Chapter 7: Equity Valuation

Multiple Choice Questions 1. Jason bought 30,000 shares of CTB Inc. on January 12, 2006. At that time, CTB Inc. had 2 million common shares outstanding. Calculate the portion of CTB Inc. that Jason owns. A. 2.3 percent B. 1.4 percent C. 6.0 percent D. 1.5 percent Level of difficulty: Easy Solution: D Jasons ownership=30,000/2,000,000=1.5% 2. Which of the following is not a difference between equity securities and fixed income securities? A. incur a tax-deductible expense B. have a fixed maturity date C. always involve fixed periodic payments D. represent ownership of the security Level of difficulty: Medium Solution: D Both debt and equity represent ownership of the security. Equity represents ownership of the firm. 3. Given that the government short-term T-bill yield is 4 percent, and the risk premium of ABC firm is 6.5 percent, calculate ABC firms required rate of return. A. 8.5 percent B. 10.5 percent C. 7.25 percent D. 11.5 percent Level of difficulty: Easy Solution: B Required rate of return (k) = RF + Risk Premium= 4% + 6.5% = 10.5% 4. Which of the following statements about equities is correct? A. Every firm pays dividends to common shareholders each year. B. Preferred dividends are usually paid annually in practice. C. Common shareholders are entitled to a firms earnings before preferred shareholders. D. Common shareholders can vote on issues, such as mergers, election of board members, and so on. Level of difficulty: Medium Solution: D Not every firm pays dividends each year. In practice, preferred dividends are paid quarterly. Preferred shareholders have claims before common shareholders.

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5. Westlake Ltd. just paid a dividend of $2.00 per share, which is expected to grow at a constant rate of 4.5 percent indefinitely. The T-bill rate is 3 percent and the risk premium of Westlake Ltd. is 6.5 percent. Calculate the current share price of Westlake Ltd. A. $42.60 B. $41.80 C. $46.05 D. $40.00 Level of difficulty: Medium Solution: B D0=$2.00. D1=$2.00 (1+.045) = $2.09. k= RF + Risk Premium = 3%+6.5% = 9.5% P0= $2.09/(.095 .045)=$41.80 6. Grace Holdings recently paid an annual dividend of $1.50 per share, and its estimated longterm growth rate in dividends is 4 percent. The current market price of each share is $26. The implied rate of return on the share is A. 9.77 percent. B. 10 percent. C. 12.5 percent. D. 13.33 percent. Level of difficulty: Medium Solution: B D1=D0 (1+g) = $1.5 (1+.04) = $1.56 k=(D1/P0)+g = (1.56/26)+4%=10% 7. Firestone Co. just paid a dividend of $1.50 per share and its EPS is $9.00. Its book value per share (BVPS) is $36. Calculate Firestones sustainable growth rate. A. 20.83 percent B. 25 percent C. 4.17 percent D. 5.25 percent Level of difficulty: Medium Solution: A Payout ratio=D0/EPS0=$1.5/$9=1/6=16.67% ROE=NI/E=EPS/BVPS=$9/$36=1/4=25% g=(1 payout)ROE=(11/6)25%=20.83% 8. The sustainable growth is negatively related to A. net profit margin. B. leverage ratio or equity multiplier. C. payout ratio. D. retention ratio. Level of difficulty: Medium Solution: C g=(1 payout)ROE

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9. Which of the following is not a limitation of the DDM model? A. It cannot be applied to firms without dividend payments. B. It can only be applied to constant growing firms. C. It cannot be used to value private firms. D. It cannot be applied to firms with negative earnings. Level of difficulty: Medium Solution: D This is one of the limitations of P/E relative valuation method. 10. Which of the following is false regarding the relative valuation approach? A. The most commonly used one is the P/E ratio approach. B. The P/B ratio may be used instead of the P/E ratio if the firm has negative earnings. C. We could use the average P/E ratio of the firms industry when appropriate. D. The leading P/E ratio can be estimated as (Payout ratio)(1 + g)/(k g ). Level of difficulty: Difficult Solution: D Leading P/E ratio equals (payout ratio)/(k - g). Practice Problems 11. Describe the characteristics of preferred shares. Level of difficulty: easy. Solution: Preferred shares essentially pay a fixed amount just like bonds. Preferred shareholders have claim on firms earnings and assets in the event of liquidation before common shareholders and they seldom have voting rights. Usually no payments can be made to common shareholders until preferred shareholders have been paid the dividends they are due in entirety. Preferred share price increases when market rates decline, and vice-versa. 12. List the elements needed for the calculation of share price by using Constant Growth DDM model. Level of difficulty: easy. Solution: Expected dividend, required rate of return, and the constant dividend growth rate. 13. Describe the Constant Growth DDM valuation method. Level of difficulty: easy. Solution: The Constant Growth DDM assumes a constant rate of growth in dividends, which is less than the required rate of return that will hold indefinitely. It discounts all the future expected dividend cash flows to the present to determine the current market share price. It is suitable for well-established companies that pay dividends that grow steadily. 14. Describe how to estimate the present value of growth opportunities (PVGO). Level of difficulty: Easy Solution: PVGO mathematically equals to P0 (EPS1/kc). It assesses the market perception of the growth opportunities available to a firm. If the market perceives that a firm has no future growth opportunities, its PVGO will be zero and its market price reflects only its zero-growth component, which equals EPS1/kc. A positive PVGO increases the firms share price.

