Chapter 8

CHAPTER 8
THE VALUATION AND CHARACTERISTICS OF STOCK
FOCUS
Like bonds, stocks are worth the present value of their expected future cash flows, but the process of
estimating that value is far less precise than it is for bonds. We begin studying stock valuation with
basic ideas comparing equity cash flows with those associated with bonds. fter mastering these
concepts we turn to growth models of valuation beginning with the constant growth case and moving on
to the more complex two!stage model.
"n the second half of the chapter we consider some issues of corporate control along with the rights
and privileges of stockholders. #he point is made, however, that most equity investors are only in for
the money, not for a voice in running the company. $referred stock is discussed briefly as is securities
analysis.
#he chapter concludes with a detailed treatment of options and warrants. #he section opens with an
introductory illustration of an option to buy real estate. #his gets students used to the option concept
before taking up a more quantitative treatment of stock options. We finish with a discussion of the
problems created by stock options as executive compensation.
PEDAGOGY
%tock valuation models can be fairly complex as is the entire sub&ect of options. careful, motivated
development of the ideas, always starting from scratch, gets the concept and method across.
TEACHING OBJECTIVES
fter this chapter students should
'. ppreciate the difference between stock and bond valuation understanding that estimating the
value of a stock is far more sub&ective.
(. )nderstand and be able to apply growth model valuation techniques including the relatively
complex two stage model.
*. +ave a basic understanding of how corporations are run and the role ,or lack of it- of stockholders.
.. Comprehend the nature of preferred stock and its valuation.
/. ppreciate the idea of securities analysis including the difference between fundamental and
technical analysis and the message behind the 01+.
2. )nderstand the basics of stock options and warrants.
OUTLINE
". C31134 %#3C5
3wnership of stock in large companies generally represents an investment only. 6ew investors
expect a role as an owner.
. #he 7eturn on an "nvestment in Common %tock
8ividend and Capital 9ains :ields
;. #he 4ature of Cash 6lows from Common %tock 3wnership
#he imprecise nature of dividends and sale proceeds compared with a bond<s cash flows.
C. #he ;asis of =alue
"ntrinsic value based on the present value of estimated future cash flows.
"". 973W#+ 1380L% 36 C31134 %#3C5 =L)#"34
#he usefulness of a model based only on an assumption about growth.
. 8eveloping 9rowth ;ased 1odels
%witching to an infinite stream of dividends.
'8(
Chapter 8
;. #he Constant 9rowth 1odel
8eveloping and applying the 9ordon 1odel.
C. #he 0xpected 7eturn
#he expected return in the constant growth case.
8. #wo %tage 9rowth
#he model applied to situations in which constant growth is preceded by super normal growth.
0. $ractical Limitations of $ricing 1odels
3ur results are no better than our inputs, which are usually pretty rough.
""". %310 "4%#"#)#"34L C+7C#07"%#"C% 36 C31134 %#3C5
. Corporate 3rgani>ation and Control
#he role of the ;oard of 8irectors
;. =oting 7ights and "ssues
1a&ority and cumulative voting
C. %tockholders< Claims on "ncome and ssets
;eing last in line can be good or bad.
"=. $70607708 %#3C5
. =aluation of $referred %tock
=aluation as a perpetuity
;. Characteristics of $referred %tock
Why and how preferred is a hybrid between debt and common equity. #ax issues and risk.
=. %0C)7"#"0% 4L:%"%
brief overview of fundamental analysis, technical analysis and the 01+.
=". 3$#"34% 48 W774#%
. 3ptions in 9eneral
n option on land provides an intuitive introduction to the concept.
;. Call 3ptions
#erminology, intrinsic value, the writer and the buyer, why options have value, detailed
explanation of leverage, a broad numerical example.
C. $ut 3ptions
;rief description.
8. Warrants
8istinguished from options. primary market phenomenon.
0mployee stock options. #he problems created by compensating top executives with stock
options.
DISCUSSION QUESTIONS
'. 8iscuss the nature of stock as an investment. 8o most stockholders play large roles in the
management of the firms in which they invest? Why or why not?
ANSWER: #he return on a stock investment comes from dividends and price appreciation. lthough
neither is guaranteed, both have the potential for growth in the future. #his is in distinct contrast to
investments in debt vehicles that guarantee future payments but offer little or no possibility of a return
that<s higher than promised.
lthough stock implies ownership, few equity investors expect to play a role in running the
companies whose shares they buy. %uch firms are widely held, and few stockholders have large enough
blocks of stock to influence management decisions.
"n small business, of course, owners usually run their companies.
'8*
#he =aluation and Characteristics of %tock
(. Compare and contrast the nature of cash flows stemming from an investment in stock with those
coming from bonds.
ANSWER: #he cash flows associated with both stocks and bonds consist of a stream of relatively
small amounts followed by a final larger payment. #he streams are dividends for stocks and interest
payments for bonds, while the final payments are the selling price of stock and the return of a bond<s
principal.
#he similarity between the flows is rather superficial, and doesn<t go far beyond the general shape
&ust described. ;oth the interest and principal payments associated with a bond are contractually
guaranteed, and tend to be very reliable. stock<s cash flows, on the other hand, are quite risky.
8ividends can increase or decrease from their current levels or be omitted entirely at the discretion of
the firm<s board of directors. %imilarly, the eventual selling price of a share is dependent on the
company<s performance and the state of the stock market at the time of sale. ;oth of these are sub&ect to
unpredictable changes.
*. =erbally rationali>e the validity of a stock valuation model that doesn<t contain a selling price as
a source of cash flow to the investor. 9ive two independent arguments.
ANSWER: "ntuitively, a stock<s value to an investor is best represented by the present value of the
dividends paid while the share is held plus the present value of the price received upon sale. +owever,
that final selling price can be replaced by a similar model of value in the mind of the investor who buys
the share. #hus at the end of the first investor<s holding period, another stream of dividends begins,
followed by an eventual selling price. "n effect the valuation model has been transformed into a longer
stream of dividends and a selling price by the consideration of two sequential investors. #his mental
