realistic. This problem is solved in the H-model, as the initial high growth rate is not constant, but declines linearly over time to reach the stable-growth rate.

(3) Dan is trying to calculate the net book value of PPE for 2016 given last years info of: Sales: 993 PPE (NVB): 312 EBITDA: 278 NI: 130 Partrino is now forecasting the balance sheet and intends to use the following assumptions: Capital expenditure will remain constant at 2.5% of sales for the foreseeable future.Depreciation will be 1.9% of sales in 2016. Partrino's forecast of the net book value of PPE at the end of 2016 is closest to: A)$318 million. B)$325 million. C)$304 million.

Answer A Beginning PPE (NVB): 312 Plus PPE Cap Ex: 24.8 Minus Depreciation: 18.67 = Ending PPE (NVB) of $318

(3)For an analyst valuing public equities, the relevant concept of value is most likely to be: A)intrinsic value. B)fair market value. C)orderly liquidation value.

Answer A For an analyst valuing public equities, the most relevant definition of value is generally intrinsic value. A value based on a going-concern assumption, rather than a liquidation assumption, is the appropriate choice for a company that will continue to produce and sell goods. Fair market value is the most relevant definition of value to use in an agreement between the owners of a private business regarding the price at which the owners can sell their ownership interest (i.e. price negotiated between two knowledgable unrelated parties at an arm's length)

(2) Garcia Mendoza is currently forecasting revenue for Remnicky Inc., a global provider of sports statistics to broadcasters. Mendoza is forecasting that Remnicky's revenue will grow 1% faster than global nominal GDP next year due to an increased interest in tracking statistics worldwide. In consultation with his economic research department, Mendoza has predicted that the real global GDP will grow at 1% next year, before flattening out and showing zero growth for the next 4 years. Inflation is predicted to remain steady at 1.5% for the next 5 years. Which of the following statements about Mendoza's forecast for next year is most accurate? A)Mendoza is forecasting growth of using a 3.5% top-down approach. B)Mendoza is forecasting growth of using 2.5% a top-down approach. C)Mendoza is forecasting growth of 3.5% using a hybrid approach.

Answer A Mendoza is using a top-down approach as he is modeling revenue by starting with a forecast of the entire economy. The predicted growth rate is 1% faster than nominal GDP = 1% + 1.5% + 1% = 3.5%.

(2) A firm has a payout ratio of 40%, a profit margin of 7%, an estimated growth rate of 10%, and its shareholders require a return of 14% on their investment. Based on these fundamentals, a reasonable estimate of the appropriate price-to-sales ratio for the firm (based on trailing sales) is: A)0.77. B)0.70. C)0.56.

Answer A P/S=(Profit Margin)*(Payout)*(1+G)/r-g or P/S=Net Margin*Trailing P/E

(1) A firm currently has sales per share of $10.00, and expects sales to grow by 25% next year. The net profit margin is expected to be 15%. Fixed capital investment net of depreciation is projected to be 65% of the sales increase, and working capital requirements are 15% of the projected sales increase. Debt will finance 45% of the investments in net capital and working capital. The company has an 11% required rate of return on equity. What is the firm's expected free cash flow to equity (FCFE) per share next year under these assumptions? A)$0.77. B)$0.38. C)$1.88.

Answer A Sales = 12.5 Net Income = 1.875 Additional sales = 2.5 FCInv = 2.5*.65 = 1.625 WCInv = 2.5*.15 = .375 DR = .45 FCFE = 1.875 - (.55*1.625)-(.55*.375) = .775 Essentially, when asked to solve for FCFE and you are given a target debt ratio use the following formula even if you aren't necessarily trying to forecast for time period 1. NI-(1-DR)(CapEX-Depreciation)-(1-DR)(WCinv) *Where DR is the target debt ratio. This kinda makes sense since FCF has two main outflows the CapEx and Working Capital. Thus, when "forecasting" FCFE, we assume that a firm maintains a constant target debt financing ratio (DR) for net new investment in fixed capital and working capital. This assumption allows forecasts of FCFE without having to specifically forecast debt issuance or repayment.

(2) In its most recent quarterly earnings report, Smith Brothers Garden Supplies said it planned to increase its dividend at an annual rate of 5% for the foreseeable future. Analyst Anton Spears is using a required return of 9.5% for Smith Brothers stock. Smith Brothers stock trades for $52.17 per share and earned $3.01 per share over the last 12 months. The company paid a dividend of $2.15 per share during the last 12-month period, and its dividend-growth rate for the last five years was 9.2%. Using the Gordon Growth model, the share price for Smith Brothers stock is most likely: A)overvalued. B)correctly valued. C)undervalued.

