California Clinics to Find Out the Stock\'s

California Clinics

To find out the stock's value with the information provided, the Gordon Growth Model would be used. The Gordon Growth Model is used to determine the price of a stock if the dividend, dividend growth rate and discount rate are all known. The underlying assumption behind the Gordon Growth Model is that the stock price is based on the expected future dividends -- investors are only investing for the known future cash flows. As a result, only the dividend and the discount rate are taken into account, along with the expected future growth rate of the dividend. Capital gains are not taken into account in the Gordon Growth Model.

The formula for the Gordon Growth Model is as follows:

Source: Investopedia (2011)

Thus, $2 / (.15-.05) = P

P = $

The stock's value if the riskiness of the stock changes would be calculated with the same formula, changing k to reflect the new risk level of the stock:

Thus, $2 / (.13-.05) = P

P = $

The stock's value if the growth rate of the dividend changes would be calculated with the same formula, changing G. To reflect the new level of dividend growth:

Thus, $2 / (.15 - .07) = P

P = $25

4. The cost of money is affected by a number of different factors. Production opportunities are one key factor in the cost of money. In an environment characterizes by slumping demand, such as the U.S. In the past few years, the demand for money will decrease. This is because firms do not feel that there are as many opportunities that will pay off. Lenders must lower rates in order to stimulate borrowing, by bringing more projects to a level where they will have a positive net present value. Conversely, if the economy is experiencing a period of strong growth and there are a lot of investment opportunities, the cost of money will be higher. Basically, the supply of money might not be high enough to meet the demand for it -- the Federal Reserve will usually restrict supply so that the economy does not become overheated -- and this drives the cost of money upward because so many companies are demanding money and there is competition among them to attract the attention of lenders with their returns.

Time preference for consumption is also a factor in the cost of money. A preference for longer-term consumption will increase long-term rates, but if the preference is for short-term consumption then it is short-term rates that will increase. Thus, a change in the time preference of consumption is going to result in a change in the cost of money at some point along the yield curve, but this change is not going to be universal across the yield curve. This leads to situations such as inverted yield curves that signal a pending recession (Amadeo, 2012).

Another factor in the cost of money is risk. Chmielowiec and Granger (2011) point out that the riskier an investment, the higher the cost of money associated with that investment will be. The reason for this is simple. An investor will choose, if all other factors are equal, the less risky of two investments. So in order to convince an investor to choose a riskier investment over a safer one, the riskier investment will need to pay a higher rate. The same is true with lenders. A bank will lend to a safer customer at a lower rate, and a risker customer at a higher rate. Without the higher rate, the riskier customer would not be able to receive credit. Thus, it is because of investor rationality that risk is a contributing factor in the price of money.

The fourth factor in the cost of money is inflation, or the expectation thereof. Simply put, a dollar today is worth more than a dollar tomorrow. That dollar tomorrow will buy less than the dollar of today because of inflation. Thus, the rate of inflation contributes to the time value of money, which is related to the cost of money (Sherrick, Ellinger & Lins, 2000). What this means is that when a bank lends money, they want the money that they receive back in the future to be the same value, plus the spread that they earn. The higher the inflation rate, the more the customer has to pay to ensure that the bank earns the same amount back as it lent. The lower the inflation rate, the lower the cost of money will be, all other things being equal.

5. Risk aversion is "a manifestation of people's general preference for certainty over uncertainty, and for minimizing the worst possible outcomes to which they are exposed" (Kolakowski, 2012). Most people are risk averse. There are a few important ramifications of this in financial decision-making. The first is that most investment theories are predicated on the assumption of investor rationality, when risk averse investors are not purely rational. This creates, in theory, misalignments between the market price of some assets and the actual value of those assets.

Another ramification of risk aversion is that financial decision making is going to reflect the risk aversion of the person making the decision. In some cases, the investor is going to be hesitant to take on a good investment because of its risk. It is important to remember not only how your client is going to react to an investment, but how the market will as well, as this is where the opportunities will be created to make valuable investments with superior returns.

6. Three ways to solve time value problems are net present value (NPV), internal rate of return (IRR) and payback period. The former reflects the time value of the cash flows incremental to the project. The first step is to determine the cash flows that are incremental to the decision at hand. Once these are known, the company can then determine a discount rate. The cash flows are then discounted according to the discount rate. Because the net present value calculation includes both cash inflows and cash outflows, any NPV higher than zero is one that adds value to the company. The NPV is also a very flexible calculation in that projects of different size can be evaluated against each other in terms of overall contribution to the company's cash flow, and because the assumptions can be tested via sensitivity analysis. While the other forms of time value evaluation can also be subject to sensitivity analysis, this analysis is not as robust as it is with NPV, because of how detailed the NPV computation is.

IRR is similar, but focused on determining a rate of return number, which is then compared to the company's cost of capital. The main advantage of IRR is that it is a very simple calculation. However, IRR tells you basically the same things that NPV tells you, only IRR does not allow for easy comparison among projects of different sizes. A decision-maker could select a small project with a high IRR but low NPV, while rejecting a larger project with lower IRR but higher NPV. Because of this, IRR is an inferior method of evaluating the time value of a project's cash flows than NPV is (Baker, 2009).