Chapter 14 Problems 6 7a C 8 A B 10a C 11a B And 12a B

Chapter 14 Problems 6 7a C 8 A B 10a C 11a B And 12a B

Chapter 14: Problems 6, 7(a-c), 8(-a-b), 10(a-c), 11(a-b), and 12(a-b) 6. Lauren Entertainment, Inc., has an 18 percent annual growth rate compared to the market rate of 8 percent. If the market multiple is 18, determine P/E ratios for Lauren Entertainment, Inc., assuming its beta is 1.0 and you feel it can maintain its superior growth rate for: a. the next 10 years. b. the next 5 years. 7.You are given the following information about two computer software firms and the S&P Industrials: a. Compute the growth duration of each company stock relative to the S&P Industrials. b. Compute the growth duration of Company A relative to Company B. c. Given these growth durations, what determines your investment decision? 8. The value of an asset is the present value of the expected returns from the asset during the holding period. An investment will provide a stream of returns during this period, and it is necessary to discount this stream of returns at an appropriate rate to determine the asset's present value. A dividend valuation model such as the following is frequently used: Identify the three factors that must be estimated for any valuation model, and explain why these estimates are more difficult to derive for common stocks than for bonds. b. Explain the principal problem involved in using a dividend valuation model to value: (1) companies whose operations are closely correlated with economic cycles. (2) companies that are of very large and mature. (3) companies that are quite small and are growing rapidly. 10. The constant-growth dividend discount model can be used both for the valuation of companies and for the estimation of the long-term total return of a stock. a. Using only the preceding data, compute the expected long-term total return on the stock using the constant-growth dividend discount model. b. Briefly discuss three disadvantages of the constant-growth dividend discount model in its application to investment analysis. c. Identify three alternative methods to the dividend discount model for the valuation of companies. 11. An analyst expects a risk-free return of 4.5 percent, a market return of 14.5 percent, and the returns for Stocks A and B that are shown in Exhibit 14.24. Exhibit 14.23 Annual Cash Flow from Lease: Show on a graph: (1) where Stocks A and B would plot on the security market line (SML) if they were fairly valued using the capital asset pricing model (CAPM). (2) where Stocks A and B actually plot on the same graph according to the returns estimated by the analyst and shown in Exhibit 14.24. b. State whether Stocks A and B are undervalued or overvalued if the analyst uses the SML for strategic investment decisions. Exhibit 14.24 Stock Information 12. Lauren Turk is reviewing Francesca Toy's financial statements in order to estimate its sustainable growth rate. Using the information presented in Exhibit 14.25: a. (1) identify and calculate the three components of the DuPont formula. (2) calculate the ROE for 2011, using the three components of the DuPont formula. (3) calculate the sustainable-growth rate for 2011. b. Turk has calculated actual and sustainable growth for each of the past four years and finds in each year that its calculated sustainable-growth rate substantially exceeds its actual growth rate. Cite two courses of action (other than ignoring the problem) that Turk should encourage Francesca Toy to take, assuming the calculated sustainable-growth rate continues to exceed the actual growth rate. Exhibit 14.25 Francesca Toy, Inc.: Actual 2010 and Estimated 2011 Financial Statements for Fiscal Year Ending December 31 ($ Millions, except Per-Share Data)

Paper For Above instruction

The analysis of corporate valuation, growth, and financial performance requires a comprehensive understanding of key financial metrics, models, and market principles. This paper explores several interconnected topics from Chapter 14, including the determination of price-to-earnings (P/E) ratios based on growth rates, the concept of growth duration, valuation challenges of different firms, dividend valuation models, expected returns, risk assessment, and the interpretation of financial ratios through the DuPont analysis. Each section leverages theoretical foundations and practical applications to illustrate how investors and analysts assess the value and potential of stocks and companies.

Determining P/E Ratios with Growth Assumptions

Lauren Entertainment, Inc., demonstrates an optimistic growth trajectory with an 18 percent annual growth rate, significantly surpassing the market rate of 8 percent. Given the market multiple of 18 and a beta of 1.0, the P/E ratio, which indicates how much investors are willing to pay per dollar of earnings, can be modeled using the Gordon Growth Model or the Dividend Discount Model (DDM). For a company maintaining a high growth rate, the P/E ratio can be expressed as:

\[ P/E = \frac{1 - b}{k_e - g} \]

where \(b\) is the retention ratio, \(k_e\) is the required rate of return, and \(g\) is the growth rate. Assuming a stable payout ratio and a required return equating to the market's beta-adjusted rate, the P/E can be approximated for the foreseeable future.

