ICAN REVISION CLASS - VALUATION OF COMMON STOCK

Valuation of Common Stock

Common Stock Valuation

 Common Stock is also known as equity shares and holders of these shares are the owners
of the company.
 Equity shares provide the long term sources of the fund and are used to finance long term
assets.
 Their liabilities, is limited to the amount of their investment.
 Common stock does not have a maturity date.
 In case of listed public limited company they can be sale in secondary market.
 In the event of liquidation, common stocks are paid only after payment of all liabilities
including liabilities for preferred shareholders.
 Par Value/face value of shares of public limited companies shall be Rs. 50 per share or
shall be equivalent to such amount exceeding Rs. 50 as is divisible by the figure ten as
provided in the memorandum of association and articles of association.


Method for Valuation of Equity

Dividend Discount Model (DDM)

Free Cash Flow Approach

1) Valuation of Shares by Dividend Discount Model (DDM) or Dividend Growth

Method:

P0=D1/(Ke-gc)

Po = D1/(1+Ke)1 +D2/(1+Ke)2 …………………………… + Dα/(1+Ke)α

Where,
Po = Intrinsic Value of shares
D = Dividend per share expected

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Ke = Required rate of return

The above equation can be modified by considering following situations:

Situation I: Price at zero period, (i.e. value today) when intension of investor is to hold the
shares for one year
P0 = (D1+ P1)/ (1+Ke)1 ---------- (i)
IF D1=D0 (1+gc)
P1=Po (1+gc) --------- (ii)
Now, substituting value of P1 from equation (ii) to equation (i),
P0 = [D1+ Po (1+gc)]/ (1+Ke)1
Or, P0(1+Ke)1= [D1+ Po (1+gc)]
Or, P0+P0Ke = D1+P0+P0gc
Or, PoKe = D1+P0gc
Or, P0Ke – P0gc =D1
Or, P0 (Ke-gc) = D1
Or, P0 =D1/(Ke-gc)

Situation II: When investor intent to hold the shares for n numbers of years
Po = D1/(1+Ke)1 +D2/(1+Ke)2 …………………… + Dn/(1+Ke)n + Pn/ (1+Ke)n
If n = 4 years
Po = D1/(1+Ke)1 +D2/(1+Ke)2 + D3/(1+Ke)3 + D4/(1+Ke)4 + P4/ (1+Ke)4
Or, Po = D1/(1+Ke)1 +D2/(1+Ke)2 + D3/(1+Ke)3 + P3/ (1+Ke)3
[Since, P3 = D4/(1+Ke)1 + P4/ (1+Ke)1]
Or, Po = D1/(1+Ke)1 +D2/(1+Ke)2 + P2/ (1+Ke)2
[Since, P2 = D3/(1+Ke)1 + P3/ (1+Ke)1]
Or, Po = D1/(1+Ke)1 + P1/ (1+Ke)1 [Since, P1 = D2/(1+Ke)1 + P2/ (1+Ke)1]
Po = D1/ (Ke-gc)

Now,
Case I: No growth (i.e. gc=0)
Po = D1/ (Ke-gc)
Or, P0=D1/Ke

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Case II: If growth is constant

Po = D1/ (Ke-gc)
Case III: Computation of Market Price of Share today (P0) when there are multiple
growth rates
Po = D1/(1+Ke)1 +D2/(1+Ke)2 ……………………… + Dn/(1+Ke)n + Pn/ (1+Ke)n

Pn (Value of share at the beginning of years when g become constant) =

D(n+1)/(Ke-gc)

Question No: 1
Compute the value of following stock, if investors require 20 percent return.
a. A stock paid Rs. 14 dividend per share, which is expected to be continued forever. b. A stock
paid Rs. 8 dividend per share in last year. Dividend is expected to grow at a constant rate of 6
percent forever.
Answer:
a. P0 = D1/Ke = Rs. 14/20% = Rs. Rs. 70
b. P0 = D1/(Ke-gc) = Rs. 8 (1.06)/(20%-6%) = Rs. 8.48/14% =Rs. 60.57

