Question

Explain each letter in the questions above.

b) If the terminal growth rate is projected to be 6%, rather than 5%, re-estimate the value of a share of Global Services. Does this new estimate make sense? c) If the expected market return is assumed to be 9%, rather than 10%, re-estimate the value of a share of Global Services. Does this new estimate make sense? d) If the systematic risk coefficient (beta) of the stock increases from 1.25 to 1.40, re-estimate the value of a share of Global Services. Does this new estimate make sense? e) If Global Services' estimated beta is statistically insignificant, suggest an alternative approach to arrive at the required rate of return (k) on the stock and use this new k to re-estimate the value of a share of Global Services. Assume Global Services' bonds outstanding are traded at a yield of 6.15% and the risk premium required for Global Services' equity shareholders over bond holders is 4.5%. Year3 Year4 Year5 Year6 Year7 Year1 Year0 Year2 Growth rate 0.09 0.09 0.15 0.15 0.15 0.15 0.09 $1.75 $2.01 $2.31 $2.66 $3.06 $3.34 $3.64 $3.96 FCF WACC 15% 15% 15% 15% 15% 15% 15% 15% Year 1 5 6 2 Discount Factor 1/((1+WACC)^YEARS OF PROJECTION Present Value $1.75 $1.76 $1.76 $1.77 $1.78 $1.69 $1.61 $1.53 Beta 1.25 Rf 0.0205 Rm-Rf 0.1 Rf+Beta(Rm-Rf САРМ Cost of equity or WACC 15% Terminal Value Terminal Value at Long Term Cash Flow Growth Rate@ 6% Sum of PV $13.65 $13.65 Sum of PV WACC 15% WACC 15% 6% Long Term Cash Flow growth rate Terminal Value 5% Long Term Cash Flow growth rate Terminal Value $16.84 $18.99 Present Value of Terminal Value Present Value of Terminal Value $6.51 $7.34

Answer 1

b) Terminal growth rate is the rate at which a firm is expected to grow indefinitely after a high growth period. Generally firm starts with a high growth rate and later the growth rate is reduced and stabilizes. That is call terminal growth rate.

c) expected market return is the rate of return that all investors are expecting from a market based on the risk in that market

d) systematic risk coefficient or beta is the measure of risk (volatility) of a stock as compared to the market. For example, If a stock beta is 1.5, it means stock is 50% more risky (volatile) than market.

e) Required rate of return - This is the returns expected from a company/stock over and above the risk free rate by investing in that company or stock. It is over and above risk free return because investor is taking some risk by investing in a risky project and hence investor needs returns over and above the risk free rate.

Risk premium - It is the return required by an investor over and above risk-free rate of return.

Value of a share is derived by the formula = Free cash flow to the firm divided by weighted average cost of capital.

Risk premium is sort of award for investors for taking the extra risk instead of investing in a risk free investment option.