Chapter 7 CFIN4

Solution Manual for CFIN 4 4th Edition Besley by Besley and

Brigham ISBN 1285434544 9781285434544
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Chapter 7 Solutions

7-1 Total dollar return per share = ($19 - $20) + 4($0.20) = -$0.20

Rate of $19 - $20 $0.80 -$0.20

a. =    0.01  1.0%
return $20 $20 $20

Rate of $19 - $20 $0.80 Capital Dividend

b. =   0.05  0.04  5.0%  4.0%  
return $20 $20 gains yield

Rate of $988 - $950 $47.50 $85.50

7-2 a. =    0.09  9.0%
return $950 $950 $950

Rate of $988 - $950 $47.50 Capital Dividend

b. =   0.04  0.05  4.0%  5.0%  
return $950 $950 gains yield

7-3 Dividend = 0.09($110) = $9.90

D $110(0.09) $9.90
Pˆ 0 =    $66
r ps 0.15 0.15

7-4 Dividend = $16.50

D $16.50
Pˆ 0 =   $150
r ps 0.11

7-5 Dividend = 0.05($40) = $2

D $2
a. rps = 10%: Pˆ 0 =   $20
r ps 0.10

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Chapter 7 CFIN4

D $2
b. rps = 8%: Pˆ 0 =   $25
r ps 0.08

7-6 D̂1  $2(1.05)  $2.10

ˆ1 (1 + g) $2.00(1.05) $2.10
Pˆ 0 =
D = D0    $30
rs - g rs - g 0.12 .05 0.07

7-7 D̂1  $3(1.04)  $3.12

ˆ1 (1 + g) $3.00(1.04) $3.12
Pˆ 0 =
D = D0    $52
rs - g rs - g 0.10 .04 0.06

7-8 D̂1  $1.20(1.025)  $1.23

ˆ1 (1 + g) $1.20(1.025) $1.23
Pˆ 0 =
D = D0    $9.84
rs - g rs - g 0.15 .025 0.125

7-9 rs = Dividend yield + Capital gains yield

= 8% + 6% = 14%

Dˆ1 $1.06
Pˆ 0 = =  $13.25
rs - g 0.14  0.06

Alternative solution:

Dividend D̂1

yield P0

$1.06
0.08 
P0

$1.06
P0   $13.25
0.08

7-10 rs = 16%

g = ?, but we know the price of the stock is P0 = $19.50

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Chapter 7 CFIN4

D̂1  $2.34

We can solve for g as follows:

D̂1
P0 
rs  g

$2.34
$19.50 
0.16  g

Solving for g, we find the growth rate to be 4 percent:

$19.50(0.16 – g) = $2.34
$3.12 – $19.50g = $2.34
g = ($3.12 - $2.34)/$19.50 = 0.04 = 4%.

The next step is to use the growth rate to project the stock price five years hence:
D0 (1  g)6 D1(1  g)5
P̂5  
rs  g rs  g

$2.34(1.04)5 $2.847
   $23.72
0.16  0.04 0.12

Therefore, Ocala Company’s expected stock price five years from now, P̂5 , is $23.72.

Alternative solution: Because the growth rate will remain constant at 4 percent, the stock price should
increase by 4 percent each year. Thus, the stock price in Year 5 can be computed as:

P̂5  $19.50(1.04)5  $19.50(1.21665)  $23.72

7-11 D0 = D̂1 = $0

D̂2 = $0.50; this actually is the first dividend that is affected by constant growth (g norm = 6%), thus it can
be used to compute the price of the stock at the end of the non-constant growth period.

D̂2 $0.50
P̂1    $6.25
rs  gnorm 0.14  0.06

Thus, the current price of the stock is

ˆ  Pˆ
D $0  $6.25
P0  1 1
  $6.25(0.87719)  $5.4825  $5.48
(1 rs )
1
(1.14)1

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Chapter 7 CFIN4

Cash flow time line for this scenario:

0
rs = 14%
1 2

gnorm = 6%
3
… ∞

0.00 0.50 0.53 0.50(1.06)∞-2

D̂2 0.50
6.25  Pˆ1  
rs  gnorm 0.14 .06
5.4825 6.25

Alternative Solution:

Students might solve the problem by computing the price at the end of Year 2, because they believe
that the first year of constant growth is in Year 3. The solution in this case would be:

