1) Investors receive dividends as payoffs for investing in equity shares.

Thus the value of a

share should be calculated by discounting expected dividends. True or false?
ANS False
Dividend that are paid out over the period of time or per say in the future does not mean much.
They should be considered only when they are to be paid as a fixed ratio of the earning. Hence
we can say that they will tie to the value of the share only if they are paid out as a fixed
proportion otherwise not. Hence they dont create value, they are value distribution.
2) Some analysts trumpet the saying Cash is King. They mean that cash is the primary
fundamental that the equity analyst should focus on. Is cash king? Should a firm that has
higher free cash flows have a higher value?
ANS. Cash is not king appositively it should be Free cash flow. Hence FCF is what an analyst
should focus upon because it the amount that is available to the shareholders once you have paid
all the debt and the interest payments. Whereas cash is biased too much by interest payments,
amortization, depreciation as it does not take into account any of these. Hence we can say an
analyst should primarily focus upon the FCFF/FCFE not the cash.
3) Information indicates that a firm will earn a return on common equity above its cost of
equity capital in all years in the future, but its shares trade below book value. Those shares
must be mispriced. True or false?
ANS. True,
V(E) = B0 + RE1/ re + RE2/re+
Residual earnings = (ROCE - required return on equity)*beginning of period book value of common
equity.
This shows us that with residual earnings the value has to be higher than the book value and therefore
the shares are mispriced.

4) Jetform Corporation traded at a price-to-book ratio of 1.01 in May 1999. Its most
recently reported ROCE was 10.1 percent, and it is deemed to have a required equity
return of 10 percent. What is your best guess as to the ROCE expected for the next fiscal
year?
ANS.To trade at book value as Jetform does, its approximately ROCE in future should be equal
to its cost of equity i.e. 10%. Thus market will also expect an ROCE of 10% in future.
5) Telesoft Corp. traded at a price-to-book ratio of 0.98 in May 1999 after reporting an
ROCE of 52.2 percent. Does the market regard this ROCE as normal, unusually high, or
unusually low?

ANS. The market views this ROCE as normal.

The reason behind this is that the P/B is .98 which is very much close to 1 and hence indicate
correct valuation of the firm.

6) A share trades at a price-to-book ratio of 0.7. An analyst who forecasts an ROCE of 12

percent each year in the future, and sets the required equity return at 10 percent,
recommends a hold position. Does his recommendation agree with his forecast?
ANS.
P/B ratio in the question is .7 which is much lower than 1. It means that the market judges asset value is
overstated, or the company is faring very badly in terms of returns on its assets. This can only be the
case if the firms operations destroy value.
But in the question the expected ROCE is 12% which means that firm would create value and its the
asset value will rise as the required return is only 10%. Hence this would be considered by the investors
and hence the value of the share will rise and therefore the recommendation given by the analyst is
correct i.e. to hold the stock.

7) Explain why analysts forecasts of earnings-per-share growth typically underestimate

the growth that an investor values if a firm pays dividends.
ANS. This is because Dividend payout is irrelevant to valuation. For cum-dividend earnings
growth is the same irrespective of dividends.

8) The historical earnings growth rate for the S&P 500 companies has been about 8.5
percent. Yet the required growth rate for equity investors is considered to be about 12
percent. Can you explain the inconsistency?
ANS.
Firms in the S&P 500 pay dividends. If we take into account the historical data the dividend
payout ratio that has been given by the firms comes out to be 45% of the earnings.
Hence the growth rate which is mentioned in the question is an ex-dividend growth rate. The
cum-dividend growth rate with 45% payout is about 12.32% or 12%.

9) The following formula is often used to value shares, where Earn1 is forward earnings, r
is the cost of capital, and g is the expected earnings growth rate. Explain why this formula
can lead to errors.
ANS.
Formula
Value of Equity = Earn1/(r-g)
This formula is wrong because it takes into account the growth rate of ex-dividend rather than
the growth rate of cum-dividends. The difference is that the Ex-dividend growth rates does not
takes into account the growth by reinvesting the dividends you are getting in that duration.
Apart from this, the formula does not work if g>k.

10) A firms earnings are expected to grow at a rate equal to the required rate of return for
its equity, 12 percent. What is the trailing P/E ratio? What is the forward P/E ratio?
ANS.
Trailing P/E ratio = 1*(1+.12)/0.12 = 9.33
Forward P/E ratio = 1/0.12 = 8.33