Chapter 9 Stocks and Their Valuation

Solutions to End-of-Chapter Problems

9-1 D0 = $1.50; g1-3 = 7%; gn = 5%; D1 through D5 = ? D1 = D0(1 + g1) = $1.50(1.07) = $1.6050. D2 = D0(1 + g1)(1 + g2) = $1.50(1.07)2 = $1.7174. D3 = D0(1 + g1)(1 + g2)(1 + g3) = $1.50(1.07)3 = $1.8376. D4 = D0(1 + g1)(1 + g2)(1 + g3)(1 + gn) = $1.50(1.07)3(1.05) = $1.9294. D5 = D0(1 + g1)(1 + g2)(1 + g3)(1 + gn)2 = $1.50(1.07)3(1.05)2 = $2.0259.
D1 = $0.50; g = 7%; rs = 15%; P0 = ? D1 $0.50 P0 = = = $6.25. rs g 0.15 0.07

9-3

9-4

P0 = $20; D0 = $1.00; g = 6%; P1 = ?; rs = ? P1 = P0(1 + g) = $20(1.06) = $21.20.

s = r

D1 $1.00(1.06) +g= + 0.06 P0 $20

$1.06 + 0.06 = 11.30%. rs = 11.30%. $20

9-5

a. The terminal, or horizon, date is the date when the growth rate becomes constant. This occurs at the end of Year 2. b. 0 | 1.25
rs = 10% gs = 20%

1 | 1.50

gs = 20%

2 | 1.80

gn = 5%

3 | 1.89

37.80 =

1.89 0.10 0.05

Chapter 9: Stocks and Their Valuation

Answ ers and Solutions

The horizon, or terminal, value is the value at the horizon date of all dividends expected thereafter. In this problem it is calculated as follows:
$1.80 (1.05) = $37.80. 0.10 0.05

c. The firms intrinsic value is calculated as the sum of the present value of all dividends during the supernormal growth period plus the present value of the terminal value. Using your financial calculator, enter the following inputs: CF0 = 0, CF1 = 1.50, CF2 = 1.80 + 37.80 = 39.60, I/YR = 10, and then solve for NPV = $34.09. 9-6 The firms free cash flow is expected to grow at a constant rate, hence we can apply a constant growth formula to determine the total value of the firm. Firm value = FCF1/(WACC g) = $150,000,000/(0.10 0.05) = $3,000,000,000. To find the value of an equity claim upon the company (share of stock), we must subtract out the market value of debt and preferred stock. This firm happens to be entirely equity funded, and this step is unnecessary. Hence, to find the value of a share of stock, we divide equity value (or in this case, firm value) by the number of shares outstanding. Equity value per share = Equity value/Shares outstanding = $3,000,000,000/50,000,000 = $60.

Each share of common stock is worth $60, according to the corporate valuation model. 9-7 Dp = $5.00; Vp = $60; rp = ? rp =
Dp Vp

$5.00 = 8.33%. $60.00

9-8

Vp = Dp/rp; therefore, rp = Dp/Vp. a. rp = $8/$60 = 13.33%. b. rp = $8/$80 = 10.0%. c. rp = $8/$100 = 8.0%. d. rp = $8/$140 = 5.71%.

Answ ers and Solutions

Chapter 9: Stocks and Their Valuation

9-9

a.

Vp =

Dp rp

$10 = $125. 0.08

b.

Vp =

$10 = $83.33. 0.12

9-10

a. The preferred stock pays $8 annually in dividends. Therefore, its nominal rate of return would be: Nominal rate of return = $8/$80 = 10%. Or alternatively, you could determine the securitys periodic return and multiply by 4. Periodic rate of return = $2/$80 = 2.5%. Nominal rate of return = 2.5% 4 = 10%. b. EAR = (1 + rNOM/4)4 1 = (1 + 0.10/4)4 1 = 0.103813 = 10.3813%.
D (1 + g) $5 [1 + (0.05)] D1 $5 (0.95) $4.75 = 0 P0 = = = = = $23.75. rs g rs g 0.15 (0.05) 0.15 + 0.05 0.20

9-11

9-12

First, solve for the current price.

P0 = D1/(rs g) = $0.50/(0.12 0.07) = $10.00.

If the stock is in a constant growth state, the constant dividend growth rate is also the capital gains yield for the stock and the stock price growth rate. Hence, to find the price of the stock four years from today:
P4 = P0(1 + g)4 = $10.00(1.07)4 = $13.10796 $13.11.

9-13

a. 1. 2. 3.

$2 (1 0.05) = $1.90 = $9.50. P0 = 0.15 + 0.05 0.20

P0 = $2/0.15 = $13.33.

$2 (1.05) $2.10 P0 = = = $21.00. 0.15 0.05 0.10

Chapter 9: Stocks and Their Valuation

Answ ers and Solutions

4. b. 1. 2.

