131. Rome Corporation is expected have EBIT of $2.3M this year. Rome Corporation is in the30% tax bracket, will report $175,000 in depreciation, will make $175,000 in capitalexpenditures, and have no change in net working capital this year. What is Rome's FCFF?A.2,300,000B.1,785,000C.1,960,000D.1,610,000E.1,435,000FCFF = EBIT(1-T) + depreciation - capital expenditures - increase in NWC or 2,300,000(.7)+ 175,000 - 175,000 - 0 = 873,000Difficulty: Moderate18-60

Chapter 18 - Equity Valuation ModelsShort Answer Questions132. Discuss the Gordon, or constant discounted dividend, model of common stock valuation.Include in your discussion the advantages, disadvantages, and assumptions of the model.The Gordon model discounts the expected dividends for the coming year by the required rateof return on the stock minus the growth rate. The growth rate is annual growth in dividends,and is assumed to be a constant annual growth rate indefinitely. Obviously such anassumption is not likely to be met; however, if dividends are expected to grow at a fairlyconstant rate for a considerable period of time the model may be used. The model alsoassumes a constant rate of growth in earnings and in the price of the stock. As a result, thepayout ratio must be constant. In reality, firms have target payout ratios, usually based onindustry averages; however, firms will depart from these target ratios in order to maintain theexpected level of dividends in the event of a decline in earnings. In addition, the constantgrowth assumes that the firm's return on equity is expected to be constant indefinitely. Ingeneral, firm's return on equity (ROE) varies considerably with the economic cycle and withother variables. Some firms, however, such a public utilities have relatively stable ROEs overtime. Finally, the model requires that the required rate of return be greater than the growth rate(otherwise the denominator is negative and an undefined firm value results). In spite of theserestricting assumptions, the Gordon model is widely used because the model is easy to useand understand, and, if the assumptions are not grossly violated, the model may produce arelatively valid valuation assessment.Feedback: The purpose of this question is to ascertain whether the student understands theGordon model, the restrictions of the model, and why the model continues to be usedextensively in spite of the restricting assumptions.Difficulty: Moderate18-61

Chapter 18 - Equity Valuation Models133. The price/earnings ratio, or multiplier approach, may be used for stock valuation.Explain this process and describe how the "multiplier" varies from the one available in thestock market quotation pages.The price earnings ratio used for stock valuation should be the predicted price/earnings ratio.That is, the ratio of the current price of the stock divided by the expected earnings per sharefor the coming year. Thus, the ratio is the stock price as a percentage of expected earnings. Allvaluation models should be based on what the investor is expecting to receive in the coming

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