FINC6001: Finance – Theory to Applications Semester 2, 2022
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FINC6001: Finance – Theory to Applications
Semester 2, 2022
WRITTEN REPORT
The impact of inflation on equity valuation: background
Inflation is impacting financial markets across the globe. The increase in prices measured by the consumer price index (CPI) in different countries was expected to be transitory and resulting purely from supply chain disruptions caused by the Covid-19 pandemic, however easing Coronavirus related restrictions has not been enough to bring prices down. In order to fulfill their price stability mandate, central banks have been increasing interest rates with the ultimate goal of cooling demand and, therefore, alleviate the pressure on prices. The impact of monetary policy on macroeconomic indicators happens with a delay which then creates uncertainty regarding the stance of central banks (most predominantly the Federal Reserve in the United States) towards future changes in the interest rate. In particular, the market is currently trying to anticipate whether the FED will increase (and if so, by how many basis points) the funds rate during its next meeting, a decision that will depend on the data available by then as announced by the FED’s Chairman, Jerome Powell.
The inflationary environment that we are currently in makes the valuation of a firm by investors even more challenging. In particular, many of the variables that are employed in discounted cash-flow (DCF) analysis and valuation by multiples are impacted either by inflation itself or/and by changes in interest rates brought about by the central bank’s response to an increase in the price level of the economy. Variables that can be given as an example are revenue (sales), cost of goods sold, interest expenses, and a company’s
weighted-average cost of capital (WACC), to cite a few: these factors are all impacted by inflation with the effects being reflected on the firm’s value.
Questions to be addressed
Although inflation is being felt across the board, some industries and firms have been more impacted than others. In this context, the goal of the written-report is to study how inflation and its by-products are affecting the performance of a specific corporation and the corresponding impact on the business value. In particular, the group should address the following questions:
1. Based on the company’s financial ratios (for profitability, efficiency, leverage, and liquidity), what is the business exposure to inflation and a persistent increase in interest rates?
2. Given the industry and line of business of the corporation that has been assigned to the group, which are the main channels through which the firm can be impacted by inflation? Please elaborate particularly on:
• Dependence of the firm on the price of commodities
• Demand elasticity for the company’s goods/services
3. Based on assumptions that the group will make in relation to future inflation and interest rates, what should be the equity value per share under the DCF methodology? Please use a 10-year forecast horizon and estimate the firm’s terminal value based on the constant dividend growth model.
4. In light of the corporation’s current share price and the value estimated in the previous question, would the group recommend buying the stock? Describe the assumptions that the recommendation relies on and explain what can go wrong with it.
Formatting and presentation
1. The report should be a maximum of 2,500 words (250 words tolerance; only sections 1-5 are counted; each figure and its caption count as 1 word) with 1.5 line spacing and size 12 (Arial or Calibri font). Normal-sized (2.54cm) margins on all sides of the report should be used. Please number the pages and sections of your report. Marks will be reduced by 10% for exceeding the word count + tolerance.
2. You will need to undertake research on industry and/or academic sources to justify your choices and conclusions: a minimum of 6 references is required. Your references do not need to be all academic journal articles.
3. Ensure you use proper academic referencing in supporting the ideas and discussion within your report. All reports must include a list of references in academic form using the APA 7th method. Further information on the APA referencing style can be found here: https://libguides.library.usyd.edu.au/citation/apa7.
4. Pay particular attention to presentation. Avoid overdoing formatting and ensure that the report is very clear, logical, and professional. Pay attention to grammar. Clear and logical presentation is a major challenge in report preparation.
5. Preparing a concise report poses a major challenge. Brevity and conciseness are key ingredients of a highly successful report. Every part of the report should somehow add to the end result; otherwise, it is superfluous and distracting.
6. Use headings in the report to separate key ideas. Using paragraphs will also assist with structuring ideas; paragraphs should not exceed 15 lines nor be less than 5 lines.
7. The report must be submitted as a PDF document. You must submit the report electronically via the Turnitin link on Canvas. Excel spreadsheets with all your calculations must be submitted as a .xlsx workbook. You must submit two files electronically via the link on Canvas.
Marking guide
Financial ratio analysis
Impact of inflation and changes in interest rates
Business valuation
Recommendation
Presentation and style
Penalties
Less than 6 references
Failure to comply with formatting requirements Failure to submit Excel file with calculations Going over the 2,500 + tolerance limit
TOTAL MARKS
/20 marks /20 marks /40 marks /10 marks /10 marks
-10 marks
-10 marks
-50 marks
-10 marks
/100
2022-09-13