FSA Assignment III Group 4 [PDF]

Zitiervorschau

ASSIGNMENT 3 Question 1 a. Investors receive dividends as payoffs for investing in equity shares. Thus the value of a share should be calculated by discounting expected dividends. True or false?  True, dividends are the payoff to equity investing. The second sentence is true in theory but not in practice. Equity value is the present value of the infinite stream of expected dividends that a going concern generates. But, in practice, one can’t forecast to infinity. Dividends paid over practical, infinite forecast horizons are not relevant to value: the dividends firm pay up to the liquidating dividend can be any amount but that amount does not affect its present value. This is dividend conudrum: value is based on expected dividends, but forecasting dividends is not relevant to value as a practical matter. b. Some analysts trumpet the saying "Cash is King." They mean that cash is the primary fundamental that the equity analyst should focus on. Is cash king?  Cash isn’t king appositively it should be free cash flow. Hence FCF is what an analyst should focus upon because it the amount that is available to the shareholders once you have paid all the debt and the interest payments. Where as cash is biased too much by interest payments, amortization, depreciation as it doesn’t take into account any of these. Hence we can say an analyst should primarily focus upon the FCFF/FCFE not the cash. c. Should a firm that has higher free cash flows have a higher value?  Not necessarily. A firm can generate higher free cash flow by liquidating its investments. A highly profitable (and highly valuable) firm can have low (or even negative) free cash flows because it is investing heavily to capitalize on its investment opportunities. d. Which of the following two measures gives a better indication of the value added from selling inventory: (a) cash receive d from customers minus cash paid for inventory, or (b) accrual revenue minus cost of goods sold? Why?  The answer is (b). Matching cash received from sales with cash spent on inventory does not match value received with value given up to earn the cash, because it recognizes the cost of unsold goods against the receipts from goods sold. Accrual accounting accomplishes the matching because only the cost of goods sold is recognized against the revenue from goods sold. e. What explains the difference between cash flow from operations and earnings?  Although both concepts are related about cash, the recognition concept of cash differs. Cash flow from operation shows the transfer intensity of physical cash in the inflows (earnings) and outflow (purchases) that is made. Since only physical cash that is used that is counted, Non-physical income are not recognized as it may be not realized yet. But it still recognized as an earning since it is resulted from the business transaction over goods or service offered. f. What explains the difference between free cash flow and earnings?  Free cash flow reflects the amount of cash that is free to use after being allocated for expenses and expenditures that must be paid. As free cash flow still refers to the generated physical cash, any non-physical inflows is still not included in the count. In earnings, all kind of transaction both physical non-physical is taken into account, including the free cash flow. g. Interest payments should not be part of cash flow from operations. Why?

 Because it is an investment to store cash that temporarily is not needed in operations. The investment in operations only comes when the T-bill is sold and the cash from the sale is invested in operating assets. Interest is excluded from operating cash flow because a firm’s operating cash flow represents the cash generated from the normal operations of business, like producing and manufacturing, selling, and distribution of its goods and services. If interest included in operating cash flow, then the result will not reflect the correct operating cash flow because interest expenses is not a part of operating expenses. h. Company X has negative free cash flows but strong earnings that yield a return on equity of 27 percent. Which of the following statements is more likely to be true? a) The company is wasting cash on unproductive activities. b) The company is investing heavily.  The true statement is B, the company is investing heavily. The waves of the reinvestment process, when firms invest large amounts of cash in some years and nothing in others, can cause the free cash flow to be negative in the big reinvestment years and positive in others. i. In 2010, a newspaper interviewed a money manager who claimed the mantle of a fundamental investor. He laid out his investment philosophy: He "seeks companies that are likely to generate strong cash flows yet are priced very cheaply." "Cash is king," he says so he is investing in Intel, Microsoft, Macy's, DuPont, Xerox, and Radio Shack, firms with significant amounts of cash. Critique his approach.  Interest draws taxes; interest income incurs tax and interest expense yields a tax deduction. So, to understand the effect of interest on earnings or cash flows, interest must be attached to the interest to put it on an after-tax basis. A profitable company can generate a lot of free cash flow. Question 2 At the end of 2012, you forecast the following cash flows (in millions) for a firm with net debt of $759 million:

You forecast that free cash flow will grow at a rate of 4 percent per year after 2015. Use a required return of 10 percent in answering the following questions. a. Calculate the firm's enterprise value at the end of 2012. b. Calculate the value of the equity at the end of 2012. 2012 Cash from operations Cash investments Free cash flow Discount rate (1.10)t Present value of free cash flows Total present value to 2015 Continuing value (CV)* Present value of CV

2013 $1,450 $1,020 $ 430 1.10 391

2014 1,576 1,124 452 1.21 374

2015 1,718 1,200 518 1.331 389

$1,154 8,979 6,746

a. Enterprise value Book value of net debt b. Value of equity *CV =

518 x 1.04 1.10−1.04

$7,900 759 $7,141

= 8,979

Question 3 At the end of 2012, you forecast the following cash flows for a firm for 2013-2016 (in millions of dollars):

What difficulties would you have in valuing this firm based on the forecasted cash flows?  The difficulties occurs because these are result in negative free cash flow over the years and it’s sign that the company need to raise and earn new equity immediately, otherwise it will not always negative as long as the company could maintain their investing lower than operation activities. What would explain the decreasing free cash flow over the four years?  Decreasing free cash flow over the years could reach the negative free cash flow which influenced by several factors, the main factor of this case is because the amount of cash investments exceeds the amount of cash from operations. Question 4 The required return for the firm is 7 percent. Growth 4%. Cash flow from operations on 2000 is 6,500; 2001 is 7,197; 2002 is 7,536; 2003 is 7,757; 2004 is 8,929. Cash investment on 2000 is 747; 2001 is 1,070; 2002 is 1,800; 2003 is 850; 2004 is 440. Book value of net debt is 2,455. Shares outstanding is 2,111. Calculate the value per share. 1999 Cash from operations Cash investments Free cash flow Discount rate (1.07)t Present value of free cash flows Total present value to 2004 Continuing value (CV)* Present value of CV Enterprise value Book value of net debt Value of equity Shares outstanding Value per share

2000 6,500 747 5,753 1.07 5,377

2001 7,197 1,070 6,127 1.1449 5,352

2002 7,536 1,800 5,736 1.225 4,682

2003 7,757 850 6,907 1.3108 5,269

2004 8,929 440 8,489 1.4025 6,053

26,733 294,285 209,829 236,562 2,455 234,107 2,111 110.899

*CV =

8,489 x 1.04 1.07−1.04

= 294,285

Present value of CV =

294,285 1.4025

= 209,829