Question

Question 1

Describe an equity cost problem and discuss why the use of Economic Value Added (EVA) may alleviate the problem.

Question 2.

Describe a back-loaded earnings problem and discuss which managers are likely to have the problem.

Question 3.

1. A CFO says, “The dividend growth model implies that the current stock price equals the present value of future dividends. We thus increase dividend payouts rather than retaining earnings to maximize the stock price." Do you agree with the CFO? Justify your answer. (You do not have to criticize the dividend growth model but discuss the CFO's interpretation of the model.)

2. Regarding the CFO's statement above, a treasurer responds as follows: “I do not agree. Retained earnings can be reinvested in our projects, which provide growth opportunities to our firm. We thus rather retain earnings as much as possible in any circumstances." Do you agree with the treasurer? Justify your answer. (Your objection to CFO's statement above does not necessarily imply that you agree with the treasurer. Assess the treasurer's statement independently.)

Question 4.

Suppose that your firm has higher fixed cost-to-variable cost ratio than comparable firms. Explain how EBITDA multiple valuation would be influenced by the difference in this ratio.

Question 5.

Provide a reason why a privately-held firm is valued higher/lower than comparable publicly-held firms. To get the full mark, you must discuss both cases.

Answer 1

Question 1

Ans.

Equity cost problem refers to problem in financial reporting or management decision making of the cost of the equity shareholders money. When preparing the income statement we deduct the interest paid on the debt capital. But we don’t deduct the cost of the equity. Because this is very difficult to calculate and it depends on the expectations of the capital providers and also it depends on the future net cash flow to the company and undertainity around the future earnings of the company.

Economic Value Added (EVA) theory refers to the concept of assessing the value created by the firm. Accoridng to this theory the cost of the equity capital is deducted from the net operating profit after tax (NOPAT) . and then the residual is referred as the economic profits or also termed as the economic profit. This theory showcase the net value generated by the company after deducting the cost of the capital for all stakeholders what is the wealth generated by the company.