$2 (1.10) $2.20 P0 = = = $44.00. 0.15 0.10 0.05

P0 = $2.30/0 = Undefined. P0 = $2.40/(-0.05) = -$48, which is nonsense.

These results show that the formula does not make sense if the required rate of return is equal to or less than the expected growth rate. c. No, the results of Part b show this. It is not reasonable for a firm to grow indefinitely at a rate higher than its required return. Such a stock, in theory, would become so large that it would eventually overtake the whole economy. 9-14
The problem asks you to determine the value of P3 , given the following facts: D1 = $2, b = 0.9, rRF = RPM = 6%, and P0 = $25. Proceed as follows: 5.6%,

Step 1:

Calculate the required rate of return: rs = rRF + (rM rRF)b = 5.6% + (6%)0.9 = 11%.

Step 2:

Use the constant growth rate formula to calculate g:

s = r 0.11 = D1 +g P0

$2 +g $25 g = 0.03 = 3%.

Step 3:

Calculate P3 : P3 = P0(1 + g)3 = $25(1.03)3 = $27.3182 $27.32.

Alternatively, you could calculate D4 and then use the constant growth rate formula to solve for P3 :

D4 = D1(1 + g)3 = $2.00(1.03)3 = $2.1855.

P3 = $2.1855/(0.11 0.03) = $27.3182 $27.32.

9-15

Calculate the dividend cash flows and place them on a time line. Also, calculate the stock price at the end of the supernormal growth period, and include it, along with the dividend to be paid at t = 5, as CF5. Then, enter the cash flows as shown on the time line into the cash flow register, enter the required rate of return as I/YR = 15, and then find the value of the stock using the NPV calculation. Be sure to enter CF0 = 0, or else your answer will be incorrect. D0 = 0; D1 = 0; D2 = 0; D3 = 1.00; D4 = 1.00(1.5) = 1.5; D5 = 1.00(1.5)2 = 2.25; D6 = 1.00(1.5)2(1.08) = $2.43. P0 = ?

Answ ers and Solutions

Chapter 9: Stocks and Their Valuation

0 |

rs = 15%

1 |
1/(1.15)3 1/(1.15)4 1/(1.15)5

2 |

3 4 | | gs = 50% 1.00 1.50

5 6 | | gn = 8% 2.25 2.43 +34.714 = 36.964

2.43 0.15 0.08

0.658 0.858 18.378

$19.894 = P0

P5 = D6/(rs g) = $2.43/(0.15 0.08) = $34.714. This is the stock price at the end of Year 5.

CF0 = 0; CF1-2 = 0; CF3 = 1.0; CF4 = 1.5; CF5 = 36.964; I/YR = 15%. With these cash flows in the CFLO register, press NPV to get the value of the stock today: NPV = $19.89.
$42.80 $40 (1.07) = = $713.33 million. 0.13 0.07 0.06

9-15

a. Terminal value = b. 0 |

WACC = 13%

($ 17.70) 23.49 522.10 $527.89

1/1.13 1/(1.13)2 1/(1.13)3

1 | -20

2 | 30
3

3 | gn = 7% 40
Vop = 713.33 753.33

4 | 42.80

Using a financial calculator, enter the following inputs: CF0 = 0; CF1 = -20; CF2 = 30; CF3 = 753.33; I/YR = 13; and then solve for NPV = $527.89 million. c. Total valuet=0 = $527.89 million. Value of common equity = $527.89 $100 = $427.89 million. Price per share =
$427.89 = $42.79. 10.00

9-17

The value of any asset is the present value of all future cash flows expected to be generated from the asset. Hence, if we can find the present value of the dividends during the period preceding long-run constant growth and subtract that total from the current stock price, the remaining value would be the present value of the cash flows to be received during the period of long-run constant growth. D1 = $2.00 (1.25)1 = $2.50 D2 = $2.00 (1.25)2 = $3.125 D3 = $2.00 (1.25)3 = $3.90625 PV(D1) = $2.50/(1.12)1 PV(D2) = $3.125/(1.12)2 PV(D3) = $3.90625/(1.12)3 = $2.2321 = $2.4913 = $2.7804

PV(D1 to D3) = $7.5038 Therefore, the PV of the remaining dividends is: $58.8800 $7.5038 = $51.3762. Compounding Chapter 9: Stocks and Their Valuation

Answ ers and Solutions

this value forward to Year 3, we find that the value of all dividends received during constant growth is $72.18. [$51.3762(1.12)3 = $72.1799 $72.18.] Applying the constant growth formula, we can solve for the constant growth rate:
P3 $72.18 $8.6616 $72.18g $4.7554 0.0625 6.25%

= D3(1 + g)/(rs g) = $3.90625(1 + g)/(0.12 g) = $3.90625 + $3.90625g = $76.08625g =g = g. 3 | D3 P3 4 | D4

9-18

0 | D0 = 2.00

rs = 12% g = 5%

1 | D1

2 | D2

a. D1 = $2(1.05) = $2.10; D2 = $2(1.05)2 = $2.2050; D3 = $2(1.05)3 = $2.31525. b. Financial calculator solution: Input 0, 2.10, 2.2050, and 2.31525 into the cash flow register, input I/YR = 12, PV = ? PV = $5.28. c. Financial calculator solution: Input 0, 0, 0, and 34.73 into the cash flow register, I/YR = 12, PV = ? PV = $24.72. d. $24.72 + $5.28 = $30.00 = Maximum price you should pay for the stock. e. f.
D (1 + g) D1 $2.10 P0 = 0 = = = $30.00. rs g rs g 0.12 0.05

No. The value of the stock is not dependent upon the holding period. The value calculated in Parts a through d is the value for a 3-year holding period. It is equal to the value calculated in Part e. Any other holding period would produce the same value of P0 ; that is, P0 = $30.00.

9-19

a. Part 1: Graphical representation of the problem: Supernormal growth Normal growth | D

0 | D0 PVD1 PVD2 PVP2 P0

1 | D1

2 | (D2 + P2 )

3 | D3

D1 = D0(1 + gs) = $1.6(1.20) = $1.92.

Answ ers and Solutions

Chapter 9: Stocks and Their Valuation

D2 = D0(1 + gs)2 = $1.60(1.20)2 = $2.304.

P2 = D3 D (1 + gn ) $2.304 (1.06) = 2 = = $61.06. rs gn rs gn 0.10 - 0.06

P0 = PV(D1) + PV(D2) + PV( P2 )

D1 D2 P2 + + 2 (1 + rs ) (1 + rs ) (1 + rs ) 2 = $1.92/1.10 + $2.304/(1.10)2 + $61.06/(1.10)2 = $54.11.

Financial calculator solution: Input 0, 1.92, 63.364(2.304 + 61.06) into the cash flow register, input I/YR = 10, PV = ? PV = $54.11. Part 2: Expected dividend yield: D1/P0 = $1.92/$54.11 = 3.55%.
Capital gains yield: First, find P1 , which equals the sum of the present values of D2 and P2 discounted for one year.

$2.304 + $61.06 = $57.60. P1 = (1.10)1

Financial calculator solution: Input 0, 63.364(2.304 + 61.06) into the cash flow register, input I/YR = 10, PV = ? PV = $57.60. Second, find the capital gains yield:
P1 P0 $57.60 $54.11 = = 6.45%. P0 $54.11

Dividend yield = 3.55% Capital gains yield = 6.45 10.00% = rs. b. Due to the longer period of supernormal growth, the value of the stock will be higher for each year. Although the total return will remain the same, rs = 10%, the distribution between dividend yield and capital gains yield will differ: The dividend yield will start off lower and the capital gains yield will start off higher for the 5-year supernormal growth condition, relative to the 2-year supernormal growth state. The dividend yield will increase and the capital gains yield will decline over the 5-year period until dividend yield = 4% and capital gains yield = 6%. c. Throughout the supernormal growth period, the total yield, rs, will be 10%, but the dividend yield is relatively low during the early years of the supernormal growth period and the capital gains yield is relatively high. As we near the end of the supernormal growth period, the capital gains yield declines and the dividend yield rises. After the supernormal growth period has ended, the capital gains yield will equal gn = 6%. The total yield must equal rs = 10%, so the dividend yield must equal 10% 6% = 4%.

Chapter 9: Stocks and Their Valuation

Answ ers and Solutions

d. Some investors need cash dividends (retired people), while others would prefer growth. Also, investors must pay taxes each year on the dividends received during the year, while taxes on the capital gain can be delayed until the gain is actually realized. Currently (2008), dividends to individuals are now taxed at the lower capital gains rate of 15%. 9-20 a. 0 | 1 | 3,000,000 2 | 6,000,000 3 | 10,000,000 4 | 15,000,000

WACC = 12%

Using a financial calculator, enter the following inputs: CF0 = 0; CF1 = 3000000; CF2 = 6000000; CF3 = 10000000; CF4 = 15000000; I/YR = 12; and then solve for NPV = $24,112,308. b. The firms terminal value is calculated as follows:
$15,000,000 (1.07) = $321,000,000. 0.12 0.07

c. The firms total value is calculated as follows: 0 |

WACC = 12%

1 | 3,000,000

2 | 6,000,000

3 | 10,000,000

4 5 | | gn = 7% 15,000,000 16,050,000 321,000,000 =

16,050,000 0.12 0.07

PV = ?

