Banking and Finance

Tutorial Exercises

BFF5220
Applied Investments
Semester 2, 2023

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https://www.monash.edu/business/banking-and-finance
 BFF5220 Applied Investments
WEEK Starting LECTURE TOPIC ASSIGNED TUTORIAL TOPIC
READING
1 24 Jul Financial Markets, BKM, Ch. 3, 5 Self-study on Pre-Semester
Securities Trading and Test, Accounting and
Performance Statistics. Group Formation.
Measurement Free-Style Discussion of
Articles on Fin Mkt News.
2 31 Jul Portfolio Theory BKM, Ch. 6, 7 Financial Markets, Securities
Trading and Performance
Measurement
3 07 Aug Asset Pricing Models BKM, Ch. 9, 10 Portfolio Theory
4 14 Aug Asset Pricing Models BKM, Ch. 9, 10, 17 Asset Pricing Models
(cont.)
Fundamental Analysis I Other reading on
Moodle In-tutorial Group Assignment
Instruction Discussion, Q&A
5 21 Aug Fundamental Analysis II BKM Ch. 18 Formative task: Online
submission of literature review
of return patterns

Fundamental Analysis I

6 28 Aug Fundamental Analysis III BKM Ch. 18 Q&A on Group Assignment

Other reading on
Moodle
7 04 Sep Market Efficiency BKM Ch. 11 Formative task: Submission
of first attempt on R
programming code for one
return pattern.

Fundamental Analysis II &

Advanced/Practical Topics in
Fundamental Analysis
8 11 Sep Behavioural Finance BKM Ch. 12 Market Efficiency

9 18 Sep Options Trading BKM Ch. 20 Behavioural Finance

Strategies
Mid-Semester Break starting on 25 Sep
10 02 Oct Option Valuation BKM Ch. 21 Options Trading Strategies

11 09 Oct Futures, Forwards and BKM Ch. 22, 23 Option Valuation

Swaps

12 16 Oct Fixed Income Securities BKM, Ch. 15, 16 Futures, Forwards and Swaps

SWOT/VAC 23 Oct SELF STUDY, Fixed Income Securities

Mid-Semester Test Mid-Semester Break Asset Pricing Group Assignment

Students are required to prepare answers for all questions. Due to time constraints, students are
encouraged to nominate the questions/problems for discussion at the commencement of each
tutorial. Solutions for all questions will be available in the form of video recordings by the end of
each week.
Topics 5 W6 – Fundamental Analysis II
Q.1. The Generic Genetic (GG) Corporation pays no cash dividends currently and is not
expected to for the next 3 years. Its latest EPS was $10, all of which was reinvested in the
company. The firm's expected ROE for the next 3 years is 15% per year, during which
time it is expected to reinvest all of its earnings. Starting in year 4, the firm's ROE on
new investments is expected to fall to 12%, and the plowback ratio is 1/2, which it will
continue to do forever after.

The risk-free rate is 5%, the expected market return is 8%, the stock of GG has a beta
coefficient of 1.4, and you are a believer of the CAPM.

A competitor in the market trades with a price-earnings (PE) ratio of 16 in the market.

a. What is the intrinsic value of a share of GG stock based on DDM?

b. Do you think it is important to use multistage dividend discount model to value a
firm? in what circumstances? and does it have any limitations, eg. compared to FCFE
model?
c. If a stock is underpriced, what is the relationship between market capitalization rate
and your belief of its expected rate of return?

Note: NASDAQ’s definition of the market capitalization rate is “the market-

consensus estimate of the appropriate discount rate for a firm’s cash flow”.

d. What is the relative valuation of GG based on the PE ratio of the competitor (that is,
assuming that the PE ratio of the competitor is equal to the PE ratio of GG)?
e. Comment on the differences in the estimated value of GG if any and the merits of
each method of valuation.
f. Assuming the company is the target of a hostile takeover and the acquirer is offering
to pay $165 for a share in GG. On the basis of your two calculations to value the firm,
should you accept the offer giving reasons for your recommendation?