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15. Fill in the missing information in the following table: Preferred Shares in Canada Par Required Dividend value return rate $100 8% 5% $50 3% $75 $50 14% $30 7% $100 4% 7% 9% 5% 6% Dividends paid per share $5.00 $8.00 $9.50 $18.00

Company A B C D E F G H

Price $60 $70 $50 $150

$18

Level of difficulty: Easy Solution: Solving these questions involves the algebraic manipulation of the preferred share valuation formula. Preferred Shares in Canada Required Par value Dividend rate return $100 8% 5% Dividends paid per share $5.00

Co. A

Price Pps = $60 $5.00 0.08 = $62.50

$50

3%

$1.80 = 3.6% $50.00 $8.00 kp $7.00 kp $8.00 = 10.67% $75.00 14%

$70

$75

$70 =

D 0.03 D = $1.80 $8.00 $60 =

k p = 11.43% D $50 $50 $50 = D = .14*50 = $7.00 D 0.07 D = $10.50 $9.50 $150 =

k p = 14% E $150 $30 7% $10.50 = 35% $30.00 $9.50 = 9.5% $100

Pps =

$9.50 0.04 = $237.50

$100

4%

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Pps = $18

$18 0.07 = $257.14

$18 = 9% Par Par = $200 $0.90 = 6% Par Par = $15

7%

9%

$18.00

5%

6%

$18 =

D 0.05 D = $0.90

16. The preferred shares of Knob and Tube Electrical Company have a par value of $100 and a dividend rate of 8 percent. The current price is $110. If the risk free rate is 2 percent, what is the risk premium associated with these preferred shares. Level of difficulty: Easy Solution: To determine the risk premium, we need to remember that the required return is equal to the sum of the risk free rate and the risk premium. Step 1: calculate the required return: $110 = Dp = 0.08*100 kp k p = 7.27%

kp Step 2: the risk premium = 7.27% - 2% = 5.27%

17. The Absent Minded Profs purchased a stock for $50. They expect to receive a dividend of $5, and to sell the stock immediately after the last dividend. Level of difficulty: Easy Solution: A. If the sale price is $75, what is the expected one year holding period return? Assuming the dividend is paid annually: D +P D +P 5 + 75 P0 = 1 1 kc = 1 1 1 = 1 = 60% 1 + kc P0 50 B. If the sale price is $35, what is the expected one year holding period return? D +P 5 + 35 kc = 1 1 1 = 1 = 20% P0 50 C. If the actual return was -4%, what was the sale price? D +P P0 = 1 1 1 + kc = $43 D. If the actual return was 15%, what was the sale price? P = 50 ( 1 + .15 ) 5 = $52.50 1

P = P0 ( 1 + kc ) D1 = 50 ( 1 + ( .04 ) ) 5 = 50*.96 5 1

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18. Fill in the missing information in the following table: Common Shares in Canada Required Dividend Current return growth rate dividend 15% $4.50 3% 1% 5% $10.00 14% 6% $9.50 15% 0% 5% 2% Dividend expected in 1 year $5.00 $8.00 $11.00 $18.00

Company A B C D E F G

Price $600 $70 $55

$40

Level of difficulty: Easy Solution: Solving these requires algebraic manipulation of the dividend discount formula. Required return 15% Common Shares in Canada Dividend Current growth rate dividend $4.50 5.00 g= 1 4.50 = 11.1111% 1% 12 D0 = 1.01 = $11.8812 5% D1 1+ g 8 = 1.05 = $7.6190 $10.00 D0 = Dividend expected in 1 year $5.00

Co. A P0 =

Price 5.00 .15 .1111 = $128.57 $600

3%

$600 =

D1 .03 .01 D1 = 600*(.03 .01) = $12

$70

70 = kc =

8 kc .05

$8.00

$55

8 + 3.50 70 = 16.43% 11 55 = kc .10 kc = 11 + 5.50 55 = 30%

10%

$11.00

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P0 = =

D0 ( 1 + g ) kc g

14%

6%

$9.50

D1 = D0 ( 1 + g ) = 9.50*1.06 = $10.07

9.50*1.06 .14 .06 = $125.875 18 P0 = .15 .0 = $120.00 $40

15%

0%

$18.00

$18.00

5%

-2%

D0 =

D1 1+ g 2.80 = 1 + ( .02 ) = $2.8571

P0 = 40 =

D1 kc g D1 .05 ( .02 )