Answer A The Gordon Growth model is as follows: Value = [dividend × (1 + dividend growth rate)] / [required return − growth rate] Correct Stock Price is 50.17= [2.15 × 1.05] / [0.095 − 0.05]

(1) Which of the following is least likely a limitation of the two-stage dividend discount model (DDM)? A)Terminal value estimate is most sensitive to estimates of future dividends. B)the length of the high-growth stage is difficult to measure. C)most of the value is due to the terminal value

Answer A The Terminal value in two-stage DDM is most sensitive to estimates of growth and required rate of return. AKA most the sensitivity comes from the denominator of D1/(R-G) where R is required return and G is growth rate.

(2) If an analyst uses a build-up model to estimate a stock's return rather than using a multifactor model or the capital asset pricing model, the analyst is probably least concerned about: A)timeliness. B)simplicity. C)accuracy.

Answer A The build-up model typically uses historical values as estimates. Historical data may no longer be relevant, so a user of the build-up model is probably not concerned with timeliness.

(2) -Current FCFE per share is $0.90. -Outstanding shares 10 million -Tax rate 40.0% -Interest expense $750,000 -Net borrowing −$100,000 -Cost of debt 7.5% -Debt-to-equity ratio 25.0% -Estimated growth rate for the firm 4.0% The free cash flow to the firm (FCFF) is closest to: A)$9.55 million. B)$9.45 million. C)$9.35 million.

Answer A The difference between the acronyms NICETIPGLAD and NEWBTIPGLAD are the after tax interest that you add in NICETIPGLAD and the net borrowing costs that you add in NEWBTIPGLAD. Note that the negatives to find FFCF are C,E,P,G. The negatives in FFCE are E,W,P,G So to get from NEWBTIP GLAD add the after tax interest but subtract the net borrowing costs. FCFF = FCFE - Net borrowing + interest expense × (1- tax rate) = $9 million - (-$100,000) + $750,000 × (1- 0.40) = $9.55 million Note that Net Borrowings= Short term debt + Long term debt. Don't include accounts payable.

(3) An analyst is performing an equity valuation for a minority equity position in a dividend paying multinational. The appropriate model for this analysis is most likely: A)The Dividend Discount approach. B)FCFE approach. C)FCFF approach.

Answer A The dividend discount model is most appropriate for valuing a minority equity position in a dividend-paying company. The free cash flow approach looks to the source of dividends from the perspective of an owner that has control rather than directly at dividends. In sum if you are taking a minority position and the company pays dividend its better to use the dividend discount model. If there aren't dividends thats when you consider using FCFF and FCFE.

(3) If the value of an 8%, fixed-rate, perpetual preferred share is $134, and the par value is $100, what is the required rate of return? A)6%. B)8%. C)7%.

Answer A The required rate of return is 6%: V0 = ($100par × 8%) / r = $134, r = 5.97%

(3) The stable-growth free cash flow to the firm (FCFF) model is most useful in valuing firms that: A)have capital expenditures that are not significantly higher than depreciation. B)are growing at a rate significantly lower than that of the overall economy. C)have capital expenditures that are significantly higher than depreciation.

Answer A The stable-growth FCFF model is useful for valuing firms that are expected to have growth rates close to that of the overall economy. Since the rate of growth approximates that for the overall economy, these firms should have capital expenditures that are not significantly different than depreciation.

(2) A firm's free cash flow to the firm (FCFF) in the most recent year is $80M and is expected to grow at 3% per year forever. If the firm has $100M in debt financing and its weighted average cost of capital is 10%. The value of the firm's equity using the single-stage FCFF model is: A)$1,077M. B)$1,177M. C)$1,043M.

Answer A The value of the firm's equity is equal to the value of the firm minus the value of the debt. Firm value = $80M × 1.03 / (0.10 − 0.03) = $1,177M, so equity value is $1,177M − $100M = $1,077M.

(3) Sustainable growth is the rate that earnings can grow: A)indefinitely without altering the firm's capital structure. B)without additional purchase of equipment. C)with the current assets.

Answer A Sustainable growth is the rate of earnings growth that can be maintained indefinitely without the addition of new equity capital. Sustainable growth rate = (1-dividend payout) * ROE

(4) A valuation of a firm based on the current market price of its assets - liabilities is referred to as the firm's: A)liquidation value. B)operating value. C)going-concern value.

Answer A The liquidation value is based on the assumption that the firm will cease to operate and all of its assets will be sold to repay liabilities.

(3) Industrial Light currently has: Free cash flow to equity = $4.0 million. Cost of equity = 12%. Weighted average cost of capital = 10%. Total debt = $30.0 million. Long-term expected growth rate = 5%. What is the value of equity? A)$60,000,000. B)$57,142,857. C)$27,142,857.

Answer A The value of equity is [($4,000,000)(1.05) / (0.12 - 0.05)] = $60,000,000.

