Financial Management HW

Please help with:

1.Estimate a possible growth value, g1viaTwo-Stage (Differential) Growth Dividend Discount Model (DGDDM)

2. Estimate g2

3. Estimate r

4.LISTand support what the best values for g1, g2 and R to use in the various growth stages of the Two-Stage Differential Growth Dividend Discount Model (DGDDM).

5.Estimate a current fair market price per share for CMI common stock

6.Perform Sensitivity Analysis (SA) on your estimate for a fair market price per share

7. Compareyour estimate of fair market value with the current market value.

Finance HW a) Estimate a possible growth value, g1, for use in the first stage of a Two-Stage (Differential) Growth Dividend Discount Model (DGDDM) by computing the average annual historical growth, g, of sales, earnings (net income) and dividends over the past five (5) years. Use these actual results to help you form an expectation for g1. You should realize by now that your text and most other finance texts ASSUME that the average annual growth of sales, earnings and dividends will be the SAME AND CONSANT for the purpose of ESTIMATING value. In the real world the growth in sales, earnings and dividends will be DIFFERENT - particularly when average annual historical values are computed! In the DDM, it is the expected future growth rate in dividends that is directly related to share value. The actual number of years that you build into the first stage of your Two-Stage DGDDM is up to you! I would suggest that you keep in simple, however, by making the first stage greater than three (3) years, but less than or equal to ten (10) years. The purpose here is for you to see that real world valuation requires personal estimates of input variables such as g1, which are uncertain. One thousand analysts can easily arrive at 1000 different estimates! b) Estimate a possible future terminal (constant growth forever) growth value, g2, for use in the second or terminal growth stage of the Two-Stage DGDDM based on your expected growth in the overall economy for many years into the future. Remember, the terminal stage of the Two-Stage CGDDM is actually the Constant Growth DDM (CGDDM) and ASSUMES an infinite life for the firm! Before you decide on your estimate for g in the terminal stage of the DGDDM, make sure that you read the Real World insert on page 176 (page number on the bottom of the page) in your text, \"How Fast is Too Fast.\" Values for g2 in the terminal stage of the DGDDM or the value of g in the CGDDM that are greater than 5 or 6 percent can often lead to high valuation estimates - all else constant. c) Estimate a value for R by computing 1) the annual historical total return on the common stock for each year then calculate 2) the arithmetic average annual historical return for the 5-year period. The arithmetic average annual historical return that the markets have rewarded a firm with is sometimes used as an \"empirical estimate\" of the future return or expected return, R. Is the market total return constant in each year? Again, the purpose here is for you to see that real world valuation requires personal estimates of input variables, which can be highly uncertain. d) Estimate R (required return on equity - the appropriate discount rate) a second way by adding a 3% equity risk premium to the YTM on CMI's bond that has at least 20 years to maturity. If your firm does not have a 20-year bond outstanding, then add 3% to the YTM on a 20 year corporate bond with the same bond rating (i.e. A, AA, or AAA). You must find the YTM on your firm's 20year bond or the YTM on a comparable corporate 20-year bond. Realize that a 20-year corporate bond must have a YTM that is greater than a 20-year Treasury bond. Again, keep in mind that your R estimates are nothing more than estimates and subject to forecast error. e) While CMI has been in business for a long time, CMI exhibits spurts of growth over finite periods. As such, a Two-Stage Differential Growth Dividend Discount Model (DGDDM) may be a more appropriate valuation model than the Constant Growth Dividend Discount Model (CGDDM). Given your estimates for g1, g2 and R from above, LIST what YOU believe are the BEST values for g1, g2 and R to