Question No: 2
An investor has made investment in the equity share of Pacific Chemicals Ltd. The capitalization
rate of the company is 20 per cent and the current dividend is 25 per share.
You are required to calculate the value of the company’s equity share if the company is slowly
sinking with an annual decline rate of 10% in the dividend. (3 Marks)
(December 2010)

Answer:
The value of the company’s equity share is given by the following formula:
Ve = D1/(k – g), where D1 is the dividend in the year 1, k is the capitalization rate and g is the
growth rate in dividend.

The value of equity share in the given condition is derived as follows:

Ve = Rs. 25 (1 – 0.10)/[(0.20 – (– 0.10)] = Rs. 25 x 0.90/0.30 = Rs. 22.50/0.30 = Rs. 75

 Multiple growth rate:

Question No. 3

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Excess Ltd. currently pays a dividend of NRs. 40 per share and this dividend is expected to grow
at a 15 per cent annual rate for 3 years, then at a 10 per cent rate for the next 3 years, after which
it is expected to grow at a 5 percent rate forever.
What value would place on the stock if an 18 percent rate of return were required?
(6 Marks) (June 2009)

Answer:
The present value of stock is NRs.452.99. The workings are as per below:
Statement showing the Value of the Share
----------------------------------------------------------------------------------------------
PV Factor
End of Dividend @ 18% PV of Dividend
----------------------------------------------------------------------------------------------
Year 1 40 (1.15) = 46.00 0.84746 38.98
2
Year 2 40 1.15) = 52.90 0.71818 37.99
3
Year 3 40 (1.15) = 60.84 0.60863 37.03
Year 4 60.84 (1.10) = 66.92 0.51579 34.52
2
Year 5 60.84 (1.10) = 73.62 0.43711 32.18
3
Year 6 60.84 (1.10) = 80.98 0.37043 30.00
210.70
----------------------------------------------------------------------------------------------

Year 7 dividend = NRs. 80.98 X 1.05

= NRs. 85.03

Market Value at the end of Year 6 = NRs. 85.029/ (0.18 – 0.05)

= NRs. 85.03/0.13
= NRs. 654.08

Present Value of Market Value at the end of Year 6 = 0.37043 X 654.08

= NRs. 242.29

Hence, Value of the Share = NRs. 210.70 + NRs. 242.29

= NRs. 452.99
Question No: 4
XYZ Ltd. is foreseeing a growth rate of 12% per annum in the next 2 years. The growth rate is
likely to fall to 10% for the third year and fourth year. After that the growth rate is expected to
stabilise at 8% per annum. If the last dividend paid was Rs. 1.50 per share and the investors'
required rate of return is 16%, find out the intrinsic value per share of Z Ltd. as of date. You may
use the following table: (10 Marks)

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Years 0 1 2 3 4 5
Discounting factor at 16% 1 0.86 0.74 0.64 0.55 0.48

(June 2010)

Answer:
Present value of dividend stream for first 2 years:
Rs. 1.50 (1.12) x 0.86 + 1.50 (1.12)2 x 0.74
Rs. 1.68 x 0.86 + 1.88 x 0.74
Rs. 1.45 + 1.39 = 2.84 (A)

Present value of dividend stream for next 2 years:

Rs. 1.88 (1.1) x 0.64 + 1.88 (1.1)2 x 0.55
Rs. 2.07 x 0.64 + 2.28 x 0.55
Rs. 1.33 + 1.25 = 2.58 (B)

Market value of equity share at the end of 4th year computed by using the constant dividend growth
model would be:

P4= D5
Ks - gn
Where D5 is dividend in the fifth year, gn is the growth rate and Ks is required rate of return.
Now, D5 =D4 (1 + gn)
D5 =Rs. 2.28 ( 1 + 0.08)
=Rs. 2.46
P4 = Rs. 2.46
0.16 - 0.08
= Rs. 30.75

