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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 The written assignment does have 5 questions with total 30 p. On the group assignment you may get a total of 45 p. To get a pass degree you need in total 38p 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! 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? 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)