Professional Documents
Culture Documents
Working Capital Management - 131218
Working Capital Management - 131218
This model assumes that dividend will grow at a constant rate till
eternity
very strong assumption and is generally not true
a. growth rate in the stable period cannot exceed the economic growth
rate
b. growth rate cannot exceed cost of capital in the long run
Where does R come from
R is Cost of equity
CAPM
Under constant growth assumption,
R = D1/P0 + g Dividend yield
Problem (previous years paper)
Let us suppose the firm has no growth opportunities and pays out all
earnings as div
Means next year Div = 10
Then we can use P0 = DPS1/(r – g)= DPS1/r as g = 0
= EPS1/r = 10/0.1 = 100
Once growth opportunity surfaces the firm has two choices in the next
and each subsequent year.
a. Earn 10 next year and pay out 10. This leaves 0 to reinvest and.
Nothing goes to retained earnings to increase the owners equity and
the firm earns 10 in the subsequent year also. In this case the
market also does not value the growth and the company share price
is 10/0.1 = 100
b. Earn 10 next year and pay out 7. This leaves 3 to reinvest and this
amount is added to owners equity and you earn 3*20% = 0.6 extra
the subsequent year making your earnings 10+0.6 = 10.6. In this
case the market also does value the growth and the company share
price is 175
Problem
The next year EPS is expected to be 2.49 and the company is expected
to continue its payout ratio of 50%. If the growth rate is 8% and
opportunity cost of capital is 12% then what is PVGO?
Ans – 10.25
Problem
Real Corp expects to earn 71 million per year in perpetuity if does not
undertake any new projects. The firm has an opportunity to invest 16
million today and 5 million in one year in a project that will generate 11
million in perpetuity, beginning two years from today. The firm has 15
million shares of common stock outstanding and the required rate of
return is 12%.
a. Price of the stock if the firm does not undertake new investment.
ans – 39.44
b. what is per stock value if firm takes on the investment.
ans – 39.44 + 4.09
Some food for thought on DDM
Dividends are less volatile than earnings and other return concepts, the
relative stability of dividends may make DDM values less sensitive to
short-run fluctuations in underlying value
However, Dividend policy can be arbitrary and not linked to value added
– “Sticky dividends”.
Is dividend discount model applicable?
Firm A
EPS 0.41 0.12 −0.36 1.31 1.86 0.39 0.88 1.58 4.26 4.92
DPS 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00
Payout ratio 244% 833% NA 76% 54% 256% 114% 63% 23% 20%
Firm B
EPS 0.62 0.66 0.77 0.79 0.52 0.72 0.93 1.11 1.2 1.3
DPS 0.18 0.22 0.25 0.29 0.3 0.39 0.32 0.33 0.35 0.37
Payout ratio 29% 33% 32% 37% 58% 54% 34% 30% 29% 28%
Free cash flow valuation
After 3 years, The free cash flow is expected to grow at a constant rate
of 5%. Find firm value if cost of capital is 10% (Tax rate = 10%)
FCFE vs FCFF (Good to know)
The FCF in the text book is FCFF (Free cash flow to the firm)
This needs to the discounted by the cost of capital (WACC) and not the
cost of equity to arrive at the firm value
If you subtract total debt to arrive at equity value
Stock A is trading 3 times its book value – that means its Price to book
ratio is 3.
Assumption: If two firms are similar in all respect then the market would
price them similarly in terms of comparable ratios (P/B , P/E)
Two uses –
1. Find IV and compare with market price
2. Find a price where one does not have one
Valuation by comparable
If the stock’s current P/E ratio is high relative to its average P/E ratio for
last several years, is the stock in question expensive?
A justified P/E ratio is the price to earnings ratio which is justified by the
company’s underlying fundamentals, i.e. growth rate and cost of equity,
etc.
𝐷𝑖𝑣0 𝐷𝑖𝑣1
𝑃0 𝐸1
∗(1+𝑔) 𝐸1 𝑃𝑎𝑦𝑜𝑢𝑡 𝑅𝑎𝑡𝑖𝑜
= = =
𝐸1 𝑟−𝑔 𝑟−𝑔 𝑟−𝑔
If the market price is different from the value of a firm, then the actual
P/E would be different from the P/E ratio justified by the fundamentals
Justified forward P/E
Undervalued or Overvalued?
Problem
JSC earned 18 million for the fiscal year ending yesterday. The firm also
paid out 30% of its earnings yesterday. The firm is expected to continue
this rate in future. The remaining 70% of the earnings is retained by the
company for use in projects. The company has 2 million shares of
common stock outstanding. The current price 93. The ROE is expected
to remain at 13%. What is the required return for the stock?
Ans – 12.27%
Types of markets
Primary vs Secondary
When a company is looking to raise capital by issuing shares to public
then these are called transactions in primary market. When the first
time a company does this exercise this is called initial public offering or
IPO. From the 2nd time onwards this is known as follow on public
offering (FPO).
When investors who already hold shares of a company sells to other
investors these transactions are known as transactions in the secondary
market. All trading volume in the world is the result of secondary market
transactions.