Spring 2021 Corporate Finance Prof.

Auh

[Stock solution]

1) High Five Corporation’s stock pays a dividend of $1.85 per share every year and
expects this to continue into the future. What is the price of the company’s stock if the
rate of return is 14%?

Notice that this is just a perpetuity with fixed and constant dividend payments
each year:
Price = D / r = $1.85 / 14% = $13.21

2) Leap Year, Co. currently pays no dividends on its stock. Management decides to
issue dividends of $2.15 per share three years from now and expect to increase
dividends by 2% every year after. What is the price of the company’s stock today if
the rate of return is 21%?

Since dividends start in year 3, we can calculate the price of the stock at year 2 as:
Price in 2 years = D/(r-g) = $2.15 / (21%-2%) = $11.32

Need to discount this back to year 0.

Price today = Price in 2 years discounted back to today = $11.32 / (1+21%)2 = $7.73

3) The common stock of Say Cheese, Inc. offers an expected total return of 9.2 percent.
The last annual dividend was $2.10 a share. Dividends increase at a constant 2.6
percent per year. What is the dividend yield?

Total return = g + D1/P = capital gains rate (growth rate) + dividend yield = 9.2%
Dividend yield (D/P) = 9.2% - 2.6% = 6.6%

All other information is extraneous!

4) Spring Break, Corp. currently has earnings per share (EPS) of $2 and expects this to
grow at 5.6 percent per year. If the benchmark price to earnings ratio (PE) ratio is 12,
what is the expected share price next year?

Benchmark price-earnings ratio (PE) = 12

Expected price next year = $2*(1+5.6%)*12 = $25.34

5) You finally found your dream home. The selling price is $640,000; you will put
$64,000 down and obtain a 30 year fixed rate mortgage at 6.4% APR for the balance of
the loan. Assume that monthly payments begin in one month.

APR = 6.4% monthly, so monthly rate = 6.4% / 12 = 0.533%

Principal = PV = $640,000 – $64,000 = $576,000

N = 30*12 = 360 months

Spring 2021 Corporate Finance Prof. Auh

a) What will each payment be?

PV = (C/r)*[1-1/(1+r)t]

$576,000 = (C/0.533%)*[1-1/(1+0.533%)360]

Solving, C = $576,000*0.533% / [1-1/(1+0.533%)360] = $3,602.91

b) Although you will get a 30 year mortgage, you plan to repay the loan by making an
additional payment each month along with your regular payment. How much
extra must you pay each month if you wish to pay off the loan in 20 years?

This is simply using the same loan details, but over N = 20 years = 20*12 = 240
months
PV = (C/r)*[1-1/(1+r)t]

$576,000 = (C/0.533%)*[1-1/(1+0.533%)240]

Solving, C = $576,000*0.533% / [1-1/(1+0.533%)240] = $4,260.66

Amount extra = $4,260.66 – $3,602.91 = $657.74 more

c) Your banker suggests that, rather than obtaining a 30 year mortgage and paying it
off early, you should simply obtain a 15 year loan for the same amount. The rate
on this loan is 4.6% APR. By how much will your monthly payment change for
the 15 year loan than the regular payment on the 30 year loan? In your answer,
specify whether the payment will be higher or lower and by what amount.

APR = 4.6% monthly, so monthly rate = 4.6% / 12 = 0.383%

N = 15*12 = 180 months

PV = (C/r)*[1-1/(1+r)t]

$576,000 = (C/0.383%)*[1-1/(1+0.383%)180]

Solving, C = $576,000*0.383% / [1-1/(1+0.383%)180] = $4,435.86

Amount extra = $4,435.86 – $3,602.91 = $832.94 more

6) Consider the following two stocks:

A: Stock A is expected to provide a dividend of $15 a share forever.

B: Stock B is expected to pay a dividend of $8 next year. Thereafter, dividend

growth is expected to be 20% a year for four years (i.e., until year 5) and 0%
thereafter.

Timing is crucial for this problem!

Spring 2021 Corporate Finance Prof. Auh

tA B

0 - -

1 $15 $8

2 $15 $8*1.2

3 $15 $8*1.22

4 $15 $8*1.23

5 $15 $8*1.24

6 $15 $8*1.24

7 $15 $8*1.24

… … …

a) What are the prices of each stock if the appropriate discount rate for each stock is
6%? Which stock is the most valuable?

This is straight forward using our perpetuity formula and our two-stage dividend
growth model (one annuity + one discounted perpetuity):

Stock A = D1 / r = $15 / 6% = $250.00

Stock B = [D1 / (r-g)]*[1-(1+g)5/(1+r)5] + (D1*(1+g)4/r) / (1+r)5

= [$8 / (6%-20%)]*[1-(1+20%)5/(1+6%)5] + ($8*(1+20%)4/6%) / (1+6%)5

= $255.71
Stock B is most valuable (highest price).

b) What are the prices of each stock if the appropriate discount rates are as follows:
for the first five years, the rate is 6%, and then 12% thereafter? Which stock is the
most valuable?

This is a bit trickier with the changing interest rates. We can split into blocks of
cashflows with the same interest rates: years 1-5 cashflows are discounted at 6%
and years 6-infinity cash flows are discounted at 12%. Here timing is crucial!

Stock A = (D1/r1)*[1-1/(1+r1)5] + (D1/ r2)/(1+r1)5

= ($15/6%)*[1-1/(1+6%)5] + ($15/12%)/(1+6%)5 = $156.59

Spring 2021 Corporate Finance Prof. Auh

Stock B = [D1/(r1-g)]*[1-(1+g)5/(1+r1)5] + (D1*(1+g)4/r2)/(1+r1)5

= [$8/(6%-20%)]*[1-(1+20%)5/(1+6%)5]+($8*(1+20%)4/12%)/(1+6%)5

= $152.41
Stock A is most valuable (highest price).
7) Consider Company A, B and C with the following information:

Company A B C

EPS1 $10 $10 $10

r (discount rate) 10% 10% 10%

b (retention rate) 0% 25% 25%

RIR - 7% 12%

a) Assuming constant growth, compute PVGO (present value of growth

opportunities) of each firm, and describe the results.

EPS1 DIV1
Growth Rate = b × RIRand PVGO = P0 − and P0 = where DIV1 = (1 −
r (r−g)
b) × EPS1

For firm A, b = 0% so PVGO = 0

For firm B, b is 25% and RIR is 7%. DIV1 is 7.5. P0 = 7.5 / (0.10 - 0.0175) = $90.91
and EPS1 / r = 100
PVGO = 90.91 – 100 = -$9.1

For firm C, b is 25% and RIR is 12%. DIV1 is 7.5. P0 = 7.5 / (0.10 - 0.03) = 107.1 and
EPS1/ r = 100.
PVGO = 107.1 – 100 = $7.1

b) Suppose you want to buy one of these stocks for your investment. Based on your
answer in (a), which one would you pick, and why?
Spring 2021 Corporate Finance Prof. Auh

One should pick stock C because it has the most promise of future growth and
upside price increase.

c) Now, you think that RIR of Company C is going to be sustainable only for the
next three years. You think that after that period it will come down to 9% level.
What is the stock price of C?

We find g for years 1 to 3 at 3% and then at 2.25% for the years onward.

In year 4, DIV4 = DIV3 ∗ (1 + 𝑔) = 7.95675*1.0225 = $8.14. We P4 = DIV4 / (r -

g) = 8.14 / 0.0775 = $105.032. PVP4 = 105.032/(1.1^3) = $78.91

Cf, DIV3 = 𝐷𝐼𝑉2 ∗ (1 + 𝑔) = 7.725 * (1.03) = 7.95675

g in DIV4 = b * RIR = 25%* 9% = 0.0225.

Then add this $78.91 to the PV of the cash flows of the first 3 years, which is PV =
C 1+g t
(1 − (1+r ) )
r−g

7.5 1+0.03 3
Therefore PV = (1 − (1+0.10) ) => 19.18
0.10−0.03

Thus, the price is 78.91 + 19.18 = 98.09

8) Next year, NPI expects net income of $16 million. It plans to reinvest 50% of its
earnings and pay out the rest as dividends. NPI will continue this policy into the
indefinite future. Its cost of equity capital is 12%. If NPI earns a 16% rate of return on
the funds reinvested, what is the growth rate and value of NPI’s equity?
Hypothetically, had the firm not reinvested any of its earnings and instead paid
them out as dividends, what would have been the equity value? How much does
reinvesting contribute to equity value?

Income = 16; b = 50%; r = 12%; RIR = 16%

The growth rate of equity is g = b * RIR = 8%.

NPI’s EV = DIV1 /( r – g ) = 8 / (0.04) = 200. Equity value is $200 million.

Assuming no reinvestment, EV = Earnings / r = 16 / 0.12= $133.33 million

Reinvesting contributes $66.666 million in equity value.
Spring 2021 Corporate Finance Prof. Auh

9) Suppose NPI’s reinvestment rate of return on all future retained earnings were
12% instead of the 16% assumed in the previous problem. (Continue to assume
initial earnings of $16 million.)

a) What happens to the growth rate and the value of equity? Compute the growth
rate and equity value if NPI reinvests:

At 12% RIR, g would drop to 0.5 * RIR = 6%. EV = 8 / 0.06 = $133.33 million

b) 25% of earnings

Assuming 25% of reinvestment, the new g is 3% and DIV1 = 12

EV = 12 / (0.12 - 0.03) = 12 / 0.09 = $133.33 million

c) 0% of earnings

At 0% reinvested there is no PVGO. We simply compute earnings / cost of

capital = 16 / 0.12 = $133.33 million

10) You are the sole equity owner of A-Team Inc. Your firm is expected to generate
the following set of cash flows ($’000) in the future:

Year 1 2 3 4 5
Cash Flows 140 150 180 220 285

The discount rate for these cash flows is 9%.

a) What is the present value of the cash flows that A-Team Inc. is expected to
generate? Call this “The Value of the Firm”1.

The best way to find this is using a financial calculator and the CF function. The
result is $734.8.

PRESS CF button

Input each cash flows as follows.

C01=140; F01=1

1
Technically this is correct if your firm has no non-operating assets. Assume this is the case.
Spring 2021 Corporate Finance Prof. Auh

C02=140; F01=1

C03=140; F01=1

C04=140; F01=1

C05=140; F01=1

PRESS NPV button

Input I=9

CPT NPV.

In previous years your firm borrowed money to finance early stage investments.
Currently A-Team Inc. still has an outstanding debt of $300K that remains on it
current balance sheet (i.e. at t=0). The debt contract you have signed commits the
firm to pay to the bank the interest on the outstanding principal each year as well
retire $100K in principal until the loan is fully repaid. All payments are made on the
last day of each year and the interest is calculated on the remaining principal from
the previous year2. The loan rate of interest is 9%.3

b) What are the cash flows that the debt holders will receive in each year? What is
the present value of these cash flow (use 9% as the discount rate)?

Year 1: interest payment of $27 and principal payment of $100.

Year 2: interest payment of $18 and principal payment of $100.
Year 3: interest payment of $9 and principal payment of $100.

c) Assume that all remaining cash flows (over above what is paid to the debt
holders) are paid out as a dividend. What is the cash flow to equity holders each
year?

Year 1:140-127= $13

Year 2: 150-118= $32

Year 3: 180-109= $71

Year 4: $220

Year 5: $285

2
So for example the interest payment due in year 1 is $300K9%=$27K.
3
Later in the semester we will focus on the more realistic scenario where the interest rate on borrowing is lower
than the discount rate for equity. This is not important for the current problem.
Spring 2021 Corporate Finance Prof. Auh

d) What is the present value of the cash flow to equity holders? You should use the
discount rate of 9% to value these although later in the semester we will learn
how to adjust this discount rate to reflect the capital structure of the firm.

Using a financial calculator and CF function we get $434.8

e) What is the difference between the value of the firm and the value of equity?
Explain.

The value of the firm is the total value of assets to which both equity holders and
creditors have a claim. The equity value is the value left to shareholders once debt
payments have been serviced.

11) You are the sole equity owner of B-Team Inc. Currently your firm has no debt.
Your firm is expected to generate the following set of cash flows ($’000) in the future

Year 1 2 3 4 5
Cash Flows 250 400 -150 600 780

The discount rate for these cash flows is 12%. Notice that in the third year cash
flow is negative (-150) indicating that you expect B-Team Inc. to undertake a large
investment in that year.
a) Suppose first that you expect to pay for this investment in the third year yourself.
All other positive cash flows will be paid out to you as a dividend. What is the
present value of your B-Team’s equity?

Again, we use the CF function in the calculator to find $ 1259.2.

b) Suppose instead that B-Team Inc. plans to finance the investment by borrowing
$150K in the third year. The firm plans to repay this debt (both interest and
principal) in the fourth year. For simplicity assume that the firm will borrow at
12%. What is the total payment that the firm will need to make to repay the loan
in year 4?

The firm needs to repay interest and principal. The payment at t=4 will be
$168(=150*1.12)

c) Suppose that any surplus cash flows (i.e. over and above what is needed to pay
the debt) will be paid out as a dividend to you in each year. What are the cash
flows will you receive in each year?
Spring 2021 Corporate Finance Prof. Auh

CF1=$250
CF2=$400
CF3=$150-$150
CF4=$600-168
CF5=$780

d) What is the present value of your equity holdings under the scenario where the
firm plans to borrow $150K in the third year? How does this differ from your
answer to a)? How does your answer contrast with the answer in the previous
question? Explain the difference.

We find the PV of each cash flow using the discount rate of 12%. In year three due
to the loan we do not factor negative cash flow but in year 4 we account for the
reimbursement of the loan for a CF of 432 instead of 600.

PV1=$223.2
PV2= $318.9
PV3=$0
PV4=$274.5
PV5=$442.6

Adding all these numbers up we get the same result as before, $1259.2. There is no
difference.

12) Southern Utilities just issued some new preferred stock. The issue will pay a
$19 annual dividend in perpetuity beginning 9 years from now. What is one
share of this stock worth today if the market requires a 7 percent return on this
investment?