construct can be applied as many times as we like and the eventual selling price pushed indefinitely far
into the future where its present value is >ero. We<re left with &ust the present value of an infinitely long
series of dividends.
lternately, imagine the investing community acting as a single unit to value stock offered for sale by
an issuing company. "n other words, imagine that the financial world consists of the company and @the
market@ only. "n that scenario, trades between investors inside the market are not observable or
relevant. ll that counts is the price the market as a whole puts on the stock. ;ut the only basis for that
price is the future payments to be made by the firm to the investing community. #hose are &ust the
dividends it pays to whoever in the community happens to own the stock. +ence the community acting
as a whole can only base value on all future dividends and nothing else.
.. Why are growth rate models practical and convenient ways to look at stock valuation?
ANSWER: 6orecasting the future of a business and the price of its stock is a difficult and imprecise
task especially for outsiders who don<t have access to the company<s detailed plans and records.
+owever, an overall evaluation is often formed based on a variety of imprecise observations and
feelings about the company. #hat sub&ective feeling can be nicely summed up in a pro&ected growth
rate. 9rowth rate models allow us to estimate stock prices based on this summary information which
although incomplete is often all we have.
/. What is meant by normal growth? Contrast normal and super normal growth. +ow long can
each last? Why?
ANSWER: 4ormal growth implies a forecast dividend growth rate that is less than the return required
on an investment in the stock. %uper normal growth implies the reverse, a growth rate greater than the
required return. %uper normal growth exists, but is generally assumed to be temporary. "t is usually
modeled to last no more than a few years. 4ormal growth can last indefinitely. #he implication of
super normal growth that lasts indefinitely is an infinite value for the company and its stock, which
'8.
Chapter 8
doesn<t make sense. ,#his is apparent from 0quation ,A!B- in which the numerators exceed the
denominators by larger and larger amounts if gCk.-
2. 8escribe the approach to valuing a stock expected to grow at more than one rate in the future.
Can there be more than two rates? What two things have to be true of the last rate?
ANSWER: #he two!stage growth model separates the future into two periods. #he first is a finite
number of years during which the growth rate can have any value but is usually assumed to be super
normal. #he second period is infinitely long and is characteri>ed by normal growth. #he procedure
pro&ects the firm<s dividends from the present until &ust after normal growth begins. #he 9ordon 1odel
is then used to determine the value of the stock at the beginning of the period of normal growth. #he
value of the stock today is the sum of the present values of the 9ordon 1odel amount and all the
calculated dividends up until that time.
A. 8iscuss the accuracy of stock valuation, and compare it with that of bond valuation.
ANSWER: %tock valuation is considerably less precise than bond valuation for two reasons. 6irst,
there<s a big difference in the predictability of the future cash flows associated with the two instruments.
;ond payments are contractually specified and generally quite reliable. 8ividends and the eventual
selling price of stocks, on the other hand, are uncertain even for stable companies. %econd, the
appropriate discount rate for taking present values is an estimate based on perceived risk for stock,
while it is a more readily known market return for bonds.
8. 8o stocks that don<t pay dividends have value? Why?
ANSWER: %tocks that don<t pay dividends have value because they are expected to pay dividends at
some time in the future. #his is true even if management states its intent never to pay out its earnings as
dividends. #he absence of dividends at some time during the firm<s life implies that stockholders would
never receive any value for their investments.
B. $referred stock is said to be a hybrid of common stock and bonds. 0xplain fully. 8escribe the
cash flows associated with preferred stock and their valuation.
ANSWER: $referred stock pays a constant dividend that is specified in amount but not guaranteed.
+owever, the cumulative feature generally requires that preferred dividends be caught up before
common dividends can be paid. #he value of a preferred share is the present value of the perpetuity of
its dividends.
$referred stock is legally equity but in some ways behaves more like debt. "t is viewed as a hybrid
because its characteristics are like those of common stock on some issues, like those of bonds on other
issues, and lie somewhere in between on still others. #he main issues are as follows.
,'- $referred dividends are constant, as are interest payments. #hey are unlike common stock
dividends, which are usually expected to grow.
,(- ;onds have maturity dates on which principal is returned. $referred, like common stock, has no
maturity, and never returns principal.
,*- "nterest must be paid, common dividends can be passed indefinitely. $referred dividends are
between in that they can be passed, but are sub&ect to a cumulative feature.
,.- "n bankruptcy, the priority of preferred is between that of bonds and common stocks.
,/- Like bondholders, preferred stockholders have no voting rights.
,2- "nterest is tax deductible to the paying company while dividends, common or preferred, are not.
'8/
#he =aluation and Characteristics of %tock
'D. 8iscuss the relative riskiness of investment in bonds, common stock, and preferred stock.
ANSWER: #he features of bonds, preferred, and common stocks create an ordering of risk. ;onds are
the safest, because their payments are the most assured. Common is the most risky, because its
payments are the least certain. $referred is in the middle. #he compensation for bearing the risk of
common stock is that the return can be very high if the company does well. #hat possibility doesn<t
exist with bonds or preferred.
''. Compare fundamental analysis and technical analysis. Which makes more sense to you?
ANSWER: 6undamental nalysis involves doing research to discover as much as possible about a
company<s business, and forecasting its future performance, including dividends and market price, based
on that knowledge.
#echnical nalysis is based on the belief that market forces dictate prices and price movements, and
that movement patterns repeat themselves. #herefore, technicians believe that recogni>able patterns can
predict stock price changes.
