Finance Problem Set #1 - Valuation Concepts
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Questions and Answers

What is the after-tax cost of debt for the firm?

  • 4.50%
  • 6.25%
  • 4.19% (correct)
  • 7.50%

    • What is the calculated cost of equity for General Motors?

  • 9.125%
  • 7.49%
  • 6.45%
  • 12.30% (correct)

    • Which of the following correctly describes the market value weight of equity?

  • 50.00%
  • 94.76% (correct)
  • 75.00%
  • 25.86%

    • What is the cost of preferred stock for GM?

    <p>9.125% (A)</p> Signup and view all the answers

    What is the primary reason for the distinction between valuing cash flows to equity investors versus valuing cash flows to the entire firm?

    <p>Mismatching cash flows and discount rates can lead to significant valuation errors, and not recognizing what the present value of cash flows measures can lead to misinterpretations. (B)</p> Signup and view all the answers

    In the context of valuing a company, what does the present value of cash flows to all investors in the firm represent?

    <p>The value of the entire firm, including equity, debt, and preferred stock. (C)</p> Signup and view all the answers

    Why is it inappropriate to treat the present value of cash flows to the firm as the value of equity?

    <p>The present value of cash flows to the firm includes the value of debt and preferred stock, which are not part of equity. (A)</p> Signup and view all the answers

    Eastman Kodak has a beta of 1.10. If the six-month treasury bill rate is 3.25% and the arithmetic mean average premium earned by stocks over treasury bills is 8.41%, what is the estimated cost of equity using the Capital Asset Pricing Model (CAPM)?

    <p>12.50% (B)</p> Signup and view all the answers

    Eastman Kodak has a beta of 1.10. If the thirty-year bond rate is 6.25% and the geometric mean average premium earned by stocks over treasury bonds is 5.50%, what is the estimated cost of equity using the Capital Asset Pricing Model (CAPM)?

    <p>12.30% (A)</p> Signup and view all the answers

    When estimating the cost of equity using the Capital Asset Pricing Model (CAPM) for valuation purposes, why is the long-term bond rate generally preferred over the treasury bill rate as the risk-free rate?

    <p>Valuation is based upon a long time horizon, making the long-term bond rate a more appropriate risk-free rate. (A)</p> Signup and view all the answers

    An investor is trying to value stocks in Malaysia and notes that the market has risen 60% annually for the past two years, while the government borrowing rate is 15%, yielding an historical premium of 45%. Why might this historical premium not be a reliable basis for future risk premium estimates?

    <p>Two years is too short a period to establish a stable risk premium. (D)</p> Signup and view all the answers

    A data service reports a beta estimate of 0.90 for BMW. Which of the following statements best describes how this beta estimate should be used?

    <p>This beta estimate can be used in the Capital Asset Pricing Model (CAPM) to estimate BMW's cost of equity. (D)</p> Signup and view all the answers

    Which firm is expected to have the highest beta based on operating leverage?

    <p>CPC International (C)</p> Signup and view all the answers

    What is the unlevered beta for Kimberly Clark after applying the formula provided?

    <p>1.00 (D)</p> Signup and view all the answers

    What is the average unlevered beta of the comparable firms listed?

    <p>0.88 (D)</p> Signup and view all the answers

    What would be the beta of the equity if the high-technology firm divested its software business and paid the cash out as a dividend?

    <p>1.31 (B)</p> Signup and view all the answers

    Which company has the lowest beta among the firms listed in the food production industry?

    <p>Kellogg’s (B)</p> Signup and view all the answers

    What is the overall beta for the high-technology firm based on its divisions before any divestiture?

    <p>1.52 (C)</p> Signup and view all the answers

    What was Chiquita's beta estimated to be if the average D/(D+E) ratio during the regression was 30%?

    <p>1.02 (A)</p> Signup and view all the answers

    If Kimberly-Clark increases its debt/equity ratio to 30%, what would be its new beta?

    <p>1.21 (C)</p> Signup and view all the answers

    What is the debt ratio for Ralston Purina?

    <p>38.32% (A)</p> Signup and view all the answers

    Which beta should be used to value the software division for divestiture?

    <p>2.00 (D)</p> Signup and view all the answers

    Which firm's fixed costs are higher than its variable costs?

