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Question 2 - Approaches to DCF Valuation There are two approaches to valuation. During the last two years, the stock market has gone up 60% a year, while the government borrowing rate has been 15%, yielding an historical premium of 45%.The first approach is to value the equity in the firm. Would you use this as your risk premium, looking into the future?
As the discount rate increases, the value of an asset increases. As the expected growth rate in cash flows increases, the value of an asset increases. As the life of an asset is lengthened, the value of that asset increases. As the uncertainty about the expected cash flows increases, the value of an asset increases. An asset with an infinite life (i.e., it is expected to last forever) will have an infinite value. Question 3 - Mismatching Cash flows and Discount Rates The following are the projected cash flows to equity and to the firm over the next five years: (The terminal value is the value of the equity or firm at the end of year 5.) The firm has a cost of equity of 12% and a cost of capital of 9.94%. Question 1 - CAPM: Historical Risk Premiums The following table summarizes risk premiums for stocks in the United States, relative to treasury bills and bonds, for different time periods: Risk Premium for Equity A. You are trying to value some stocks in Malaysia, which does not have a long history of financial markets.
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APPROACHES TO VALUATION Analysts use a wide range of models in practice, ranging from the simple to the sophisticated. A troubled firm, which has made significant losses and is not expected to get out of trouble for a few years. A firm, which is in the process of restructuring, where it is selling some of its assets and changing its financial mix. A firm, which owns a lot of valuable land that is currently unutilized. Would you use all the comparable firms in calculating the average? ESTIMATION OF DISCOUNT RATES The discount rate is a critical ingredient in discounted cash flow valuation.
These models often make very different assumptions about pricing, but they do share some common characteristics and can be classified in broader terms. Question 5 - Relative Valuation: Fundamentals An analyst tells you that he uses price/earnings multiples, rather than discounted cash flow valuation, to value stocks, because he does not like making assumptions about fundamentals - growth, risk, and payout ratios. Question 6 - Industry Average P/E Ratios You are estimating the price/earnings multiple to use to value Paramount Corporation, by looking at the average price/earnings multiple of comparable firms. Errors in estimating the discount rate or mismatching cash flows and discount rates can lead to serious errors in valuation.
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What assumptions are you making when you use the industry-average P/E ratio to value Paramount Communications?
If not, what would you base your estimate of the premium on?
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