use in the various growth stages of the Two-Stage Differential Growth Dividend Discount Model (DGDDM). EXPLAIN (provide a written statement) defending your choices for g1, g2 and R in the DGDDM. Important Note: As emphasized above, when your text talks about g and R in the Constant Growth Model (CGDDM) and terminal stage of the DGDDM, it assumes that BOTH g and R are constant (sustainable) forever. Further, most textbooks, including your text, assume that the SAME g value holds for sales, net income and dividends! You should quickly see from your analysis so far that this is not the case in the real world. That is, estimates for both g and R are dependent on the method used to make your forecast. In short, all estimates are subject to what is called forecast error. First and foremost, your estimates for R (a risky discount rate) in both the CGDDM and DGDDM should always be greater than the YTM on CMI's longterm bonds (bonds with 20 years to maturity). This is because the markets generally require, on average, a 3 to 5 percent risk premium on a firm's required return on equity (cost of equity) over its required return on its own long-term debt. Suppliers of debt capital get paid from a firms earnings before interest and taxes (EBIT). Suppliers of equity capital get paid from net income (NI). More specifically, a firm's equity is riskier than its debt and, therefore, requires a higher cost of capital. Second, when estimating R and g values for the final phase of the DGDDM, which is the CGDDM, realize that you are estimating these g and R values to hold forever! As mentioned earlier, before you decide on your estimate for g in the terminal stage of the DGDDM, make sure that you read the Real World insert on page 176 (page number on the bottom of the page) in your text, \"How Fast is Too Fast.\" Values for g in the terminal stage of the DGDDM or the value of g in the CGDDM that is greater than 5 or 6 percent can often lead to high valuation estimates - all else constant. Key Learning Point: After estimating both g1, g2 and R and most likely (I hope!) arriving at a variety of values, you should now have a better understanding of the forecasting risk concept and its effect on valuation estimates. f) Estimate a current fair market price per share for CMI common stock based on what you learned in Chapter 6 using a Two-Stage Differential Growth Model (DGDDM - Case 3). Realize that you could build an N-Stage DGDDM, but that this question only requires a Two-Stage DGDDM. You must decide (form your own opinion about) on the number of first stage finite (unique) growth periods when estimating equity value using the DGDDM. Remember, the final stage of the DGDDM (terminal value stage) is nothing more than the CGDDM. That is, at some point you must stop trying to estimate unique g and R values and simply assume constant g and R forever. If you do not assume the CGDDM holds at some future point in time, you would spend \"forever\" discounting unique cash flows to the investors. g) Perform Sensitivity Analysis (SA) on your estimate for a fair market price per share in by varying both your expected growth rates and discount rates by +/- 2.0 percent in .5 percent increments while holding one of the two parameters (growth or discount rate) constant. How sensitive are your value estimates to your growth and discount rate estimates? Years ended December 31, In millions (except per share amounts) NET SALES Cost of sales GROSS MARGIN 2014 g1 2013 9.99% g1 $ $ $ 17,301 12,918 4,383 -0.19% $ $ $ 19,221 14,360 4,861 $ $ 2,095 754 $ $ $ 370 $ 2012 g1 2011 -4.12% g1 $ $ $ 18,048 13,459 4,589 26.72% $ $ $ 17,334 12,826 4,508 1,920 713 $ $ 1,900 728 $ $ 361 $ 384 2010 $ $ $ 13,226 10,058 3,168 1,837 629 $ $ 1,487 414 $ 416 $ 351 6 16 $ $ 121 21 -$ 16 OPERATING EXPENSES AND INCOME Selling, general and administrative expenses Research, development and engineering expenses Equity, royalty and interest income from investees Gain on sale of businesses Other operating income (expense), net -$ 17 -$ 10 $ -$ OPERATING INCOME Interest income Interest expense Other income (expense), net $ $ $ $ 2,365 23 64 110 $ $ $ $ 2,101 27 41 32 $ $ $ $ 2,254 25 32 24 $ $ $ 2,681 34 44 $ $ $ $ 1,602 21 