6ollowers of the two schools of thought tend to be opposed to one another, although many people use
both ideas. cademics are generally fundamentalists. %tatistical studies have been unable to prove that
either approach is right or wrong.
'(. What does the efficient market hypothesis say? What is its implication for stock analysis?
ANSWER: #he efficient market hypothesis says that financial markets are efficient in that new
information is disseminated very rapidly. #his means that at any time, all available information is
reflected in stock prices, and studying historical patterns of price movement can<t consistently help
an investor in earning above average returns. #he 01+, therefore, contradicts the premise underlying
technical analysis.
"t also implies that fundamental analysis won<t help individual investors much, because professionals
are doing it all the time. #hey discover and disseminate anything an individual can figure out long
before he or she does.
'*. 3ptions are more exciting than investing in the underlying stocks because they offer leverage.
0xplain this statement.
ANSWER: Leverage is any technique that amplifies return. 3ptions amplify return because a given
percentage change in a stockEs price drives a percentage option price change that can be many times
larger. 6or example a 'DF change in a stock price might result in a (DDF change in the price of an
option on that stock. #hat means large gains and losses are possible in options due to only small or
moderate changes in stock prices.
'.. "s investing in options really investing or is it more like gambling?
ANSWER: "tEs more like gambling. 6or the following reasonsG
'. "tEs a high!risk search for large short!term gains rather than long term growth with low or
moderate risk.
(. #hereEs no economic benefit in that thereEs no transfer of funds from savers to companies that
will invest the money in productive assets.
'82
Chapter 8
BUSINESS ANALYSIS
'. :our cousin Charlie came into a large inheritance last year and invested the entire amount in the
common stock of ";8 "nc., a large computer company. %ubsequently he<s been very interested in the
company and watches it closely. 7ecently the newspaper carried a story about ma&or strategic changes
at ";8 including massive layoffs and business realignments. Charlie was devastated. +e doesn<t
understand how the firm could have made such changes without the knowledge and approval of its
stockholders. Write a brief letter to Charlie explaining how things really work.
ANSWER: Companies are run by managers, who are appointed by boards of directors. #he directors
in turn are elected by stockholders. #hus stockholders control companies only indirectly by electing
their boards. #ypically stockholders are not consulted on decisions relating to the running of the
company. #his is true even regarding ma&or issues. %tockholders do vote on a few issues spelled out in
the corporate bylaws. #hese typically include mergers.
Where no individual or group owns a substantial portion of a company, the board can become
entrenched and virtually run the firm as it pleases. 1ost stockholders view the firm strictly as an
investment, and are unlikely to @revolt@ unless financial performance becomes very bad.
PROBLEMS
Divided !d C!"i#!$ G!i Yie$d%& P!'e ()*
'.$aul 8argis has analy>ed five stocks and estimated the dividends they will pay next year as well as
their prices at the end of the year. +is pro&ections are shown below.
Current $ro&ected $ro&ected
%tock $rice 8ividend %tock $rice
H*A./D H'../ H.*.DD
; H(../D HD.BD H(2./D
C H/A.8D H(.'D H2*./D
8 HA..*/ 4one H8'.DD
0 H2..8D H*.'/ H2*.DD
Compute the dividend yield, capital gains yield, and total one!year return implied by $aulEs
estimates for each stock.
SOLUTION:
S#+,- A
8ividend :ieldG H'../IH*A./D J *.8AF
Capital 9ains :ieldG ,H.*.DD ! H*A./D-IH*A./D J '..2AF
#otal :ieldG *.8AF K '..2AF J '8./.F
S#+,- B
8ividend :ieldG H.BDIH(../D J *.2AF
Capital 9ains :ieldG ,H(2./D ! H(../D-IH(../D J 8.'2F
#otal :ieldG *.2AF K 8.'2F J ''.8*F
S#+,- C
8ividend :ieldG H(.'DIH/A.8D J *.2*F
Capital 9ains :ieldG ,H2*./D ! H/A.8D-IH/A.8D J B.82F
#otal :ieldG *.2*F K B.82F J '*..BF
'8A
#he =aluation and Characteristics of %tock
S#+,- D
8ividend :ieldG HDIHA..*/ J D.DF
Capital 9ains :ieldG ,H8'.DD ! HA..*/-IHA..*/ J 8.B.F
#otal :ieldG 8.B.F
S#+,- E
8ividend :ieldG H*.'/IH2..8D J ..82F
Capital 9ains :ieldG ,H2*.DD L 2..8D-IH2..8D J ,(.A8F-
#otal :ieldG ..82F K ,(.A8F- J (.D8F
S#+,- V!$.!#i+ B!%ed + P/+0e,#ed C!%1 F$+2% 3 E4!5"$e 86*& P!'e ()(
(. #he stock of %edly "nc. is expected to pay the following dividendsG
:ear ' ( * .
8ividend H(.(/ H*./D H'.A/ H(.DD
t the end of the fourth year its value is expected to be H*A./D. What should %edly sell for today if the
return on stocks of similar risk is '(F?
SOLUTION:
Cash 6low $=6'(,n $=
H(.(/ .8B(B H(.D'
H*./D .ABA( H(.AB
H'.A/ .A''8 H'.(/
H*B./D .2*// H(/.'D
H*'.'/
*. 6red #ibbits has made a detailed study of the denim clothing industry. +e<s particularly
interested in a company called 8enhart 6ashions that makes stylish denim apparel for children and
teenagers. 6red has done a forecast of 8enhart<s earnings and looked at its dividend payment record.
+e<s come to the conclusion that the firm will pay a dividend of H/.DD for the next two years followed
by a year at H2./D. 6red<s investment plan is to buy 8enhart now, hold it for three years and then sell.
+e thinks the price will be about HA/ when he sells. What is the most 6red should be willing to pay for
a share of 8enhart if he can earn 'DF on investments of similar risk?
SOLUTION:
Cash 6low $=6'D,n $=
H/.DD .BDB' H../2
H/.DD .8(2. H..'*
H8'./D .A/'* H2'.(*
H2B.B(
G/+2#1 R!#e% 7 C+,e"# C+e,#i+ E4!5"$e 868& P!'e ())
.. 1itech CorpEs stock has been growing at approximately 8F for several years and is now H*D.
;ased on past growth rate performance, what would you expect the stockEs price to be in five years?
SOLUTION:
$nK' J $n ,'Kg-
$/ J $D ,'.D8-
/
J $D,'.D8- ,'.D8- ,'.D8- ,'.D8- ,'.D8- J H*D.DD,'..2B*- J H...D8
'88
Chapter 8
T1e C+%#!# G/+2#1 9G+/d+: M+de$ 3 E4!5"$e 86(& P!'e ()8
/. #he %pinnaker Company has paid an annual dividend of H( per share for some time. 7ecently
the board of directors voted to grow the dividend by 2F from now on. What is the most you would be
willing to pay for a share of %pinnaker if you expect a 'DF return on your stock investments?
SOLUTION:
pply the 9ordon 1odel
$D J 8D,' K g- I ,k L g-
J H(,'.D2- I ,.'D .D2-
J H(.'( I .D.
J H/*.DD
2. #he $ancake Corporation recently paid a H* dividend, and is expected to grow at /F forever.
"nvestors generally require an expected return of at least BF before they<ll buy stocks similar to
$ancake.
a. What is $ancake<s intrinsic value?
b. "s it a bargain if it<s selling at HA2 a share?
SOLUTION:
a. A/ . A8 H
D/ . DB .
- D/ . ' , DD . * H
g k
- g ' ,
D
8
$
D
=

