# Investment Analysis (FIN 670) Fall 2009

Homework 8

Instructions: please read carefully • • You should show your work how to get the answer for each calculation question to get full credit The due date is Tue Dec 15, 2009. Late homework will not be graded.

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A constant-growing stock just paid \$2 dividend and has a current market price of \$30. 8. a. Assume that the rate of return on the stock is 14% and its last dividend was \$1 per share. \$16. Southwest just paid a \$2 dividend. Its dividend is expected to grow by 5% in the coming year. a.05) = 16. 5% b. \$15. 12% d.14-0. D2 D1 = D0(1+g*) = 1(1+.8 b.2 1.3% 3.2 D2 = D1(1+g*) = 1. \$16. Determine the current price of the company's stock.512 P2 = 1.05) = 2.1 1 2 (1 + 0. D2. b dividend yield = D1/P0 D1 = D0(1+g) = 2(1+0. Stock analysts just predicted that Hybrid Engine Company's earnings and dividends will grow at 20% each year for the next two years due to its new invention. The required rate of return on Southwest is 15%. After that.44 Step 2: compute P2 = D3/(k-g) D3 = D2(1+g) = 1.8 2.12 2.1 So dividend yield = 2.1/30 = 0. Determine the common stock's dividend yield and capital gain yield for the first year.2)= 1.05 = 0. 7% c.8 Step 3: Compute P0 by discounting D1.05)= 1. 5% b. b Step 1: compute D1. 6.14) (1 + 0. \$13.14) 2 3. Determine the stock's required rate of return if the company's constant growth rate is 5%.44(1+0.05)/30 + 0. 14% 1. 7%. its growth rate will stabilize at 5% per year indefinitely.1 d. Southwest Technology's common stock is selling at \$30 per share today.512/(0. 5%. a. and P2 to present P0 = 1.7%. 10% d. 10%.1 c.2(1+1.1.2) = 1. c R = D1/Po + g = 2(1+0.8 + + = 15. 8% c.14) (1 + 0.44 16.07 .

so the current stock price not only depends on dividend. their stocks must sell at the same current price or else the market will not be in equilibrium.1) 4 5. D2. All of the above are correct.We have total return = dividend yield + capital gain yield 15% = 7% + capital gain yield So capital gain yield = 15% . the current stock price of a company is ______________. will not pay any dividends for the next three years. True. Heavenly Hotels. \$15 Step 1: Compute D1. \$20 b. What price should the stock be selling now? a. D3. . False. D4 to present. so we only need to discount D4 and P4 P0 = 2. \$12 d. D4 D1 = D2 = D3 = 0 D4 = 2 Step 2: compute P4 = D5/(k-g) P4 = 2/(0. b. The required rate of return on the company's common stock is 10%.b P0 = D1/(k-g). If two firms have the same current P/E ratio and the same EPS. a. Heavenly will pay its first dividend of \$2. the sum of the present values of all future dividends c. 5. D2. D3.00 per share at the end of year four and its dividends will stay the same forever. \$16 c. zero if the company does not pay dividends d. D1 = D2= D3 = 0.1) (1 + 0.0 20 + = 15 4 (1 + 0. According to the dividend discount model. Inc. but also on required return k 6. 6. If two firms have the same current dividend and the same expected growth rate.1-0) = 20 Step 3: Find P0 by discounting D1. their stocks must sell at the same current price or else the market will not be in equilibrium. a. the sum of all future dividends b. growth rate. In this case.b 7.7% = 8% 4.

