Jim Williams, a financial analyst with Churn Brothers Brokerage, is attempting to value share of Intelligent Semiconductor. In his calculation, Jim calculates the following for each subperiod:
[Net income + Depreciation - Capital Expenditures - Increases in Working Capital - Principal Repayments + New Debt Issues]. The results of this calculation will be referred to as "X."
The second step in the process is the determination of the "multiple" of X that shares of Intelligent will trade for in three years. This figure will be referred to as "M."
Finally, Jim determines the required equity rate of return for shares of Intelligent Semiconductor. This figure will be referred to as "r."
These calculations are inputted into the following equation:
Price of Intelligent Semiconductor = {[X during year 1 / (1 + r)] + [X during year 2 / (1 + r)(1 + r)] + [X in year 3 / (1 + r)(1 + r)(1 + r)] + [M * X in year 3/ (1 + r)(1 + r)
(1 + r)]}
The results of this calculation are used as the value of Intelligent shares.
Which of the following best characterized the valuation method employed by Jim Williams?
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A. B. C. D. E.A
The method illustrated in this example is the free cash flow to equity method.
The valuation method employed by Jim Williams can be best characterized as the "Multi-period dividend discount model."
The equation provided in the question is a variation of the dividend discount model (DDM), which is commonly used to value stocks. The DDM calculates the present value of all expected future dividends, discounted at an appropriate rate of return. However, in this case, instead of using dividends, Jim Williams uses a measure called "X" to represent the cash flows associated with Intelligent Semiconductor.
Let's break down the equation to understand how it corresponds to the multi-period dividend discount model:
The first part of the equation represents the present value of X during year 1, discounted at the required equity rate of return ("r"). This captures the cash flows expected in the first year of investment.
The second part represents the present value of X during year 2, discounted at (1 + r)(1 + r). This accounts for the cash flows expected in the second year, adjusted for the time value of money.
The third part represents the present value of X during year 3, discounted at (1 + r)(1 + r)(1 + r). This captures the cash flows expected in the third year, adjusted for the time value of money.
The final part represents the multiple ("M") of X in year 3. This multiple reflects the expected market price-to-X ratio in three years. By multiplying the multiple with X, the future cash flows are estimated, and then they are discounted back to present value using (1 + r)(1 + r)(1 + r).
The sum of these present values represents the estimated price of Intelligent Semiconductor shares.
While this approach resembles the dividend discount model, it differs in terms of using the "X" measure instead of dividends. Additionally, the inclusion of the multiple in the third year adds an additional layer to the valuation calculation.
Therefore, the best characterization of the valuation method employed by Jim Williams is the "Multi-period dividend discount model."