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FIn420 Exam 3 CH 17-20
Terms in this set (158)
The global economy
- international economy affects fits prospects.
- international economy affects everything.
- it is harder for a business to succeed in a contracting economy than it is to succeed in an expanding one.
Top down analysis (5 steps)
1. global macro.
2. domestic macro.
3. business cycle.
4. industry analysis.
5. company level.
- export prospects.
- competition: Europe has high employment - some may figure out how to give jobs because low wages = high competition.
- correlation: want uncorrelated assets when buying something new - correlations go up during bad periods globally.
- political risk.
- the edge comes from not following the consensus, it comes from deviating from it.
move relative to another currency. they seesaw.
Strongest currency is at....
competitive disadvantage because it costs other countries more to buy from the country with the high currency.
The domestic economy.....
- gross domestic product: used to solve for regression for next quarters earnings, largest component is consumer (make up about 2/3)
- unemployment rates.
- inflation (CPI-U): get from beta, core cpi is all items less food and energy. shelter is considered average cost of living rentals.
- consumer sentiment: consumer confidence.
- federal budget deficits.
use regression. try and find robust regression equation between revenue and gdp.
- huge macro factor; it affects almost everything in the economy; affects money and valuation of bonds; interest rates go up if we think inflation is going up.
- Supply: funds from savers.
- Demand: funds from borrowers.
- Governments net supply/demand for fund modified by federal reserve.
- expectations are key.
- barometer of inflation.
The government's toolbox
1. fiscal policy.
2. monetary policy.
- the government's spending and taxing actions.
- THE FED (federal reserve bank).
- most targeted way to stimulate or slow the economy.
- formulation of fiscal policy is often a slow cumbersome political process.
- government can target very well what they want to stimulate.
- spending and taxation are tools of fiscal policy.
- manipulation of the money supply.
- THE FEDERAL GOVERNMENT.
- Adjustments of reserve requirements, discount rate, and open market operations.
- less targeted but fast market stimulation.
- because of the fed that we didn't have a second great recession.
- if they want to expand the economy they decrease the interest rate, lower reserve requirements, and buy stuff.
how much bank has to keep versus lend out
what they do when they change interest rates
Open Market operations
when they go out and buy stuff (reserve - repo agreement)
- recurring cycles of recession and recovery.
- peak: upper transition point.
- trough: lower transition point.
- when you hit a trough and move up sell defensive stocks and bonds, go for high betas with a short duration.
- going from peak to trough want all stock with a beta greater than one and bonds that are extremely price sensitive (long duration, low coupon).
- above average sensitivity to the state of the economy.
- examples include producers of consumers durables (e.g. auto) and capital goods.
- consumption can be easily postponed if times are bad (ex. harley davidson bike)
- high betas (greater than 1)
- little sensitivity to the business cycle.
- examples include food producers, pharma firms, and public utilities.
- consumption difficult to postpone even if times are bad.
- low betas (lower than 1)
- leading economic indicators (LEI) tend to rise and fall in advance of the economy.
- coincidence economic indicators (CEI) move with the market.
- lagging economic indicators (Lag Index) changes subsequent to market movements.
similar to ailing macro economy, it is unusual for a firm in a troubled industry to perform well.
- economic performance can vary widely across industries.
Sensitivity to business cycles
three factors determine how sensitive a firm's earnings are to the business cycle.
1. sensitivity of sales.
2. operating leverage.
3. financial leverage.
Sensitivity of sales
- necessities vs. discretionary goods.
- items that are not sensitive to income levels (such as tobacco and movies) vs. items that are (such are machine tools, steel, autos.
- the split between fixed and variable costs.
- firms with low operating income leverage (less fixed assets) are less sensitive to business conditions.
- firms with high operating leverage (more fixed assets) are more sensitive to the business cycle.
- lots of fixed costs means hurting more in a poor economy.
- the use of borrowing money.
- interest is a fixed cost that increases the sensitivity of profits to the business cycle.
Industry life cycle
1. start- up: rapid and increasing growth; really low market penetration.
2. consolidation: stable growth, more market share.
3. maturity: slowing growth, see price wars in this phase; realize growing out of profitable investment opportunities, telecom industry is in maturity phase.
4. relative decline: tend to do mergers and acquisitions here; minimal or negative growth.
The point of equity valuation is....
intrinsic value for stock is saying where true value is estimated to be; actual may be low; one reason to buy but not the only reason.
