Chapter 11 HW

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Finance

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Jan 9, 2024

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Chapter 11 HW 1. Explain how companies can be valued using the dividend discount model. The Dividend Discount Model (DDM), specifically the constant growth dividend model, is used to value dividend-paying companies like dividend aristocrats such as Clorox, Coca Cola, and Johnson and Johnson. This model assumes stable dividend growth and calculates the present value of future dividends by dividing the next expected dividend by the difference between the required rate of return and the constant growth rate. However, users should be cautious of the model's sensitivity to assumed growth rates and required rates of return. It is most suitable for companies with consistent dividend growth but may not apply to non-dividend-paying stocks or those with unpredictable growth rates. Regular reassessment and adjustment of assumptions are crucial for accurate valuations in dynamic financial markets. 2. Discuss when it is appropriate to value a company using a fair market value model. 3. The fair market value (FMV) model is appropriate in situations where the traditional discounted cash flow (DCF) method may not be suitable. It is particularly useful when a company is not a going concern, such as during financial distress, liquidation, or when tangible assets, rather than projected cash flows, drive its value. This model is well-suited for natural resource companies facing volatile cash flows due to external factors like commodity prices. Additionally, the FMV model is valuable in complex capital structures, helping assess a company's value by considering current market conditions and tangible assets while accounting for preferred stock rights and liabilities. In summary, the FMV model is suitable when future cash flows are uncertain, and the value is better represented by current market values of assets and liabilities. 4. Explain the relationship between the required return and expected growth rates in the dividend discount model. 5. In the constant growth dividend discount model, the relationship between the required return and expected growth rates is critical for determining the value of a stock. The model operates on the premise that the required return must be greater than the growth rate of the dividend for the valuation to be meaningful. The sensitivity of the model to changes in these rates is significant: small adjustments in the required return or the dividend growth rate can lead to substantial variations in the stock's valuation. When the investor's required return closely approaches the growth rate of the dividend, the model indicates a pronounced exponential increase in the stock's value. This sensitivity highlights the delicate balance between the investor's expected return and the anticipated growth in dividends, underscoring the importance of accurate estimation and alignment of these factors for a reliable stock valuation.

6. Define an undervalued firm in the context of its intrinsic value. In the context of intrinsic value, an undervalued firm is characterized by a current market price that is lower than its calculated intrinsic value based on fundamental analysis. Intrinsic value represents the theoretical worth of a security, considering factors such as the company's financial health and growth prospects. When the intrinsic value surpasses the market price, it signals that the market is undervaluing the company. Recognizing a firm as undervalued suggests an opportunity for investors, as the expectation is that over time, the market will adjust the stock price upward to align with the company's true value. This strategy assumes that markets can temporarily misprice assets, providing investors with the potential for capital appreciation as the market corrects its valuation. 7. Discuss the critical input variables a financial analyst must use in order to estimate a company’s sustainable growth rate. Estimating a company's sustainable growth rate (SGR) requires a thorough analysis of various critical input variables by a financial analyst. The sustainable growth rate represents the rate at which a company can grow its sales, earnings, and dividends over the long term without having to increase debt or equity. 8. Describe the difference between using dividends and free cash flows in discount valuation models. Ultimately, the choice between using DDM and FCFE models depends on the nature of the company being valued, its dividend policy, and the preferences of the investor conducting the valuation. Both models offer insights into different aspects of a company's financial health and are valuable tools in the valuation toolkit. 9. Identify the main reason that the H Model is used to value a firm. 10. The H model is a dividend discount model in which dividends change gradually from a high growth rate to a low normal growth over the years. 11. Describe how an investor can value a firm with substantial growth for a few years followed by more normal growth afterwards. For firms that do not pay dividends that are substantially different from their earnings, free cash flow can be used as an input variable in a present value model to estimate intrinsic value. The sustainable growth method can account for the maximum rate of growth a firm can attain without having to acquire more equity or debt. 12. Explain the concept of free cash flow to equity.

Free cash flow to equity is the amount of cash available to the common shareholders after the free cash flow to the firm has been determined and the firm’s bondholders and preferred shareholders have been paid. 10. Compare and contrast PE, PS, PCF, and PB ratios. The price-to-earnings ratio is the most commonly used relative valuation measure. Price divided by earnings for one firm is compared to PE ratios of other firms to judge relative value. The PEG ratio is a firm’s PE ratio divided by its EPS growth rate. Lower PEG ratios imply undervaluation. The price-to-sales ratio is the ratio of a firm’s stock price to its revenues per share. The price to cash flow ratio is the ratio of a firm’s stock price to its cash flow per share. The price-to-book ratio is the ratio of the firm’s stock price to its book value of equity per share.

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