Financial Management Chapter 8 K

ey Chapter 8 Stocks and Their Valuation LEARNING OBJECTIVES After reading this chapter, students should be able to Identify rough of the more burning(prenominal) rights that come with crease ownership and define the avocation terms proxy, proxy fight, final paymentover, and preemptive right. Briefly exempt why classified air might be practiced by a corporation and what founders sh ars are. Differentiate between closely held and publicly owned corporations and list the three distinct types of gun threadbare market transactions. Determine the prise of a contri just nowion of common crease when (1) divid deaths are contained to rootage come in at some unvarying regularize, (2) dividends are search to remain unbroken, and (3) dividends are expect to grow at some super-normal, or non uniform, ontogeny rate. Calculate the expected rate of return on a constant emersion stock certificate. Apply the total social club (corporate look on) model to nurture a whol e in situations when the unanimous does not pay dividends or is privately held. explain why a stocks inhering value might differ between the total comp all model and the dividend ripening model. Explain the avocation terms equilibrium, marginal investor, and Efficient Markets Hypothesis (EMH) distinguish among the three levels of market efficiency briefly explain the implications of the EMH on financial decisions and discuss the results of empirical studies on market efficiency and the implication of behavioral pay on those results. Read and understand the stock market page given in the daily tonicspaper. Explain the reasons for investing in international stocks and identify the bets an investor is making when he does invest overseas. Define preferable stock, doctor the value of a share of preferred stock, or given its value, calculate its expected return. 1. LECTURE SUGGESTIONS This chapter provides important and useful information on common and preferred stocks. Moreov er, the valuation of stocks reinforces the concepts covered in both Chapters 6 and 7, so Chapter 8 extends and reinforces those chapters. We begin our lecture with a discussion of the characteristics of common stocks, after which we discuss how stocks are valued in the market and how stock tolls are reported in the press. We conclude the lecture with a discussion of preferred stocks.The details of what we cover, and the way we cover it, can be seen by scanning Blueprints Chapter 8. For some other suggestions about the lecture, please see the Lecture Suggestions in Chapter 2, where we describe how we conduct our classes. DAYS ON CHAPTER 3 OF 58 DAYS (50-minute degrees) doS TO END-OF-CHAPTER QUESTIONS 8-1True. The value of a share of stock is the PV of its expected future dividends. If the two investors expect the same future dividend stream, and they agree on the stocks riskiness, accordingly they should reach similar conclusions as to the stocks value. -2A perpetual bond is sim ilar to a no-growth stock and to a share of preferred stock in the pursuit ways 1. All three derive their value from a serial of cash in emanatescoupon payments from the perpetual bond, and dividends from both types of stock. 2. All three are assumed to have undefined lives with no maturity value (M) for the perpetual bond and no groovy gains consequence for the stocks. 8-3Yes. If a company decides to increase its payout ratio, then the dividend exit component give rise, but the expected semipermanent seat of government gains feed will reject. 