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Homework Assignment 3
Due ___________________
See the attached question set and solve the following questions.
Questions 2,3a,4,6,11,12,14a,15,18,20a-c,29,37,38a-b,39

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The present value of a share is equal to the stream of expected dividends per share up to some
horizon date plus the expectedprice at this date, all discounted at the return that investorsrequire.
If the horizon date is far away, we simply say that stock price equals the present value of all future dividends per share.This is the dividend discount model.
If dividends are expected to grow forever at a constant rate g, then the expected return on
the stock is equal to the dividend yield (DIV1/P6) plus the expected rate of dividend growth.
The value of the stock according to this constant-growth dividend discount model is P6 =
DIVl/(r * g).
How should inveslors interplel price-eornings rotios?
You can think of a share'svalue as the sum of two parts-the value of the assetsin place and the
present value of growth opportunities, that is, of future opportunities for the firm to invest in
high-return projects. The price-earnings (P/E) ratio reflects the market's assessmentof the
firm's growth opportunities.
How does compelition omong invesfors leod lo efficient morkets?
Competition between investors will tend to produce an efficient market-that is, a market in
which prices rapidly reflect new information, and investors have difficulty making consistently
superior returns. Of course, we all hope to beat the market, but, if the market is efficient, all we
can rationally expect is a return that is suffrcient on averageto compensatefor the time value of
money and for the risks we bear.
The efficient market theory comes in three flavors. The weak form statesthat prices reflect all
the information contained in the past series of stock prices. In this case it is impossible to earn
superior profits simply by looking for past patterns in stock prices. The semistrong form of the
theory statesthat prices reflect all published information, so that it is impossible to make consistently superior returns just by reading the newspaper,looking at the company's annual accounts,
and so on. The strong form statesthat stock prices effectively impound all available information.
This form tells us that private information is hard to come by, becausein pursuing it you are in
competition with thousands-perhaps millions-of active and intelligent investors.The best you
can do in this case is to assumethat securities are fairly priced.
The evidence for market efficiency is voluminous and there is little doubt that skilled professional investors find it difficult to win consistently. Nevertheless,there remain some puzzling instanceswhere markets do not seem to be efficient. Some financial economists attribute these apparent anomalies to behavioral foibles.

Dividend Discount Model. Amazon.com has never paid a dividend, but in December 1999 the
market value of its stock was $37 billion. Does this invalidatethe dividend discount modei?

2 . Dividend Yield. Favored stock will pay a dividend this year of $2.40 per share. Its dividend
yield is 8 percent. At what price is the stock selling?

3 . Preferred Stock. Preferred Products has issued preferred stock with an $8 annual dividend that
will be paid in perpetuity.
a. If the discount rate is 12 percent, at what price should the prefened sell?
b. At what price should the stock sell I year from now?
c. What is the dividend yield, the capital gains yield, and the expected rate of return of the
stock?

4. Constant-Growth Model. Waterworkshas a dividend yield of 8 percent.If its dividend is expected to grow at a constant rate of 5 percent, what must be the expected rate of return on the
company'sstock?

5 . Dividend Discount Model. How can we say that price equals the presentvalue of all future dividends when many actual investors may be seeking capital gains and planning to hold their
sharesfor only ayear or two? Explain.

6 . Rate of Return. SteadyAs She Goes, Inc., will pay a year-enddividend of $3 per share.Investors expect the dividend to grow at a rate of 4 percent indefinitely.
a. If the stock currently sells for $30 per share,what is the expectedrate of return on the stock?
b. If the expectedrate of return on the stock is 16.5 percent,what is the stock price?

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7 . Dividend Yield. BMM Industries pays a dividend of $2 per quarter. The dividend yield on its
stock is reported at 4.8 percent. What price is the stock selling at?

8 . Forrns of Efficient Markets. Supply the missing words from the following list: fundamental,
semistrong,strong, technical, weak.
There are three forms of the effrcient market theory. Tests that have found there are no patterns in shareprice changesprovide evidence for the
form of the theory. Evidence
for the
form of the theory is provided by tests that look at how rapidly markets respondtonewpublicinformation,andevidenceforthe-formofthetheoryisprovided by tests that look at the performance of professionally managed portfolios. Market efficiency resuits from competition between investors.Many investors searchfor information about
the company's businessthat would help them to value the stock more accurately.This is known
as-analysis.Suchresearchhelpstoensurethatpricesreflectallavailableinformation. Other investors study past stock prices for recurrent patterns that would allow them to
makesuperiorprofits.Thisisknownas-ana1ysis.Suchresearchhelpstoeliminate
any patterns.

