Anz Tutorial 2 PDF

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Suggested Solutions for Tutorial Questions of Lecture Week 2 Valutaion I Chapter 11: 1) The price of a security is the current price someone would receive for exchanging the security in the market place. Prices are set by market forces. In the case of actively traded assets such as financial securities, the current price is readily determined by reference to market quotations. Moreover, when dealing with equity instruments such as shares, market prices can easily be obtained via trading activity on the stock exchange. However, the value of a security is what the security is worth to the investor. The value takes into account future cash flows and expected return-risk trade-offs. One view is that price is a relative concept while value is an absolute concept. When considering any investment, the investor will assess the value of the asset and then compare this value to the current price of the asset. The assessment of value is subjective and investor specific, whereas price is objective and determined in the market. If the asset’s value is less than its current price then the asset is over-priced and the investor will either leave the asset out of their portfolio or seek to short sell the asset at the prevailing market price. Conversely, if the asset’s value exceeds its current price then the asset represents a bargain to the purchaser and its purchase is expected to increase the net wealth of the investor’s portfolio.

2) The present value model seeks to identify future cash flows which flow to the asset and discount these cash flows using a rate which reflects the time value of money and relative risk. The idea is to express all asset values at a common point in time (i.e. current time) so that a comparison can be made. The present value is the amount that creates indifference between receiving the present value today and receiving the equivalent set of future cash flows implied by the asset.

4)

The difference between the dividend and earnings streams is timing, when the company’s directors decide to distribute the earnings (i.e. the dividend payout ratio). If the company adopts a 100% payout ratio, then the dividend and earnings streams will be identical. However, even if the payout ratio is less than 100% (i.e. some earnings are retained), in theory it can be demonstrated that in perfect capital markets dividend policy is independent of firm value. If we invoke an assumption of zero growth such that any new investment earns a return equal to the cost of capital such that the new investment has a zero NPV. In this case the model collapses into perpetuity. As no growth occurs, all periodic earnings are equal.

5) Both the dividend discount model (DDM) and earnings capitalisation model (ECM) are based upon the present value model. Hence, both models start from the same base of (1) attempting to forecast future cash flows and (2) discount them back to the current time. The difficulty with the present value model is forecasting the future cash flows. To make this task easier, various assumptions can be invoked. The DDM invokes the assumption of a constant growth rate indefinitely while the ECM assumes zero growth. It can be shown that the ECM flows from the DDM. Hence, the models are internally consistent. The key is to recognise that each model makes different assumptions about future cash flows and therefore their applicability depends upon the relationship of these assumptions to the actual circumstances.

8)

In its strict form, the dividend discount model posits that the value is a function of a constant growth rate assumption over an indefinite horizon. This assumption is generally inconsistent with reality. However, the DDM can be modified to cope with other growth situations. For example, the model can be adapted to the situation of deferred growth where there is zero growth over some initial period. Similarly, a situation of no growth can be accommodated by simply entering a value for g of zero, thereby collapsing the model to a perpetuity. The one situation where the DDM is problematic is continual variable growth. If growth is constant over some periods but varies between these periods, the DDM can still be used by valuing each stage of growth separately and then estimating total value as the sum of these components. However, if growth varies each period, the DDM cannot generally be used and the original present value model is most appropriate.

9) Most valuation models have a sound theoretical base. However, as valuation models require estimates of future events these are subject to the problems of forecasting. Hence, necessarily there is subjectivity in the practical implementation of valuation models. That is, the problem is not the model itself, but rather obtaining the necessary values of the input parameters to implement the model. The present value model requires estimates of future cash flows and assumptions can be made to simplify the forecasting task. However, the assumptions themselves usually require further subjective input such as a growth rate in the case of the dividend discount model. Moreover, any model which is based on the present value concept requires a discount rate which incorporates the time value of money and relative risk. There are many different approaches to obtaining values for the input parameters, especially the growth rate of cost of capital. Most approaches seek to utilise available data to provide some objectivity to the task. Examples include trend lines based on past data, time-series models, expert forecasts, formal models (e.g. the CAPM), inverting of valuation models where the price is known and the use of other financial data (e.g. the plowback technique). No one approach will always provide the most accurate estimate and hence each technique results in estimation, and ultimately, valuation errors. The extent of the error depends upon individual circumstances prevailing at the time. However, it is not uncommon for small input errors to result in large valuation errors, especially when the

values of the cost of capital and growth rate are close to each other.

11) Free cash flows (FCF) are generally defined as those cash flows which remain in the business after meeting all expenditure and investment outlays. That is, FCF can be viewed as the residual cash available for distribution to shareholders. If the FCF is valued then this is the same as valuing the potential cash dividend stream. The advantage of using FCF rather than dividends as the focus of valuation is that dividends are difficult to forecast because of such factors as sticky dividend policies. FCF is a different way of viewing dividends. First, FCF are derived from reported numbers on which future estimates are usually available. Second, FCF are taken from the overall firm perspective (rather than per share). The FCF approach still involves present value principles as the FCFs are discounted back to a present value. Thus, the concept is simply another way of estimating future cash flows within the context of the general present value model. The FCF approach requires a forecast of each of the component FCF items and arrives at a series of FCFs which are then discounted at the appropriate cost of equity. However, the components in the FCF calculation are linked. The rate of return on investment outlays yields the earnings figure, and the growth of the firm yields the investment outlay. An advantage of the FCF approach is that these links reduce the need for many separate forecasts.

12 a P

D1 0.29(1.03)  ( k e  g) (0.07  0.03)  $7.47

b

P

D1 0.29(1.03)  ( k e  g) (0.09  0.03)  $4.98

c

P

D1 0.29(1.04)  ( k e  g) ( 0.09  0.04)  $6.03

d

P

D1 (ke  g )

That is; k e  D1 / P  g ke  0.29(1 .03) / 7 .20  0 .03  0 .0715  7 .15%

17 P = EPS x P/E P/E = P/EPS P/E = 4.89/ 0.66 = 7.41

18 D0 (1  g) (ke  g ) P(k e  g )  D0 (1  g )

P

Pk e  Pg  D0  D0 g Pk  D0 g e (D0  P ) 18.76(0.10)  0.80  0.055 (0.80  18.76)  5.5% g...