Models of equity valuation
- book value models.
- dividend discount models (DDM): single, multistage, h-model.
- discounted cash flows (DCF) models.
- ROIC model.
- valuation by comparables: price/earnings ratios, free cash flows model.
Limitations of book value
- dangerous as primary decision making tool because of historical cost.
- book values are based on historical cost, not actual market values; requires a great deal of adjustment to be valuable information.
- it is possible but uncommon for market value to be less than book value.
- perceived floor is the liquidation value.
- $ to liquidation should not trade less than liquidation value; if lower then is it a value play.
Intrinsic Value vs. Market price
- the return on a stock is composed of dividends and capital gains or losses.
- the expected HPR may be more or less than the required rate of return, based on a stock's risk.
Exprected HPR = E(D1) - E(P1)-P0/P0.
dividend - capital gains/ beginning.
CAPM gives the required return, k:
k=risk free rate+beta*market risk premium.
- if the stock is priced correctly, k should equal expected return.
- k is the market capitalization rate or the market's required return.
Trading signals for market value versus intrinsic value
IV> MV - Buy.
IV<MV - Sell or Short Sell.
IV = MV hold or fairly priced.
Preferred stock and the DDM
- no growth case.
- value a preferred stock paying a fixed dividend or $2 per share when the discount rate is 8%.
- V0=2/.08-0=$25 or value of p/s.
Constant Growth DDM
- Vr=Dr+1/k-g or Dr=D0(1+g)^t.
- k = appropriate risk adjusted interest rate.
- g = dividend growth rate.
The constant growth rate DDM implies that a stock's value will be greater:
1. the larger its expected dividend per share.
2. the lower the market capitilization rate, k.
3. the higher the expected growth rate of dividends.
- the stock price is expected to grow at the same rate as dividends.
Estimated Dividend Growth Rates
- g = steady state growth rate in dividends.
- ROE = return on equity for the firm.
- b = plowback or retention percentage rate (1-dividend payout percentage rate).
Present Value of Growth opportunities (PVGO)
- the value of the firm equals the value of the assets already in place, the no growth value of the firm.
- plus the NPV of its future investments.
- which is called the present value of growth opportunities or pvgo.
- P0=E1/k + PVGO
Discounted cash flow (DCF) models
FCFF = EBIT(1-t) +depreciation _NCS - change in NWC.
- ebit = earnings before interest and taxes.
- t = corporate tax rate.
- NCS = new capital spending.
- NWC = net working capital.
Problems with DCF Models
1. estimates are always somewhat imprecise.
2. heavily weighted terminal cash flows.
3. growth rate assumptions (very sensitive to this).
What truly creates value for a company?
- cash flow growth.
- revenue growth.
- ROIC = NOPAT/invseted capital.
- NOPAT = operating income (EBIT) * (1- tax rate).
- invested capital = [working capital(CA-CL) - cash] + net fixed assets.
What enhances ROIC (cause it to go up)
- innovative products(difficult to copy or patent protection, quality (real or perceived), brand(brand name), customer lock in (high switching costs).
Cost of Capital Efficiency.
- innovation business process (innovative and efficient process that is difficult to copy), unique access to resources, economies of scale, and scalability (add customers or capacity at minimal marginal costs).
Valuation by comparables
- compare valuation ratios of firm to industry average and its own historical range.
- ratios like price/sales are useful for valuing start-ups that have yet to generate positive earnings.
- price to sales is only used for companies without EPS (only really speculative companies) or when P/E number gets way too high
Justified PE Ratio
- can growth rate justify an acceptable PE?
- P/E = 1-b/k-g or p/e= retention ratio/dividend payout.
The PEG ratio
- a negative peg means it is extremely undervalued.
- a peg of 1 means it is fairly valued.
Aggregate stock market DDM
some analysts use aggregate version of DDM.
use of earnings yield approach at aggregate level.
Profitability OVER TIME
Financial conditions AT A POINT IN TIME, usually at the end of year. Shows financial position.
Statement of cash flows
Tracks the CASH IMPLICATIONS of transactions
Sustainable cash flow that can be paid to stockholders without impairing productive capacity of the firm. The statement of cash flows is most important to this.
Affected by conventions regarding the valuation of assets.
A = L+E or....
CA + NFA = CL + LTD + OE
What we compare to....
Time series - how does it work over time.
S & P 500.
Peer comparison - ROE compared to other company ROEs
Return on Assets (ROA).