Present market value of P4= 30.75 x 0.55 = Rs. 16.91 (C)

Hence the intrinsic value per share of Z Ltd. would be
A + B + C i.e. Rs. 2.84 + 2.58 + 16.91 = Rs. 22.33

Question No: 5
XYZ, Inc, has an odd dividend policy. The company has just paid a dividend of Rs. 12 per share
and has announced that it will increase the dividend by Rs. 6 per share for each of the next four
years, and then never pay another dividend. If you required 10 percent return on the company's
stock, how much will you pay for a share today?
Answer:

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Do= Rs. 12
D1=Rs.12+Rs.6 =Rs. 18
D2=Rs.18+Rs.6=Rs.24
D3= Rs. 24+Rs.6=Rs.30
D4=Rs.30+Rs.6=Rs.36
D5 to Dœ =0
Now,
P0 =D1/(1+Ke)1+D2/(1+Ke)2+D3/(1+Ke)3+D4/(1+Ke)4+P4/(1+Ke)4
=18/(1+0.1)1+24//(1+0.1)2+30/(1+0.1)3+36/(1+0.1)4+0
=16.38+19.92+22.50+24.48
=Rs. 83.28

Question No: 6
Kantipur Enterprises recently paid a dividend, Do, of Rs. 12.5. The company expects to have
supernormal growth of 20 percent for 2 years before the dividend is expected to grow at a constant
rate of 5 percent. The firm's cost of equity is 10 percent. a. What year is the terminal, or horizon,
date? b. What is the firm's horizon, or terminal, value? c. What is the firm's intrinsic value today,
Po?
Answer: (Self Practice)
Question No 7:
Max Mobile Ltd (MM) is expanding rapidly, and it currently needs to retain all of its earnings,
hence it does not pay any dividends. However, investors expect MM to begin paying dividends,
with first dividend of Rs. 4 coming 3 years from today. The dividend should grow rapidly-at a rate
of 20 percent per year –during Years 4 and 5. After Year 5, the company should grow at a constant
rate of 6 percent per year. If the required return on the stock is 12 percent, what is the value per
share of your firm's stock?
Answer: (Self Practice)
 Computation of growth under the Gordon Model:

Growth (gc)

gc= br
Simple average method or
compound average method

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Question No. 8
a) If retention ratio = 60% and IRR of the new investment =20%, what will be
growth of the company?
b) If, D0 = Rs. 6 and D4 =Rs 8.16, find the growth rate?
Solution:
a) gc = br=60% X 20%=60% X 0.2 =12%
b) Simple average method,
= (Rs. 8.16- Rs. 6)/Rs. 6*100% =36%, therefore gc = 36%/4 = 9%

Compound average method,

D4=D0 (1+gc)4
Or, Rs.8.16=Rs. 6(1+gc)4
Or, (1+gc)4 =Rs 8.16/Rs 6 =1.36
Or, 1+gc = (1.36)1/4 =1.08
Or, gc=1.08-1=8%

 Main assumption of Gordon, Ke> gc

Question No. 9
A company has a total investment of Rs. 4,000,000 in assets and 40,000 outstanding ordinary
shares at Rs. 100 per share (par value). It earns at a rate of 15 percent on its investment, and has a
consistent policy of retaining 50 percent of the earnings. If the appropriate discount rate of the firm
is 10 percent:
(3+4=7 Marks)
i) Determine the price of its share using Gordon’s model.
ii) What shall happen to the price of the shares if the company has a payout of 20 per cent and
60 per cent respectively?
(December 2009)
Answer:

(a) Price of Share using Gordon’s model:

The share valuation model of Gordon is as follows:

P0 = DIV1 = (1 – b)EPS1 = (1 – b)rA , where

k–g k – br k – br

A denotes investment per share, which is Rs. 100 in the present case.

