204 Part 2 Interest Rates and Valuing Cash Flows

1. What rights come with a share of stock?

Critical
Thinking 2. Which two components make up the total return to an investor in a share of stock?
3. What does the dividend-discount model say about valuing shares of stock?
4. What is the relationship between the return from reinvesting cash flows and the
change in the price of the stock?
5. How can the dividend-discount model be used with changing growth rates in future
dividends?
6. What are some of the drawbacks of the dividend-discount model?
7. What are share repurchases, and how can they be incorporated into the valuation of
a stock?

All problems in this chapter are available in MyFinanceLab. An asterisk * indicates prob-
Problems lems with a higher level of difficulty.

Stock Basics
1. If you own 15,000 shares of stock of Nike and it pays a dividend of $0.27 per share,
then what is the total dividend you will receive?
2. You own 20% of the stock of a company that has ten directors on its board. How
much representation can you get on the board if the company has cumulative
voting? How much representation can you ensure if the company has straight
voting?
3. Anzio, Inc., has two classes of shares. Class B has ten times the voting rights as Class
A. If you own 10% of the class A shares and 20% of the Class B shares, what
percentage of the total voting rights do you hold?

The Dividend-Discount Model

4. Assume Evco, Inc., has a current stock price of $50 and will pay a $2 dividend in one
year; its equity cost of capital is 15%. What price must you expect Evco stock to sell
for immediately after the firm pays the dividend in one year to justify its current
price?
5. Anle Corporation has a current stock price of $20 and is expected to pay a dividend
of $1 in one year. Its expected stock price right after paying that dividend is $22.
a. What is Anle’s equity cost of capital?
b. How much of Anle’s equity cost of capital is expected to be satisfied by dividend
yield and how much by capital gain?
6. Achi Corp. has preferred stock with an annual dividend of $3. If the required return
on Achi’s preferred stock is 8%, what is its price? (Hint: For a preferred stock, the
dividend growth rate is zero.)
7. Ovit, Inc., has preferred stock with a price of $20 and a dividend of $1.50 per year.
What is its dividend yield?
8. Suppose Acap Corporation will pay a dividend of $2.80 per share at the end of this
year and a dividend of $3 per share next year. You expect Acap’s stock price to be $52
in two years. Assume that Acap’s equity cost of capital is 10%.
 Chapter 7 Stock Valuation 205

a. What price would you be willing to pay for a share of Acap stock today, if you
planned to hold the stock for two years?
b. Suppose instead you plan to hold the stock for one year. For what price would you
expect to be able to sell a share of Acap stock in one year?
c. Given your answer to part (b), what price would you be willing to pay for a share
of Acap stock today, if you planned to hold the stock for one year? How does this
price compare to your answer in part (a)?
9. Krell Industries has a share price of $22.00 today. If Krell is expected to pay a
dividend of $0.88 this year and its stock price is expected to grow to $23.54 at the
end of the year, what is Krell’s dividend yield and equity cost of capital?