Return on Capital (ROC).
net income divided by total assets
net income divided by long term capital
Economic Value Added (EVA)
- the dollar of the firm's return in excess of opportunity cost.
- the spread between ROA and WACC multiplied by capital invested in the firm.
- EVA = (ROA - WACC) * Invested Capital.
- EVA is hard to manipulate.
- EVA is economic value provided to shareholders.
Return on equity (ROE)
net income divided by shareholders equity (simplified version.
DuPont Identity (ROE)
ROE = [net income/sales]
[assets/equity] = [net income/equity].
ROE = ROA * EM.
- [net income/sales] is profit margin.
- [sales/assets] is total asset turnover.
- [assets/equity] is equity multiplier.
The PM - TAT tradoff
- if PM is really high then we expect a really low TAT.
Fixed assets and inventory turnover
- FA Turnover.
- Inventory Turnover.
sales/average fixed assets.
beginning plus ending divided by 2.
a higher number means that inventory is selling faster.
how many days until I have to replenish my inventory.
if you have a super high number better have a huge profit margin to make up for it.
Receivables turnover ratios
don't want it to be high, should be around 30 since that is normally the billing period.
current assets divided by current liabilities.
want to be higher than one.
should be able to cover all short term liabilities with short term assets.
current assets minus inventory divided by current liabilities.
cash divided by current liabilities
Total Debt ratio.
Debt to equity ratio.
Total Debt ratio
total assets minus total equity divided by total assets
Debt to equity ratio
total debt divided by total equity.
total assets/total equity.
1 + d/e ratio
Market Price Ratios
total equity/shares outstanding
market price/book value per share
Interest Coverage (Times Interest Earned)
International Accounting Differences
Reserves - many other countries allow more flexibility in use of reserves.
Depreciation - US allows separate tax and reporting presentations.
Intangibles - treatments varies widely.
- derivatives are securities that get their value from the price of other securities.
- can be powerful tools for hedging and speculation.
- Options are traded both on organized exchanges and OTC.
- derivatives derive value from something else.
guarding against risk
actively taking risk.
mirror image of hedging.
In the money (ITM)
- exercise of the option produces a positive cash flow.
- Call : exercise price < asset price.
- Put: exercise price > asset price.
Out of the money (OTM)
- exercise of the option would not be profitable.
- Call: asset price < exercise price.
- Put: asset price > exercise price.
At the money (ATM)
- exercise price = asset price.
Option Contracts Types
American options and European Options.
all options expire on the third Friday of the month.
can be exercised on or before expiration
can be exercised only at the expiration
a call option gives its holder the right to buy an asset at the exercise or strike price, on or before the expiration date.
Exercise the option to buy the underlying asset if market value is greater than strike price.
unlimited profit; capped loss
Naked Short Call
really small potential profit and really large potential loss
a put option gives its holder (buyer) the right to sell an asset at the exercise or strike price, on or before the expiration date.
Exercise the option to sell the underlying asset is market value is less than strike price.
Insurance is like put options; if you have a car accided then they pay for it, if you don't then insurance company keeps the money.
right to buy
Call Seller (writer)
option to sell to the call buyer
right to sell
Put Seller (writer)
obligation to buy from the put buyer
- puts can be used as insurance against stock price declines.
- combining a long put contract with ownership.
- the cost of the insurance is the put premium.
- problem is they have an expiration date so you have to keep paying for the insurance.
- only use if you are really certain that stock is going to go down but if you are so sure then why own the stock.
- purchase stock and write calls against it.
- call writer gives up any stock value above X in return for the initial premium.
- if you planned to sell the stock when the price rises above X anyway, the call imposes sell discipline.
- best for a neutral market.
- doesn't work when the market is trending down.
- long straddle: buy a call and a put with the SAME STRIKE price and maturity.
- a long straddle is a bet on volatility.
- there is a breakeven point to hurdle over since you paid two premiums.
a collar is an options strategy that brackets the value of a portfolio between two bounds.
Combines stock ownership, protective put (long call), covered call (short call)
Bull call spread
a combination of BUYING a call and SELLING a call with a higher strike
Option like securities
- issued with a higher coupon rate than offered on straight debt.
- usually includes a call protection period.
- option owed by issuer.
- a pair trade.
- paired bond ownership with option of their own stock.
- pairing bond with a short call
- options are owned by the holder rather than issue.
- typically gives holder right to exchange for common stock, regardless of market price.
- like pairing a bond with a call option.