40 34 INCOME BEFORE INCOME TAXES Income tax expense $ $ 2,434 698 $ $ 2,119 531 $ $ 2,271 533 $ $ 2,671 725 $ $ 1,617 477 CONSOLIDATED NET INCOME Less: Net income attributable to noncontrolling interests $ 1,736 $85 $ $ 1,588 105 $ $ 1,738 93 $ $ 1,946 98 $ $ 1,140 100 NET INCOME ATTRIBUTABLE TO CUMMINS INC . Diluted earnings per common share attributable to Cummins Inc. $ $ 1,651 9.02 10.18% 12.31% $ $ 1,483 7.91 -10.92% -9.61% $ $ 1,645 8.67 -12.34% -10.15% $ $ 1,848 9.55 43.72% 44.71% $ $ 1,040 5.28 $3.51 19.94% $2.81 19.93% $2.25 20.00% $1.80 26.33% Dividend $1.33 Date Open High Low 12/1/2014 $145.64 $151.25 11/3/2014 $146.02 $149.71 10/1/2014 $131.40 $147.14 9/2/2014 $145.37 $145.63 8/1/2014 $139.22 $148.04 7/1/2014 $153.37 $158.25 6/2/2014 $153.45 $161.03 5/1/2014 $150.46 $154.87 4/1/2014 $149.39 $151.80 3/3/2014 $144.17 $150.34 2/3/2014 $127.13 $148.60 1/2/2014 $140.43 $141.67 12/2/2013 $132.55 $141.39 11/1/2013 $127.42 $133.86 10/1/2013 $132.01 $139.17 9/3/2013 $125.00 $136.50 8/1/2013 $122.60 $128.30 7/1/2013 $109.25 $123.90 6/3/2013 $119.75 $120.71 5/1/2013 $105.25 $122.32 4/1/2013 $115.81 $118.69 3/1/2013 $114.96 $119.77 2/1/2013 $115.56 $122.54 1/2/2013 $111.50 $117.95 12/3/2012 $98.86 $109.78 11/1/2012 $94.06 $101.99 10/1/2012 $92.87 $94.98 9/4/2012 $97.08 $104.71 8/1/2012 $97.18 $105.63 7/2/2012 $97.25 $101.21 6/1/2012 $94.70 $100.55 5/1/2012 $113.99 $114.47 4/2/2012 $120.62 $123.34 3/1/2012 $121.47 $129.51 2/1/2012 $105.34 $124.69 1/3/2012 $90.45 $110.95 12/1/2011 $96.06 $98.00 11/1/2011 $94.21 $103.95 10/3/2011 $80.90 $103.54 9/1/2011 $92.80 $99.73 8/1/2011 $108.60 $108.75 7/1/2011 $103.80 $114.00 6/1/2011 $104.79 $105.33 5/2/2011 $121.32 $121.49 4/1/2011 $110.88 $120.54 3/1/2011 $102.38 $110.75 2/1/2011 $106.98 $114.30 1/3/2011 $111.08 $114.81 12/1/2010 $99.74 $111.87 11/1/2010 $87.90 $98.73 10/1/2010 $91.37 $96.13 9/1/2010 $77.07 $92.86 8/2/2010 $81.48 $82.69 7/1/2010 $64.87 $82.34 6/1/2010 $67.08 $77.10 5/3/2010 $72.67 $76.23 4/1/2010 $62.47 $76.95 3/1/2010 $57.20 $63.44 2/1/2010 $45.73 $58.63 1/4/2010 $46.35 $55.41 Close Volume Adj Close $137.97 $144.17 1412300 $140.07 $141.26 $145.62 1585100 $141.48 $124.30 $146.18 2349900 $141.26 $131.24 $131.98 1485000 $127.54 $137.09 $145.11 1398500 $140.23 $139.31 $139.39 1564000 $133.97 $151.70 $154.29 1030700 $148.29 $147.00 $152.93 995500 $146.98 $139.01 $150.85 1467600 $144.37 $139.16 $148.99 1363300 $142.59 $122.64 $145.92 2181300 $139.65 $124.03 $126.98 1600300 $121.00 $127.81 $140.97 1224000 $134.33 $127.00 $132.36 1259900 $126.12 $122.52 $127.02 1786600 $120.46 $123.46 $132.87 1350500 $126.01 $120.71 $123.20 1464100 $116.84 $107.51 $121.19 1751000 $114.35 $105.55 $108.46 2034500 $102.34 $103.41 $119.63 1999900 $112.88 $105.86 $106.39 2213200 $99.97 $111.58 $115.81 1696700 $108.82 $110.87 $115.87 1828300 $108.87 $109.19 $114.83 1659200 $107.44 $96.76 $108.35 1956400 $101.38 $93.98 $98.16 2157200 $91.84 $85.88 $93.58 2932100 $87.12 $91.16 $92.21 2362000 $85.84 $93.00 $97.11 2195600 $90.40 $82.20 $95.90 3908900 $88.84 $88.31 $96.91 3099100 $89.78 $95.43 $96.95 2834900 $89.82 $110.02 $115.83 2344700 $106.89 $114.88 $120.04 2599100 $110.78 $104.25 $120.57 2535200 $111.26 $90.37 $104.00 2857400 $95.66 $85.51 $88.02 2402700 $80.96 $86.04 $96.33 2924600 $88.61 $79.53 $99.43 4156000 $91.08 $81.51 $81.66 4578200 $74.81 $79.62 $92.92 4698100 $85.12 $101.80 $104.88 3291400 $95.66 $91.13 $103.49 3640200 $94.39 $101.74 $105.24 2843000 $95.99 $101.16 $120.18 2609800 $109.34 $93.50 $109.62 2705400 $99.74 $97.20 $101.12 3163000 $92.00 $102.58 $105.88 2299300 $96.11 $99.25 $110.01 1583000 $99.86 $87.51 $97.12 2126700 $88.16 $87.00 $88.10 2802100 $79.74 $77.00 $90.58 2712900 $81.99 $71.51 $74.41 3021900 $67.35 $63.04 $79.61 3687300 $71.82 $62.80 $65.13 3311000 $58.76 $58.91 $67.98 4362600 $61.33 $61.96 $72.23 3203200 $65.00 $57.20 $61.95 2821600 $55.75 $45.55 $56.78 3015900 $51.10 $44.84 $45.16 2518200 $40.52 Dividend 2014 Q4 Q3 Q2 Q1 2013 Q4 Q3 Q2 Q1 2012 Q4 Q3 Q2 Q1 2011 Q4 Q3 Q2 Q1 2010 Q4 Q3 Q2 Q1 $0.98 $0.98 $0.78 $0.78 $0.78 $0.78 $0.63 $0.63 $0.63 $0.63 $0.50 $0.50 $0.50 $0.50 $0.40 $0.40 $0.40 $0.40 $0.26 $0.26 $3.51 $2.81 $2.25 $1.80 $1.33 Annual Return 2014 2013 2012 2011 2010 -1% 30% 23% -20%