Question

Please answer the questions below .

In this discussion, I would like you to discuss, expound and elucidate on the following: o Describe, in words, the Law of One Price value for a common stock, including the discount rate that should be used. o Describe, in words, the Law of One Price value for a common stock, including the discount rate that should be used. o Describe circumstances in which cutting the firm's dividend will raise the stock price. o What discount rate do you use to discount the future cash flows of a stock? o What discount rate do you use to discount the future cash flows of a stock? o What discount rate do you use to discount the future cash flows of a stock? o What is the enterprise value of a firm? o What are the implicit assumptions made when valuing a firm using multiples? o Explain why several valuation models are required to value a stock o Explain why several valuation models are required to value a stock o Discuss why investors who identify positive-NPV trades should be skeptical about their findings, unless they have inside information or a competitive advantage. As part of that, describe the return the average investor should expect to get. o What is the efficient market hypothesis? What are its implications for corporate managers?

Answer 1

1.) The Law of one price states that two assets which are producing similar cash flows should have the same price. In the case of common stocks, if two stocks are going produce the same amount of dividend as well as the price appreciation then those two assets should be priced similarly. When the cash flow is same that means the expected risk associated with those cash flows should also be same and their price should be similar.

2.) The cutting of dividend would increase the stock price of the company if the expected growth rate is higher. The growth rate is calculated as return on equity and retention ratio, which is equal to 1- dividend payout ratio. So lower payout ratio means higher growth rate and price might increase. The company reduces the dividend when it is going to reinvest the earning and future ROE is going to increase significantly, this will also increase the growth rate and will increase the price.

3.) The discount rate used to value the stock should be appropriately adjusted for the risk premium attached with the cash flow. In the case of equity, we use the CAPM model where we calculate the Beta of stock and then calculate the equity risk premium. The equity risk premium is added to the risk-free rate and that rate is used to discount the future dividends.

4.) The enterprise value of firm is equal to value you would pay to acquire the firm today. The enterprise value is calculated as market value of equity plus market value of debt minus the net cash balance.

5.) There are different measures of valuations, valuing firms using multiples is one of them. When you are using multiples to value a firm, the major implicit assumption is that both the companies are comparable and they are similar in terms business risk, their operation, their capital structure. The multiples should be used only when the company business and risk are similar in nature, then only the output can be reliable.