Strictly for course ECA5333 internal circulation only.

NUS Business School

ECA5333 Financial Markets and Portfolio Management
Tutorial 6 Solution

1) The following are projections of the cash flow next year:

Net Income = $1000.00 proportion of debt = 0.6

Interest payments = $600 cost of debt = 4.167%
Depreciation = $650 cost of equity = 15%
Tax rate = 20%
Increase in Current Asset = $2,500 Debt value = $3500
Increase in Current Liability = $2,400 FCFF grows at 3%
Increase in fixed assets at cost = $1,230 # of shares = 1,000

Assuming a one stage FCFF model, compute the stock price.

Answer: $12.50.

2) (BKMC18CFAQ8) Janet Ludlow’s firm requires all its analysts to use a two-stage
dividend discount model (DDM) and the capital asset pricing model (CAPM) to value
stocks. Using the CAPM and DDM, Ludlow has valued QuickBrush Company at $63 per
share. She now must value SmileWhite Corporation.

a) Calculate the required rate of return for SmileWhite by using the information in the
following table.
QuickBrush SmileWhite
Beta 1.35 1.15
Market price $45.00 $30.00
Intrinsic value $63.00 ?

Notes:
Risk-free rate 4.50%
Expected market return 14.50%

b) Ludlow estimates the following EPS and dividend growth rates for SmileWhite:

First 3 years 12% per year

Years thereafter 9% per year

Estimate the intrinsic value of SmileWhite by using the table above, and the two-stage
DDM. Dividends per share in the most recent year were $1.72.
c) Recommend QuickBrush or SmileWhite stock for purchase by comparing each
company’s intrinsic value with its current market price.
d) Describe one strength of the two-stage DDM in comparison with the constant-growth
DDM. Describe one weakness inherent in all DDMs.

Answer: a. k = rf + β (kM – rf) = 4.5% + 1.15(14.5%  4.5%) = 16%

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b. Year Dividend
2009 $1.72
2010 $1.72  1.12 = $1.93
2011 $1.72  1.122 = $2.16
2012 $1.72  1.123 = $2.42
2013 $1.72  1.123  1.09 = $2.63
Present value of dividends paid in 2010 – 2012:
Year PV of Dividend
2010 $1.93/1.161 = $1.66
2011 $2.16/1.162 = $1.61
2012 $2.42/1.163 = $1.55
Total = $4.82

Price at year-end 2012

PV in 2009 of this stock price

Intrinsic value of stock = $4.82 + $24.07 = $28.89

c. The data in the problem indicate that Quick Brush is selling at a price
substantially below its intrinsic value, while the calculations above demonstrate
that SmileWhite is selling at a price somewhat above the estimate of its intrinsic
value. Based on this analysis, Quick Brush offers the potential for considerable
abnormal returns, while SmileWhite offers slightly below-market risk-adjusted
returns.
d. Strengths of two-stage versus constant growth DDM:
 Two-stage model allows for separate valuation of two distinct periods in a
company’s future. This can accommodate life cycle effects. It also can avoid
the difficulties posed by initial growth that is higher than the discount rate.
 Two-stage model allows for initial period of above-sustainable growth. It
allows the analyst to make use of her expectations regarding when growth might
shift from off-trend to a more sustainable level.
A weakness of all DDMs is that they are very sensitive to input values. Small
changes in k or g can imply large changes in estimated intrinsic value. These
inputs are difficult to measure.

3) (RBC11P6) Over the long run, you expect dividends for BBC in Problem 4 to grow at 8
percent and you require 11 percent on the stock Using the infinite period DDM, how
much would you pay for this stock?

Answer:
Dividends at the end of this year: $6 x 1.08 = $6.48
Required rate of return 11%
Growth rate of dividends 8%

Thus, you would be willing to pay up to $216.00 for BBC’s stock.

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4) (RBC11P8-10) The Shamrock Dogfood Company (SDC) has consistently paid out 40
percent of its earnings in dividends. The company's return on equity is 16 percent. What
would you estimate as its dividend growth rate?
Given the low risk in dog food, your required rate of return on SDC is 13 percent. What
PIE ratio would you apply to the firm's earnings?
What P/E ratio would you apply if you learned that SDC had decided to increase its
payout to 50 percent? (Hint: This change in payout has multiple effects.)

Answer:
Dividend payout ratio 40%
Return on equity 16%

Growth rate = (Retention rate) x (Return on equity)

= (1 - payout ratio) x (Return on equity)
= (1 - .40) x (.16)
= .60 x .16
= 9.6%
Dividend payout ratio 40%
Dividend growth rate 9.6%
Required rate of return 13%

Dividend payout ratio 50%

Required rate of return 13%

Growth rate = (1 - .50) x (.16)

(new) = .50 x .16
= .08

5) (RBC11P14) You have been reading about the Madison Computer Company (MCC),
which currently retains 90 percent of its earnings ($5 a share this year). It earns an ROE of
almost 30 percent.
a) Assuming a required rate of return of 14 percent, how much would you pay for MCC on
the basis of the earnings multiplier model? Discuss your answer.
b) What would you pay for Madison Computer if its retention rate was 60 percent and its
ROE was 19 percent? Show your work.

Answer: Required rate of return (k) 14%

Return on equity (ROE) 30%
Retention rate (RR) 90%
Earnings per share (EPS) $5.00
Then growth rate = RR x ROE
= .90 x .30 = .27

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Since the required rate of return (k) is less than the growth rate (g), the earnings
multiplier cannot be used (the answer is meaningless).

However, if ROE = .19 and RR = .60,

then growth rate = .60 x .19 = .114

If next year’s earnings are expected to be: $5.57 = $5.00 x (1 + .114)

Applying the P/E: Price = (15.38) x ($5.57) = $85.69

Thus, you would be willing to pay up to $85.69 for Madison Computer Company
stock.

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