 Solutions to Problems

1. a. Earnings next year = $100 million × 10% = $10 million or $2 per share.
b. Total dividends next year are $5 million (half of earnings), and dividing that by the number of
share outstanding yields dividends per share of $1
c. The expected stock price is 24.5 × $2 or $49.
d. The expected holding period return is ($49 – $40 + $1) / $40 = 25%.

3. With total equity of $400 million and an ROE of 20%, Granger earned net income of $80 million.
Divide that by 100 million outstanding shares to obtain EPS of $0.80.

5. Growth rate  ROE  Retention rate

Retention rate  1 – Payout ratio
Payout ratio  $0.20/$2.00  0.10
Retention rate  1 – 0.10  0.90 or 90%
Growth rate  0.15  0.90  0.135 or 13.5%

7. a. The intrinsic worth (or justified price) is equal to the present value of expected dividends and
future price discounted at the required rate of return (12% here).
Financial calculator solution N=3, i=12, PV=?, PMT=4, FV=60, PV=Intrinsic Worth=$52.31 ans
(the calculator result will be a negative number because the price is a negative cash flow.
b. N=3, i=?, PV=–48, PMT=4, FV=60, i=expected return=15.5%
The rate of return which discounts future cash flows such that their sum equals the current stock
price is 15.5%. Hence, the expected return of the stock is 15.5%.

9. Intrinsic value  Annual dividend/ Required rate of return  $2/.12  $16.67

Danny should not buy the stock, as it is overpriced based on his valuation.

11. a. Value of stock  4.32  PVIF15%, 1 YR. + 4.67  PVIF15%, 2 YRS.

 (5.04  77.75)  PVIF15%, 3 YRS.
 4.32(0.870)  4.67(0.756)  82.79(0.658)
 $61.76
b. Expected return can also be calculated using the present-value-based internal rate of
return (IRR):
($4.32  PVIF1 YR)  ($4.67  PVIF2 YRS)  ($5.04  PVIF3 YRS)
 ($77.75  PVIF3 YRS)  $61.76
The rate of return which discounts future cash flows such that their sum equals the current stock
price is 15%. This is also the required rate of return used in part a. Hence, the answer to the
following item has been verified.
c. Using the dividend valuation model:
$4.00(1.08) $4.32
Value of stock    $61.71
15  0.08 0.07
where 15% is the desired rate of return, and 8% is the dividend growth rate.

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 d. The dividend in year 4 will be $5.04  (1.08)  $5.44.
$5.44
The price in year 3 will be  $77.71
0.15  0.08
Looking at the information given in the problem, the above value is very close to the $77.75
given as the price of the stock in year 3. (The difference can probably be attributed to rounding
errors.) Since the cash flow model is simply an extension of the dividend valuation approach,
when the underlying assumptions about growth rates and required rates of return are the same
(as they are here), the two models will give the same results.

13. Calculator solution: N=4, i=?, PV=–80, PMT=0, FV=110. I=8.3% ans. Because 8.3% is below Mrs.
Bossard’s required rate of return of 10%, she should not buy the stock.

Alternatively: N=4, i=10, PV=-?, PMT=0, FV=110, PV= $75.13, ans. Using this approach, the
justified price is found to be well below the market price, which leads us to the same conclusion.

15. a. Valuation using the DVM:

D1 D (1  g )
Intrinsic value   0
kg kg
Buggies-Are-Us:
$2.25(1 + 0)
Intrinsic value   $22.50
0.10  0.06
Steady Freddie, Inc.:
$2.25(1  0.06) $2.385
Intrinsic value    $59.63
0.10  0.06 0.04
Gang Buster Group:
Step 1: Present value of dividends using a required rate of return of 10%:

Year Dividends  PVIF, 10% Present Value

1 $2.53 0.909 $2.30
2 2.85 0.826 2.35
3 3.20 0.751 2.40
4 3.60 0.683 2.46
Total: $9.51

Step 2: Price of stock at the end of year 4:

D5 D 4 (1  g )
P4  
kg kg
$3.60(1  0.06) $3.82
   $95.50
0.10  0.06 0.04

Step 3: Present value of the stock price:

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 PV  $95.50  PVIF10%, 4 YRS.
 $95.50  .683
 $65.23

Step 4: Value of stock  $9.51 (Step 1) + $65.23 (Step 3)  $74.74

b. The intrinsic value of Gang Busters is $74.74, compared to $59.63 for Steady Freddie and $22.50
for Buggies-Are-Us. The difference in the values is caused by the difference in dividend growth
rates. The Buggies-Are-Us dividends do not grow, resulting in a very low intrinsic value for its
stock. The dividends of Steady Freddie, Inc., grow at a constant rate of 6% forever, whereas
Gang Busters dividends grow at approximately 12% for the first four years and 6% from year 5
into the future. This higher growth in dividends in the earlier years causes Gang Buster Group to
be worth much more than Steady Freddie.

17. To solve this problem, first compute future sales, profits, dividends, and share price.

Future sales:
Year 1: $250 million 1.20  $300 million
Year 2: $300 million  1.10  $330 million

Future profits:
Year 1: $300 million  0.08  $24 million
Year 2: $330 million  0.08  $26.4 million

Future EPS:
Year 1: $24 million/15 million  $1.60
Year 2: $26.4 million/15 million  $1.76
Future dividends:
Year 1: $1.60  0.50  $0.80
Year 2: $1.76  0.50  $0.88

Future share price:

Year 1: $1.60 15  $24.00
Year 2: $1.76  15  $26.40

Now we can find the stock’s intrinsic value, approximate yield, and HPRs.
a. Intrinsic value/justified price:
Intrinsic value  Present value of future dividends and share price
 ($.80  0.833)  ($0.88  0.694)  ($26.40  0.694)
 $19.60
b. Calculate the IRR:
($0.80  PVIF1)  ($0.88  PVIF2)  ($26.40  PVIF2)  $15.00
IRR  37.50%
c. Holding period returns:

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 $0.80  $24.00  $15.00
HPR (year 1)   65.3%
$15.00
$0.88  $26.40  $24.00
HPR (year 2)   13.7%
$24.00

19. (i) Find the growth rate in dividends:

g  ROE  Firm's retention rate, rr
rr  1  Dividend payout ratio
g  0.20  (1  0.4)
g  0.12 or 12%
(ii) Use the constant growth rate dividend model:
D (1  g )
Value of the stock in four years  4 
kg
$3.00(1.12)

0.15  0.12
 $112.00
(iii) Value of stock today:
$112.00  PVI15%, 4  Present value
$112.00  0.572  $64.06
21. a. Using the P/E approach:
Stock price  EPS  P/E ratio (  Market P/E  Relative P/E)
 $4.00  (18.5  1.25)
 $4.00 (23.125)
 $92.50
b. ($110 – $87.50)/$87.50  25.7%

23. The most logical approach based on the data presented is to value the stock based on a multiple of
sales. Market values are fairly consistent at 10% of sales, so a good estimate would be $1 per share.
If, however, Newco is expected to grow much faster than its competitors, then the price should be
adjusted upward for the growth.

Smart/Gitman/Joehnk, Fundamentals of Investing, 12/e Chapter 8