FINA1221 Lecture Notes - Lecture 3: Discount Window, Net Present Value, Byrsonima Crassifolia
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Ques.1 Attempt ALL multiple choice question (1 x 5 = 5)
1.
1. consider a corporate bond with a $1000 face value, 10% coupon with semiannual coupon payments, 5 years until maturity, and currently is selling for (has a cash price of) $1,113.80. The next coupon payment will be made in 63 days and there are 182 days in the current coupon period. The clean price for this bond is closest to
a. | $1146.50 |
b. | $1065.70 |
c. | $1113.80 |
d. | $1081.10 |
2. Which ofthe costs would you consider when making a capital budgeting decision ?
a. Sunk cost
b. Opportunity cost
c. Interest expense
d. Fixed overhead cost
3.Which of the statements is False ?
a. In general, the difference between the cost of capital and the IRR is the maximum amount of estimation error in the cost of capital estimate that can exist without altering the original decision.
b. The IRR can provide information on how sensitive your analysis is to errors in the estimate of your cost of capital.
c. If you are unsure of your cost of capital estimate, it is important to determine how sensitive your analysis is to errors in this estimate.
d. If the cost of capital estimate is more than the IRR, the NPV will be positive.
4.Which of the follwoing statements is False ?
a. If investors have homogeneous expectations, then each investor will identify the same portfolio as having the highest Sharpe ratio in the economy.
b.Homogeneous expectations are when all investors have the same estimates concerning future investments and returns.
c.There are many investors in the world, and each must have identical estimates of the volatilities, correlations, and expected returns of the available securities.
d. The combined portfolio of risky securities of all investors must equal the efficient portfolio.
5.Which ofthe statements is false regarding profitable and unprofitable growth ?
a. If a firm wants to increase its share price, it must cut its dividend and invest more.
b. If the firm retains more earnings, it will be able to pay out less of those earnings, which means that the firm will have to reduce its dividend.
c. A firm can increase its growth rate by retaining more of its earnings.
d. Cutting the firmâs dividend to increase investment will raise the stock price if, and only if, the new investments have a positive NPV.
As a financial analyst, you must evaluate one of your companyâs proposed projects to produce
widgets. The necessary equipment would cost $55,000 plus $10,000 for installation. Annual sales
of widgets are expected to be 4,000 units at a price of $50 each. The projectâs life is 3 years. As a
result of the project, current assets would increase by $5,000 and payables would increase by
$3,000. At the end of the 3 years, the equipment purchased could be sold for $10,000.
Depreciation would be based on the MACRS 3-year class so the applicable rates would be 33.33%,
44.44%, 14.82% and 7.41%. Variable costs are estimated to be 70% of sales revenue, fixed costs
excluding depreciation would be $30,000 per year, the marginal tax rate is 40% and the
corporationâs cost of capital is 11%.
a.
Calculate the initial capital outlay, operating cash flows, and terminal cash flow for this project.
b.
Should the project be accepted?
c.
Suppose management is uncertain about the exact unit sales. What would be the projectâs
NPV if unit sales turned out to be 20% below forecast but other inputs were as forecasted?
Would this change the decision?
d.
The CFO asks you to do a scenario analysis using these inputs:
Scenario | Probability | Unit Sales | Variable Cost % |
Best Case | 25% | 4,800 | 65% |
Base Case | 50% | 4,000 | 70% |
Worst Case | 25% | 3,200 | 75% |
Calculate the expected NPV, standard deviation and coefficient of variation.
e.
The firmâs projects CVs generally range from 1.0 to 1.5. A 3% risk premium is added to the
wacc if the intial CV exceeds 1.5, and the wacc is reduced by 0.5% if the CV is 0.75 or less.
What should be the wacc for this project? What are the revised values for expected NPV,
standard deviation and CV? Would you recommend that the project be accepted? Explain.
International Research Journal of Applied Finance ISSN 2229 â 6891
Vol. VI Issue â 8 August, 2015 Case Study Series
A Stock Valuation Case: An Application of the âMethod of Comparablesâ for Macyâs Shares
Halil D. Kaya* ,Julia S. Kwok
Abstract
The primary focus of this case is the application of the âMethod of Comparablesâ in the estimation of the value of a security. An investment decision will be made based on the comparison of the selling price and the estimated value. A security will be good for purchase if the estimated value is higher than the market price. This method utilizes basic financial ratios that are commonly provided by financial web sites. First, using Yahoo Finance website, the pricing, sales, book value of equity and shares outstanding data are collected for both the target firm and the competitor firms. Then, the pricing multiples (i.e. price earnings ratio, price to sales ratio and price to book ratio) of the competitors are calculated. After that, those multiples along with the target firmâs earnings, sales, book value and shares outstanding data are used to estimate target firmâs share value. The case also examines the impact of treating ânegativesâ in the data. Students will learn that replacing negative earnings with zeros tend to induce less bias in target firmâs value estimation than excluding the ânegativeâ data altogether.