9 . Information and Efficient Markets. "It's competition for information that makes securities
markets efficient." Is this statement correct? Explain.

1 0 . Stock Values. Integrated Potato Chips paid a $1 per share dividend yesterda.y.You expect the
dividend to grow steadily at a rate of 4 percent per year.
a.
b.
c.
d.

What is the expected dividend in each of the next 3 years?

If the discount rate for the stock is 12 percent, at what price will the stock sell?
What is the expected stock price 3 years from now?
If you buy the stock and plan to hold it for 3 years, what payments will you receive? What
is the present value of those payments? Compare your answer to (b).

1 1 . Constant-Growth Model. A stock sells for $40. The next dividend will be $4 per share.If the
rate of return earned on reinvested funds is 15 percent and the company reinvests40 percent of
earnings in the firm, what must be the discount rate?

1 2 . Constant-Growth Model. Gentleman Gym just paid its annual dividend of $3 per share, and
it is widely expected that the dividend will increaseby 5 percent per year indefinitely.
a. What price should the stock sell at? The discount rate is 15 percent.
b. How would your answerchangeif the discountrate were only 12 percent?Why doesthe answer change?

1 3 . Constant-Growth Model. Arts and Crafts, Inc., will pay a dividend of $5 per share in 1 year.
It sells at $50 a share, and firms in the same industry provide an expected rate of return of 14
percent. What must be the expected growth rate of the company's dividends?

t4.

Constant-Growth Model. Eastern Electric currently pays a dividend of about $1.64 per share
and sells for $27 a share.
a. If investors believe the growth rate of dividends is 3 percent per year, what rate of return do
they expect to earn on the stock?
b. If investors' required rate of return is 10 percent, what must be the growth rate they expect
of the firm?
c. If the sustainablegrowth rate is 5 percent, and the plowback ratio is .4, what must be the rate
of return earned by the firm on its 4ew investments?

1 5 . Constant-Growth Model. You believe that the Non-stick Gum Factory will pay a dividend of
$2 on its common stock next year. Thereafter, you expect dividends to grow at a rate of 6 percent a year in perpetuity.If you require a return of 12 percent on your investment,how much
should you be preparedto pay for the stock?

1 6 . Negative Growth. Horse and Buggy Inc. is in a declining industry. Sales, earnings, and dividends are all shrinking at a rate of 10 percent per year.
a. lf. r = 15 percent and DlVr - $3, what is the value of a share?
b. What price do you forecast for the stock next year?
c. What is the expected rate of return on the stock?

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d. Can you distinguishbetween "bad stocks" and "bad companies"?Does the fact that the industry is declining mean that the stock is a bad buy?
fl,

Constant-Growth Model. Metatrend's stock will generateearningsof $6 per sharethis year.

The discount rate for the stock is 15 percentand the rate of return on reinvestedearningsalso
is 15 percent.
a. Find both the growth rate of dividends and the price of the stock if the company reinveststhe
following fraction of its earnings in the firm: (i) 0 percent; (ii) 40 percent; (iii) 60 percent.
b. Redo part (a) now assumingthat the rate of return on reinvestedearnings is 20 percent.What
is the present value of growth opportunities for each reinvestment rate?
c. Considering your answersto parts (a) and (b), can you briefly statethe differencebetween
companiesexperiencinggrowth versuscompanieswith growth opportunities?

1 8 . Nonconstant Growth. You expect a shareof stock to pay dividendsof $1.00, $1.25, and $1.50
in each of the next 3 years.You believe the stock will sell for $20 at the end of the third year.
a. What is the stock price if the discount rate for the stock is 10 percent?
b. What is the dividend yield?

1 9 . Constant-Growth Model. Here are data on two stocks,both of which have discount rates of
15 percent:
Stock A

Stock B

Return on equity

15%

10%

Earningsper share
Dividends per share

$2.00
$1.00

$t.so
$1.00

a. What are the dividend payout ratios for each firm?

b. What are the expected dividend growth rates for each firm?
c. What is the proper stock price for each firm?