+
=
b. #hat<s not apparent. lthough our calculated intrinsic price exceeds the market price, it only does
so by about .F. #he modeling technique isn<t accurate enough to identify .F differences. 3ur result
says that the stock has probably been priced about right by the market.
A. #yler "nc.<s most recent annual dividend was H*.// a share. #he firm has been growing at a
consistent .F rate for several years, but analysts generally believe that better times are ahead, and that
future growth will be in the neighborhood of /F. #he stock is currently selling for HA/. %tocks similar
to #yler earn returns ranging from 8F to 'DF.
a. Calculate values for a share of #yler at interest rates of 8F, BF, and 'DF.
b. 8o you think #yler is a good investment for the long run, that is, for someone planning to hold
onto it for ten or more years?
c. 8o you think it<s a good investment for the short term? #hat is, should you buy it with the
expectation of selling in a relatively short period, say a year or less?
d. 7epeat the calculations of part a assuming that instead of rising, #yler<s growth rate ,'- remains at
.F or ,(- declines to *F.
e. Comment on the range of prices that you<ve calculated.
SOLUTION:
a.
05 . k
73 . 3 $
05 . k
) 05 . 1 ( 55 . 3 $
g k
) g 1 (
0
D

+
=
D
$

k $D

8F H'(..**
BF H B*.(/
'DF H A..2D
'8B
#he =aluation and Characteristics of %tock
b. #yler would appear to be a good investment based on the figures in part a. #he stock is priced at the
low end of a range of reasonable values. #his implies that, barring a ma&or unforeseen problem, it
should move generally upward over the next several years.
c. #yler<s value isn<t so clear in the short run, because we can<t say how long it will take the market to
recogni>e its intrinsic value and bid the price up.
d. g k $D
,'- .F 8F HB(.(/
.F BF HA*.8D
.F 'DF H2'./D
,(- *F 8F HA*.(D
*F BF H2'.DD
*F 'DF H/(.(B
e. "t<s important to understand how sensitive the model results are to changes in the assumptions about
return and growth rate. Whether the stock is a good buy at HA/ boils down to how good we feel about
those rates. 4otice that the rates in all the calculations seem reasonable but result in a range of values
from about H/( to H'(*, a wide spread indeed.
8. #he nderson $ipe Co. &ust paid an annual dividend of H*.A/ and is expected to grow at 8F for
the foreseeable future. +arley ;evins generally demands a return of BF when he invests in companies
similar to nderson.
a. What is the most +arley should be willing to pay for a share of nderson?
b. "s your answer reasonable? WhatEs going here? What should +arley do with this result?
SOLUTION:
a. pply the 9ordon 1odel
$D J 8D,' K g- I ,k L g-
J H*.A/,'.D8- I ,.DB .D8-
J H..D/ I .D'
J H.D/.DD
b. #he answer probably isnEt reasonable. #he valuation is too high because the denominator of
the model is too small a number. #hatEs because the growth rate and the required rate of return are too
close together. +arley probably isnEt demanding enough return to compensate him adequately for the
level of risk in nderson stock. +e should rethink his return requirement or disregard the modelEs
result.
B. Cavanaugh Construction speciali>es in designing and building custom homes. ;usiness has
been excellent, and Cavanaugh pro&ects a 'DF growth rate for the foreseeable future. #he company &ust
paid a H*.A/ dividend to its stockholders. Comparable stocks are returning ''F.
a. What is the intrinsic value of Cavanaugh stock based on this information?
b. 8oes this seem reasonable? Why or why not?
c. "f CavanaughEs growth rate is only 8./F and comparable stocks are really returning '(F, what
would the intrinsic value of CavanaughEs stock be?
d. 8o those relatively small changes in assumption &ustify the change in the intrinsic value of the
stock? Why or why not?
'BD
Chapter 8
SOLUTION:
a. #he 9ordon 1odel yields
MH*.A/ ,'.'D-N I ,.'' ! .'D- J H.'(./D
b. 4o, it does not seem reasonable. #he problem is that the growth rate of 'DF and the discount
rate of ''F are too close together for the constant growth model to work effectively.
c. MH*.A/ ,'.D8/-N I ,.'( ! .D8/- J H''2.(/
d. $robably not. #he assumptions in part c. appear to be more reasonable than those in part a., in
that they provide a sufficient spread in the growth and discount percentages for the constant
growth model to work more effectively. #he spread in the results is due to the fact that use of
the model is inappropriate with part a inputs.
V!$.!#i+ B!%ed + T2+ S#!'e G/+2#1 3 E4!5"$e 86;& P!'e (<*
'D. #he 1iller 1ilk Company has &ust come up with a new lactose free dessert product for people
who canEt eat or drink ordinary dairy products. 1anagement expects the new product to fuel sales
growth at *DF for about two years. fter that competitors will copy the idea and produce similar
products, and growth will return to about *F which is normal for the dairy industry in the area. 1iller
recently paid an annual dividend of H(.2D,which will grow with the company. #he return on stocks like
the 1iller Company is typically around 'DF. What is the most you would pay for a share of 1iller?
SOLUTION:
6irst draw a time line for the problem and enter the following data.
D ' ( *
8DJH(.2D 8'JH*.*8 8(JH...*B 8*JH../(

