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Finance SL8

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# Finance

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Sub: Finance Question: Calculation of Value of Stock.

Topic: Bond Valuation

GROWTH, Inc.’s next year earning is expected to be \$4 per share. The company pays out half of its earning as dividend. Both dividends and earnings are expected to grow by 10% a year for the first 5 years, and grow by 5% a year indefinitely thereafter. STABLE, Inc. is like GROWTH in all respects except that its growth will stop after year 5. In year 6 and afterward, it will pay out all earnings as dividends. Both companies’ expected returns are 8%. (a) What are the stock prices for each company? (b) What are the P/E ratios and PEG ratios for each company? Assuming the average growth rates for GROWTH and STABLE are 6% and 3.33%, respectively. (c) Which stock would you buy using the PEG rule? Now, suppose the stock prices computed in (a) are the actual traded prices. However, if you have assumed that both companies’ earnings will grow by 5% a year indefinitely in computing the fair values, which stock should you buy?

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Sub: Finance

Topic: Bond Valuation

Solution :
(a) A 1 2 3 4 5 6 7 8 9 1 2 \$2.00 \$2.20 \$2.42 \$2.66 \$2.93 Growth, Inc. Earnings per share in Year 1 Dividend per share in Year 2 Dividend growth rate for the first 5 years Expected return Year Dividend PV Factor PV of at 8% 0.9259 0.8573 0.7938 0.7350 0.6806 Dividend \$1.85 \$1.89 \$1.92 \$1.96 \$1.99 \$4 \$2 10% 8% B C D E F

10 3 11 4 12 5

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Sub: Finance
13 PV of dividends up to year 5 14 Dividend growth rate from years 6 to 10 15 Year 16 17 6 18 7 19 8 20 9 21 10 22 Total Value of dividends from years 6 to 10, as at 23 the end of year 5 24 PV of dividends from years 6 to 10 \$3.07 \$3.23 \$3.39 \$3.56 \$3.74 Dividend

Topic: Bond Valuation
\$9.61 5% PV Factor PV of at 8% 0.6302 0.5835 0.5403 0.5002 0.4632 Dividend \$1.94 \$1.88 \$1.83 \$1.78 \$1.73 \$9.16

\$9.16 \$6.24 \$15.8

25 PV of dividends from years 1 to 10 26 Dividend for year 11 (D11) 27 Dividend growth rate (g) \$1.82 5%

5

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Sub: Finance
28 Required Rate of Return (K) Value of stock at the end of year 10 (P10) = 29 D11/(K-g)

Topic: Bond Valuation
8% \$60.5 9 \$28.0

30 PV of P10 Price of Stock = PV of dividends up to 10 31 years + PV of price of stock at year 10

6

\$43.9 32 33 34 Stable, Inc. 35 Earnings per share in Year 1 36 Dividend per share in Year 2 37 Dividend growth rate for the first 5 years 38 Expected return 39 Year 40 41 1 \$2.00 Dividend PV Factor PV of at 8% 0.9259 Dividend \$1.85 \$4 \$2 10% 8% 1

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Sub: Finance
42 2 43 3 44 4 45 5 46 PV of dividends up to year 5 \$2.20 \$2.42 \$2.66 \$2.93

Topic: Bond Valuation
0.8573 0.7938 0.7350 0.6806 \$1.89 \$1.92 \$1.96 \$1.99 \$9.61 \$5.8

47 Earnings for year 5

6 \$5.8

48 Earnings for year 6

6 \$5.8

49 Dividend for year 6(D6) 50 Dividend growth rate (g) 51 Required Rate of Return (K) Value of stock at the end of year 5 (P5) = 52 D6/(K-g)

6 0 8% \$73.2 1 \$49.8

53 PV of P5 54

2

Price of Stock = PV of dividends up to 5 years

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Sub: Finance
+ PV of price of stock at year 5

Topic: Bond Valuation

\$59.4 55 3

Excel Workings A 1 2 3 Growth, Inc. Earnings per share in Year 1 Dividend per share in Year 2 Dividend growth rate for the first 5 4 5 6 7 8 1 2 years Expected return Year Dividend PV Factor PV of at 8% =1/1.08 Dividend =2*0.9259 0.1 0.08 4 =4/2 B C D E F