When the payout is 50 per cent, the price of share will be:

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P0 = (1 – 0.5) 0.15 x 100 = 0.5 x 15 = 7.5/0.025 = Rs. 300

0.10 – (0.15 x 0.5) 0.10 – 0.075

(b) Price of Share at Payout of 20 and 60 percent:

(i) Payout of 20 per cent

gc = br = 80% x 0.15 = 12%, since Ke (10%) < gc (12%) value could not be computed by
Gordon model.
P0 = (1 – 0.8) 0.15 x 100 = 0.2 x 15 = 3/-0.02 = Rs. -150
0.10 – (0.15 x 0.8) 0.10 – 0.12

(ii) Payout of 60 per cent:

P0 = (1 – 0.4) 0.15 x 100 = 0.6 x 15 = 9/0.04 = Rs. 225

0.10 – (0.15 x 0.4) 0.10 – 0.06

 Computation of Ke :
 CAPM Model, Ke=RL + (Rm-RL)ꞵ
 Earning to price ratio, Ke =EPS/P0 =1/P/E ratio
 Ke =Bond Yield + risk premium approach

Question No. 10
An investor is seeking the price to pay for a security, whose standard deviation is 4%. The
correlation coefficient for the security with the market is 0.9 and the market standard deviation is
3.2%. The return from the government security and the market portfolio are 6.2% and 10.8%
respectively. The investor knows that, by calculating the required return, he can then determine
the price to pay for the security.
Required:
(2.5+2.5=5 Marks)
i) What is the required return on the security?
ii) What is the price of the security, if it is paying Rs. 25 of dividend per share
and its expected growth rate is 4?
[July 2015]
Answer:
i) The market sensitivity index i.e. the beta factor:

Standard deviation of an asset 0.04

β= ------------------------------------------------------*CORsm = -------------*.9 = 1.125
Standard deviation of Market 0.032

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Now, the expected return on the security can be ascertained with the help of CAPM equation as
follows:
Ke = Rf + (Rm-Rf) β
=6.2 + (10.8-6.2) × 1.125
=11.375%
ii) Price of security
Do (1+g)
Po = Ke-g

25(1+0.04)
= 0.11375-0.04

=Rs. 352.54

Question No. 11
You are considering an investment in the common stock of NEA Corp. The stock is expected to
pay a dividend of Rs. 14 a share at the end of the year. The stock has a beta equal to 1.5, the risk-
free rate is 6 percent, and the market risk premium is 4 percent. The stock's dividend is expected
to grow at some constant rate, g. The stock currently sells for Rs. 200 a share. Assuming the market
is in equilibrium, what does the market believe will be the stock price at the end of 3 years?

Answer:
Ke = Rf + (Rm-Rf) β = 6% + 4%x1.5 [Market risk premium = (Rm-R L)]
=12%
Po = D1/(Ke-gc)
Or, Rs. 200 = Rs. 14/( 12%-gc)
Or, gc = 5%
Now,
P3= D4/(Ke-gc) =Rs.16.21/(12%-5%) =Rs. 16.21/0.07 = Rs. 231.57

D4 =D1 (1+gc)3 =Rs 14(1+0.05)3 = Rs.16.21

 Additional questions

Question No. 12
Northern California Fruit Company’s latest earnings are Rs. 2 per share. Earnings per share are
expected to grow at a 20 percent compounded annually for 4 years, at a 12 percent annually for the
next 4 years and at 6 percent thereafter. The dividend-pay-out ratio is expected to be 25 percent for
the first 4 years, 40 percent for the next 4 years and 50 percent thereafter. At the end of year 8, the

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price -earnings ratio for the company is expected to be 8.5 times, where year 9’s expected earnings
per share are used in the denominator.
Required:
(4+4=8 Marks)
i) If the required rate of return is 14 present, what is the present market price
per share?
ii) If the present market price per share is Rs. 30, what is the stocks expected
return?
[June 2018]

Answer:

Growth Earning(Rs.) DP Ratio Dividend(Rs.)

