ch.8 Flashcards by Sara Garzon Huertas

The Stopperside Wardrobe Co. just paid a dividend of $1.45 per share on its
stock. The dividends are expected to grow at a constant rate of 6% per year
indefinitely. If investors require an 11% return on the Stopperside Wardrobe
Co. stock, what is the current price? What will the price be in three years? In
15 years?

from tutorial

P0 = $1.45(1 + 0.06)/(0.11 − 0.06) = $30.74. For stock price in three years,
we have P3 = D4
r−g = 0$1.45(1+0.06)4
0.11−0.6 = $36.61. For stock price in 15 years, we
have P15 = D16
r−g = $1.45(1+0.06)16
0.11−0.06 = $73.67.

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The next dividend payment by Kilbride Inc. will be $1.89 per share. The
dividends are anticipated to maintain a 5% growth rate forever. If the stock
currently sells for $38.00 per share, what is the required return?

from tutorial

Solving for r , we have r = D1
P0
+ g = $1.89
$38 + 0.05 = 9.97%.

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Big Pnd Inc. has an issue of preferred stock outstanding that pays a $4.75
dividend every year in perpetuity. If this issue currently sells for $93 per share,
what is the required return?

from tutorial

Solving for r , we get r = D
P0
= $4.75
$93 = 5.11%.

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Red, Inc., Yellow Corp., and Blue Company each will pay a dividend of $3.65
next year. The growth rate of dividends for all three companies is 4%. The
required return for each company’s stock is 8%, 11%, and 14%, respectively.
What is the stock price for each company? What do you conclude about the
relationship between the required return and stock price?

from tutorial

PRed =
$3.65
0.08 − 0.04
= $91.25
PYellow =
$3.65
0.11 − 0.04
= $52.14
PBlue =
$3.65
0.14 − 0.04
= $36.50.

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Foxtrap Bearings Inc. is a young start-up company. No dividends will be
paid on the stock over the next nine years because the firm needs to plow back
its earnings to fuel growth. The company will pay a $12 per-share dividend in
ten years and will increase the dividend by 5% per year thereafter. If the
required return on this stock is 13.5%, what is the current share price?

tutorial

$45.16.

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Condor Corporation stock currently sells for $64 per share. The market
requires a 10% return on the firm’s stock. If the company maintains a constant
4.5% growth rate in dividends, what was the most recent dividend per share
paid on the stock?
tutorial

$3.37.

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Peachytown Bank just issued some new preferred stock. The issue will pay
$20 annual dividend in perpetuity, beginning 20 years from now. If the market
requires a 5.8% return on this investment, how much does a share of preferred
stock cost today?

tutorial

$118.13.

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Lance Cove Choppers Inc. is experiencing rapid growth. The company
expects dividends to grow at 18% per year for the next 11 years before levelling
off at 5% into perpetuity. The required return on the company’s stock is 12%.
If the dividend per share just paid was $1.94, what is the stock price?

tutorial

$81.25.

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If you buy a share of stock, you can receive cash in two ways

The company pays dividends.
You sell your shares, either to another investor in the market or back to the company

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Suppose you are thinking of purchasing the stock of Moore Oil, Inc. and you expect it to pay a $2 dividend in one year and you believe that you can sell the stock for $14 at that time.
If you require a return of 20% on investments of this risk, what is the maximum you would be willing to pay?

Compute the PV of the expected cash flows
Price = (14 + 2)/(1.2) = $13.33

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Now what if you decide to hold the stock for two years? In addition to the $2 dividend in one year, you expect a dividend of $2.10 in two years and a stock price of $14.70 at the end of year 2.
Now how much would you be willing to pay now?

PV = $2/(1.2) + ($2.10 + $14.70)/(1.2)2 = $13.33

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Finally, what if you decide to hold the stock for three periods? In addition to the dividends at the end of years 1 and 2, you expect to receive a dividend of $2.205 at the end of year 3 and a stock price of $15.435.
Now how much would you be willing to pay?

PV = $2/1.2 + $2.10/(1.2)2 + ($2.205 + $15.435)/(1.2)3 = $13.33

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that the price of the stock is really just

the present value of all expected future dividends

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Constant dividend

The firm will pay a constant dividend forever.
This is like preferred stock.
The price is computed using the perpetuity formula.

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Constant dividend growth
( growing perpetuity)

The firm will increase the dividend by a constant percent every period.

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Supernormal growth

Dividend growth is not consistent initially, but settles down to constant growth eventually.

Zero Growth (constant dividend)

If dividends are expected at regular intervals forever, then this is like preferred stock and is valued as a perpetuity
P0 = D/r

Suppose stock is expected to pay a $0.50 dividend every quarter and the required return is 10% with quarterly compounding.
What is the price?

P0 = $0.50/(0.1/4) = $20

Suppose Big D, Inc. just paid a dividend of $0.50. It is expected to increase its dividend by 2% per year.
If the market requires a return of 15% on assets of this risk, how much should the stock be selling for?

