FMI Assignment #8

Ind_PS_PS_A1 MCQs
7. The constant dividend growth model:
A. is more complex than the differential growth model.
B. requires the growth period be limited to a set number of years.
C. is never used because firms rarely attempt to maintain steady dividend growth.
D. can be used to compute a stock price at any point in time.
E. most applies to stocks with differential growth rates.
Ans- Option (D) – can be used to compute stock price at any point in time

17. A forward PE is generally based on the projected:

A. average earnings for the next five years.
B. average earnings for the next three years.
C. earnings for the upcoming quarter.
D. earnings for the next year.
E. stock price in one year.
Ans- Option (D) – earnings for the next year.

47.
S&P Enterprises will pay an annual dividend of $2.08 a share on its common stock next year.
Last week, the company paid a dividend of $2.00 a share. The company adheres to a constant
rate of growth dividend policy. What will one share of S&P common stock be worth ten years
from now if the applicable discount rate is 8 percent?
A. $71.16
B. $74.01
C. $76.97
D. $80.05
E. $83.25
Ans-

Div1 = $2.08

Div0 = $2.00
Discounted rate (ke) = 8% = 0.08
Growth rate (g) = (Div1 / Div0) – 1 = (2.08/2) – 1 = 0.04 = 4%
P0 = Div1 / (ke – g) = 2.08 / (0.08 – 0.04) = $52
Future value of P0 = P10 = 52 (1.04)10 = $76.97

Option (C) – $76.97

57.
The Elder Co. is in downsizing mode. The company paid a $2.50 annual dividend last year. The
company has announced plans to lower the dividend by $.50 a year. Once the dividend amount
becomes zero, the company will cease all dividends permanently. The required rate of return is
14.5 percent. What is one share of this stock worth?
A. $3.85
B. $3.48
C. $4.87
D. $4.13
E. $4.39
Ans-
 Div1 = $2.00, Div2 = $1.50, Div3 = $1.00, Div4 = $0.5
ke = 14.5% = 0.145
P4 = Div1/(1+ke)1 + Div2/(1+ke)2 + Div3/(1+ke)3 + Div4/(1+ke)4
P4 = 2/(1.145)1 + 1.5/(1.145)2 + 1/(1.145)3 + 0.5/(1.145)4
P4 = 1.75 + 1.14 + 0.67 + 0.29 = $3.85

Option (C) – $3.85

67.
Engine Builders stock sells for $24.20 a share. The firm just paid an annual dividend of $2 per
share and has a long-established record of increasing its dividend by a constant 2.5 percent
annually. What is the market rate of return on this stock?
A. 10.97%
B. 14.41%
C. 10.70%
D. 12.34%
E. 11.46%
Ans-
ke is the market rate of return
Div0 = $2
P0 = $24.20
g = 2.5%
Therefore,
P0 = [Div0 (1+g)] / (ke – g)
$24.20 = $2*(1+ 0.025)/( ke - 0.025)
$24.20 = $2.05/( ke - 0.025)
ke = 10.97%

Option (A) = 10.97%

Ind_PS_PS_A2

Concept Questions

2. A substantial percentage of the companies listed on the NYSE and the NASDAQ don’t
pay dividends, but investors are nonetheless willing to buy shares in them. How is this
possible given your answer to the previous question?

Ans –

Dividends are essentially a way of paying shareholders a return on their investment. It

becomes a regular source of income for the investors irrespective of the value of the stock price.

However, if a company doesn’t pay dividends, one of the reasons could be that the company has got
great investment opportunities and is reinvesting its profits to gain a higher percentage of returns.
Thus, in anticipation of greater capital gains, investors may choose to invest in such a company.

Questions and Problems

2. The next dividend payment by ECY Inc. will be $2.90 per share. The dividends are
anticipated to maintain a growth rate of 5.5%, forever. If the stock currently sells for
$53.10 per share, what is the required rate of return?

Ans –
ke is the market rate of return
Div0 = $2.90
P0 = $53.10
g = 5.5%
Therefore,
P0 = [Div0 (1+g)] / (ke – g)
$53.10 = $2.90 * (1+ 0.055)/( ke - 0.055)
$53.10 = $2.90 / ( ke - 0.055)
ke = 0.1096 = 10.96%

Ans – Required rate of return is 10.96%

12. Metallica Bearings, Inc., is a young start-up company. No dividends will be paid on the
stock over the next nine years, because the firm needs to plow back its earnings to fuel
growth. The company will pay a dividend of $17.50 per share in 10 years and will increase
the dividend by 5.5 percent per year thereafter. If the required return on this stock is 12
percent, what is the current share price?

Ans –
Using Dividend Discount Model, the price at the end of 9th year is as follows -
ke = 12% = 0.12
Div10 = $17.50
g = 5.5%
Therefore,
P9 = Div10 / (ke – g)
P9 = $17.50 / (0.12 - 0.055)
P9 = 17.50 /0.065 = $269.23

P9 = $269.23
PV of the stock = 269.23 / (1.12)9 = $97.09

Ans – Current share price is $97.09

22. Briley Inc. is expected to pay equal dividends at the end of each of the next two years.
Thereafter, the dividend will grow at a constant annual rate of 4%, forever. The current
stock price is $53. What is next year’s dividend payment if the required rate of return is 11
percent?

Ans –
Let dividend (Div2) for next two years be $x,

ke = 11% = 0.11
g = 4% = 0.04
P2 = Div2 (1+g)] / (ke – g)
P2 = $x * (1+ 0.04) / (0.11 - 0.04) = $14.8571 x

Current price = future dividends * PVIF (11,2)

 $53 = x / 1.11 + (x + 14.8571x) / (1.11)2
  $53 = x / 1.11 + 15.8571 x / (1.11)2
 16.9671 x = 65.3013
 x = $ 3.848

Ans – Dividend payment for next year is $3.848

32. Suppose the current share price for the firm in the previous problem is $62.40 and all the
dividend information remains the same. What required return must investors be
demanding on Storico stock?

Ans –
Information from previous question,

ke =?
g0 = 20% = 0.2
g1= 15% = 0.15
g2 = 10% = 0.1
g3 = 5% = 0.05
Div = $3.40
Current price = $62.40

Current price = Div (1+g)] / (ke – g)

Current price = (3.40) (1+ 0.2) / (1 + ke) + (3.40) (1+ 0.2) (1+0.15) / (1 + ke)2 + (3.40) (1+ 0.2)
(1+0.15) (1+0.1) / (1 + ke)3 + [{(3.40) (1+ 0.2) (1+0.15) (1+0.1) (1+0.05)} / (ke – 0.05)] / (1 +
ke)3

 62.40 = (3.40) (1.2) / (1 + ke) + (3.40) (1.2) (1.15) / (1 + ke)2 + (3.40) (1.2) (1.15) (1.1) / (1
+ ke)3 + [{(3.40) (1.2) (1.15) (1.1) (1.05)} / (ke – 0.05)] / (1 + ke)3

After trial and error, it is concluded that the rate of return (k e) = 0.1242

Ans- Rate of return is 12.42%