Estimating Dividends in the Dividend-Discount Model

10. NoGrowth Corporation currently pays a dividend of $0.50 per quarter, and it will
continue to pay this dividend forever. What is the price per share of NoGrowth stock
if the firm’s equity cost of capital is 15%?
11. Summit Systems will pay a dividend of $1.50 this year. If you expect Summit’s
dividend to grow by 6% per year, what is its price per share if the firm’s equity cost
of capital is 11%?
12. Dorpac Corporation has a dividend yield of 1.5%. Its equity cost of capital is 8%, and
its dividends are expected to grow at a constant rate.
a. What is the expected growth rate of Dorpac’s dividends?
b. What is the expected growth rate of Dorpac’s share price?
13. Laurel Enterprises expects earnings next year of $4 per share and has a 40%
retention rate, which it plans to keep constant. Its equity cost of capital is 10%,
which is also its expected return on new investment. Its earnings are expected to
grow forever at a rate of 4% per year. If its next dividend is due in one year, what do
you estimate the firm’s current stock price to be?
*14. DFB, Inc., expects earnings this year of $5 per share, and it plans to pay a $3 dividend
to shareholders. DFB will retain $2 per share of its earnings to reinvest in new
projects that have an expected return of 15% per year. Suppose DFB will maintain
the same dividend payout rate, retention rate, and return on new investments in the
future and will not change its number of outstanding shares.
a. What growth rate of earnings would you forecast for DFB?
b. If DFB’s equity cost of capital is 12%, what price would you estimate for DFB
stock?
c. Suppose instead that DFB paid a dividend of $4 per share this year and retained
only $1 per share in earnings. That is, it chose to pay a higher dividend instead of
reinvesting in as many new projects. If DFB maintains this higher payout rate in
the future, what stock price would you estimate for the firm now? Should DFB
follow this new policy?
15. Cooperton Mining just announced it will cut its dividend from $4 to $2.50 per share
and use the extra funds to expand. Prior to the announcement, Cooperton’s
dividends were expected to grow at a 3% rate, and its share price was $50. With the
planned expansion, Cooperton’s dividends are expected to grow at a 5% rate. What
share price would you expect after the announcement? (Assume that the new
expansion does not change Cooperton’s risk.) Is the expansion a good investment?
16. Gillette Corporation will pay an annual dividend of $0.65 one year from now.
Analysts expect this dividend to grow at 12% per year thereafter until the fifth year.
206 Part 2 Interest Rates and Valuing Cash Flows

After then, growth will level off at 2% per year. According to the dividend-discount
model, what is the value of a share of Gillette stock if the firm’s equity cost of capital
is 8%?
17. Colgate-Palmolive Company has just paid an annual dividend of $0.96. Analysts are
predicting an 11% per year growth rate in earnings over the next five years. After
then, Colgate’s earnings are expected to grow at the current industry average of 5.2%
per year. If Colgate’s equity cost of capital is 8.5% per year and its dividend payout
ratio remains constant, for what price does the dividend-discount model predict
Colgate stock should sell?
*18. Halliford Corporation expects to have earnings this coming year of $3 per share.
Halliford plans to retain all of its earnings for the next two years. Then, for the
subsequent two years, the firm will retain 50% of its earnings. It will retain 20% of
its earnings from that point onward. Each year, retained earnings will be invested in
new projects with an expected return of 25% per year. Any earnings that are not
retained will be paid out as dividends. Assume Halliford’s share count remains
constant and all earnings growth comes from the investment of retained earnings.
If Halliford’s equity cost of capital is 10%, what price would you estimate for
Halliford stock?

Share Repurchases and the Total Payout Model

19. Zoom Enterprises expects that one year from now it will pay a total dividend of $5
million and repurchase $5 million worth of shares. It plans to spend $10 million on
dividends and repurchases every year after that forever, although it may not always
be an even split between dividends and repurchases. If Zoom’s cost of equity capital
is 13% and it has 5 million shares outstanding, what is its share price today?
20. AFW Industries has 200 million shares outstanding and expects earnings at the end
of this year of $700 million. AFW plans to pay out 60% of its earnings in total, paying
40% as a dividend and using 20% to repurchase shares. If AFW’s earnings are
expected to grow by 8% per year and these payout rates remain constant, determine
AFW’s share price assuming an equity cost of capital of 12%.
21. Suppose Cisco Systems pays no dividends but spent $5 billion on share repurchases
last year. If Cisco’s equity cost of capital is 12%, and if the amount spent on
repurchases is expected to grow by 8% per year, estimate Cisco’s market
capitalization. If Cisco has 6 billion shares outstanding, to what stock price does this
correspond?
*22. Maynard Steel plans to pay a dividend of $3 this year. The company has an expected
earnings growth rate of 4% per year and an equity cost of capital of 10%.
a. Assuming that Maynard’s dividend payout rate and expected growth rate remain
constant, and that the firm does not issue or repurchase shares, estimate
Maynard’s share price.
b. Suppose Maynard decides to pay a dividend of $1 this year and to use the remain-
ing $2 per share to repurchase shares. If Maynard’s total payout rate remains con-
stant, estimate Maynard’s share price.
c. If Maynard maintains the dividend and total payout rate given in part (b), at what
rates are Maynard’s dividends and earnings per share expected to grow?