(3) If the investment in fixed capital and working capital offset each other, free cash flow to the firm (FCFF) may be proxied by: A)after-tax EBIT plus non-cash charges. B)net income plus after-tax interest. C)earnings before interest and taxes (EBIT). If the investment in fixed capital and working capital offset each other, free cash flow to the firm CFF) may be proxied by: A) net income plus after-tax interest. B) earnings before interest and taxes (EBIT). C) free cash flow to equity (FCFE). D) net income plus non-cash charges plus after-tax interest.

Answer A and then D Q1 is A because you never subtracted interest in EBITDA so theres no reason to add back to EBITDA. However, you do have to find the after Tax EBITDA since FCFF begins with Net Income. The answer is indicated by the definition of FCFF: FCFF = EBIT (1 - tax rate) + Dep - FCInv - WCInv, which assumes that depreciation is the only non-cash charge. Further: FCFF = NI + NCC + Int (1 - tax rate) - FCInv - WCInv.

(2) Lorson is analyzing the revenue growth of Symphonica Inc., a retailer of audio visual equipment. Relevant data for the last two years is shown below: Years 2013 and 2012 Revenue Numbers 1,408 1,375 Total market size 17,606 17,450 Nominal GDP growth 16,451 16,400 He is looking at three methods of predicting revenue for 2014: -Assume that Symphonica retains its 2013 share of the market for 2014, and the total market grows at the same rate as it did last year. -Assume that revenue growth rate is equal to previous year's nominal GDP growth rate. -A bottom-up approach which assumes that the growth rate of Symphonica's revenue will be the same as last year Which of the following statements regarding Lorson's forecast is most accurate? A)Lorson's market growth and market share model predicts a higher 2014 revenue figure for Symphonica than his bottom-up approach. B)Lorson's bottom-up approach predicts the highest revenue for 2014. C)Lorson's growth relative to GDP growth model predicts a higher 2014 revenue figure for Symphonica than his market growth and market share model.

Answer B

(3) Q-Partners is expected to have earnings in ten years of $12 per share, a dividend payout ratio of 50%, and a required return of 11%. At that time, ROE is expected to fall to 8% in perpetuity and the trailing P/E ratio is forecasted to be eight times earnings. The terminal value at the end of ten years using the P/E multiple approach and DDM is closest to: P/E multiple DDM A)96.32 89.14 B)96.00 89.14 C)96.32 85.71

Answer B

(-1) Methods for estimating the terminal value in a DDM are least likely to include: A)the market multiple approach. B)PVGO. C) The Gordon Growth Model

Answer B .No matter which dividend discount model we use, we have to estimate a terminal value using either the Gordon growth model or the market multiple approach. The Gordon growth model assumes that in the future, dividends will begin to grow at a constant, long-term rate. Then the terminal value at that point is just the value derived from the Gordon growth model. Using market price multiples to estimate the terminal value involves, for example, forecasting earnings and a P/E ratio at the forecast horizon and then estimating the terminal value as the P/E multiplied by the earnings estimate.

(3) In using the capital asset pricing model (CAPM) to determine the appropriate discount rate for discounted cash flow models (DCFs), the asset's beta is used to determine the amount of: A)the expected return in addition to the return required by the risk of the position. B)equity premium. C)risk-free rate applicable to the time period of the investment.

Answer B Beta measures the correlation between the equity market or index for which the market risk premium is calculated and the particular asset being valued. Beta is used to approximate the proportion of the equity risk premium applicable to the asset (in relation to the market or index used).

(2) Given an equity risk premium of 3.5%, a forecasted dividend yield of 2.5% on the market index and a U.S. government bond yield of 4.5%, what is the consensus long-term earnings growth estimate? A)8.0%. B)5.5%. C)10.5%.

Answer B Equity risk premium = forecasted dividend yield + consensus long term earnings growth rate - long-term government bond yield. Therefore, 3.5= 2.5 + X -4.5 X=5.5

(1) Cost of equity = 12.0%. Cost of debt = 6.0%. Tax rate = 30.0%. Outstanding shares = 100 million. New debt borrowing = 15.0 million. Debt repayment = 30.0 million. Interest expense = 7.1 million If Hiller's total free cash flow to equity is 380 million and the growth rate of the firm is 3.5%, and the WACC is 9.66% the value of Hiller (Firm) using the stable growth model is closest to: A)4.8 billion. B)6.7 billion. C)8.9 billion.

Answer B FCFF = FCFE − Net borrowing + interest expense × (1 − tax rate). FCFF = 380 million + (7.1 million (1 − 0.3)) − (15 million-30 million) = 399.7 million. The value of the firm is then: [399.7 million × (1 + 0.035)] / (0.0966 − 0.035) = 6,720 million.

