AFM273 Chapter 7: C7 Valuing Stocks

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cyanbat359

4 Nov 2016

School

University of Waterloo

Department

Accounting & Financial Management

Course

AFM273

Professor

Kenneth Vetzal

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Document Summary

Law of one price implies that to value any security, we must determine the expected cash flows an investor will receive from owning it. Dividend discount model: how to value a stock. Consider the cash flows for an investor in a 1 year stock. Future dividend payment and stock price in the timeline above are not known with certainty (based on investor"s expectations at the time the stock is purchased) The investor will be willing to pay a price today up to the point that this transaction has a 0. Npv (current price = pv of expected future dividend and sale price) Since cash flows are risky, cannot discount them using the risk-free interest rate, use equity cost of capital re. Equity cost of capital re: expected return of other investments available in the market with equivalent risk to the firm"s shares.

Related Questions

Ques.1 Attempt ALL multiple choice question (1 x 5 = 5)

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.

True or False questions

1-Starting to invest early for retirement increases the benefits of compound interest.

2- If the discount (or interest) rate is positive, the future value of an expected series of payments will always exceed the present value of the same series.

3- The market value of any real or financial asset, including stocks, bonds, or art work purchased in hope of selling it at a profit, may be estimated by determining future cash flows and then discounting them back to the present.

4- Yield to maturity is higher than the coupon interest rate if a bond is trading at Premium.

5- There exists a negative relationship between outstanding bond prices and going market interest rates.

6- The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock. No adjustment is needed for taxes because preferred dividends, unlike interest on debt, are not deductible by the issuing firm.

7- In case of conflict, one should always choose the IRR method (over the NPV method) because the IRR is inherently superior to the NPV method.

8- For capital budgeting and cost of capital purposes, the firm should assume that each dollar of capital is obtained in accordance with its target capital structure, which for many firms means partly as debt, partly as preferred stock, and partly common equity.

9- NPV and IRR methods are based on identical assumptions regarding reinvestment rate of future cash flows.

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Suppose that you have reached agreement with an equity investor over a forecast of your start-up companyâs operating and investing cash flows over the next 5 years. The forecast calls for operating cash flow to be -$100,000 in yearâs 1 and 2, turning and staying positive in year 3 and thereafter. Operating cash flow forecasts are $125,000, $175,000, and $250,000 in years 3, 4, and 5 respectively. The company would like to hold cash reserves (an ongoing cash balance) of $50,000 from the end of year 1 and will pay excess reserves (whatever cash is leftover) as dividends to investors, provided that future cash balances are not expected to become negative. At the end of the 5^th year the company is to be sold at a projected price that is 10 x operating cash flow (approximately net income). The investor is willing to invest upfront as much as necessary to finance the company until it becomes self-sufficient. The investor will receive a 40% interest in the company (40% of the stock).

Find the investorâs up-front investment in the company and her/his cash payments in years 1-5.

What is the investorâs return requirement (IRR) for this project?

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AFM273 Chapter 7: C7 Valuing Stocks

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