Essay about Solutions to Valuation Questions

Solution – QUESTION 2 (written by Asher Curtis) - 10 Marks Suggestions only: 1. (3 marks for identifying the three dimensions) Applications of cost and equity differ on three dimensions. First, the treatment of dividends, is written against the investment account (Equity) or recognised as revenue (Cost). Second, the treatment of profits reported by the associated entity and the ammortisation of goodwill (the difference in the cost paid and the fair value of the net assets acquired) are not recognised when applying the cost method. The only case where net profit is not affected by choice of the method is where there is no goodwill (cost = fair value of net assets acquired) and the firm pays out all of its profit as dividends. Any of the following alternatives provide examples (2 marks for any of the following): a. The case for a profitable company that pays less than 100% profits out as dividends: The net value of the investment increases under the equity method, which will be more than cost unless the investment is revalued. b. The case for a loss company that pays no dividends: Unless the investment is subject to a recoverable amount test, application of the equity method

1. Apple Corporation has 2.5 million shares outstanding with a market value of $2.00 each (expected return = 16%) and debt with a market value of $1, 000,000 and a return of 10%

(10 points) Banana, Inc. has had debt with market value of $0.5 million that has paid a 5% coupon and has had an expiration date that is far, far away. The expected annual earnings before interest and taxes for the firm are $1 million and the firm has not grown, nor does it have plans for any growth. The firm however has just raised more equity to retire all its debt. If the required rate of return to equity-holders (after the capital structure change) is now 10%, what is the market value of the firm? Assume there are no taxes. (Enter just the number without the $ sign or a comma; round to the nearest whole dollar.) Answer for Question 8

9. (10 points) You are provided with the following monthly expected returns, each of which is represented by E(Ri), and betas for the following stocks. Please estimate the capital asset pricing model and draw conclusions about the significance and realism of the results. (Note: Please use conventional tests of the R-squared and coefficients.) On the basis of your results, please name at least three of the stocks that you would recommend as “buys.”

Some applications of dividend discount modeling can be more complex. One method divides the future growth in dividends into three periods, all of which have different growth rates. This is useful when a company’s profits are expected to grow rapidly and then gradually decline to an industry average. The complexities of this model are outside of the scope of this report, and the model can easily be run using tools found online. The assumptions of this calculation as follows. Walmart is no longer in a growth phase, so this calculation assumes that it is at the transitional phase. Because of this, 2007 data is used to initialize the calculation (EPS, dividend, etc.,) and the ‘growth’ period was 3 years. Initial growth of EPS still assumed to be 10.4%. 14 transitional years, as required by the model (total of 17 years for growth and transition is required). All of these assumptions result in a 3 stage DDM

One of them is CAPM. However, Linda wants to calculate the cost of common equity by growth rate. In order to calculate, we need to know growth rate of dividend, last year dividend amount and stock price. At the very beginning, I calculate the dividend amounts for last 10 years by multiplying Earning per Share by dividend payout ratio (0.3). Then, I find out the average of the growth rate for last 10 years to use that rate as company’s growth rate (Table 1). The reason for finding adjusted dividend is that it is not possible for company to have negative dividend. It is expected the company’s growth rate would be 125 percent of that experienced from 1988 to 1998. So, I found growth rate as 7.799%. So,

Question 2 [5 points]: Storico Co. just paid a dividend of $3.50 per share. The company will increase its dividend by 20 percent next year and will then reduce its dividend growth rate by 5 percentage points per year until it reaches the industry average of 5 percent dividend growth, after which the company will keep a constant growth rate, forever. If the required return on Storico stock is 13 percent, what will a share of stock sell for today? Answer: Here we have a stock with differential growth, where the dividend growth changes every year for the first four years. We can find the price of the stock in Year 3 since the dividend growth rate is constant after the third dividend. The price of the stock in Year 3 will be the dividend in Year 4, divided by the required return minus the constant dividend growth rate. So, the price in Year 3 will be: P3 = $3.50(1.20)(1.15)(1.10)(1.05) / (.13 – .05) = $69.73 (2 points: 1 point for set up and 1 point for answer) The price of the stock today will be the PV of the first three dividends, plus the PV of the stock price in Year 3, so: P0 = $3.50(1.20)/(1.13) + $3.50(1.20)(1.15)/1.132 + $3.50(1.20)(1.15)(1.10)/1.133 + $69.73/1.133 (2 points for set up) P0 = $59.51 (1 point)

Explain the advantages and disadvantages to use the CAPM model as the method to compute the cost of common equity. Compare and contrast this method with the dividend growth model approach. (10 pts)

If a company earns net income of $25 million in Year 8, has 10 million shares of stock, pays a dividend of $1.00 per share, and has annual interest costs of $10 million, then | |

Question #1: Ameritrade is planning on spending $155M in the next two fiscal years on advertising and $100M on technology upgrades. Management would need to consider if this large capital investment would directly result in future cash flows large enough to offset these investments at a rate that would satisfy the debt owners and shareholders. Management would need to determine the rate of return for these investments and compare this to the cost of capital, calculated using betas from comparable companies to determine accurate relationships to market fluctuations. If the rate of return for the project is less than the cost of capital, management can conclude that the investment would be more wisely spent on

b. If the firm’s beta is 1.6, the risk free rate is 9% and the expected return on the market is 13%, what will be the firm’s cost of equity using the CAPM approach?

1a. Please use the capital asset pricing model to estimate the cost of equity. At the date of the case, the 74 over T-bonds. Which beta, risk-free rate, and risk premium did you use? Why? Financing Components Debt Equity Market Values Weight Cost of Capital (After Tax) $ 6,823,736,197 0.85 3.72% $ 1,176,263,803 0.15 28.18% Total: $ 8,000,000,000 1.00 WACC WACC Inputs: Beta: Risk-Free Rate: Market Risk Premium: Pre-tax Cost of Debt: Income Tax Rate:

The standard method of calculating a stock price using the perpetual dividend growth model is done by assessing a company’s dividend one year into the future adding the future expected growth rate. The formula is written as: P0 = D1/(Ke − g), where Ke is the investor required return, D1 is next year’s dividend and g is the

Finally, we come up with the value for the operating after-tax operating cash flows for the next three years and the terminal value. We calculate the present value of these cash flows by discounting by the unlevered cost of capital, rU given as 8.7%, which gives us a value of the unlevered firm of ca. $566m.

In philosophy, things, properties, and acts contain values. They would fall into three categories of value: intrinsic value, extrinsic value, and both intrinsic and extrinsic value. Things containing intrinsic value means people value those things with intrinsic value for its own reason (Zimmerman). In contrast, things containing extrinsic value means the value of these things are depending on other things but not by itself. This is the basic difference between intrinsic value and extrinsic value. In addition, knowledge is extrinsic valuable in general, but some kinds of knowledge can also be intrinsic valuable. Also, Knowledge is more extrinsic valuable than a true belief because it provides a higher possibility for an agent to succeed in pursuing his/her goals (Pritchard 13).