(3) Deployment Specialists pays a current (annual) dividend of $1.00 and is expected to grow at 20% for two years and then at 4% thereafter. If the required return for Deployment Specialists is 8.5%, the current value of Deployment Specialists is closest to: A)$33.28. B)$30.60. C)$25.39.

Answer B First estimate the amount of each of the next two dividends and the terminal value. The current value is the sum of the present value of these cash flows, discounted at 8.5%.

(2) Which of the following statements regarding pricing power is most accurate? A)A company operating in an industry with a high intensity of rivalry will have a high level of pricing power. B)A company operating in an industry that has high barriers to entry will have a high level of pricing power. C)A company operating in an industry that has a low threat of entrants will have a low level of pricing power.

Answer B High barriers to entry mean a low threat of entrants. In this situation the incumbent has a high level of pricing power. Intense rivalry reduces pricing power.

(3) Important considerations for choosing an appropriate approach for valuing a given company are least likely to include: A)Is the model suitable given the purpose of the analysis? B)Is the model consistent with the investor's IPS? C)Is the model appropriate based on the quality and availability of input data?

Answer B Important considerations when choosing a valuation model include: Does the model fit the characteristics of the company? Is the model suitable given the purpose of the analysis? Is the model appropriate based on the quality and availability of input data?

(3) A common price to earnings (P/E) based method for estimating terminal value in multi-stage models is the: A)P/E to growth (PEG) approach. B)fundamentals approach. C)dividend yield approach.

Answer B It is common to restate the Gordon growth model price as a multiple of expected future book value per share or earnings per share (EPS) Analysts often use price multiples such as P/E, P/B, P/S, and P/CF to estimate terminal value. No matter which ratio we use, terminal value is calculated as the product of the expected price multiple (e.g., P/E ratio) and the terminal value of the fundamental variable (e.g., EPS).

(2) In the process of estimating beta for a private company, unlevering the beta calculated for the publicly traded comparable company accomplishes what goal? A)Establishing a baseline level of leverage. B)Isolating market risk. C)Improving the accuracy of the estimate in the event that the private company's debt is of low quality.

Answer B Market risk, also known as systematic risk, is the risk common to all assets within a certain class. Deleveraging the beta strips out the company-specific risk related to the target company's leverage, thereby isolating market risk. Beta calculations do not require a baseline level of leverage. The equation for calculating beta for private companies assumes the company in question has high-grade debt. The deleveraging process will not help if the assumption is incorrect.

(3) Middle Hickory has negative FFCE and substantial capital investment. Lower Elm has Positive and growing FCCE and decreasing capital investment. Which dividend-discount model is the best option for valuing the two companies? Middle Hickory Lower Elm A)Two-stage Gordon Growth B)Three-stage Two-stage C)Gordon Growth Three-stage

Answer B Middle Hickory is in the initial-growth phase, while Lower Elm is in the transition phase. The three-stage model is appropriate for new, fast-growing companies. The two-stage model is appropriate for companies in the transitional phase.

(3) Current share price $100.00. Current earnings $3.50. Current dividend $0.75. Growth rate 11%. Required return 13%. Based on this information and the Gordon growth model, what is the firm's justified trailing price to earnings (P/E) ratio? A)11.3. B)11.9. C)8.9.

Answer B Remember that with trailing you multiply by growth. With Leading you start with expected earnings and expected dividends so you wouldn't multiply by growth since its already built in. The justified trailing P/E is 11.9: P0 / E0 = [($0.75)(1 + 0.11)/$3.50] / (0.13 - 0.11) = 11.8929 Formula is Justified P/E= (D1/E1)/r-g Or Justified P/E= (Payout Ratio)*(1+G)/r-g Thus (.75/3.50*1.11)/.02

(2) Xerxes, Inc. forecasts earnings to be permanently fixed at $4.00 per share. Current market price is $35 and required return is 10%. Assuming the shares are properly priced, the present value of growth opportunities is closest to: A)+$5.00. B)-$5.00. C)+$3.50

Answer B Share price = (no-growth earnings / required return) + PVGO 35 = (4 / 0.10) + PVGO PVGO = -$5.00

(3) Dynamite, Inc., has current earnings of $26, current dividend of $2, and a returned on equity of 18%. What is its sustainable growth? A)14.99%. B)16.62%. C)13.37%.

Answer B Sustainable Growth Rate= ROE*(1-Div/Earnings) sustainable growth= .18*(1-2/26)

(2) In its most recent quarterly earnings report, Smith Brothers Garden Supplies said it planned to increase its dividend at an annual rate of 13% for the foreseeable future. Analyst Clinton Spears has an annual return target of 15.5% for Smith Brothers stock. He decides to use the dividend-growth rate to back out another return estimate to test against his. Smith Brothers stock trades for $55 per share and earned $3.01 per share over the last 12 months. The company paid a dividend of $2.15 per share during the 12-month period, and its dividend-growth rate for the last five years was 9.2%. Using the Gordon Growth model, the required annual return for Smith Brothers stock is closest to: A)19.18%. B)17.42%. C)13.47%.

