Homework and Assigned Reading
Security Analysis (FIN 40610)
Professor Zambrana
Lecture 1 – Introduction to Valuation
Lecture 1 provides an introduction to valuation. This lecture provides an overview of alternative
valuation models, with an emphasis on discounted cash flow, including Free Cash Flow to Equity (FCFE)
and Free Cash Flow to the Firm (FCFF), and relative valuation techniques. The lecture also provides a
refresher on the basic present value calculations underlying a DCF model. During the semester, we will
cover both the estimation of model inputs, such as the cost of capital, future cash flows, and growth,
and the practical application of DCF models to real world companies.
Homework:
Complete the homework problems on the attached pages and turn in your solutions by the assigned
due date. Be prepared to discuss your solutions in class.
Required and Related Reading:
The table below describes the required reading from the McKinsey book. I recommend reviewing all
end-of-chapter review questions associated with the required McKinsey readings. In both the readings
and review questions, you should focus your attention on the topics that are covered in class and in
your course notes.
For those who want to gain a deeper knowledge of valuation, I have listed additional related readings
from both the McKinsey book and the Damodaran book.
Required Reading:
Book Chapter Topic
McKinsey Ch. 3 Fundamental Principles of Value Creation
McKinsey Ch. 7 The Stock Market is Smarter than you Think
McKinsey Ch. 10 Frameworks for Valuation
Optional Related Reading:
Book Chapter Topic
McKinsey Ch. 1, 2, 4, 5, 6 Additional Foundations of Value Chapters
Damodaran Ch. 1 Introduction to Valuation
Damodaran Ch. 2 Approaches to Valuation
Damodaran Ch. 6 Market Efficiency
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Problem Set #1
1. Discounted cash flow valuation is based on the notion that the value of an asset is the present value
of the expected cash flows on that asset, discounted at a rate that reflects the riskiness of those cash
flows. Specify whether the following statements about discounted cash flow valuation are true or
false, assuming that all variables are constant except for the one mentioned. If a statement is false,
explain why:
a. As the discount rate increases, the value of an asset increases.
True____False____
b. As the expected growth rate in cash flows increases, the value of an asset increases.
True____False____
c. As the life of an asset is lengthened, the value of that asset increases.
True____False____
d. As the uncertainty about the expected cash flow increases, the value of an asset increases.
True____False____
e. An asset with an infinite life (i.e., it is expected to last forever) will have an infinite value.
True____False____
2. You are valuing a firm using a DCF model based on FCFF. The firm’s FCFF in 2023 was $200m,
which you expect to grow at a rate of 10% in 2024, 8% in 2025, 6% in 2026. Beginning in 2027,
cash flows will grow steadily at a rate of 3%. The firm’s WACC is 12%.
a. Suppose you are valuing the firm as of 12/31/2023. What is the enterprise value for this firm
on 12/31/2023 based on the assumptions described above?
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b. For convenience (and to be consistent with present value formulas), it is typical to assume that
all cash flows for a given year arrive at the end of that year. To be more realistic, many analysts
instead assume that the cash flows for any given period arrive midway through that period.
This is referred to as mid-year discounting. Suppose again that you are valuing the firm as of
12/31/2023. What is the enterprise value for this firm on 12/31/2023 based on mid-year (or
mid- period) discounting?
c. It is often the case that we must value a firm in the middle of the year. This requires us to
estimate and discount cash flows for a partial year (or stub period). Suppose you are valuing
the firm above as of 6/30/2024. Recalculate the enterprise value for this firm on 6/30/2024
assuming:
i. standard discounting
ii. mid-year (or mid-period) discounting
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3. You are analyzing a company with the expected future cash flows shown below. Based on current
market prices, the market value of the firm’s equity is $1,962.9. The outstanding debt has both a
market and book value of $800. The firm's cost of equity (ke) is 11.0%, the firm’s past and future
cost of debt is 10%, and the firm's tax rate is t=50%. Use this information to answer the questions
below.
Year FCF to Firm Int Exp (1-t) FCF to Equity
1 $ 140.0 $ 40 $ 100.0
2 $ 150.0 $ 40 $ 110.0
3 $ 161.0 $ 40 $ 121.0
4 $ 173.1 $ 40 $ 133.1
5 $ 186.4 $ 40 $ 146.4
Terminal Value $ 3339.6 $2562.2
a. Calculate the value of the firm's equity by discounting the listed Free Cash Flows to Equity.
b. Calculate the value of the overall firm by discounting the listed Free Cash Flows to the Firm.
