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Financial
Management
(FIN501)

Assignment # 2

Submitted to:
Dr. Mohammad Irfan

GROUP B
Hira Naz (20212-29384)

Najia Batool (20201-27378)

Abdul Waseh (20212-29379)

Soha Navaid (20212-29387)

Muhammad Haseeb Ali Khan (20201-28210)

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MBA FRM (20201-27378)
1. A stock sells for $40. The next dividend will be $4 per share. If the rate of return
earned on reinvested funds is 15 percent and the company reinvests 40 percent of
earnings in the firm, what must be the discount rate?

Solution

Po = 40
Div. (1) = 4
R =?

Using Constant-growth Model,

¿(1)
stock price: P=¿ (r −g)

Where,

Po = $40
Div (1) = Next dividend = $4
R = Discount rate =?
g=Growth rate=Rate of return on reinvested fund × Retention rate
g=0.15× 0.4 0
g=0.0 6

Hence,

As per Constant growth model,

4
40 ¿ (r −0.06)

4
r −0.06 ¿
40

r =0.1+0.0 6

r =0.16

Discount rate=16 % (Answer)

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2. The DAP Company has decided to make a major investment. The investment
will require a substantial early cash out-flow, and inflows will be relatively late. As
a result, it is expected that the impact on the firm's earnings for the first 2 years
will be a negative growth of 5% annually. Further, it is anticipated that the firm
will then experience 2 years of zero growth after which it will begin a positive
annual sustainable growth of 6%. If the firm's cost of capital is 10% and its current
dividend (D0) is $2 per share, what should be the current price per share?

Solution

Step 1: Compute the dividend every year.

Dividend =Dividend last year x (1+Growth rate)

LET
Year 1:
D 1=$ 2 x (1+−5 % )
D 1=$ 2 x 0.9 5
D 1=$ 1.90

Year 2:
D 2=$ 1.90 x(1±5 %)
D 2=$ 1.90 x 0.95
D 2=$ 1.81

Year 3:
D 3=$ 1.81 x(1+ 0 %)
D 3=$ 1.81 x 1
D 3=$ 1.81

Year 4:
D 4=$ 1.81 x (1+0 % )
D 4=$ 1.81 x 1
D 4=$ 1.81

Terminal value

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 ( $ 1.81 x 1.06)
= (10 %−6 % )

$ 1.91
= $ 4%

¿ $ 47.8 3

Step 2: Compute the present value of each year's cash flow.

Year 1:
$ 1.90 x (1.10)−1

= $1.73
Year 2:
$1.81 x (1.10)−2
= $1.49
Year 3:
$1.81 x (1.10)−3
= $1.36
Year 4:
$1.81 x (1.10)−4
= $1.23
Terminal value:
$47.83 x (1.10)−4
= $32.67
Step 3: Compute the stock price today.
Stock price today= Sum of all present value Stock price today
1
= $1.73 + 1.49 + 1.36 + 23 + 32.67

Stock price today is $38.48 (Answer)

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3. You expect a share of stock to pay dividends of $1.00, $1.25, and $1.50 in each
of the next 3 years. You believe the stock will sell for $20 at the end of the third
year. a. What is the stock price if the discount rate for the stock is 10 percent? b.
What is the dividend yield?

Solution
a.
( 1.00 ) ( 1.25 ) ( 20+1.50 )
Po = + 2 + 3
( 1+ 0.10 ) ( 1+ 0.10 ) (1+0.10)

P o=$ 18.09541 7 (Answer)

b.
¿(1)
Dividend Yield=¿
P0

1.00
Dividend Yield=¿
18.095417

Dividend Yield=5.526 % (Answer)

4. Here are data on two stocks, investor required return is 15 percent:

Stock A Stock B
Return on Equity 12% 10%
Earnings Per Share $2.00 $1.50
Dividends per share $1.00 $1.00

a. What are the dividend payout ratios for each firm?

b. What are the expected dividend growth rates for each firm?
c. What is the proper stock price for each firm?

