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ACF5130 Financial statement analysis and business valuation

Week 10: Valuation Theory 1 Tutorial Questions

Discussion Question 1: Dividend Discount Model

ABC Ltd is a power generating company listed on the Utopia Stock Exchange. It has recorded a steady earnings growth of 5% annually over the past 10 years. ABC Ltd has a current (stable) dividend payout ratio of 50%. ABC Ltd has 1,200 million shares outstanding. The company reported earnings per share of $2.31 for the year ended 31st December 2023. The company announced that it would pay a special dividend of U$0.10 per share in 2024 and 2025. ABC Ltd has a current beta of 0.40. The current risk-free rate is 2% and the equity risk premium is 5%. ABC Ltd has a current WACC of 3.5%. Assume that the growth in earnings will be 2% annually in perpetuity after 2028. The current share price of ABC Ltd is $40.

Required:

Estimate the share price of ABC Ltd. What is your stock recommendation?

Discussion Question 1a: Dividend Discount Model

Use the same data as Question 1, except that Utopia is experiencing high inflation, as a result of which the Utopian Central Bank has increased the cash rate. The new risk-free rate is 5%, and the equity risk premium is 8%.

Required:

Estimate the share price of ABC Ltd. What is your stock recommendation?

Would you use the new cost of equity to estimate the share price of ABC Ltd or stick with the historical rate? Explain.

Discussion Question 2: Dividend Discount Model

HDD Ltd is listed on the Utopia Stock Exchange. It’s current share price is U$34.85. Over the last 10 years, HDD Ltd’s earnings have been growing steadily at 5% annually, and the company has been increasing its dividend payout steadily over this time. It’s current dividend payout ratio is 50%. HDD Ltd reported earnings per share of U$1.49 in 2023. HDD Ltd has a current cost of equity of 6.25%. Analysts at High Hopes Ltd, a leading brokerage firm have valued the equity at U$315.88 per share and have issued a STRONG BUY recommendation. Assume that the analysts have used the constant growth dividend discount model.

Required:

Do you agree with the valuation? What assumption would produce this valuation?

Discussion Question 3: Classification of cash flows and effect on FCFE, FCFF

Cash Flow                                                               Kind                                     FCFF                                       FCFE

Payment of receivable by  customer

Credit Sale

Expenditure on plant

Payment of interest

Repayment of debt

Purchase of short-term  marketable securities

Interest income on short term marketable  securities

Payment of dividends

Issuance of common  shares

Discussion Question 4: Free Cash Flow Valuation

iFly Ltd is an airline company in Imaginaryland. It is the biggest and most profitable domestic airline in Imaginaryland, with strong financial performance and a stable market share of 30%. The Table below provides some information for the year ended 31st December 2023. Analysts expect sales to grow at 5% annually until 2028. Analysts expect the terminal growth rate of free cash flows to the firm to be 2%. Assume that the effective tax rate is 30%. iFly Ltd has current net debt of $1,925 million. iFly Ltd has 125 million shares outstanding and has a current cost of equity of 9%. Estimate the share price of iFly Ltd.

                                                                             2023

Sales ($ million)                                                     1,320

Shares outstanding (million)                                       125

EBIT Margin                                                            15%

Depreciation to Sales Ratio                                         2%

Net non-cash Working Capital to Sales Ratio               15%

Capex to Sales Ratio                                                  5%

Effective tax rate                                                      30%

Discussion Question 5: Free Cash Flow Valuation

iFly Ltd is an airline company in Imaginaryland. It is the biggest and most profitable domestic airline in Imaginaryland, with strong financial performance and a stable market share of 30%. The Table below provides some information for the year ended 31st December 2023. Analysts expect sales to grow at 5% annually until 2028. Analysts expect the terminal growth rate of free cash flows to the firm to be 2%. Assume that the marginal tax rate is 30%. iFly Ltd has current net debt of $1,925 million. iFly Ltd has 125 million shares outstanding and has a current WACC of 5%. Estimate the share price of iFly Ltd.

                                                                        2023

Sales ($ million)                                                1,320

Shares outstanding (million)                                  125

EBIT Margin                                                       15%

Depreciation to Sales Ratio                                    2%

Net non-cash Working Capital to Sales Ratio           15%

Capex to Sales Ratio                                              5%

Effective tax rate                                                 30%