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FIN5IFM: International Financial Management Tutorial 8 Topic 5 Equity: Concepts and Techniques Topic 7 Alternative Instruments 1. An investor wants to evaluate an apartment building using the income approach. She gathers the following data on the apartment complex. All income items are on an annual basis. Gross potential rental income Estimated vacancy and collection losses Insurance and taxes Utilities Repairs and maintenance Depreciation Interest on proposed financing Investment under consideration $100,000 5% $8,000 $5,000 $12,000 $15,000 $6,000 Two apartment buildings have recently been sold in the area. Building A had a sales price of $5 million with an annual net operating income of $500,000. Building B had a sales price of $1 million with an operating income of $95,000. Except for size, both buildings have characteristics (location, age, quality,...) similar to that of the apartment building under consideration. According to the income approach, what is the value of the apartment complex? 2. A real estate company has prepared a simple hedonic model to value houses in a specific downtown area. A summary list of the house's characteristics that can affect pricing are: The number of main rooms The surface of the garden (if any) The construction material (wood or brick) The distance to a subway station A detailed statistical analysis of a large number of recent transaction in the area allowed to derive the following slope coefficients: Characteristics Units Number of rooms Surface of the garden Construction material Distance to subway station Number Square metres 1 if bricks and 0 if wood In metres 1 Slope Coefficient in Euros per Unit 30,000 200 30,000 -100 (a) You wish to value a house that has 7 rooms, a small garden of 100 square metres, constructed in wood and a distance of 100 metres to the nearest subway station. What is the appraisal value based on this sales comparison approach of hedonistic price estimation? (b) Give 3 limitations of the hedonic pricing approach in valuing houses. (c) Explain the income approach and the discounted after-tax cash flow approach to estimating a property's value. 3. Let's assume that you are a U.S. investor who wants to invest $10,000 in gold. The current price of gold is $400, and you expect it to go up by 10% in the very short term. You consider buying shares of gold mines; you are debating whether to invest in Bel Or or Schoen Gold. Your broker gives you the following information: Production cost per ounce Gold beta () Bel Or $147 1.6 Schoen Gold $340 6 The gold is obtained by running a regression of the percentage movements in the gold mine stock price against the percentage price movements in gold bullion. It indicates the stock market price sensitivity to gold. (a) Explain why a gold mine with a high production cost should have a value that is more sensitive to gold price movements than a gold mine with low production costs. (b) Which mine would you buy and why? (c) What is your expected return, given this scenario? 2 4. In a dividend discount model (DDM), the stock price is equal to the stream of forecasted dividends D discounted at the required rate of return r. a) Assuming that the dividends paid out in each period are constant, what is the price of the stock, Po? b) Now assume that dividends grow indefinitely at a constant compounded annual growth rate, g. How does this assumption change your answer in part (a)? Explain what is the implication of the growing dividends on share price? c) Suppose that dividends are a proportion of earnings that are paid out to shareholders. Let the earning retention rate be denoted by b. Show how you may use the expression in (b) to obtain a mathematical expression for priceearning ratio. d) Using the expression in (c), derive an expression for the PE ratio when the return on equity is equal to the market interest rate. Should earning be retained in this scenario? Explain your answer. e) The intrinsic P/E value of a corporation can be divided into two components: a tangible PE and franchise PE, and the franchise PE can be further decomposed into franchise and growth factors. Using the equation below explain how the different parts of the equation relate to the tangible and franchise PE, and the franchise and growth factors. f) Suppose the return of equity (ROE) is greater than the market required return. As a financial advisor to the company, what would be your recommendation about paying shareholders dividends from earnings if the objective is to maximise the company's P/E value? 3