CHAPTER 5 The Value of Common Stocks Answers to Practice Questions 14. 15.

Horizon Period (H) Expected Future Values Present Values Dividend Price Cumulative Future (DIVt ) (Pt ) Dividends Price Total 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 Newspaper exercise, answers will vary

0 100.00 100.00 1 10.00 105.00 8.70 91.30 2 10.50 110.25 16.64 83.36 3 11.03 115.76 23.88 76.12 4 11.58 121.55 30.50 69.50 10 15.51 162.89 59.74 40.26 20 25.27 265.33 83.79 16.21 50 109.21 1,146.74 98.94 1.06 100 1,252.39 13,150.13 99.99 0.01 Assumptions 1. Dividends increase at 5% per year compounded. 2. Capitalization rate is 15%. PA = PB = PC = PC = DIV1 $10 = = $100.00 r 0.10 DIV1 $5 = = $83.33 r−g 0.10 − 0 .04 1   DIV7 + × 6   0.10 1.10 

16.

DIV1 DIV2 DIV3 DIV4 DIV5 DIV6 + + + + + 1.101 1.10 2 1.103 1.10 4 1.105 1.10 6

5.00 6.00 7.20 8.64 10.37 12.44  12.44 1  + + + + + + ×  = $104.50 1 2 3 4 5 6 1.10 1.10 1.10 1.10 1.10 1.10  0.10 1.10 6 

At a capitalization rate of 10%, Stock C is the most valuable. For a capitalization rate of 7%, the calculations are similar. The results are: PA = $142.86 PB = $166.67 PC = $156.48

5-1

00 × 0.095 − 0 .10 The last term in the above calculation is dependent on the payout ratio and the growth rate after year 4.14 = 0.90 r−g 0.072 = $4. compute the real discount rate as follows: (1 + rnominal) = (1 + rreal) × (1 + inflation rate) 1.5753 × 0.115 = 0.07 = $7.115 1.08) × 0.07 Next.5 = $3. First. a.50 × 1.0657 = 6. Plowback ratio = 1 – payout ratio = 1.35 = $1.50 × 1.693 1 + + + + × 1 2 3 4 4 1.073 = $4.023 1.0657 18.4900 × 0.17.0275 P0 = DIV0 + = $1.0143 × 0. DIV1 $1.0.6933 EPS and dividends for year 5 and subsequent years grow at 2.3866 DIV $7.00 × 1.65  3.5 = $3.50 EPS and dividends for subsequent years are: Year 0 1 2 3 4 5 EPS $7.0143 $7.115 1.072 = $8.023 P0 = b.5 = $3.5 = $3.115 1.115 1. g = 0.4900 $7.5 = $3.115  0.57% In real terms.00 Therefore: DIV0 = payout ratio × EPS0 = 0.50 × 1.074 × 1.074 = $9.5 Dividend growth rate = g= Plowback ratio × ROE = 0.588  4. Therefore: P0 = DIV0 + DIV1 $1.115  0.1756 × 0.50 $7. compute EPS0 as follows: ROE = EPS0 /Book equity per share 0.5878 $9.0275) – 1 = .115    = $45.074 × 1. b.007 4.14 = EPS0 /$50 ⇒ EPS0 = $7.5 = 0.00 × 1. = DIV3 DIV1 DIV2 DIV4 1   DIV5 + + + + ×  1 2 3 4 4 1.35 + = $21.00 × 1. Stock B is the most valuable.2877 $9.90 r−g 0.023 = $4.35 × 1. 5-2 .288 4.5 × $7.00 $7.35 + = $21.5753 $7.0275 a.00 × 1.5 = $3.095 = (1 + rreal) × 1.50 × 1.50 × 1.095/1.00 × 1. Therefore.023 = $9.073 = $8.1756 $7.3866 × 0.07 = $3.115 .7450 $8.745 4.3% per year.115 1.115 1.0 – 0. as indicated by the following calculation: Dividend growth rate = g = Plowback ratio × ROE = (1 – 0.074 = $4.00 = $3.5 × 0.0072 $8.0275 (1 + rreal) = (1.115 1.