8-4No. The correct equation has D1 in the numerator and a minus sign in the denominator. -5a. The average investor in a listed firm is not really interested in maintaining his proportionate share of ownership and control. If he wanted to increase his ownership, he could simply buy more stock on the open market. Consequently, about investors are not concerned with whether new shares are sold directly (at about market bells) or throu gh rights offerings. However, if a rights offering is macrocosm used to effect a stock split, or if it is being used to reduce the underwriting cost of an issue (by substantial underpricing), the preemptive right may well be beneficial to the firm and to its stockholders. . The preemptive right is cl primal important to the stockholders of closely held firms whose owners are interested in maintaining their relative control positions. SOLUTIONS TO END-OF-CHAPTER PROBLEMS 8-1D0 = $1. 50 g1-3 = 5% gn = 10% D1 through D5 = ? D1 = D0(1 + g1) = $1. 50(1. 05) = $1. 5750. D2 = D0(1 + g1)(1 + g2) = $1. 50(1. 05)2 = $1. 6538. D3 = D0(1 + g1)(1 + g2)(1 + g3) = $1. 50(1. 05)3 = $1. 7364. D4 = D0(1 + g1)(1 + g2)(1 + g3)(1 + gn) = $1. 50(1. 05)3(1. 10) = $1. 9101. D5 = D0(1 + g1)(1 + g2)(1 + g3)(1 + gn)2 = $1. 50(1. 05)3(1. 10)2 = $2. 1011. 8-2D1 = $0. 50 g = 7% ks = 15% pic = ? pic -3P0 = $20 D0 = $1. 00 g = 10% pic = ? ks = ? pic = P0(1 + g) = $20(1. 10) = $22. ks= pic + g = pic + 0. 10 = pic + 0. 10 = 15. 50%. ks = 15. 50%. 8-4Dp = $5. 00 Vp = $60 kp = ? kp = pic = pic = 8. 33%. 8-5a. The terminal, or horizon, date is the date when the growth rate becomes constant. This occurs at the end of Year 2. b. 0 1 2 3 1. 25 1. 50 1. 80 1. 89 37. 80 = pic The horizon, or terminal, value is the value at the horizon date of all dividends expected thereafter. In this problem it is reason as follows pic c. The firms intrinsic value is calculated as the sum of the move over value of all dividends during the supernormal growth blockage plus the present value of the terminal value. Using your financial calculator, write down the following arousals CF0 = 0, CF1 = 1. 50, CF2 = 1. 80 + 37. 80 = 39. 60, I = 10, and then solve for NPV = $34. 09. 6. The firms free cash shine is expected to grow at a constant rate, hence we can apply a constant growth code to determine the total value of the firm. Firm cherish = FCF1/(WACC g) Firm Value = $150,000,000/(0. 10 0. 05) Firm Value = $3,000,000,000.To disclose the value of an equity claim upon the company (share of stock), we must subtract out the market value of debt and preferred stock. This firm happens to be entirely equity funded, and this step is unnecessary. Hence, to begin the value of a share of stock, we divide equity value (or in this case, firm value) by the number of shares outstanding. lawfulness Value per share = Equity Value/Shares outstanding Equity Value per share = $3,000,000,000/50,000,000 Equity Value per share = $60. Each share of common stock is worth $60, according to the corporate valuation model. 8-7a. 0 1 2 3 4 3,000,000 6,000,000 10,000,000 15,000,000 Using a financial calculator, enter the following inputs CF0 = 0 CF1 = 3000000 CF2 = 6000000 CF3 = 10000000 CF4 = 15000000 I = 12 and then solve for NPV = $24,112,308. b. The firms terminal value is calculated as follows pic c. The firms total value is calculated as follows 0 1 2 3 4 5 3,000,000 6,000,000 10,000,000 15,000,0 00 16,050,000PV = ? 321,000,000 = pic Using your financial calculator, enter the following inputs CF0 = 0 CF1 = 3000000 CF2 = 6000000 CF3 = 10000000 CF4 = 15000000 + 321000000 = 336000000 I = 12 and then solve for NPV = $228,113,612. d. To summon Barretts stock outlay, you need to first find the value of its equity. The value of Barretts equity is equal to the value of the total firm less the market value of its debt and preferred stock. perfect firm value$228,113,612 Market value, debt + preferred 60,000,000 (given in problem) Market value of equity$168,113,612Barretts price per share is calculated as pic 8-8FCF = EBIT(1 T) + Depreciation pic (pic = $500,000,000 + $100,000,000 $200,000,000 $0 = $400,000,000. Firm value = pic = pic = pic = $10,000,000,000. This is the total firm value. direct find the market value of its equity. MV match= MVEquity + MVDebt $10,000,000,000= MVEquity + $3,000,000,000 MVEquity= $7,000,000,000. This is the market value of all the equity. Divide by the number of shares to find the price per share. $7,000,000,000/200,000,000 = $35. 