Investments Ch 11

Answer 1

VALUATION

An individual security (or market sector) is analyzed in terms of its
intrinsic value (based on fundamental analysis).
There are several valuation models. Most are based on the concept of discounted cash flows.
* Future dividends
* Future earnings
* Future cash flows

Answer 2

VALUATION MODELS

Two broad types of valuation models for common stocks:

1. Absolute valuation models
2. Relative valuation models

Answer 3

PRESENT VALUE MODELS

• Determine the value of assets that generate future cash flows, such
  as bonds, common stocks, and preferred stocks.
• Discount the future cash flows at appropriate discount rates to
  determine the present value of the future cash flows.

Question 4

BASIC PRESENT VALUE MODEL

Answer 4

BASIC PRESENT VALUE MODEL

Question 5

EXAMPLE OF BASIC PRESENT VALUE
An investor estimates the value of Arc Industries (AI). AI pays an annual dividend of $4, and the investor believes that the shares will be worth $90 at the end of three years. The investor also believes that a risk-adjusted discount rate of 14% is appropriate.
The intrinsic value of AI based on the PV of the dividends plus the futureselling price can be computed as follows:

Answer 5

EXAMPLE OF BASIC PRESENT VALUE
An investor estimates the value of Arc Industries (AI). AI pays an annual dividend of $4, and the investor believes that the shares will be worth $90 at the end of three years. The investor also believes that a risk-adjusted discount rate of 14% is appropriate.
The intrinsic value of AI based on the PV of the dividends plus the future selling price can be computed as follows:

          $ 4             $ 4          $94  PV= --------------+ ------------ +------------- = $70.03 
     ( 1+.14)      ( 1+.14)      ( 1+.14)

Question 6

DIVIDEND DISCOUNT MODEL

Answer 6

DIVIDEND DISCOUNT MODEL

The dividend discount model uses dividends as the cash flow inputs
in the model.

• Constant Growth Dividend Model
• Zero Growth Model
• Two-Stage Dividend Discount Model

Question 7

CONSTANT DIVIDEND GROWTH MODEL

Answer 7

CONSTANT DIVIDEND GROWTH MODEL

• Dividends grow at a constant rate.
• The required rate of return is greater than the growth rate.

    Do   ( 1 + g )              D1 V= --------------------- = --------------
         ( k - g )              ( k - g ) 

V = value of the stock
Do = the current dividend per share
D1 = the dividend per share one period from today
k = required return of the investor
g = the dividend growth rate

Question 8

CONSTANT GROWTH MODEL: EXAMPLE
An investor considers whether to buy Parker Inc (PI) stock, which is
currently trading at $72 per share. PI is currently paying a $3.00 per
share dividend. Assume that the growth rate of the dividend is 4% and the investor’s required return is 8%. According to the constant growth model, the intrinsic value can be computed as follows

Answer 8

CONSTANT GROWTH MODEL: EXAMPLE
An investor considers whether to buy Parker Inc (PI) stock, which is
currently trading at $72 per share. PI is currently paying a $3.00 per
share dividend. Assume that the growth rate of the dividend is 4% and the investor’s required return is 8%. According to the constant growth model, the intrinsic value can be computed as follows :

    Do   ( 1 + g )            3 ( 1 + .04)        V= --------------------- = ---------------------- = $ 78 
         ( k - g )              (   .08  - .04)

Question 9

GROWTH OF DIVIDENDS

Answer 9

GROWTH OF DIVIDENDS

The growth rate of dividends and earnings used in the model can be
estimated. A firm’s sustainable growth rate is a function of:

• the percentage of earnings that is reinvested back into the firm
• firm’s return on equity

Retention Ratio = 1 - Dividend Payout Ratio

or
Net Income - Dividends
Retention Ratio = ————————————
Net Income

g = ROE x Retention Ratio

Question 10

EXPECTED GROWTH RATE: EXAMPLE
Assume the dividend payout ratio is 20% and the firm’s ROE is 15%,
what is the growth rate of the dividends?

Answer 10

EXPECTED GROWTH RATE: EXAMPLE
Assume the dividend payout ratio is 20% and the firm’s ROE is 15%,
what is the growth rate of the dividends?

Retention Ratio = 1 - Dividend Payout Ratio
Retention Ratio = 1 - .20
Retention Ratio = .80

g = ROE x Retention Ratio
.15 x .80 = .12 = 12%

Question 11

EXPECTED RATE OF RETURN

Answer 11

EXPECTED RATE OF RETURN

The dividend discount model can be used to derive the assumed
expected rate of return. The formula is rearranged algebraically to
solve for the rate of return.

