Unit 6: Valuation Methods & Cost Of Capital

Question 1

Dividend growth model

Answer 1

Expected dividend per share / (Discount rate - Dividend growth rate)

= the $ value of a common stock

Question 2

Expected dividend

Answer 2

Last annual dividend paid x (1+ growth rate) ^ t

Question 3

Two stage dividend discount model

Answer 3

1. Sum of the PV of dividends in the high growth period
2. Calculate the PV of the stock in steady growth period discounting back to year 1
3. Sum total

For common stock

Question 4

Preferred stock valuation

Answer 4

Dividend per share / Cost of capital

When preferred stock pays a fixed dividend ex. 12$

Question 5

Rate of return on investment

Answer 5

Return on investment / Amount invested

Question 6

Marginal cost of capital
(Definition)

Answer 6

The weighted -average cost to the firm of the next dollar of new capital raised after existing internal sources are exhausted.

Question 7

Cost of new capital
(Formula)

Answer 7

= Annual interest / Net issue proceeds

Question 8

Cost of new preferred stock
(Formula)

Answer 8

Next dividend / Net issue proceeds
*This includes flotation costs

Question 9

Cost of new common stock
(Formula)

Answer 9

(Next dividend / Net issue proceeds) + Dividend growth rate
*Mature firms rarely issue new stock

Question 10

Derivative instrument

Answer 10

an investment transaction in which the parties’ gain or loss is derived from some other economic event, for example, the price of a given stock, a foreign currency exchange rate, or the price of a certain commodity

Question 11

Hedging

Answer 11

the process of using offsetting commitments to minimize or avoid the impact of adverse price movements

Question 12

Long Position

Answer 12

A person who would like to sell an asset in the future.
They benefit from a rise in value of the asset

Question 13

Short Hedge

Answer 13

Owner of a long position can purchase an instrument whose value will rise if the asset’s value falls

Question 14

Short Position

Answer 14

Someone who wants to buy an asset in the future.
They benefit from a fall in value of the asset.

Question 15

Long Hedge

Answer 15

Someone in a short position obtains an instrument whose value will rise if the asset’s value rises.

Question 16

Natural Hedge

Answer 16

Normal operations that mitigate risk.
Ex. financing long term asset over same period as the life of the equipment.

Question 17

Forward Contract

Answer 17

Two parties agree that at a set future date one will perform and the other will pay a set price. Neither has the option of non performance.
Ex. wholesaler agrees to buy clothes from a retailer on x/x for $$

Question 18

Futures Contract

Answer 18

A commitment to buy or sell an asset at a fixed price during a specific future month. Unlike forward contracts, the counterparty is unknown.

Question 19

Future contracts are traded on _______

Answer 19

Futures Exchanges

Question 20

In futures exchanges, the _____________ matches sellers who will deliver during a given month with buyers who are seeking delivery during the same month.

Answer 20

Clearing House

Question 21

Do futures contracts take delivery?

Answer 21

Not necessarily. Parties can exchange the difference between the market price and contracted price.

Question 22

Option

Answer 22

Party purchases the right to demand that the counterparty (seller) perform some action on or before a specified date.
The buyer can exercise or not.

Question 23

Exercise Point (Strike Price)

Answer 23

Price at which the owner of a option can purchase or sell the asset underlying the option contract. The set price for the option.

Question 24

Option Price (Option Premium)

Answer 24

the amount the buyer pays to the seller to acquire an option

Question 25

Naked (uncovered) Option

Answer 25

a speculative instrument, the writer does not hold the underlying asset, they may have to acquire it in the future to satisfy their obligations

Question 26

Call Option

Answer 26

Gives the buyer the right to purchase the underlying asset at a fixed price. A long position for the buyer.

Question 27

Put Option

Answer 27

Gives the buyer the right to sell the underlying asset at a fixed price. A short position for the buyer.

Question 28

Risk Free Put-Call Parity
(formula)

Answer 28

PV of exercise price = Value of put + Value of underlying - Value of call
Buying a put, buying the underlying asset, and selling a call, provides the same return as investing the PV of the exercise price at the risk free rate.

Question 29

Models for Valuing Options

Answer 29

1. Black-Scholes formula
2. Binomial Method

Question 30

Interest Rate Swap

Answer 30

agreements to exchange interest payments based on one interest structure for payments based on another structure.

Question 31

Currency Swap

Answer 31

agreements to exchange cash flows denominated in one currency for cash flows denominated in another