\$20. Which of the following statements is most correct for a zero growth stock? a. At what price and P/E ratio would you expect the firm to sell e. Investor expect 12% rate of return on the stock 10.06 P/E = \$23.33 and 12. None of the above is correct.33 and 11. As a result.12 12.67 h.30.40 = = \$23.00 = \$23. A company's stock price will rise with an increase of its plowback ratio if ______________.20 × 0. . 6.30) = \$1. 7.23 and 13.66 d.47 i. d. What is the present value of growth opportunity a. d 9. the firm projects an ROE of 20%. g = ROE × b = 0.a PVGO = P0 – E0 \$2. b.66 11.66 k 0. the company's ROE = its growth rate d. 9. \$23.66 b.0% D1 = \$2(1 – b) = \$2(1 – 0.06 = 6.33 – = \$6.40 P0 = D1 \$1. \$23. a. a 8. \$24. and it will maintain a plowback ratio of 0.67 f.a.66 c. Its earning this year will be \$2 per share (E1=2). the company's ROE = its required rate of return b.67 11. 33 and 12. The stock's price one year from now should be the same as its current price. Calculate the P/E ratio and the present value of growth opportunities if the firm planned to reinvest only 20% of its earning. the company's ROE > its required rate of return 8.67 a. 5.30 = 0.00 and 11. 7.50 g. The stock pays zero dividends. False.33/\$2 = 11. the company's ROE < its required rate of return c. The stock's dividend yield is larger than the stock's required rate of return. b. \$22.12 − 0. 8.33 k − g 0. True. c. a The following information is for question 10-12 Even Better Products has come out with a new and improved product.

00 = = \$25.0% D1 = \$2(1 – b) = \$2(1 – 0.08 = 8. required return is 12%.12 − 0. c.33 = \$20.16 × 0.12 13.00 k − g 0.00 P0 = D1 \$1. b.20) = \$1. 25 26 27 28 29 a.04 P/E = \$20/\$2 = 10.0 PVGO = P0 – E0 \$2.g = ROE × b = 0.12 − 0.08 .0% D1 = \$2(1 – b) = \$2(1 – 0.60 = = \$20.00 k − g 0. If the coming year earning are expected to be \$2 per share (E1=2). e. g = ROE × b = 0.60 P0 = D1 \$1.50) = \$1.20 × 0.00 = \$3.20 = = 0. MF Corp. has an ROE of 16% and a plowback ratio of 50%. d.5 = 0. What price will the stock sell today? a.00 – k 0.04 = 4.

14 × 0. Intrinsic value = V0 \$1/(0.5 = 7.728% 16.04728) = \$18.00 25 Expected return on equity. The required return for both stock A and B is 10% per year Stock A 14% \$2. What is the intrinsic value of each stock (assume constant growth dividend model) c.07) = \$33.00 1. Which stock would you choose to buy? Which stock would you choose to sell/short sell .00 27 Stock B 12% \$1.65 = 0.12 × 0. What are the expected dividend payout ratios for the 2 stocks Dividend payout ratio = 1 – b Stock A \$1/\$2 = 0. ROE Estimated earnings per share E1 Estimated dividends per share.97 17. P0 14.10 – 0.50 Stock B \$1/\$1.Your preliminary analysis of two stocks has yielded the information set forth below.394 = 4.10 – 0. D1 Current market price per share.606 15.33 \$1/(0.0% 0.65 1. What are the expected dividend growth rates of each? Growth rate = g = ROE × b 0.

16 ⎛ DPS ⎞ ⎛ \$0. You might choose to sell short stock B since its intrinsic value is lower than market price 18. what should be the intrinsic value of the stock on December 31. To begin. so I would like you to analyze the value of the company. equity shares. Katrina Shaar: “We have been considering the purchase of Rio National Corp.0934 = 9. 2002. 2002? The sustainable growth rate of Rio National is 9. using the constant growth model and the capital asset pricing model. She decides to calculate the growth rate of the company itself.-based company and the largest competitor in its industry.20 ⎞ = ⎜1 − = 0. 2002. is a U. Exhibit 18D presents relevant industry and market data.34% ⎜1 − ⎟× ⎟× EPS ⎠ Average Equity ⎝ \$1. Exhibits 18A–18C present financial statements. Use 2002 beginning-of-year balance sheet values. Rio National Corp.You would choose to invest in Stock A since its intrinsic value exceeds its price.31 + 270.07 k−g 0.8(9% – 4%) = 13% Calculate the share value using the Gordon growth model: P0 = D o × (1 + g) \$0. Assume this rate is constant over time.40.5 × (307. calculated as follows: g = b × ROE = Earnings Retention Rate × ROE = (1 – Payout Ratio) × ROE = Net Income \$30. a.12 b.20 × (1 + 0. The portfolio manager of a large mutual fund comments to one of the fund’s analysts.35) ⎝ P0 = D o × (1 + g) \$0.89 ⎠ 0. you can assume that the company will grow at the same rate as the industry. Calculate the sustainable growth rate of Rio National on December 31. based on Rio National’s past performance.40 k−g 0.0934 .13 − 0. as shown below.S.20 × (1 + 0. The value of a share of Rio National equity using the Gordon growth model and the capital asset pricing model is \$22.12) = = \$22. Now if Katrina Shaar decides not to use the growth rate of the industry to be the growth rate of Rio National.0934) = = \$6. Assumes this growth rate is constant over time. Calculate the required rate of return using the capital asset pricing model: k = rf + β (kM – rf) = 4% + 1. calculate the value of a share of Rio National equity on December 31.13 − 0. a.97%.