00. 8-9a. Terminal value = pic = pic= $713. 33 million. . 0 1 2 3 4 -20 30 40 42. 80 ($ 17. 70) 23. 49 522. 10 753. 33 $527. 89 Using a financial calculator, enter the following inputs CF0 = 0 CF1 = -20 CF2 = 30 CF3 = 753. 33 I = 13 and then solve for NPV = $527. 89 million. c. Total valuet=0 = $527. 89 million. Value of common equity = $527. 89 $100 = $427. 89 million. Price per share = pic = $42. 79. 8-10The problem asks you to determine the value of pic, given the following facts D1 = $2, b = 0. 9, kRF = 5. %, RPM = 6%, and P0 = $25. Proceed as follows metre 1Calculate the required rate of return ks = kRF + (kM kRF)b = 5. 6% + (6%)0. 9 = 11%. Step 2Use the constant growth rate formula to calculate g pic Step 3Calculate pic pic = P0(1 + g)3 = $25(1. 03)3 = $27. 3182 ( $27. 32. Alternatively, you could calculate D4 and then use the constant growth rate formula to solve for pic D4 = D1(1 + g)3 = $2. 00(1. 03)3 = $2. 1855. pic = $2. 1855/(0. 11 0. 03) = $27. 3182 ( $27. 32. 8-11Vp = Dp/kp therefore, kp = Dp/Vp. a. kp = $8/$60 = 13. 3%. b. kp = $8/$80 = 10. 0%. c. p = $8/$100 = 8. 0%. d. kp = $8/$140 = 5. 7%. 8-12pic 8-13a. ki = kRF + (kM kRF)bi. kC = 9% + (13% 9%)0. 4 = 10. 6%. kD = 9% + (13% 9%)(-0. 5) = 7%. Note that kD is below the risk-free rate. But since this stock is same(p) an insurance policy because it pays off when something bad happens (the market falls), the low return is not unreasonable. b. In this situation, the expected rate of return is as follows pic = D1/P0 + g = $1. 50/$25 + 4% = 10%. However, the required rate of return is 10. 6 pct. Investors will seek to sell the stock, dropping its price to the following pic At this point, pic, and the stock will be in equilibrium. 8-14Calculate the dividend cash flows and place them on a time line. Also, calculate the stock price at the end of the supernormal growth period, and include it, along with th e dividend to be paid at t = 5, as CF5. Then, enter the cash flows as shown on the time line into the cash flow register, enter the required rate of return as I = 15, and then find the value of the stock using the NPV calculation. Be sure to enter CF0 = 0, or else your answer will be incorrect. D0 = 0 D1 = 0 D2 = 0 D3 = 1. 0 D4 = 1. 00(1. 5) = 1. 5 D5 = 1. 00(1. 5)2 = 2. 25 D6 = 1. 00(1. 5)2(1. 08) = $2. 43. pic = ? 0 1 2 3 4 5 6 1. 00 1. 50 2. 25 2. 43 0. 658 +34. 71 = 0. 858 18. 378 36. 96 $19. 894 = pic pic = D6/(pic g) = $2. 43/(0. 15 0. 08) = $34. 71. This is the stock price at the end of Year 5.CF0 = 0 CF1-2 = 0 CF3 = 1. 0 CF4 = 1. 5 CF5 = 36. 96 I = 15%. With these cash flows in the CFLO register, press NPV to get the value of the stock straight off NPV = $19. 89. 8-15a. The preferred stock pays $8 annually in dividends. Therefore, its nominal rate of return would be Nominal rate of return = $8/$80 = 10%. Or alternatively, you could determine the securitys periodic return and multiply by 4. Periodic rate of return = $2/$80 = 2. 5%. Nominal rate of return = 2. 5% ( 4 = 10%. b. EAR = (1 + NOM/4)4 1 EAR = (1 + 0. 10/4)4 1 EAR = 0. 103813 = 10. 3813%. -16The value of any asset is the present value of all future cash flows expected to be generated from the asset. Hence, if we can find the present value of the dividends during the period preceding long-run constant growth and subtract that total from the ongoing stock price, the remaining value would be the present value of the cash flows to be received during the period of long-run constant growth. D1 = $2. 