20. PIE Ratios. Web Cites Researchprojects a rateof return of 20 percenton new projects.Managementplans to plow back 30 percentof all earningsinto the firm. Earningsthis year will be
$3 per share, and investors expect a 12 percent rate of return on the stock.
a.
b.
c.
d.
e.
f.

What is the sustainablegrowth rate?

What is the stock price?
What is the presentvalue of growth opportunities?
What is the P/E ratio?
What would the price and PIE ratio be if the firm paid out all earningsas dividends?
What do you concludeabout the relationshipbetweengrowth opportunitiesand P/E ratios?

Model. Fincorp will pay a year-enddividend of $2.40 per share,which is

expectedto grow at a 4 percentrate for the indefinite future. The discount rate is 12 percent.

2 r . Constant-Growth

a. What is the stock selling for?

b. If earningsare $3.10 a share,what is the implied value of the firm's growth opportunities?

22. P/E Ratios. No-Growth Industriespays out all of its earningsas dividends.It will pay its next
$4 per sharedividend in a year.The discountrate is 12 percent.
a. What is the price-earningsratio of the company?
b. What would the P/E ratio be if the discountrate were 10 percent?

2 3 . Growth Opportunities. Stormy Weather has no attractive investment opportunities. Its return
on equity equals the discount rate, which is 10 percent.Its expectedearningsthis year are $4
per share.Find the stock price, PIE ratio, and growth rate of dividendsfor plowback ratios of
a. zefo
b. .40
c. .80
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Growth Opportunities. Trend-line Inc. has been growing at a rate of 6 percent per year and is
expectedto continue to do so indefinitely.The next dividend is expectedto be $5 per share.
a. If the market expects a 10 percent rate of return on Trend-line, at what price must it be
sellins?

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b. If Trend-line's earningsper sharewill be $8, what part of Trend-line'svalue is due to assets

in place, and what part to growth opporfunities?

2 5 . P/E Ratios. Castlesin the Sand generatesa rate of return of 20 percenton its investmentsand
maintainsa plowback ratio of .30. Its earningsthis year wiil be $4 per share.Invesrorsexpecra
12 percentrate of return on the stock.
a. Find the price and PIE rario of rhe firm.
b. what happensto the P/E ratio if the plowback ratio is reducedto .20?why?
c. Show that if plowback equalszero, the earnings-priceratio E/P falls to the expectedrate of
return on the stock.

26. Dividend Growth. GrandioseGrowth has a dividend growth rate of 20 percent.The discount
rate is 10 percent.The end-of-yeardividend will be $2 per share.
a. what is the presentvalue of the dividend to be paid in year 1?year z? ye3n_
3?
b. Could anyonerationally expectthis growth rate to continue indefinitely?

27. Stock Valuation. Start-upIndustriesis a new firm that has raised$200 million by selling shares
of stock. Management plans to earn a 24 percent rate of return on equity, which is more than
the 15 percentrate of return availableon comparable-riskinvestments.Half of all earningswill
be reinvestedin the firm.
a. What will be Start-up'sratio of market value to book value?
b: How would that ratio change if the firm can earn only a 10 percent rate of return on its investments?

28. Nonconstant Growth. PlannedObsolescencehas a product that will be in vogue for 3 years,
at which point the firm will close up shop and liquidate the assets.As a result, forecastdividendsare DIVI = $2, DIVz = $2.50, and DIV3 = $18. What is the stock price if the discountrate
is 12 percent?

2 9 . Nonconstant Growth. Tattletale News Co.p. has been growing at a rate of 20 percenrper year,
and you expect this growth rate in earnings and dividends to continue for another 3 years.
a. If the last dividend paid was $2, what will the next dividend be?
b' If the discount rate is 15 percentand the steadygrowth rate after 3 years is 4 percent,what
should the stock price be today?

30. Nonconstant Growth. ReconsiderTattletaleNews from the previousproblem.

a. What is your prediction for the stock price in 1 year?
b. Show that the expectedrate of return equalsthe discount rate.
31. Interpreting the Efficient Market Theory. How would you respond to the following comments?
a. "Effrcient market, my eye! I know lots of investorswho do crazy things."
b. "Efficient market? Balderdash!I know at least a dozen people who have made a bundle in
the stock market."
c. "The trouble with the efficient market theory is that it ignoresinvestors'psychology."

3 2 . Real versus Financial Investments. Why do investmentsin financial markets almost always
have zero NPVs, whereas firms can find many,investmentsin their product markets with positive NPVs?
a a
JJ.

