Homework 5 Due Nov 30

1homework 5 Due Nov 30name

Rewrite the assignment prompt: Remove any rubric, grading criteria, point allocations, due dates, meta-instructions to the student or writer, and any repetitive or duplicated lines, focusing solely on the core assignment question and essential context.

The core assignment involves solving financial valuation problems including estimating stock prices using PE ratios, dividend discount models, option pricing, and free cash flow calculations for a corporate firm.

Paper For Above instruction

The assignment encompasses several interrelated financial analysis exercises. It begins with stock valuation based on EPS and P/E ratios, projecting current and future stock prices, and calculating implied returns. It then advances into dividend discount models considering different dividend payout frequencies, assessing their impact on stock valuation, and the appropriateness of the model assumptions.

Subsequently, it explores corporate valuation through option theory, examining the value of Panther Corp.’s equity and debt under different asset value scenarios, using no-arbitrage principles. Further, it addresses options pricing: calculating the price of a put option from a known call using put-call parity, and devising a portfolio of options and stocks to replicate a certain payoff structure, including selecting strike prices.

The assignment also involves applying put-call parity to determine the fair value of a put option, given specific parameters. It extends to detailed free cash flow analysis for Miami Corp., calculating FCFF and FCFE under various assumptions, and determining the firm's equity value based on projected growth rates and discount rates. It also requires assessing the cost of equity based on growth in FCFE.

Throughout, students are asked to explicitly state their assumptions, including the use of dividend growth models, option replication strategies, and valuation techniques, demonstrating an understanding of financial theory and practical application.

Complete Academic Paper

Financial valuation techniques serve as foundational tools in corporate finance, enabling investors and managers to estimate the worth of stocks, bonds, and entire firms. This paper addresses a series of problems connecting theoretical models with practical valuation exercises, illustrating the application of fundamental concepts such as price-to-earnings ratios, dividend discount models, option pricing, and free cash flow valuation.

Initially, the focus is on equity valuation using the Price-to-Earnings (PE) ratio. Florida Corp. has an EPS of $4.04 and a benchmark PE ratio of 21, with earnings expected to grow at 5.5% per annum. The current stock price can be estimated by multiplying the EPS by the PE ratio, assuming market efficiency and comparable companies' valuation standards. Therefore, the current stock value is approximately $4.04 × 21 = $84.84. Future stock price in one year, adjusted for earnings growth, can be projected as $4.04 × 1.055 = $4.2642, which leads to a forecasted stock price of $4.2642 × 21 ≈ $89.55. The implied return over the next year then is (Forecasted Price - Current Price) / Current Price = ($89.55 - $84.84) / $84.84 ≈ 5.55%, aligning with earnings growth assumptions and PE valuation dynamics.

Next, dividend discount models (DDM) are employed to assess stock valuation with different dividend payout structures. For a company paying an annual dividend of $3.60, growing at 3.8% annually, and requiring a 10.5% return, the current stock price can be computed using the Gordon Growth Model: P = D / (r - g) = $3.60 / (0.105 - 0.038) ≈ $52.94. When dividends are paid quarterly, the valuation can be adjusted by converting the annual dividend into quarterly installments, then using the present value of a growing annuity formula for quarterly payments. Since the quarterly dividend is $0.90, the current share price becomes: P = D_quarterly / (r_period - g / 4) with appropriate discounting. This approach yields a comparable valuation, yet highlights that the timing and compounding frequency impact the valuation accuracy. The quarterly dividend model generally reflects more granular cash flows, potentially providing a more precise valuation if dividends grow steadily and reinvestment occurs at the same rate.

Assessing corporate valuation through option theory offers a valuable perspective, particularly in cases involving risky assets. Panther Corp.’s bond scenario involves considering the firm’s assets as a call option on its underlying assets. The debt’s value equals the present value of the bond’s face value, considering the firm’s asset volatility and potential default. Using no arbitrage principles, the equity can be modeled as a call option on the assets with strike price equal to the debt's face value ($1,000). The value of the firm's assets today is $1,090, which exceeds the debt obligation; thus, the equity’s value reflects the optionality of the firm’s assets surpassing the debt. Given the possible asset values in a year ($920 or $1,380), and the risk-free rate of 4.8%, the probability-weighted valuation indicates that the equity’s value equals the expected payoff of the call option, discounted at the risk-free rate. Similar reasoning allows deriving the debt value as the residual after subtracting equity value from total assets.