00 ( (1. 25)1 = $2. 50PV(D1) = $2. 50/(1. 12)1= $2. 2321 D2 = $2. 00 ( (1. 25)2 = $3. 125PV(D2) = $3. 125/(1. 12)2= $2. 4913 D3 = $2. 00 ( (1. 25)3 = $3. 90625PV(D3) = $3. 0625/(1. 12)3= $2. 7804 ( PV(D1 to D3)= $7. 5038 Therefore, the PV of the remaining dividends is $58. 8800 $7. 5038 = $51. 3762. Compounding this value forward to Year 3, we find that the value of all dividends received du ring constant growth is $72. 18. $51. 3762(1. 12)3 = $72. 18. Applying the constant growth formula, we can solve for the constant growth rate pic= D3(1 + g)/(ks g) $72. 1807= $3. 90625(1 + g)/(0. 12 g) $8. 6616 $72. 18g= $3. 90625 + $3. 90625g $4. 7554= $76. 08625g 0. 0625= g 6. 25%= g. 8-17First, solve for the current price. P0 = D1/(ks g) P0 = $0. 50/(0. 2 0. 07) P0 = $10. 00. If the stock is in a constant growth state, the constant dividend growth rate is also the capital gains yield for the stock and the stock price growth rate. Hence, to find the price of the stock four years from today pic = P0(1 + g)4 pic = $10. 00(1. 07)4 pic = $13. 10796 ? $13. 11. pic 8-18a. pic b. pic 8-19 0 1 2 3 4 D0 = 2. 00 D1 D2 D3 D4 g = 5% pic a. D1 = $2(1. 05) = $2. 10 D2 = $2(1. 05)2 = $2. 21 D3 = $2(1. 5)3 = $2. 32. b. pecuniary calculator Solution Input 0, 2. 10, 2. 21, and 2. 32 into the cash flow register, input I = 12, PV = ? PV = $5. 29. c. monetary Calculator Solution Input 0, 0, 0, and 34. 73 into the cash flow register, I = 12, PV = ? PV = $24. 72. d. $24. 72 + $5. 29 = $30. 01 = Maximum price you should pay for the stock. e. pic f. No. The value of the stock is not dependent upon the holding period. The value calculated in Parts a through d is the value for a 3-year holding period. It is equal to the value calculated in Part e except for a small rounding error.Any other holding period would produce the same value of pic that is, pic = $30. 00. 8-20a. 1. pic 2. pic = $2/0. 15 = $13. 33. 3. pic 4. pic b. 1. pic = $2. 30/0 = Undefined. 2. pic = $2. 40/(-0. 05) = -$48, which is nonsense. These results show that the formula does not make sense if the required rate of return is equal to or less than the expected growth rate. c. No. 8-21The answer depends on when one works the problem. We used the February 3, 2003, issue of The Wall bridle-path Journal a. $16. 81 to $36. 72. b. Current dividend = $0. 75. Dividend yield = $0. 75/$19. 8 ( 3. 9%. You might wan t to use ($0. 75)(1 + g)/$19. 48, with g estimated somehow. c. The $19. 48 close was up $0. 98 from the previous days close. d. The return on the stock consists of a dividend yield of about 3. 9 percent plus some capital gains yield. We would expect the total rate of return on stock to be in the 10 to 12 percent range. 8-22a. End of Year 02 03 04 05 06 07 08 D0 = 1. 75 D1 D2 D3 D4 D5 D6 Dt= D0(1 + g)t D2003= $1. 75(1. 15)1 = $2. 01. D2004= $1. 5(1. 15)2 = $1. 75(1. 3225) = $2. 31. D2005= $1. 75(1. 15)3 = $1. 75(1. 5209) = $2. 66. D2006= $1. 75(1. 15)4 = $1. 75(1. 7490) = $3. 06. D2007= $1. 75(1. 15)5 = $1. 75(2. 0114) = $3. 52. b. Step 1 PV of dividends = pic. PV D2003 = $2. 01/(1. 12)= $1. 79 PV D2004 = $2. 31/(1. 12)2= $1. 84 PV D2005 = $2. 66/(1. 12)3= $1. 89 PV D2006 = $3. 06/(1. 12)4= $1. 94 PV D2007 = $3. 52/(1. 12)5= $2. 00 PV of dividends= $9. 46 Step 2 pic This is the price of the stock 5 years from now. The PV of this price, discounted blanket 5 years, is as follow s PV of pic = $52. 80/(1. 12)5 = $29. 6. Step 3 The price of the stock today is as follows pic= PV dividends years 2003-2007 + PV of pic = $9. 46 + $29. 96 = $39. 