A firm has net operating assets of $1000 and each year generates (before-tax) cash of $200 on these assets. Depreciation is $50 and represents the cost of replacing the assets. Assume depreciation is tax allowable and taxes are paid in cash at the rate of 30% of profits. The firm has $500 of debt outstanding on which (tax allowable) interest is payable at 8% p.a. Assume the market value of debt equals its book value. The cost of its equity capital is 10%. The firm has no plans to expand and will keep leverage at a constant level. Assume the firm pays out all its net income as dividends.

Calculate the value of the equity and the value of the firm using:

(a) DDM;

and (b) FCF.

Hint: try calculating (a) first and using the market value of equity to calculate the WACC for (b).

The following two questions (c)-(d) are for next week exercise. All four methods should generate an identical answer.

(c) the P/E ratio; and

(d) the economic profit or residual income model (RIVM).