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Finance Topics: Valuation Models, Decomposition, Liquidity, Solvency, Growth Rate

Earnings-based vs. Cash Flow-based Valuation Models

a) Discuss. “Earnings-based valuation models are affected by

(i) arbitrary accounting choices such as the choice of depreciation policy;

(ii) understatement of intangible assets caused by the regulatory framework. Therefore cash flow based valuation methods are more reliable”.

b) What are the disadvantages of the DDM (dividend discount model), compared to the other valuation models with which you are familiar?

c) A company with a required return on assets of 8% has a value of net debt of £1,350 million witha borrowing cost of 4% and a tax rate of 30%. The firm’s equity is worth £4,050 million. What is the required return for its equity?

d) Assume that Manamana’s cost of debt capital is 5%. Its debt to equity ratio is 40% and its weighted average cost of capital is 10%.

If Manamana changes its capital structure so that its ratio of debt to equity becomes 30%, what will be the new cost of equity capital? 

Assume that the cost of debt does not change, and that there are no taxes. 

2.) Lathes Group is a manufacturer. This is the company’s condensed balance  sheet,

at the end of the financial year 2019, in € '000: 

Image 1

All assets and current liabilities are considered to be operating.

The non-current liabilities pay annual interest at 5%.

The rate of corporation tax is 25%.

Comprehensive income (CE) for the financial year 2019 was € 1,600,000.

a) Using the “alternative decomposition approach” (additive ROE decomposition), determine whether financial leverage benefits Lathes Group’s shareholders. Explain each component of your results.

b) Assuming that Lathes Group’s ROS (return on sales) for 2019 is equal to 10.5%, show the ROE disaggregation according to the so-called “traditional decomposition approach” (also known as multiplicative ROE decomposition or DuPont ROE decomposition). Explain each component of your results.

c) Decompose RNOA (return on net operating assets) into two components. Compare your RNOA decomposition with your ROA decomposition implicit in part (b) and explain the differences.

d) Using two appropriate ratios, assess the liquidity and solvency of Lathes Group. 

3.) Koala Limited has a share price of AUD 50 at the end of 2019. It has 500,000 shares outstanding, and no share issues or buybacks are planned in the future. Predicted abnormal earnings for 2020 and 2021 are AUD 1.75 million and AUD 1.90 million, respectively. The book value of equity per share at the end of 2019 is AUD 12.10. Koala’s cost of equity capital is 10%.

a) Assume constant growth of abnormal earnings from 2022 onwards. Use the PVAE (present value of abnormal earnings) model to infer the stock market’s forecast of the long-term abnormal earnings growth rate, g.

b) Using the implied growth rate calculated in part (a) and given that Koala’s predicted book value of equity per share for the end of 2021 is AUD 17.10, find the predicted net income for 2022.

c) Explain why the long-term growth rates which you might use in your valuation of Koala Limited may differ from the implied growth rate priced into Koala’s share price by the market. In so doing, explain the stages of analysis which lead to your forecasts, and how they relate to each other.

4.) a) Briefly summarise the findings of Penman and Sougiannis (1998) concerning the ex post performance of the abnormal earnings method, the dividend discount model and the discounted cash flow method.

b) Explain what Business Strategy Analysis is and why it is a prerequisite for understanding the results of our ratio analysis, and for making good forecasts in the context of our Prospective Analysis.

c) When making forecasts for the growth rate of FCF (free cash flows) in the post- horizon period, how would you decide what growth rate to choose? What would be the rationale behind a zero growth assumption?

d) Imagine that you are comparing the financial performance of two companies using ratio analysis as part of your Financial Analysis. Provide an example of why you need to perform Accounting Analysis first. Your example should describe (in some detail) one of the following:

(i) differences in revenue recognition

(ii) differences in the recognition of cost of sales

(iii) differences in the accounting treatment of intangible assets. 

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