A stock is expected to pay the following dividends:
Cash Flows of a Stock | ||||||
Time (yrs) | 0 | 1 | 2 | 3 | 4 | ... |
Dividend ($) | 0.00 | 1.15 | 1.10 | 1.05 | 1.00 | ... |
After year 4, the annual dividend will grow in perpetuity at -5% pa. Note that this is a negative growth rate, so the dividend will actually shrink. So,
- the dividend at t=5 will be ##$1(1-0.05) = $0.95##,
- the dividend at t=6 will be ##$1(1-0.05)^2 = $0.9025##, and so on.
The required return on the stock is 10% pa. Both the growth rate and required return are given as effective annual rates.
What is the current price of the stock?
Which statement(s) are correct?
(i) All stocks that plot on the Security Market Line (SML) are fairly priced.
(ii) All stocks that plot above the Security Market Line (SML) are overpriced.
(iii) All fairly priced stocks that plot on the Capital Market Line (CML) have zero idiosyncratic risk.
Select the most correct response:
There are many different ways to value a firm's assets. Which of the following will NOT give the correct market value of a levered firm's assets ##(V_L)##? Assume that:
- The firm is financed by listed common stock and vanilla annual fixed coupon bonds, which are both traded in a liquid market.
- The bonds' yield is equal to the coupon rate, so the bonds are issued at par. The yield curve is flat and yields are not expected to change. When bonds mature they will be rolled over by issuing the same number of new bonds with the same expected yield and coupon rate, and so on forever.
- Tax rates on the dividends and capital gains received by investors are equal, and capital gains tax is paid every year, even on unrealised gains regardless of when the asset is sold.
- There is no re-investment of the firm's cash back into the business. All of the firm's excess cash flow is paid out as dividends so real growth is zero.
- The firm operates in a mature industry with zero real growth.
- All cash flows and rates in the below equations are real (not nominal) and are expected to be stable forever. Therefore the perpetuity equation with no growth is suitable for valuation.
Where:
###r_\text{WACC before tax} = r_D.\frac{D}{V_L} + r_{EL}.\frac{E_L}{V_L} = \text{Weighted average cost of capital before tax}### ###r_\text{WACC after tax} = r_D.(1-t_c).\frac{D}{V_L} + r_{EL}.\frac{E_L}{V_L} = \text{Weighted average cost of capital after tax}### ###NI_L=(Rev-COGS-FC-Depr-\mathbf{IntExp}).(1-t_c) = \text{Net Income Levered}### ###CFFA_L=NI_L+Depr-CapEx - \varDelta NWC+\mathbf{IntExp} = \text{Cash Flow From Assets Levered}### ###NI_U=(Rev-COGS-FC-Depr).(1-t_c) = \text{Net Income Unlevered}### ###CFFA_U=NI_U+Depr-CapEx - \varDelta NWC= \text{Cash Flow From Assets Unlevered}###Your firm's research scientists can begin an exciting new project at a cost of $10m now, after which there’s a:
- 70% chance that cash flows will be $1m per year forever, starting in 5 years (t=5). This is the A state of the world.
- 20% chance that cash flows will be $3m per year forever, starting in 5 years (t=5). This is the B state of the world.
- 10% chance of a major break through in which case the cash flows will be $20m per year forever starting in 5 years (t=5), or instead, the project can be expanded by investing another $10m (at t=5) which is expected to give cash flows of $60m per year forever, starting at year 9 (t=9). Note that the perpetual cash flows are either the $20m from year 4 onwards, or the $60m from year 9 onwards after the additional $10m year 5 investment, but not both. This is the C state of the world.
The firm's cost of capital is 10% pa.
What's the present value (at t=0) of the option to expand in year 5?
Question 398 financial distress, capital raising, leverage, capital structure, NPV
A levered firm has zero-coupon bonds which mature in one year and have a combined face value of $9.9m.
Investors are risk-neutral and therefore all debt and equity holders demand the same required return of 10% pa.
In one year the firm's assets will be worth:
- $13.2m with probability 0.5 in the good state of the world, or
- $6.6m with probability 0.5 in the bad state of the world.
A new project presents itself which requires an investment of $2m and will provide a certain cash flow of $3.3m in one year.
The firm doesn't have any excess cash to make the initial $2m investment, but the funds can be raised from shareholders through a fairly priced rights issue. Ignore all transaction costs.
Should shareholders vote to proceed with the project and equity raising? What will be the gain in shareholder wealth if they decide to proceed?
Which of the following equations is NOT equal to the total return of an asset?
Let ##p_0## be the current price, ##p_1## the expected price in one year and ##c_1## the expected income in one year.
Question 727 inflation, real and nominal returns and cash flows
The Australian Federal Government lends money to domestic students to pay for their university education. This is known as the Higher Education Contribution Scheme (HECS). The nominal interest rate on the HECS loan is set equal to the consumer price index (CPI) inflation rate. The interest is capitalised every year, which means that the interest is added to the principal. The interest and principal does not need to be repaid by students until they finish study and begin working.
Which of the following statements about HECS loans is NOT correct?
Question 883 monetary policy, impossible trinity, foreign exchange rate
It’s often thought that the ideal currency or exchange rate regime would:
1. Be fixed against the USD;
2. Be convertible to and from USD for traders and investors so there are open goods, services and capital markets, and;
3. Allow independent monetary policy set by the country’s central bank, independent of the US central bank. So the country can set its own interest rate independent of the US Federal Reserve’s USD interest rate.
However, not all of these characteristics can be achieved. One must be sacrificed. This is the 'impossible trinity'.
Which of the following exchange rate regimes sacrifices convertibility?
Question 884 monetary policy, impossible trinity, foreign exchange rate, no explanation
According to the impossible trinity, a currency can only have two of these three desirable traits: be fixed against the USD; convertible to and from USD for traders and investors so there are open goods, services and capital markets; and allow independent monetary policy set by the country’s central bank, independent of the US central bank.
Which of the following exchange rate regimes sacrifices fixing the exchange rate to the USD? In other words, which regime uses a floating exchange rate?