Chapter 08 - Valuing Stocks

Unit 5 answers
CHAPTER 8 – VALUING STOCKS

Questions

LG5 10. What are the differences between common stock and preferred stock?

Common stock dividends change over time, hopefully increasing in the long-term. Preferred
stock pays a constant dividend. Preferred stockholders have higher precedence for payment in
the event of firm liquidation from bankruptcy. However, preferred stockholders do not have
voting rights that common stockholders enjoy. Preferred stock prices fluctuate with market
interest rates and behave like corporate bond prices. Common stock price changes with the value
of the company’s underlying business.

Problems

LG5 8-11 Value of a Preferred Stock A preferred stock from Duquesne Light Company (DQUPRA)
pays $3.55 in annual dividends. If the required return on the preferred stock is 6.7 percent,
what’s the value of the stock?

Use equation 8-6, noting that for preferred stock, the growth rate g equals zero:

D0 (1+g ) $ 3 . 55
Constant growth model=P 0 = = =$ 52. 99
i−g 0 . 067−0

LG5 8-22 Expected Return Paychex Inc. (PAYX) recently paid an $0.84 dividend. The dividend is
expected to grow at a 15 percent rate. At a current stock price of $40.11, what is the return
shareholders are expecting?

First convert D0 to D1: $0.84 × (1 + 0.15) = $0.966.

Then use equation 8-7:

D1
Expected return=i= +g=( $ 0 . 966 /$ 40 .11)+0 . 15=17 . 41 %
P0

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 Chapter 08 - Valuing Stocks

LG6 8-23 Dividend Initiation and Stock Value A firm does not pay a dividend. It is expected to pay
its first dividend of $0.20 per share in three years. This dividend will grow at 11 percent
indefinitely. Using a 12 percent discount rate, compute the value of this stock.

First compute the year 2 value of the stock using equation 8-6 and then discount this back two
years to get the present value of the stock price:

D3
Constant growth model=P 2= =$ 0 . 20/( 0 . 12−0 .11 )=$ 20 . 00
i−g
2
P0 =( $ 20/ 1 .12 )=$ 15 . 94

LG7 8-26 P/E Ratio Model and Future Price New York Times Co. (NYT) recently earned a profit
of $1.21 per share and has a P/E ratio of 19.59. The dividend has been growing at a 7.25 percent
rate over the past six years. If this growth rate continues, what would be the stock price in five
years if the P/E ratio remained unchanged? What would the price be if the P/E ratio increased to
22 in five years?

Under these two scenarios, the future price estimates using equation 8-10 are:

P5 = ( P E ) × E ×( 1+ g ) =19 . 59× $ 1. 21× (1+ 0. 0725 ) = $ 33 .64

n
0
n 5

P5 = ( P E ) × E ×( 1+ g ) =22×$ 1 . 21×( 1+0 . 0725 ) =$ 37 . 77

n
0
n 5

LG5 8-28 Value of Future Cash Flows A firm recently paid a $0.60 annual dividend. The dividend
is expected to increase by 12 percent in each of the next four years. In the fourth year, the stock
price is expected to be $110. If the required return for this stock is 14.5 percent, what is its
current value?

Find the dividends in the next four years:

D1 = $0.60 × (1 + 0.12) = $0.672
D2 = $0.672 × (1 + 0.12) = $0.7526
D3 = $0.7526 × (1 + 0.12) = $0.8430
D4 = $0.8430 × (1 + 0.12) = $0.9441

Now use equation 8-3:

D1 D2 D3 D4 +P4
P0 = + + +
1+i ( 1+ i) ( 1+i ) ( 1+i )4
2 3

¿ $ 0. 672/1. 145+$ 0 .7526 /1. 1452 +$ 0 . 8430/1. 1453 +($ 0 .9441+$ 110)/1. 1454 =$ 66 . 27

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 Chapter 08 - Valuing Stocks

LG6 8-34 Variable Growth A fast-growing firm recently paid a dividend of $0.40 per share. The
dividend is expected to increase at a 25 percent rate for the next four years. Afterwards, a more
stable 11 percent growth rate can be assumed. If a 12.5 percent discount rate is appropriate for
this stock, what is its value?

Use equation 8-8:

D0 ( 1+g 1 ) 4 ( 1+g2 )
2 3 D0 ( 1+g1 )4 +
D0 ( 1+g1 ) D0 ( 1+g 1 ) D0 ( 1+g 1 ) i−g2
P0 = + + +
1+i ( 1+i )2 ( 1+i )3 ( 1+i )4
4
4 $ 0 . 40 ( 1. 25 ) (1+0. 11 )
2 3 $ 0 . 40 ( 1. 25 ) +
$ 0 . 40 ( 1+0 . 25 ) $ 0 . 40 ( 1. 25 ) $ 0. 40 ( 1 .25 ) 0 . 125−0 . 11
P0 = + + +
1+0 .125 ( 1 .125 )2 ( 1. 125 )3 ( 1 .125 )4
¿ $ 0. 444 +$ 0 . 494+$ 0 . 549+$ 45 .725=$ 47 . 21

8-3
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Education.