Q.2. Abbey Naylor, CFA, has been directed to determine the value of Sundanci's stock
using Free Cash Flow to Equity (FCFE) model. Naylor believes that Sundanci's FCFE
will grow at 25% for 2 years and 10% thereafter. Capital expenditures, depreciation, and
working capital are expected to increase proportionately with FCFE. The cost of equity
capital is estimated as 14% p.a.

a. Calculate the amount of FCFE per share for the year 2011, using the most recently
available historical data from the table below.
b. Calculate the current value of a share based on the two-stage FCFE model.
c. Describe one limitation of the two-stage DDM model that is addressed by using the
two-stage FCFE model.
d. Describe one limitation of the two-stage DDM model that is not addressed by using
the two-stage FCFE model.

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Most recently available historical financial data ($mil, except per share data):

Income Statement Fiscal Year 2010 Fiscal Year 2011

Revenue $474 $598

Depreciation 20 23
Other operating costs 368 460
Income before taxes 86 115
Taxes 26 35
Net Income 60 80
Dividends 18 24
Earnings per share $0.714 $0.952
Dividend per share $0.214 $0.286
Common shares outstanding (millions) 84 84

Balance Sheet Fiscal Year 2010 Fiscal Year 2011

Current Assets $201 $326
Net Property, Plant, and Equipment 474 489
Total Assets 675 815
Current Liabilities 57 141
Long-term debt 0 0
Total Liabilities 57 141
Shareholder’s Equity 618 674
Total Liabilties and Equity 675 815

Capital Expenditure 34 38

Q.3. Suppose you have made the following assessment for Company XYZ for four years:

20X1 20X2 20X3 20X4

EBITDA* 80 95 110 120
Depreciation and amortization 20 22 25 28
Pre-tax operating profit 60 73 85 92
Capital investment 12 30 30 20
* EBITDA = Earnings before interest, taxes, depreciation and amortization.
The estimates are for the end of the next 4 years and the estimates for year 4 are expected to
remain constant for subsequent years. The amounts are in millions of dollars. Additional
information:
 Company XYZ has $400,000,000 of debt
 Company XYZ has 1,000,000 shares outstanding.
 For this kind of investment opportunity, the firm considers that its weighted average cost of
capital defined as:
D  E 
WACC    rdebt  (1  TC )    requity 
V  V  to be 7.40%

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 The corporate tax rate is 40 percent.

Required:

a. Calculate the value of Company XYZ in millions of dollars.

b. Calculate the intrinsic value of a share in Company XYZ.

Q.4. Twenty years after the original Fama-French model, Fama and French (2015) have
proposed a new, five-factor model, incorporating two additional factors, RMW and
CMA. RMW (robust-minus-weak) is the difference in returns between a portfolio of
firms with robust and weak profitability; CMA (conservative-minus-aggressive) is the
difference in returns between a portfolio of firms with conservative (i.e. low) and
aggressive (i.e. high) investment.

Recall the constant growth dividend discount model:

The economic intuition behind why HML, CMA and RMW are risk “premiums” can be
derived easily from the above fundamental valuation formula. Explain how.

Q.5. The Earnings Factory

a. According to many analysts, The Earnings Factory is a ‘darling’ of the ASX. Its
current market price is $15 per share and its book value is $5 per share. Analysts
forecast that the firm’s book value will grow by 10% per year indefinitely, and the
cost of equity is 15%. Given these facts, what is the market’s expectation of the
firm’s long-term average ROE?

b. Given the information in part a, what will be The Earnings Factory’s share price if the
market revises its expectations of long-term average ROE to 20%?

c. Analysts reassess The Earnings Factory’s future performance as follows: growth in

book value increases to 12% per year, but the ROE of the incremental book value is
only 15%. What is the impact on the market-to-book ratio?