42. This problem could also be solved by substituting the proper values into the following equation pic. Calculator dissolver Input 0, 2. 01, 2. 31, 2. 66, 3. 06, 56. 32 (3. 52 + 52. 80) into the cash flow register, input I = 12, PV = ? PV = $39. 43. c. 2003 D1/P0 = $2. 01/$39. 43= 5. 10% Capital gains yield= 6. 90* Expected total return= 12. 00% 2008 D6/P5 = $3. 70/$52. 80= 7. 00% Capital gains yield= 5. 00 Expected total return= 12. 00% We know that ks is 12 percent, and the dividend yield is 5. 10 percent therefore, the capital gains yield must be 6. 90 percent. The main points to note here are as follows 1. The total yield is always 12 percent (except for rounding errors). 2. The capital gains yield starts comparatively high, then declines as the supernormal growth period approaches its end. The dividend yield rises. 3. After 12/31/07, the stock will grow at a 5 percent rate. The dividend yield will equal 7 percent, the capital gains yield will equal 5 percent, and the total return will be 12 percent. d.People in high income tax brackets will be more inclined to purchase growth stocks to take the capital gains and thus delay the payment of taxes until a later date. The firms stock is fester at the end of 2007. e. Since the firms supernormal and normal growth rates are lower, the dividends and, hence, the present value of the stock price will be lower. The total return from the stock will becalm be 12 percent, but the dividend yield will be larger and the capital gains yield will be smaller than they were with the original growth rates. This result occurs because we assume the same last dividend but a much lower current stock price. . As the required return increases, the price of the stock goes down, but both the capital gains and dividend yields increase initially. Of course, the long-term c apital gains yield is still 4 percent, so the long-term dividend yield is 10 percent. 8-23a. Part 1 Graphical representation of the problem Supernormal Normal growth growth 0 1 2 3 ( D0 D1 (D2 + pic) D3 D( PVD1PVD2 pic P0 D1 = D0(1 + gs) = $1. 6(1. 20) = $1. 92. D2 = D0(1 + gs)2 = $1. 60(1. 20)2 = $2. 304. pic pic= PV(D1) + PV(D2) + PV(pic) = pic = $1. 92/1. 10 + $2. 304/(1. 10)2 + $61. 06/(1. 10)2 = $54. 11. Financial Calculator solution Input 0, 1. 92, 63. 364(2. 304 + 61. 06) into the cash flow register, input I = 10, PV = ? PV = $54. 11. Part 2 Expected dividend yield D1/P0 = $1. 92/$54. 11 = 3. 55%. Capital gains yield First, find pic, which equals the sum of the present values of D2 and pic discounted for one year. pic Financial Calculator solution Input 0, 63. 364(2. 304 + 61. 6) into the cash flow register, input I = 10, PV = ? PV = $57. 60. Second, find the capital gains yield pic Dividend yield = 3. 55% Capital gains yield = 6. 45 10. 00% = ks. b. Due to the longer p eriod of supernormal growth, the value of the stock will be higher for each year. Although the total return will remain the same, ks = 10%, the distribution between dividend yield and capital gains yield will differ The dividend yield will start off lower and the capital gains yield will start off higher for the 5-year supernormal growth condition, relative to the 2-year supernormal growth state.The dividend yield will increase and the capital gains yield will decline over the 5-year period until dividend yield = 4% and capital gains yield = 6%. c. Throughout the supernormal growth period, the total yield will be 10 percent, but the dividend yield is relatively low during the early years of the supernormal growth period and the capital gains yield is relatively high. As we near the end of the supernormal growth period, the capital gains yield declines and the dividend yield rises. After the supernormal growth period has ended, the capital gains yield will equal gn = 6%.The total yie ld must equal ks = 10%, so the dividend yield must equal 10% 6% = 4%. d. Some investors need cash dividends (retired people), bit others would prefer growth. Also, investors must pay taxes each year on the dividends received during the year, while taxes on capital gains can be delayed until the gain is actually realized. 