FINA3326 Tutorial 1

THE UNIVERSITY OF HONG KONG

HKU BUSINESS SCHOOL
FINA3326 – EQUITY VALUATION AND INVESTMENT MANAGEMENT
FIRST SEMESTER, 2022-2023

Tutorial 1 – Course Overview and Introduction

General Information
Instructor: Mr. Jimmy WOO Email: jimmywoo@hku.hk
Tutor: Hermione Oi Ching KWOK Email: oichingk@hku.hk
Office: Room 1026, KKL Building Phone: 28578514
Office Hours: MON 10:30 – 11:20, THUR 10:30 – 11:20, 13:30 – 15:20

Tutorial Schedule

Session Tutorial Schedule

1 Monday 11:30 – 12:20 KK925
2 Monday 12:30 – 13:20 KK925
3 Thursday 15:30 – 16:20 KK925
4 Thursday 16:30 – 17:20 KK925

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Overview of Valuation
2 basic propositions
1. For an asset to have value, the expected cash flows have to be positive some time
over the life of the asset
2. Assets that generate cash flows early in their life will be worth more than assets
that generate cash flows later; the latter may however have greater growth and
higher cash flows to compensate.

First principle of Valuation: Consistency

- Do not mismatch cash flows and discount rates

Elements in DCF Valuation

- Growth
- Discount rate
- Cash Flow

Discount rate
For FCFF model, WACC would be more appropriate
For FCFE model, cost of equity would be more appropriate

Estimating Cost of Equity

Elements needed:
1. Risk-free interest rate
2. Equity Risk Premium
3. Beta

Risk-free rate
- Time horizon
- Default risk
o Is CDS available?
o Is there a credit rating assigned?
- Real VS Nominal → depends on CF

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Equity Risk Premium (US ERP / Mature ERP)

Choose the ERP based on your assumptions:
1. Premiums revert back to historical norms and your time period yields these
norms
• N years of data → T-year forecast.
• Blume’s formula:
(𝑇−1)𝐺𝑒𝑜𝑚𝑒𝑡𝑟𝑖𝑐 𝐴𝑣𝑔 + (𝑁−𝑇)𝐴𝑟𝑖𝑡ℎ𝑚𝑒𝑡𝑖𝑐 𝐴𝑣𝑔
𝐶𝑜𝑚𝑏𝑖𝑛𝑒𝑑 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 = 𝑁−1

2. Market is correct
• index value
• forecast dividend (plus buyback) yield
• growth rates
• → IRR
• ERP = IRR – risk free rate

Country Risk Premium (for countries other than US)

Estimates needed: Default spread, volatility on country bond and equity
• CRP =
• Total ERP =

Choices on CRP
• Location based VS Operation based

Beta: 2 approaches
1. A regression approach
• regression beta & adjusted beta
• high standard error
2. Bottom-up approach

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Tutorial Exercise

Question 1
Specify whether the following statements about discounted cash flow valuation are true
or false, assuming that all variables are constant except for the variable discussed below:
A. As the discount rate increases, the value of an asset increases.
B. As the expected growth rate in cash flows increases, the value of an asset increases.
C. As the uncertainty about the expected cash flows increases, the value of an asset
increases.
D. An asset with an infinite life (i.e., it is expected to last forever) will have an infinite
value.

Question 2
Why might discounted cash flow valuation be difficult to do for the following types of
firms?
A. A private firm, where the owner is planning to sell the firm.
B. A biotechnology firm, with no current products or sales, but with several promising
product patents in the pipeline.
C. A cyclical firm, during a recession.
D. A troubled firm, which has made significant losses and is not expected to get out of
trouble for a few years.
E. A firm, which is in the process of restructuring, where it is selling some of its assets and
changing its financial mix.
F. A firm, which owns a lot of valuable land that is currently unutilized.