Homework 2
1) Discuss the nature of the numerators and denominators in the dividend discount model and the free cash flow valuation model. What makes these approaches similar; what makes these different? Explain why the term consistency is important in the application of these two competing valuation models. Give an example of inconsistency.

2) Why do market analysts employ price multiples (e.g., price/earnings, price/book, etc.) in their valuation work? Besides the obvious, what does a price/earnings multiple of 18 versus a price/earnings multiple of 10 financially suggest? What does a price/book of 3 suggest? Conceptually, would you ever purchase a stock with a price/book of 3?

3) What is the difference between a call and a put option? (Be clear in your answer.) What does the exercise—or strike—price denote? Of the five inputs discussed, what are three important inputs in the Black-Scholes option pricing model? For each of the three that you have chosen, what happens to the call option premium, all else being equal, when that variable increases?

4) Discus the three pairs of elements of the weighted average cost of capital formula. What does the WACC denote? (For example, what does the WACC = 9.7% suggest to the analyst?) Which WACC element, if any, is calculated “after tax”? Why? What does this suggest about using this asset class, courtesy of the US government?

5) What asset pricing model does the WACC use to compute equity capital costs? In this model, what does the market risk premium and the Beta, respectively, seek to address? Using this model that you described, what would be the cost of equity if the Beta is 0? Is a Beta of -1 even possible, and if it is, what would it suggest?

6) Capital budgeting is the process of analyzing potential projects. What does net present value (NPV) represent in capital budgeting analysis? How does NPV compare to internal rate of return (IRR); specifically, what makes them similar and different? What functional flaw exists in the discounted payback period calculation that makes this capital budgeting tool suspect?

7) Explain how the cash flow statement and the income statement are similar and, in turn, how they are different. (You may want to form two columns.) Discuss the important differences between sensitivity analysis and scenario analysis in the risk analysis of capital budgeting and, maybe more importantly, why these tools are used by analysts. What, if anything, does Monte Carlo simulation add to the discussion of project risk?

8) What is the difference between forecasting the operating plan and forecasting the financial plan? In what ways are they similar, different, and interlinked? What does the additional funds needed (AFN) equation method seek to answer? Conceptually, why is the AFN important in a project budgeting analysis?

9) With respect to the dividend discount model (constant and nonconstant forms), net present value model, FCF enterprise value model, etc., it has been suggested that the complexity is not the actual formula but the inputs. Use the constant growth dividend discount model (P = D / r – g) to explain why—and what about—the complexity of the inputs is key to the analysis.

10) Explain residual risk as it relates to common stock ownership. Do fixed income instruments have residual risk? Explain sunk costs and externalities as they pertain to capital budgeting. How should they be treated, if at all? Finally, explain the use of lattices in graphically explaining option valuation. What does the lattice help to visually explain?

Homework 2 1) Discuss the nature of the numerators and denominator...