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Growth and Return on Invested Capital, Required Rate of Return, Competition

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3. How does growth and return on invested capital drive free cash flow? Illustrate with an example employing constant and non-constant growth rates.

7. Why might large firms experience lower rates of growth than smaller firms? What is the danger of having a large company attempt to match the growth of a small company?

3. Why is the required rate of return on common stock greater than on bonds?

5. If interest on debt is deductible in arriving at taxable income, and dividends on stock is not so, how does that situation alter the optimal capital structure?

9. How is competition in the product markets related to the valuation of the firm in the economic profit model?

10. In the economic profit model (i.e. EVA), is the opportunity cost of equity capital treated as cost, as debt capital is?

11. How can management's plan to change the outlays for new capital investment impact the enterprise DCF model's estimate of business valuation?

12. When interest rates rise, how does that impact the cost of capital?

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3. How does growth and return on invested capital drive free cash flow? Illustrate with an example employing constant and non-constant growth rates.

Return on invested capital usually leads to more revenue and earnings for a company that leads to higher growth in the company. Since more earnings would lead to increase in free case flow, so growth and return on invested capital will result in more cash inflow for the company. (Mckinsy et al, 2003).

A constant growth stock is a stock whose dividends are expected to grow at a constant rate in the foreseeable future. This condition fits many established firms, which tend to grow over the long run at the same rate as the economy whereas non-constant growth stocks presents a more general approach which allows for the dividends/growth rates during the period of rapid growth to be forecast. Then, it assumes that dividends will grow from that point on at a constant rate which reflects the long-term growth rate in the economy That implies both constant and non-constant growth rates result in better cash flow for the company.

7. Why might large firms experience lower rates of growth than smaller firms? What is the danger of having a large company attempt to match the growth of a small company?

Large firms and small firms have different characteristics and have different level of performances for same invested capital. Both kind of firms have different economies of scale, different cost of capital, different cost curves, and different ...

Solution Summary

The solution examines the growth and return on invested capital. How the competition in product markets relates to the valuation of the firm in the economic profit model is given.

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TF: future cash flows, forecasts, market structure, discounting methods, WACC

Answer true or false to each question with one or two sentences of explanation for each.

1. The greater the uncertainty of the future, the greater the need for alternative scenarios in projecting future cash flows.

2. The reliability of continuing value estimates is greater than of explicit forecast estimates.

3. Competition is a factor in forecasts that relates more to the pricing estimates in a forecast than to the costs to produce a firm's product.

4. Forecasting labor costs over the future is more difficult for an industry that is seriously restructuring than for a firm in the retailing sector.

5. Forecasting cash flows in the last five years for major airlines has become much easier than fifteen or twenty years ago.

6. The changing market structure facing a firm in its product market has more impact on a firms pricing policy than do changes in tax laws.

7. A firm's balance sheet is a stock statement while its income statement is a flow statement reflecting the changes in two consecutive balance sheets.

8. In Marshall's economic profit model, economic profit increases the more competitive are product markets.

9. Because of the time value of money, the discounted present values of a given absolute dollar amount are smaller for estimates of continuing value than the explicit forecasted values of the near term or explicit forecasts.

10. The Payback model has more significance in an industry with rapid technological change than in one where such rapid changes do not occur.

11. The greater the discontinuities in addition to a firm's fixed capital, the more difficult are forecasts of near term cash flows.

12. In times of rapid technological change in product markets and in the determination of such things as the labor to capital ratio, the assumptions in the continuing value model are less reliable than if the firm operated in product and resource markets where little change occurred.

13. As opposed to the Discounted Cash Flow (DCF) Models, the Economic Profit Model does not involve the estimation of future profits and cash flows.

14. Free cash flows (FCF) are subject to management decisions for increasing or decreasing capital investments.

15. Charges for depreciation must be added back to profits in calculating FCF.

16. Corporate taxes paid in-cash must be added back in determining FCF.

17. Growth is only a successful driver of increased business value if Return on Invested Capital (ROIC) exceeds weighted average cost of capital (WACC).

18. As industries become increasingly competitive, economic profit, as defined by Alfred Marshall, tends to increase in size.

19. As interest rates rise, in a persistent and significant manner, the WACC tends to decrease.

20. According to the Modigliani-Miller Model, in a tax-free world, the enterprise value of company is independent of the capital structure, that is, the ratio of debt to equity.

21. Return on Assets (ROA) and Return on Equity (ROE) are metrics determined by FCF.

22. On the balance sheet, the values of fixed assets are based on historical costs, not on the present value on expected FCF.

23. In estimating the WACC, we use the current cost of the capital components as viewed in current markets, rather than the historical costs, when the existing capital was raised.

24. If interest rate expense on debt capital is deductible in determining the tax liability, while dividends on capital stock are not, the component weight of debt capital will be greater than if dividends and interest rates were treated equally for tax purposes.

25. If you anticipated rising interest rates over the next several years and you wished to issue long-term debt bonds to raise capital, callable bonds would make more sense than if interest rates were to fall over the next few years.

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