Answer B The Gordon Growth model is as follows: Price = [dividend × (1 + dividend growth rate)] / [required return − growth rate] 55 = [2.15 × 1.13] / [required return − 0.13] 55 = 2.4295 / [required return − 0.13] 22.6384 = 1 / [required return − 0.13] [Required return − 0.13] = 0.04417 Required return = 0.17417 = 17.42%

(2) Which of the following would NOT be appropriate to value a firm with two expected growth stages? A(an): A)H-model. B)Gordon growth model. C)free cash flow model.

Answer B The Gordon growth model would not be appropriate for a firm with two stages of growth but is useful to value a firm with steady slow growth.

(2) Obsidian Glass Company has current earnings of $2.22, a required return of 8%, and the present value of growth opportunities (PVGO) of $8.72. What is the current value of Obsidian's shares? A)$10.94. B)$36.47. C)$27.75.

Answer B The current value is $36.47. V0 = ($2.22 / 0.08) + $8.72 = $36.47

(3) -CAPM is 12% -Outstanding shares 10 million -Tax rate 40.0% -Interest expense $750,000 -Net borrowing −$100,000 -Cost of debt 7.5% -Debt-to-equity ratio 25.0% -Estimated growth rate for the firm 4.0% The weighted average cost of capital (WACC) is closest to: A)10.9%. B)10.5%. C)11.1%.

Answer B The debt-to-equity ratio of 25.0% means that the debt-to-total value is 25.0%/125.0% or 20.0%. The weight of debt is thus 20.0% and the weight of equity is 80.0%. Another way of thinking is debt to equity is 1:4. Thus Debt to Equity=5. and deb/debt+equity=1/5 and equity/debt+equity=4/5 Thus .75(1/5)(1-.6)+.12(4/5)=10.5%

(2) Earnings per Share (EPS) Year 0: $4.00 Year 1: $6.00 Year 2: $9.00 Year 3: $13.50 Note: Shareholders of Ski, Inc., require a 20% return on their investment in the high growth stage compared to 12% in the stable growth stage. The dividend payout ratio of Ski, Inc., is expected to be 40% for the next three years. After year 3, the dividend payout ratio is expected to increase to 80% and the expected earnings growth will be 2%. Using the information contained in the table, what is the value of Ski, Inc.'s, stock? A)$39.50. B)$71.38. C)$43.04.

Answer B The dividends in the next four years are: Year 1: 6 × 0.4 = 2.4 Year 2: 9 × 0.4 = 3.6 Year 3: 13.5 × 0.4 = 5.4 Year 3: (13.5 × 1.02) × 0.8 = 11.016/(.12-.02)=110.16 2.4/(1.2) + 3.6/(1.2)^2 + 5.4+110.16 /(1.2)^3 = $71.38

(3) When an analyst is developing long term projections of earnings for a company, which of the following statements is least accurate? A)A perpetuity should only be used if the analyst does not anticipate any inflection points occurring in the industry or economic environment. B)Earnings projections should be based on the most recent earnings for growing companies as it reflects the current state of the economy. C)When forecasting long term earnings for a highly cyclical company, an expected mid-cycle level of earnings should be used.

Answer B The most recent earnings figure may not sustainable. Even growing companies may face a downturn due to changes in the industry. The most recent data is not necessarily the most appropriate.

(3) A firm's dividend per share in the most recent year is $4 and is expected to grow at 6% per year forever. If its shareholders require a return of 14%, the value of the firm's stock (per share) using the single-stage dividend discount model (DDM) is: A)$28.57. B)$53.00. C)$50.00.

Answer B The value of the firm's stock is: $4 × [1.06 / (0.14 − 0.06)] = $53.00

(2) Glad Tidings Gifts (GTG) recently reported annual earnings per share (EPS) of $2.25, which included an extraordinary loss of $0.17 and an expense of $0.12 related to acquisition costs during the accounting period, neither of which are expected to recur. Given that the most recent share price is $50.00, what is a useful GTG's trailing price to earnings (P/E) for valuation purposes? A)22.22. B)19.69. C)25.51.

Answer B Using an underlying earnings concept, an analyst would add back the temporary charges against earnings: $2.25 + $0.17 + $0.12 = $2.54. The resulting trailing P/E = 50.00 / 2.54 = 19.69.

(2) If an asset was fairly priced from an investor's point of view, the holding period return (HPR) would be: A)lower than the required return. B)the same as the required return. C)equal to the alpha returns.