8-24a. ks = kRF + (kM kRF)b = 11% + (14% 11%)1. 5 = 15. 5%. pic = D1/(ks g) = $2. 25/(0. 155 0. 05) = $21. 43. b. ks = 9% + (12% 9%)1. 5 = 13. 5%. pic = $2. 25/(0. 135 0. 05) = $26. 47. c. ks = 9% + (11% 9%)1. 5 = 12. 0%. pic = $2. 25/(0. 12 0. 5) = $32. 14. d. New data given kRF = 9% kM = 11% g = 6%, b = 1. 3. ks = kRF + (kM kRF)b = 9% + (11% 9%)1. 3 = 11. 6%. pic = D1/(ks g) = $2. 27/(0. 116 0. 06) = $40. 54. 8-25a. Old ks = kRF + (kM kRF)b = 9% + (3%)1. 2 = 12. 6%. New ks = 9% + (3%)0. 9 = 11. 7%. Old price pic New price pic Since the new price is lower than the old price, the expansion in consumer products should be rejected. The decrease in risk is not sufficient to offset the decline in profitability and the reduced growth rate. b. POld = $38. 21. PNew = pic. Solving for ks we have the following $38. 1= pic $2. 10= $38. 21(ks) $1. 9105 $4. 0105= $38. 21(ks) ks= 0. 10496. Solving for b 10. 496% = 9% + 3%(b) 1. 496% = 3%(b) b = 0. 49865. Check ks = 9% + (3%)0. 49865 = 10. 496%. pic = pic = $38. 21. Therefore, only if managements analysis concludes that risk can be lowered to b = 0. 49865, or approximately 0. 5, should the new policy be put into effect. SPREADSHEET PROBLEM 8-26The detailed solution for the spreadsheet problem is operable both on the instructors resource CD-ROM and on the instructors slope of South-Westerns web site, http//brigham. swlearning. com. INTEG commitD CASEMutual of Chicago Insurance Company Stock Valuation 8-27ROBERT BALIK AND CAROL KIEFER ar SENIOR VICE-PRESIDENTS OF THE MUTUAL OF CHICAGO INSURANCE COMPANY. THEY ARE CO-DIRECTORS OF THE COMPANYS PENSION FUND way DIVISION, WITH BALIK HAVING RESP ONSIBILITY FOR FIXED INCOME SECURITIES (PRIMARILY BONDS) AND KIEFER BEING RESPONSIBLE FOR EQUITY INVESTMENTS. A MAJOR NEW CLIENT, THE CALIFORNIA alliance OF CITIES, HAS REQUESTED THAT MUTUAL OF CHICAGO PRESENT AN INVESTMENT SEMINAR TO THE MAYORS OF THE REPRESENTED CITIES, AND BALIK AND KIEFER, WHO WILL MAKE THE ACTUAL PRESENTATION, return ASKED YOU TO HELP THEM.TO ILLUSTRATE THE COMMON billet VALUATION PROCESS, BALIK AND KIEFER HAVE ASKED YOU TO ANALYZE THE BON TEMPS COMPANY, AN usageMENT AGENCY THAT SUPPLIES banter PROCESSOR OPERATORS AND COMPUTER PROGRAMMERS TO BUSINESSES WITH TEMPORARILY HEAVY WORKLOADS. YOU ARE TO dress THE next QUESTIONS. A. DESCRIBE BRIEFLY THE juristic RIGHTS AND PRIVILEGES OF COMMON telephone lineHOLDERS. ANSWERSHOW S8-1 THROUGH S8-5 present. THE COMMON STOCKHOLDERS ARE THE OWNERS OF A CORPORATION, AND AS SUCH THEY HAVE original RIGHTS AND PRIVILEGES AS DESCRIBED BELOW. 1. OWNERSHIP IMPLIES CONTROL.THUS, A FIRMS COMMON STOCKHOLDERS HAVE THE RIGHT TO elite ITS FIRMS DIRECTORS, WHO IN TURN ELECT THE OFFICERS WHO MANAGE THE BUSINESS. 2. COMMON STOCKHOLDERS OFTEN HAVE THE RIGHT, CALLED THE pre-emptive RIGHT, TO PURCHASE ANY ADDITIONAL tractS SOLD BY THE FIRM. IN SOME STATES, THE PREEMPTIVE RIGHT IS automatically INCLUDED IN EVERY CORPORATE CHARTER IN OTHERS, IT IS NECESSARY TO INSERT IT SPECIFICALLY INTO THE CHARTER. B. 1. frame show up A sourULA THAT do-nothing BE USED TO look on ANY STOCK, REGARDLESS OF ITS DIVIDEND PATTERN. ANSWERSHOW S8-6 HERE. THE VALUE OF ANY STOCK IS THE PRESENT VALUE OF ITS evaluate DIVIDEND swarm pic = picHOWEVER, SOME STOCKS HAVE DIVIDEND result PATTERNS THAT ALLOW THEM TO BE VALUED USING SHORT-CUT FORMULAS. B. 2. WHAT IS A aeonian harvest-home STOCK? HOW ARE ceaseless evolution STOCKS VALUED? ANSWERSHOW S8-7 AND S8-8 HERE. A unending