S. Summary income statement for the year ended December 31. Summary year-endbalance sheets (U. \$ millions) . 2002 (U. \$ millions) EXHIBIT 18B Rio National Corp.EXHIBIT 18A Rio National Corp.S.

2002 . Common equity data for 2002 EXHIBIT 18D Industry and market data December 31.EXHIBIT 18C Rio National Corp.

is Rio National’s equity overvalued or undervalued on a P/E-to-growth (PEG) basis. Assume that the risk of Rio National is similar to the risk of the industry. Shaar (from the previous problem) has revised slightly her estimated earnings growth rate for Rio National and.90/12 = 1.33 Industry Price-to-Earnings Ratio = 19. on a growth-adjusted basis.33 is below the industry PEG ratio of 1. using normalized (underlying) earnings per share.66. EXHIBIT 19A Rio National Corp. vs. Selected information about Rio National and the industry is given in Exhibit 19A. Rio National’s PEG ratio of 1. which is adjusted for temporary impacts on earnings.90 Growth Rate (as a percentage) = 12 PEG Ratio = 19. now wants to compare the current value of Rio National’s equity to that of the industry. The lower PEG ratio is attractive because it implies that the growth rate at Rio National is available at a relatively lower price than is the case for the industry. Rio National’s equity is relatively undervalued compared to the industry on a P/E-togrowth (PEG) basis.19.66 .62 Growth Rate (as a percentage) = 11 PEG Ratio = 14.62/11 = 1. using normalized (underlying trend) EPS.71 Price-to-Earnings Ratio = \$25/\$1. The PEG ratios for Rio National and the industry are calculated below: Rio National Current Price = \$25.71 = 14. industry Compared to the industry.00 Normalized Earnings per Share = \$1.

Morgan anticipates that Sundanci’s earnings and dividends will grow at 32% for two years and 13% thereafter.20. CFA. Assume the current year is the year 2000 (year 0). Calculate the current value of a share of Sundanci stock by using a two-stage dividend discount model and the data from Tables 20A and 20B. TABLE 20A Sundanci actual 1999 and 2000 financial statements for fiscal years ending May 31 (\$ million. has been asked to use the DDM to determine the value of Sundanci. Use the data in year 2000 as the data in year 0. Inc. Helen Morgan. except pershare data) TABLE 20B Selected financial information .

Peninsular Research is initiating coverage of a mature manufacturing industry.2566 × 0.32)2 = \$0. the current value of a share of Sundanci is calculated as follows: D3 D1 D2 (k − g) V0 = + + 1 2 (1 + k ) (1 + k ) (1 + k ) 2 \$0.32)2 × 1. CFA.32)3 × 1.4976 (0.13 = \$0.952 D0 = \$0.30 = \$0.30 = \$1.98 1.13 = \$1. Use government bond yield to proxy for risk-free rate.30 = \$1.952 × (1.5623 \$0. head of the research department.14 − 0.Using a two-stage dividend discount model.286 E1 = E0 (1.8744 × 0.14 2 1.32 = \$1.6588 × 0.32)2 = \$1.30 = \$0.4976 E3 = E0 × (1.952 × (1.2566 D1 = E1 × 0.3770 E2 = E0 (1.3770 \$0.30 = \$0.32)1 = \$0.8744 D3 = E3 × 0. Compute the price-to-earnings (P0/E1) ratio for the industry based on this fundamental data.952 × 1.6588 D2 = E2 × 0. . gathered the following fundamental industry and market data to help in his analysis: a.13) = + + = \$43.141 1.5623 21.14 2 where: E0 = \$0. John Jones.30 = \$1.