Answer B A fairly priced asset would be one that has an expected HPR just equal to the investor's required return.

(2) JAD just paid a dividend of $0.80. Analysts expect dividends to grow at 25% in the next two years, 15% in years three and four, and 8% for year five and after. The market required rate of return is 10%, and Treasury bills are yielding 4%. JAD has a beta of 1.4. The estimated current price of JAD is closest to: A) $25.42. B) $29.34. C) $45.91.

Answer B JAD's stock price today can be calculated using the three-stage model. Start by finding the value of the dividends for the next four years with the two different dividend growth rates. D1 = D0(1+g) = $0.80(1.25) = $1.00 D2 = D1(1+g) = $1.00(1.25) = $1.25 D3 = D2(1+g) = $1.25(1.15) = $1.4375 D4 = D3(1+g) = $1.4375(1.15) = $1.6531 D4= 1.6531*1.08/(.124-.08)=40.5767 Add this to the other D4 cash flow above and discount the cashflows by .124. Use calculator cash flow input option. You get the discount rate of .124 by doing the CAPM

(3) Cash flows to the firm should be discounted at the: A)rate determined by the capital asset pricing model. B)firm's weighted average cost of capital. C)market's estimated rate of return.

Answer B The weighted average cost of capital is the preferred discount rate for cash flows to the firm, as it reflects the cost of both debt and equity. Cash flows to just equity would be discounted using only the CAPM since CAPM is the required return of just equity.

(3) Which of the following statements regarding dividends and free cash flow to equity (FCFE) is least accurate? A)FCFE can be negative but dividends cannot. B)FCFE discount models usually result in higher equity values than do dividend discount models (DDMs). C)Required returns are higher in FCFE discount models than they are in dividend discount models, since FCFE is more difficult to estimate.

Answer C Although FCFE may be more difficult to estimate than dividends, the required return is based on the risk faced by the shareholders, which would be the same under both models.

(3) An increase in financial leverage will cause free cash flow to equity (FCFE) to: A)decrease in the year the borrowing occurred. B)decrease or increase, depending on its circumstances. C)increase in the year the borrowing occurred.

Answer C An increase in financial leverage will increase net borrowing and, hence, increase FCFE in the year the borrowing occurred because: FCFE = FCFF - [interest expense] (1 - tax rate) + net borrowing. Net Borrowings= Short term debt + Long term debt. Don't include accounts payable.

(3) For the purpose of forecasting proforma financial statements, which of the following statements is most accurate? A)Forecasted capital expenditure is usually based on historic information whereas forecasted depreciation rates are usually based on forecasted data. B)Forecasted depreciation rates and capital expenditure are usually based on forecasted data. C)Forecasted depreciation rates are usually based on historic information whereas forecasted capital expenditure is usually based on forecasted data.

Answer C Depreciation rates are usually taken from historic disclosures regarding rates used in prior periods. Capital expenditure is usually forecast using analysts' judgment regarding future needs for PPE.

(2) The value of a conglomerate derived using a sum-of-the-parts valuation would least accurately be called the: A)private market value. B)breakup value. C)liquidation value.

Answer C Sum-of-the-parts valuation totals the estimated values of each of the company's business divisions as independent going concerns. The value derived using a sum-of-the-parts valuation is also sometimes called the private market value or the breakup value, even when such a restructuring is not necessarily expected.

(2) If a firm has a return on equity of 15%, a current dividend of $1.00, and a sustainable growth rate of 9%, what are the firm's current earnings? A)$1.50. B)$1.75. C)$2.50.

Answer C Sustainable Growth Rate= ROE*(1-Div/Earnings) plug in numbers given and solver for earning. .09=.15*(1-1/X) X=2.5

(2) At a regional security analysts conference, Sandeep Singh made the following comment: "A PEG ratio is a very useful valuation metric because it generates meaningful results for all equities, regardless of the rate of dividend growth." Is Singh correct? A)Yes, because the computation of the PEG ratio does include the rate of expected dividend growth. B)Yes, because the expected dividend growth rate is cancelled out in the computation of the PEG ratio. C)No, because the PEG ratio generates highly questionable results for low-growth companies.

Answer C The PEG ratio measures the tradeoff between P/E and expected earnings growth (g). The formula for the PEG ratio is: PEG = (P/E) / g. PEG ratios generate questionable results for low-growth companies. Also, the PEG ratio is undefined for companies with zero expected growth (division by zero) or meaningless for companies with negative expected earnings growth.

(2) Junior analyst Quentin Haggard is struggling with a required return calculation. His main concern is compensating for exchange rate fluctuations between the country where his company is based and the home country of a portfolio of stocks he is analyzing. Haggard should calculate the return in his home country's currency, then adjust: A)the beta to account for exchange-rate fluctuations. B)for expected changes in the foreign country's inflation rate. C)for expected changes in the foreign country's currency value.