Furthermore, if Panther’s assets could reconfigure to values of $800 or $1,600, the decision hinges on whether stockholders prefer increased upside potential despite higher downside risk. If the reconfiguration increases the probability of surpassing the debt threshold ($1,000), shareholders might favor this change, assuming their payoff benefits from higher potential gains. Conversely, increased risk of default might deter this move if it exposes stockholders to substantial losses.

Option pricing extends to derivatives, exemplified by calculating the put option’s value given a call option, exercising price, stock price, and risk-free rate. Applying put-call parity: P = C + PV(K) - S, where PV(K) is the present value of the strike price, allows deriving the put’s fair value as P = $3.80 + $35 / (1 + 0.048/12)^{4} - $42.75, resulting in an approximate put price. This parity underscores the deep relationship between calls and puts, facilitating arbitrage-based valuations and hedging strategies.

A replicated payoff strategy employs combinations of call options and shares to mimic security payoffs. For example, constructing a payoff that benefits only if the stock exceeds a certain strike involves buying calls and holding positions in shares. Selecting strike prices for call options depends on the targeted payoff shape and risk preferences, ensuring replicability and cost-effectiveness of the strategy.

Applying put-call parity further allows calculating the theoretical value of a put option based on known parameters, ensuring parity holds in efficient markets. For Miami Corp., the EBIT, depreciation, amortization, capital expenditures, and net working capital changes facilitate computing FCFF and FCFE. With an EBIT of $300, depreciation of $14, and amortization of $6, the operating cash flows are adjusted for taxes at a rate of 35%. Capital expenditures and changes in net working capital are deducted to derive free cash flows. FCFF involves adjusting operating cash flows for reinvestment needs and reflecting the firm’s financed capital structure, while FCFE considers equity holders’ residual cash flows after debt obligations.

Estimating the firm’s valuation involves projecting growth rates of FCFF and FCFE, discounting them at the weighted average cost of capital and cost of equity respectively. The valuation then adjusts for the projected growth beyond initial years, applying perpetuity models or multi-stage growth models. The firm’s equity value results from discounting future FCFE, incorporating growth assumptions of 7% per annum, which aligns with the calculated cost of equity derived from the investment’s risk profile. This comprehensive approach underscores the interconnectedness of operational performance, capital structure, and valuation metrics in corporate finance analysis.

References

  • Brealey, R. A., Myers, S. C., & Allen, F. (2020). Principles of Corporate Finance (13th ed.). McGraw-Hill Education.
  • Damodaran, A. (2012). Investment Valuation: Tools and Techniques for Determining the Value of any Asset (3rd ed.). Wiley Finance.
  • Hull, J. C. (2018). Options, Futures, and Other Derivatives (10th ed.). Pearson.
  • Ross, S. A., Westerfield, R. W., & Jaffe, J. (2019). Corporate Finance (12th ed.). McGraw-Hill Education.
  • Copeland, T., Weston, J. F., & Shastri, K. (2005). Financial Theory and Corporate Policy. Pearson Education.
  • Fama, E. F., & French, K. R. (1993). Common risk factors in the returns on stocks and bonds. Journal of Financial Economics, 33(1), 3-56.
  • McKinsey & Company. (2012). Valuation: Measuring and Managing the Value of Companies. Wiley Finance.
  • Shapiro, A. C. (2019). Multinational Financial Management. Wiley.
  • Vasicek, O. (1977). An Equilibrium Characterization of the Term Structure. Journal of Financial Economics, 5(2), 177-188.
  • Harrison, J. M., & Pliska, S. R. (1981). Martingales and Stochastic Integrals in the Theory of Continuous Trading. Stochastic Processes and Their Applications, 11(3), 215-260.

Related Assignments