Question

Using the free cash flow method of valuation, an analyst determines the value of Company A’s stock to be $10 and the value of Company B’s stock to be $14. Based on this information, which of the following statements is most accurate?
a. Using the dividend valuation model, the value of company A's stock will be lower than the value of Company B’s stock.
b. Other things being equal, if Company A and Company B have the same firm value, Company B must have more debt, thus leveraging its returns for the benefit of shareholders.
c. Other things being equal, if Company A and Company B have the same firm value, Company A may have more shares of stock outstanding than Company B.
d. Company B’s required rate of return is higher than Company A's required return.

Answer 1

Answer:

(A) Using the dividend valuation model, the value of company A's stock will be lower than the value of Company B’s stock

Explanation:

The free cash flow method of valuation uses the same discounting technique used in the dividend valuation method to arrive at the value of a company. The free cash flow method begins by discounting the free cash flow to the firm to arrive at the value of the firm, and thereafter deducts the present value of debt, to arrive at the value of equity. The dividend discount model discounts the expected dividend of the company, and includes a growth rate which accounts for the expected growth in dividend, to arrive at the value of equity. As such, if the value of company A is less than the value of company B using the free cash flow method, the same conclusion is likely to be arrived at using the dividend valuation model.

Option (B) is inaccurate because if both companies have the same firm value, then company A is more likely to have a higher debt since it has a lower equity. Note that $Equity + Debt = Firm Value$.

Option (C) is inaccurate because we do not have sufficient information to conclude that either of the company will have more shares of stock. The question only provided for the value of the firm. We need additional information regarding the price of each stock to be able to determine which company has more shares of stock outstanding.

Option (D) is inaccurate because company B is likely to have a lower required rate of return than company A due to its higher value. This is due to the inverse relationship between value and the required rate of return. the higher the valuation of a company, the lower its required rate of return is likely to be.