Tutorial 7 Chapter 10

10-2 Why is the required rate of return for a stock the discount rate to be used in
valuation analysis?

The required rate of return for a stock is the minimum expected rate of return
necessary to induce an investor to purchase a stock. It accounts for opportunity cost and the
risk involved for a particular stock. If an investor can expect to earn the same return
elsewhere at a lesser risk, why buy the stock under consideration?

If your opportunity cost for a given risk level is 15%, you should not purchase a stock
with that risk level unless you can expect to earn 15% or more from that stock.

m
er as
10-4 What is the dividend discount model? Write this model in equation form.

co
eH w
The Dividend Discount Model is a widely used method to value common stocks. A present

o.
rs e
value process is used to discount expected future dividends at an appropriate required rate of
ou urc
return to determine intrinsic value. The equation is:
D1 D2 D3 D∞
o

PVcs = ───── + ────── + ────── + ... + ──────

aC s

(1+k) (1+k)2 (1+k)3 (1+k) ∞

v i y re
ed d

10-9 Assume that two investors are valuing General Foods Company and have agreed to
ar stu

use the constant-growth version of the dividend valuation model. Both use $3 a share as
the expected dividend for the coming year. Are these two investors likely to derive
sh is

different prices? Why or why not?

Th

The two investors are likely to derive different prices because:

(a) They will probably use different estimates of g, the expected growth rate in dividends.
(b) They are likely to use different required rates of return.

10-10 Once an investor calculates intrinsic value for a particular stock, how does he or
she decide whether or not to buy it?

Investors compare intrinsic value (IV) to the current market price (CMP) of the stock.

This study source was downloaded by 100000800904700 from CourseHero.com on 11-30-2021 04:44:47 GMT -06:00

https://www.coursehero.com/file/72166304/Tutorial-7docx/
 If IV > CMP, the stock is undervalued -- buy
If IV < CMP, the stock is overvalued -- sell
If IV = CMP, the stock is correctly valued and in equilibrium.

10-12 The P/E ratio can be used in valuation analysis in two completely different ways.
Explain.

The P/E ratio can be used:

(a) in the multiplier model.
(b) as a relative valuation technique

m
er as
co
10-2 Jay Technology is currently selling for $60 a share with an expected dividend in the

eH w
coming year of $2 per share. If the growth rate in dividends expected by investors is 5

o.
rs e
percent, what is the required rate of return for Jay?
ou urc
Using the constant growth version of the Dividend Discount Model:
k = D1/P0 + g
o
aC s

= $2.00/$60 + .05
v i y re

= .0833 or 8.33%

Price = D1/(k-g)
ed d

(k-g)P = D1
ar stu

k-g = D1/p
k = (D1/p) + g
sh is

10-5
Th

a. Given a preferred stock with an annual dividend of $3.50 per share and a price of
$40, what is the required rate of return?

k = D0/P0 = $3.50/$40 = 8.75%

price = D/k
k = D/P
b. Assume now that interest rates rise, leading investors to demand a required rate of
return of 10 percent. What will the new price of this preferred stock be?

This study source was downloaded by 100000800904700 from CourseHero.com on 11-30-2021 04:44:47 GMT -06:00

https://www.coursehero.com/file/72166304/Tutorial-7docx/
 The price will decline because required rates of return rise while dividends remain fixed.

Specifically,
P = $3.50/.10 = $35

10-10 The Parker Dental Supply Company sells at $36 per share, and Ray Parker, the
CEO of this well-known Research Triangle firm, estimates the latest 12-month earnings
are $3 per share with a dividend payout of 50 percent. Dr. Parker’s earnings estimates
are very accurate.

a. What is Parker’s current P/E ratio?

m
The current P/E ratio is $36/$3 = 12

er as
co
b. If an investor expects earnings to grow by 10 percent a year, what is the projected

eH w
price for next year if the P/E ratio remains unchanged?

o.
E0 = $3
rs e
ou urc
E1 = E0(1+g)
= $3(1+.10)
o

= $ 3.30
aC s
v i y re

With an unchanged P/E of 12, the new price will be

12 x $3.30 = $39.60
ed d

c. Dr. Parker analyzes the data and estimates that the payout ratio will remain the same.
ar stu

Assume the expected growth rate of dividends is 10 percent, and an investor has a
required rate of return of 16 percent, would this stock be a good buy? Why or why not?
sh is

D/E = 50% -- payout ratio

Th

g = 10% -- expected growth rate of dividends

k = 16% -- required rate of return
expected rate of return = D1/P0 + g
= $1.65/$36 + .10
= .146 or 14.6%
Alternatively,
P0 = D1/(k-g)
= $1.65/(.16-.10)

This study source was downloaded by 100000800904700 from CourseHero.com on 11-30-2021 04:44:47 GMT -06:00

https://www.coursehero.com/file/72166304/Tutorial-7docx/
 = $27.5
This stock is not a good buy because the expected return is less than the required return or,
alternatively, the estimated value (price) of the stock less than the current market price.

d. If interest rates are expected to decline, what is the likely effect on Parker’s P/E
ratio?

If interest rates are expected to decline, the likely effect is an increase in the P/E ratio (as
price will increase because of decline in k) for this stock as well as other stocks.

m
er as
co
eH w
o.
rs e
ou urc
o
aC s
v i y re
ed d
ar stu
sh is
Th

This study source was downloaded by 100000800904700 from CourseHero.com on 11-30-2021 04:44:47 GMT -06:00

https://www.coursehero.com/file/72166304/Tutorial-7docx/
Powered by TCPDF (www.tcpdf.org)