BUS306 Financial Management

Week 5: Seminar 4: The Value of Common Stocks

Question 1

Pharmecology just paid an annual dividend of $1.35 per share. It’s a mature company, but
future EPS and dividends are expected to grow with inflation, which is forecasted at 2.75% per
year. What is Pharmecology’s current stock price? The nominal cost of capital is 9.5%.

Question 2

Stock A Stock B
Return on Equity 15% 10%
Earnings per share $2.00 $1.50
Dividends per share $1.00 $1.00
Here are forecasts for next year for two stocks:
i. What are the dividend payout ratios for each firm?
ii. What are the expected dividend growth rates for each stock?
iii. If investors require a return of 15% on each stock, what are their values?

Question 3

Consider the following three stocks:

i. Stock A is expected to provide a dividend of $10 a share forever.

ii. Stock B is expected to pay a dividend of $5 next year. Thereafter, dividend growth is
expected to be 4% a year forever.
iii. Stock C is expected to pay a dividend of $5 next year. Thereafter, dividend growth is
expected to be 20% a year for five years (i.e., years 2 through 6) and zero thereafter.

If the market capitalization rate for each stock is 10%, which stock is the most valuable? What
if the capitalization rate is 7%?

Question 4

Company Q’s current return on equity (ROE) is 14%. It pays out one half of earnings as cash
dividends (payout ratio = .5). Current book value per share is $50. Book value per share will
grow as Q reinvests earnings. Assume that the ROE and payout ratio stay constant for the next
four years. After that, competition forces ROE down to 11.5% and the payout ratio increases
to 0.8. The cost of capital is 11.5%.

i. What are Q’s EPS and dividends next year? How will EPS and dividends grow in years
2, 3, 4, 5, and subsequent years?

ii. What is Q’s stock worth per share? How does that value depend on the payout ratio and
growth rate after year 4?
 Solutions

Question 1
P0 = [DIV0 × (1 + g)] / (r – g)
P0 = [($1.35 × (1 + .0275)] / (.095 – .0275)
P0 = $20.55

Question 2
Assuming steady growth of dividends for both stocks, the estimates are as follows:

i. Stock A: Payout ratio = Dividends/Earnings = $1.00/$2.00 = 50%

Stock B: Payout ratio = Dividends/Earnings = $1.00/$1.50 = 67%

ii. Stock A: Growth rate = plowback ratio × ROE = (1 – 50%) × 15% = 7.5%
Stock B: Growth rate = plowback ratio × ROE = (1 – 67%) × 10% = 3.3%

iii. Stock A: PVA = DIV1/(r-g) = $1.00/(.15-.075) = $13.33

Stock B: PVB = DIV1/(r-g) = $1.00/(.15-.033) = $8.55

Question 3
At 10 percent capitalization rate:
P0 Stock A = DIV1 / r = $10 / .1 = $100
P0 Stock B = DIV1 / (r – g) = $5 / (.1 – .04) = $83.33
DIV1 DIV1 × (1 + 𝑔) DIV1 × (1 + 𝑔)2 DIV1 × (1 + 𝑔)3
𝑃0 Stock C = + + +
1+𝑟 (1 + 𝑟)2 (1 + 𝑟)3 (1 + 𝑟)4
DIV1 × (1 + 𝑔)4 DIV1 × (1 + 𝑔)5
+ +
(1 + 𝑟)5 (1 + 𝑟)6
[DIV1 × (1 + 𝑔)5 × (1 + 𝑔2 )] / 𝑟
+
(1 + 𝑟)6
P0 Stock C = $5 / 1.1 + ($5 × 1.2) / 1.12 + ($5 × 1.22) / 1.13 + ($5 × 1.23) / 1.14 +
($5 × 1.24) / 1.15 + ($5 × 1.25) / 1.16 + {[$5 × 1.25 × (1 + 0)] / .1} / 1.16
P0 Stock C = $104.51
At a 10% capitalization rate, Stock C has the largest present value.

Using the same formulas as above with a 7% capitalization rate, the values are:
P0 Stock A = $10 / .07 = $142.86
P0 Stock B = $5 / (.07 - .04) = $166.67
P0 Stock C = $5 / 1.07 + ($5 × 1.2) / 1.072 + ($5 × 1.22) / 1.073 + ($5 × 1.23) / 1.074 +
($5 × 1.24) / 1.075 + ($5 × 1.25) / 1.076 + {[$5 × 1.25 × (1 + 0)] / .07} / 1.076
P0 Stock C = $156.50
At a 7% capitalization rate, Stock B has the largest present value.
Question 4
a) Plowback ratio = 1 – payout ratio
Plowback ratio = 1 – .5
Plowback ratio = .5

gYears 1-4 = plowback ratio × ROE

gYears 1-4 = .5 × .14
gYears 1-4 = .07

EPS0 = ROE × book equity per share

EPS0 =.14 × $50
EPS0 = $7.00

DIV0 = payout ratio × EPS0

DIV0 = .5 × $7.00
DIV0 = $3.50

g Year 5 and later = plowback ratio × ROE

g Year 5 and later = (1 – .8) × .115
g Year 5 and later = .023, or 2.3%

The annual EPS and DIV are as follows:

Year EPS DIV

0 $7.00
1 $7.00 × 1.07 = $7.49 $7.49 × .5 = $3.75
2 $7.00 × 1.072 = $8.01 $8.01 × .5 = $4.01
3 $7.00 × 1.073 = $8.58 $8.58 × .5 = $4.29
4 $7.00 × 1.074 = $9.18 $9.18 × .5 = $4.59
5 $7.00 × 1.074 × 1.023 = $9.39 $9.39 × .8 = $7.51

b) PH = [DIV5 × (1 + g2)] / (r – g2)

PH = ($7.51 × 1.023) / (.115 - .023)
PH = $83.50

P0 = DIV1 / (1 + r) + DIV2 / (1 + r)2 + DIV3 / (1 + r)3 + DIV4 / (1 + r)4

+ DIV5 / (1 + r)5 + PH / (1 + r)5
P0 = $3.75 / 1.115 + $4.01 / 1.1152 + $4.29 / 1.1153 + $4.59 / 1.1154
+ $7.51 / 1.1155 + $83.50 / 1.1155
P0 = $65.45

The last term in the above calculation is dependent on the payout ratio and the growth rate
after year 4.