SOLUTIONS TO END-OF-CHAPTER PROBLEMS

7-1 D0 = $1.50; g1-3 = 5%; gn = 10%; D1 through D5 = ?

D1 = D0(1 + g1) = $1.50(1.05) = $1.5750.

D2 = D0(1 + g1)(1 + g2) = $1.50(1.05)2 = $1.6538.

D3 = D0(1 + g1)(1 + g2)(1 + g3) = $1.50(1.05)3 = $1.7364.

D4 = D0(1 + g1)(1 + g2)(1 + g3)(1 + gn) = $1.50(1.05)3(1.10) = $1.9101.

D5 = D0(1 + g1)(1 + g2)(1 + g3)(1 + gn)2 = $1.50(1.05)3(1.10)2 = $2.1011.

7-2 D1 = $1.50; g = 6%; rs = 13%;

P^ 0 =?

D1 $ 1.50
P^ 0 = r s −g = 0.13−0.06 = $21.43.

¿
^
P r
7-3 P0 = $22; D0 = $1.20; g = 10%; 1 = ?; s= ?

P^ 1 = P (1 + g) = $22(1.10) = $24.20.
0

¿
D1 $1.20 (1.10)
r s = P0 +g= $22 + 0.10

$1.32 ¿
= $22 + 0.10 = 16.00%. r s = 16.00%.
7-4 Dps = $5.00; Vps = $50; rps = ?

D ps
$5.00
rps =
v ps = $50.00 = 10%.
7-5 0 1 2 3

| | | |

D0 = 2.00 D1 D2 D3

P^ 2

Step 1: Calculate the required rate of return on the stock:

rs = rRF + (rM - rRF)b = 7.5% + (4%)1.2 = 12.3%.

Step 2: Calculate the expected dividends:

D0 = $2.00

D1 = $2.00(1.20) = $2.40

D2 = $2.00(1.20)2 = $2.88

D3 = $2.88(1.07) = $3.08

Step 3: Calculate the PV of the expected dividends:

PVDiv = $2.40/(1.123) + $2.88/(1.123)2 = $2.14 + $2.28 = $4.42.

Step 4: Calculate
P^ 2 :

P^ 2 = D3/(rs– g) = $3.08/(0.123 – 0.07) = $58.11.

Step 5: Calculate the PV of

P^ 2 :
 PV = $58.11/(1.123)2 = $46.08.

Step 6: Sum the PVs to obtain the stock’s price:

P^ 0 = $4.42 + $46.08 = $50.50.

Alternatively, using a financial calculator, input the following:

CF0 = 0, CF1 = 2.40, and CF2 = 60.99 (2.88 + 58.11) and then enter I/YR = 12.3 to solve for NPV
= $50.50.

7-6 Value of operations = Vop = PV of expected future free cash flow

FCF(1+g ) $ 400 ,000 (1 .05 )

Vop = WACC−g = 0 .12−0 .05 = $6,000,000.

7-7 The growth rate in FCF from 2018 to 2019 is g = ($750.00-$707.55)/$707.50 = 0.06.

$ 707 .55(1.06 )
HV2019= VOp at 2019= 0. 11−0.06 = $15,000.
7-8 The problem asks you to determine the constant growth rate, given the following facts: P 0 = $80,
D1 = $4, and rs = 14%. Use the constant growth rate formula to calculate g:

¿
D1
r s = P0 +g

$4
0.14 = $80 + g

g = 0.09 = 9%.
7-9 The problem asks you to determine the value of
P^
3 , given the following facts: D 1 = $3, b =
0.8, rRF = 5.2%, RPM = 6%, and P0 = $40. Proceed as follows:

Step 1: Calculate the required rate of return:

rs = rRF + (rM– rRF)b = 5.2% + (6%)0.8 = 10%.

Step 2: Use the constant growth rate formula to calculate g:

¿
D1
r s = P0 +g

$3
0.10 = $ 40 + g

g = 0.025 = 2.5%.

Step 3: Calculate
P^ 3 :

P^ 3 = P0(1 + g)3 = $40(1.025)3 = $43.076 ≈ $43.08.

Alternatively, you could calculate D4 and then use the constant growth rate formula to solve for
P^ 3 :

D4 = D1(1 + g)3 = $3.00(1.025)3 = $3.2307.

