FNCE30001 Lecture Notes - Lecture 11: Muumuu
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The discounted dividend model can be used to value divisions and firms that do not pay dividends. For the discounted dividend model, a firm's weighted average cost of capital is used as the discount rate. For the corporate valuation model, a firm's cost of equity is used as the discount rate. |
For the constant growth model to hold, a firm's cost of equity needs to be greater than its constant dividend growth rate (i.e., rs > g). From the constant growth model, if the constant dividend growth rate is equal to zero, a firm's share price is equal to the constant dividend divided by the cost of equity (i.e., g=0). If a company's constant dividend growth rate is negative, the formula for the constant growth model cannot be applied. |
The internal rate of return method (IRR) assumes that cash flows are reinvested at the internal rate of return. The modified internal rate of return method (MIRR) assumes that cash flows are reinvested at the weighted average cost of cpaital. For mutually exclusive projects, if there is a conflict between NPV and IRR, the project with the highest IRR is chosen. The IRR is independent of a firm's weighted average cost of capital. |
The WACC only represents the "hurdle rate" for a typical project with average risk. Therefore, the project's WACC should be adjusted to reflect the project's risk. Firms with riskier projects generally have a lower WACC. Holding all else constant, an increase in the target debt ratio tends to lower the WACC. |
Short-term bond prices are less sensitive than long-term bond prices to interest rate changes. Companies are not likely to call bonds unless interest rates have declined significantly. Thus, the call provision is valuable to firms but detrimental to long term investors. On balance, bonds that have a sinking fund are regarded as being safer than those without such a provision. |
If beta < 1.0, the security is less risky than average. According to the Security Market Line (SML), in general, a company’s expected return will double when its beta doubles. According to the Security Market Line (SML), if a portfolio of real world stocks has a beta of zero, the required rate of return for the portfolio is equal to the risk-free rate. |
7.37%. 11.05%. 8.32%. |
It ignores cash flows occurring after the payback period. It ignores the time value of money, that is, dollars received in different years are all given the same weight. |
1.82. 2.00. 1.94 |
undervalued. overvalued. |
13.92%. 16.34%. 12.17%. |
$221.86. $195.23. $257.35. |
10.82%. 11.76%. 9.64%. |
10 years. 4.58 years. 6.12 years. |
12.04%. 14.93%. 9.15%. |
1.24 years. 1.62 years. 1.15 years.
|
- Classify the following changes in each of the accounts as either an outflow or an inflow of cash. (1 Mark – 0.2 each)
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a. Is a decrease in land and buildings an inflow or an outflow of​ cash?
b. Is an increase in accounts payable an inflow or an outflow of​ cash?
c. Is a decrease in vehicles an inflow or an outflow of​cash?
d. Is an increase in accounts receivable an inflow or an outflow of​cash?
e) Is the payment of dividends an inflow or an outflow of​cash?
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- Robert Arias recently inherited a stock portfolio from his uncle. Wishing to learn more about the companies in which he is now​invested, Robert performs a ratio analysis on each one and decides to compare them to each other. Some of his ratios are listed here:
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 |
Island |
Burger |
Fink |
Roland |
 |
Ratio |
Electric Utility |
Heaven |
Software |
Motors |
|
Current ratio |
1.06 |
1.35 |
6.79 |
4.55 |
|
Quick ratio |
0.92 |
0.87 |
5.23 |
3.73 |
|
Debt ratio |
0.69 |
0.45 |
0.04 |
0.34 |
|
Net profit margin |
6.25% |
14.33% |
28.46% |
8.43% |
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Assuming that his uncle was a wise investor who assembled the portfolio with​ care, Robert finds the wide differences in these ratios confusing. Help him out.
a. What problems might Robert encounter in comparing these companies to one another on the basis of their​ratios? (Select all the answers that​) (0.25 Marks)
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- The four companies are in very different industries.
- The operating characteristics of firms across different industries vary significantly resulting in very different ratio values.
- Financial ratios from software companies are never very reliable.
- Caution must be exercised when comparing older to newer​firms,g., utility company vs. software'
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b. Why might the current and quick ratios for the electric utility and the​fast-food stock be so much lower than the same ratios for the other​ companies? (Select all the answers that​) (0.25 Marks)
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- Their inventory balances are going to be very close to zero because it is impossible to stockpile electricity and burgers.
- The explanation for the lower current and quick ratios most likely relates to poor management performance.
- Their accounts receivable balances are going to be much lower than for the other two companies.
- The explanation for the lower current and quick ratios most likely rests on the fact that these two industries operate primarily on a cash basis.
 c. Why might it be all right for the electric utility to carry a large amount of​debt, but not the software​ company? (Select all the answers that​) (0.25 Marks)
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- A high level of debt can be maintained if the firm has a​large, predictable, and steady cash flow.
- The software firm will have very uncertain and changing cash flow.
- Utilities tend to have steady cash flow requirements.
- The software industry is subject to greater competition resulting in more volatile cash flow.
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d. Why​ wouldn't investors invest all of their money in software companies instead of in less profitable​ companies? (Focus on risk and​) (Select all the answers that​ apply.) (0.25 Marks)
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1. Software companies tend to carry large debt which represents senior claims on the​companies'
2.Investors​wouldn't invest all of their money in software companies because their average collection period is usually very high.
3. By placing all of the money in one​stock, the benefits of reduced risk associated with diversification are lost.
4. Although the software industry has potentially high profits and investment return​performance, it also has a large amount of uncertainty associated with the profits.
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3.You have $5,100 to invest today at 11​% interest compounded annually. Find how much you will have accumulated in the account at the end of​: (0.5 Marks each)
(1)4years,
(2) 8 years, and​Â
(3) 12 years.
4.Using the values​ below, answer the questions that follow:
Amount of annuity |
Interest rate |
Deposit period​ (years) |
 |
​$500 |
9​% |
10 |
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- Calculate the future value of the​annuity, assuming that it is
- ​An ordinary annuity. (0.5 marks)
- ​An annuity due. (0.5 marks)
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- Compare your findings in parts a​(1) and a​(2). All else being​identical, which type of annuity—ordinary or annuity due—is preferable as an​ investment? Explain why. (0.5 Marks)
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