Answer C The proper method of compensating for changes in exchange rates is to calculate the required return in the home currency, then adjust the return using forecasts for changes in the exchange rate.

(2) EBIT: $500 Depreciation: $200 Capital Spending: $300 Working Capital Additions: $30 Tax Rate: 40% Assumed Constant Growth Rate in Free Cash Flow: 5% Weighted-average Cost of Capital: 11% Using the stable growth free cash flow to the firm (FCFF) model, what is the value of Quality Builders? A)$6,475.00. B)$2,833.33. C)$2,975.00.

Answer C The stable growth FCFF model assumes that FCFF grows at a constant rate forever. FCFF in Year 0 is equal to EBIT(1 − tax rate) + Depreciation − Capital Spending − Working Capital Additions = 500(1 − 0.4) + 200 − 300 − 30 = 170. The Firm Value = FCFF1 / (r − gn) = 170(1.05) / (0.11 − 0.05) = $2,975. Using NICETIPGLAD. If you start with EBIT to get to Net Income all you have to do is take away taxes and interest, but since you add back interest all you really have to do is take away taxes and the rest is the same.

(2) If year 0 dividend is $1.50 per share, the required rate of return of shareholders is 15.2%, what is the value of ABC, Inc.'s stock price using the H-Model? Assume that the growth in dividends has been 20% for the last 8 years, but is expected to decline 3% per year for the next 5 years to a stable growth rate of 5%. A)$24.26.B)$19.85.C)$20.95.

Answer C Use the H-Model to value the firm. The H-Model assumes that the initial growth rate (ga) will decline linearly to the stable growth rate (gn). The high growth period is assumed to last 2H years. Hence, the value per share = DPSo(1 + gn) / (r − gn) + DPSo × H × (ga − gn) / (r − gn) (1.5 × 1.05) / (0.152 − 0.05) + [1.5 × (5 / 2) × (0.20 − 0.05)] / (0.152 − 0.05) 1.575 / 0.102 + 0.5625 / 0.102 15.44 + 5.51 = $20.95

(1) The following table provides background information on a per share basis for TOY Inc. in the year 0: Current Information: Year 0 Earnings: $5.00 Capital Expenditures: $2.40 Depreciation: $1.80 Change in Working Capital: $1.70 TOY Inc.'s target debt ratio is 30% and has a required rate of return of 12%. Earnings, capital expenditures, depreciation, and working capital are all expected to grow by 5% a year in the future. Assume that capital expenditures and working capital are financed at the target debt ratio. In year 0, what is the free cashflow to equity (FCFE) for TOY Inc.? A)$2.70. B)$4.31. C)$3.39.

Answer C Year 0 FCFE = Earnings per share − (Capital Expenditures − Depreciation)(1 − Debt Ratio) − Change in working capital (1 − Debt Ratio) = 5.00 − (2.40 − 1.80)(1 − 0.3) − (1.7)(1 − 0.3) = 3.39. Essentially, when asked to solve for FCFE and you are given a target debt ratio use the following formula even if you aren't necessarily trying to forecast for time period 1. NI-(1-DR)(CapEX-Depreciation)-(1-DR)(WCinv) *Where DR is the target debt ratio. This kinda makes sense since FCF has two main outflows the CapEx and Working Capital. Thus, when "forecasting" FCFE, we assume that a firm maintains a constant target debt financing ratio (DR) for net new investment in fixed capital and working capital. This assumption allows forecasts of FCFE without having to specifically forecast debt issuance or repayment.

(3) Joe Dentice has an opportunity to buy 5% of Gold Star Oil, Inc., a closely held oil company. He wants to value the company so as to be able to make a decision on the fair price to pay for the investment. Which of the following models would be most suitable to value Gold Star? A)Relative valuation. B)Absolute valuation. C)Liquidation value.

Answer: B Absolute valuation models or intrinsic value models such as the dividend growth rate model and the free cash flow model value a company independent of peer valuation. The valuation is based on the present value of cash-flows for the specific company. Relative valuation models such as P/E ratio compare the earnings multiple to that of similar companies to make a judgment about the valuation. If the P/E ratio is higher than peer company P/E ratio, it is said to be overvalued. Conversely, if the P/E ratio is lower than peer company P/E ratio, it is said to be undervalued. Caution should be taken to make sure that peer companies are indeed comparable. For the valuation of Gold Star, absolute valuation would be suitable since it is closely held and hence market valuation is not available.

(2) What are the two main ways to estimate beta?

