Exam 11: Risk-Adjusted Expected Rates of Return and the Dividends Valuation Approach

For each of the following scenarios determine the value as of the beginning of 2012 of the continuing dividend: Forecast of Dividend in year 2016 Long-Run Growth Forecast Cost of Capital Scenario A \ 28 4\% 11\% Scenario B \ 54 9\% 15\% Scenario C \ 123 5\% 14\% Amounts in thousands)

Explain why analysts and investors use risk-adjusted expected rates of return as discount rates in valuation. Why do risk-adjusted expected rates of return increase with risk?

In theory, the value of a share of common equity is the present value of ____________________________________________________________.

Why are dividends value-relevant to common equity shareholders?

Shady Sunglasses operates retail sunglass kiosks in shopping malls. Below is information related to the company: \begin{array}{c}\begin{array}{l}\text {(dolar aHiounts in thousands)}\\ \text {Net Cash Flow from Operations}\\ \text {Interest Expense after tax}\\ \text {Decrease (Increase) in Cash Required for Operations}\\ \text { Net Cash Flow from Investing}\\ \text {Net Cash from Debt Financing}\\\\ \text {Present Value Factors \left(\mathrm{R}_{\mathrm{c}}=8.5 \%\right) }\\ \text {Common SharesOutstanding}\\ \text {in thousands} \end{array}\begin{array}{l}\underline{2012}\\564\\122 \\-75 \\-287 \\210 \\\\0.922 \\1,512\\\\ \end{array}\begin{array}{l}\underline{2013}\\628 \\134 \\-54 \\-300 \\204 \\\\0.849\\\\ \\\end{array}\begin{array}{l}\underline{2014}\\854 \\148 \\-48 \\-310 \\140 \\\\0.783\\\\\\ \end{array}\begin{array}{l}\underline{2015}\\1059 \\145 \\-32 \\-285 \\85 \\\\0.722\\\\ \\\end{array}\begin{array}{l}\underline{2016}\\1345 \\155 \\-61 \\-294 \\-40 \\\\0.665\\\\\\\end{array}\begin{array}{l}\underline{2017}\\1655\\148 \\-48 \\-277 \\-46\\\\\\\\\\ \end{array}\end{array} Using the above information and assuming that steady-state growth in year 2017 and beyond will be 4% calculate Shady Sunglasses value per share.

The following data pertains to Zonk Corp., a manufacturer of ball bearings (dollar amounts in millions): Total assets \6 ,840 Interest-be aring debt \3 ,562 Average pre-tax borrowing cost 11.5\% Common equity. Book value \2 ,560 Market value \1 2,850 Income tax rate 35\% Market ecuity beta 1.24 - Assume that Zonk is a potential leveraged buyout candidate. Assume that the buyer intends to put in place a capital structure that has 70 percent debt with a pretax borrowing cost of 14 percent and 30 percent common equity. Compute the revised equity beta for Zonk based on the new capital structure.

Why do investors typically accept a lower risk-adjusted rate of return on debt capital than equity capital? Suppose a stable, financially healthy, profitable, tax-paying firm that has been financed with all equity and no debt decides to add a reasonable amount of debt to its capital structure. What effect will that change in capital structure likely have on the firm's weighted average cost of capital?

Provide the rationale for using expected dividends in a valuation model.

Suppose a firm has a market beta of 1.34 and the risk free interest rate is 5.3%. In addition, the excess return over the risk-free rate is 5.9%. Calculate the firm's cost of equity capital using the CAPM model.

Investors typically accept a lower risk-adjusted rate of return on debt capital than on equity capital because

All of the following are steps in the analysis and valuation framework used to understand the fundamentals of a business and determine estimates of its value except:

According to the text, dividends are value-relevant even though the firm's dividend policy is irrelevant. How can that be true? What is the key assumption in the theory of dividend policy irrelevance?

When deriving the equity value of a firm, an analyst forecasts the real dividends expected to be paid in the future. In this case, which discount rate should be used?

In some valuation scenarios, such as a leveraged buyout, it may be necessary to adjust the market equity beta to reflect a ________________________________________.

Conceptually, why should an analyst expect the dividends valuation approach to yield equivalent value estimates to the valuation approach that is based on free cash flows available to be distributed to common equity shareholders?

Dividends measure the cash that ____________________ ultimately receive from investing in an equity share.

The dividends valuation approach measures value-relevant dividends to encompass various transactions between the firm and the common shareholders. What transactions should the analyst include in value-relevant dividends for purposes of implementing the dividends valuation model? Why?

The following data pertains to Zonk Corp., a manufacturer of ball bearings (dollar amounts in millions): Total assets \6 ,840 Interest-beaning debt \3 ,562 Average pre-tax borrowing cost 11.59\% Common equity: Book value \2 ,560 Market value \1 2,850 Income tax rate 35\% Market equity beta 1.24 - Determine the weight on equity capital that should be used to calculate Zonk's weighted-average cost of capital:

With respect to dividends and priority in liquidation, what has priority over common stock?

The following data pertains to Zonk Corp., a manufacturer of ball bearings (dollar amounts in millions): Total assets \6 ,840 Interest-beaning debt \3 ,562 Average pre-tax borrowing cost 11.59\% Common equity: Book value \2 ,560 Market value \1 2,850 Income tax rate 35\% Market equity beta 1.24 - Determine the weight on debt capital that should be used to calculate Zonk's weighted-average cost of capital: