FIN 7810

Homework 4
Qiguang Wang

1. Up&Down company is expected to go through multiple expansion phases before it reaches

maturity stage. Its dividend today is $5. The dividends are expected to grow by 3% each
year for the next 3 years and 2% for the following two years. Then the company is hit by
the pandemic at the end of the Year 5 and its growth rate drops to -5% for the next 2 years.
The pandemic ends at the end of Year 7 and then the dividend growth bounces back to zero
thereafter and stays at zero forever. What is the stock price of Up&Down if the discount rate
r = 5%?
Solution:
D1 = (1)(1.03) = $1.03
D2 = (1.03)(1.03) = $1.609
D3 = (1.609)(1.03) = $1.0927
D4 = (1.0927)(1.02) = $1.1146
D5 = (1.1146)(1.02) = $1.1369
D6 = (1.1368)(0.95) = $1.0800.
D7 = (10800)(0.95) = 1.0260
D7 = D8 = D9 = · · ·

D8 1.0260
P7 = = = 20.52
r 0.05
D1 D2 D6 + P6
P0 = + 2
+ ··· + = 104.07
1 + r (1 + r) (1 + r)6

2. LUCK company is expected to generate $8 earnings every period from t=1 on. The return
on equity is 10%. At t=5, the firm has an opportunity to investment in a new project. The
new project needs the firm to pay $5 at t=5, and it will generate $0.45 profit from t=6 on
forever. At t=7, the firm has another opportunity that costs $3 at t=7 and generates $0.45
from t=8 on forever. The discount rate r = 10%. What is the price of LUCK company’s
stock?
Solution:
Consider the investment opportunity in year five first. The value of the investment at year 5
is
0.45
−5 + = −$0.5
0.1
Thus LUCK company won’t take this investment opportunity. Consider the investment op-
portunity in year 7, and its NPV is
0.45
−3 + = +$1.5
0.1
.

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 It is a positive NPV project, so LUCK should undertake it. Therefore,
EP S
P0 = + P V GOt=7
r
8 1.5
= +
10% (1 + 10%)7
= $80.76

3. Suppose a firm’s book value per share is BVPS0 today. Return on equity for Year 1 is ROE1
and dividend payout ratio in Year 1 is p1 . Because of the pandemic, the return on equity and
payout ratio will be different for Year 2, let them be ROE2 and p2 . What is the growth rate
in dividend from Year 1 to Year 2?
Solution:

D1 = BV P S0 × ROE1 × p1
D2 = BV P S1 × ROE2 × p2 = BV P S0 × (1 + ROE1 × (1 − p1 )) × ROE2 × p2
D2 BV P S0 × (1 + ROE1 × (1 − p1 )) × ROE2 × p2
g= −1= −1
D1 BV P S0 × ROE1 × p1
(1 + ROE1 × (1 − p1 )) × ROE2 × p2
= −1
×ROE1 × p1

4. Realforce’s expected EPS next year is $8.5. Its ROE is 20% forever. The CEO of Realforce
believes that a lucky number is crucial for business success. Therefore, he would like to
achieve a target stock price of $88. Assume that discount rate r = 10%.

(a) In order to do so, what is the dividend payout ratio the firm should commit to?
Solution:
D1 EP S1 × p
P0 = =
r−g r − (1 − p)ROE
8.5 × p
88 =
0.1 − (1 − p) × 0.2
p = 96.7%

(b) If ROE = 10% instead and there is only one-time growth opportunity at t = 1 with
investment return of 20% for Realforce. This growth opportunity generates 20% return
every year forever starting t = 2 but can only be funded by earnings at t = 1. If today’s
stock price is $88, what is the firm’s dividend payout policy at t = 1, 2, 3, . . . ?
Solution: If the payout ratio at t = 1 is p, then the firm invests retained earnings
EPS1 × (1 − p) in the growth opportunity, which generates positive cashflow of EPS1 ×
(1 − p) every year starting form t = 2 forever. Therefore,
EP S1
P0 = + P V GO
r

2
 where  
1 EP S1 × (1 − p) × rgrowth
P V GO = −EP S1 × (1 − p) +
1+r r
Plug in  
8.5 1 8.5 × (1 − p) × 0.2
88 = + −8.5 × (1 − p) +
0.1 1.1 0.1
Solve the equation
p = 61.17%
Therefore, the dividend payout ratio should be 61.17% for t = 1. Starting form t = 2,
the firm reaches maturity stage (since ROE = r = 10%). As a result, dividend payout
ratios do not matter after t = 2.

5. TW is expected to earn $1.00 per share next year. Book value per share is $10.00 now.
Therefore, the return on equity is 10% per year (i.e., $10 total equity invested with 10%
return produces $1 earnings per year). The firm can distribute all earnings as dividends or
reinvest with retained earnings. The discount rate is r = 10%.

(a) If the firm decides to pay 20% of all future earnings as dividends, calculate earnings-per-
share EPSt and dividend Dt for the next five year t = 1, 2, . . . , 5.
Solution: EPS and dividends both grows at a constant rate

g = ROE(1 − p) = (0.10)(1 − 0.2) = 0.08.

EP S1 = 1.00
EP S2 = 1.08
EP S3 = 1.082 = 1.1664
EP S4 = 1.083 = 1.2597
EP S5 = 1.084 = 1.3605
D1 = (1)(0.2) = 0.20
D2 = (1.08)(0.2) = 0.216
D3 = (1.1664)(0.2) = 0.23328
D4 = (1.2597)(0.2) = 0.2519
D5 = (1.3605)(0.2) = 0.2721

(b) What is the stock price?

Solution:
D1 0.2
P0 = = = $10
r−g 0.10 − 0.08

(c) With the low payout ratio, the CEO of the firm is concerned that the stock price would
be too low. Therefore, he proposes to increase the payout ratio from 20% to 40% in
order to boost the stock price. As the CFO of the firm, you perform numerical analysis
by applying dividend growth model. What is the stock price with 40% dividend payout
ratio?
Solution: If p = 40%, then

g = (10)(1 − 0.4) = 0.06

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 D1 = EP S1 × p = (1)(0.4) = $0.40
0.40
P0 = = $10
0.10 − 0.06

(d) Based on your estimate, do you think lowering payout ratio can effectively increase stock
price? If yes, explain why; if not, explain why it is not effective. [Hint: calculate the
stock price when all earnings are paid out as dividend and then consider the growth
opportunity]
Solution: No, it is not effective. In fact, if ROE = r, the stock price is invariant to the
dividend payout ratio. In other words, when the firm is at maturity stage, the dividend
policy does not matter for stock prices. To see this, note that g = r(1 − p) and
EP S1 × p EP S1
P0 = =
r − r(1 − p) r
This indicates that the stock price is always given by EP S1 /r when the firm is at the
maturity stage. This is also the same price it the firm pays out 100% of earnings as
dividends.
Another way to look at his is to consider NPV of the reinvestment project. If the firm
deviates from 100% payout policy and invest amount Inv at year t, which generates
Inv×ROE cash flow starting at t+1 each year forever, then the NPV of this reinvestment
at t is given by
Inv × ROE Inv × r
NPVt = −Inv + = −Inv + = 0.
r r
There is no positive NPV projects, and consequently PVGO= 0. And the stock price is
simply equal to the no-growth component EP S1 /r.

6. One firm’s investment using its asset in place can generate EPS $10 every period forever. The
discount rate is r = 10%.

(a) If the firm has no positive NPV investment opportunities in the future. What is the
price of the firm’s stock?
Solution:

10
P rice = = $100
10%

(b) If the firm has only one growth opportunity in period t = 3. The firm has to use
the cash generated by the asset in place to pay the initial investment costs of the new
growth opportunity. The new growth opportunity requires $2 initial investment and will
generate 20% return every period forever. What is the PVGO? What is the stock price?
Solution:

−2 + 2×20%
10%
P V GO = = $1.50
(1 + 10%)3

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 P rice = 100 + 1.5 = $101.50

(c) Suppose the firm will have the investment opportunity every period from t = 1 on. The
firm decides to use 20% of its earning for the new investment in every period. Every
new investment will generate 20% return every period from the next period on. That is,
the investment in t = 1 costs $2 and will generate $0.4 cash flow every period from t = 2
on. Note, 20% of TOTAL earning in t = 2 will be used for the new investment. (Don’t
forget the $10 generated by the asset in place.) What is the firm’s dividend growth rate,
g? What is the stock price? What is PVGO?
Solution: Easy way:
Using constant growth dividend model, we first calculate the growth rate: g = ROE(1 −
p) = 20% × (1 − 80%) = 4% and D1 = EPS1 × p = 10 · 80% = $8. Hence,

D1 8
P0 = = = $133.33.
r−g 0.1 − 0.04
Since price is the sum of the non-growth component and PVGO:
10
$133.33. = + P V GO
0.1
P V GO = $33.33

To see this step-by-step

Step 1. Consider total earning cash flows (EPS) in year t: they are consist of return
from new project in year t − 1, return from new project in year t − 2, t − 3, ..., year
1, and year 0 (which is $10 return each year). Thus we have the following cash inflow
table:

Year EPSt
1 10
2 10+(10*0.04)
3 10+(10*0.04)+[10+(10*0.04)]*0.04
4 10+(10*0.04)+[10+(10*0.04)]*0.04+10+(10*0.04)+[10+(10*0.04)]*0.04*0.04
5 ...

Explanation:
Denote total earnings per share in year t as EPSt .
Year 1: just regular return from the investment of year 0, which is $10.
Year 2: $10 from investment of year 0, and 20% of investment of year 1, which is
10 ∗ 20% ∗ 20% = 10 ∗ 0.04 = EPS1 ∗ 0.04.
Year 3: $10 from investment of year 0, and 20% of investment of year 1, which is
10 ∗ 20% ∗ 20% = 10 ∗ 0.04, and 20% of investment of year 2, which is (10 + EPS1 ∗ 0.04) ∗
20% ∗ 20% = EPS2 ∗ 0.04.

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Year 4: Now you get the idea.
As we can see in the table, EPSt = EPSt−1 ∗ 1.04.

Step 2. Year t’s total earning is 4% more than Year t − 1’s total earning. Thus we have
the following dividend table (keep in mind that we are only left with 80% total earnings
to pay out as dividend):

Year Dt
1 10 ∗ 0.8
2 10 ∗ 1.04 ∗ 0.8
3 10 ∗ 1.042 ∗ 0.8
4 10 ∗ 1.043 ∗ 0.8
5 ...

Step 3. As we can see in the table the company’s dividend growth rate is 4%. The stock
price is
10 ∗ 0.8
= $133.33
0.1 − 0.04

10
P V GO = 133.33 − = 33.33
0.1