Question

You are analyzing the U.S. equity market based upon the S&P Industrials Index and using the present value of free cash flow to equity technique. Your inputs are as follows: Beginning FCFE: $60 k = 0.09 Growth Rate: Year 1–3: 9% 4–6: 7% 7 and beyond 5% Assuming that the current value for the S&P Industrials Index is 2,000, would you underweight, overweight, or market weight the U.S. equity market? Do not round intermediate calculations. Round your answer to the nearest cent. You should -Select- underweight overweight market weightItem 1 the U.S. equity market as the estimated value of the stock of $   is -Select-higher than lower than equal torItem 3 the S&P Industrials Index. Assume that there is a 1 percent increase in the rate of inflation — what would be the market’s value, and how would you weight the U.S. market? Assume that the required return would increase from 9% to 10%, decreasing the value. Also assume that the nominal cash flow growth rates would increase for all time periods by one percentage point. Do not round intermediate calculations. Round your answer to the nearest cent. You should -Select- underweight overweight market weightItem 4 the U.S. equity market as the estimated value of the stock of $   is -Select-higher than lower than equal torItem 6 than the S&P Industrials Index.

Answer 1

Year (n)	Growth rate (g)	FCFE (FCFEn-1*(1+g))	Perpetuity value (FCFEPerpetuity/(k-g))	PV of FCFE (FCFE/(1+k)^n)
1	9%	65.40	65.40	60.00
2	9%	71.29	71.29	60.00
3	9%	77.70	77.70	60.00
4	7%	83.14	83.14	58.90
5	7%	88.96	88.96	57.82
6	7%	95.19	95.19	56.76
7	5%	99.95	99.95	54.67
Perpetuity	5%	104.94	2,623.62	1,435.21
			Equity value of the company	1,843.36

a). Difference = 2,000 -1,843.36 = 156.64

If the S&P Industrial index is currently at 2,000 then one would underweight the U.S. equity market as estimated value of the stock is $156.64 lower than the index.

b). If inflation increases by 1% then the 1% increase in growth rates would increase the FCFE per year but since the discount rate would also go up by 1%, the effect would be almost neutralized.

Index value would be 2,000*1.01 = 2,020

Year (n)	Growth rate (g)	FCFE (FCFEn-1*(1+g))	Perpetuity value (FCFEPerpetuity/(k-g))	PV of FCFE (FCFE/(1+k)^n)
1	10%	66.00	66.00	60.00
2	10%	72.60	72.60	60.00
3	10%	79.86	79.86	60.00
4	8%	86.25	86.25	58.91
5	8%	93.15	93.15	57.84
6	8%	100.60	100.60	56.79
7	6%	106.64	106.64	54.72
Perpetuity	6%	113.03	2,825.87	1,450.12
			Equity value of the company	1,858.37

Difference = 2,020-1,858.37 = 161.63

You should underweight the U.S. equity market as the estimated value of the stock of $ 161.63 lower than the S&P Industrial Index.