    D1  r = ---------------   +   g 
       P 

p = current price of the stock.

EXAMPLE EXPECTED RATE OF RETURN______________________
An investor determines the implicit expected rate of return for Boats
Incorporated (BI) stock. The current dividend of BI stock is $2, and the
dividend growth rate is 5%. The current price of the stock is $42. The
expected return on BI can be computed as follows:

   2 ( 1.05)  r = ----------------- + .05   = .10 = 10% 
      $ 42

Question 12

ZERO GROWTH MODEL

Answer 12

ZERO GROWTH MODEL

Preferred Stock & Perpetuities: Zero Growth

• The constant growth dividend model can be used to value stocks
  with non-growing dividend streams (such as preferred stock).

   Do  ( 1 + g )  v= ------------------- 
      ( k - g ) 

If growth is assumed to be zero (g=0), then the formula becomes:

     Do  v = -------- 
      K

Question 13

ZERO GROWTH MODEL: EXAMPLE
Alpo Technology’s (AT) preferred shares paying an annual dividend of $4.00 per share. The required rate of return equals 10%. The intrinsic value of AT can be computed as follows:

Answer 13

ZERO GROWTH MODEL: EXAMPLE

Alpo Technology’s (AT) preferred shares paying an annual dividend of
$4.00 per share. The required rate of return equals 10%. The intrinsic
value of AT can be computed as follows:

     Do             4 v = -------- =   -----------  = $ 40
      K            .10

Question 14

TWO-STAGE DIVIDEND GROWTH MODEL

Answer 14

TWO-STAGE DIVIDEND GROWTH MODEL

The two-stage dividend growth model allows for growth rates to
change.

Two components:
1. The cash flows during the initial growth period
2. The cash flows during the constant growth period (the value of
these constant growth cash flows is often referred to as the
terminal value)

Question 15

TWO-STAGE DIVIDEND GROWTH MODEL: EXAMPLE

Stark, Inc. creates a new product and expects that its dividend will
increase significantly over the next few years

Answer 15

TWO-STAGE DIVIDEND GROWTH MODEL: EXAMPLE

Stark, Inc. creates a new product and expects that its dividend will
increase significantly over the next few years

TWO-STAGE DIVIDEND GROWTH MODEL: PART 1
The constant growth model can be used at year 4 (from year 4 on there will be constant dividend growth). The value at year 4 is $46.67:

              Do               $ 4.20  v= -------------------  = -----------------  =  $ 46.67
      ( k - g )            ( .14 - .05 )

TWO-STAGE DIVIDEND GROWTH MODEL: PART 2

Question 16

FREE CASH FLOW VALUATION

Answer 16

FREE CASH FLOW VALUATION

• A dividend model may not be appropriate in the following cases:
• The company is not paying dividends.
• The company pays a dividend, but it is not representative of the
  firm’s ability to pay dividends

Question 17

FREE CASH FLOW TO EQUITY
Free cash flow to equity (FCFE)

Answer 17

FREE CASH FLOW TO EQUITY

Free cash flow to equity (FCFE)
* Cash flow available to the company’s common shareholders after
making necessary investments in current and long-term assets, and
after both debtholders and preferred stockholders have been paid.

• The dividend discount model is adjusted to reflect FCFE

         FCFE 1 V= ------------------- 
        ( k  - g )

Question 18

FREE CASH FLOW TO EQUITY FORMULA

Answer 18

FREE CASH FLOW TO EQUITY FORMULA

+ Net Income
+ Depreciation and Amortization ( add back non - cash expenses)
- Capital expenditures ( cash that reinvested back into the company)
- Change in net working capital(Working Cap = Curr ASS- Cur. Liability
+ New Bond Issues or Bank Loan
- Debt Repayments
__________________________________________________
= FREE CASH FLOW TO EQUITY

Question 19

FREE CASH FLOW: EXAMPLE
A firm has a current FCFE per share of $9.00 and is expected to
increase at 3.5% for the foreseeable future. The required return is
12%. The value of the firm can be computed as follows:

Answer 19

FREE CASH FLOW: EXAMPLE

A firm has a current FCFE per share of $9.00 and is expected to
increase at 3.5% for the foreseeable future. The required return is
12%. The value of the firm can be computed as follows:

   Do  ( 1 + g )             $ 9.00  ( 1 + .035 ) v= ------------------- = ----------------------------------=  $ 109.59 
      ( k - g )                          ( .12 - .035 )

Question 20

RELATIVE VALUATION

Answer 20

RELATIVE VALUATION

Relative valuation methods are generally referred to as price multiples and can provide insight into asset values.

