Question

Alice Werd is a new project analyst; he is working on capital budgeting analysis of two mutually exclusive projects. The followings are the cash flow forecasts for both the projects

years Project A Expected Cash flows Project B Expected Cash flows
0 (1000,000) ($900,000)
1 50000 650,000
2 200,000 650,000
3 600,000 550,000
4 1000,000 300,000
5 1500,000 100,000


The following metrics presents the key information based on capital budgeting indicators. For purposes of analysis, he plans to use a required rate of return of 20% for both projects. Ideally, he would prefer that the project he chooses to have a payback period of less than 3.5 years and a discounted payback period of less than 4 years
Metrics Project a Project b
Payback period (in years) 3.15 1.38
Discounted payback period (in years) 3.98
Net Present Value (NPV) $596,206
Internal Rate of Return (IRR) 35.93%
Profitability Index  
Accounting Rate of Return (ARR) 1.25 1.58

i.Please calculate the missing values in the table and help Mr. Werd to decide which project to select and why?


ii.Explain the different stock valuation methods?


iii.What are the advantages of dividend discount model?

Answer 1

Time period Project A Cash flow Project B Cash flow (1,000,000.00) (900,000.00) 50,000.00 650,000.00 200,000.00 650,000.00 600,000.00 550,000.00 1,000,000.00 300,000.00 1,500,000.00 100,000.00 Time period Project B Cash flow Present value @ 20% Cumulative value (900,000.00) (900,000.00) (900,000.00) 650,000.00 541,666.67 (358,333.33) 650,000.00 451,388.89 93,055.56 550,000.00 318,287.04 300,000.00 144,675.93 100,000.00 40,187.76 un WNO hence payback period = 2+ (93055.56/318287.04) Metrices Project A Project B 2.29 Profitability index = 1 +NPV/initial investment Payback period Discounted payback period Net present value Internal rate of return Profitability index Accounting rate of return 3.15 3.98 612,847.22 35.93% 1.61 1.25 1.38 2.29 596,206.28 55.07% 1.66 1.58 Mr. Werd should choose project A because it has higher net present value, it discounted payback period is less than 4 and its payback period is less than 3.5

ii) There are basically three methods of stock valuation: Dividend discount model: The dividend discount model uses dividend and it growth rate to value the stock at the required rate of return. The model assumes that the intrinsic value of the stock is the present value of all the dividend payment. This model is applicable only when the company pays the dividend and growth rate in dividend is less than the required rate. Discounted cash flow: The discounted cash flow model instead of discounting the dividend, it discounts the present value of all the free cash flows to its equity holders. The benefit of this model is that it does not assume that dividend has to be paid and is suitable for companies valuing which are not paying dividend. Comparable analysis: Comparable analysis use the relative valuation approach where it values the company stock on the basis of the comparable multiple like P/E ratio, EV/EBITDA multiple. Relative valuation is one of the simplest methods to value the stock. iii) Advantages of dividend discount model: • • It is one of the simplest methods to value the stock today The subjectivity bias is less in this method since the dividend and its growth rate is taken on the historical data. The model provides values which can be relied upon, it is simply providing the sum of present value of all the expected dividends. This model is very much suitable to value mature business which has a history of paying dividends.