P0 = [$0.50 × (1+.02)]/(0.15 - 0.02) = $3.92

If the dividend is expected to grow at 5% per year and the required return is 20%, what is the price?

P0 = 2/(0.2 – 0.05) = $13.33

As the growth rate approaches the required return, the stock price __________

increases dramatically.

As the required return approaches the growth rate, the price .

increases dramatically

Gordon Growth Company is expected to pay a dividend of $4 next period and dividends are expected to grow at 6% per year. The required return is 16%.
What is the current price? What is the price expected to be in year 4?

What is the current price?
P0 = $4/(0.16 – 0.06) = $40

What is the price expected to be in year 4?
P4 = D4(1 + g)/(r – g) = D5/(r – g)
P4 = [$4 × (1+0.06)4]/(0.16 – 0.06) = $50.50

Suppose a firm is expected to increase dividends by 20% in one year and by 15% in two years. After that dividends will increase at a rate of 5% per year indefinitely.
If the last dividend was $1 and the required return is 20%, what is the price of the stock?

Compute the dividends until growth levels off
D1 = $1 × (1.2) = $1.20
D2 = $1.20 × (1.15) = $1.38
D3 = $1.38 × (1.05) = $1.449
Find the expected future price
P2 = D3/(r – g) = $1.449/(0.2 – 0.05) = $9.66

Find the present value of the expected future cash flows
P0 = $1.20/(1.2) + ($1.38 + $9.66)/(1.2)2 = $8.67

What is the value of a stock that is expected to pay a constant dividend of $2 per year if the required return is 15%? What if the company starts increasing dividends by 3% per year, beginning with the next dividend? Assume that the required return stays at 15%.

Zero growth – 2 / .15 = 13.33 Constant growth: 2(1.03) / (.15 - .03) = $17.17

Suppose a firm’s stock is selling for $10.50. They just paid a $1 dividend and dividends are expected to grow at 5% per year. What is the required return? What is the dividend yield? What is the capital gains yield?

What is the required return? r = [$1 × (1.05)]/10.50 + 0.05 = 15% What is the dividend yield? [$1 × (1.05)]/$10.50 = 10% What is the capital gains yield? g =5%

Benchmark P/E ratio could come from either

1) Similar companies in the same industry or 2) Historical average

Shareholders’ Rights to vote

Shareholders have the right to vote for the board of directors and other important issues. Cumulative voting increases the likelihood of minority shareholders getting a seat on the board (more on this in Appendix A).

Shareholder rights

Share proportionally in declared dividends Share proportionally in remaining assets during liquidation( if company goes bankrupt) Preemptive right - first shot at new stock issue to maintain proportional ownership if desired

Classes of stock

Unequal voting rights ( When dividends are issued (you get class A shareholder or class B) it doesn’t matter\ When voting, class A shares can vote, but class B cannot ) Control of firm Coattail provision

Dividend characteristics

Dividends are not a liability of the firm until a dividend has been declared by the Board. Consequently, a firm cannot go bankrupt for not declaring dividends. Dividends and Taxes

dividends and taxes

Dividend payments are not considered a business expense and are not tax deductible. Dividends received by individual shareholders are partially sheltered by the dividend tax credit. Dividends received by corporate shareholders are not taxed. This prevents double taxation of dividends.

purchasing a canadian stock

When you purchase the Canadian stock when you get dividend, it will be tax exempt( there is a maximum amount). To encourage Canadians to invest in Canadian stocks. As individuals.

Features of Preferred Stock

Most preferreds have a stated dividend that must be paid before common dividends can be paid. Dividends are not a liability of the firm and preferred dividends can be deferred indefinitely. Most preferred dividends are cumulative - any missed preferred dividends have to be paid before common dividends can be paid. Preferred stock generally does not carry voting rights.

In reality, firms choose to retain some (or all) of its earnings for reinvestment, so that it can grow further Therefore, the current stock price reflects this growth opportunity in addition to the current

EPS

NPVGO

net present value of the growth opportunity

massey motors is a new firm in a rapidly growing industry. the company is planning on increasing its annual dividend by 10% a year for the next 3 years and then decreasing the growth rate to 4% per year. the company just paid its annual dividend in the amount of $1.00 per share. what is the current value of one share of this stock if the required rate of return is 13.75%? multiple choice $12.08 $12.21 $12.26 $12.37 $12.45

12.45

berkshire homes recently paid $2.20 as an annual dividend. future dividends are projected at $2.30, $2.50, and $2.75 over the next 3 years, respectively. beginning four years from now, the dividend is expected to increase by 3% annually. what is one share of this stock worth to you today if you require an 11% rate of return? multiple choice $32.00 $32.96 $34.14 $34.86 $35.52

mdk, inc. is a high growth firm that has never paid a dividend. the company just issued a press release stating that next year it plans on paying an annual dividend of $0.34. it also stated that dividends are expected to increase by 40% a year for each of the following four years and then increase by 4% annually thereafter. the required rate of return on this stock is 15%. what is the expected price per share of mdk stock six years from now? multiple choice $9.12 $9.42 $12.35 $12.84 $14.14