• Price-to-earnings (PE) ratio
• Price-to-book ratio
• Price-to-sales ratio
• PEG ratio

Question 21

P/E RATIO

Answer 21

P/E RATIO

• The P/E Ratio reflects how much investors are willing to pay for each
  $1 in earnings. The P/E ratio is a useful tool to estimate the relative
  value of a firm’s stock

           Current Market Price per share  PE = --------------------------------------------------------
                       Earnings per Share

Question 22

P/E RATIO INPUTS

Answer 22

P/E RATIO INPUTS

The PE ratio is impacted by:
* Payout ratio of the firm
* Required return
* Growth rate of dividends

                        Payout Ratio  PE Ratio  =    -------------------------
                             ( k - g )

Question 23

P/E RATIO: EXAMPLE
Topo, Inc. stock has a dividend payout of 75%, a required return of 12%, and a dividend growth rate of 8%. Based on this information, an appropriate PE ratio for Topo is 18.75, as follows:

Answer 23

P/E RATIO: EXAMPLE

Topo, Inc. stock has a dividend payout of 75%, a required return of 12%, and a dividend growth rate of 8%. Based on this information, an
appropriate PE ratio for Topo is 18.75, as follows:

                      Payout Ratio                75  %  PE Ratio  =    ------------------------- = -------------------- = 18.75
                             ( k - g )                   12% - 8%

If it is expected that Topo will earn $4.00 per share next year, the
estimated stock price is:

stock price = EPS x PE
so
Stock Price = $ 4.00 x 18.75 = $ 75

Question 24

PEG RATIO

Answer 24

PEG RATIO

The PEG ratio equals a company’s PE ratio divided by the growth rate
of its expected earnings.

                PE Ratio  PEG =   -------------------------- 
              EPS Growth

Question 25

PEG RATIO: EXAMPLE
Leaf Company: PE ratio = 15; earnings growth = 20%; PEG ratio = 0.75. Branch Company: PE ratio = 36; earnings growth = 30%; PEG ratio = 1.2.

Answer 25

PEG RATIO: EXAMPLE

Leaf Company: PE ratio = 15; earnings growth = 20%; PEG ratio = 0.75.
Branch Company: PE ratio = 36; earnings growth = 30%; PEG ratio = 1.2.

               PE Ratio  PEG =   -------------------------- 
              EPS Growth

                                    15 Leaf Co PEG =  --------------------=    .75 
                                  20 
      
                       
                                  36 Branch Co PEG =  -----------------=  1.20
                                 30

Question 26

OTHER PRICE MULTIPLES

Answer 26

OTHER PRICE MULTIPLES

• Price-to-Sales Ratio
• Price-to-Cash-Flow Ratio
• Price-to-Book ratio

Question 27

According to fundamental analysis, which phrase best defines the intrinsic value of a share of common stock?

The par value of the common stock.
The book value of the common stock.
The liquidating value of the firm on a per share basis.
The discounted value of all future dividends.

Answer 27

The discounted value of all future dividends.

Question 28

Jim and Anne Taylor are baby boomers who would like to add an equity investment to their portfolio. They require a 12% rate of return and are considering the purchase of one of the following two common stocks:
Stock 1: dividends currently are $1.50 annually and are expected to increase 8% annually; market price = $35
Stock 2: dividends currently are $2.25 annually and are expected to increase 7% annually; market price = $50

Using the dividend growth model, determine which stock would be more appropriate for the Taylors’ to purchase at this time:

Stock 2, because the stock is undervalued.

Stock 2, because the return on investment is greater than the Taylor's required rate of return.

Stock 1, because its dividend growth rate is greater than Stock 2's growth rate.

Stock 1, because the expected return on investment is greater than the Taylor's required rate of return.

Answer 28

Jim and Anne Taylor are baby boomers who would like to add an equity investment to their portfolio. They require a 12% rate of return and are considering the purchase of one of the following two common stocks:
Stock 1: dividends currently are $1.50 annually and are expected to increase 8% annually; market price = $35
Stock 2: dividends currently are $2.25 annually and are expected to increase 7% annually; market price = $50

Using the dividend growth model, determine which stock would be more appropriate for the Taylors’ to purchase at this time:

Stock 2, because the stock is undervalued.