In calculating the P/E ratios for the next 10 and 5 years, adjustments are made to account for the growth sustainability and market expectations. The high-growth scenario (10 years) warrants a higher P/E multiple due to growth expectations, whereas the shorter 5-year period considers the possibility of decelerating growth or market saturation. The temporal scope influences the valuation, with longer periods generally leading to higher valuation multiples due to compounded growth effects.

The Concept of Growth Duration and Investment Decisions

Growth duration measures the span over which a company's growth rate favorably compares to a benchmark index like the S&P Industrials. This metric helps assess how long an investor can expect a company's returns to outperform the market. Similarly, comparing growth durations between firms A and B provides insight into their relative stability and growth prospects. A longer growth duration indicates sustained superior performance, which can inform strategic investment decisions.

Investment choices depend critically on these growth durations. A company with a longer expected outperforming period is typically viewed as less risky and more attractive for long-term holdings. Conversely, shorter durations may signal temporary advantages or imminent decay in growth prospects. Investors thus prefer firms with favorable growth durations aligned with their risk tolerance and investment horizon.

Valuation of Assets and the Challenges of Dividend Discount Models

Assets are valued based on the present value of expected future returns, discounted at an appropriate rate reflective of risk and opportunity cost. Popular valuation models, such as the Dividend Discount Model (DDM), require estimates of future dividends, growth rates, and discount rates. Accurately forecasting dividends is more challenging for common stocks than for bonds, because stocks are subject to broader economic influences, management decisions, and market sentiment.

Particularly, companies closely tied to economic cycles pose difficulties because their earnings—and thus dividends—are highly volatile and sensitive to macroeconomic conditions. Large, mature companies often have more predictable dividends, simplifying valuation. In contrast, small and rapidly growing firms offer uncertain dividend trajectories, complicating estimates and increasing valuation risk.

Constant-Growth Dividend Discount Model and Long-Term Returns

Using the constant-growth DDM, the expected long-term total return can be calculated by summing the dividend yield and the growth rate:

\[ R = \frac{D_1}{P_0} + g \]

where \(D_1\) is the expected dividend next year, \(P_0\) is the current stock price, and \(g\) is the growth rate.

However, this model has limitations. Its assumptions of perpetual constant growth are unrealistic for many firms, especially those experiencing rapid change or cyclicality. Practical disadvantages include its sensitivity to small inaccuracies in growth estimates, its reliance on stable dividend policies, and its limited applicability to firms with irregular or no dividend payments.

Alternative valuation methods include Price/Earnings ratios, discounted cash flow (DCF) analysis, and multiples based on Enterprise Value. Each offers unique insights and is suited to different types of firms depending on their growth characteristics, dividend policies, and industry dynamics.

Risk Assessment and Market Valuation

The Capital Asset Pricing Model (CAPM) links expected returns to systematic risk, quantified by beta. Given a risk-free rate of 4.5 percent and a market return of 14.5 percent, Stocks A and B's expected returns depend on their respective betas. Plotting these stocks on the Security Market Line (SML) reveals whether they are fairly valued—accurately priced according to their risk—or mispriced.

If a stock plots above the SML, it implies undervaluation, offering higher-than-expected returns for its risk profile. Conversely, a position below the line suggests overvaluation. Such analyses guide strategic investment decisions, enabling investors to select stocks with favorable risk-return trade-offs.

Financial Ratios and the DuPont Analysis

The DuPont analysis decomposes Return on Equity (ROE) into three components: profit margin, asset turnover, and financial leverage. Applying this to Francesca Toy, Inc., helps understand the underlying drivers of profitability and growth. Calculating these components involves analyzing income statements and balance sheets, providing a comprehensive view of operational efficiency and financial health.

Furthermore, the sustainable growth rate (SGR) reflects the maximum growth a company can achieve using internally generated funds without issuing new equity or incurring debt. Discovering that the calculated SGR exceeds actual growth suggests potential overestimation of growth capacity. To address this discrepancy, the company should consider strategies such as improving operational efficiencies or managing dividend policies to better align with sustainable growth opportunities. Encouraging prudent financial management ensures that growth projections remain realistic and attainable over the long term, preventing potential overexpansion and financial distress.

Conclusion

Analyzing stock valuation, growth expectations, risk profiles, and financial health requires an integrated approach that combines theoretical models with practical insights. Understanding how to interpret P/E ratios, growth durations, valuation models, and financial ratios enables investors and analysts to make informed decisions, manage risks, and optimize portfolios. In the dynamic landscape of financial markets, continual assessment and adjustment based on robust analysis are essential to achieving sustainable value creation and investment success.

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