- issued directly by a company.
- longer maturities.
- terms of the contract are open to negotiation.
- exercise of a warrant creates new shares and dilutes ownership.
Call Options Characteristics
- issued by options exchangers.
- shorter maturities.
- terms are standardized by the exchanges.
- exercise does not create new shares.
- if the options expires unexercised then the gain is linked to term of option contract ownership only and typically short term unless LEAPS are used.
- if the option is exercised then the gain or loss is automatically linked to the underlying if the underlying was owned and could be a long term gain even if the option itself only owned for a short term period.
T or F: The surest way to consistently enjoy abnormally high returns is the accurately calculate macro-level factors and company-specific factor that match consensus estimates.
FALSE: The surest way to consistently enjoy high returns and beat the market is not to accurately calculate the consensus estimates. You will need to calculate something different than everyone else, believe in your opinion with enough conviction to take action against the grain of sentiment...oh yeah, and be right in your conviction. Out-sized returns come from having a correct opinion that differs from the way everyone else views a stock.
T or F: Gross Domestic Product (GDP) has substantial investment impact because it is a direct barometer on the health of an economy.
TRUE: GDP is a direct barometer on the health of an economy. Two consecutive quarters of negative GDP is technically defined as a recession. The health of GDP will in many ways determine the health of the jobs market and it will also impact the revenue forecasts deployed by stock analysts in determining a given stock's intrinsic value.
Exports are a significant consideration for the well-being of any country. If America's exchange rate suddenly and unexpectedly jumps upwards relative to the Euro, then what impact might this have on the respective economies?
A. American's export would likely increase.
B. Europe's exports would likely increase.
C. Europe's exports would likely decrease.
D. The currency movement should have no impact on export between America and Europe.
If you expected that the American economy is about to enter a recession, then which of the following trade moves would not be beneficial?
A. Load up on consumer stable products.
B. Load up on growth stocks.
C. Increase your allocation of bonds.
D. Sell your basic materials stocks.
The economy has been in a recession for 18 months and you are willing to speculate that a recovery is about to emerge. Which move below would make the least amount of sense?
A. Buy technology stocks that were beaten up during the recession.
B. increase allocation to utilities.
C. increase your allocation to consumer discretionary stocks.
D. decrease your allocation to health care.
Which statement below is correct about the industry life cycle?
A. a common trait of the start-up phase is high levels of market penetration.
B. in the consolidation stage, price wars are common as rivalry reaches an apex.
C. In the maturity stage, market penetration is reaching a high plateau and dividend payments are more common.
D. In the relative decline stage, companies are merely trying to fend off bankruptcy.
T or F: Sentiment indicators, like the Consumer Confidence Index published by the Conference Board, are just noise in the investment decision-making process. They add very little to the process.
FALSE: Sentiment indicators can actually add very valuable information to the investment decision-making process. Sentiment indicators provide a window into consumer's and investor's emotional and psychological lives. Since consumers comprise such a substantial percentage of GDP their impact is potentially significant.
T or F: The impact of interest rates on the bond and stock markets is significant because of what the interest rate level communicates about future expectations for economic growth and inflation.
TRUE: The impact of interest rates on the bond and stock markets IS significant because of what the interest rate level communicates about future expectations for economic growth and inflation. Rates up to roughly 3% can be good for stocks...too much higher and they can begin to slow down the economy, while very low rates are like pouring fuel on a fire.
_______________ policy comes from the Federal Reserve (the Fed), while __________________ policy comes from the federal government. _________________ policy is considered to be the easier to enact.
A. fiscal; monetary; monetary.
B. monetary; fiscal; fiscal.
C. fiscal; monetary; fiscal.
D. monetary; fiscal; monetary.
The general economy goes through ups and downs. This is known as the ______________ cycle, and it is important because it directly impacts ________________.
A. business; asset allocation choices.
B. industry life; asset allocation choices.
C. business; who wins the Superbowl.
D. industry life; who wins the Superbowl.
What is typically true of corporate dividend payout rates in the early stages of an industry life cycle? Why does this make sense?
Companies tend to pay very low, if any, dividends early in their business life cycle since these firms need to reinvest as much capital as possible in order to grow.
If the nominal interest rate is 5% and the inflation rate is 3%, then what is the real interest rate? (Note: this question is a review from Corporate Finance in applying the Fisher Effect. We did not expressly review this calculation, but you should be familiar with it.)