Investment Performance. It seemsthat every month we read an article tn The Wall StreetJour,
nal about a stockpickerwith a marveloustrack record. Do theseexamplesmean that financial
markets are not efficient?

34. Implications of Efficient Markets. The presidentof Good Fortunes,Inc., statesat a pressconference that the company has a 30-year history of ever-increasingdividend payments.Good
Fortunes is widely regardedas one of the best-run firms in its industry. Does this make the
firm's stock a good buy? Explain.

3 5 . Implications of Efficient Markets. "Long-term interest rates are at record highs. Most companies,therefore,find it cheaperto financewith common stock or relatively inexpensiveshortterm bank loans."Discuss.

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36. Expectations and Efficient Markets. Geothermal Corp. just announced good news: its earnings have increasedby 20 percent. Most investorshad anticipatedan increaseof 25 percent.
Will Geothermal'sstock price increaseor decreasewhen the announcementis made?

37. Sustainable Growth. Computer Co.p. reinvests60 percent of its earnings in the firm. The stock
sells for $50, and the next dividend will be $2.50 per share.The discount rate is 15 percent.
What is the rate of return on the company's reinvestedfunds?

3 8 . Nonconstant Growth. A company will pay ^ $2 per share dividend in 1 year. The dividend in
2 years will be $4 per share, and it is expected that dividends will grow at 5 percent per year
thereafter.The expectedrate of return on the stock is 12 percent.
a. What is the current price of the stock?
b. What is the expectedprice of the stock in a year?
c. Show that the expectedreturn, 12 percent,equalsdividend yield plus capital appreciation.

39. Nonconstant Growth. Phoenix Industries has pulled off a miraculous recovery. Four years ago
it was near bankruptcy. Today, it announceda $1 per sharedividend to be paid a year from noq
the first dividend sincethe crisis.Analysts expectdividendsto increaseby $1 a year for another
2 years.After the third year (in which dividends are $3 per share) dividend growth is expected
to settle down to a more moderatelong-term growth rate of 6 percent. If the firm's investors expect to earn a return of 14 percent on this stock, what must be its price?

40. Nonconstant Growth. Compost Science,Inc. (CS!, is in the businessof convertingBoston's

sewage sludge into fertilizer. The businessis not in itself very profitable. However, to induce
CSI to remain in business,the Metropolitan District Commission (MDC) has agreed to pay
whatever amount is necessaryto yield CSI a 10 percent return on investment.At the end of the
year, CSI is expectedto pay a $4 dividend. It has been reinvesting40 percent of earningsand
growing at 4 percent ayear.
a. SupposeCSI continues on this growth trend. What is the expected rate of return from purchasingthe stock at $100?
b. What part of the $100 price is attributable to the present value of growth opportunities?
c. Now the MDC announcesa plan for CSI to treat Cambridge sewage.CSI's plant will therefore be expandedgradually over 5 years. This means that CSI will have to reinvest 80 percent of its earningsfor 5 years. Starting in Year 6, however,it will again be able to pay out
60 percentof earnings.What will be CSI's stock price once this announcementis made and
its consequencesfor CSI are known?

4 L Nonconstant Growth. Better Mousetrapshas come out with an improved product, and the
world is beating a path to its door. As a result, the firm projects growth of 20 percent per year
for 4 years. By then, other firms will have copycat technology,competition will drive down
profit margins, and the sustainablegrowth rate will fall to 5 percent.The most recent annual dividend was DIV6 = $1.00 per share.
a.
b.
c.
d.
e.
f.

What are the expected values of DlV1, DIV2, DIV3, and DIVa?
What is the expected stock price 4 years from now? The discount rate is l0 percent.
What is the stock price today?
Find the dividend yield, DIV1/Pg.
What will next year's stock price, P1,be?
What is the expected rate of return to an investor who buys the stock now and sells it in 1
yeat?

42. Yield Curve and Efficient Markets. If the yield curve is downward-sloping,meaning that
long-term interest rates are lower than short-terminterest rates, what might investorsbelieve
aboutfuture short-terminterestrates?

srexoenn
apoons

1 . Go to www.mhhe.com/edumarketinsight. Review Table 6-2, which lists the market value of

several firms. Update the table. Which company's value changed by the greatest percentage
since 2002, when the table was created?(Hint: Look for the price per shareand the number of