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Financial Management Basic Concepts Practice Using PV, FV, Constant Dividend Growth Model Calculations

1/30/2012

Question # 1:

Eight years ago, you bought one share of norealbusiness.com for $150. It hasn't paid any dividends and it currently has a price of $30. If you sell it today, what compound annual rate of return will you earn? Solution: Working: The Compound Annual Growth Rate would be the ratio of your ending value to beginning value

= 150/30 (.20) = 1/8 (.125) = .20 ^ .125 = .8177 CAGR =.8177-1 = -18.22%

EXPLANATION:

Over the course of 8 periods your investment declined from $150.00 to $30.00, and its compound annual growth rate or its overall return, is -18.22%. CAGR essentially smoothes out the progress of your investment over a period of time, providing a clearer picture of your annual return. However, although your investment started at $150.00 and ended with $30.00, its growth in any one year may have been quite a bit lower or even positive (if the investment gained money over that time). Consequently, the CAGR figure may give the impression that the investment has produced a stable return (or, in this case, a decline) throughout its life, even if the investment was extremely volatile, fluctuating a great deal from year to year.

Question # 2:

Because of many reinvestment opportunities, the XYZ Company is not currently paying any dividends. However, beginning 2 years from today, investors expect to receive a dividend of $3.00 per share for 5 years and $4.00 per share for 3 years. Then dividends are expected to grow at 4% per year forever. If investors require a 20% return, what is the price per share? Solution: WORKING:

First Solution:

$3/1.20^2 + 3/1.20^3 + 3/1.20^4 + 3/1.20^5 + 3/1.20^6 + 4/1.20^7 + 4/1.20^8 + 4/1.20^9 + [(4*1.04)/(0.20 - 0.04)] / 1.20^9 = $15.33733 or rounded, $15.34...

Second Solution:

Year `1 2 3 4 5 6 7 8 9 Total cash flow= 10.3 Using formula DIV0(1+g)/r-g= Putting the value in this formula 4*1.04/0.20-0.04 =26*0.194=5.044 10.3+5.044 =15.344 Explanation present value of future dividend stream for next 9 year is 10.30 . for shar value using formula DIV0(1+g)/r-g in the 9th year 26 of which P>V @20% after 9 year is 5.044. today value of share =10.30+5.044 Cash flow 0 2..082 1.737 1.446 1.206 1.005 1.116 0.932 0.776

Question # 3:

A $1,000 maturity value bond currently has 15 years left to maturity. The bond has a 9% coupon rate and pays interest annually. (PART A) If you want to earn a 12% rate of return, how much would you be willing to pay today for this bond?

(SOLUTION PART A) Working: Interest =90 Using formula = 1-(1+i)-n/i = 90* {1-(1+0.12)-15}/0.12 = 90*(1.12)-15/0.12 =90*1-0.0183/0.12 = 612.75 =1000*1/(1.12)15 (183) Willing to pay today for this Bond =183 Explanation: After the calculation we just got figure of $183. According to Value of Money concept the money that we have today is worth more than the funds in future. So, same case with this question. The bond which has $1,000 value today and have maturity life of 15 years with an annual interest rate of 12% should be bought today for $183 as our value of money will decrease from time to time and we will surely get value only $183 for a bond of $1,000 par value today.

(PART B) Suppose you buy the bond for the value you calculated in part a. After holding the bond for 4 years and receiving 4 interest payments, you sell the bond for $712.43. What annual, compound rate of return have you earned over this 4 year period? Prove your answer by showing that PV get equals PV give up. (Hint: Try 7%, 9%, or 12%). (SOLUTION PART B) WORKING: The Compound Annual Growth Rate would be the ratio of your ending value to beginning value

= 712.43/183 (3.90) = 1/4 (.25) = 3.90 ^ .25 = 1.4047 CAGR =1.4047-1 = 40.47%

EXPLANATION:

Over the course of 4 periods your investment grew from $183.00 to $712.43, its compound annual growth rate, or its overall return, is 40.47%. CAGR essentially smoothes out the progress of your investment over a period of time, providing a clearer picture of your annual return. However, although your investment started at $183.00 and ended with $712.43, its growth in any one year may have been quite a bit higher or even negative (if the investment ever lost money over that time). Consequently, the CAGR figure may give the impression that the investment has produced a stable return throughout its life, even if the investment was extremely volatile, fluctuating a great deal from year to year.