$( J
/A . 2. H
DA .
/( . . H
g k
8
*
*
= =

8' J 8D,'.*D- J H(.2D,'.*D- J H*.*8
8( J 8','.*D- J H*.*8,'.*D- J H..*B
8* J 8(,'.D*- J H..*B,'.D*- J H../(
$( J 8* I ,k L g(- J H../( I ,.'D .D*- J H2../A
$D J 8'M$=6'D,'N K 8(M$=6'D,(N K $(M$=6'D,(N
J H*.*8,.BDB'- K H..*B,.8(2.- K H2../A,.8(2.-
J H*.DA K H*.2* K H/*.*2
J H2D.D2
Problems 11 through 13 refer to Softek Inc., a leader in the computer software field. Softek has two
potentially big-selling products under development. lpha, the first new product, seems very likely to
catch on and is e!pected to drive the firm"s growth rate to #$% for the ne!t two years. &owever,
software products have short lives, and growth can be e!pected to return to a more normal rate of '%
after that period if something new isn"t launched immediately.
'B'
g( J *F g' J *DF
#he =aluation and Characteristics of %tock
(eta, the second product, is a logical follow-up, but management isn"t as confident about its success
as it is about lpha"s. Softek"s most recent yearly dividend was )*.++, and firms in the industry typically
return 1*% on stockholder investments.
''. :ou are an investment analyst for a brokerage firm, and have been asked to develop a
recommendation about %oftek for the firm<s clients. :ou<ve studied the fundamentals of the industry and
the firm, and are now ready to determine what the stock should sell for based on the present value of
future cash flows.
a. Calculate a value for %oftek<s stock assuming product lpha is successful but ;eta isn<t. "n other
words, assume two years of growth at (/F followed by 2F growth lasting indefinitely.
b. Calculate a price, assuming ;eta is also successful and holds %oftek<s growth rate at (/F for two
additional years.
SOLUTION:
a.
D ' ( *
8DJH..DD 8'JH/.DD 8(JH2.(/ 8*JH2.2*
88 . 8( H
D8 .
2* . 2 H
(
$ = =
$D J 8' M$=6'.,'N K ,8( K $(- M$=6'.,(N
$D J H/.DD,.8AA(- K ,H2.(/KH8(.88-,.A2B/-
$D J HA(.B8
b.

g' J (/F g( J 2F
D ' ( * . /
8iJH..DD H/.DD H2.(/ HA.8' HB.AA H'D.*/

*8 . '(B H
D8 .
*/ . 'D H
.
$ = =

$D J 8'M$=6'.,'N K 8(M$=6'.,(N K 8*M$=6'.,*N K ,8.K$.-M$=6'.,.N
$D J H/.DD,.8AA(- K H2.(/,.A2B/- K HA.8',.2A/D- K ,HB.AAKH'(B.*8-,./B('-
$D J HB2.82
'(. Calculate a price for %oftek assuming that lpha is successful and ;eta is successful, but doesn<t
do quite as well as lpha. ssume that %oftek grows at (/F for two years and then at '8F for two
more. fter that it continues to grow at 2F. ,&intG 8on<t be confused by the fact there are now three
growth periods. Oust calculate successive dividends multiplying by one plus the growth rate in effect
until you get the first dividend into the period of normal growth. #hen apply the 9ordon model. time
line is a must for this problem.-
SOLUTION:
'B(
g( J 2F g' J (/F
Chapter 8