GROWTH STOCK IS ace WHOSE DIVIDENDS ARE pass judgment TO GROW AT A eonian RATE always. CONSTANT GROWTH MEANS THAT THE BEST work out OF THE FUTURE GROWTH RATE IS SOME CONSTANT NUMBER, NOT THAT WE REALLY EXPECT GROWTH TO BE THE SAME EACH AND EVERY stratum. MANY COMPANIES HAVE DIVIDENDS THAT ARE expect TO GROW STEADILY INTO THE predictable FUTURE, AND SUCH COMPANIES ARE VALUED AS CONSTANT GROWTH STOCKS.FOR A CONSTANT GROWTH STOCK D1 = D0(1 + g), D2 = D1(1 + g) = D0(1 + g)2, AND SO ON. WITH THIS REGULAR DIVIDEND PATTERN, THE GENERAL STOCK VALUATION MODEL CAN BE SIMPLIFIED TO THE FOLLOWING VERY IMPORTANT EQUATION pic = pic = pic. THIS IS THE WELL-KNOWN GORDON, OR CONSTANT-GROWTH MODEL FOR VALUING STOCKS. HERE D1 IS THE NEXT EXPECTED DIVIDEND, WHICH IS false TO BE PAID 1 YEAR FROM NOW, kS IS THE REQUIRED RATE OF render ON THE STOCK, AND g IS THE CONSTANT GROWTH RATE. B. 3. WHAT HAPPENS IF A COMPANY HAS A CONSTANT g THAT EXCEEDS ITS ks? WILL MANY STOCKS HAVE EXPECTED g ks IN THE SHORT RUN (THAT IS, FOR THE NEXT FEW YEARS)?IN THE LONG RUN (THAT IS, FOREVER)? ANSWERSHOW S8-9 HERE. THE MODEL IS DERIVED MATHEMATICALLY, AND THE DE RIVATION REQUIRES THAT ks g. IF g IS GREATER THAN ks, THE MODEL GIVES A NEGATIVE STOCK expenditure, WHICH IS NONSENSICAL. THE MODEL just now CANNOT BE USED UNLESS (1) ks g, (2) g IS EXPECTED TO BE CONSTANT, AND (3) g CAN REASONABLY BE EXPECTED TO CONTINUE INDEFINITELY. STOCKS MAY HAVE PERIODS OF supranormal GROWTH, WHERE gS ks HOWEVER, THIS GROWTH RATE CANNOT BE SUSTAINED INDEFINITELY. IN THE LONG-RUN, g ks. C. ASSUME THAT BON TEMPS HAS A BETA COEFFICIENT OF 1. , THAT THE RISK-FREE RATE (THE recall ON T-BONDS) IS 7 share, AND THAT THE REQUIRED RATE OF overstep ON THE MARKET IS 12 PERCENT. WHAT IS THE REQUIRED RATE OF RETURN ON THE FIRMS STOCK? ANSWERSHOW S8-10 HERE. HERE WE USE THE SML TO CALCULATE BON TEMPS REQUIRED RATE OF RETURN ks= kRF + (kM kRF)bBon Temps = 7% + (12% 7%)(1. 2) = 7% + (5%)(1. 2) = 7% + 6% = 13%. D. ASSUME THAT BON TEMPS IS A CONSTANT GROWTH COMPANY WHOSE stand up DIVIDEND (D0, WHICH WAS PAID YESTERDAY) WAS $2. 00 AND WHOSE DIVIDEND IS EXPECTED TO G ROW INDEFINITELY AT A 6 PERCENT RATE. 1.WHAT IS THE FIRMS EXPECTED DIVIDEND STREAM OVER THE NEXT 3 YEARS? ANSWERSHOW S8-11 HERE. BON TEMPS IS A CONSTANT GROWTH STOCK, AND ITS DIVIDEND IS EXPECTED TO GROW AT A CONSTANT RATE OF 6 PERCENT PER YEAR. EXPRESSED AS A TIME LINE, WE HAVE THE FOLLOWING SETUP. JUST ENTER 2 IN YOUR CALCULATOR indeed KEEP MULTIPLYING BY 1 + g = 1. 06 TO GET D1, D2, AND D3 0 1 2 3 D0 = 2. 00 2. 12 2. 247 2. 382 1. 88 1. 76 1. 65 . . . D. 2. WHAT IS THE FIRMS CURRENT STOCK terms? ANSWERSHOW S8-12 HERE. WE COULD tend THE TIME LINE ON OUT FOREVER, FIND THE VALUE OF BON TEMPS DIVIDENDS FOR EVERY YEAR ON OUT INTO THE FUTURE, AND THEN THE PV OF EACH DIVIDEND DISCOUNTED AT k = 13%. FOR EXAMPLE, THE PV OF D1 IS $1. 8761 THE PV OF D2 IS $1. 7599 AND SO FORTH. NOTE THAT THE DIVIDEND PAYMENTS INCREASE WITH TIME, BUT AS LONG AS ks g, THE PRESENT VALUES DECREASE WITH TIME. IF WE EXTENDED THE GRAPH ON OUT FOREVER AND THEN SUMMED THE PVs OF THE DIVIDENDS, WE WOULD HAVE THE VALUE OF THE STOCK. HOWEVER, SINCE THE STOCK IS GROWING AT A CONSTANT RATE, ITS VALUE CAN BE ESTIMATED USING THE CONSTANT GROWTH MODEL pic = pic = pic = pic = $30. 29. D. 3. WHAT IS THE STOCKS EXPECTED VALUE hotshot YEAR FROM NOW? ANSWERSHOW S8-13 HERE. AFTER ONE YEAR, D1 WILL HAVE BEEN PAID, SO THE EXPECTED DIVIDEND STREAM WILL THEN BE D2, D3, D4, AND SO ON. THUS, THE EXPECTED VALUE ONE YEAR FROM NOW IS $32. 10 pic = pic = pic = pic = $32. 10. D. 4. WHAT ARE THE EXPECTED DIVIDEND outturn, THE neat GAINS abide, AND THE TOTAL RETURN DURING THE FIRST YEAR? ANSWERSHOW S8-14 HERE. THE EXPECTED DIVIDEND give in IN ANY YEAR n IS DIVIDEND dampen = pic, WHILE THE EXPECTED bang-up GAINS throw ISCAPITAL GAINS give way = pic = k pic. THUS, THE DIVIDEND YIELD IN THE FIRST YEAR IS 7 PERCENT, WHILE THE CAPITAL GAINS YIELD IS 6 PERCENT TOTAL RETURN = 13. 