    <p>CPC International (D)</p> Signup and view all the answers

    What does the unlevered beta indicate about a firm?

    <p>The firm's risk relative to the market without debt. (B)</p> Signup and view all the answers

    How does the financial leverage of Chiquita affect its beta?

    <p>It misrepresents the risk level. (B)</p> Signup and view all the answers

    Based on the information provided, which company's beta indicates the lowest risk associated with its equity?

    <p>Kimberly-Clark (B)</p> Signup and view all the answers

    What would happen to the equity beta if the high-technology firm kept the cash from the divestiture within the firm?

    <p>It would decrease to 0.92 (C)</p> Signup and view all the answers

    What is the beta of International Paper, based on its given data?

    <p>1.05 (A)</p> Signup and view all the answers

    What is the Old Debt/Equity Ratio calculated in the content?

    <p>0.4286 (B)</p> Signup and view all the answers

    Which company has the highest expected growth rate in dividends (DPS)?

    <p>Merck (D)</p> Signup and view all the answers

    What is the New Levered Beta calculated based on the provided information?

    <p>1.985 (D)</p> Signup and view all the answers

    Which of the following reasons justifies using the CAPM estimate over the DDM cost of equity?

    <p>CAPM cost of equity has logical constraints. (B)</p> Signup and view all the answers

    What is the market price of Honda (ADR)?

    <p>$25.00 (A)</p> Signup and view all the answers

    What is the book value of the outstanding debt for Merck & Company?

    <p>$1.918 billion (A)</p> Signup and view all the answers

    Estimate the cost of equity for Merck using the Dividend Discount Model (DDM). What is the estimated percentage?

    <p>18.81% (B)</p> Signup and view all the answers

    Which company is unlikely to provide a valid estimate using the Dividend Discount Model?

    <p>Microsoft (A)</p> Signup and view all the answers

    Flashcards

    Risk Premium

    The expected return above the risk-free rate, compensating for risk.

    Cost of Equity

    The return required by investors for holding equity, used for discounting cash flows.

    Present Value (PV)

    The current worth of a future sum of money, based on a specific rate of return.

    Weighted Average Cost of Capital (WACC)

    The average rate of return a company is expected to pay to all its security holders.

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    Mismatching Cash Flows

    Using an incorrect discount rate for the cash flows being discounted can lead to valuation errors.

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    CAPM

    Capital Asset Pricing Model; used to determine the expected return on an asset based on its risk.

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    Arithmetic Mean Premium

    The average premium returned by stocks over treasury bills historically calculated arithmetically.

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    Geometric Mean Premium

    The average premium returned by stocks over treasury bonds, calculated geometrically.

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    Beta (in finance)

    A measure of a stock's volatility relative to the market.

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    Estimating beta

    Calculating beta using regression of stock returns against an index.

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    Weighted average beta

    The beta of a firm calculated by weighing the betas of its divisions by market value.

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    Impact of divestiture on beta

    Selling a division can change a firm's overall beta depending on the division's beta.

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    Unlevered beta

    The beta of a firm with no debt, reflecting only business risk.

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    Debt/Equity Ratio

    A measure of a company's financial leverage, calculated by dividing total debt by total equity.

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    Leveraging impact on beta

    Increasing debt can raise a firm's beta, indicating higher risk due to financial leverage.

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    Beta for valuation purposes

    The beta used to value a business must align with its risk profile and financing structure.

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    After-tax Cost of Debt

    The effective interest rate on debt after accounting for tax deductions.

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    Cost of Capital

    The average cost of financing a firm’s operations from all capital sources.

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    Preferred Stock Cost

    The dividend yield required by preferred stockholders.

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    Market Value Weights

    Proportions of debt and equity based on their current market values.

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    Leveraged Beta

    A measure of a company's risk that includes the impact of debt on its equity.

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    Dividend Growth Model (DDM)

    A method used to estimate the cost of equity, assuming constant dividend growth.

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    Capital Asset Pricing Model (CAPM)

    A model that describes the relationship between risk and expected return for assets.

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    Market Value of Debt

    The total value of a company's debt in the market, different from book value.

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    Beta

    A measure of a stock's volatility in relation to the overall market.

