CHAPTER 18: EQUITY VALUATION MODELS

Solutions to Suggested Problems

4. In the next two years, dividend will grow at a rate of 20%. Therefore, the present value of the
next two dividends:

$1.20 $1.202 $1.20 $1.44

+ = + = $2.3292
1.085 1.0852 1.085 1.0852
After that, dividend is expected to grow at a rate of 4% forever. In year 3, dividend will be:
$1.44(1.04) = $1.4976. Therefore, the present value of all the expected dividends in year 2 is:

𝐷3 $1.4976
𝑉2 = = = $33.28
𝑘 − 𝑔 0.085 − 0.04

So, 𝑃𝑉 of all the dividends from year 3 onwards is:

33.28
= $28.2699
1.0852
Finally, intrinsic value of the stock is: 𝑉0 = $2.3292 + $28.2699 = $30.5991

D1 $1.22  (1.05)
5. The required return is 9%. k  g  0.05  .09, or 9%
P0 $32.03

D1 $1 (1.05)
6. The required return is 8%. k  g  0.05  .08, or 8%
P0 $35

7. The PVGO is $0.56:

$3.64
PVGO  $41   $0.56
0.09

1
8. a. D1
k g
P0
$2
0.16   g  g  0.12, or 12%
$50

b. If the growth forecast is revised to 5%, then price would fall:

D1 $2
P0    $18.18
k  g 0.16  0.05

The price falls in response to the more pessimistic dividend forecast. Therefore, ceteris paribus,
i.e., everything else remaining constant, the 𝑃/𝐸 ratio would fall. The lower 𝑃/𝐸 ratio is evidence
of the diminished optimism concerning the firm's growth prospects.

9. a. g = ROE  b = 16%  0.5 = 8%

D1 = $2  (1 – b) = $2  (1 – 0.5) = $1
D1 $1
P0    $25.00
k  g 0.12  0.08

b. P3 = P0(1 + g)3 = $25(1.08)3 = $31.49

10. a. k  rf   [ E (rm )  rf ]  6%  1.25  (14%  6%)  16%

2
g  9%  6%
3
1
D1  E0  (1  g )  (1  b)  $3  (1.06)   $1.06
3
D1 $1.06
P0    $10.60
k  g 0.16  0.06

b. Leading P0/E1 = $10.60/$3.18 = 3.33

Trailing P0/E0 = $10.60/$3.00 = 3.53

E1 $3.18
c. PVGO  P0   $10.60   $9.275
k 0.16
The low P/E ratios and negative PVGO are due to a poor ROE (9%) that is less than
the market capitalization rate (16%).

2
 d. Now, you revise b to 1/3, g to 1/3  9% = 3%, and D1 to:
E0  (1 + g)  (2/3)
$3  1.03  (2/3) = $2.06
Thus:
V0 = $2.06/(0.16 – 0.03) = $15.85

V0 increases because the firm pays out more earnings instead of reinvesting a poor
ROE. This information is not yet known to the rest of the market.

D1 $8
11. a. P0    $160
k  g 0.10  0.05

b. The dividend payout ratio is 8/12 = 2/3, so the plowback ratio is b = 1/3. The implied
value of ROE on future investments is found by solving:
g = b  ROE with g = 5% and b = 1/3  ROE = 15%

c. Assuming ROE > k, no-growth value of the share is equal to:

E1 $12
NGV0    $120
k 0.10
Therefore, 𝑃𝑉𝐺𝑂 = $160 − $120 = $40, i.e., the market is paying $40 per share for
growth opportunities.