Stock 2, because the return on investment is greater than the Taylor's required rate of return.

Stock 1, because its dividend growth rate is greater than Stock 2's growth rate.

Stock 1, because the expected return on investment is greater than the Taylor's required rate of return. \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ he correct answer is D.

The correct answer choice is the application of the following calculation. If a stock is calculated as undervalued using the required rate of return in the constant growth model, it will also exceed the client’s required rate of return.

USE Formula to compare :

   Do  ( 1 + g )  v= ------------------- 
      ( k - g ) 

Stock 1:
$1.50( 1+ 1.08 )
V =———————-= $40.50 vs Market Price of $35, SO undervalued.
( .12 - .08 )

You can use the rate of return based on current price formula to double check your calculation: r = [(D1/P) + g]

[(1.50 x 1.08)/35] + .08 = .1262 or 12.62%. This exceeds the expected return of 12%.

Stock 2:
2.25( 1+ 1.07 )
——————-=$48.15 vs Market Price $50, so stock is overpriced
( .12 - .07 )

Using the rate of return based on current price formula to double check your calculation: r = [(D1/P) + g]

[(2.25 x 1.07) / 50] + .07 = .118150 or 11.82% which does not meet the 12% required return.

Question 29

An investor with a required rate of return of 12.5% is looking at a stock that pays a $3.75 dividend per share, has a growth rate of 6%, and is selling in the market for $60.00 per share. What would you recommend?

Buy; it meets the buyer's return requirements and is underpriced

Buy; does not meet the buyer's return requirements, but it is underpriced.

Do not buy; it does not meet the buyer's return requirements and is overpriced.

Do not buy; it meets the buyer's return requirements, but is overpriced

Answer 29

An investor with a required rate of return of 12.5% is looking at a stock that pays a $3.75 dividend per share, has a growth rate of 6%, and is selling in the market for $60.00 per share. What would you recommend?
A. Buy; it meets the buyer’s return requirements and is underpriced
B,.Buy; does not meet the buyer’s return requirements, but it is underpriced.
C. Do not buy; it does not meet the buyer’s return requirements and is overpriced.
D. Do not buy; it meets the buyer’s return requirements, but is overpriced
_________
The correct answer is A.

Use the intrinsic value formula and the expected rate of return formula to arrive at the correct solution for this problem. Formula:

   Do  ( 1 + g )  v= ------------------- 
      ( k - g ) 

V = 3.75 (1.06)
——————- = 3.975/.065
(.125-.06)

V = $61.1538; therefore, the stock is undervalued since it is trading at $60.

You can further verify by:

D1 = 3.75(1.06) = $3.98

r = (D1/P) + g

(3.98/60) + .06 = 12.63%

Question 30

Using the constant growth dividend valuation model, calculate the intrinsic value of a stock that pays a dividend this year of $2.00 and is expected to grow at 6%. The beta for this stock is 1.5, the risk free rate of return is 3% and the market return is 12%.

$48.27
$35.33
$28.75
$20.19

Answer 30

Using the constant growth dividend valuation model, calculate the intrinsic value of a stock that pays a dividend this year of $2.00 and is expected to grow at 6%. The beta for this stock is 1.5, the risk free rate of return is 3% and the market return is 12%.

$48.27
$35.33
$28.75
$20.19 \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ Solution: The correct answer is D. = $20.19 

Use the constant growth dividend model to solve for intrinsic value. The question does not provide the required rate of return,
however the capital asset pricing model can be used solve for required rate of return.

1. R = Rf + b (Rm - Rf)
   Expected Rate Return= Risk free Ret+ Beta(Return on Mrk-Risk Free)

R = .03 + 1.5 (.12 - .03) R = .165

watch your order of operations here, PEMDAS:
.12 - .03 = .09 x 1.5 = .135 + .03 = .165

Now use the 16.50 % expected Rate of Return in Formula below:

    Do  ( 1 + g )  v= ------------------- 
      ( k - g ) 

  2  (1.06)
 --------------------- = 20.19    (  .165  - .06  )

Question 31

Bristol-Buyers Company has a market price of $36.00 per share with earnings of $3.00 per share, a beta of 1.1 and a dividend of $1.20, which means a dividend payout ratio of 40%. Earnings for next year are projected to increase by 25%, and the retention ratio is projected to remain at 60%. Using the price/earnings multiplier, to what level might your client expect to see market prices move in a year?

$39.60
$45.00
$50.40
$57.60

Answer 31

Bristol-Buyers Company has a market price of $36.00 per share with earnings of $3.00 per share, a beta of 1.1 and a dividend of $1.20, which means a dividend payout ratio of 40%. Earnings for next year are projected to increase by 25%, and the retention ratio is projected to remain at 60%. Using the price/earnings multiplier, to what level might your client expect to see market prices move in a year?

$39.60
$45.00
$50.40
$57.60 \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_

The correct answer is B.

       Price          $36 PE = ------------=  -------------= 12
        EPS             $ 3

The $36.00 per share price is divided by the $3.00 earnings per share resulting in a price/earnings multiplier of 12.

so

The increase of earnings by 25% results in a projected $3.75 earnings next year. Stock Price = 12 × $3.75 = $45.00

Question 32

The current annual dividend of ABC Corporation is $2.00 per share. Five years ago the dividend was $1.36 per share. The firm expects dividends to grow in the future at the same compound annual rate as they grew during the past five years. The required rate of return on the firm’s common stock is 12%. The expected return on the market portfolio is 14%. What is the value of a share of common stock of ABC Corporation using the constant dividend growth model (round to the nearest dollar)? (CFP® Certification Examination - Released 3/95)

$11
$17
$25
$36
$54

Answer 32

The current annual dividend of ABC Corporation is $2.00 per share. Five years ago the dividend was $1.36 per share. The firm expects dividends to grow in the future at the same compound annual rate as they grew during the past five years. The required rate of return on the firm’s common stock is 12%. The expected return on the market portfolio is 14%. What is the value of a share of common stock of ABC Corporation using the constant dividend growth model (round to the nearest dollar)? (CFP® Certification Examination - Released 3/95)

$11
$17
$25
$36
$54 -----------------------------------------------------

Solution: The correct answer is E.

Formula for Growth Rate

  Do  ( 1 + g )       <<< but need to solve for 'g'  Dividend Growth first. v= -------------------            since its missing. 
      ( k - g ) 

Step 1:_______________________________
MST SOLVE FOR g Div Growth
USE TIME VALUE OF MONEY TO SOLVE FOR “I”

N = 5
i = ? = .08 = 8 % Div Growth
PV = <1.36>
PMT = 0
FV = 2

Step 2:

D1 = 2 × 1.08 (from Step 1) = 2.16

Step 3:

   Do  ( 1 + g )         $2 ( 1   + .08)  v= -------------------  = ----------------        = $54
      ( k - g )             (.12 - .08)

Answer is $54

Question 33

Hydra, Inc. pays a current dividend of $3.40 and shareholders require a 12.5% return. The dividend will grow at a high rate of 30% and then gradually decline to 4% over a six-year period. The value of Hydra shares using the H Model is closest to:

$51.80.
$71.20.
$72.80.
$104.00

Answer 33

Hydra, Inc. pays a current dividend of $3.40 and shareholders require a 12.5% return. The dividend will grow at a high rate of 30% and then gradually decline to 4% over a six-year period. The value of Hydra shares using the H Model is closest to:

Div0 = The firm’s current dividend
ag = The firm’s long-term average growth rate
k = The required return on equity
H = The half-life of the transition time from high growth to low growth ( this is 3 years , or half of the 6 years )
hg = The firm’s short-term high growth rate

3.40 x ( 1 + .04 ) 3.40 x 3 x ( .30 - .04 )
————————– + —————————————- = 72.80
( .125 - .04 ) ( .125 - .04 )

V = 41.60 + 31.20 = 72.80

Question 34

Cisco Tech is a growth company that has been paying a dividend of $1.00 per share for the last ten years and has recently paid the same $1 for the current year. Cisco has just created “new tech” that should revolutionize artificial intelligence and therefore has decided to pay higher dividends two years from today. That dividend will be $3.00, followed by a $6.00 dividend the next year, and a $9.00 dividend the following year. It is expected that the following dividend payments will increase by 9% annually. What is the value of Cisco if the required rate of return equals 14%?

