Chapter 13  Equity Valuation
CHAPTER 13
EQUITY VALUATION
1.
Theoretically, dividend discount models can be used to value the stock of rapidly
growing companies that do not currently pay dividends; in this scenario, we would be
valuing expected dividends in the relatively more distant future.
However, as a
practical matter, such estimates of payments to be made in the more distant future are
notoriously inaccurate, rendering dividend discount models problematic for valuation
of such companies; free cash flow models are more likely to be appropriate.
At the
other extreme, one would be more likely to choose a dividend discount model to value
a mature firm paying a relatively stable dividend.
2.
It is most important to use multistage dividend discount models when valuing
companies with temporarily high growth rates.
These companies tend to be companies
in the early phases of their life cycles, when they have numerous opportunities for
reinvestment, resulting in relatively rapid growth and relatively low dividends (or, in
many cases, no dividends at all).
As these firms mature, attractive investment
opportunities are less numerous so that growth rates slow.
3.
The intrinsic value of a share of stock is the individual investor’s assessment of the true
worth of the stock.
The market capitalization rate is the market consensus for the
required rate of return for the stock.
If the intrinsic value of the stock is equal to its
price, then the market capitalization rate is equal to the expected rate of return.
On the
other hand, if the individual investor believes the stock is underpriced (i.e., intrinsic
value < price), then that investor’s expected rate of return is greater than the market
capitalization rate.
4.
MV = 10 + 90 = 100 mil
BV = 10 + 60 – 40 = 30 mil
MV / BV = 100 / 30 = 3.33
5.
g = .6 x .10 = .06
price = 2 / (.08  .06) = 100
P/E = 100 / 5 = 50
6.
k = .04 + .75 (.12.04) = .10
Price = 4 / (.10  .04) = 66.66
7.
Price with no growth = 6 / .10 = 60
g = .60 x .15 = .09
Price with growth = 2.40 / (.10  .09) = 240
PVGO = 240 – 60 = 180
131
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Chapter 13  Equity Valuation
8.
300
EBIT
105
Taxes
195
Net Income
20
+ depreciation
60
 CapEx
30
 increase in WC
125
FCF
9.
FCFE = 205 – 22 x (1  .35) + 3 = 193.70
Value = 193.70 / (.12  .03) = $2,152.22
10. P = $2.10/0.11 = $19.09
11. HighFlyer stock
k = r
f
+
β
(k
M
– r
f
) = 5% + 1.5(10% – 5%) = 12.5%
Therefore:
41
.
29
$
04
.
0
125
.
0
50
.
2
$
1
0
=

=

=
g
k
D
P
12.
a.
False. Higher beta means that the risk of the firm is higher and the discount rate applied
to value cash flows is higher.
For any expected path of earnings and cash flows, the
present value of the cash flows, and therefore, the price of the firm will be lower
when risk is higher.
Thus the ratio of price to earnings will be lower.
b.
True.
Higher ROE means more valuable growth opportunities.
c.
Uncertain.
The answer depends on a comparison of the expected rate of return
on reinvested earnings with the market capitalization rate.
If the expected rate
of return on the firm's projects is higher than the market capitalization rate, then
P/E will increase as the plowback ratio increases.
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 Spring '11
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 Current, Dividend yield, P/E ratio, PEG ratio

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