D1 = $2.80

19. The ToolWerks Company is expected to earn $10,000,000 next year. There are 2,000,000 shares outstanding and the company uses a dividend payout ratio of 40 percent. The required rate of return for companies like ToolWerks is 8 percent. The current share price of ToolWerks is $75. Level of difficulty: Easy Solution: A. What are the expected earnings per share for ToolWerks? The total earnings of ToolWerks is $10 million. On a per share basis, the EPS is $10 million divided by 2 million shares which equals $5. B. What are the expected dividends per share for ToolWerks? The expected dividends are determined by the dividend payout ratio multiplied by the earnings. The total dividends are 40% of $10 million or $4 million. On a per share basis, the expected dividends per share are $2.00. C. What is the dividend growth rate expected for ToolWerks? D1 2.00 P0 = 75 = g = 5.33% kc g .08 g D. What is the present value of growth opportunities for this firm? The value of the firm, assuming no growth opportunities and 100% dividend payout is $5/.08 = $62.50. PVGO = $75 - $62.50 = $12.50 20. Determine the present value of growth opportunities for a company with a leading EPS of $1.85, a required rate of return of 8 percent and a current stock price of $50. Level of difficulty: Easy Solution: Value of firm, assuming no growth opportunities, is 1.85/.08 = $23.125
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PVGO = $50 - 23.125 = $26.875 21. The Widget Manufacturing Companys most recent earnings were $300,000. From these earnings, it paid dividends on common equity totaling $175,000. There are 50,000 common shares outstanding. The ROE for Widget is 12 percent. Determine the following: Level of difficulty: Easy Solution: A. Earnings per share. Which can you calculate: leading or lagging EPS? Lagging EPS (current earnings per share) are $300,000/50,000 = $6. To calculate the leading EPS, I need an estimate of the growth rate of the earnings. B. Dividends per share Dividends per share = $175,000/50,000 = $3.50 C. Earnings retention ratio Earnings retention ratio = 1 dividend payout ratio = 1 3.50/6 = 41.6667% D. Sustainable growth rate The sustainable growth rate equals 41.6667%*12% = 5% 22. State the relationship that the required rate of return, the expected growth rate, and expected dividends have with the market share price, according to the Constant Growth DDM. Level of difficulty: Medium D0 (1 + g ) D1 = Solution: As indicated by Equation P0 = , market share price is kc g kc g positively related to the expected dividend D1 and expected growth rate g, but negatively related to the required rate of return kc. 23. Star Corporation has issued $1 million in preferred shares to investors with a 7.25 percent annual dividend rate on a par value of $100. Assuming the firm pays dividends indefinitely and the required rate is 10.5 percent, calculate the price of the preferred share. Level of difficulty: Medium Solution: Annual dividend=$1007.25%=$7.25 Pps=Dp/kp=7.25/.105=$69.05 24. Calculate the leading P/E ratio, given the following information: retention ratio = 0.6, required rate of return = 10 percent, expected growth rate = 5 percent. Level of difficulty: Medium Solution: Payout=1 Retention ratio=1 0.6=0.4 Leading P/E=payout ratio/(kc g)= 0.4/(.10 .05)=8 25. You have just been to see your broker at the Fly-by-Night Brokerage Company for advice about investing in the Empire Bank. The broker indicates that the Empire Bank has three different types of securities: debt, preferred stock, and common shares. She states: Debt is safe because it is a bank and Canadian banks are safe. Empire Bank preferred stock entitles
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you to vote at the annual general meeting. The Empire Bank has paid a dividend of $2.50 per year for the last 18 years so you are guaranteed to receive $2.50 next year; if you dont the Bank will go bankrupt. Comment on your brokers statement. Is she correct? Level of difficulty: Medium Solution: No, my broker is incorrect. Debt: banks are not immune from failure and default and consequently the debt of the Empire bank is not safe. In fact, in 1985 two Alberta based banksthe Northlands Bank and the Canadian Commercial Bankfailed. Preferred stock: there are no voting rights associated with preferred stock. Common stock: there is no legal obligation to pay a dividend and the failure to pay a dividend on common stock does not trigger bankruptcy. The fact that the firm has paid a dividend of $2.50 per year for the last 18 years is irrelevant. 26. The Absent Minded Profs purchased the stock for $50. They expect to hold the stock for two years, and to receive a dividend of $1.50 each year and to sell the stock immediately after the last dividend (Excel or financial calculator recommended). Level of difficulty: Medium Solution: A. If the sale price is $75, what is the expected annual return? D1 = D2 = $1.50

D1 D + P2 + 2 (1 + k c ) (1 + k c ) 2 1.50 1.50 + 75 50 = + (1 + k c ) (1 + k c ) 2 P0 =
Note: the expected annual return, kc , is the IRR. The IRR of this series of cash flows is determined by (Using CF functions on BAII+): CF0 = -50; C01 =1.5; F01 = 1; C02 = 76.5; F01 = 1 Compute IRR: 25.20% Alternatively: using the TVM functions on the BAII+ N = 2, PV = -50, PMT = 1.5, FV = 75 compute I/Y also gives 25.20%. B. If the sale price is $35, what is the expected annual return? Expected annual return = 13.05% C. If the actual return was -4%, what was the sale price? Using TVM functions on BAII+ N = 2, PV = -50, I/Y = -4, PMT = 1.5, compute FV Sale price = FV = $43.14

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D. If the actual return was 15%, what was the sale price? Sale price = $62.90 27. The Ibis Company is expected to pay a $1.50 dividend next year. Dividends are expected to grow at 3 percent forever and the required rate of return is 7 percent. Level of difficulty: Medium Solution: A. What is the price of Ibis today? D1 1.50 P0 = = = $37 .50 k c g .07 .03 B. What is the expected dividend yield? The expected dividend yield, ( D1 / P0 ) , is 1.50 / 37.50 = 4% C. What is the expected capital gains yield? P 1 1 , is given by the growth rate (g) = 3% The expected capital gain yield, P0 D. In one year, immediately after the dividend is paid, i) What is the price of the stock?
P1 = D2 1.50 (1.03) = = $38 .625 kc g .07 .03

ii) What was the one year holding period return? The one year holding period return = (1.50 + 38.625)/37.5 - 1 = 7% iii) Looking forward one year, what are the expected dividend and capital gains yields? The expected dividend yield = D2 / P1 = 1.545 / 38.625 = 4%.. The expected capital gains = the expected growth rate of 3%. E. In year 10, immediately after the dividend is paid, i) What is the price of the stock?
P = 10 D11 1.50 (1.03 )10 = = $50 .40 kc g .07 .03

ii) What was the one year holding period return (year 9 to 10)? The one year holding period return must equal the required rate of return = 7%. iii) Looking forward one year, what are the expected dividend and capital gains yields? The expected divided yield is 4% and the expected capital gains yield is 3%.

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28. The LMX Company is expected to pay a $2.00 dividend in one year. The required rate of return is 9 percent. The firm uses a dividend payout ratio of 25 percent. Calculate the leading P/E ratio in the following cases: Level of difficulty: Medium Solution: A. Expected growth rate = 4% i)Today We have two ways of solving this problem: The long way: determine the price and calculate the P/E ratio. To determine the leading P/E ratio, we need to calculate the price of the stock today and the estimate of the earnings next period. P0 = 2.00 = $40 .09 .04

The firm uses a dividend payout ratio of 25% so the earnings next year must be $8.00 (25% of 8.00 equals the expected dividend of $2.00) Therefore the leading P/E ratio is 40/8 = 5.00 Alternatively, we can use the P/E ratio approach: D1 P0 = EPS1 kc g

P0 .25 = =5 EPS1 .09 .04 ii) In one year (immediately after dividend paid) In one year, the expected dividend will be 2 x 1.04 = $2.08 and the price of the stock will be $41.60. The expected earnings will be 4 x 2.08 = $8.32. So in one year, the expected leading P/E ratio will be 41.6/8.32 = 5 B. Expected growth rate = 8% i) Today Using the P/E ratio approach: P/E = .25/(.09-.08) = 25. Alternatively we can solve for the P/E ratio by:

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2.00 = $200 . The expected earnings are still $8 (the payout .09 .08 ratio hasnt changed), so the leading P/E ratio is 25. The expected price today is: ii) In one year (immediately after dividend paid) Using the P/E ratio approach: P/E = .25/(.09-.08) = 25. Alternatively we can solve for the P/E ratio by: 2.00 ( 1 + .08 ) = $216 and the expected earnings are .09 .08 4*(2*1.08)) = $8.64. The leading P/E ratio is 25 In one year, the price of the stock will be: C. If a firm is expected to have a constant dividend growth rate, do you expect the P/E ratio to change over time? Explain. The P/E ratio will not change over time as long as the dividend payout ratio is constant. The price will grow over time by, ( 1 + g ) , the capital gains rate. The capital gains rate is exactly the same rate at which dividends and earnings grow. Therefore, the P/E ratio will not change (P and E both grow by the same rate). Note: if the dividend payout ratio changes, then the P/E ratio will also change. 29. The NLF Company currently doesnt pay any dividends but is expected to start paying dividends in 5 years. The first dividend is expected to be $1.00 and to grow at 6 percent thereafter. The required rate of return for the firm is 10 percent. What is the current stock price for NLF? Level of difficulty: Medium Solution: The first dividend occurs at the end of year 5. The price of the stock at the end of year 4 is D5 1.00 P4 = = = $25 kc g .10 .06 To obtain the price today, we discount the price back 4 years to time 0. The discount rate is 10% (the required rate of return for the stock). The price of the stock today is $17.0753 30. The ExD Company is expected to pay a dividend1 on $5.00 on January 20th. The firm has zero growth and the required rate of return for type of firm is 10 percent. Calculate the expected stock price for ExD on January 19th and January 21st. Level of difficulty: Medium Solution:
1