Equity risk premium would cause P/E ratios to be generally higher for Country B. Jones wants to analyze how fundamental P/E ratios might differ among countries. they must be computed using the following formulas: gind = ROE × retention rate = 0. iii. (ii) (iii) .05) = 0. A lower equity risk premium implies a lower required return and a higher P/E.12 Therefore: P0/E1 = 0.2 × 0. He gathered the following economic and market data: Determine whether each of these fundamental factors would cause P/E ratios to be generally higher for Country A or higher for Country B.25 × 0.12 − 0. A lower government bond yield implies a lower risk-free rate and therefore a higher P/E. (i) Forecast growth in real GDP would cause P/E ratios to be generally higher for Country A.40 = 0.10 rind = government bond yield + ( industry beta × equity risk premium) = 0. ii.0 b.The industry’s estimated P/E can be computed using the following model: P0/E1 = payout ratio/(r − g) However. Government bond yield would cause P/E ratios to be generally higher for Country B.10) = 30. Higher expected growth in GDP implies higher earnings growth and a higher P/E.06 + (1.60/(0. since r and g are not explicitly given.

a.12 P = \$68.60 per share in one year. In this case.99 P = \$70.75 + 1. The company has no growth and pays out all earnings as dividends. What is the value per share of the company's stock assuming the firm does not undertake the investment opportunity? If the company does not make any new investments. the stock price will be the present value of the constant perpetual dividends.25. The project is only a two-year project. we get: P = Dividend / R P = \$8. all earnings are paid dividends.123 PVGO = \$1. assume the company undertakes the investment.75. If the company does undertake the investment. It has a new project which will require an investment of \$1. and it will increase earnings in the two years following investment by \$2. .45 / 1.74 c. the price of the stock will revert back to \$68.122 + \$2.25 / . we need the no growth price plus the PVGO. In this case. the value of the company as a cash cow.75 b. the PVGO will be: PVGO = C1 / (1 + R) + C2 / (1 + R)2 + C3 / (1 + R)3 PVGO = –\$1. So. so. applying the perpetuity equation. what is the value per share of the stock now? The investment is a one-time investment that creates an increase in EPS for two years. what will be the price per share 4 years from now? After the project is over.12 + \$2. Investors require a 12% return on Stambaugh stock. the price of the stock if the company undertakes the investment opportunity will be: P = \$68. the PVGO is simply the present value of the investment plus the present value of the increases in EPS.60 / 1.99 So.22.10 / 1. The Stambaugh Corporation currently has earnings per share of \$8. and the earnings increase no longer exists. respectively.10 and \$2. To calculate the new stock price.45 per share. Again.

what would happen to its stock price? What if Nogro eliminated the dividend? Since k = ROE.20 = 20.23.5 × 0.0% \$10 P0 b. This situation is expected to continue indefinitely. By how much does its value exceed what it would be if all earnings were paid as dividends and nothing were reinvested? Since k = ROE. The company has a policy of paying out 50% of its earnings each year in dividends. what rate of return do Nogro’s investors require? a. D1 = 0.10 = 0. Assuming the current market price of the stock reflects its intrinsic value as computed using the constant growth rate DDM. this would have no impact on Nogro’s stock price since the NPV of the additional investments would be zero.20 = 0. The rest is retained and invested in projects that earn a 20% rate of return per year. If Nogro were to cut its dividend payout ratio to 25%. the NPV of future investment opportunities is zero: PVGO = P0 − E0 = \$10 − \$10 = \$0 k c. if Nogro eliminated the dividend. a. . The stock of Nogro Corporation is currently selling for \$10 per share. the stock price would be unaffected if Nogro were to cut its dividend payout ratio to 25%. The additional earnings that would be reinvested would earn the ROE (20%).10 Therefore: k= D1 \$1 +g = + 0.5 × \$2 = \$1 g = b × ROE = 0. Again. Earnings per share in the coming year are expected to be \$2.