Download Written exam 2008 spring

LINKÖPING UNIVERSITY
Department of Finance
Name:
Id:
Øystein Fredriksen
Written assignment nr. 1
June 7, 2008, Saturday 08-12
Group
assignment
+
Written
assignment
+
Total
points
Grade
INVESTMENT VALUATION
722G79
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The written assignment does have 5 questions with total 30 p.
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On the group assignment you may get a total of 45 p.
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To get a pass degree you need in total 38p
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All answers must be written on this paper. Do not use extra paper.

If there are question you don’t understand the meaning of the question, write down your
interpretation of the question.
Good luck!
Øystein
The examiner will show up during the examinations hours.
Name
Id
Question 1 (5 p).
Explain the relationship between the P/E-ratio and the DCF model?
P/E-ratio
Value of company  P0 
DIV1
re  g
DIV1 = expected dividend next year
re = cost of equity
g = growth
Let dividends consist of earnings per share * b (payout ratio)
DIV1 = b * EPS1
Next years profits are related to this years profit + growth rate:
EPS1 = EPS0 * (1 + g)
We then get:
P0 
DIV1 = b * EPS0 * (1 + g)
b * EPS0 * (1  g )
re  g
And then
dividing
with EPS
P0
b * ( 1  g)
 P/E 
EPS0
re  g
Question 2 (5 p).
2(7)
Name
Id
Mention 5 situations or scenarios where the DCF model is not appropriate to
use as a valuation tool!
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Firms in trouble
Cyclical firms
Firms with unutilized assets
Firms with patents or product options
Firms in the process of restructuring
Firms involved in acquisitions
Private firms
Question 3 (5 p).
3(7)
Name
Id
a) When are the P/S-ratio better to use than the P/E-ratio?
When the company has has negative earnings
b) When is the relative valuation approach easiest to use?
• This approach is easiest to use when:
– There are a large number of assets comparable to the one being
valued
– These assets are priced in a market
– There exists some common variable that can be used to
standardize the price.
c) When is the DCF approach easiest to use?
• This approach is designed for use for assets (firms) that derive their
value from their capacity to generate cash flows in the future. It does
make your job easier, if the company has a history that can be used in
estimating future cash flows. It works best for investors who either
– have a long time horizon, allowing the market time to correct its
valuation mistakes and for price to revert to “true” value or
– are capable of providing the catalyst needed to move price to
value, as would be the case if you were an activist investor or a
potential acquirer of the whole firm.
d) What do beta measure?
The relative risk of one company compared to the market
e) What factors affect the risk premium?
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Risk free rate
Market (stock market) situation
Political risk
Structure of the country’s economic situation
Question 4 (5 p)
4(7)
Name
Id
Let’s assume that you have done a DCF valuation of a company. Below we
present 5 situations. You should decide how each situation affects the DCF
value of your company. It doesn’t matter what kind of company we are talking
about.
a) The company takes on more debt but also give out dividends in the same
amount, meaning the capital structure has not changed?
The question is wrong because you can’t change proportion of debt and have
the same capital structure, sorry
b) Increasing growth rate?
Higher cash-flows – higher value of the company
c) The company takes on more debt and gets a higher financial leverage.
Higher financial leverage – higher cost of capital – lower value of the company
d) Increasing interest rates.
More expensive debt – higher cost of capital – lower value of the company
e) The beta value of the company goes from 1,4 to 1,2.
The risk of the company has gone down – lower cost of capital – higher value of
the company
Question 5 (10 p)
5(7)
Name
Id
National City, a bank holding company, reported earnings per share of $2.40 in
1993, and paid dividends per share of $1.06. The earnings had grown 7.5% a
year over the prior five years and where expected to grow 6% a year in the long
term (starting in 1994). The stock had a beta of 1.05 and traded for 10 times
earnings. The bond rate was 7%, the risk premium is 5.5%
a) Estimate the P/E-ratio for Nation City. (5 p)
Payout ratio 
1,06
 44,07%
2,40
Expected growth rate = 6%
Cost of equity = 7% + 1,05 * 5,5% = 12,8%
P/E - ratio 
0,4417 *1,06
 6,91 (same calculation as in question 1)
0,128 - 0,06
6(7)
Name
Id
b) What long-term growth rate is implied in the firm’s current P/E-ratio?
(5 p)
P/E - ratio  10 
g
0,4417 * (1  g)
Then we solve the equation find g:
0,12775 - g
1,2775 - 0,4417
 8%
1,4417
7(7)