Strictly speaking, we should say the ex-dividend date is January 20th. If an investor purchases the stock prior to the ex-dividend date, he or she is entitled to the dividend if he or she purchases on or after the ex-dividend date, he or she is no longer entitled to receive the dividend.
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The price immediately after the dividend is paid (January 21st) is 5.00/.10 = $50.00 The price just before the dividend is paid (January 19th) is $55.00. Determining the price immediately after the dividend is similar to determining the present value of an ordinary annuity. Determining the price just before the dividend is similar to determining the present value of an annuity due (cash flows at the beginning of the period). 31. Company As current dividend is $5.00. You expect the growth rate to be 0 percent for years 1 to 5, and 2 percent for years 6 to infinity. The required rate of return on this firms equity is 10 percent. Determine the following: Level of difficulty: Solution: A. The expected dividend at the end of year 5 $5.00 (expect no growth during this period) B. The expected dividend at the end of year 6 D6 = D5 (1 + g ) = 5.0*1.02 = $5.10 C. The expected price of the stock at the end of year 5 (immediately after the year 5 dividend) D6 5.10 P5 = = = $63.75 kc g .1 .02 D. The price of the stock today We have to take into account the present values of the dividends during the first 5 years plus 5 5 63.75 + the present value of the stock price in year 5. P0 = t 5 Note: the first 5 t =1 ( 1.10 ) ( 1.10 ) payments are an annuity so we can use the TVM function on the BAII+ calculator. N=5, PMT = 5.0, FV=$63.75, I/Y = 10%, compute PV. The price of the stock today is: $58.5377 32. Company Bs current dividend is $5.00. You expect the growth rate to be 8 percent for years 1 to 5, and 2 percent from years 6 to infinity. The required rate of return on this firms equity is 10 percent. Determine the following: Level of difficulty: Medium Solution: A. The expected dividend at the end of year 5 5 5 D5 = D0 ( 1 + g1 ) = 5 ( 1.08 ) = $7.3466

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B. The expected dividend at the end of year 6 D6 = D5 (1 + g2 ) = D0 ( 1 + g1 ) (1 + g2 ) = 5(1.08)5 (1.02) = $7.4936 C. The expected price of the stock at the end of year 5 (immediately after the year 5 dividend) D6 7.4936 P5 = = = $93.6697 kc g 2 .1 .02 D. The price of the stock today As this is a very tedious calculation, we will use excel to solve it. Stock price at Present Dividend end of year 5 value 5 5.4 4.909091 5.832 4.819835 6.29856 4.732201 6.802445 4.646161 7.34664 93.6696649 62.72318 81.83047

Year 1 2 3 4 5

Price of stock in year 0 The price of the stock today is $81.83047 The formulas used in Excel are given below: A Year 0 1 2 3 4 5

1 2 3 4 5 6 7 8 9 Price of stock in year 0: 10

B C D Dividend Stock price at end of year 5 Present value 5 =1.08*B2 =B3/(1+0.1)^A3 =1.08*B3 =B4/(1+0.1)^A4 =1.08*B4 =B5/(1+0.1)^A5 =1.08*B5 =B6/(1+0.1)^A6 =1.08*B6 =(B7*1.02/(0.1-0.02)) =B7/(1+0.1)^A7+C7/1.1^A7 =SUM(D3:D7)

33. Company Cs current dividend is $3.60. Dividends are expected to grow by 9 percent for years 1 to 3, 6 percent for years 4 to 7 and 2 percent thereafter. The required rate of return on the stock is 12 percent. What is the current stock price for Company C? Level of difficulty: Medium Solution:
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The easiest way to solve this problem is to use Excel. Year 0 1 2 3 4 5 6 7 8 Growth rate 9% 9% 9% 6% 6% 6% 6% 2% Dividend 3.6000 3.9240 4.2772 4.6621 4.9418 5.2383 5.5526 5.8858 6.0035 12% $48.9771 Stock price at Present value of end of year 7 each cash flow 3.5036 3.4097 3.3184 3.1406 2.9724 2.8131 29.8193

60.0352

Discount rate: Price of stock in year 0: The Excel formulas: A 1 2 3 4 5 6 7 8 9 10 11 12 13 14 Year 0 =1+A2 =1+A3 =1+A4 =1+A5 =1+A6 =1+A7 =1+A8 =1+A9 B Growth rate 0.09 0.09 0.09 0.06 0.06 0.06 0.06 0.02 C Dividend

D E Stock price at end Present value of each cash of year 7 flow =(C3+D3)/(1+C$12)^A3 =(C4+D4)/(1+C$12)^A4 =(C5+D5)/(1+C$12)^A5 =(C6+D6)/(1+C$12)^A6 =(C7+D7)/(1+C$12)^A7 =(C8+D8)/(1+C$12)^A8 =(C9+D9)/(1+C$12)^A9

3.6 =(1+B3)*C2 =(1+B4)*C3 =(1+B5)*C4 =(1+B6)*C5 =(1+B7)*C6 =(1+B8)*C7 =(1+B9)*C8 =C10/(C12-B10) =(1+B10)*C9 0.12

Discount rate:

Price of stock in year 0:

=SUM(E3:E10)

34. Company Ds current dividend is $4.00. Dividends are expected to grow by 25 percent for years 1 to 3 and 10 percent thereafter. The required rate of return on the stock is 15 percent. What is the current stock price for Company D? Level of difficulty: Medium Solution: The easiest way to solve this problem is to use Excel; however, we will show how to solve it using the BA II+.
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Step 1: determine the value of the stock at the end of year 3. 3 3 Expected dividend in year 3 is: D3 = D0 (1 + g1 ) = 4.00(1 + .25) = 7.8125 The expected value of the stock at the end of year 3: D (1 + g2 ) 7.8125*1.10 P3 = 3 = = $171.8750 kc g 2 .15 .10 Step 2: Using the Cash Flow Worksheet in the BAII+ CF0 = 0 CF 1 2 3 Calculation 4*1.25 5*1.25 = 6.25 6.25*1.25 plus the stock price at the end of year 3 Value 5 6.25 7.8125+171.8750 F 1 1 1

NPV: I = 10; compute NPV = 127.2212 Value of stock today is $127.22 35. The Absent Minded Profs are concerned about the impact of errors in their estimates of the future dividend payout ratio for the LCI Company. Assume that the current dividend is $1, ROE is fixed at 10 percent and the required rate of return is 15 percent. Using Excel, calculate the current stock price for dividend payout ratios ranging between 5 percent and 75 percent in 5 percentage point increments. Is the percentage change in the stock price for a 5 percentage point change in dividend payout ratio constant? Level of difficulty: Medium Solution: No. As the dividend payout ratio increases, the percentage change in stock prices decreases. Dividend payout ratio 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% Sustainable growth rate 9.50% 9.00% 8.50% 8.00% 7.50% 7.00% 6.50% 6.00% 5.50% 5.00% 4.50% 4.00% Stock Percentage change price in stock price $19.9091 $18.1667 -8.75% $16.6923 -8.12% $15.4286 -7.57% $14.3333 -7.10% $13.3750 -6.69% $12.5294 -6.32% $11.7778 -6.00% $11.1053 -5.71% $10.5000 -5.45% $9.9524 -5.22% $9.4545 -5.00%

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65% 70% 75%

3.50% 3.00% 2.50%

$9.0000 $8.5833 $8.2000

-4.81% -4.63% -4.47%

36. List three reasons one firm may have a higher leading P/E ratio than a comparable firm. Level of difficulty: Difficult Solution: It has (All else equal): 1. A lower required rate of return 2. A lower retention ratio, or a higher payout ratio 3. A higher expected growth rate 37. Firm A has a patent that will expire in two years. The firm is expected to grow at 10 percent for the next two years and dividends will be paid at year end. It just paid a dividend of $1.00. After two years, the growth rate will decline to 4 percent immediately and the firm will grow at this rate forever. If the required rate of return is 11 percent, value the firms current share price. Level of difficulty: Difficult Solution: D0=$1.00, D1=$1.001.1=$1.10, D2=$1.11.1=$1.21 D3=$1.211.04=$1.2584. P2=D3/(kcg)=1.2584/(.11.04)=$17.98
P0 = 1.10 1.21 +17 .98 + = 0.99 +15 .58 = $16 .57 1 (1 + .11) (1 + .11) 2

Or, Using a financial calculator (TI BA II Plus): PV(D1): N = 1; I/Y (or i) = 11%; PMT = 0; FV = -1.10; CPT then PV, gives 0.99 PV(D2+P2): N = 2; I/Y (or i) = 11%; PMT = 0; FV = -19.19(1.21+17.98); CPT then PV, gives 15.58 P0=.99+15.58=$16.57 38. DE Inc. just paid a dividend of $4.00 and its current earnings per share is $5. Current T-bill rate is 3 percent and DEs risk premium is 12 percent. Net profit margin, asset turnover, and the debt-to-equity (D/E) ratio are 20 percent, 1.5, 0.67, respectively. Calculate the current share price by using the P/E ratio approach. Level of difficulty: Difficult Solution: Payout=D0/EPS0=$4/$5=0.8, Retention ratio (b)=1 Payout ratio=10.8= 0.2 D/E=0.67, leverage ratio A/E=(D+E)/E=(0.67+1)/1=1.67 ROE=Net profit margin Asset turnover leverage ratio= 20%1.51.67=50% g = b ROE=0.250%=10% EPS1=EPS0 (1+g)=$51.1=$5.5 k=3%+12%=15% Leading P/E=payout/(k g)=0.8/(.15 .10)=16 P0=leading P/E EPS1=165.5=$88

