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922 Chapter 11 Risk-Adjusted Expected Rates of Return and the Dividends Valuation Approach

various transactions between the firm and the common shareholders. What transactions
should the analyst include in value-relevant dividends for purposes of implementing the
dividends valuation model? Why?

11.7 FIRMS THAT DO NOT PAY PERIODIC DIVIDENDS. Why is the divi-
dends valuation approach applicable to firms that do not pay periodic (quarterly or
annual) dividends?

11.8 VALUATION APPROACH EQUIVALENCE. Conceptually, why should an

analyst expect the dividends valuation approach to yield equivalent value estimates to the
valuation approach that is based on free cash flows available to be distributed to common
equity shareholders?

11.9 DIVIDEND POLICY IRRELEVANCE. The chapter asserts that dividends

are value-relevant even though the firm’s dividend policy is irrelevant. How can that be
true? What is the key assumption in the theory of dividend policy irrelevance?

Problems and Cases

11.10 CALCULATING REQUIRED RATES OF RETURN ON EQUITY
CAPITAL ACROSS DIFFERENT INDUSTRIES. The data in Exhibit 11.3 on
industry median betas suggest that firms in the following three sets of related industries
have different degrees of systematic risk.

Median Beta during 1999–2007

Utilities versus Petroleum Refining 0.32 versus 0.65
Grocery Stores versus Retailing—Apparel 0.50 versus 1.08
Depository Institutions (such as Banks) versus
Security and Commodity Brokers 0.39 versus 1.24

Required
a. For each matched pair of industries, describe factors that characterize a typical firm’s
business model in each industry. Describe how such factors would contribute to dif-
ferences in systematic risk.
b. For each matched pair of industries, use the CAPM to compute the required rate of
return on equity capital for the median firm in each industry. Assume that the risk-
free rate of return is 4.0 percent and the market risk premium is 5.0 percent.
c. For each matched pair of industries, compute the present value of a stream of $1 divi-
dends for the median firm in each industry. Use the perpetuity-with-growth model
and assume 3.0 percent long-run growth for each industry. What effect does the dif-
ference in systematic risk across industries have on the per dollar dividend valuation
of the median firm in each industry?

11.11 CALCULATING THE COST OF CAPITAL. Whirlpool manufactures and

sells home appliances under various brand names. IBM develops and manufactures com-
puter hardware and offers related technology services. Target Stores operates a chain of gen-
eral merchandise discount retail stores. Selected data for these companies appear in the
following table (dollar amounts in millions). For each firm, assume that the market value
of the debt equals its book value.
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Questions, Exercises, Problems, and Cases 923

Whirlpool IBM Target Stores

Total Assets $13,532 $109,524 $44,106
Interest-Bearing Debt $ 2,597 $ 33,925 $18,752
Average Pretax Borrowing Cost 6.1% 4.3% 4.9%
Common Equity:
Book Value $ 3,006 $ 13,465 $13,712
Market Value $ 2,959 $110,984 $22,521
Income Tax Rate 35.0% 35.0% 35.0%
Market Equity Beta 2.27 0.78 1.20

Required
a. Assume that the intermediate-term yields on U.S. government Treasury securities
are roughly 3.5 percent. Assume that the market risk premium is 5.0 percent.
Compute the cost of equity capital for each of the three companies.
b. Compute the weighted average cost of capital for each of the three companies.
c. Compute the unlevered market (asset) beta for each of the three companies.
d. Assume for this part that each company is a candidate for a potential leveraged buy-
out. The buyers intend to implement a capital structure that has 75 percent debt
(with a pretax borrowing cost of 8.0 percent) and 25 percent common equity.
Project the weighted average cost of capital for each company based on the new capi-
tal structure. To what extent do these revised weighted average costs of capital differ
from those computed in Part b?

11.12 CALCULATION OF DIVIDENDS-BASED VALUE. Royal Dutch Shell

is a petroleum and petrochemicals company. It engages primarily in the exploration, pro-
duction, and sale of crude oil and natural gas and the manufacture, transportation, and sale
of petroleum and petrochemical products. The company operates in approximately 200
countries worldwide—in countries in North America, Europe, Asia-Pacific, Africa, South
America, and the Middle East. During 2006–2008, Royal Dutch Shell generated the follow-
ing total dividends to common equity shareholders (in USD millions):

2006 2007 2008

Common Dividend Payments $ 8,142 $ 9,001 $ 9,516
Stock Repurchases 8,047 4,387 3,573
Total Dividends $16,189 $13,388 $13,089

Analysts project 5 percent growth in earnings over the next five years. Assuming concur-
rent 5 percent growth in dividends, the following table provides the amounts that analysts
project for Royal Dutch Shell’s total dividends for each of the next five years. In Year 6,
total dividends are projected for Royal Dutch Shell assuming that its income statement and
balance sheet will grow at a long-term growth rate of 3 percent.

Year ⴙ1 Year ⴙ2 Year ⴙ3 Year ⴙ4 Year ⴙ5 Year ⴙ6

Projected Growth 5% 5% 5% 5% 5% 3%
Projected Total Dividends
to Common Equity $13,743 $14,431 $15,152 $15,910 $16,705 $17,206
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924 Chapter 11 Risk-Adjusted Expected Rates of Return and the Dividends Valuation Approach

At the end of 2008, Royal Dutch Shell had a market beta of 0.71. At that time, yields on
intermediate-term U.S. Treasuries were roughly 3.5 percent. Assume that the market
required a 5.0 percent risk premium. Royal Dutch Shell had 6,241 million shares outstand-
ing at the end of 2008 that traded at a share price of $24.87.

Required
a. Calculate the required rate of return on equity for Royal Dutch Shell as of the begin-
ning of Year 1.
b. Calculate the sum of the present value of total dividends for Year 1 through 5.
c. Calculate the continuing value of Royal Dutch Shell at the start of Year 6 using the
perpetuity-with-growth model with Year 6 total dividends. Also compute the pres-
ent value of continuing value as of the beginning of Year 1.
d. Compute the total present value of dividends for Royal Dutch Shell as of the begin-
ning of Year 1. Remember to adjust the present value for midyear discounting.
e. Compute the value per share of Royal Dutch Shell as of the beginning of Year 1.
f. Given the share price at the start of Year 1, do Royal Dutch Shell shares appear
underpriced, overpriced, or correctly priced?

11.13 VALUING THE EQUITY OF A PRIVATELY HELD FIRM. Refer to the

financial statement forecasts for Massachusetts Stove Company (MSC) prepared for Case
10.2. The management of MSC wants to know the equity valuation implications of adding
gas stoves under the best, most likely, and worst case scenarios. Under the three scenarios
from Case 10.2, the actual amounts of net income and common shareholders’ equity for
Year 7 and the projected amounts for Year 8–Year 12 are as follows:

Actual Projected
Year 7 Year 8 Year 9 Year 10 Year 11 Year 12
Best-Case Scenario:
Net Income $154,601 $148,422 $123,226 $173,336 $ 271,725 $ 390,639
Common Equity $552,080 $700,502 $823,728 $997,064 $1,268,789 $1,659,429
Most Likely Scenario:
Net Income $154,601 $135,343 $ 74,437 $ 72,899 $ 109,357 $ 149,977
Common Equity $552,080 $687,423 $761,860 $834,759 $ 944,116 $1,094,093
Worst-Case Scenario:
Net Income $154,601 $128,263 $ 18,796 $(39,902) $ (58,316) $ (77,156)
Common Equity $552,080 $680,343 $699,139 $659,238 $ 600,921 $ 523,766

MSC is not publicly traded and therefore does not have a market equity beta. Using the
market equity beta of the only publicly traded woodstove and gas stove manufacturing firm
and adjusting it for differences in the debt-to-equity ratio, income tax rate, and privately
owned status of MSC yields a cost of equity capital for MSC of 13.55 percent.
Required
a. Use the clean surplus accounting approach to derive the projected total amount of
MSC’s dividends to common equity shareholders in Years 8 through 12.
b. Given that MSC is a privately held company, assume that ending book value of com-
mon equity at the end of Year 12 is a reasonable estimate of the value at which the