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Chapter 7 Tutorial

1.

Anton, Inc., just paid a dividend of $1.95 per share on its stock. The dividends are expected to grow at
a constant rate of 4.1 percent per year, indefinitely. If investors require a return of 10.2 percent on this
stock, what is the current price? What will the price be in three years? In 15 years?
2. The next dividend payment by Wyatt, Inc., will be $2.30 per share. The dividends are anticipated to
maintain a growth rate of 4.5 percent forever. If the stock currently sells for $39.85 per share, what is
the required return?
3. For the company in the previous problem, what is the dividend yield? What is the expected capital
gains yield?
4. Nofal Corporation will pay a $3.65 per share dividend next year. The company pledges to increase its
dividend by 5.1 percent per year, indefinitely. If you require a return of 12 percent on your investment,
how much will you pay for the company's stock today?
5. Raffalovich, Inc., is expected to maintain a constant 4.9 percent growth rate in its dividends,
indefinitely. If the company has a dividend yield of 5.7 percent, what is the required return on the
company's stock?
6. Suppose you know that a company's stock currently sells for $58 per share and the required return on
the stock is 12 percent. You also know that the total return on the stock is evenly divided between
capital gains yield and dividend yield. If it's the company's policy to always maintain a constant growth
rate in its dividends, what is the current dividend per share?
7. Bui Corp. pays a constant $12 dividend on its stock. The company will maintain this dividend for the
next nine years and will then cease paying dividends forever. If the required return on this stock is 10
percent, what is the current share price?
8. Rabie, Inc., has an issue of preferred stock outstanding that pays a $3.80 dividend every year, in
perpetuity. If this issue currently sells for $78.45 per share, what is the required return?
9. The stock price of Webber Co. is $68. Investors require an 11 percent rate of return on similar stocks. If
the company plans to pay a dividend of $3.85 next year, what growth rate is expected for the company's
stock price?
10. Alexander Corp. will pay a dividend of $2.72 next year. The company has stated that it will maintain a
constant growth rate of 4.5 percent a year forever. If you want a return of 12 percent, how much will
you pay for the stock? What if you want a return of 8 percent? What does this tell you about the
relationship between the required return and the stock price?
11. The Sleeping Flower Co. has earnings of $1.75 per share. The benchmark PE for company is 18. What
stock price would you consider appropriate? What if the benchmark PE were 21?
12. TwitterMe, Inc., is a new company and currently has negative earnings. The company's sales are $1.2
million and there are 130,000 shares outstanding. If the benchmark price-sales ratio is 5.2, what is your
estimate of an appropriate stock price? What if the price-sales ratio were 4.6?
ANSWERS:

The constant dividend growth model is:


Pt = Dt (1 + g) / (R g)
So, the price of the stock today is:
P0 = D0 (1 + g) / (R g)
P0 = $1.95(1.041) / (.102 .041)
P0 = $33.28
The dividend at Year 4 is the dividend today times the FVIF for the growth rate in dividends and
four years, so:

P3 = D3 (1 + g) / (R g)
P3 = D0 (1 + g)4 / (R g)
P3 = $1.95(1.041)4 / (.102 .041)
P3 = $37.54
We can do the same thing to find the dividend in Year 16, which gives us the price in Year 15, so:
P15 = D15 (1 + g) / (R g)
P15 = D0 (1 + g)16 / (R g)
P15 = $1.95(1.041)16 / (.102 .041)
P15 = $60.80
There is another feature of the constant dividend growth model: The stock price grows at the
dividend growth rate. So, if we know the stock price today, we can find the future value for any
time in the future we want to calculate the stock price. In this problem, we want to know the
stock price in three years, and we have already calculated the stock price today. The stock price
in three years will be:
P3 = P0(1 + g)3
P3 = $33.28(1 + .041)3
P3 = $37.54
And the stock price in 15 years will be:
P15 = P0(1 + g)15
P15 = $33.28(1 + .041)15
P15 = $60.80
2.

We need to find the required return of the stock. Using the constant growth model, we can solve
the equation for R. Doing so, we find:
R = (D1 / P0) + g
R = ($2.30 / $39.85) + .045
R = .1027, or 10.27%

3.

The dividend yield is the dividend next year divided by the current price, so the dividend yield is:
Dividend yield = D1 / P0
Dividend yield = $2.30 / $39.85
Dividend yield = .0577, or 5.77%
The capital gains yield, or percentage increase in the stock price, is the same as the dividend
growth rate, so:
Capital gains yield = 4.5%

4.

Using the constant growth model, we find the price of the stock today is:
P0 = D1 / (R g)
P0 = $3.65 / (.12 .051)
P0 = $52.90

5.

The required return of a stock is made up of two parts: The dividend yield and the capital gains
yield. So, the required return of this stock is:

R = Dividend yield + Capital gains yield


R = .057 + .049
R = .1060, or 10.60%
6.

We know the stock has a required return of 12 percent, and the dividend and capital gains yield
are equal, so:
Dividend yield = 1/2(.12)
Dividend yield = .06 = Capital gains yield
Now we know both the dividend yield and capital gains yield. The dividend is simply the stock
price times the dividend yield, so:
D1 = .06($58)
D1 = $3.48
This is the dividend next year. The question asks for the dividend this year. Using the
relationship between the dividend this year and the dividend next year:
D1 = D0(1 + g)
We can solve for the dividend that was just paid:
$3.48 = D0(1 + .06)
D0 = $3.48 / 1.06
D0 = $3.28

7.

The price of any financial instrument is the present value of the future cash flows. The future
dividends of this stock are an annuity for 9 years, so the price of the stock is the present value of
an annuity, which will be:
P0 = $12.00(PVIFA10%,9)
P0 = $69.11

8.

The price a share of preferred stock is the dividend divided by the required return. This is the
same equation as the constant growth model, with a dividend growth rate of zero percent.
Remember, most preferred stock pays a fixed dividend, so the growth rate is zero. This is a
special case of the dividend growth model where the growth rate is zero, or the level perpetuity
equation. Using this equation, we find the price per share of the preferred stock is:
R = D/P0
R = $3.80/$78.45
R = .0484, or 4.84%

9.

We need to find the growth rate of dividends. Using the constant growth model, we can solve the
equation for g. Doing so, we find:
g = R (D1 / P0)
g = .11 ($3.85 / $68)
g = .0534, or 5.34%

10. Here, we need to value a stock with two different required returns. Using the constant growth
model and a required return of 12 percent, the stock price today is:
P0 = D1 / (R g)
P0 = $2.72 / (.12 .045)
P0 = $36.27
And the stock price today with a required return of 8 percent will be:
P0 = D1 / (R g)
P0 = $2.72 / (.08 .045)
P0 = $77.71
All else held constant, a higher required return means that the stock will sell for a lower price.
Also, notice that the stock price is very sensitive to the required return. In this case, the required
return fell by 1/3 but the stock price more than doubled.
11. Using the equation to calculate the price of a share of stock with the PE ratio:
P = Benchmark PE ratio EPS
So, with a PE ratio of 18, we find:
P = 18($1.75)
P = $31.50
And with a PE ratio of 21, we find:
P = 21($1.75)
P = $36.75
12. First, we need to find the sales per share, which is:
Sales per share = Sales / Shares outstanding
Sales per share = $1,200,000 / 130,000
Sales per share = $9.23
Using the equation to calculate the price of a share of stock with the PS ratio:
P = Benchmark PS ratio Sales per share
So, with a PS ratio of 5.2, we find:
P = 5.2($9.23)
P = $48.00
And with a PS ratio of 4.6, we find:
P = 4.6($9.23)
P = $42.46