D̂3 = $0.50(1.06) = $0.53

D̂3 $0.53
P̂2    $6.625
rs  gnorm 0.14  0.06

ˆ
D ˆ  Pˆ
D $0 $0.50  $6.625
P0  1
 2 2
   $0  $7.125(0.76947)  $5.4825  $5.48
(1 rs ) (1 rs ) (1.14)
1 2 1
(1.14)2

Cash flow time line for this scenario:

0
rs = 14%
1 2

gnorm = 6%
3
… ∞

0.00 0.50 0.53 0.50(1.06)∞-2

D̂2 0.53
6.625  Pˆ2  
rs  gnorm 0.14 .06
5.4825 7.125
7.125
P0   5.4825
(1.14)2

7-12 D0 = $0

ˆ D
D ˆ D
ˆ  $0
1 2 3

D̂4 = $3.00; this actually is the first dividend that is affected by constant growth, which equals 0 percent
(g = 0%), thus it can be used to compute the price of the stock at the end of the non-
constant growth period.
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Chapter 7 CFIN4

D̂4 $3.00
P̂3    $30.00
rs  gnorm 0.10  0

Thus, the current price of the stock is

P̂3 $30.00
P0    $30.00(0.751315)  $22.5394  $22.54
(1 rs )3 (1.10)3

Cash flow time line:

0
rs = 10%
1 2 3 4
…
gnorm = 0%
∞

0.00 0.00 0.00 3.00 3.00

0.0000 D̂4 3.00

30.00  Pˆ3  
rs  gnorm 0.10  0
22.5394 30.00
22.5394

Alternative Solution:

Students might solve the problem by computing the price at the end of Year 4, because they believe
that the first year of constant growth is in Year 4. The solution in this case would be:

D̂4 = $3.00

D̂5 $3.00
P̂4    $30
rs  gnorm 0.10  0

ˆ  Pˆ
D $3.00  $30.00
P̂0  4 4
  $33(0.68301)  $22.5394  $22.54
(1 rs ) 4
(1.10)4

7-13 D0 = $1.00

D̂1 = D̂2 = $1.00

D̂3 = $1.00(1.08) = $1.08; this is the first dividend that is affected by constant growth (g norm = 8%), thus it
can be used to compute the price of the stock at the end of the non-constant
growth period.

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accessible website, in whole or in part.
Chapter 7 CFIN4

D̂3 $1.08 $1.08

P̂2     $12.00
rs  gnorm 0.17  0.08 0.09

Thus, the current price of the stock is

ˆ
D ˆ  Pˆ
D $1.00 $1.00  $12.00
P0  1
 2 2
 
(1 rs ) (1 rs ) (1.17)1
1 2
(1.17)2

 $1.00(0.85470)  $13.00(0.73051)
 $0.8547  $9.4966  $10.35

Cash flow time line:

0
rs = 17%
1 2

gnorm = 8%
3
… ∞

0.8547 1.00 1.00 1.08 1.00(1.08)∞-2

D̂3 1.08
12.00  Pˆ2  
rs  gnorm 0.17 .08
9.4966 13.00
10.3513

7-14 D0 = $0

D̂1 = $0

D̂2 = $2.00

Because the $2 dividend actually represents the first constant-growth dividend, the constant growth
model can be used to compute the value of the stock at the end of Year 1 as follows:

D̂2 $2.00
P̂1    $20.00
rs  gnorm 0.15  0.05

The PV of $20 one year from today is: PV = P0 = $20/1.15 = $17.39

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Chapter 7 CFIN4

Cash flow time line:

0
rs = 15%
1 2

gnorm = 5%
3
… ∞

0.0000 0.00 2.00 2.10 2.00(1.05)∞-2

D̂3 2.10
21.00  Pˆ2  
rs  gnorm 0.15 .05
17.3913 23.00
17.3913

Alternative solution:

D̂3 = $2.00(1.05) = $2.10; Because this is affected by constant growth (g norm = 5%), it can be used to
compute the price of the stock at the end of Year 2.

D̂3 $2.10 $2.10

P̂2     $21.00
rs  gnorm 0.15  0.05 0.10

Thus, the current price of the stock is

ˆ
D ˆ  Pˆ
D $0 $2.00  $21.00
P0  1
 2 2
 
(1 rs ) (1 rs ) (1.15)
1 2 1
(1.15)2

 $0(0.86957)  $23.00(0.75614)  $17.39

7-15 D0 = $0

D̂1 = $1.50

D̂2 = $2.00

D̂3 = $2.00(1.05) = $2.10; Because this is affected by constant growth (g norm = 5%), it can be used to
compute the price of the stock at the end of Year 2.