0% (and assuming r remains at 11. a. stock prices in mid-2006 were based on lower expected earnings (and dividends) and were therefore low relative to earnings in prior periods.83 pesos r − g 0.75% P0 200 g = Plowback ratio × ROE = (1 − 0.06 = 6. a. If investors expected future oil prices to decline from what were then historically high levels in mid-2006. In the case of Textron. 21.0.075 = 0. but the cause of the expected increase in future earnings and dividends is different.5) × 0.5 +g = + 0. then investors’ expectations were that future earnings of the major oil companies would be less than earnings being reported at that time.1175 = 11. Extremely high P/EPS ratios can be misleading for a number of reasons.r= 19. Since stock price is the present value of future cash flows to stockholders. and (perhaps) below what investors expected Textron’s EPS to be in the future.5 = = 147. 5-3 . b. Newspaper or Internet exercise.1175 .0% The stated payout ratio and ROE are inconsistent with the security analysts’ forecasts. answers will vary b.06 20. this is a result similar to Textron’s. the extremely high P/EPS of 63 resulted from a large one-time loss which reduced EPS below what it would otherwise have been. DIV1 8. With g = 6.12 = 0. A somewhat more common scenario resulting in an extremely high P/EPS ratio is a growth stock which investors expect will experience significant increases in earnings in the near term future.75%) then: P0 = DIV1 8. Mathematically.

22. which has been growing at a steady 5 percent rate for decades. growth will continue for two years at this rate and then there will be no further growth in EPS or dividends. Its EPS1 = $10.65 + 1 + r r(1 + r) Solving algebraically (using the quadratic formula) or by trial and error. in fact. and next year’s dividend is projected at $1. An Incorrect Application.1201= 12. The value of the company’s stock is the present value of the expected dividend of $2. Hotshot Semiconductor’s earnings and dividends have grown by 30 percent per year since the firm’s founding ten years ago.30 = 0 .30 to be paid in 2017 plus the present value of the perpetuity of $2.25% P0 100 This is wrong because the formula assumes perpetual growth. 5-4 . The security analyst’s forecast is wrong because it assumes a perpetual constant growth rate of 15% when.30 $2. Thus: r= DIV1 1. A Correct Application.10 = 10.25 +g= + 0 .25.05 = 0 . Thus: r= DIV1 5 +g= + 0 . and P0 = $100.01% $21.75 = 23.65 beginning in 2018.3125 = 31. we find that: r = 0.0% P0 100 Even here. an energy crisis could turn it into a growth stock. If Old Faithful hauls coal. you should be careful not to blindly project past growth into the future. it is not possible for Hotshot to grow at 30 percent per year forever. Therefore. the actual expected rate of return is the solution for r in the following equation: $2. Current stock price is $100. a. DIV1 = $5. The formula might be correctly applied to the Old Faithful Railroad.

08) + The statement in the question implies the following: NPVβ (rβ − 0. The reason P0 is so high relative to earnings is not that r is low.15) NPVβ (rβ − 0. r = 10.05 = 5. r = 12.15)   α  5-5 . Suppose PVGO = $60: P0 = EPS1 + PVGO r 5 100 = + 60 r Therefore. but rather that Hotshot is endowed with valuable growth opportunities.b. Thus: r= EPS1 5 = = 0 . An Incorrect Application.0% P0 100 This is too low to be realistic.0% Share price = 24.08)  (rα − 0.15)  β   EPS α1 NPVα    +  r (rα − 0. Unfortunately.08)  EPSβ1 NPVβ    > NPVα +  r (rβ − 0. Since PVGO = 0: P0 = EPS1 + PVGO r 10 +0 r 100 = Therefore. Hotshot has current earnings of $5.00 per share. Therefore: Ρα = Ρβ = EPS1 NPV + r r−g EPS α 1 rα EPSβ1 rβ + NPVα (rα − 0.5% A Correct Application. Old Faithful has run out of valuable growth opportunities.