1 + real interest rate = 1+nominal interest rate/1+inflation rate.
Given nominal interest rate, R, is 5% and inflation rate, i, is 3%, we can solve for the real interest rate, r.
1+r=1.0194br = 1.94%
What monetary and fiscal policies might be prescribed for an economy in a deep recession?
Expansionary (i.e., looser) monetary policy to lower interest rates would help to stimulate investment and expenditures on consumer durables. Expansionary fiscal policy (i.e., lower taxes, higher government spending, increased welfare transfers) would directly stimulate aggregate demand.
According to supply-side economists, what will be the long-run impact on prices of a reduction in income tax rates?
Supply side economists believe that a reduction in income tax rates will make workers more willing to work at current or even slightly lower (gross-of-tax) wages. Such an effect ought to mitigate cost pressures on the inflation rate and thus the price level.
General Weedkillers dominates the chemical weed control market with its patented product Weed-X. However, the patent is about to expire. What do you expect to see change within the industry? Specifically, what will likely happen to industry prices, sales, profitability, and the prospects for General Weedkillers' competitors? What stage of the industry life cycle do you think is relevant for the analysis of this market?
The expiration of the patent means that General Weedkillers will soon face considerably greater competition from its competitors. We would expect prices and profit margins to fall, and total industry sales to increase somewhat as prices decline. The industry will probably enter the consolidation stage in which producers are forced to compete more extensively on the basis of price, although the fiercest price competitions and price wars will not occur until the maturity stage.
What is the purpose of equity valuation?
A. The purpose of equity valuation is to calculate an estimate of the future value of a stock.
B. The purpose of equity valuation is to pinpoint the exact value at which a stock should trading updated in real-time.
C. The purpose of equity valuation is to measure if the current stock price is either a good entry or exit point.
D. The purpose of equity valuation is to provide a guaranteed answer to a stock's current worth given market psychology.
T or F: Book value establishes a price floor for a stock (i.e. Price-to-book will stay above 1.0).
FALSE: While it would be nice to think that a stock would never trade for less than its book value...that is not the case in the real world. As of mid-2014, Delta Apparel (ticker symbol DLA) had a price-to-book of 0.83. Book value is carried at historical cost on the company's Balance Sheet. A low book value could simply mean that an analyst need to make adjustments to bring the number up to reality OR it could mean that the company's assets are actually losing value and the company could go bankrupt.
A certain company just paid a dividend of $1.75 and it currently has a very high growth rate of 15%. Analysts expect this high growth rate to remain at this pace for 3 years and then in year 4 it will decay to the average economic growth rate which is currently assumed to be 3%. If the relevant market cap rate is 12%, then what is the stock's intrinsic value using the Dividend Discount Model?
A certain stock has a Return on Equity of 15%, an expected dividend at the end of the year of $2.45, and a retention rate of 65%. If the stock's current market price is $108.89, then what is the market's implied market cap rate for this stock?
C. Given ROE = 15% and retention rate of .65. Use this to solve for the steady state growth rate of 9.75% (15% x .65). Then...[(2.45/108.89) + .0975] = 12%
The P/E Ratio for any given company should be compared against all of the following except:
A. The 5 year range of various benchmarks.
B. Its own 5 year average P/E multiple.
C. The industry average P/E multiple.
D. Its own P/E range in recent history.
A P/E multiple could be high relative to the S&P 500 Index because its high growth rate justifies it. If a certain stock has an ROE of 18.5% with a dividend payout ratio of 55% and a market cap rate of 12%, then investors consider ____________to be the justified P/E for the stock? However, if the dividend payout rate drops to 45% the justified P/E would jump up to _______________.
A. 13.43; 23.71.
B. 14.97; 24.66.
C. 14.56; 25.22.
D. 15.17; 24.12.
B. This question requires several different steps. You are given ROE, dividend payout, and required return. You need retention ratio and growth rate to solve for justified PE. Where to begin? In the first scenario, the retention rate equals .45 (1-.55). Remember that Net Income only goes to either pay dividends or to retained earnings...so if you are given dividend payout, then retention is just 1 - dividend payout. Now for the steady state growth rate...g = 8.325 (18.5 x .45), which means that the justified PE equals 14.965986 [(1-.45)/(.12 - .08325)]. In the second scenario, you are now given the dividend payout to be .45, which means that the retention rate is now .55 (1-.45). This also means that the steady state growth rate has changed to 10.175 (18.5 x .55) and that the new justified PE ratio is 24.657534 [(1-.55)/((.12 - .10175)].
