Chapter 14: Discounted Cash Flow Valuation (CAIIB – Paper 3)
1. In discounted cash flow (DCF) valuation, which of the following is considered a critical input?
A. Historical stock price trends only
B. Company’s legal structure
C. Cash flows and discount rate
D. Number of employees
DCF valuation relies on estimating future cash flows and discounting them at an appropriate rate to determine present value.
2. Which approach to DCF focuses on estimating cash flows available to equity holders after meeting all expenses, taxes, and debt obligations?
A. Free Cash Flow to Firm (FCFF)
B. Free Cash Flow to Equity (FCFE)
C. Dividend Discount Model (DDM)
D. Asset-based valuation
FCFE calculates the cash flows available to equity holders after accounting for operating expenses, taxes, and debt payments, unlike FCFF which considers cash flows to all capital providers.
3. Which of the following is a common method to estimate the discount rate in DCF valuation?
A. Weighted Average Cost of Capital (WACC)
B. Book value of assets
C. Price-to-earnings ratio
D. Dividend payout ratio
The discount rate in DCF is typically estimated using WACC, which reflects the weighted cost of equity and debt capital.
4. Which of the following is a limitation of DCF valuation?
A. It ignores future cash flows
B. It does not consider the time value of money
C. It is only used for asset-based valuation
D. Results are highly sensitive to input assumptions
DCF results depend heavily on estimates of cash flows, growth rates, and discount rates, making the valuation sensitive to assumptions.
5. In the DCF approach, which of the following statements about terminal value is correct?
A. Terminal value represents short-term cash flows
B. Terminal value captures the value beyond the projection period
C. Terminal value is always zero
D. Terminal value ignores growth rate
Terminal value estimates the present value of all future cash flows beyond the forecast period, often using a perpetual growth model or exit multiple.
6. Which of the following is a type of discounted cash flow model that values a company based on cash flows available to all providers of capital?
A. Free Cash Flow to Firm (FCFF) model
B. Dividend Discount Model (DDM)
C. Residual Income Model
D. Asset-based valuation model
The FCFF model calculates cash flows available to all capital providers, including debt and equity, and discounts them at WACC.
7. The Dividend Discount Model (DDM) is most appropriate for valuing which type of company?
A. Start-ups with no dividend history
B. Companies with negative earnings
C. Stable, dividend-paying companies
D. Companies with only debt financing
DDM focuses on valuing equity based on expected future dividends, making it suitable for stable, dividend-paying companies.
8. Which DCF model incorporates the concept of residual income to estimate value?
A. Free Cash Flow to Equity (FCFE) model
B. Residual Income Model (RIM)
C. Adjusted Present Value (APV) model
D. Net Asset Value model
The Residual Income Model values a company by considering the net income above the cost of equity, i.e., income residual after deducting equity charge.
9. The Adjusted Present Value (APV) approach separates which of the following components?
A. Short-term and long-term cash flows
B. Operating and non-operating income
C. Equity and dividend payments
D. Base-case value (all-equity firm) and value of financing effects
APV values the firm by separately estimating the value of an all-equity firm and then adding the present value of financing side effects like tax shields.
10. Which DCF approach explicitly considers the impact of leverage and debt financing on firm value?
A. Adjusted Present Value (APV) model
B. Dividend Discount Model (DDM)
C. Free Cash Flow to Equity (FCFE) without leverage adjustment
D. Net Asset Value model
APV allows for the separate valuation of a firm’s base-case (unlevered) value and the value of debt tax shields, explicitly capturing the impact of leverage.
11. The Dividend Discount Model (DDM) primarily values a company based on:
A. Future earnings per share
B. Book value of assets
C. Expected future dividends
D. Historical cash flows
DDM calculates the value of equity by discounting the expected future dividends back to present value at the required rate of return.
12. In the Gordon Growth Model (a type of DDM), which of the following assumptions is made?
A. Dividends remain constant forever
B. Dividends grow at a constant rate indefinitely
C. Dividends decline linearly over time
D. Dividends are unpredictable
The Gordon Growth Model assumes a constant, perpetual growth rate of dividends to calculate the present value of equity.
13. Which of the following is a limitation of the Dividend Discount Model?
A. It considers future dividends
B. It accounts for the time value of money
C. It is simple to apply for stable dividend-paying firms
D. It is not suitable for companies that do not pay regular dividends
DDM cannot be applied effectively to companies that do not have a stable dividend policy or do not pay dividends at all.
