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1.
A company's cost of capital is the return that investors get for their investments in the company.
True. This includes interest and dividends.
2.
Suppose we're using a DCF model with 10 years' worth of projections for a company with a 9.5% cost of capital. We estimate that the company's free cash flow in Year 10 will be $350 million, and that its cash flow will grow at 4% in perpetuity after that. The present value of the perpetuity value will equal _______.
$2.7 billion. Step 1 is to calculate the value of the perpetuity. Plugging the values into the equation: 350,000,000 x (1 + .04) / (.095-.04) = $6,618,181,818, or $6.6 billion. Step 2 is to express the value of the perpetuity in today's dollars, using the perpetuity value as a single cash flow: $6,618,181,818 / (1.095^10) = $2,670,530,254, or $2.7 billion.
3.
Suppose Company A has a long history of profitability, and its outlook is stable, and Company B has yet to make a profit in its short history, and its outlook is much more uncertain. Company A's cost of equity should be _______.
Less than that of Company B. This is because estimated cash flow in the future from Company A is much more certain than it is from Company B. Risk and assumed cost of equity (the return equity investors require) should be concurrent. Lower risk should mean a lower cost of equity assumption, and vice versa.
4.
When it comes to finding a stock's intrinsic value, what is the problem with simply counting up all the future dividend payments a company is expected to make and expressing them in today's dollars?
Some companies do not pay dividends. That is why cash flow is used.
5.
When calculating discounted cash flow, why are we discounting it at all?
Because the further out a cash flow is, the less it is worth in today's dollars. The math will bear this out.