T or F: The PEG ratio is useful because it puts valuation (P/E) is units of growth. This enables investors to better compare companies with different growth rates.
TRUE: The PEG ratio does enable investors to better compare companies with different growth rates.
Be cautious in using the price-to-sales metric for valuation because ___________________________.
A.sales are often a prime target for financial statement manipulation.
B. this metric is often cited when a company does not have any earnings.
C. it usually under-values the stock's true worth.
D. historical comparisons are not available.
T or F: Analysts will sometimes use a free cash flow (FCF) valuation model because not all companies pay a dividend and cash flow is the lifeblood of any company.
T or F: Analysts love to use the 10-year Treasury yield to forecast the aggregate stock market level because the 10-year Treasury can be used to predict the earnings yield through regression analysis.
TRUE: 10-year Treasury is very closely correlated to the earnings yield, which is the inverse of the P/E ratio. Analysts will often use regression between the 10-year Treasury and the earnings yield to solve for the expected earnings yield given the observed 10-year Treasury yield. The estimated earnings yield is then converted into a P/E ratio and applied to a consensus estimate of earnings...viola the estimate price level of the aggregate market.
The most recent dividend for Deployment Specialists was $1.00 and it is expected to grow at 20% for the next two years and then normalize to 4% thereafter. If the required return for Deployment Specialists is 8.5%. What is the intrinsic value of Deployment Specialists stock?
Solve for each dividend first. You were given D0, so D1 would be $1.20 ($1.00 x [1+.20]). D2 would be $1.44 ($1.20 x [1+.20]). The key is to then solve for the for the first dividend with a normal growth rate (D3) and then use that dividend to solve for the previous period's price (V2) using the Gordon Growth Model.
- V2= [(1.44*1.04)/(.085-.04)]= $33.28
- Intrinsic Value = [(1.2)/(1 + .085) + (1.44 +33.28)/(1+.085)^2] = $30.60
Tandey, Inc. currently pays a dividend of 1.22, which is expected to grow indefinitely at 5%. If the current value of Tandey's shares based on the constant-growth dividend discount model is $32.03. What is the required rate of return?
- Intrinsic value = V0 = r = [(1.22*1.05)/(32.03) + .05] = .089994 or 8.8994%.
The market capitalization rate for Admiral Motors Company is 8%. Its expected ROE is 10% and its expected EPS is $5.00. If the firm's plowback (retention) ratio is 60%, then what is Admiral Motors' justified P/E ratio?
Sustainable growth rate = "g" = (ROE x retention rate) = 0.10 x 0.6 = 0.06 or 6%.
Expected Dividend = EPS x (1-retention rate) = $5.00 x (1-.6) = $2.00.
Justified P/E = (1-b) / (r -g) = (1-.6) / (.08 - .06) = 20.
Eagle Products' EBIT is $300, its tax rate is 35%, depreciation is $20, capital expenditures are $60, and the planned increase in net working capital is $30. What is the free cash flow to the firm?
FCFF = EBIT(1 - t) + Depreciation - Capital expenditures - Increase in NWC.
= $300 ´ (1 - 0.35) + $20 - $60 - $30 = $125
The risk-free rate of return is 5%, the required rate of return on the market is 10%, and High-Flyer stock has a beta coefficient of 1.5. If the dividend per share expected during the coming year, D1, is $2.50 and g = 4%. At what price should the shares be selling?
E(r) = rf + β [E(rM) - rf ] = 0.05 + [1.5 ´ (0.10 - 0.05)] = 0.125 or 12.5%.
P0 = D1/ r-g = 2.5/.125-.04 = $29.4
MF Corp. has an ROE of 16% and a plowback ratio of 50%. If next year's EPS is expected to be $2 per share and the market capitalization rate is 12%., then...
a. What is the estimated current price (value) for this investor?
b. What price would you expect to see in 3 years?
a. P0 = D1/r-g = EPS
b) = $2
.05 = 1/.12-.08 = $25.
B. P3 = EPS
(1+g)^3/r-g = $2
(1+.08)^3/.12-/08 = $31.49.
Note that D1 = EPS x (1-b) because the EPS given is NEXT YEAR'S EPS...it is essentially EPS1. For any given year, the dividend is a function of the dividend payout rate (1-b) and the EPS. Remember that EPS (Net Income per Share) goes to either dividends or it is retained in Retained Earnings.
