QUESTIONS

1. Firm D and Firm E have the same performance characteristics. They both have a P/E of 20× and they also have the same cost of capital, return on equity, etc. The only difference is that Firm E's economic book value is $25 billion and Firm D's economic book value is $25 million. Explain why, in the language of the FFM, Firm E's P/E is more likely to decline than Firm D's.
2. Firm F is an excellent firm with superior management and a long history of steady earnings. After a long period of expansion, the Firm F has run out of opportunities to expand by building out new businesses. Toward what values are its TV, FV, and P/E likely to converge?
3. Why is it hard for CEOs of large successful companies to maintain the firm's P/E?
4. What is a reasonable level for the long-term P/E of a market under the following assumptions: economic book value = $500 billion, roe = 15%, cap rate = 9%, return on new investments = 18%, total investment in new businesses = $20 billion per year for the next 10 years? How does the projected P/E change if the cap rate is 8% or 10%? How does the projected P/E change if total investment is (a) $20 billion per year for 20 years? (b) $300 billion per year for 20 years? (c) $400 billion per year for 20 years?
5. Explain the long term decline in value of an investment in Firm A or Firm B in terms of the FFM.

¹ For further discussion see Zvi Bodie, Alex Kane, and Alan Marcus, Investments (New York: McGraw-Hill/Irwin, 2010) and Myron J. Gordon, The Investment Financing and Valuation of the Corporation (Homewood, IL: Richard D. Irwin, 1962).

² Martin L. Leibowitz and Stanley Kogelman, Franchise Value and the Price/Earnings Ratio (Charlottesville, VA: The Research Foundation of Chartered Financial Analysts, 1994); and Martin L. Leibowitz, Franchise Value: A Modern Approach to Security Analysis (Hoboken, NJ: John Wiley & Sons, 2004).

³ Modigliani and Miller showed that the theoretical total cost of capital is independent of both dividend policy and of the balance between debt and equity financing. See Franco Modigliani and Merton H. Miller, “Dividend Policy, Growth, and the Valuation of Shares,” Journal of Business 31, no. 4 (October 1958): 411–443

⁴ Aswath Damodaran, Damodaran on Valuation (New York: John Wiley & Sons, 1994).

⁵ James Tobin, “A General Equilibrium Approach To Monetary Theory,” Journal of Money, Credit, and Banking 1, no. 1 (1969): 15–29.

⁶ For further discussion see Leibowitz, Franchise Value: A Modern Approach to Security Analysis.

⁷ Gary S. Becker, Human Capital (Chicago: University of Chicago Press, 1993).

⁸ Leibowitz, Franchise Value: A Modern Approach to Security Analysis.