Without PVGO.15) EPS α1 (rβ − 0.08) rβ rα < EPS α1 EPSβ1 . The PVGO of $10.08)  = $23. P3 would equal earnings for year 4 capitalized at 12 percent: $2.12 − 0 .15  1 $1.0. a. we have: NPVβ rβ NPVα r × α < × (rα − 0.25 is lost at year 3.08).75 0. everything else equal.49 = $20.12) (1. everything else equal.12 − 0 . the current stock price of $23.15) > (rβ .12) 3 The new stock price will be: $23.50 $0.60 $1.81  (1. . The horizon value contributes: PV(PH ) = 1 $1.00 – $20. Therefore. b.30 = $16. NPVβ NPVα < (rα − 0.15) (rβ − 0. everything else equal.07 3 (1.25 = $7. NPVα < NPVβ.75 = $10.0.Rearranging.24 × = $22. (rα .12) 3 × (0.81 will decrease by: $10.25 d. Growth-Tech’s stock price should be: P=  $0.12 Therefore: PVGO = $31.30 (1. everything else equal.12) (1. d.12) (0. 25.08) c.24 + + + 2 3  (1. c.51 5-6 .12)   b.08) EPS β1 a.81 – $7.

26.07 6 5.81 9. .44 7.04 Therefore.55 7. Thus: EPS1 = 4/0.68 8.04 and P0 = $100: r= DIV1 $4 +g= + 0 .21 2 3 1.33 6.08 5 27.08 1.08 = 8.08 − 0 .0% P0 $100 The $4 dividend is 60 percent of earnings.20 3 1.81 + 147 + + + + = $106. g = 0.63 b.67 = $1.80 7.88 9.55 1. a. by plowing back 80 percent of earnings. DIV1 will decrease to: 0. CSI’s stock price will increase to: P0 = 1.04 = 0 . Continued growth at 4 percent Note that DIV6 increases sharply as the firm switches back to a 60 percent payout policy. Forecasted stock price in year 5 is: P5 = DIV6 5. Here we can apply the standard growing perpetuity formula with DIV1 = $4.67 2 1.33 However.88 = = $147 r − g 0.08 $100 = PVGO = $16.08 1.33 1.40 5 1.6 = $6.20 × 6. Thus: Year DIVt EPSt 1 1. 8 .78 4 1. answers will vary depending on time period.67 Also: P0 = EPS1 + PVGO r $6. . CSI will grow by 8 percent per year for five years.68 1.44 1. 5-7 . Internet exercise.08 4 1.08 1.67 + PVGO 0.

09 3 $121.340 37.662.78 5-8 . we use the fact that production decreases 7% per year while the price of oil increases 5% per year.000 41.012.028.012.662.065 + + = 1.8000 65 25 117. Since production will decrease 7% per year while costs per barrel remain constant.5 25 70.000 45.000 72.389.440.4478 50 25 72. the present value (in 2009) of expenses beginning in 2010 is: PV2009 = 33.600 2009 1.477.490.000 2008 1.690.09 1.920.574 Production (million barrels) Price of oil/barrel Costs/barrel Revenue Expenses Net Income (= Dividends) Next.000.000 shares outstanding.000.827.624 + $318.000 2007 1.392. the growth rate of expenses is: –7. so that the growth rate of revenues is: [1.000 58.(-0.065 36.671 The total value of the company is: $121.000.196.09 .196.690.850. a.295 Since there are 7.3465 52.000.340 = $210.295 / 7.05 × (1 – 0. we use the following Excel spreadsheet to compute net income (or dividends) for 2006 through 2010: 2006 1.6 25 0.07)] – 1 = –0.0235) Similarly. and then discounting back three years to 2006.000 = $62.6740 60 25 100. First.590.09 2 1.100 38. 2008 and 2009: P0 = 58.624 The present value of dividends to be paid in 2010 and subsequent years can be computed by recognizing that both revenues and expenses can be treated as growing perpetuities.130 36.28.4 45 0.(-0.09 .625. we find that the present value of dividends paid in 2010 and subsequent years is: $318.915 33.000.5568 55 25 85.600 36.000 46.500 46.590. the present value (in 2009) of revenues beginning in 2010 is: PV2009 = 70.915 = $622. the present value per share is: $439.0235 = –2. we compute the present value of the dividends to be paid in 2007.477.704.671 = $439.0% To compute the growth rate of revenues.35% Therefore.704.196.07) Subtracting these present values gives the present value (in 2009) of net income.065 2010 1.490.