Beta estimation: -A regression of the returns of a publicly traded company's stock returns on the returns of an index provides an estimate of beta. For forecasting required returns using the CAPM, an analyst may wish to adjust for beta drift. The objective of an adjusted beta measure is to compensate for beta drift, or the tendency of beta to revert to 1.0 (or the industry average). For thinly traded stocks and non-publicly traded companies, an analyst can estimate beta using a 4-step process: (1) identify publicly traded benchmark company, (2) estimate the beta of the benchmark company, (3) unlever the benchmark company's beta, and (4) relever the beta using the capital structure of the thinly traded/nonpublic company.

(2) T/F T/F: The dividend discount model can be used to calculate the required return for a stock, though only if the growth rate remains constant. T/F: Dividend Discount models are useful for calculating the value of a stock, they should not be used to calculate required returns.

Both are False Dividend discount models can be used to calculate required returns, assuming you have the stock price, dividends, and dividend-growth rates, so Hatchett is wrong. Strong is right about the fact that a DDM can calculate required returns, but wrong about the growth rate assumption. Multistage dividend discount models can account for expected changes in the growth rate.

(2) What is the Fama French model and how does it differ from the Pastor-Stambaugh model?

Both models are used to calculate required rates of return and are multi factor models (they compete with the CAPM model but the CAPM is a single factor model). The Fama french uses Equity Premium, Company Size, Book to Market, as its factors. The Pastor Stambaugh model uses the same thing but adds a liquidity factor to account that investors need higher returns for illiquid securities. Look at picture. R small is the return on small cap portfolios and R big is the return on big cap portfolios.HBM equals High book market value and LBM is low book market value.

(2) Starting from CFO how do you find FCFE and FCFF

FCFE= CFO-CapEx+Net Borrowings Net Borrowings= Short term debt + Long term debt. Don't include accounts payable. FCFF=CFO+Interest(1-tax)-CapEx CFO already takes out taxes which is why you don't have to. Interest it taken out for CFO which is why you add back. Working Capital Investment: Current Assets-Current Liabilities. However be aware that if current assets and liabilities are broken out the use the specific formula of: (Current Assets-Cash)-(Current Liabilities-Debt). I.E (current assets-cash)-(current assets-short term debt). I.E (current assets-cash)-(current assets-current portion of long term debt).

What are the four types to estimate equity returns?

There are four types of estimates of the equity risk premium: historical estimates, forward-looking (ex-ante) estimates, macroeconomic model estimates, and survey estimates.

(3) Which of the following Free Cash Flow valuation models belongs to the following: Stable Growth, Two Stage, Three Stage model. Companies with patents or firms in an industry with significant barriers to entry. Companies growing at a rate similar to or less than the nominal growth rate of the economy. Companies in high growth industries that will face increasing competitive pressures over time, leading to a gradual decline in growth to a stable level.

Two Stage Model Stable Growth Model Three Stage Model

(0) Using the information below, value the stock of Symphony Publishing, Inc. using the free cash flow from equity (FCFE) valuation method. Required return of 13.0%. -Value at the end of year 3 of 13 times FCFE3. -Shares outstanding: 10.0 million. -Net income in year 1 of $10.0 million, projected to grow at 10% for the next two years. -Depreciation per year of $3.0 million. -Capital Expenditures per year of $2.5 million. -Increase in working capital per year of $1.0 million. Principal repayments on debt per year of $1.5 million. The value per share of Symphony Publishing is approximately: A)$14.10. B)$112.10. C)$11.21.

Use NEWBTIP to get FFCE @ Time 1 of 10-2.5-1-1.5+3=8. FFCE @ Time 2=10*1.1-2.5-1-1.5+3=9 FFCE @ Time 3=11*1.1-2.5-1-1.5+3=10.1 Terminal @ Time 3= 10.1*13=131.3 Thus discount the following cash flows by 13% t1=9 t2=10.1 t3=131.3 Present value=112.10 Value per Share= 112.10/10

(1) When is a build up model best to use? What are their pros/cons

When trying to find required returns. Build-up models are generally used for closely held companies for which betas are not easy to obtain (i.e. closely held companies). The bond-yield method is a type of Build Up model that adds a risk premium to the yield on the company's publicly traded debt. Alternatives to finding Required Returns: -The CAPM is simple but may have low explanatory power. -Multifactor models have more explanatory power but are more complex and costly. -Build-up models are simple and can apply to closely held companies, but they typically use historical values as estimates that may or may not be relevant to the current situation.

(1) What is ROIC, how is it calculated and what does it indicate?

While analysts use varying definitions of ROIC, it can be thought of as net operating earnings less adjustments for taxes (NOPLAT), divided by invested capital (book value of long term debt+book value of equity), and is a return to both equity and debt. Firms with ROIC consistently higher than those of peer companies are likely exploiting some competitive advantage in the production and sale of their products. ROIC is also equal to EBIT(1-Tax)/Invested Capital