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I both two stage valuation models allow for two

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i. Both two-stage valuation models allow for two distinct phases of growth, an initial finite period where the growth rate is abnormal, followed by a stable growth period that is expected to last indefinitely. These two-stage models share the same limitations with respect to the growth assumptions. First, there is the difficulty of defining the duration of the extraordinary growth period. For example, a longer period of high growth will lead to a higher valuation, and there is the temptation to assume an unrealistically long period of extraordinary growth. Second, the assumption of a sudden shift form high growth to lower, stable growth is unrealistic. The transformation is more likely to occur gradually, over a period of time. Given that the assumed total horizon does not shift (i.e., is infinite), the timing of the shift form high to stable growth is a critical determinant of the valuation estimate. Third, because the value is quite sensitive to the steady-state growth assumption, over- or under-estimating this rate can lead to large errors in value. The two models share other limitations as well, notably difficulties in accurately forecasting required rates of return, in dealing with the distortions that result from substantial and/or volatile debt ratios, and in accurately valuing assets that do not generate any cash flows. 11. a. The formula for calculating a price earnings ratio (P/E) for a stable growth firm is the dividend payout ratio divided by the difference between the required rate of return and the growth rate of dividends. If the P/E is calculated based on trailing earnings (year 0), the payout ratio is increased by the growth rate. If the P/E is calculated based on next year’s earnings (year 1), the numerator is the payout ratio. P/E on trailing earnings: P/E = [payout ratio × (1 + g)]/(r g) = [0.30 × 1.13]/(0.14 0.13) = 33.9 P/E on next year's earnings: P/E = payout ratio/(r g) = 0.30/(0.14 0.13) = 30.0 18-5
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b. The P/E ratio is a decreasing function of riskiness; as risk increases the P/E ratio decreases. Increases in the riskiness of Sundanci stock would be expected to lower the P/E ratio. The P/E ratio is an increasing function of the growth rate of the firm; the higher the expected growth the higher the P/E ratio. Sundanci would command a higher P/E if analysts increase the expected growth rate. The P/E ratio is a decreasing function of the market risk premium. An increased market risk premium would increase the required rate of return, lowering the price of a stock relative to its earnings. A higher market risk premium would be expected to lower Sundanci's P/E ratio. 12. a. The sustainable growth rate is equal to: plowback ratio × return on equity = b × ROE where b = [Net Income – (Dividend per share × shares outstanding)]/Net Income ROE = Net Income/Beginning of year equity In 2000: b = [208 – (0.80 × 100)]/208 = 0.6154 ROE = 208/1380 = 0.1507 Sustainable growth rate = 0.6154 × 0.1507 = 9.3% In 2003: b = [275 – (0.80 × 100)]/275 = 0.7091 ROE = 275/1836 = 0.1498 Sustainable growth rate = 0.7091 × 0.1498 = 10.6% b. i. The increased retention ratio increased the sustainable growth rate.
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