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aem4280_finanalTA2009

aem4280_finanalTA2009 - AEM 4280 Spring 2009 TA review...

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AEM 4280 Spring 2009 TA review section for final

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Three Valuation Models DDM DCF RIM
Dividend Discount Model Terminal dividend is assumed to follow perpetuity with growth g d P TV E T T T - = = + ρ 1 Dividend discount model says: T E T T t t t E TV d P ρ ρ + = = - 1 0 3 1 2 0 2 3 ..... T T T T E E E E E d d d d TV P ρ ρ ρ ρ ρ = + + + + + In other words…. G

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Two small points E ρ refers to gross discount rate e.g. 1.12, while r refers to net discount rate e.g. 0.12 In terminal value calculation, gross discount rate should be used with gross growth rate e.g. 1.05, and net discount rate should be used with net growth rate e.g. 0.05. refers one plus growth rate i.e. G = 1+g G
Does Dividend Discount Analysis make sense? YES Dividends are what shareholders get, so forecast them Dividends are usually fairly stable in the short run and hence easy to forecast NO Dividends payout is not related to value, at least in the short run; dividend forecasts ignore the capital component of payoffs You have to forecast for much longer periods Terminal values for shorter periods are hard to calculate with any reliability. Bottom Line: DDM works best when payout is permanently tied to the value generation in the firm. For example, when a firm has a fixed payout ratio (dividends/earnings).

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Cash flows from all projects for a going concern: + ρ - + ρ - + ρ - = 3 F 3 3 2 F 2 2 F 1 1 F 0 I C I C I C V D 0 F 0 E 0 V V V - = The Discounted Cash Flow Model (DCF):
The Continuing Value for the DCFM g I C CV F T T T - - = + + ρ 1 1 Capitalize terminal free cash flow with growth g g I C CV F T T T - - = ρ ) ( OR... G G G

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Notice a couple of things 1) In DCF model, you want to use the discount rate for firm (cost of capital for the firm) rather than cost of capital for equity. 2) In DDM, you use cost of capital for equity . 3) We are ignoring tax here for now, but will introduce it later. 3) The growth rate G here refers to the gross growth rate (i.e. 1.09 rather than 0.09)
How to calculate free cash flow from financial statements? There are two cases: I) If you have the cash flow from operations from Statements of Cash Flows, then: Free Cash Flow = Cash Flow from Operations - Cash Investments in Operations II) If you have net income(earnings) but not the statement of cash flows, then you need to make accrual adjustment to net income to obtain FCF. We will first examine how to get FCF from reported cash flow.

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Example: Calculating Free Cash Flow Dell Computer, 2002 Reported cash flow from operations 3,797 Interest payments 31 Interest income* (314) Net interest payments (283) Taxes (35%) 99 Net interest payments after tax (65%) (184) Cash flow from operations 3,613 Reported cash used in investing activities 2,260 Purchases of interesting-bearing securities 5,382 Sales of interest-bearing securities (3,425) 1,957 Cash investment in operations 303 Free cash flow 3,310 *Interest payments are given as supplemental data to the statement of cash flows, but interest receipts usually are not. Interest income (from the income statement) is used instead; this includes accruals but is usually close to the cash interest received.
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