Use your solution to calculate the value of the firm's equity.
c. Are the equity values you obtained using the two methods the same? What real world firm
characteristics might cause you to get different values for equity in the FCFE and FCFF
models?
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4. You use a valuation model to arrive at a value of $2500 for a stock. The market price of the stock is
$3000. Below are possible explanations, which ones can explain the difference and why.
a. A market inefficiency: the market is overvaluing the stock.
b. The use of the wrong valuation model to value the stock.
c. Errors in the inputs to the valuation model.
5. As a valuation specialist for a M&As unit, you have been asked to place a value on Inter Depot Corp.
(IDC) stock. You learn that IDC is a superior company, but it is currently paying no dividends. You
estimate that IDC will pay its next dividend of $30 per share exactly 3 years from today. In the
following year, the company’s dividend will increase by 25%. Thereafter, IDC’s dividend growth rate
will decrease by 5 percentage points per year, until it reaches the industry average of 5%. Once
IDC’s dividend growth rate reaches 5% per year, it will never change. The required rate of return
on IDC stock is 10% per year. Please place a current value on a share of IDC stock.
6. You learn of a company that is growing rapidly but is currently paying no dividends. Analysts
estimate the firm will pay its first annual dividend of $14, 4 years from today. Dividends will then
grow at 12% per year over the next 5 years. At the end of this period of rapid growth, dividend
growth will stabilize at 4% per year forever. Until the time of payment of its first dividend, the firm
is considered a risky investment, with a required rate of return of 15% per year. Immediately after
the payment of its first dividend, the required rate of return decreases to 11% per year and remains
there forever. Please determine the value of the stock and state whether it is a good investment if
the current price is $170 per share.
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7. Consider a firm with the financial characteristics described below. Use this information to answer
the following valuation questions:
WACC = 8.015% Financial Forecast for Year
Book value of Equity = $60.0 mil EBIT $40.00 mil
Book value of Debt = $100 mil - Taxes (at 40%) -16.00
Mkt value of Debt = $100 mil = EBIT(1-T) 24.00
Cost of equity = 10.0% - Reinvestment (at 20%) -4.80
Cost of debt = 4.0% = FCFF $19.20 mil
a. Assuming cash flows grow at a stable rate of 3% per year, use discounted cash flows to
estimate the value of the firm and the value of the firm’s equity.
b. Use the Economic Profit (or EVA) formula to estimate the value of the firm and the value of
the firm’s equity. As in the previous problem, assume that the economic profit generated by
the firm grows at a stable rate of 3% per year.
c. How do your answers based on the two valuation methods compare?
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8. What is the primary advantage of using Real Option Valuation (ROV) in investment decision-
making?
a. It simplifies the valuation process by ignoring the uncertainty of future outcomes.
b. It provides a fixed, predetermined value for investment projects.
c. It allows managers to account for flexibility and adapt to changes in the market environment.
d. It assumes that all investments have the same risk profile.
9. Why might the Residual Income Model (RIM) be considered a useful alternative to the Discounted
Cash Flow (DCF) model for equity valuation, particularly in certain contexts?
a. RIM is less sensitive to the accuracy of terminal value assumptions, as it focuses on the excess
earnings generated above the required return on equity, whereas DCF heavily relies on
estimating future free cash flows and terminal values.
b. RIM simplifies the valuation process by only requiring current earnings and book value,
ignoring future performance, and thus providing a more straightforward calculation than
DCF.
c. RIM assumes that all future residual incomes are reinvested at the risk-free rate, thereby
eliminating the need for a discount rate, unlike DCF which requires a discount rate based on
the firm's cost of capital.
d. RIM uses the firm's current market value as a starting point, making it more adaptable to
short-term market fluctuations than the DCF model, which focuses on long-term intrinsic
value.
10. A company is considering the acquisition of another firm in its industry. The acquisition is
expected to increase the firm’s free cash flow by $5 million in the first year, and this contribution
is expected to grow at a rate of 4% per year from then on. The firm has negotiated a purchase
price of $110 million that will be financed with $95.24 million in new debt initially. Assume the
firm will maintain a constant debt-equity ratio of 2 for the acquisition, the company’s cost of
equity is 12.3%, its cost of debt is 8.5%, and its tax rate is 40%. Compute the value of the
acquisition using the APV Method.