Introduction
March 14, 2015 was a sunny day. Mary took advantage of the nice weather to have lunch at the Mall. On her way back to work, she walked by Susanâs investment office. Susan was Maryâs college roommate. They both liked shopping together to find new fashionable clothes. Looking at her watch, Mary realized she had half an hour to spend. She thought she would drop by and say hello to Susan.
The Performance of Macyâs
âHi, Susan, how are you?â How is your business?â said Mary. Susan was a recent finance graduate. Susan replied, âI am doing fine. Thank you. After so many years, the market is still recovering from the mortgage crisis; many investors have been buying back stocks that they have sold during the crisis. What are you up to?â âI want to start my investment in securities, too. I have a couple thousand dollars, would Macyâs be a good stock to invest in now? That was our favorite store to shop among all of the department stores,â Mary exclaimed. She added, âAlso, I read from Motleyâs Foolâs article on Macyâs today about its earnings per share growth for the last 16 quartersâ (Zahid Waheed, 2014).
In response to Maryâs questions, Susan checked the monthly adjusted returns of Macyâs in Yahoo Finance. She found that, since March 2010, Macyâs stock price had an average annual increase of 23.5% over the last 5 years. The stock rose from $19.98 to $57.38. Susan then told Mary that Macyâs was indeed a growing stock. She added that its success could be attributed to the omni-channel integration, e-commerce and magic selling strategies which allowed merging of sales channels, online shopping and better customer care. Since investment strategy 101 is to buy low, and sell high, given Macyâs stock price had been going up, Susan was not sure whether Macyâs was currently overvalued or undervalued by the market.
The Method of Comparables
Susan remembered her class lecture on the two types of valuation of stocks, namely absolute and relative evaluation. The absolute evaluation focuses on finding the intrinsic value of the security based on fundamentals. That involves more complicated models of discounting cash flows from dividends, operations and residual income.
On the other hand, relative evaluation is quick and easy to use. It assumes two similar securities should sell for one price in an efficient market, i.e. âLaw of One Price.â So an analyst can estimate its stock price by multiplying target companyâs specific earnings, sales and equity value data by the earning, sales and equity âper shareâ financial multiples of its competitors.
Since Mary was not familiarized with financial models, Susan decided to use the easy-toperform-and-analyze âComparables Methodâ to estimate the relative value of Macyâs stock.
The Financial Data
Dillards, JC Penney and Nordstrom were selected as competitors of Macyâs as they were all in retail department store business. Susan would need some financial data regarding these companies. She went to SECâs (i.e. Securities and Exchange Commission) website and downloaded these companiesâ most recent balance sheet and income statement data. Out of those statements, she knew that she would need the EPS (i.e. earnings per share), the sales number, the number of outstanding shares, and the book value of equity. She also knew that she would need the current share price for each company. After some work, she had found all the necessary information to run the analysis. Below were the data that she had gathered:
All data are in US$ except for the number of outstanding shares. The share price as of March 15, 2014 is shown in the first column. The âEarnings per shareâ is shown in the second column. The third column reports the book value of equity. The last column shows the number of outstanding shares.
Firm | P ($) | EPS ($) | Sales ($) | BV of equity ($) | # of shares |
Macy's | 58.58 | 3.93 | 27,931 mil. | 6,249 mil. | 378.3 mil. |
Dillard's | 90.61 | 7.10 | 6,532 mil. | 1,992 mil. | 45.6 mil. |
JC Penney | 8.71 | -5.57 | 11,859 mil. | 3,087 mil. | 249.3 mil. |
Nordstrom | 61.33 | 3.77 | 12,166 mil. | 2,080 mil. | 194.5 mil. |
The Decision
Susan thinks that the following steps would be necessary to perform the analysis:
1.Based on the data above, calculate Sales per share, BV of equity/share values of all firms. Note that EPS is directly given.
2.Calculate P/E, P/Sales, and P/B for all of Macyâs competitors based on the data obtained.
3.Find the average of the P/E, P/Sales, and P/B multiples for the three competitors.
4.Multiply those averages calculated in step 3 with Macyâs EPS, Sales per share, and BV of equity/share values, respectively to get three value estimates for Macyâs shares.
5.The average of the three estimates would then be Susanâs best estimate of Macyâs value per share.
answer # 1-5 please