D̂3 $2.10 $2.10

P̂2     $35
rs  gnorm 0.11 0.05 0.06

Thus, the current price of the stock is

ˆ
D ˆ  Pˆ
D $1.50 $2.00  $35.00
P0  1
 2 2
 
(1 rs )1
(1 rs )2 (1.11)1 (1.11)2

 $1.50(0.90090)  $37.00(0.81162)  $31.38

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Chapter 7 CFIN4

Cash flow time line:

0
rs = 11%
1 2

gnorm = 5%
3
… ∞

1.3514 1.50 2.00 2.10 2.00(1.05)∞-2

D̂3 2.10
35.00  Pˆ2  
rs  gnorm 0.11.05
30.0300 37.00
31.3814

Alternative solution: Because the $2 dividend actually represents the first constant-growth dividend (the
starting basis for constant growth), the constant growth model can be used to compute the value of the
stock at the end of Year 1 as follows:

D̂2 $2.00
P̂1    $33.33
rs  gnorm 0.11 0.05

Thus, if the stock is sold in one year, the investor would have received one dividend payment equal to
$1.50 and the $33.33 stock price. The PV of $34.83 one year from today is: PV = P0 = $34.83/1.11 =
$31.38

7-16 D̂1 = $0.60

D̂2 = $0.90

D̂3 = $2.40

D̂4 = $3.50

D̂5 = $3.50(1.04) = $3.64; Because this is affected by constant growth (g norm = 4%), it can be used to
compute the price of the stock at the end of Year 4.

D̂5 $3.64 $3.64

P̂4     $22.75
rs  gnorm 0.20  0.04 0.16

Thus, the current price of the stock is

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Chapter 7 CFIN4

ˆ
D ˆ
D ˆ
D ˆ  Pˆ
D
P0  1
 2
 3
 4 4
(1 rs ) (1 rs ) (1 rs ) (1 rs )4
1 2 3

$0.60 $0.90 $2.40 $3.50  $22.75

 1
 2
 3

(1.20) (1.20) (1.20) (1.20)4
 $0.60(0.83333)  $0.90(0.69444)  $2.40(0.57870)  $26.25(0.48225)  $15.17

Cash flow time line:

0 1 2 3 4 5 ∞

0.5000
rs = 11%

0.60 0.90 2.40 3.50

gnorm = 4%
3.64
… 3.50(1.05)∞-4
0.6250
1.3889 D̂5 3.64
22.75  Pˆ 4  
rs  gnorm 0.20 .04
12.6591 26.25
15.1730

Alternative solution: Because the $3.50 dividend actually represents the first constant-growth dividend
(the starting basis for constant growth), the constant growth model can be used to compute the value of
the stock at the end of Year 3 as follows:

D̂4 $3.50
P̂3    $21.875
rs  gnorm 0.20  0.04

Thus, if the stock is sold in three years, the investor would have received three dividend payments equal
to $0.60, $0.90, and $2.40, respectively, and the $21.875 stock price at the end of Year 3. The PV of
this cash flow stream is:

ˆ
D ˆ
D ˆ  Pˆ
D $0.60 $0.90 $2.40  $21.875
P0  1
 2
 3 3
  
(1 rs )1
(1 rs )2
(1 rs ) 3
(1.20) 1
(1.20) 2
(1.20)3

 $0.60(0.83333)  $0.90(0.69444)  $24.275(0.57870)  $15.17

7-17 P0  19 x $3.70 = $70.30

7-18 Price range: 28 x $4 = $112 to 30 x 4 = $120

7-19 NI = $65,000

T = 35%
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Chapter 7 CFIN4

Interest expense = $40,000

Invested capital = $800,000

Cost of funds = 12%

Net income = $65,000 = Taxable income(1 - 0.40)

Taxable income = ($65,000)/(1 - 0.35) = $100,000

EBIT = $100,000 + $40,000 = $140,000

EVA = (EBIT)(1 - T) – (Cost of funds)(Invested capital)

EVA = $140,000(1 – 0.35) – 0.12($800,000) = $91,000 - $96,000 = -$5,000

7-20 Net income = $1.2 million = Taxable income(1 - 0.40)

Taxable income = ($1.2 million)/(1 - 0.40) = $2.0 million

EBIT = Taxable income + Interest

= $2.0 million + $1.5 million
= $3.5 million

EVA = EBIT(1 - T) - (WACC x Invested capital)

= $3.5 million(1 - 0.40) - (0.10 x $8.0 million)
= $2.1 million - $0.8 million
= $1.3 million

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