wk 5 - DDM and FCFE_2011s2

wk 5 - DDM and FCFE_2011s2 - FINS3641 SECURITY ANALYSIS AND...

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Prepared by Henry Yip 1 FINS3641 SECURITY ANALYSIS AND VALUATION PART 2: DISCOUNT CASH FLOW VALUATION MODELS Week 5: Dividend Discount Models and Free Cash Flow to Equity Discount Models Topics: Constant growth, 2-stage and 3-stage dividend discount models (DDMs) Usage of DDMs Free cash flows to equity (FCFE) defined Constant growth, 2-stage and 3-stage FCFE discount models Learning Outcomes: Learn when and how to use the various DCF valuation models Reading: Damodaran Chapter 13-14
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FINS3641 SAV Week 5: DDMs and FCFE Discount Models 2 What’s the Next Step? After discussing the terminal value of a firm for each of the three DCF models: FCFF: TV n = ࡱ࡮ࡵࢀ ࢔శ૚ ሺ૚ି࢚ࢇ࢞ ࢘ࢇ࢚ࢋሻሺ૚ିࢉࢇ࢖࢏࢚ࢇ࢒ ࢘ࢋ࢏࢔࢜ࢋ࢙࢚࢓ࢋ࢔࢚ ࢘ࢇ࢚ࢋ ࡯࢕࢙࢚ ࢕ࢌ ࡯ࢇ࢖࢏࢚ࢇ࢒ – ࡿ࢚ࢇ࢈࢒ࢋ ࢍ࢘࢕࢚࢝ࢎ ࢘ࢇ࢚ࢋ where b n = stable growth rate ÷ ROC FCFE: TV n = ࡲ࡯ࡲࡱ ࢔శ૚ ࡯࢕࢙࢚ ࢕ࢌ ࡱ࢛ࢗ࢏࢚࢟ – ࡿ࢚ࢇ࢈࢒ࢋ ࢍ࢘࢕࢚࢝ࢎ ࢘ࢇ࢚ࢋ DDM: TV n = ࡰࡼࡿ ࢔శ૚ ࡯࢕࢙࢚ ࢕ࢌ ࡱ࢛ࢗ࢏࢚࢟ – ࡿ࢚ࢇ࢈࢒ࢋ ࢍ࢘࢕࢚࢝ࢎ ࢘ࢇ࢚ࢋ where DPS n +1 = EPS n +1 (1- b n ) stable retention ratio = b n = stable growth rate ÷ RO E stable payout ratio = (1- b n ) = 1 - stable growth rate ÷ RO E It’s time to explain the choice of cash flows and the models to discount the cash flows, growth patterns assumed for the cash flows prior to n, after which the firm enters the final stage of stable growth
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FINS3641 SAV Week 5: DDMs and FCFE Discount Models 3 The Choice between Equity Valuation and Firm Valuation 1) Use Equity Valuation i) for firms which have stable leverage , whether high or not, for the following reasons: For firms with unstable leverage, we have to estimate the amount of net debt issued (new debt raised - old debt paid off) year after year: FCFE = Net income – Equity reinvested (recall our discussion in Wk 4, page 10) = Net income – [(capital expenditure – depn) + ( non-cash working capital) - (new debt issued – debt repaid)] With stable leverage , we can apply the short cut method to simplify the estimation of FCFE by assuming that a fixed proportion of the firm’s reinvestment is funded by debt . Denote δ as the proportion of net capital expenditure and non-cash working capital changes that is funded by debt, then we may write FCFE = Net income – [(capital expenditure – depn) + ( non-cash working capital)] × (1 – δ ) = Net income – (capital expenditure – depn) × (1 – δ ) – ( non-cash working capital) × (1 – δ ) ii) if equity (stock) is being valued
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FINS3641 SAV Week 5: DDMs and FCFE Discount Models 4 The Choice between Equity Valuation and Firm Valuation 2) Use Firm Valuation i) for firms with a leverage, whether too high or too low, that is expected to change over time Rationale: Unstable leverage would require the estimation of new issues and repayments of debts to
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This note was uploaded on 03/01/2012 for the course FINS 3641 taught by Professor Hyip during the Three '11 term at University of New South Wales.

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wk 5 - DDM and FCFE_2011s2 - FINS3641 SECURITY ANALYSIS AND...

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