CHAPTER PROBLEMS Kimberly A
Kimberly A. McCullough
Professor Lawrence Murphy
Colorado Christian University
April 5, 2018
Valuation is the first step toward intelligent investing. When an investor attempts to determine the worth of her shares based on the fundamentals, it helps her make informed decisions about what stocks to buy or sell. The cost of equity is the cost to the company of providing equity holders with the return they require on their investment. Valuation methods typically fall into two main categories: absolute and relative valuation models. Absolute valuation models attempt to find the intrinsic or “true” value of an investment based only on fundamentals. These methods generally involve calculating multiples or ratios, such as the price-to-earnings multiple, and comparing them to the multiples of other comparable firms. These methods generally involve calculating multiples or ratios, such as the price-to-earnings multiple, and comparing them to the multiples of other comparable firms.
Chapter 7: Equity Markets and Stock Valuation
Critical Thinking and Concepts Review.
7.1 Equity Valuation
Determining the total value of a company involves more than reviewing assets and revenue figures. An equity valuation takes several financial indicators into account; these include both tangible and intangible assets, and provide prospective investors, creditors or shareholders with an accurate perspective of the truth. (Ross, S., Westerfield, R., & Jordan, B. 2017, Chapter 7, pg. 1-7).
7.2 Stock Valuation
Stock valuation is the process of calculating the fair market value of a stock by using a predetermined formula that factors in various economic indicators. Stock valuation can be calculated using several different methods. (Swift, L., & Piff, S. 2016)
8.1 Net Present Value and Other Investment Criteria
Profitability Index: (1) There are discounted and non-discounted cash-flow, capital budgeting criteria to evaluate proposed investments. They are 2) Net present value: NPV is a discounted cash flow technique, which is the difference between an investment’s market value and its cost. (PI is a discounted cash flow technique in which present value of an investment’s future cash inflows divided by its initial cash outflow. It is also called benefit/cost ratio. (Dlabay, L. 2016)
Questions and Problems
8. 1 Net Present Value
NPV is a central tool in discounted cash flow (DCF) analysis and is a standard method for using the time value of money to appraise long-term projects. Used for capital budgeting, and widely throughout economics, finance, and accounting, it measures the excess or shortfall of cash flows, in present value terms once financing charges are met. The NPV of a sequence of cash flows takes as input the cash flows and a discount rate or discount. (Cornett, M., Advair.T., & Nofsinger, J. 2016)
8. 3. Other Investment Criteria
Why might agency costs be larger for an MNC than for a purely domestic firm? ANSWER: The agency costs are normally larger for MNCs than purely domestic firms for the following reasons. First, MNCs incurs larger agency costs in monitoring managers of distant foreign subsidiaries. Second, foreign subsidiary managers raised in different cultures may not follow uniform goals. Third, the sheer size of the larger MNCs would also create large agency problems. (Dunn, J. 2008-2009).
8.6 An investment should be accepted if the net present value is positive and it should be rejected if the net present value is negative. Net present value uses the discounted cash flow of valuation, which is the process of valuing an investment by discounting future cash flows. Comparison to another rule, which is called the Internal rate of return, uses the discount rate that makes the NPV of an Investment zero. IRR finds the single rate that summaries the rate of return of a project. We only depend on the cash flow of a particular investment not the rates offered elsewhere. (Collier, P. 2016)
Making Capital Investment Decisions
Critical Thinking and Concepts Review.
9.1 Capital investment decisions that involve the purchase of items such as land, machinery, buildings, or equipment is among the most important decisions undertaken by the business manager. These decisions typically involve the commitment of large sums of money, and they will affect the business over several years. Furthermore, the funds to purchase a capital item must be paid out immediately, whereas the income or benefits accrue over time. (Hussain, A. 1989)
9.2 Because investment decisions rank among the most critical types of managerial decisions made in a company and can have major long-term implications, both positive and negative, for the success of a company, managers must understand how financial investment decisions are made if they are to participate in improving corporate performance. (Webster, W. 2004)
Questions and Problems.
1 Theories of Capital Budgeting Techniques
Capital budgeting decisions are very important and complex and have inspired many research studies. The literatures in early years indicated the nature of capital budgeting which could be helpful to understand capital budgeting theoretically. Capital budgeting is investment decision-making as to whether a project is worth undertaking. Capital budgeting is the planning process used to determine whether a firm’s long-term investment is worth pursuing. (Finkler, S. 2017)
3. Capital Budgeting and Net Present Value
Capital budgeting is the process in which a company makes financial decisions about long-term investments of the company’s capital into operations. These decisions are the most critical decisions that are made by management. “Capital expenditures involve large amounts of money, are critical to achieving the firm’s strategic plan, define the firm’s line of business over the long term, and determine the firm’s profitability for years to come, they are considered the most important investment decisions made by management” Nikbakht, E., & Groppelli, A.A. 2012).
5. Investment Appraisal Techniques
This method is used to find out the period in which the future cash inflows would be sufficient, to cover the initial investment. Once this figure is obtained, it is then compared with any arbitrarily chosen time period, set as a threshold by the company. If the payback period is shorter or equal to this chosen time period, then the investment is acceptable else it is rejected. (Press, T. 2015)
20. Opportunity Costs and Sunk Costs
Opportunity costs and sunk costs are the two types of costs which fall under this category. Opportunity cost is the revenue lost by using the resources forming part of the project, under consideration. These resources might be rented out or sold or used elsewhere. The sunk cost is the cost which the firm has already incurred and has no effect on present or future decisions. It is the previous cost which was incurred in the past, and is irrecoverable irrespective of the fact, whether the company accepts the project or not. (Moschella, J. 2014)
Thus, according to the various surveys and information available from different sources we can conclude that investment appraisal is an important section of capital budgeting process. Entire analysis conducted under this makes it possible for the company to judge whether the company would be better off or worse off if it undertakes any project. Various approaches are analyzed here and what can be concluded is as follows:
1. Understanding the critical importance of cash flow forecasts in project evaluation, adequate care must be given to avoid certain biases which may lead to overstatement or understatement of true project viability.
2. Weighted average cost of capital is the most commonly used discount rate.
3. Firms use multiple evaluation methods.
Value chain analysis is advanced as a useful tool to help businesses identify their strategically important value-creating activities and develop appropriate competitive strategies. In this excel it is a technology road mapping is emerging as an approach at the cutting edge of strategic decision-making developments.
Ross, S., Westerfield, R., & Jordan, B. (2017). Essentials of Corporate Finance (9th ed.).
Swift, Louise; Piff, Sally (2016) Quantitative Methods: for Business, Management and Finance
Dlabay, Les (2016) Business Finance (1 Edition): Cengage Learning
Cornett, Millon, Marsha, Adair, Troy & Nofsinger (2014) M: Finance 3rd Edition, Kindle Edition
Dunn, Daniel, (2008-2009) Business & Finance: NEW STUDENT TEXTBOOKS
Collier, M. Paul (2016) Accounting for Managers: Interpreting Accounting Information for Decision Making 5th Edition
Hussain, Ashiq (1989) A Textbook of Business Finance
Webster, William (2009) Accounting for Managers (Briefcase Books Series) 1st Edition
Finkler, A. Stevens (2017) Finance & Accounting for Nonfinancial Managers (5th Edition)
Nikbakht, Ehsan, & Groppelli, A. Anthony (2012) Finance (Barron’s Business Review Series) Paperback
Press, Tyco, (2015) Accounting for Small Business Owners Paperback
Moschella, John (2014) Financial Modeling For Equity Research: A Step-by-Step Guide to Earnings Modeling Kindle Edition