FIN 340 EXAM 2 LATEST VERSION OF QUESTIONS AND
ANSWERS TO SUPPORT SUCCESSFUL FINANCE EXAM
PREPARATION
motivation for valuing stocks - ANSWER how do investors decide whether to
buy or sell a stock? what drives its value?
price of security - ANSWER PV of expected cash flows an investor will
receive from owning it
valuing a stock (general) - ANSWER we need to obtain estimates of expected
cash flows and the appropriate risk adjusted cost of capital
adjusted cost of capital methods - ANSWER dividend discount model of stock
valuation
FCF valuation of stock (indirect method)
1 year investor - ANSWER potential cash flows is the dividend and sale of
stock
year 0 the cash flow is the outflow of the initial price
year 1 the cash flow is the dividend + price y1
since cash flows are risky we must discount them at equity cost of capital so
price y0 = (div y1 + price y1)/(1+re)
current stock price relation to price 0 - ANSWER if current stock price <
amount then expect investors to rush in and buy it, driving up the price
if stock price > than the amount then selling it causes the price to fall
equity cost of capital - ANSWER re= ((Div y1 + price y1)/price y0 )-1
or div yield + capital gain rate
,use CAPM re=rf+be*market risk premium or div discount model
re=e[div1]/po+g
div yield - ANSWER div y1 / price y0
capital gain rate - ANSWER (price y1 - price y0)/price y0
total return - ANSWER dividend yield + capital gain rate
the expected total return of stock should = the expected return of other
investments available in market w equivalent risk
dividend discount model - ANSWER multi year investors for N years
Po = div y1/(1+re) + div y2 /(1+re)^2 + ... + (divn + price n)/(1+re)^n
holds for any horizon N thus all investors attach the same value to a stock
the sum to infinity is the DivN / (1+re)^n
relies on market efficiency. the prices should reflect the fundamental value
otherwise if price is lower people will rush in and it will go up. if greater than,
then people sell and would need ot be able to short (sell what they don't have).
formula itself not very useful bc need a method to forecast future divs
special case: constant dividend growth - ANSWER simplest forecast for the
firms future divs growing at a constant rate g forever
Po = div y1 / (re -g)
re = Div y1 / Po + g
g represents the capital gains rate
value of firm depends on dividend level, cost of equity and growth rate
need to be at a steady state and giving out dividends
, dividend payout ratio - ANSWER fraction of earnings paid as dividends each
year
simple model of growth - ANSWER Div t = earnings / shares outstanding t
*dividend payout rate t
assuming # shares outstanding is constant, to increase the dividends you have to
increase earnings (net income) or increase dividend payout rate
what to do with earnings - ANSWER 1. can pay out to investors
2. can retain/reinvest
dividend payout rate = 1-retention rate
retention rate = 1- dividend payout rate
dividend policy - ANSWER determines rate of growth in future
earnings/dividends for a firm
changing growth rate - ANSWER at some point the growth rate becomes
constant growth in terms of one years dividends
cash flows are div 1, div 2.... divn + price n , divn+1, divn+1 * (1+g) + div n+1
* (1+g)^2 ...
Pn = divn+1 / (re-g)
leads into dividend discount model w constant long term growth
dividend discount model w constant long term growth - ANSWER Po = div1 /
(1+re) + div2/(1+re)^2 + ... + (div N + (divN+1/re-g))/(1+re)^n
remember that the divn+1 has to be multiplied by (1+re)^n and then for div N
you have to take price of N+1 and discount
common stock - ANSWER share of ownership w rights to common dividends
and vote in elections
ticker symbol - ANSWER abbrev assigned to publically traded company
ANSWERS TO SUPPORT SUCCESSFUL FINANCE EXAM
PREPARATION
motivation for valuing stocks - ANSWER how do investors decide whether to
buy or sell a stock? what drives its value?
price of security - ANSWER PV of expected cash flows an investor will
receive from owning it
valuing a stock (general) - ANSWER we need to obtain estimates of expected
cash flows and the appropriate risk adjusted cost of capital
adjusted cost of capital methods - ANSWER dividend discount model of stock
valuation
FCF valuation of stock (indirect method)
1 year investor - ANSWER potential cash flows is the dividend and sale of
stock
year 0 the cash flow is the outflow of the initial price
year 1 the cash flow is the dividend + price y1
since cash flows are risky we must discount them at equity cost of capital so
price y0 = (div y1 + price y1)/(1+re)
current stock price relation to price 0 - ANSWER if current stock price <
amount then expect investors to rush in and buy it, driving up the price
if stock price > than the amount then selling it causes the price to fall
equity cost of capital - ANSWER re= ((Div y1 + price y1)/price y0 )-1
or div yield + capital gain rate
,use CAPM re=rf+be*market risk premium or div discount model
re=e[div1]/po+g
div yield - ANSWER div y1 / price y0
capital gain rate - ANSWER (price y1 - price y0)/price y0
total return - ANSWER dividend yield + capital gain rate
the expected total return of stock should = the expected return of other
investments available in market w equivalent risk
dividend discount model - ANSWER multi year investors for N years
Po = div y1/(1+re) + div y2 /(1+re)^2 + ... + (divn + price n)/(1+re)^n
holds for any horizon N thus all investors attach the same value to a stock
the sum to infinity is the DivN / (1+re)^n
relies on market efficiency. the prices should reflect the fundamental value
otherwise if price is lower people will rush in and it will go up. if greater than,
then people sell and would need ot be able to short (sell what they don't have).
formula itself not very useful bc need a method to forecast future divs
special case: constant dividend growth - ANSWER simplest forecast for the
firms future divs growing at a constant rate g forever
Po = div y1 / (re -g)
re = Div y1 / Po + g
g represents the capital gains rate
value of firm depends on dividend level, cost of equity and growth rate
need to be at a steady state and giving out dividends
, dividend payout ratio - ANSWER fraction of earnings paid as dividends each
year
simple model of growth - ANSWER Div t = earnings / shares outstanding t
*dividend payout rate t
assuming # shares outstanding is constant, to increase the dividends you have to
increase earnings (net income) or increase dividend payout rate
what to do with earnings - ANSWER 1. can pay out to investors
2. can retain/reinvest
dividend payout rate = 1-retention rate
retention rate = 1- dividend payout rate
dividend policy - ANSWER determines rate of growth in future
earnings/dividends for a firm
changing growth rate - ANSWER at some point the growth rate becomes
constant growth in terms of one years dividends
cash flows are div 1, div 2.... divn + price n , divn+1, divn+1 * (1+g) + div n+1
* (1+g)^2 ...
Pn = divn+1 / (re-g)
leads into dividend discount model w constant long term growth
dividend discount model w constant long term growth - ANSWER Po = div1 /
(1+re) + div2/(1+re)^2 + ... + (div N + (divN+1/re-g))/(1+re)^n
remember that the divn+1 has to be multiplied by (1+re)^n and then for div N
you have to take price of N+1 and discount
common stock - ANSWER share of ownership w rights to common dividends
and vote in elections
ticker symbol - ANSWER abbrev assigned to publically traded company
