Olivia Stevens is trying to value Wonderland’s shares, which are not growing at all. Wonderland declared and paid a $5 dividend last year. The required rate of return for its industry is 11%, but Olivia is unsure about the financial reporting integrity of Wonderland’s finance team, which has short-term focus. She decides to add an extra 1% ‘credibility’ risk premium to the required return as part of her valuation analysis.
a) What is the value of Wonderland’s shares, assuming that the financials are trustworthy?
b) What is the value of Wonderland’s shares, assuming that Olivia includes the extra 1% ‘credibility’ risk premium?
c) What is the difference between the values found in parts a and b, and how might one interpret that difference?
d) What are the key issues for valuation when the finance team adopts a short-term focus? (1 X 4 = 4 Marks)
b) Consider the mixed streams of cash flows shown in the following table.
Cash flow stream
Year A B
1 $50 000 $10 000
2 40 000 20 000
3 30 000 30 000
4 20 000 40 000
5 10 000 50 000
Totals $150 000 $150 000
a) Calculate the present value of each stream using a 15% discount rate.
b) Compare the calculated present values and discuss them in light of the fact that the undiscounted cash flows total $150 000 in each case.