185760_40902_Solution1

Answer: a

Stock is having negative correlation with market returns hence this stock will perform in a opposite way in comparison with market. The cost of capital is the price for the funds raised by the corporates. It’s the minimum income which the corporation has to build on its own investments so that it can repay to its investors without paying the same from its own pocket; to earn the money flows out of the money which the investors have paid. Value of capital is a cost of finance for the company which every investor investing in business desires and needs to earn.

Cost of capital = minimum rate of income + premium for taking business risk + premium for taking monetary risk

Source of Finance and Relative price

The cost of debt is under the price of equity as the equity holders are the real owners of the business while debt holders are creditors of the business with fixed rate of return; as a result of debt is a smaller amount risky from the debt holders’ viewpoint. Also when the time of liquidation arrives, the debt holders have a prior claim as compared to the equity holders. Considering this, the debt holders have a safer investment as compared to equity holders so their return is also lower as compared to equity holders. They claim a lower rate of return as compared to equity holders. Debt interest is also corporation tax deductible and tax allowable creating it even cheaper to a tax paying company.

Cost of equity

The model of dividend growth is wont to estimate a price of equity, on the idea that the market price of share is associated directly with the future dividends which is expected from the shares.

How will the price of equity on retain earnings be calculated?

The cost of equity for new problems and maintained earnings is calculable victimization the model of dividend valuation, on the idea that the market price of the shares is associated directly with dividends on shares which is expected in the future.

Ke = D/P0

Here Ke = price of Equity,

D = annual dividend per share, beginning at year one, P0 = ex X dividend share worth

Shareholders can usually expect dividends to grow year by year and not stay constant and non moving in eternity. The elementary theory of share worth states that the market value of a share is that that value of the discounted future money flows of revenue from the share, that the market price given is able to justify it based on future growth prospects.

Ke = D0 (1+g)/P0 + g

How are you able to estimate the expansion rate?

There are two ways for estimating the rate of expansion:

• Dividend within the first year x (1 + g) n = Dividends within the original or zero year

• Gordon’s growth approximation theory:

Growth = Portion of profits maintained x rate of income on new investments

What is the price of debt?

The cost of debt is that the income which the investee enterprise should pay to its lenders. It’s the price which is paid continuously by the enterprise to use the finance instead of redeeming the securities at their current market value. For redeemable debt, the price is that the internal rate of income of money flows. In case of irredeemable debt, this can be the (post tax) interest as a share of the market price of ex-interest of the bonds or preference shares. Also, it’s the price of raising extra interest capital assuming the price of the extra capital that would be adequate of the price which is already issued.

Answer: b

Yield to maturity is a rate associated with the bond or other instrument with fixed rate of return; it is  internal rate of return (IRR) of the investment over the life of investment until its maturity. Market value per share: (Earnings less interest / shares) x (1/Ke) The conclusion of cyberspace operative financial gain approach is that the amount of gears may be a matter of indifference to the enterprise, as a result of it doesn’t have an effect on the market price of the corporate, nor of a private share. This can be because of because the level of gears rises; therefore the price of equity will move in such the way to keep the WACC and therefore the market price of the shares will remain constant. Statue maker and Miller, the statisticians had changed their theory to admit that tax relief on interest payments will reduce the WACC and hence it is beneficial. The saving coming from tax relief on debt interest may be tax advantage. They claimed that the WACC will still fall, up to gears upto 100 percent. This implies that corporations ought to have a capital structure created up entirely of debt however, this does not happen in observe as a result of the existence of alternative market imperfections.

There are various different kind of yield curves which are as follows.

–          Normal Yield Curve: When the short term yields will have lower value than having long term yield then such situation is known as normal yield curve as this knows as positive yield curve.

–          Curve of Inverted Yield: When the short term yields are higher than yield of long term then in such a situation the yield curve is inverted.

–          Flat yield curve: This is a situation where in the short term and long term both curves are having same value.

Answer: c

The two approaches are likely to yield different equity value since the use of stock price will be influenced by the market volatility while using cash flow approach will be influenced by current financial operation of the firm been analyzed in determining the value of the firm. Consequently, an optimal approach should be determined in allowing analysts to determine the value of a equity of a firm correctly. In determining the equity value of Shell that is publicly listed in London Stock Exchange, the price/earnings ratio and discounted cash flow have been utilized.

Royal Dutch Shell PLC, dividends per share (DPS) forecast

Royal Dutch Shell PLC, forecast of free cash flow to equity (FCFE)

Answer: d

Methods used in valuation of share of company are as follows,

–          Dividend discount model – 63.75

–          Discounted free cash flow to firm – 55.32

–          Discounted free cash flow to equity – 68.72

Hence out of these 3 different models Dividend discount model is having a realistic value and as per the valuation the market value expected is 63.75 while the actual market value is 68.72 hence the share should be sold on the current rate as there fundamentals shows that the value of share will reduce in future. The dividend growth model is there to estimate a price of equity, in the context that the market price of share is directly associated with the expected future dividends derived from the shares.

How will the price of equity on new problems and retain earnings be calculated?

The cost of equity based on maintained earnings is calculable by the dividend valuation model, on the idea that the market price of shares is directly associated with expected future dividends on shares to be derived in future. Modigliani and Miller expressed that, given the absence of tax, a company’s capital structure will not have any impact upon its WACC. They projected that the entire market price of a corporation is confirmed by its total earnings and therefore the level of operation risk is hooked up to those earnings.

References:

^T.E. Copeland, J.F. Weston (1988): Financial Theory and Corporate Policy, Addison-Wesley, West Sussex

^E.J. Elton, M.J. Gruber, S.J. Brown, W.N. Goetzmann (2003): Modern Portfolio Theory and Investment Analysis, John Wiley & Sons, New York

^E.F. Fama (1976): Foundations of Finance, Basic Books Inc., New York

^Marc M. Groz (2009): Forbes Guide to the Markets, John Wiley & Sons, Inc., New York

^R.C. Merton (1992): Continuous-Time Finance, Blackwell Publishers Inc.

^Keith Pilbeam (2010) Finance and Financial Markets, Palgrave

^Steven Valdez,(2011), An Introduction To Global Financial Markets, Macmillan Press Ltd.

^Steven Valdez  (2010) The Business Finance Market, Industrial Systems Research Publications, Manchester (UK)

^Needles, Belverd E.; Powers, Marian (2013). Principles of Financial Accounting. Financial Accounting Series (12 ed.). Cengage Learning.

^ Weber, Richard P., and W. C. Stevenson. 1981. “Evaluations of Accounting Journal and Department Quality.”