=0.9259/1 =2.20*0.85 9 2 =2*110% .08 73

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Sub: Finance

Topic: Bond Valuation
=8573/1.0 =2.42*0.79

10 3

=2.20*110% 8

38

=0.4938/1 =2.66*0.73 11 4 =2.42*110% .08 50

=0.7350/1 =2.93*0.68 12 5 =2.66*110% .08 06 =SUM(1.85 13 PV of dividends up to year 5 Dividend growth rate from years 6 to 14 10 15 Year 16 Dividend PV Factor PV of at 8% Dividend 0.05 :1.99)

=0.6806/1 =3.07*0.63 17 6 =2.93*105% .08 02

=0.6302/1 =3.23*0.58 18 7 =3.07*105% .08 35

=0.5835/1 =3.39*0.54 19 8 20 9 =3.23*105% .08 =3.39*105% 03

=0.5403/1 =3.56*0.50

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Sub: Finance
.08

Topic: Bond Valuation
02

=0.5002/1 =3.74*0.46 21 10 =3.56*105% .08 32 =SUM(1.94: 22 Total Value of dividends from years 6 to 10, 23 as at the end of year 5 =9.16 =9.16/POWER 24 PV of dividends from years 6 to 10 25 PV of dividends from years 1 to 10 =1.73*105 26 Dividend for year 11 (D11) 27 Dividend growth rate (g) 28 Required Rate of Return (K) Value of stock at the end of year 10 29 (P10) = D11/(K-g) =1.82/(8-5) =60.59/POWE 30 PV of P10 31 R(1.08,10) % 0.05 0.08 (1.08,5) =9.61+6.24 1.73)

Price of Stock = PV of dividends up to 10 years + PV

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Sub: Finance
of price of stock at year 10 32 33 34 Stable, Inc. 35 Earnings per share in Year 1 36 Dividend per share in Year 2 37 Dividend growth rate for the first 5 years 38 Expected return 39 Year 40 41 1 2

Topic: Bond Valuation

=15.85+28.06

4 =4/2 0.1 0.08 Dividend PV Factor PV of at 8% =1/1.08 Dividend =2*0.9259

=0.9259/1 =2.20*0.85 42 2 =2*110% .08 73

=2.20*110 =0.8573/1 =2.42*0.79 43 3 % .08 38

=2.42*110 =0.7938/1 =2.66*0.73 44 4 % .08 50

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Sub: Finance

Topic: Bond Valuation
=2.66*110 =0.7350/1 =2.93*0.68

45 5

%

.08

06 =SUM(1.85

46 PV of dividends up to year 5

:1.99) =1.99*

47 Earnings for year 5 48 Earnings for year 6 49 Dividend for year 6(D6) 50 Dividend growth rate (g) 51 Required Rate of Return (K) Value of stock at the end of year 5 (P5) = 52 D6/(K-g)

2 =5.86 =5.86 0 0.08

=5.86/(0.08-0) =73.21/POWE

53 PV of P5 Price of Stock = PV of dividends up to 5 years + PV of 54 price of stock at year 5 55

R(1.08,5)

=9.61+49.82

(b)

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Sub: Finance
A 57 B C

Topic: Bond Valuation

Growth, Stable, Inc. Inc. \$59.43 \$4 14.9 3.33% 4.5

58 59 60 61 62 63

Price of Stock Earnings per share P/E Ratio Average Growth Rate PEG Ratio

\$43.91 \$4 11.0 6% 1.8

Excel Workings A 57 58 59 60 61 Price of Stock Earnings per share P/E Ratio Average Growth Rate PEG Ratio B Growth, Inc. =43.91 4 =43.91/4 0.06 C Stable, Inc. =59.43 4 =59.43/4 0.0333

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Sub: Finance
62 63 =11.0/6 =14.9/3.33

Topic: Bond Valuation

(c) A higher PEG Ratio indicates that the stock has been overvalued. Therefore, though Stable, Inc. has a high P/E Ratio, it also has a higher PEG Ratio than Growth, Inc. one should buy Growth, Inc. which will have a bettr value in future. (d) Growth, Stable, Inc. P/E Ratio 11.0 Inc. 14.9 5% 3.0

Average Growth Rate 5% PEG Ratio 2.2

Excel Workings P/E Ratio Growth, Inc. Stable, Inc. =14.9 0.05

Average Growth Rate =11.0 PEG Ratio 0.05

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Sub: Finance
=11.0/5 =14.9/5

Topic: Bond Valuation

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Sub: Finance

Topic: Bond Valuation

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