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39. ABC Companys preferred shares have a par value of $50, a dividend rate of 7 percent and trade at a price of $70. PWT Companys preferred shares have a par value of $60, a dividend rate of 4 percent, and trade at a price of $45. Which companys preferred stock is riskier? Level of difficulty: Difficult Solution: The required rates of return for the two stocks: Dp 0.07 *50 = k p = 5.00% ABC: $70 = kp kp 0.04*60 k p = 5.33% kp kp As the risk free rate is the same for both firms, the only way PWT can have a higher required return is if the risk premium is higher. A higher risk premium reflects a higher level of risk; therefore, PWT is the riskier preferred stock. PWT: $45 = = 40. The Xcalibur Sword Company is currently selling for $150. The current dividend is $10 and the required rate of return is 10 percent. What is the expected dividend growth rate? Level of difficulty: Difficult Solution: P0 = 150 = D0 ( 1 + g ) kc g Dp

10 ( 1 + g ) .10 g 15 150 g = 10 + 10 g 5 = 160 g g = 3.13%

41. The Absent Minded Profs are interested in investing in the XML Software Company. XMLs current dividend is $5.50 and XML shares are selling for $40. The required rate of return for firms like XML is 8 percent. The Profs have conducted an extensive analysis of the company and believe that the dividend growth rate should be 5 percent. Level of difficulty: Difficult Solution: A. Should the Profs buy the stock at $40? Why or why not? To solve this problem we need to determine what the price of the stock should be (if the Profs growth rate is correct) and then compare it to the market price. If the market price is lower than the price based on our analysis, we should buy.

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D0 ( 1 + g ) 5.50*1.05 = = $192.50 . As the market price is lower than the price based on kc g .08 .05 the Profs analysis, they should buy. P0 = B. Do you expect the stock price to stay at $40? Explain. I expect the stock price to increase for two reasons: first, as the Profs start buying they will increase demand for the stock and the price will rise. Secondly, the Profs are not the only smart people examining this company and if anyone else comes to the same conclusion, they will all buy and will push the stock price up until the price reaches the correct price of $192.50. 42. As part of your duties at the Absent Minded Profs, you have been asked to review the analysis carried out by a rival companythe PHD groupof the Frivolous Radio Company. Serious has had a constant P/E ratio for the last 5 years. PHDs analyst has made the following statement: Frivolous constant P/E ratio is due to zero growth in their earnings and therefore, Frivolous is not a good investment. Comment on PHDs statement. Level of difficulty: Difficult Solution: There are two problems with the PHD analysts statement: first, a constant P/E ratio implies a constant growth over timethe growth could be zero, positive or negative. The more important problem with the statement is that Frivolous is only a good investment if its return is greater than or equal to the required rate of return. If the investment earns less than its required rate of return, then by definition, it is a bad investment regardless of the growth rate of the earnings. 43. The XYZ Company has an expected profit margin of 10 percent, turnover ratio of 1.8 and a leverage ratio of 0.30. The leading EPS is $2.50 and the firm uses a dividend payout ratio of 35 percent. The required return on firms with XYZs risk characteristics is 5 percent. Calculate the expected current stock price of XYZ. Level of difficulty: Difficult Solution: To solve this problem, we need to find the inputs to the DDM model. 1. The expected dividend next year: Leading EPS = earnings per share expected next year. We know the dividend payout ratio is 35%, so the expected dividends next year are .35*2.50 = $0.875. 2. The sustainable growth rate = retention ratio * ROE a. Retention ratio = 1 dividend payout ratio = 65% b. ROE using the DuPont system we find that the ROE = .10*1.8*.30 = 5.40% c. Growth rate = 0.65*0.054 = 3.51% Therefore the expected current stock price of XYZ is $58.7248

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44. Company Es current dividend is $4.00. Dividends are expected to decline by 4 percent per year for the next 3 years, and then remain constant thereafter. The required rate of return for this type of company is 15 percent. What is the current stock price for Company E? Level of difficulty: Difficult Solution: Year Growth rate Dividend 0 1 2 3 4 -4% -4% -4% 0% 4.0000 3.8400 3.6864 3.5389 3.5389 15% $23.9662 Stock price at end Present value of each of year 3 cash flow 3.3391 2.7874 17.8397

23.5930

Discount rate: Price of stock in year 0:

45. The Absent Minded Profs have completed a fundamental analysis of the MKL Company. MKL is a young company and expects to invest heavily in facilities and research and development during the next 5 years; it expects to reap the benefits of its research and development during years 6 to 10; however, it expects rivals to enter the market and margins and profitability to stabilize at a lower level after year 10. The details of the analysis are presented below: Fundamental Analysis of the MKL Company Net profit Dividend Period Turnover Leverage margin payout ratio Years 1-5 1% 0.75 3.0 .05 Years 6-10 15% 3.00 2.0 .10 Years 11- 5% 1.40 1.0 .50 The current dividends for MKL is $3.00 and the required rate of return for this type of firm is 15 percent. Determine the current stock price for MKL. Level of difficulty: Difficult Solution: Begin by determining the sustainable growth rate for the three periods: Years 1-5, g1 = 1% *0.75*3.0*(1 .05) = 2.1375% Years 6-10: g 2 = 15% *3.0* 2.0*(1 .10) = 81.00% Years 11-: g3 = 5% *1.40*1.0*(1 .50) = 3.50% Year Growth rate Dividend Stock price at Present value of end of year 10 each cash flow