g' J (/F g( J '8F g* J 2F
D ' ( * . /
8iJH..DD H/.DD H2.(/ HA.*8 H8.AD HB.((

(8 . ''/ H
D8 .
- D2 . ' , AD . 8 H
.
$ =
+
=
$D J 8'M$=6'.,'N K 8(M$=6'.,(N K 8*M$=6'.,*N K ,8.K$.-M$=6'.,.N
$D J H/.DD,.8AA(- K H2.(/,.A2B/- K HA.*8,.2A/D- K ,H8.ADKH''/.(8-,./B('-
$D J H8A./B
'*. +ow would you advise clients on the stock as an investment under the following conditions?
a. %oftek is currently selling at a price very near that calculated in part a of problem ''.
b. "t is selling near the price calculated in problem '(.
c. "t is selling at a price slightly above that calculated in part b of problem ''.
SOLUTION:
a. #his could be a good buy because the calculated price is counting on only the success of lpha,
which is fairly certain. ny success from ;eta will raise its value further.
b. #his a risky but not unreasonable investment, because moderate success from ;eta is factored into
the price. "t<s a middle of the road opportunity in that actual performance could be better or worse than
what is capitali>ed into the market price.
c. #his probably isn<t a wise investment. lthough the firm has good prospects in pro&ects lpha and
;eta, their success is already factored into the market price. %ince they aren<t likely to do better than the
performance included in the model, and could do worse, there<s nowhere for value to go but down.
#his is an important general point with respect to investing. %tudents tend to confuse good business
prospects with a good investment. firm with a good future isn<t a particularly good investment if its
current price already reflects those optimistic expectations.
'.. 9arrett Corp. has been going through a difficult financial period. 3ver the past three years, its
stock price has dropped from H/D.DD to H'8.DD per share. #hroughout this downturn, 9arrett has
managed to pay a H'.DD dividend each year. 1anagement feels the worst is over, but intends to
maintain the H'.DD dividend for three more years, after which they plan to increase it by 2F per year
indefinitely. Comparable stocks are returning ''F. "f these pro&ections are accurate, is 9arrett stock a
good buy at H'8.DD? +ow do you think the market feels about 9arrettEs management?
SOLUTION:
'B*
#he =aluation and Characteristics of %tock
a.

g' J DF g( J 2F
D ' ( * . /
8DJH'.DD H'.DD H'.DD H'.DD H'.D2 HB.((

H'.DD ,'.D2-
$* J PPPP!PP J ('.(D
.D/
$D J 8'M$=6'','N K 8(M$=6'',(N K 8*M$=6'',*N K ,$(-M$=6'',*N
$D J H'.DD,.BDDB- K H'.DD,.8''2- K H'.DD,.A*'(- K ,H('.(-,.A*'(-
$D J H'A.B.
t H'8, 9arrett is fairly priced but is not a bargain.
b. t ''F, the $= of the cash flows is H'A.B.. #his is very close to the current market price of the
stock, so apparently the market has some confidence that 9arrett will be able to deliver on its
earnings and dividend pro&ections. 9arrett stock is not a bargain, but appears to be priced &ust
about right.
'/. 9eneral 1achine Works "nc. ,91W- has been losing money for some time but has managed to
maintain an annual dividend of H'.. #he companyEs strategy is to restructure by getting smaller while
working on labor and product line problems at the same time. 3nce thatEs done management feels the
firm will return to profitability and begin a long period of growth at about *F per year. 91WEs stock
price has been declining steadily for some time and is now the neighborhood of H(D per share.
:ouEre an analyst for ;arnstead and +eath, a small brokerage firm that employs a number of
financial consultants who advise clients on stock investments. %ome of the consultants feel that 91WEs
strategy will work as planned and have asked you if they should tell their clients that this is a good time
to buy 91W stock. +ow would you advise them? ssume clients demand a return of about 'DF and
that dividends will shrink by 'DF per year for * years.
SOLUTION:
WeEll approach this problem by modeling 91W managementEs assumptions using the two
stage growth model assuming a negative 'DF growth rate for three years followed by an indefinite
period of normal growth at *F. 3ur goal will be to see if the model gives us an intrinsic value that
exceeds H(D per share. "f it does, now might be a good time to by the stock. "f our result is below that
price, however, the implication is that our investors should stay away from 91W at this time.
6irst draw a time line out four years and walk the dividends forward until one period after the
assumed growth rate changes. %tart with 8D J H'.DD and multiply successively in the first three periods
by ,'Kg'- which is .B in this case since g' is !'DF. #hen multiply by '.D* for 8.
!'DF *F
'B.
Chapter 8
D ' ( * .QQQQ
H'.DD H.BD H.8' H.A* H.A/
4ext calculate $*, the price at the point at which the growth rates change
8. H.A/ .A/
$* J PPPP J PPPP J PPP J H'D.A'
k ! g( .'D ! .D* .DA
6inally, sum the present values of 8', 8(, 8*, and $* to get $D, the intrinsic value of the stock today.
$D J ,H.BD-,.BDB'- K ,H.8'-,.8(2.- K ,H.A*-,.A/'*- K ,H'D.A'-,.A/'*-
J H.8( K H.2A K H.// K H8.D/
J H'D.DB
#his result implies that 91W is substantially over priced at H(D. We should advise our clients to avoid
the investment.
'2. %udsy "nc. recently paid an annual dividend of H'.DD per share. nalysts expect that amount to
be paid for three years after which dividends will grow at a constant /F per year indefinitely. #he stock
is currently trading at H(D, and investors require a '/F return on similar issues. +as the stock market
properly priced %udsyEs stock?
SOLUTION
WeEll solve this problem using a variant on the two stage growth model with a DF first stage
growth rate. #he stockEs value today will be the sum of the present value of three H' dividends plus the
present value of all dividends to be paid after /F growth starts in year .. )se the present value of an
annuity formula to calculate the present value of the first three dividends.
$= J$1# M$=6k,nN J H'.DDM$=6'/,*N J H'.DDM(.(8*(N J H(.(8
#hen apply the 9ordon 1odel at the end of year three to get the present value of the growing stream of
future dividends at that time. #his figure is the pro&ected price of the stock at the end of year three.
$* J 8.I,k!g- J H'.DD,'K.D/- I ,.'/!.D/- J H'D./D
#his sum is discounted back three years as an amount for a current present value.
$= J $= M$=6k,nN J H'D./D M$=6'/,*N J H'D./DM.2/A/N J H2.BD
#he stockEs price today is the sum of these present values.
$D J H(.(8 K H2.BD J HB.'8
which is substantially less than H(D. +ence the stock is significantly overvalued.
P/i,i' P/e=e//ed S#+,- 3 E4!5"$e 86)& P!'e (8>
'A. ;lackstone Corporation<s HA preferred was issued five years ago. #he risk!appropriate interest
rate for the issue is currently ''F. What is this preferred stock selling for today?
SOLUTION:
2. . 2* H
'' .
A H
k
p
8
p
$ = = =
'8. 6ox Woodworking "nc. issued preferred shares at a face value of H/D to yield BF 'D years ago.
#he shares are currently selling at H2D. What return are they earning for investors who buy them today?
'B/
#he =aluation and Characteristics of %tock
SOLUTION:
8p J H/D .DB J H../D