(PART C) Suppose you buy the bond for the value you calculated in part a. After holding the bond for 5 years and receiving 5 interest payments, you sell the bond. What price must you receive (at time 5) to earn your desired 12% rate of return? (SOLUTION PART C) WORKING: Bond Purchase (PV) = $183 Period = 5 years Sale of Bond = ? Interest = 12%

Year 0 1 2 3 4 5 $ $ $ $ $ $

PV 183.00 183.00 204.96 229.56 257.10 287.95 $ $ $ $ $

Interest 12% 21.96 24.60 27.55 30.85 34.55

Sales Price $ $ $ $ $ $ 183.00 204.96 229.56 257.10 287.95 322.51

EXPLANATION:

If today you were to invest $183.00 at a rate of 12%, you would have $322.51 at the end of 5 time periods (e.g. weeks, months, or years). In other words, a future value of $322.51 is equal to a present value of only $183.00. What does this mean to you? Well, if you had a choice between taking an amount higher than the $183.00 today and taking the $322.51 at the end of 5 time periods, you should take the money today. By doing so, you would be able to invest the higher amount at 12% for 5 equal time periods, which would end up giving you more than $322.51.

QUESTION # 4:

The current price of DUMBA's common stock is $50 per share. You plan on buying it today, holding it for 3 years, and then selling it. You anticipate receiving a dividend per share of $1.00 one year from today, $2.00 two years from today, and $2.00 three years from today. If you want to earn 20% on your investment, what Price must you receive when you sell the stock three years from today?

(SOLUTION) WORKING: PV = $50, Formula Interest Rate = %20, Sale Price (FV) = ?, Years = 3 = F * P (1+r)n = 50 (1+.2)3 = 50 (1.728) = 86.4 Explanation

If today you were to invest $50.00 at a rate of 20%, you would have $86.40 at the end of 3 time periods (e.g. weeks, months, or years). In other words, a future value of $86.40 is equal to a present value of only $50.00. What does this mean to you? Well, if you had a choice between taking an amount higher than the $50.00 today and taking the $86.40 at the end of 3 time periods, you should take the money today. By doing so, you would be able to invest the higher amount at 20% for 3 equal time periods, which would end up giving you more than $86.40

(QUESTION # 5)

Your stock just paid a dividend of $2.00. Investors expect the dividend to grow forever at 3% per year and require a 13% rate of return. The Federal Reserve announced the implementation of a new, restrictive monetary policy that will increase the equity investors' required return to 16%. For you to keep your stock price at the value it is now, what must be the increase in the expected dividend growth rate? (SOLUTION) WORKING:

Where

• • • • • •

P0 = the stock price at time 0, (Not available in the question) D0 = the current dividend, ($2 provided in the question) D1 = the next dividend (i.e., at time 1), g = the growth rate in dividends, (3% as expected by the Investors) r = the required return on the stock, (13% as Expected by the Investors) g < r. = $2(1+.03) / (.13-.03)

Stock Value = $20.6 Increase in the expected dividend growth rate? Current Annual Dividend = $2, Current Price = $20.6, k (Required Rate of Return) = 16%

So, Const Growth Rate / Expected Dividend Growth Rate = 5.7345% Increase = 3%-5.7345% = 2.7345% Explanation: According to information provided in the example we have required rate of return and also dividend price that is $2 but we needs to calculate price.. So according the information provided the best model for this is to find Stock Price using Constant Dividend Growth Model. So, after that we got the price is $20.6. So, now with the help of this price we calculated the increase in the expected dividend growth rate. That is 2.7345%.

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