P^ 3 = $3.2307/(0.10– 0.025) = $43.0756 $43.08.

7-10 Vps = Dps/rps; therefore, rps = Dps/Vps.

a. rps = $3.5/$30 = 11.67%.

b. rps = $3.5/$40 = 8.75%.

c. rps = $3.5/$50 = 7.00%.

d. rps = $3.5/$70 = 5.00%.

D1 D 0 (1+g) $6 [ 1+(−0.04 )] $5.76

7-11
P^ 0 = r s −g = r s −g = 0.14−(−0. 04 )] = 0.18 = $32.00.
7-12 D0 = $1, rS = 7% + 6% = 13%, g1 = 50%, g2 = 25%, gn = 6%.

rs = 13%
0 1 2 3 4

| | | | |
g1 = 50% g2 = 25% gn = 6%
1.501.875 1.9875

1.327+ 28.393 = 1.9875/(0.13 – 0.06)

= 30.268

23.704

$25.03

7-13 Calculate the dividend stream and place them on a time line. Also, calculate the price of the stock
at the end of the nonconstant growth period, and include it, along with the dividend to be paid at t
= 5, as CF5. Then, enter the cash flows as shown on the time line into the cash flow register, enter
the required rate of return as I = 15, and then find the value of the stock using the NPV
calculation. Be sure to enter CF0 = 0, or else your answer will be incorrect.

D0 = 0; D1 = 0, D2 = 0, D3 = 0.50

D4 = 0.50(1.8)=0.9; D5 = 0.50(1.8)2=1.62; D6 = 0.80(1.8)2(1.07)

=$1.7334.

P^ 0 =?

rs = 16% g = 80% g = 7%
0 1 2 3 4 56

| | | | | | |

0.50 0.901.62
1 .7334
0.16−0.07
0.3219.26

0.5020.88

9.94
 $10.76 =
P^ 0

P^ 5 = D6/(rs– g) = 1.7334/(0.16– 0.07) = 19.26. This is the price of the stock at the end of Year
5.

CF0 = 0; CF1-2 = 0; CF3 = 0.5; CF4 = 0.9; CF5 = 20.88; I = 16%.

With these cash flows in the CFLO register, press NPV to get the value of the stock today: NPV
= $10.76.

D ps
$10
7-14 a. Vps =
r ps = 0.08 = $125.

$10
b. Vps = 0.12 = $83.33.

7-15 a. g = $1.1449/$1.07 – 1.0 = 7%.

Calculator solution: Input N = 1, PV = -1.07, PMT = 0, FV = 1.1449,

I/YR = ? I = 7.00%.

b. $1.07/$21.40 = 5%.

¿
c. r s= D1/P0 + g = $1.07/$21.40 + 7% = 5% + 7% = 12%.
 $3(1−0.05 ) $2.85
7-16 a. 1.
P^ 0 = 0.13+0. 05 = 0.18 = $15.83.

2.
P^ 0 = $3/0.13 = $23.08.

$ 3(1. 05) $3.15

3.
P^ 0 = 0. 13−0. 05 = 0.08 = $39.38.

$ 3 (1 . 10) $3.30
4.
P^ 0 = 0. 13−0. 10 = 0.03 = $110.00.

b. 1.
P^ 0 = $3.39/0 = Undefined.

2.
P^ 0 = $3.45/(-0.02) = -$172.5, which is nonsense.

These results show that the formula does not make sense if the required rate of return is equal
to or less than the expected growth rate.

c. No.

$ 108 , 000
7-17 a. HV2 = 0. 12−0 . 08 = $2,700,000.

b. 0 1 2 3 N g = 8%
WACC = 12%
| | | |  |
 $80,000 $100,000 $108,000

$ 71,428.57

79,719.39

2,152,423.47

$2,303,571.43

$ 40(1. 07)
7-18 a. HV3 = 0. 13−0. 07 = $713.33.

b. 0 1 2 3 4 N
WACC = 13% g = 7%
| | | | |  |

-20 30 40

($ 17.70)

V op
23.49 3 = 713.33

522.10753.33

$527.89

c. Total valuet=0 = $527.89 + $10.0 = $537.89.

Value of common equity = $537.89 - $100 = $437.89.

$ 437.89
Price per share = 10 .0 = $43.79.