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: $70

k = 0.09

Growth Rate:

Year 1–3: 9%

4–6: 8%

7 and beyond: 7%

a. Assuming that the current value for the S&P Industrials Index is 4,950, 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 (underweight/overweight/market weight) the U.S. equity market as the estimated value of the stock of $___ is (higher than/lower than/equal to) the S&P Industrials Index.

b. 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 (underweight/overweight/market weight) the U.S. equity market as the estimated value of the stock of $___ is (higher than/lower than/equal to) than the S&P Industrials Index.

Answer 1

a). Value comes out to be 4,059.04. S&P index has is 4,950 so you should underweight the U.S. equity market as the estimated value of the stock of $4,059.04 is lower than the S&P index.

Formula 0 1 5 6 1 9% 76.30 2 9% 83.17 3 9% 9 0.65 796 8% 97.90 8% 105.74 8% 114.20 70.00 122.19 6109.46 Year (n) Growth rate (g) FCFE Horizon value (HV) Total Cash Flow to Equity (CF) Discount factor @ 9% PV of CF Total PV 76.30 FCFEn-1*(1+g) FCFE7/(k-g) Year 6: FCFE + HV 1/(1+k)an CF*Discount factor Sum of all PVS 83.171 0.917 0.842 90.651 0.772 70.000 97.901 0.708 69.36 105.746223.65 0650 0.596 68.72 3710.96 70.00 70.00 4059.04

b). Value now becomes 4,094.05. You should underweight the U.S. equity market as the estimated value of the stock of $ is $,4094.05 which is lower than the S&P Industrials Index.

Formula 3 1 10% 77.00 2 10% 84.70 10% 93.17 9% 101.56 5 9% 110.70 6 9% 120.66 70.00 130.31 6515.52 FCFEn-1*(1+g) FCFE7/(k-g) Year 6: FCFE + HV 1/(1+k)an CF*Discount factor Sum of all PVS Year (n) Growth rate (g) FCFE Horizon value (HV) Total Cash Flow to Equity (CF) Discount factor @ 9% PV of CF Total PV 77.00 0.909 70.00 84.701 0.826 70.00 93.17 0.751 101.56 0.6831 69.36 110.70 0.621 68.73 6636.18 0.564 3745.95 70.000 4094.05