Do you have the same opinion about the market risk premium?

This assignment serves as a capstone for the entire class and encompasses elements of the earlier modules. The assignment aligns with the two module seven objectives: 1. Integrating course concepts to form a general valuation model 2. Relating the financial manager’s decisions to firm value ASSIGNMENT Based on the valuation model and your work in the other modules answer the following five questions related to the choices made by financial managers when trying to increase firm value. Each question is worth 20 points and each should incorporate elements of the firm valuation model outlined in this document as well as information from Modules 1-6. Each answer should be ½ to 1 page in length. Submit your answers via Blackboard by 11:59 pm on the last day of class. As a mid level executive in the finance department the CFO has asked for your help in explaining the theoretical firm value to other members of the executive team with less formal finance training. She would like you to explain the difference between using FCFF and FCFE to create an estimate of the theoretical value of a share. Briefly explain what each cash flow is intended to measure, how they are different and how they are the same. Finally make sure to explain if you would expect the value of a share of the firm’s stock to be the same using FCFF and FCFE (hint think about the PV of debt and the differences between the two cash flows and try to relate this to PV concepts from Module 2). In Module 3 you estimated the optimal capital structure for the firm and made a recommendation concerning whether or not the firm should change its capital structure. Revisit your recommendation now that you have a more complete picture of the firm valuation model. Considering the possible impact on the firm valuation model would you change any aspects of your recommendation from module 3? Explain in detail why you would or would not change your recommendations. Combine your analysis in Module 3 and module 5 and relate your answers to the valuation model (how does the WACC impact the value of the firm as measured by the valuation model). Some possible examples of things to consider or discuss (you don’t have to do all of theses – just trying to prompt your thoughts: In Module 5, you estimated the optimal mix of debt and equity, di the knowledge you gained in module 5 impact your evaluation of the assumptions used in Module 3 (for example – do have the same opinion about the use long term debt? Do you have the same opinion about the market risk premium? Would changes in Module 3 – possibly change the optimal capital structure found in module 5? Would Also consider if the firm could undertake any initiatives to change the market’s perception of the firms risk (keep in mind the market problem and information problems from Module 1) of the firms riskiness (what if is sold a division that is risky acquired competitor or supplier or other changes that could impact risk) which could also decrease the cost of capital? Be as specific as possible in your answer and explain your thinking in detail. In module 4 you evaluated the projects undertaken by the firm and their ability to generate cash flows. What recommendations would you make in relation to the firms projects that might increase the value of the firm? (which of the inputs in the valuation model are impacted by your answer – and how would the changes impact the value of the firm. Explain how your recommendation(s) would result in an increase in firm value using the firm valuation model. Make sure to also revisit your views on the competitive advantages (discussion questions in module 4) that are currently helping the firm or how more competitive advantages could be created that might enhance firm value. Throughout the semester we made choices and assumptions when developing the models we used for analysis. We also discussed the theoretical basis for the models. Often the data used in conducting analysis is not a perfect match for the theoretical models and assumptions. Therefore, adjustments must be made when developing quantitative models. A few examples from the semester (this is not a complete list of all the assumptions and adjustments discussed): In Module 3 we estimated the WACC based upon your choice of beta, and a simple approach to estimating the cost of debt – but beta changes over time we did a very broad approximation of the cost of debt based on long term debt. In Modules 3 and 5 we used a long run average for the market risk premium and used the 10-Year treasury bond yield in the CAPM and as a starting point for the cost of debt. (you may have already discussed these issues in question 2) In Module 4, the correct project cost of capital would need to be found, based upon the WACC found in module 3, then adjusting for project risk. We did not discuss in detail how to adjust the WACC for an individual project – how might changes in the firms projects or the market impact the WACC used for projects. In Module 5 we conducted a scenario analysis based upon the assumption that the current yield spreads related to different bond ratings would remain constant. However, the yield spreads change over time and our model implicitly assumed that all debt would be refinanced at the new cost of debt (which could be argued is an average across all maturities – but long term and short term debt do differ in their costs). How much of an impact did our assumptions have on the estimated optimal capital structure – would we get a dramatically different answer if we changed our method to calculate the cost of debt? In Module 5 we assumed that the interest coverage ratio was a good proxy for approximating the bond rating, but bond ratings are much more complex and based on numerous inputs from the financial statements and analysis of the current market risk. In Module 7 the theoretical value of the firm is shown to include assumptions about the long term sustainable growth of the firm, and short term forecasts of future revenues and costs. How accurate are those forecasts? How do variations impact the theoretical value of the firm? In Module 7 we introduced different options for the choice of cash flows used to value the firm, each choice of cash flow requires using consistent estimates for the discount rate and growth assumptions. Choose an assumption or adjustment we made when conducting our empirical modeling and discuss its impact on the specific results of that module in detail, then discuss how the results also influence the firm valuation model. How do the modeling choices impact the strategic goal of the financial manager – maximizing the value of the firm? Do the modeling choices limit the ability of the financial manager to help guide the firm in achieving its strategic objectives (explain in detail why or why not)? Assume that recently your firm has undertaken a new initiative to increase its efforts to be a good corporate citizen. The firm is especially interested in attempting to develop a sustainable business model that has no environmental impact on the communities in which it operates (keep in mind the discussions related to society as a stakeholder, and the impact societal concerns have on the firm). The CFO is concerned the increased costs associated with this will decrease future cash flows and decrease the value of the firm. From a broad perspective – do you agree or disagree with the CFO? You must use the firm valuation model in your answer – explain how the new policy might impact the value of the firm in our model (your points depend upon your ability to defend either answer based on the valuation model and the links you make to the other modules). BACKGROUND In the first module the theoretical value of the firm was defined as: The present value of its expected cash flows, discounted back at a rate that reflects both the riskiness of the firms projects and the financing mix used to fund those projects. Throughout the course we have elaborated on different components of the theoretical value of the firm and you have applied the financial theory to real world data for a firm. The different elements of the theoretical definition can be broken down throughout the semester as follows “The present value…” Module 2 outlined the mathematical tools used to calculate the time value of money, with a focus on the calculation of present values. “…discounted back at a rate that reflects both the riskiness of the firms projects …” Module 3 introduced the relationship between risk and return and developed models for calculating the weighted average cost of capital (WACC) – the rate used to discount free cash flows in the most broad version of the valuation model. The WACC incorporates how both the bondholders and equity holders measure risk and relate risk to the return they require when supplying capital to the firm. “…expected cash flows…” Module 4 defined two measures of cash flow FCFF and FCFE used by financial mangers and discussed how investments in projects use forecasts of the incremental change in expected future cash flows to make decisions about which project undertake. It is the success of the project that ultimately determine the future cash flows. Positive NPV projects add value to the firm by increasing the expected cash flows. “…the financing mix used to fund those projects” Module 5 discussed the choice of using debt or equity (the financing mix) to finance the operations. We calculated the optimal mix which decreases the WACC to its lowest value, increasing the PV of cash flows and the value of the firm). Additionally Module 1 defined the relationships that form the governance of the firm. It is these relationships that influence how the financial markets perceive risk, how conflicts between bondholders and shareholders are resolved, and how financial mangers make decisions about future projects (and cash flows). Finally, Module 6 discussed how the firm returns money to shareholders. Dividends and share buybacks are a use of cash that can decrease growth of the firm, create a need for a change in the capital structure, and influence the choice of projects thus indirectly impacting elements of the theoretical value of the firm. The valuation model outlined in chapter 12 provides a more detailed review of the value of the firm which is enhanced by the knowledge you have gained throughout the semester. The text introduces variations of the valuation model, but the basic concept introduced in Module 1 still defines the value of the firm regardless of the variation of the model under consideration. The variations of the theoretical value of the firm can be separated into two different cateories1) the choice of cash flow and associated interest rate and 2) the assumptions made about growth of the cash flows. Choice of cash flows There are three possibilities for the cash flows used in the theoretical value of the firm. For each possibility the correct interest rate corresponding to the cash flows must be used. Dividends – since dividends are paid to the shareholders, the interest rate used to find the PV of the dividends should correspond to the riskiness of the shareholders, therefore the cost of equity is used as the interest rate. This represents a departure from the definition since the financing mix is not part of the rate. When this approach is taken the value of the firm to the shareholders is being calculated. This assumes that the share value represents the value to the shareholder after paying debt and all other commitments. FCFE – the free cash flow to equity is by definition the amount of cash available to the shareholders after paying outstanding debt and it includes any new borrowing. Again the focus is on the shareholder and the cost of equity is the correct interest rate to use. The choice of dividends of FCFE is highlighted in Module 6. FCFE represents the amount of money available for dividends. If a firm pays dividends equal to its FCFE, the value of the firm would be the same using either dividends of FCFE in the model. When the firm pays less than FCFE, the difference in the models depends upon the return earned by the cash retained and invested in new projects. FCFF – Using free cash flow to the firm is the most consistent with the original definition of the theoretical value of the firm. By definition FCFF includes cash that can be used to pay off debt and this valuation looks at the value of the firm to all stakeholders. Therefore the correct interest rate to use is the WACC which incorporates the financing mix. Module 5 emphasized the impact of changing the financing mix on the WACC, and thus on the value of the firm. Ignoring the financing choice is consistent with the ideas of Modigliani and Miller in Module 5. This effectively says that the choice of financing does not determine the choice of projects. Using FCFF provides an estimate of firm value, while using FCFE or dividends provides the value of the firm its owners. Starting with FCFF then subtracting the PV of the debt payments that are scheduled from the value of the firm, you would get the value of the equity portion. In theory the value of the equity portion should be the same using either FCFE or FCFF. The difference is that FCFE subtracts debt at each point in time in the calculation of FCFE and FCFF first calculates the value of the firm, then subtracts the PV of the debt portion to get to the value of the equity. Assumptions about growth The growth of the cash flows over time are the key to determining the expected future cash flows. It is impossible to accurately forecast the cash flows far into the future (for example in 20 years). It is more likely that cash flows in the near future can be forecasted with more accuracy. Two stage growth models assume a period of faster growth followed by a period of stable long-term growth. Three stage growth models assumes a period of fast growth followed by a slowing of growth that transitions to third stable growth period. Regardless of the choice of cash flow used, the model could adopt a two stage or three stage approach. The ability of the firm to achieve and maintain high growth is directly related to the comparative advantages that create barriers to competitors from Module 4. Therefore project choice is critical in determining the value of the firm. The longer the amount of time that fast growth continues, the larger the future cash flows become and the value of the firm increases. The different assumptions about cash flows each come with different expectations about calculating growth rates which must be consistent with the choice of cash flow. However, the basic idea of splitting the forecasts into stale growth and nonstable (faster) growth periods holds across all the possible choices of cash flows. The basic v