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    Debt to Equity Ratio (D/E)

    A financial ratio indicating the relative proportions of debt and equity.

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    Average Unlevered Beta

    The mean unlevered beta of comparable firms, adjusted for leverage.

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    Corporate Tax Rate

    The percentage of company profits paid as tax.

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    Financial Leverage

    Use of debt to amplify potential returns on investment.

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    Operating Leverage

    The proportion of fixed costs in a company’s cost structure.

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    Chiquita's Beta

    Chiquita’s risk estimate which is affected by its debt ratio.

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    Study Notes

    Problem Set #1 - Solution

    • Problem 1: Investor valuing Asian stocks; two-year stock market growth of 60% per year and government borrowing rate of 15% creating a 45% historical premium. Should the investor use this historical premium to value future risk? No, and future risk premium should be based on other factors impacting the market, not just historical returns. Valuation relies on discounting cash flows at the cost of equity to determine the present value of the equity stake.
    • Problem 1: Valuation distinctions; mismatching cash flows and discount rates, or misinterpreting the calculated present value of cash flows, can cause significant valuation errors.
    • Problem 2: Eastman Kodak beta (1.10); six-month treasury bill rate (3.25%) and thirty-year bond rate (6.25%).
      • Part a): Cost of equity using treasury bill rate; CAPM formula. Using the treasury bill rate as the risk-free rate in the Capital Asset Pricing Model.
      • Part b): Cost of equity using treasury bond rate; CAPM formula using the treasury bond rate as the risk-free rate..
      • Determining which estimate to use: Long-term bond rate (risk-free rate) is more suitable for valuation on long-term investment horizons since it reflects long-term potential returns.
    • Problem 3: Valuing BMW; beta of 0.90 relative to the Frankfurt Stock Exchange (DAX). Use of an international index for beta calculation is preferred since it provides a more relevant comparison for an international portfolio.
    • Problem 4: High-technology firm with three divisions; personal computers (beta 1.60, market value $100 million), software (beta 2.00, market value $150 million), and computer mainframes (beta 1.20, market value $250 million).
      • Part a): Weighted average beta of the firm's equity portfolio.
      • Part b): Change in beta if the firm divested its software division.
      • Part c): Beta to use for valuing the software division; the beta for the software division (2.00) should be used in valuation.
    • Problem 5: Four forestry/paper product companies' equity betas and debt/equity ratios; Weyerhaeuser, Champion International, International Paper, and Kimberly-Clark.
      • Part a): Calculation and interpretation of unlevered betas for each firm; measure business and operating leverage risk.
      • Part b): Kimberly-Clark's new beta with a 30% debt/equity ratio; calculation using the unlevered beta.
      • Part c): Beta for an initial public offering in the paper products market should use the average unlevered beta of comparable firms and relever it using the projected 40% debt/equity ratio.
    • Problem 6: Five food production companies; CPC International, Ralston Purina, Quaker Oats, Chiquita, and Kellogg's; details about their cost structures (fixed vs. variable costs) and betas.
      • Part a): High and low operating leverage betas; CPC will have the highest and Kellogg's the lowest.
      • Part b): New estimate of Chiquita's beta due to increased financial leverage; calculation using the average leverage ratio from period of beta calculation.
    • Problem 7: Company stock prices, dividends per share, and expected dividend growth rates for Merck, Ogden Co., Honda, and Microsoft; use of dividend growth model & CAPM
      • Part a): DDM cost of equity calculations and reasonable DDM candidates; candidates and why they're appropriate for DDM.
      • Part b): CAPM cost of equity calculation.
      • Part c): Estimate choice for valuation calculations & reasons; CAPM estimate is used for valuations unless dividend growth model cannot be calculated.
    • Problem 8: Merck & Company's market and book values for debt and equity; cost of equity calculation, after-tax cost of debt, and cost of capital.
    • Problem 9: General Motors cost of capital calculation; Equity, preferred stock cost calculation; and cost of debt.

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    Description

    This quiz covers essential concepts in finance, focusing on stock valuation, risk premiums, and the Capital Asset Pricing Model (CAPM). It includes practical examples such as valuing Asian stocks and calculating the cost of equity for Eastman Kodak. Ideal for students looking to deepen their understanding of financial valuation methods.

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