14. In DDM, the required rate of return on equity is denoted by:
A. WACC
B. Ke (Cost of Equity)
C. Beta
D. Dividend payout ratio
The cost of equity (Ke) represents the required rate of return for equity investors and is used to discount expected dividends in the DDM.
15. If a company’s expected dividend next year is ₹10, the required rate of return is 12%, and dividends are expected to grow at 5% per year, what is the value of the stock using the Gordon Growth Model?
A. ₹100
B. ₹83.33
C. ₹142.86
D. ₹120
Using the Gordon Growth Model: Price = D1 / (Ke - g) = 10 / (0.12 - 0.05) = 10 / 0.07 = ₹142.86.
16. The Dividend Discount Model is most applicable to which type of companies?
A. Start-ups with no dividend history
B. Highly leveraged companies with irregular dividends
C. Mature, stable, dividend-paying companies
D. Companies undergoing bankruptcy proceedings
DDM works best for mature companies that have a stable and predictable dividend policy.
17. Which of the following conditions reduces the reliability of the DDM?
A. Company pays regular dividends
B. Dividends grow at a steady rate
C. Required rate of return is constant
D. Dividends are unpredictable or irregular
Unpredictable or irregular dividends make it difficult to estimate future cash flows accurately, reducing the model’s reliability.
18. For which type of growth scenario is the multi-stage DDM particularly useful?
A. Constant dividend growth forever
B. High initial growth followed by stable growth
C. No growth in dividends
D. Declining dividends only
Multi-stage DDM is useful when a company is expected to have high growth initially and then stabilize to a constant growth rate in the long term.
19. Which of the following sectors would generally be a good candidate for DDM valuation?
A. Early-stage technology start-ups
B. Highly cyclical commodity companies
C. Utilities and telecommunication companies
D. Companies under restructuring
Stable, mature sectors like utilities and telecoms that pay consistent dividends are suitable for DDM valuation.
20. Which of the following factors must be known to apply the DDM effectively?
A. Company’s market share and employee count
B. Expected dividends and required rate of return
C. Total assets and liabilities only
D. Historical stock price volatility
DDM requires knowledge of expected future dividends and the investor’s required rate of return to calculate the present value of equity.
21. A company is expected to generate the following free cash flows over the next 3 years: Year 1: ₹50 lakh, Year 2: ₹60 lakh, Year 3: ₹70 lakh. If the discount rate is 10%, what is the present value of these cash flows?
22. A firm has Free Cash Flow to Equity (FCFE) of ₹12 lakh next year. Expected growth rate is 6%, and cost of equity is 12%. Using the Gordon Growth Model, calculate the value of equity.
23. A project has cash flows of ₹20 lakh per year for 5 years. Discount rate is 8%. Calculate the present value of these cash flows using the annuity formula.
24. A company is expected to pay a dividend of ₹8 next year. Dividends are expected to grow at 5% per year, and required return is 12%. What is the value of the stock?
25. A firm’s Free Cash Flow to Firm (FCFF) is ₹15 lakh next year. Discount rate (WACC) is 10%. Expected growth rate after 3 years is 4%. Calculate the terminal value at the end of year 3 using the Gordon Growth Model.
A. ₹160 lakh
B. ₹145 lakh
C. ₹525 lakh
D. ₹480 lakh
Terminal Value = FCFF × (1+g) / (WACC - g) = 15 × 1.04 / (0.10 - 0.04) = 15.6 / 0.06 ≈ ₹260 lakh.
(If multiple year adjustments considered: PV of terminal value at year 3 = 260 × (1.1^-3) ≈ 195 lakh – can vary depending on assumption)
26. A company has expected FCFE of ₹50,000 next year, growing at 8% per year for 3 years, then 4% thereafter. Cost of equity is 12%. Calculate the value of equity using multi-stage DDM.
A. ₹550,000
B. ₹533,333
C. ₹500,000
D. ₹480,000
Multi-stage DDM involves discounting high growth stage for 3 years and adding PV of terminal value using stable growth:
PV = Σ(Future dividends discounted) + Terminal Value discounted.
27. A firm’s FCFF for next 4 years is projected as ₹30 lakh, ₹35 lakh, ₹40 lakh, ₹45 lakh. If WACC = 10%, what is the total PV of FCFF for 4 years?
29. A project requires an investment of ₹100 lakh and will generate cash flows of ₹30 lakh annually for 5 years. If the discount rate is 8%, what is the NPV?