k
H../D
H2D =
k J H../D I H2D.DD J A./F
'B. #he following preferred stocks are returning 8./F to their ownersG
%tock 8ividend F Current $rice
/F H'..A'
; AF H.'.'8
C ''F H'(B..'
Calculate the prices at which they were issued.
SOLUTION:
Current return J H 8ividend I Current price
and
H 8ividend J ,8ividend F- R ,"ssue price-
%ubstituting
Current return J M,8ividend F- R ,issue price-N I Current price
%olving for "ssue price yields
"ssue price J current return R current price I dividend F
%tock G "ssue price J .D8/,H'..A'- I .D/ J H(/.DD
%tock ;G "ssue price J .D8/,H.'.'8- I .DA J H/D.DD
%tock CG "ssue price J .D8/,H'(B..'- I .'' J H'DD.DD
(D. 5oski and +ass ,5S+- &ust paid a H( dividend which is expected to grow at /F indefinitely.
#he return on comparable stocks is BF. What percent of the intrinsic value of 5S+ stock is
derived from dividends paid more than (D years into the future?
SOLUTION:
)se the 9ordon 1odel to estimate the stockEs intrinsic valueG
$D J 8D,'Kg- I ,k!g- J H(.DD ,'.D/-I,.DB ! .D/- J H/(./D
#he $= of all of the dividends after the first (D is found by estimating the value of the
stock after (D years of growth at /F, and discounting it back to the present at BF.
%tock price in (D years J H/(./D ,'.D/-
(D
J H'*B.*D
#he present value of that amount is H'*B.*DI,'.DB-
(D
J H(..82
#herefore, H(..82IH/(./D or about .A..F of the intrinsic value of the stock comes from
dividends more than (D years into the future.
S#+,- O"#i+% 3 E4!5"$e 86<& P!'e (8?
('. %eth +arris is an avid investor who likes to speculate on stock price changes. Lately heEs
become bored with the slow movement of most stock prices and thinks options might be more exciting.
+eEs been following the stock of Chelsea Club "nc., a womenEs apparel manufacturer. ChelseaEs stock
'B2
k
p
8
p
$ =
Chapter 8
price has been stable for more than a year, but %eth is convinced it will increase in the near future but
probably not rapidly.
manda Oohnson owns ',DDD shares of Chelsea Club purchased a year ago at H*A. %he thinks
the stockEs price will continue in the upper H*Ds indefinitely and may even fall a little. +er broker has
recommended writing options as a source of income on stagnant stocks.
Chelsea is selling for H*8, and six month call options at a H*2 strike price sell for H..
#his morning manda wrote call options on her ',DDD shares which %eth bought through an
options exchange. t the time of that transactionG
a. What was the intrinsic value of an option?
b. What was the optionEs time premium?
c. Was the call in or out of the money?
d. +ow much has manda invested?
e. What is the most %eth can make or lose?
f. What is the most manda can make or lose?
"tEs almost six months later, Chelsea is selling for H.., mandaEs options are about to expire, and %eth
exercises.
g. What is %ethEs profit or loss?
h. What is mandaEs profit or loss?
i. 8oes manda incur an Topportunity loss?U "f so how much is it?
&. What would mandaEs profit or loss have been if her call had been written naked.
SOLUTION:
a. ="C J $s ! $%trk
J H*8 ! H*2
J H(
b. #ime $remium J $3p ! ="C
J H. ! H(
J H(
c. #he call option was in the money because the stockEs market price was above the options
strike price.
d. manda committed the shares she had previously purchased for H*A offset by the receipt of
the option price of H.. 3n a per share basis her investment was
"nvestment J $% L $3p
J H*A ! H.
J H**
3n ',DDD shares her investment was H**,DDD.
e. %eth canEt lose any more than the option price of H., H.,DDD in total. "n theory, thereEs no
limit to what he can make.
f. #he most manda can make is the option price of H. or H.,DDD. #his happens if %eth doesnEt
exercise the options. "f he does, sheEll have to sell him shares for H*2 that she bought at H*A.
+ence her per share gain will be reduced by H' to H*, for a total of H*,DDD. #hatEs the worst she
can do on paper. "n fact, sheEll have an Topportunity lossU of the difference between H*2 and
the share price at the time of exercise, reduced by the option price.
g. 1arket price of stock at time of exercise H..
LessG %trike price ,H*2-
$rice of option , .- ,H.D-
'BA
#he =aluation and Characteristics of %tock
9ain H .
#otal gain H. x 'DDD H.,DDD
h. $rice manda originally paid for the stock ,H*A-
$lusG %trike price H*2
$rice of option . H.D
9ain H *
#otal gain H* x 'DDD H*,DDD
i. "f manda hadnEt written the option, at the time it was exercised she could have sold her stock
for H... "t cost her H*A, so her gain would have been HA per share. %ince she made only H*, her
opportunity loss is H. per share, or H.,DDD in total.
&. 1arket price of stock at time of exercise ,H..-
$lusG %trike price H*2
$rice of option . H.D
Loss ,H .-
#otal loss ,H.- x 'DDD ,H.,DDD-
COMPUTER PROBLEMS
((. #he 7ollins 1etal Company is engaged in a long!term planning process and is trying to choose
among several strategic options, which imply different future growth rates for the company.
1anagement feels that the main benefit of higher growth is that it enhances the firm<s current stock
price. +owever, high growth strategies have a cost in that they generally involve considerable risk.
+igher risk means that investors demand higher returns which tends to depress current stock price.
1anagement is having a hard time evaluating this cost!benefit trade!off because growth and risk are
conceptual abstractions. "n other words, it<s hard to visuali>e how growth and risk interact with each
other as well as with other things to produce stock prices. 1anagement can, however, intuitively
associate each strategy option with a growth rate and a required rate of return implied by risk.
:ou are a financial consultant who<s been hired to help make some sense out of the situation. :ou
feel your best approach is to develop a systematic relationship between return, growth and stock price
that you can show to management visually.
)se the STCKVAL program to develop the following chart assuming the strategic options result in
different constant growth rates that start immediately. #he firm<s last dividend was H(.*/ per share.
T1e P/i,e += R+$$i% S#+,-
!% ! F.,#i+ += G/+2#1 R!#e
Ad #1e Re#./ Re@.i/ed AB Ive%#+/%
'B8
Chapter 8
973W#+ 7#0%

