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Stocks 403: Introduction to Discounted Cash Flow

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1.
A company's cost of capital is the return that investors get for their investments in the company.
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True. This includes interest and dividends.
2.
Illini Widgets will earn $350 million in cash flow four years from now. Assuming an 8.5% weighted average cost of capital, what is that cash flow worth today?
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$253 million. $350,000,000/1.085^4 = $252,550,999, or $253 million. One hint: remember that future cash flow is always going to be worth less in today's dollars, so you could have automatically eliminated the choice of $380 million.
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 _______.
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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.
Projecting a company's future cash flow means simply projecting current trends into the future and putting a dollar value on them.
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False. This is a misleading approach. There are a lot of other variables that need to go into the calculation, such as projected costs, economic trends, and other variables. The actual work is very involved.
5.
The concept of perpetuity value involves estimating a company's future cash flows for a certain period and then estimating the value of all cash flows after that in what form?
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One lump sum. The perpetuity value will be expressed in one lump sum, then discounted for its present value.