Year 0 - 2.00 - -
Year 1 20% 2.40 25% 0.60
Year 2 20% 2.88 25% 0.72
Year 3 20% 3.46 25% 0.86
Year 4 20% 4.15 25% 1.04
Year 5 12% 4.65 40% 1.86
Year 6 12% 5.21 40% 2.08
Year 7 12% 5.84 40% 2.34
Year 8 12% 6.54 40% 2.62
Year 9 6% 6.93 50% 3.47

B. Price at the End of Eight Year

Given,
P8/E9 = 8.5Times
P8 = 8.5 * E9
P8 = 58.90
Therefore, price per share at the end of year 8 ( P8) will be = Rs. 58.90
C. Calculation of Current Market Price Per Share

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2.34 2.62 58.90

Rs 26.72 / Share
ii) Calculation of Stock’s Expected Return on Market Price of Rs. 30 Per Share
2.34

2.62 58.90

The expected rate of return needs to be calculated using interpolation technique.

Therefore we need to use Hit and Trial Method at different rate.
Try at 10 % of Discount Rate

2.34 2.62 58.90

P0 = Rs. 34.87
As given market price of Rs. 30 lies in between the price per share of Rs. 32.76 and Rs.
25.25 calculated using the discount rate at 10% and 14% respectively; therefore value can
be interpolated in between 10% and 14%.
Through interpolation
Expected Rate of Return = LR X [HR-LR]
= 10% + 34.87 - 30 X [14%-10%]
34.87 - 26.72
= 10 + 4.87/8.15
= 12.39%
Therefore the expected return at current market Price of NRs 30 is
11.47%.

Question No. 13
SSC Ltd. is considering the immediate purchase of some, or all, of the share capital of one of two
firms- SG Ltd. and CG Ltd. Both SG and CG have one million ordinary shares issued and neither
company has any debt capital outstanding.

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Both SG Ltd. and CG Ltd. are expected to pay a dividend in one year’s time. SG's expected
dividend amounts to Rs. 30 per share and that of CG is Rs. 27 per share. Dividends will be paid
annually and are expected to increase over time. SG’s dividends are expected to display perpetual
growth at a compound rate of 6% per annum. CG’s dividend will grow at the annual compound
rate of 33⅓% until a dividend of Rs. 64 per share is reached in year 4. Thereafter CG’s dividend
will remain constant.

If SSC is able to purchase all the equity capital of either company, then the reduced competition
would enable SSC to save some advertising and administrative costs which would amount to Rs.
225,000 per annum indefinitely and, in year 2, to sell some office space for Rs. 800,000. SSC would
change some operations of any company completely taken over, the details are:

SG – No dividend would be paid until year 3. Year 3 dividend would be Rs. 25 per share and
dividends would then grow at 10% per annum indefinitely.

CG – No change in total dividends in years 1 to 4, but after year 4 dividend growth would be 25%
per annum compounded until year 7. Thereafter annual dividend per share would remain constant
at the year 7 amount.
An appropriate discount rate for the risk inherent in all the cash flows mentioned is 15%.
Required:
(4+6=10 Marks)
i) Calculate the value per share for a minority investment in each of the companies, SG
and CG, which would provide the investor with a 15% rate of return.

ii) Calculate the maximum amount per share which SSC should consider paying for each
company in the event of a complete takeover.
[June 2019]

Answer:
i) Using the dividend valuation model, the value of ordinary shares is given by;

Vs = D0 (1+g)
Ke-g

Where D0 (1 + g) is the dividend due in one year.