2F 8F 'DF '(F

7equired AF
7eturns ,k-
BF
''F
'*F
Can you make any general comments about the risk!return tradeoff based on your chart?
SOLUTION: T1e P/i,e += R+$$i% S#+,-
!% ! F.,#i+ += G/+2#1 R!#e
Ad #1e Re#./ Re@.i/ed AB Ive%#+/%
973W#+ 7#0%
2F 8F 'DF '(F

7equired AF
7eturns ,k-
BF
''F
'*F

#he stock price is relatively constant along diagonal lines within the matrix where k!g is also constant.
#hat implies the main driver of value in the model is the difference between the growth rate and the
return ,the denominator-. "f that reflects reality, it makes little sense to go after the high growth!high
return situations in the lower right, as they should entail a high risk of failure. ccording to the model,
prices nearly as high can be achieved at lower risk levels where required returns are similarly low. #his
interpretation strains the model<s credibility.
(*. %uppose the strategic options available to the 7ollins Company in the last problem result in
temporarily enhanced growth. 0ach option can be associated with a super normal growth rate that lasts
for some period after which growth returns to the firm<s normal /F. 6urther suppose the duration of the
super normal growth is a variable that can also be affected by strategic policy. )se the STCKVAL
program for two!stage growth to develop the following chart assuming a required return of 'DF.
T1e P/i,e += R+$$i% S#+,-
!% ! F.,#i+ += Te5"+/!/B G/+2#1 R!#e !d D./!#i+
!# ! Re@.i/ed R!#e += Re#./ += *>C
'BB
H(.B 4 4 4
H8* H(/. 4 4
H/D H8/ H(/B 4
H*2 H/' H82 H(2*
#he =aluation and Characteristics of %tock
%)$07 4371L 973W#+ 7#0%,g'-

'(F '.F '2F '8F

8uration (
of g' in
years ,n- .
2
8
Can you use your charts to make any general comments about the risk!return tradeoff under this
assumption about the nature of the strategic options?
SOLUTION:
T1e P/i,e += R+$$i% S#+,-
!% ! F.,#i+ += Te5"+/!/B G/+2#1 R!#e !d D./!#i+
!# ! Re@.i/ed R!#e += Re#./ += *>C
%)$07 4371L 973W#+ 7#0%,g'-

'(F '.F '2F '8F

8uration (
of g' in
years ,n- .
2
8

#he benefit of extending the duration of the super normal growth is substantial. 6or the figures
shown it is in the same order of magnitude as raising the rate of super normal growth. +ence, it<s a
viable policy option.
DEVELOPING SOFTWARE
(.. $rogram your own two!stage growth model for two years of super normal growth ,g'- followed
by normal growth ,g(- lasting forever. #reat both growth rates, the last dividend ,8D-, and the required
rate of return ,k- as inputs. +ere<s how to do it.
'. Lay out four cells hori>ontally in your spreadsheet ,to represent a time line starting with time
>ero-.
(. $ut 8D in the first cell.
*. 6orm the next two cells by multiplying the one before by ,'Kg'-.
.. 6orm the fourth cell by multiplying the third by ,'Kg(-.
(DD
H/2 H/8 H2D H2(
H2* H2A HA( HAA
HAD HAA H8/ HB*
HAA H88 H'DD H''*
Chapter 8
/. Calculate $( in another cell using the 9ordon 1odel with the fourth cell in the numerator and ,k!
g(- in the denominator.
2. 6orm $D as the sum of the present values of the middle two cells in the time line and the present
value of the cell carrying $(.
SOLUTION: sample solution is on the Website under "nstructor<s 7esources.
(/. $rogram a model for three years of super normal growth.
SOLUTION: sample solution is on the Website under "nstructor<s 7esources.
(D'