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# Question: Discuss the main differences between the Dividend Discount Model and the Free Cash Flow to Equity Discount Model.

08 Oct 2022,10:33 PM

Part A (22%)
The MEDCOM firm is currently selling for €32, with trailing 12-month earnings and dividends of €1.23 and €0.64, respectively. The Price to Earnings ratio (P/E) is 26, the Price to Book Value ratio (P/BV) is 6.5 and the Price to Sales ratio (P/S) is 2.8. The return on equity is 27
percent and the profit margin on sales is 11 percent. The Treasury bond rate is 4.5 percent, the equity risk premium is 6 percent and MEDCOM’s beta is 1.3.
i. Calculate the MEDCOM’s required return, based on the Capital Asset Pricing Model.
ii. Assume that the dividend and earnings growth rates are 9.5%. Calculate the P/E, P/BV and P/S ratios that would be justified given the required rate of return in i) and current values of the dividend payout ratio, ROE and profit margin.
iii. Given that the assumptions of the constant growth model are appropriate, state whether MEDCOM is fairly priced, overpriced, or underpriced.

Part B (8%)
You work in an Investment Bank and you have a client who has inquired about the most suitable valuation ratio in order to compare the companies in an industry with the following characteristics:
 The companies in the industry are located in the USA, Japan, France and Brazil.
 The industry is currently operating at a cyclical low, i.e. many companies in the industry report losses.
Determine which one of the three valuation ratios, P/E, P/BV and P/S is most appropriate for comparing companies in this industry and advice your client.

Subject 2 (40%)
Part A (20%)
ABC Investment Bank is evaluating LaFurge Company, headquartered in Paris, France. In 2021, when ABC is performing the analysis, LaFurge is not profitable and it pays no dividends on its common shares. ABC decides to use the forecasts of the Free Cash Flows to the Equity to value LaFurge. To this end, the analyst makes the following assumptions:
 LaFurge has 18 billion outstanding shares.
 LaFurge’s sales in 2022 will be €6.5 billion and they expect to increase at 25% for the next four years (through 2026).
 The Net Income is expected to be 32% of sales.
 Investment in fixed assets is expected to be 36% of sales, investment in working capital 6% of sales, and depreciation 8% of sales.
 The 20% of the investment in assets will be financed with debt.
 Interest expenses will be 2% of sales.
 The tax rate is 10%.
 LaFurge’s beta is 2.1, the risk-free rate is 4.6%, and the equity risk premium is 4%.
 At the end of 2026, ABC projects that LaFurge’s price will be 17 times its Net Income.
Estimate the value per share of the LaFurge Company.

Part B (15%)
The price of WatchBit’s stock is €45. ABC Investment Bank attempts to determine whether WatchBit is fairly priced. The financial information ABC has assembled for this valuation is as follows:
 The required rates of return on WatchBit debt, common stock and preferred stock are 7%, 12% and 8%, respectively.
 The target capital structure is: 30% debt, 15% preferred stock, and 55% common stock.
 The market value of debt is €145 million.
 The market value of preferred stock is €65million.
 The Free Cash Flow to the Firm (FCFF) for the year just ended is €28 million and is expected to grow at a constant rate equal to 5% for the years that follow.
 WatchBit has 8 million outstanding shares.
 The tax rate is 30%.

Calculate the estimated value per share for WatchBit stock and decide whether it is underpriced or overpriced.

Part C (5%)
Assume a €100 increase in the depreciation expense. Indicate the effect on this year’s Free Cash Flow to Equity (FCFE) if the tax rate is 40% and all the other variables, including the capital expenditures, remain constant. Explain your answer.
Subject 3 (30%)

Part A (24%)
Assume that you own shares of company "ALPHA". The current price is € 49.84 per share, while last week it paid a dividend of € 1.67. Consider whether you should sell your shares or increase the number of "ALPHA" shares you hold. Based on the estimates for future dividends you will evaluate the following scenarios:
Scenario 1: Dividends will increase over the next three years at a rate of 30%, 28% and 24% respectively. After three years, the dividend growth rate is expected to stabilize at 8% per year.
Scenario 2: The annual dividend will remain constant (€ 1.67) for all years.
The return you require for shares in this risk category is 14%. Consider the following:
i. If scenario 1 applies, estimate the value of the "ALPHA" share today. What should be your investment decision regarding "ALPHA" shares? Justify your answer.
ii. If the 2nd scenario applies, estimate the value of the "ALPHA" share today. What should be your investment decision regarding "ALPHA" shares? Justify your answer.
iii. Using the forecasts of the 1st scenario calculate the share price of "ALPHA" in the 2nd year (P2).

Part B (6%)
Discuss the main differences between the Dividend Discount Model and the Free Cash Flow to Equity Discount Model.

The dividend discount model (DDM) and the free cash flow to equity discount model (FCF to Equity) are both methods of valuing a company. The DDM discounts expected dividends, while the FCF to Equity discounts free cash flow available to equity investors. The FCF to Equity model is considered more accurate because it takes into account the company's ability to generate cash flow.

The DDM is based on the assumption that a company's share price is equal to the present value of its expected future dividends. The model discounts the expected dividends at the cost of equity, which is the rate of return that investors require for investing in a company. The FCF to Equity model is based on the assumption that a company's share price is equal to the present value of its free cash flow available to equity investors. The model discounts free cash flow at the cost of equity.

The FCF to Equity model is more accurate than the DDM because it takes into account a company's ability to generate cash flow. A company's ability to generate cash flow is affected by many factors, such as its investment decisions, operating efficiency, and financial leverage. The DDM does not take into account these factors.

The FCF to Equity model is also more flexible than the DDM. The DDM uses a single discount rate, while the FCF to Equity model allows for different discount rates to be used for different periods of time. This flexibility makes the FCF to Equity model more accurate in valuing a company.

The FCF to Equity model is the preferred method of valuation for many reasons. It is more accurate than the DDM, it is more flexible, and it takes into account a company's ability to generate cash flow. When valuing a company, the FCF to Equity model should be used.

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