Ke is the cost of equity or required return.
g is the anticipated growth in dividends.
Now,
Value per share of SG =30/(0.15-0.06)
= Rs. 333.33

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The model must be modified slightly to estimate the value per share of CG as follows:
= D1/(1+Ke)1 + D2/(1+ Ke)2+ D3/(1+ Ke)3+ D4/(1+ Ke)4 × 1/ Ke
= 27/(1.15)1 + 27(1.33)/(1.15)2 +27(1.33)2/(1.15)3 +64/(1.15)3 ×1/0.15
=23.48+27.15+31.40+243.95
= Rs. 362.8

ii) Maximum price in the event of a complete take-over:

Present value of cost savings:
Administrative costs= 225,000/0.15
= Rs. 1,500,000
Sale of office space = 800,000 x 0.7562
= Rs. 604,960

Total = Rs. 2,104,960

Saving per share = Rs. 2,104,960/1,000,000 = Rs.2.10
Value per share of SG (with change in operations):
Vs =25/(1.15)2×1/(0.15-0.10) = Rs.378.05
Maximum price = Rs. 378.05+Rs. 2.10 = Rs. 380.15

Value per share of CG:

Vc=27/1.15+(27×1.33)/(1.15)2 +

27×(1.33)2/(1.15)3+64/(1.15)4+(64×1.25)/(1.15)5+64×(1.25)2/(1.15)6+64×(1.25)
3
/(0.15) ×(1/(1.15)6

=23.48+27.15+31.40+36.59+39.77+43.23+313.25
=Rs. 562.13
Maximum price = 562.13+2.10
=Rs. 564.23

 Valuation of equity by Free Cash Flow approach:

(I) Free Cash Flow of Firm (FCFF) method:
 FCFF is the excess cash to the firm after reinvestment.
 Computation
 FCFF = EBIT x (1-t) +D&A - Change on working capital-CAPEX
OR
FCFF = Net income +Non cash expenses+Interest (1-t) - Change on working capital -
CAPEX
 Value of Firm = FCFF1/(K0-gc)

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 Total Value of Equity = Value of Firm-Value of Debts

 Per share value of equity =Total value of equity/No. of equity shares

Question No: 14
Balance sheet
Assets 2020 2019
Cash 30 15
Accounts receivables 90 45
Inventory 120 90
Current assets 240 150
Gross PPE 1100 900
Accumulated Depreciations 570 420
Net PPE 530 480
Total Assets 770 630

Liabilities 2020 2019

Sundry Creditors 60 60
Short term debt 60 30
Current Liabilities 120 90
Long term debt 242 300
Common Stock 150 150
Retained earnings 258 90
Total Capital and Liabilities 770 630

Income Statement
Particulars 2020 2019
Sales 900 750
Less: Cost of sales 360 300
Gross Profit 540 450
Administration and selling expenses 105 90
EBITDA 435 360
Depreciation 150 120
EBIT 285 240
Interest Expenses 45 30
EBT 240 210
Less: Tax (@30%) 72 63
EAT 168 147

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Required compute FCFF.

Answer:

FCFF = EBIT x (1-t) +D&A+/- Change on working capital-CAPEX

EBIT 285
tax rate 30%
EBIT x (1-t) 199.5

Depreciation and Amortization 150

Changes in WC 2020 2019 Changes Remarks

Accounts receivables 90 45 45 outflow
Inventory 120 90 30 outflow
Sundry Creditors 60 60 0
75 Outflow
Note: Cash and short term debts should not be taken for computing changes in WC

CAPEX 2020 2019 Changes Remarks

PPE 1100 900 200 Outflow

FCFF Computation
EBIT x (1-t) 199.5
Depreciation and Amortization 150
Changes in WC -75
CAPEX -200
FCFF 74.5

Question No: 15
Bhardhwaj Trader Ltd. is a growing supplier of office materials. Analysts project the following
free cash flow during the next 3 years of operation of the company, after which the free cash flow
is expected to grow at a constant rate of 7%.
Year 1 2 3
Free cash flow (Rs. in millions) (20) 30 40
The firm's weighted average cost of capital is 13%.
Required:
(3+2+2=7 Marks)
i) What is the terminal value of free cash flows after 3 rd year?