Using your financial calculator, enter the following inputs: CF0 = 0; CF1 = 3000000; CF2 = 6000000; CF3 = 10000000; CF4 = 15000000 + 321000000 = 336000000; I/YR = 12; and then solve for NPV = $228,113,612. d. To find Barretts stock price, you need to first find the value of its equity. The value of Barretts equity is equal to the value of the total firm less the market value of its debt and preferred stock. Total firm value Market value, debt + preferred Market value of equity $228,113,612 60,000,000 (given in problem) $168,113,612

Barretts price per share is calculated as:

$168,113,612 = $16.81. 10,000,000

9-21

FCF = EBIT(1 T) + Depreciation

Net operating Capital working capital expenditures

= $500,000,000 + $100,000,000 $200,000,000 $0 = $400,000,000.

Answ ers and Solutions

Chapter 9: Stocks and Their Valuation

Firm value =

FCF WACC g $400,000,000 = 0.10 0.06 $400,000,000 = 0.04 = $10,000,000,000.

This is the total firm value. Now find the market value of its equity. MVTotal = MVEquity + MVDebt $10,000,000,000 = MVEquity + $3,000,000,000 MVEquity = $7,000,000,000. This is the market value of all the equity. Divide by the number of shares to find the price per share. $7,000,000,000/200,000,000 = $35.00. 9-22 a. End of Year: 08 | 09 | D1 10 | D2 11 | D3 12 | D4 13 | D5 14 | D6

D0 = 1.75 Dt = D0(1 + g)t.

rs = 12% gs = 15%

gn = 5%

D2009 = $1.75(1.15)1 = $2.01. D2010 = $1.75(1.15)2 = $1.75(1.3225) = $2.31. D2011 = $1.75(1.15)3 = $1.75(1.5209) = $2.66. D2012 = $1.75(1.15)4 = $1.75(1.7490) = $3.06. D2013 = $1.75(1.15)5 = $1.75(2.0114) = $3.52. b. Step 1: PV of dividends =

(1 + r )
t =1 s

Dt

PV D2009 = $2.01/(1.12) = $1.79 PV D2010 = $2.31/(1.12)2 = $1.84 PV D2011 = $2.66/(1.12)3 = $1.89 PV D2012 = $3.06/(1.12)4 = $1.94 PV D2013 = $3.52/(1.12)5 = $2.00 PV of dividends = $9.46 Step 2:
D D (1 + g) $3.52(1.05) $3.70 P2013 = 2014 = 2013 = = = $52.80 . 0.12 0.05 0.07 rs gn rs gn

Chapter 9: Stocks and Their Valuation

Answ ers and Solutions

This is the price of the stock 5 years from now. The PV of this price, discounted back 5 years, is as follows:
PV of P2013 = $52.80/(1.12)5 = $29.96

Step 3: The price of the stock today is as follows:

P0 = PV dividends Years 2009-2013 + PV of P2013 = $9.46 + $29.96 = $39.42.

This problem could also be solved by substituting the proper values into the following equation:
P0 =

t =1

D 0 (1 + g s ) t D 6 + r g (1 + rs ) t n s

1 1 + r s

Calculator solution: Input 0, 2.01, 2.31, 2.66, 3.06, 56.32 (3.52 + 52.80) into the cash flow register, input I/YR = 12, PV = ? PV = $39.43. c. 2009 D1/P0 = $2.01/$39.43 = 5.10% Capital gains yield = 6.90* Expected total return = 12.00% 2014 D6/P5 = $3.70/$52.80 = 7.00% Capital gains yield = 5.00 Expected total return = 12.00% *We know that rs is 12%, and the dividend yield is 5.10%; therefore, the capital gains yield must be 6.90%. The main points to note here are as follows: 1. The total yield is always 12% (except for rounding errors). 2. The capital gains yield starts relatively high, then declines as the supernormal growth period approaches its end. The dividend yield rises. 3. After 12/31/13, the stock will grow at a 5% rate. The dividend yield will equal 7%, the capital gains yield will equal 5%, and the total return will be 12%. d. People in high-income tax brackets will be more inclined to purchase growth stocks to take the capital gains and thus delay the payment of taxes until a later date. The firms stock is mature at the end of 2013. e. Since the firms supernormal and normal growth rates are lower, the dividends and, hence, the present value of the stock price will be lower. The total return from the stock will still be 12%, but the dividend yield will be larger and the capital gains yield will be smaller than they were with the original growth rates. This result occurs because we assume the same last dividend but a much lower current stock price. 10

Answ ers and Solutions

Chapter 9: Stocks and Their Valuation

f.

As the required return increases, the price of the stock goes down, but both the capital gains and dividend yields increase initially. Of course, the long-term capital gains yield is still 4%, so the long-term dividend yield is 10%.

Chapter 9: Stocks and Their Valuation

Answ ers and Solutions

11

12

Answ ers and Solutions

Appendix 9A: Stock Market Equilibrium