the present value of the business is: -$2.000 = $10.38 8 28.5% 11.5. in year 9 and all later years. [Note: In this problem.10 The present value of the growing perpetuity that begins in year 8 is:  1 1. 30.66 3.1. EPS2006 = $72.00 -0.40 1.07 3.49 2.20 2.1343  PV =   (1.96 3 14.10) 7 × (0.0% 8.10    Therefore.27 1.15 4 17.0% Computing the present value of the free cash flows.10 7 -$2.96 .10 − 0 .28 2.0% 11.65 1.10 6 23.10 0.23 7 25.88 -1.000/7.36 3.10 = $26. 31.] The free cash flow for years 1 through 10 is computed in the following table: Year 1 10.000.10 1.08 2.00 1.0% 10.29 EPS/P = $10.32 Asset value Earnings Investment Free cash flow Earnings growth from previous period 20.74 2.10 1.78 = 0.13 9 30.0% 20.94 + $29. we find that the present value of the free cash flows occurring in years 1 through 7 is: PV = . answers will vary depending on time period.10 1.08 3. following the approach from Section 5.16 million 5-9 .97 2.73 2.94 1.68 2.0% 20.0% 20.38 0.69 0.45 1. answers will vary depending on time period.23 0.63 3.0% 20.12 2.40 2.80 .40 -0.29/$62.1.0.44 2.000.38 0.0. should be 8%.5% 8.164 29.10 1.b. Internet exercise.77 2.23 10 33. the long-term growth rate.38 5 20.00 1.10 1.80 2 12.38 + + + + + + = 1 2 3 4 5 6 1.46 -1.15 . Internet exercise.54 0.08)  = $29.

as ROE increases. the value of the contract is given by the first payment (0. Assume the portfolio value given. price-to-book equals one.04 5-10 .5 million 0.005 × $100 million = $10 million 0.05 For stocks with a 4 percent yield: r – growth rate = dividend yield = 0. Then.005 × $100 million = $12. Also: r = dividend yield + growth rate Hence: r – growth rate = dividend yield = 0. V. the value of the contract. and. is the value as of the end of the first year.0% Thus. From the equation given in the problem. the value of the contract. is: V= 0. is: V= 0.05 = 5.0% Thus. the price-to-book ratio also increases. V. $100 million.5 percent of portfolio value) divided by (r – g). it follows that: P0 ROE × (1− b) 1− b = = BVPS r − (b × ROE) (r / ROE) − b Consider three cases: ROE < r ⇒ (P0/BVPS) < 1 ROE = r ⇒ (P0/BVPS) = 1 ROE > r ⇒ (P0/BVPS) > 1 Thus. assuming constant growth.Challenge Questions 32.04 = 4. 33. when ROE = r.

36 million / $33. then the value of Concatco equals the discounted value of the cash flows (as computed in Section 5.10 – 0.5): $18.000 = 190.6 million financing requirement. the value of the existing stockholders’ shares must remain at $18.300 shares Share price in year 6 equals: $39. the expected value of their shares in year 6 is: $18.59 million / (0.6 million comes from new investors. new stockholders will own: ($6.39 million) × 1.75 million – $33.75 million Compensation to new stockholders in year 6 is: $39.8 million. Since the new investors buy shares at a fair price.75 million / 1.000.34. who buy shares each year at a fair price. Since the existing stockholders own 1 million shares.39 million = $6.80. Since existing stockholders expect to earn 10% on their investment.1903 million = $33.06) = $39.39 5-11 .39 million The total value of the firm in year 6 is: $1.8 million.10) 6 = $33.36 million Since existing stockholders own 1 million shares. If existing stockholders buy newly issued shares to cover the $3. the value per share is $18.8 million × (1. then in year 6. Now suppose instead that the $3.

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