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0 1 2 3 4 5 6 7 8 9 10 11

2.1375% 2.1375% 2.1375% 2.1375% 2.1375% 81.0000% 81.0000% 81.0000% 81.0000% 81.0000% 3.5000%

3.0000 3.0641 3.1296 3.1965 3.2648 3.3346 6.0357 10.9246 19.7735 35.7900 64.7799 67.0472 15%

583.0191

2.6645 2.3664 2.1018 1.8667 1.6579 2.6094 4.1070 6.4640 10.1738 160.1260

Discount rate: Price of stock in year 0:

$194.1373

46. The ClearWaters Lobster Company (CWL) is a privately held lobster farming company based in Nova Scotia. It has hired the Absent Minded Profs to help evaluate an offer for the company. Currently CWL has a net income of $150,000 on sales of $350,000it processes 250,000 lobsters each year. The total assets are $2,500,000 and the book value of equity is $2,000,000. The firm is the sole source of income for the owners, the Wong family, and consequently the dividend payout ratio is 65 percent. The risk free rate is 2 percent and the appropriate risk premium for this firm is 5 percent. Level of difficulty: Difficult Solution: A. StarLobster has approached the Wongs about buying CWL. What is the minimum price the Wongs should consider (using only DCF analysis)? Step 1: Determine the sustainable growth rate: Determine the ROE: Using the DuPont system, we determine the net profit margin, turnover and leverage ratios: Net profit margin: Net Income / Sales = $150,000/$350,000 = 42.8571% Turnover: Sales / Total assets = $350,000/$2,500,000 = 0.14 Leverage: Total assets / Equity = $2,500,000/$2,000,000 = 1.25 ROE = .428571*.14*1.25 = 7.5% The earnings retention ratio = 1-.65 = 35% Sustainable growth rate = .35*.075 = 2.625% Step 2: Determine the dividend Earnings this year: $150,000 Dividends this year = $150,000*.65 = $97,500 Step 3: Determine the required rate of return for this firm: Required rate of return = risk free rate + risk premium
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Required rate = 2% + 5% = 7% Step 4: calculate the market value of the equity: D (1 + g ) 97500*(1 + .02625) P0 = 0 = = $2, 287,071.43 kc g .07 .02625 Note: this is the value of all the equity because we are using the total dividends paid. If we used dividends per share, we would get price per share. The minimum price the Wongs should consider for the firm is $2,287,071.43 B. There are three other publicly traded lobster farming companies in Nova Scotia. Summary data on those firms is presented below: Company Price per share Number of shares outstanding Market value of company per lobster processed P/E SeaLobster ToroLobster AgriLobster $25 $10 $15 1,000 10,000 500,000 5 15 7 5 12 35

Given the data on these firms, determine the value of CWL. Discuss the strengths and weaknesses of the comparable firms approach to valuation. Average value based AgriLobster on comparable $7.5m 625,000 $3m $5.25m $2m $2.75m

Company Market value of equity of comparable company Number of lobsters processed by comparable firm Market value of CWL using MV/lobster processed ratio P/E

SeaLobster $25,000 5,000 5*250,000 =$1.25m 15*$150,000 =$2.25m

ToroLobster $100,000 14,286 $1.75m $0.75m

Valuation based on the comparables: the value of CWL is between $2 and $2.75 million (assuming that P/E and MV/Lobster are appropriate valuation metrics in this industry). Strengths of approach: - Ease of calculation there is no need to estimate future cash flows, growth rates and discount rates - Reflects market valuations. Weaknesses: - How comparable are the companies? Are SeaLobster and ToroLobster really comparable to CWL? They appear to be much smaller in terms of lobster production while AgriLobster appears to be much bigger.
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How do we deal with the differences in the valuation estimates? We see that the value of CWL ranges between $750,000 and $5.25 million depending on which ratio and which comparable firm we use. In general, we take averages, but, this approach can be very sensitive to extreme observations

C. StarLobster believes that it can make several changes to the operations of CWL that will increase value. It believes that it can improve the net profit margins to 50 percent without changing the turnover ratio. It will also increase the leverage ratio to 1.50 and will reduce the payout ratio to 40 percent. What is the maximum price StarLobster should consider? We will need to assume that StarLobsters operating changes will not affect the risk of CWL so we can still use 7% as the required rate of return. The new sustainable growth rate is: o 50% * 0.14*1.50*(1-.4) = 6.3% Value of the firm with the changes (assuming that the new growth will occur immediately), D (1 + g ) 97500*(1 + .063) = = $14,806,071.43 o P0 = 0 kc g .07 .063 The maximum that StarLobster should consider paying for CWL is $14.8 million (if they are extremely confident in their ability to create the operating improvements).

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