In order to be healthy, investors want to see a company have sustainable cash flow from _____________________ activities.
Which of the following is a true statement concerning return on capital (ROC)?
A. Return on capital is a subcomponent of DuPont ROE.
B. Return on capital is a measurement of asset efficiency.
C. Return on capital is a measurement of on short-term asset efficiency.
D.Return on capital is a measurement of profitability.
A certain company has invested capital of $97 billion, an ROE of 15%, a weighted average cost of capital (WACC) of 6%, and an equity multiplier of 1.25. What is this company's economic value added (EVA)?
A. $6.73 billion.
B. $8.73 billion.
C. $5.82 billion.
D. $7.42 billion.
C. EVA = (ROA - WACC) x Invested Capital.
ROE = ROA x EM
.15 = ROA x 1.25
ROA = .12.
EVA = (.12 - .06) x 97 billion = 5.82 billion.
A certain company has net income of $150 million, sales of $675 million, and total assets of $850 million, current assets of $100 million, and a debt-to-equity ratio of 37%. What is their return on equity (ROE)?
T or F: A certain lender is concerned about a prospective borrower's financial health. One measure that they consider is the current ratio, which is found to be 1.75. The lender also notes that the industry average is 1.53. The lender would not feel comfortable lending to this borrower based solely upon this information.
FALSE: The current ratio is simply the current assets divided by the current liabilities. Any number above 1.0 suggests that the company has more current assets than current liabilities. This company's number of 1.75 is very healthy! It is also well above the industry average of 1.53, which also communicates financial healthy. Of course, the lender would look at other criteria, but based solely upon the current ratio, they would be willing to lend money to the prospective borrower.
T or F: A certain company has a debt-to-equity ratio of .94. This means that this company is roughly equally financed with equity and debt.
TRUE: A debt-to-equity ratio of .94 does communicate that the company is financed almost equally with debt and equity. Consider an example with a company that has $94 million in total debt and $100 million is total equity. They will have a debt-to-equity ratio of .94 and you can see how they are financed almost equally with debt and equity.
A certain company has 100,000,000 shares outstanding and a current market price of $32.50. Their net income is $200,000,000. This company's 5-year average P/E is 17.62 and their 5-year range is from 19.75 to 13.82. The industry average is 15.34. You calculate this company's P/E multiple to be ____________, and your general thoughts on this number are: ____________________.
A. 16.25; the P/E is above the industry average and should be considered as too expensive.
B. 18.43; the P/E is above the industry average and should be considered as too expensive.
C. 16.25; the P/E is above the industry average, but based on its own relative valuation still looks good.
D. 18.43; the P/E is above the industry average, but based on its own relative valuation still looks good.
A certain company has revenue of $175 million, EBT of $85 million, taxes of $17 million, interest of $8 million, and net income of $68 million. This company's times interest earned (TIE) ratio is ___________ and this number is ______________________.
A. 11.625; healthy.
B. 10.625; not healthy.
C. 11.625; not healthy.
D. 10.625; healthy.
T or F: A certain company has a Current Ratio of 0.85. If they used $15 million dollars to pay off short-term debts, then their current ratio would certainly rise.
FALSE: With a Current Ratio of 0.85, we could make up a number for CA of $85 million and CL of $100 million.
85/100 = 0.85
Now if we pay $15 million (reducing CA) and pay off short-term debts (reducing CL) we would have...
70/85 = 0.82
In this case, the Current Ratio declined. If the Current Ratio were above 1.0, then this same action would have increased the CR.
If Ross Shale Exploration has a Total Debt Ratio of 0.475, then what is its Equity Multiplier?
B. (1 / (1 - 0.475)) - 1 = Debt to Equity = 0.904762.
Equity Multiplier = 1 + Debt to Equity = 1.904762.
The Crusty Pie Company, which specializes in apple turnovers, has return on sales higher than the industry average, yet its ROA is the same as the industry average. How can you explain this?
ROA = (Net Income/Sales) ´ (Sales/Average Total Assets) = Return on Sales ´ TAT
The only way that Crusty Pie can have a return on sales higher than the industry average and an ROA equal to the industry average is for its TAT to be lower than the industry average.
A company's current ratio is 2.0. If the company uses cash to retire notes payable due within one year, would this transaction increase or decrease the current ratio? What about the asset turnover ratio?