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ii) What is the value of the firm today?

iii) If the company has Rs. 100 million in debt and 10 million ordinary shares
outstanding, what is the price per share?
[June 2017]
Answer:
i) Terminal Value of Free Cash Flows after 3rd year:
Free Cash Flow of 3rd year (1+g)
= (WACC-g)

40(1+0.07)
=
0.13-0.07

=
Rs. 713.33 Million

ii) Calculation of Value of the Firm Today

Year FCF/Terminal Value (Rs. in millions) PVIF @ 13% PV (Rs. in millions)
1 (20) 0.8850 (17.70)
2 30 0.7831 23.493
3 40 0.6931 27.724
3 713.33 0.6931 494.41
Value of the Firm Today 527.927

iii) Calculation of Price Per Share

Value of Common
Equity = Value of Firm Today - Value of Debt

= 527.927 Million - 100 Million

= Rs. 427.927 Million

Value of Equity
Price Per Share =
No. of Equity Share

Rs. 427.927 Million

=
10 Million

= Rs. 42.7927

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Question No: 16
The valuation of a company has been done by an investment analyst. Based on an expected free
cash flow of Rs. 5.40 million for the following year and an expected growth rate of 9 percent, the
analyst has estimated the value of the company to be Rs. 180 million. However, he committed a
mistake of using the book values of debt and equity.
The book value weights employed by the analyst are not known, but you know that the company
has a cost of equity of 20 percent and post-tax cost of debt of 10 percent. The market value of
equity is thrice its book value, whereas the market value of its debt is nine-tenth of its book value.
Required:
[7 Marks]
Calculate the correct value of the company.
[June 2019]

Answer:
Cost of capital by applying Free Cash Flow to Firm (FCFF) Model is as follows:
Value of Firm (V0) = FCFF1 / (Ko - gn)
Where, FCFF1 = Expected FCFF in year 1
Ko = Cost of Capital
gn = Growth rate =9%
Thus Rs. 180 m = 5.4 m / (Kc - gn)
Since, g = 9%
Ko -9% = 5.4/180
Ko = 0.03 +0.09 = 12%
Now, let X be the weight of debt and given cost of equity = 20% and cost of debt=10%,
Then 20% (1-X) + 10%X = 12%
Hence, X=0.80, so book value weight of debt was 80% and accordingly book value
weight of equity was 20%
Thus, correct weight should be 60 (thrice of book value of equity) and 72 (nine-tenth of
book value) of debt
Cost of capital = Ko= 20% (60/132) + 10% (72/132) = 14.55%
Correct value of the firm = Rs. 5.4 m / (0.1455 - 0.09) = Rs. 97.3 m

 Computation of Return on shares

I) Dividend Yield = D1/P0
D1= Expected dividend
P0 = Current Price
II) Capital Gain or Loss Yield = (P1-P0)/P0
P1= Closing Price

CA RAJENDRA MANGAL JOSHI 17

 ICAN REVISION CLASS - VALUATION OF COMMON STOCK

P0= Opening Price

III) Rate of Return on stock (Ke) =Dividend Yield + Capital Gain or Loss Yield

Question No: 17
Chaudhary Automobile Company is experiencing a period of repaid growth. Earnings and
dividends are expected to grow at a rate of 12 percent during the next 2 years, at 10 percent in the
third year, and at a constant rate of 5% thereafter. Company's last dividend was Rs. 10, and the
required rate of return on the stock is 15 percent. a. Calculate the value of the stock today b.
Calculate P1 and P2. c. Calculate the dividend yield and capital gain yield for year 1, 2 and 3.

Answer: (Self practice)

Year Dividend Yield Capital gain or loss Total Return
yield (ke)=Dividend Yield
+ Capital gain or loss
Yield
1 =D1/P0= =(P1-P0)/P0
2 =D2/P1= =(P2-P1)/P1
3 =D3/P2= =(P3-P2)/P2

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CA RAJENDRA MANGAL JOSHI 18