Preparatory Question Set: FCFs and Corporate Valuation $($Module IV$)$

What is net operating working capital? Why does it exclude most short$-$term investments and notes payable? What is total net operating capital? Why is it important for managers to calculate a company$$s capital requirements?

Two investors are evaluating General Electric$$s stock for possible purchase. They agree on the expected value of D$1$ and also on the expected future dividend growth rate. Further, they agree on the risk of the stock. However, one investor normally holds stocks for $2$ years and the other normally holds stocks for $10$ years. On the basis of the type of analysis done in this chapter, they should both be willing to pay the same price for General Electric$$s stock. True or false? Explain.

Answer the following questions regarding dividend discount models:

What are the two components of most stocks$$ expected total return?

What is the general formula to calculate the capital gains yield and the dividend yield of a stock $($one that holds when firm$$s dividends are growing at a constant rate and when they are not$)?$

Write out and explain the dividend discount model formula for a constant growth stock. What is the capital gains yield and dividend yields for a constant growth stock?

How does one calculate the capital gains yield and the dividend yield of a non$-$constant growth stock during the time period over which dividends grow at a non$-$constant rate?

What is the relationship between stocks$$ total expected return and capital gains yield for a new growth stock that is paying no dividends?

Answer the following questions regarding free cash flow models

Write out the equation for the value of operations.

What is the horizon value? Why is it also called the terminal value or continuing value?

Explain how to use the free cash flow valuation model to find the price per share of common equity.

What are value drivers? Does an increase in the operating profitability ratio always cause an increase in the value of operations? Does a decrease in the capital requirement ratio always cause an increase in the value of operations? Does an increase in the long$-$term growth rate of free cash flows always cause an increase in the value of operations? Explain your answers.

Are stock values more affected by short$-$term cash flows or by long$-$term cash flows? Describe two reasons why managers might focus on quarterly earnings. Explain. Describe two reasons why managers might focus on quarterly earnings.

The FCF formulas make several assumptions $$ see slide $4$ of this module. How would calculating future FCF change if the firm i$)$ currently has Pension liabilities and you expect to pay it off by the time the firm matures and ii$)$ currently has Goodwill $($due to acquisition activities$)$ but you believe the firm will not engage in any additional significant activities?

Answer the following questions related to equity valuation:

What constitutes a bigger proportion of current equity value $$ the PV of terminal value $($value at maturity$)$ or the PV of cash flows till maturity? Briefly explain.

Provide a rational reason why unexpected performance in the short$-$term can substantially impact stock price?

Answer the following questions regarding the differences between the various stock pricing models.

Theoretically, should the dividend discount model and free cash flow model yield the same stock price? Explain.

What are the advantages and disadvantages of the free cash flow valuation model relative to the dividend growth model? What situation is ideally suited to valuation with the dividend growth model?

What are the advantages of the free cash flow valuation model relative to the market multiple method? What is the best use of market multiple method of stock price valuation?

A company currently pays a dividend of $$2$ per share $($D$0=$ $$2).$ It is estimated that the company$$s dividend will grow at a rate of $20\%$ per year for the next $2$ years and then at a constant rate of $7\%$ thereafter. The company$$s stock has a beta of $1\mathrm{.}2,$ the risk$-$free rate is $7\mathrm{.}5\%,$ and the market risk premium is $4\%.$ What is your estimate of the stock$$s current price?

$($End$-$of$-$chapter numerical problem $8\mathrm{.}8)$ A stock is trading at $$80$ per share. The stock is expected to have a year$-$end dividend of $$4$ per share D$1=$ $$4,$ and it is expected to grow at some constant rate, g$,$ throughout time. The stock$$s required rate of return is $14\%($assume the market is in equilibrium with the required return equal to the expected return$).$ What is your forecast of g$?$

$($End$-$of$-$chapter numerical problem $8\mathrm{.}20)$ Reizenstein Technologies $($RT$)$ has just developed a solar panel capable of generating $200\%$ more electricity than any solar panel currently on the market. As a result, RT is expected to experience a $15\%$ annual growth rate for the next $5$ years. By the end of $5$ years, other firms will have developed comparable technology, and RT$$s growth rate will slow to $5\%$ per year indefinitely. Stockholders require a return of $12$