Solution

Dividend per Share

Dividend Payout Ratio=¿
EPS

1.00
DPR of Stock A=¿
2.00

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DPR of Stock A=50 %

1.00
DPR of Stock B=¿
1.50

DPR of Stock B=66.67 %

g=ROE ×(1−DPR)

g of Stock A=12 ×(1−0 . 5)

g of Stock A=6 %

g of Stock B=10 ×(1−0.6667)

g of Stock B=3.333 %

D 1(1+ g)
Po=
r−g

1(1+6)
Po of Stock A=
15 %−6 %

Po of Stock A=11.777 %

1(1+ 3.333)
Po of Stock B=
15 %−3.333 %

Po of Stock B=8.85 %

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5. Assume that IBM is expected to pay a total cash dividend of $5.60 next year and
that dividends are expected to grow at a rate of 5% per year forever. Assuming
annual dividend payments, what is the current market value of a share of IBM
stock if the required return on IBM common stock is 10%?

Solution

P=?
D1= 5.60
R= 10%
G=5%

D1
P0 = r−g

5.60
P0 = 10 %−5 %

5.60
P0 = 5 %

P0 = 112 (Answer)

6. Consider the following for a firm. Its stock price (P0) is at $50, its payout ratio
(POR) is 0.4, its EPS1 is $2.00, and its expected return on the money retained (i) is
0.10. What is the investor’s required rate of return?

Solution

D1= POR (EPS1)

Substitute this and the equation

g = (1- POR) i

D1
In to equation, r = P0 + g
D1
Now we can express the firm’s expected return as r = P 0 +g

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 ( POR)(EPS 1)
= P0
+ ( 1−POR ) i

(0.4)($ 2.0)
¿ + (1−0.4 ) (0.1)
$ 50

= 0.016 + 0.060

=0.076

= 7.76% (Answer)

7. You own a stock that is currently selling for $50. You expect a dividend of
$1.50 next year and you require a 12% rate of return. What is the dividend growth
rate for your stock assuming constant growth?

Solution

To solve for the dividend growth rate (g)

Rearrange the equation for the dividend valuation model with constant growth.

Now, we have

D1
g=r−
P0

D1
Where r is the required rate of return and P 0 is the dividend yield. 

(The growth rate, g, is the capital gains yield and is often known as the price
appreciation.)
Inserting the values,

Therefore,

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 $ 1.50
g = 0.12 – $ 50

= 0.12 – 0.03

=0.09

=9.00%. (Answer)

8. How many round lots were traded in a specific stock on a day in which
467,800 shares changed hands?
A. 467.8 round lots
B. 4,678 round lots
C. 467,800 round lots
D. Price must be known to determine round lots.

Solution

In a specific stock on a day in which 467800 shares change hands

467,800 shares
= 100

= 4,678 round lots. (Answer)

9. The book value of a firm's equity is determined by:

A. multiplying share price by shares outstanding.
B. multiplying share price at issue by shares outstanding.
C. the difference between book values of assets and liabilities.

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D. the difference between market values of assets and liabilities.

Solution

C. the difference between book values of assets and liabilities.

10. What is the current price of a share of stock for a firm with $5 million in
balance-sheet equity, 500,000 shares of stock outstanding, and a price/book value
ratio of 4?
A. $2.50
B. $10.00
C. $20.00
D. $40.00

Solution

$ 5,000,000
Book value per share ¿ 500,000

=$10

If price/book value = 4

Then price = $10 x 4

= $40 (Answer)

11. If the liquidation value of a firm is negative, then:

A. the firm's debt exceeds the market value of assets.
B. the firm's debt exceeds the book value of equity.
C. the book value of assets exceeds the firm's debt.
D. the market value of assets exceeds the firm's debt.
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Solution

A. the firm's debt exceeds the market value of assets.

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