a What are the relevant cash flows for valuing a stock using

a. What are the relevant cash flows for valuing a stock using different valuation methods (Free Cash Flow to Equity and Dividend Discount Model)?

b. What are the different ways you can find cost of equity? Which is your preferred method?

c. When is a dividend discount model most suitable? When is it not suitable?

d. What would be the input to Excel Rate function if you are trying to find yearly dividend growth rate for a company which paid $2.5 as dividend exactly 4 years ago and has paid $3.5 today?

e. What is the difference between unsystematic and systematic risk according to the Capital Asset Pricing model?

Solution

a)The relevant cash flow for Free cash flow to equity can be calculated as follows
FCFE = Net income + Depreciation/Amortisation +/- Change in inventory +/1 change in capital expenditure + Net borrowing.
For Dividend discount model the cash flow for dividend of successive years factoring growth of dividends needed to be taken.

b) The Cost of Equity can be found out BY
CAPM model Cost of Equity = Risk free Rate + Beta * (Market Return - Risk Free rate)
Dividend Discount Model Cost of Equity = Dividend next Year/Price of Stock + Growth of dividends.
CAPM method is better because it takes into consideration the diversifiable and non-diversifiable risk into consideration. It correlates with market risk . Hence CAPM is more preferable Than Dividend discount model

c) For dividend Discount Model the company should be paying dividends regularly. If the company does not pay dividends at all or pays out irregular dividends dividend discount method fails. Hence only for a dividend paying company it should be used.

d) To calculate growth through rate function we use following method
= RATE(Nper,PMT,PV,FV) = RATE(4,0,-2.5,3.5) = 8.77573%
Since 4years hence NPER = 4,
Dividend Between years PMT=0

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