Florida International University

MSF Spring 2021

Case Study

FIN 6406 Corporate Finance

Zion Willaims
Carla Otero
Sloen Julus
Luarine Flavius

February 28th, 2021

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 THE GREAT RECESSION 2007-2010

Yes, I believe financial institutions should be prevented from becoming too big to fail.
The failure of large financial institutions can undermine the entire financial system. An
unfortunate example of this is back in 2007 the Lehman Brothers were the fourth largest
investment bank but however in 2008 they went bankrupt, this kickstarted the beginning of the
2008 financial crisis. The Lehman Brothers at the time decided to invest heavily in risky
mortgage backed securities as housing prices began to drop causing them to incur tremendous
losses which forced them to liquidate. We need more regulations in place to prevent this from
occurring again, and in 2010 the Dodd-Frank Act was passed. The Dodd-Frank Act called for
stricter rules for bank capital, liquidity, and risk management practices, and since its
passing we have yet to undergo another financial crisis so more regulation is proving to
be effective.

As unemployment rises and governments are faced with losses in their GDP,
they may implement policies known as quantitative easing. Quantitative easing is the
process where governments increase spending by purchasing long term securities
such as treasury notes and bonds from the open market to counteract private
sector losses in business and consumer spending. These policies that are implemented
to stimulate the economy could eventually lead to a rise of inflation, which can lead to a
recession if left unchecked as the economy starts to recover. In the case of the current
pandemic, I would advise the Federal Reserve to gradually stop their quantitative
easing procedures, for example the government should gradually stop buying bonds
and the Fed should also step in and increase interest rates gradually. There is no
perfect timing, but I would suggest we adopt these ideas by the end of the next quarter
as vaccines become widely more available and congress passes the next stimulus
package, we will be able to weather the temporary effects of increasing interest rates
and the reduction in quantitative easing measures .

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 Valuing Wal-Mart Stock

1.
The intrinsic value of Walmart can be found by dividing the dividend by the
required rate of return minus the constant growth rate.

Required return

Risk free rate = 3.68%

Market risk premium = 5.05%
Beta = 0.66

= 0.0368 + (0.66 x 0.0505)

= 0.07013 or 7.013%

Current intrinsic value

P = D/(r - g)
= 1.21/(0.07013 - 0.05)
= $60.11

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Intrinsic value after 3 years

= 1.21 (1.05)^3/7.013 - 5
= 1.40/2.013
= $69.55

2.

P/E ratio ( price to earnings ratio) of a stock is a measure of the price paid
for a share relative to the annual net income or profit earned by the firm per
share. The P/E looks at the relationship between the stock price and the
company's earnings. It might be the most popular metric of stock analysis. A
valuation ratio of a company’s current share price compared to its per-share
earnings. For example, if a company is currently trading at $20 a share and
earnings over the last 12 months were $2 per share. The P/E ratio for this
specific stock would be 10, which is $20/$2= 10. It shows how much an investor
is willing to pay for $1 of earnings.

Over the last 4 quarters wal-mart P/E ratio is $27.47. This is showing us
that wal-mart investors are willing to invest $27.47 for $1 of earnings. In fact, the
forward P/E ratio for the next four quarters is $24.04.In order to get a complete
valuation, we can use the formula of the P/E, which is the market price divided by
earnings per share. We are not using any assumptions for the EPS, as of today
wal-mart EPS is $4.73. As a result; with the formula stated above we can
calculate the price of wal-mart:

Price=P/E ratio * EPS

Today P/E ratio:

P=$27.47 * 4.73
P= $129.93

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 Forward P/E ratio=
P=$24.04 * 4.73
P= $113.71

With these two numbers above we can draw some conclusions. When we
use the today P/E ratio, it shows that the stock is overvalued.On the other hand,
when we use the forward P/E ratio, it shows that the stock is undervalued. The
recommendation would be to buy the stock because the forward P/E ratio clearly
shows the price is undervalued.

3.

Based on the information found in valuing Walmart stock, I would recommend

holding the stock for investors that already own shares. I would oppose buying the stock
because the leading P/E valuation would show the price was overvalued. The dividend
discount model shows the stock price being rather undervalued, given that the margin to
overcome the risk associated with the leading P/E multiple is not great enough. My view
about Wal-Mart’s stock has not changed, overall the stock prices have continued to
increase. For steady growth and low risk this would be a good stock for investors to hold
on to over the years. Wal-Mart may not have a huge payout to allure investors but it
would help balance a portfolio if the stock is held.

Critical Concepts of Capital Structure Decisions

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 Capital Structure decisions of a firm incorporate different variables including a
firm’s choice of target capital structure, the average maturity of its debt, and the distinct
type of financing it decides to use at any certain time. These decisions are taken by
management and are very important to the firm in order to expand its value. Some
factors that come in when making decisions are business and financial risk which
combined determine the total risk of the firm’s ROE. Business risk is the risk
stockholders would face if the firm had no debt and causes uncertainty in EBIT,
NOPAT, and ROIC. While financial risk is the risk added to stockholders by using
financial leverage. When financial risk runs higher then there is greater risk for
bankruptcy or events like the liquidity crisis in 2008. Operating leverage is an important
factor to consider when assessing business risk, it is the change in the EBIT caused by
a change in quantity sold. The higher the proportion of fixed costs to variable cost the
higher the operating leverage. Higher operating leverage leads to more business risk.
Since capital structures vary among different industries and firms there have been many
theories developed to explain these differences and what factors directly affect these
changes.
Modigliani and Miller have created different models included in the No Taxes
which explains that both unleveraged and leveraged firms have identical cash flows and
value which results in equal WACC. They also analyzed the created effect of corporate
taxes when laws allow interest to be deducted, which in turn reduces taxes paid for
levered firms. The effect of Corporate and Personal Taxes is that personal taxes helps
reduce the advantage of corporate debt. They favor equity financing since no capital
gain is made until stock is sold and long-term gains are taxed lower. Beyond Modigliani
and Miller Models there are more theories created which include the Trade-off theory,
Signaling theory, Pecking Order, Debt and Agency Costs.
Trade-off Theory answers the question of why have equity if having 100% debt is
great? When debt is added the finance yield risk increases which does reduce business
risk, but it also adds on a higher bankruptcy risk. Signaling Theory is assumed for
managers and investors to have the same information so if a manager sells stock, they
believe it is overvalued and sell bonds if they are undervalued. Investors would see
selling of stocks as a negative signal. Pecking Order Theory states that firms use their

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generated funds first to avoid flotation costs, then if more funds are needed, they issue
debt, and if more funds are still needed after that they issue equity. Following would be
the Debt and Agency Cost theories which is an agency problem that managers can use
corporate funds for any projects and investments even if it does not maximize the firm’s
value. This theory creates discipline for managers and restrains them to only use funds
for maximizing projects. This can be negative because it over disciplines the managers
and can lead to underinvestment for the firm. There are so many capital structure
theories and they have been tested and given empirical evidence based on market
values of leverage.

APPLE DEBT-EQUITY RATIO (LAST 3 YEARS)

APPLE DEBT-EQUITY RATIO (2018-2020)

2018 .09732

2019 1.210

2020 1.692