Answer 34

Cisco Tech is a growth company that has been paying a dividend of $1.00 per share for the last ten years and has recently paid the same $1 for the current year. Cisco has just created “new tech” that should revolutionize artificial intelligence and therefore has decided to pay higher dividends two years from today. That dividend will be $3.00, followed by a $6.00 dividend the next year, and a $9.00 dividend the following year. It is expected that the following dividend payments will increase by 9% annually. What is the value of Cisco if the required rate of return equals 14%?

Question 35

A firm’s price-to-earnings ratio will increase when:

Answer 35

A firm’s price-to-earnings ratio will increase when:

The payout ratio increases.

Rationale

From the equation below, it should be obvious that as the numerator increases, so does the PE ratio. The other three answer choices will result in a drop in PE.

                      ( D1 /  E )                  Payout Ratio  PE Ratio    = ---------------------  =      --------------------- 
                          K - g                             K - g

Question 36

Free cash flow to equity in the current year will most likely increase when a firm:

Has substantial capital expenditures.
Issues bonds.
Increases its investment in net working capital.
Experiences a decline in net income.

Answer 36

Issues bonds.

Rationale

FCFE will fall after large capital expenditures, at least during the current year, when there are increases in net working capital, and if profitability declines. A bond issue will increase FCFE.
FCFE:
+ Net Income
+ Depreciation and Amortization (Add back non-cash expenses)
- Capital Expenditures (Cash that is reinvested back into the company)
- Changes in Net Working Capital (Working Capital = Current Assets – Current Liabilities)
+ New Bond Issues or Bank Loans
- Debt Repayments
= Free Cash Flow to Equity

Question 37

After examining a tech firm’s cash flows, its executive leadership, and its likelihood of becoming a takeover target, a research analyst estimates the intrinsic value for this firm to be $64.50. The current market price on the NASDAQ exchange is $61.10. The analyst is most likely to recommend:

Answer 37

Buying the shares.

Rationale

Since the shares have an intrinsic value that exceeds their current market value, the shares are considered to be undervalued. A buy recommendation is the most likely choice as the analyst believes the price will rise to its intrinsic value. Increasing allocation to the entire tech sector is probably an overreaction to this news.

Question 38

LEP Tech is expected to pay its first dividend in exactly one year of $1.25 per share. The annual growth rate in dividends is expected to be 6% and LEP’s shareholders require a return of 12%. The value of the stock is closest to:

Answer 38

LEP Tech is expected to pay its first dividend in exactly one year of $1.25 per share. The annual growth rate in dividends is expected to be 6% and LEP’s shareholders require a return of 12%. The value of the stock is closest to:

   Do  ( 1 + g )  v= ------------------- 
      ( k - g ) 

        (1.25) -----------------------------  =20.83
    (0.12   -  0.06)

Question 39

FLASH Delivery has EPS of $6.00 per share and has a payout ratio of 40%. Its dividend is expected to grow at a rate of 5.25%. If FLASH stock is trading at $22.86, then the shareholder’s required return is closest to:

14.2%.
15.7%.
16.3%.
16.9%.

Answer 39

FLASH Delivery has EPS of $6.00 per share and has a payout ratio of 40%. Its dividend is expected to grow at a rate of 5.25%. If FLASH stock is trading at $22.86, then the shareholder’s
required return is closest to ??

16.3%.
D1
req’d Rate of Return= ——————–+ g , where P is the current Price
P

                       Div per share  Payout ratio =  -------------------     OR    DIv per share  = Payout  x  EPS 
                              EPS   
                                                                  $   2.40   = .40 x $ 6 

                                               ( 2.40  x 1.0525 )  Required Rate of Return = ----------------------------  = .163 = 16.30 % 
                                                 22.86 + .0525

Question 40

Patch Software is expected to pay its first dividend in exactly one year of $0.25 per share. The growth rate in dividends is expected to be 4.5% and Patch’s shareholders require 13.8%. The stock value is closest to:

Answer 40

Patch Software is expected to pay its first dividend in exactly one year of $0.25 per share. The growth rate in dividends is expected to be 4.5% and Patch’s shareholders require 13.8%. The stock value is closest to:

          Do                       .25 v= -------------------   =  ----------------------  = $2,288
      ( k - g )               (.138  - .045 )

Question 41

BCOOL pays a current dividend of $0.75 per share. The annual growth rate in dividends is expected to be 5% and BCOOL’s shareholders require a return of 12.5%. The value of the stock is closest to:

Answer 41

BCOOL pays a current dividend of $0.75 per share. The annual growth rate in dividends is expected to be 5% and BCOOL’s shareholders require a return of 12.5%. The value of the stock is closest to:

  Do  ( 1 + g )  v= -------------------  
      ( k - g ) 

(0.75 ( 1+.05 ) )
———————————- = 10.50
(0.125 - 0.05)

Question 42

Crazy Fans Inc pays a current dividend of $1.36 with a growth rate of 2.9%. Crazy Fans shareholders require an 11.1% rate of return. The value of the stock using the dividend discount model is closest to:

Answer 42

Crazy Fans Inc pays a current dividend of $1.36 with a growth rate of 2.9%. Crazy Fans shareholders require an 11.1% rate of return. The value of the stock using the dividend discount model is closest to:

 Do  ( 1 + g )  v= -------------------  
      ( k - g ) 

1.36 ( 1+.029 ) )
———————————- = $ 17.07
(0.111 - 0.029 )

Question 43

The preferred stock for CRYSTAL pays an annual dividend of $8.42 while the firm’s preferred shareholders require an 13.5% return. The value of this firm is closest to:

Answer 43

The preferred stock for CRYSTAL pays an annual dividend of $8.42 while the firm’s preferred shareholders require an 13.5% return. The value of this firm is closest to:

     D                      8.42 V= ------------- =    -------------  =   62.37
     K                       .135

Question 44

Compute the free cash flow to equity for a firm with the following conditions (each account is reported on a per share basis):

Net Income $9.25
Depreciation $1.52
Proceeds from a Bond Issue $3.00
Total Debt Repayments $0.45
Change in Net Working Capital -$1.00

Answer 44

Compute the free cash flow to equity for a firm with the following conditions (each account is reported on a per share basis):

Net Income $9.25
Depreciation $1.52
Proceeds from a Bond Issue $3.00
Total Debt Repayments - $0.45
Change in Net Working Capital $ 1.00
——————————————————————-

FCFE = 9.25 + 1.52 + 3.00 - 0.45 + 1.00 = 14.32
FCFE:
+ Net Income
+ Depreciation and Amortization (Add back non-cash expenses)
- Capital Expenditures (Cash that is reinvested back into the company)
- Changes in Net Working Capital (Working Capital = Current Assets – Current Liabilities)
+ New Bond Issues or Bank Loans
- Debt Repayments
= Free Cash Flow to Equity

Answer 45

TEST

• Calculate Stock Price Applying

− PE multiple
− Constant Growth Dividend Model

Answer 46

TEST
Constant Growth Dividend Model
* This model is also known as the intrinsic value model.
* The dividend discount model values a company’s stock by
discounting the future stream of cash flows.

            D1  V = -----------------------
          ( r - g ) 

• D1 is the next expected dividend, and is arrived at using the
  current dividend and earnings growth rate as follows:

D 1 = D0 ( 1 + g )

next expected div = Current Div and Div. earnings Growth

Answer 47

TEST ??? check with review

Through a restructuring of the DDM formula one can calculate
an expected rate of return (r). This formula uses ‘price’ (P), that is
market price, in place of value (V) in the calculation, as follows:

         D0 ( 1 + g )    r  =  ----------------------  + G 
            P

EXAMPLE:
A stock recently paid a dividend of $3.25. The market price is
$45.00 and the company’s growth rate is 6%. Your investor
requires an 11% return on all investments.

1. What is the intrinsic value of this stock?
   Do ( 1 + g ) 3.25 ( 1 + 06 )
   v= ——————- = ———————- = $ 68.90 ??
   ( k - g ) ( .11 - .06 )
2. If he buys at market price what is his expected rate of return?

       D0 ( 1 + g )                         3.25  (  1 + .06  )  r  =  ----------------------  + G           ------------------------ + .06 = .1366= 13.66%   
            P                                                     45

3. Is the stock over or under-valued at its current market price?

–Market price is $5,, but v= 68.90, so undervalued

Answer 48

TEST

Relative PE = ( stock PE / Market PE )

• Ice Cream Corp has EPS of $2 and has a P/E ratio of 20.
  What is the stock price?

Stock Price = PE x EPS
20 x 2 = 40

• What if the relative P/E is 1.5 and EPS were $2 and the market
  P/E is 10, what is the stock price?

                         Stock   PE              Relative PE   =  -------------------     or   Stock PE  =Relative PE x market PE 
                        Market  PE                   20                  1.5                 10

Stock Price = PE x EPS
40 = 20 x 2