Make up some numbers that would yield a current ratio of 2.0. Let's use CA = $400 and CL = $200, therefore the current ratio = 2.0 ($400/$200). Let's use $50 as our cash payment. Now we have CA = $350 and CL = $150, therefore our current ratio = 2.33 ($350/$150). This transaction would increase the current ratio. The transaction reduces both current assets and current liabilities by the same amount, but the reduction has a larger proportionate impact on current liabilities than on current assets. Therefore, the current ratio would increase.
This transaction would increase the asset turnover ratio. Sales should remain unaffected, but assets are reduced.
Recently, Galaxy Corporation lowered its allowance for doubtful accounts by reducing bed debt expense from 2% of sales to 1% of sales. Ignoring taxes, what are the immediate effects on
(a) operating income.
(b) operating cash flow?
A. Lower bad debt expense will result in higher operating income and also higher net income, which becomes EPS. This is one way for a firm to manage its earnings.
B. Lower bad debt expense will have no effect on operating cash flow until Galaxy actually collects receivables.
Use the DuPont Method and the following data to find the return on equity.
Total asset turnover=2.0.
Net profit margin=5.5%.
Dividend payout ratio=31.8%.
ROE = net profit margin
total asset turnover
equity multiplier (leverage ratio).
average assets/average equity.
Jones Group has been generating stable after-tax return on equity (ROE) despite declining operating income. Explain how this might happen?
Since ROE is a function of net profit and equity, it is possible to maintain a stable ROE while net profits decline, so long as equity also declines proportionally. Using DuPont, we know that Jones group could be offsetting lower net income with either a higher total asset turnover or higher leverage. Higher leverage is the most likely cause.
Options strategies can be used to either scale up or reduce overall portfolio risk. What are some examples of risk-increasing and risk-reducing options strategies?
Options provide numerous opportunities to modify the risk profile of a portfolio. The simplest example of an option strategy that increases risk is investing in an 'all options' portfolio of at-the-money options (as illustrated in the Bodie textbook). The leverage provided by options makes this strategy very risky and potentially very profitable.
An example of a risk-reducing options strategy is a protective put strategy. Here, the investor buys a put on an existing stock or portfolio, with exercise price of the put near or somewhat less than the market value of the underlying asset. This strategy protects the value of the portfolio because the minimum value of the stock-plus-put strategy is the exercise price of the put.
You purchase (long) one IBM September 160 put contract for a premium of $2.62. What is you breakeven point? What is your maximum potential profit?
The breakeven point is $157.38 ($160 strike price - $2.62 option premium). This is also your maximum potential profit if IBM were to fall to zero during the time when you own the contract. Assuming 100.000 shares per contract, the total potential profit is $15,738 per contract.
You purchase (long) one call contract with a strike price of $40 and a premium of $4.50. What is you breakeven point? What is your maximum potential profit?
The breakeven point is $45.50 ($40 + $4.50). The maximum potential profit is technically unlimited. Any value of the stock above $45.50 on or at the expiration date creates value for the long call buyer. The higher the stock price, the higher the profit.
You are a portfolio manager who uses options positions to customize the risk profile of your clients. In each case, what strategy is best given your client's objective?
a) Performance year-to-date is 16%, client objective is to earn at least 15%, there is a good chance of large stock gains or large losses before the end of the year. Which strategy is best for this client?
i. Long Straddle.
ii. Long Bullish Spread.
iii. Short Straddle.
b) Performance year-to-date is 16%, client objective is to earn at least 15%, there is a good chance of large stock losses only before the end of the year. Which strategy is best for this client?
iv. Long Put Options.
v. Short Call Options.
vi. Long Call Options.
i. A long straddle produces gains if prices move up or down and limited losses if prices do not move. A short straddle produces significant losses if prices move significantly up or down. A bullish spread produces limited gains if prices move up.
i. Long put options gain when stock prices fall and produce very limited losses if prices instead rise. Short calls also gain when stock prices fall but create losses if prices instead rise. The other two positions will not protect the portfolio should prices fall.
An investor purchases a stock for $38 and a put for $0.50 with a strike price of $35. The investor also sells a call for $0.50 with a strike price of $40. What is the maximum profit and loss from this strategy? Draw the profit and loss diagram for this strategy as a function of the stock price at expiration.
The initial outlay of this position is $38 and the payoff of such a strategy will be between two boundaries, $35 and $40. The maximum profit will thus be $2 ($40 - $38 + $0.50 - $0.50), and the maximum loss will be $3 ($35 - $38 +$0.50 - $0.50).
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