37 Questions
What was the initial reason for Don's loan request being rejected by the bank?
The bank considered Don's venture to be too risky
What is the term referred to as the three Fs in financial management?
Friends, family, and fools
Why did Don's friends and relatives refuse to give him a loan?
They thought the highest interest rate offered was still too low
What is the percentage of claim each partner has on the firm's assets and earnings?
20%
What is the total value of the assets in Don's company?
$100,000
What is the rate of return on equity (ROE) of the firm?
10%
What is the earnings per share (EPS) of the firm?
$2,000
What is the price per share of the firm's equity?
$20,000
What is the dividend yield if the partners decide to pay out all of the earnings as dividends?
10%
What happens to the firm's assets and equity if the partners decide to reinvest the earnings in the firm?
They increase by $10,000.
What is the return on equity if the firm's equity has gone up by $10,000?
10%
What is the fundamental purpose of capital goods?
To produce other goods
What is the capital gains if the firm's equity has gone up by $10,000?
10%
What is the capital structure of a firm?
The liabilities on a firm's balance sheet
Why did the buyer of the share buy it for $40,000?
The buyer expects the demand for customized cars to grow with the growth of the county.
What is the cost of raising debt to a firm?
The interest a firm has to pay on the bond it issues or loans it takes out
What does the cost of raising equity to a firm intuitively represent?
The rate of return investors expect to earn on their shares
What is the dividend yield at the new price per share of $40,000?
5%
Why does the buyer accept a rate of return on equity that is only half the 10% everyone else requires?
The buyer is naive and discounting DPS/P at a discount rate of only 5%.
Why does Don need to raise capital for his start-up?
To invest in lifts and diagnostic tools
What can be inferred from the fact that the buyer is willing to buy the share for $40,000?
The buyer values the share more than its book value.
How much does Don need to invest in his start-up?
$100,000
What are capital instruments?
The stocks, bonds, and loans that represent equity and debt claims on assets
What are the different dimensions of capital?
Capital goods, capital structure, capital flows, and capital markets
What is the expected return on equity based on the formula re = DPS/P + g?
10%
What does the variable 'g' represent in the formula re = DPS/P + g?
Growth rate of earnings and/or dividends
What is the Gordon Dividend Discount Model used to calculate?
Market price of the share
What does the cliché 'the expected return is yield plus growth' mean?
The expected return is equal to the sum of the yield and growth rate
What is the relationship between growth in earnings and/or dividends and capital gains?
Growth in earnings and/or dividends eventually translates into capital gains
What is the formula to calculate the market price of the share according to the Gordon Dividend Discount Model?
P = DPS / (re – g)
What is the relationship between earnings per share and stock prices according to the S&P 500 Index?
They are cointegrated, meaning their movements do not stray far from one another
What is the market capitalization of the firm if the price per share is $40,000 and the number of shares is 5?
$200,000
What is the firm's price-to-book ratio?
1.8
What is the market value of the firm's assets in market value terms?
$200,000
What is the value of the firm's brand, management, or customizing expertise in market value terms?
$90,000
What is the notation for return on equity in the context of this text?
re
What does the traditional notation 'ROE' stand for in the context of this text?
Return on Equity
Study Notes
What is Capital?
- Capital can refer to different things, including capital goods (fixed assets used in production), capital structure (liabilities on a firm's balance sheet), capital flows (transfer of financial assets across borders), or stocks and bonds traded in capital markets.
Capital as Fixed Assets and Claims
- Capital goods are fixed assets used in producing other goods.
- Capital instruments are stocks, bonds, and loans that represent equity and debt claims on assets.
- Capital structure refers to the relative amounts of debt and equity in a firm's liabilities.
Cost of Raising Capital
- The cost of raising debt is the interest a firm pays on bonds or loans.
- The cost of raising equity is the rate of return investors expect to earn on their shares.
Example: Raising Capital for a Start-up
- Don, a new entrepreneur, needs $100,000 to start a custom auto body shop.
- He tries to get a loan from a bank but is rejected due to high risk.
- He turns to friends and relatives for funds, who agree to invest in exchange for equity shares.
Equity in the Firm
- Don takes on four equity partners, each contributing $20,000 and receiving a 20% share in the firm.
- The initial ownership structure of the firm shows $100,000 in assets and $100,000 in equity.
- The equity is permanent and cannot be withdrawn, but shareholders can sell their shares.
Cost of Equity
- The rate of return on equity (ROE) is 10%, and earnings per share (EPS) is also 10%.
- The return on equity can take two forms: dividends or capital gains.
Book vs. Market Values of Equity
- One of Don's partners sells his shares for $40,000, almost twice the book value.
- The buyer expects the firm's value to grow due to demand for customized cars in the area.
- The buyer's expected return on equity is 10%, consisting of a 5% dividend yield and 5% growth rate (g).
Yield Plus Growth
- The expected return on equity is yield plus growth: re = DPS/P + g.
- The Gordon Dividend Discount Model: P = DPS / (re – g).
Growth of What?
- The growth rate (g) represents capital gains or the growth rate of earnings and/or dividends.
Note
- The firm's market capitalization is $200,000, and its price-to-book ratio is 1.8.
- The market is capitalizing the value of the firm's brand, management, or customizing expertise at $90,000.
Understand the concept of capital in financial management, including its various forms such as capital goods, capital structure, and capital flows. Learn about its significance in finance and business.
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