0% DIVIDEND YIELD = $2. 12/$30. 29 = 7. 0% CAPITAL GAINS YIELD = 6. 0% E. NOW ASSUME THAT THE STOCK IS CURRENTLY SELLING AT $30. 29. WHAT IS THE EXPECTED RATE OF RETURN ON THE STOCK? ANSWERTHE CONSTANT GROWTH MODEL CAN BE REARRANGED TO THIS FORM pic = pic. HERE THE CURRENT PRICE OF THE STOCK IS KNOWN, AND WE SOLVE FOR THE EXPECTED RETURN. FOR BON TEMPS pic = $2. 12/$30. 29 + 0. 060 = 0. 070 + 0. 060 = 13%. F. WHAT WOULD THE STOCK PRICE BE IF ITS DIVIDENDS WERE EXPECTED TO HAVE ZERO GROWTH? ANSWERSHOW S8-15 HERE. IF BON TEMPS DIVIDENDS WERE NOT EXPECTED TO GROW AT ALL, THEN ITS DIVIDEND STREAM WOULD BE A PERPETUITY. PERPETUITIES ARE VALUED AS SHOWN BELOW 0 1 2 3 2. 00 2. 00 2. 00 1. 77 1. 57 1. 39 . . . P0 = 15. 38 P0 = D/kS = $2. 00/0. 13 = $15. 38. NOTE THAT IF A PREFERRED STOCK IS A PERPETUITY, IT MAY BE VALUED WITH THIS FORMULA. G.NOW ASSUME THAT BON TEMPS IS EXPECTED TO pass SUPERNORMAL GROWTH OF 30 PERCENT FOR THE NEXT 3 YEARS, THEN TO RETURN TO ITS LONG-RUN CONSTANT GROWTH RATE OF 6 PERCENT. WHAT IS THE STOCKS VALUE UNDER THESE CONDITIONS? WHAT IS ITS EXPECTED DIVIDEND YIELD AND CAPITAL GAINS YIE LD IN YEAR 1? YEAR 4? ANSWERSHOW S8-16 THROUGH S8-18 HERE. BON TEMPS IS NO LONGER A CONSTANT GROWTH STOCK, SO THE CONSTANT GROWTH MODEL IS NOT APPLICABLE. NOTE, HOWEVER, THAT THE STOCK IS EXPECTED TO extend A CONSTANT GROWTH STOCK IN 3 YEARS. THUS, IT HAS A NONCONSTANT GROWTH PERIOD FOLLOWED BY CONSTANT GROWTH.THE EASIEST WAY TO VALUE SUCH NONCONSTANT GROWTH STOCKS IS TO SET THE SITUATION UP ON A TIME LINE AS SHOWN BELOW 0 1 2 3 4 2. 600 3. 380 4. 394 4. 65764 2. 301 2. 647 3. 045 46. 114 54. 107 exclusively ENTER $2 AND MULTIPLY BY (1. 30) TO GET D1 = $2. 60 MULTIPLY THAT RESULT BY 1. 3 TO GET D2 = $3. 38, AND SO FORTH. THEN RECOGNIZE THAT AFTER YEAR 3, BON TEMPS BECOMES A CONSTANT GROWTH STOCK, AND AT THAT POINT pic CAN BE FOUND USING THE CONSTANT GROWTH MODEL. pic IS THE PRESENT VALUE AS OF t = 3 OF THE DIVIDENDS IN YEAR 4 AND BEYOND AND IS ALSO CALLED THE TERMINAL VALUE. WITH THE CASH fuseS FOR D1, D2, D3, AND pic SHOWN ON THE TIME LINE, WE DISCOUNT EACH VALUE BACK TO Y EAR 0, AND THE SUM OF THESE FOUR PVs IS THE VALUE OF THE STOCK TODAY, P0 = $54. 107. THE DIVIDEND YIELD IN YEAR 1 IS 4. 80 PERCENT, AND THE CAPITAL GAINS YIELD IS 8. 2 PERCENT DIVIDEND YIELD = pic = 0. 0480 = 4. 8%. CAPITAL GAINS YIELD = 13. 00% 4. 8% = 8. 2%. DURING THE NONCONSTANT GROWTH PERIOD, THE DIVIDEND YIELDS AND CAPITAL GAINS YIELDS ARE NOT CONSTANT, AND THE CAPITAL GAINS YIELD DOES NOT EQUAL g.HOWEVER, AFTER YEAR 3, THE STOCK BECOMES A CONSTANT GROWTH STOCK, WITH g = CAPITAL GAINS YIELD = 6. 0% AND DIVIDEND YIELD = 13. 0% 6. 0% = 7. 0%. H. SUPPOSE BON TEMPS IS EXPECTED TO EXPERIENCE ZERO GROWTH DURING THE FIRST 3 YEARS AND THEN TO RESUME ITS STEADY-STATE GROWTH OF 6 PERCENT IN THE FOURTH YEAR. WHAT IS THE STOCKS VALUE NOW? WHAT IS ITS EXPECTED DIVIDEND YIELD AND ITS CAPITAL GAINS YIELD IN YEAR 1? YEAR 4? ANSWERSHOW S8-19 AND S8-20 HERE. NOW WE HAVE THIS SITUATION 0 1 2 3 4 2. 00 2. 0 2. 00 2. 00 2. 12 1. 77 1. 57 1. 39 20. 99 25. 72 = pic DURING YEAR 1 DIVIDEND YIE LD = pic = 0. 0778 = 7. 78%. CAPITAL GAINS YIELD = 13. 00% 7. 78% = 5. 22%. AGAIN, IN YEAR 4 BON TEMPS BECOMES A CONSTANT GROWTH STOCK HENCE g = CAPITAL GAINS YIELD = 6. 0% AND DIVIDEND YIELD = 7. 0%. I. FINALLY, ASSUME THAT BON TEMPS EARNINGS AND DIVIDENDS ARE EXPECTED TO DECLINE BY A CONSTANT 6 PERCENT PER YEAR, THAT IS, g = -6%. WHY WOULD ANYONE BE WILLING TO BUY SUCH A STOCK, AND AT WHAT PRICE SHOULD IT SELL? WHAT WOULD BE THE DIVIDEND YIELD AND CAPITAL GAINS YIELD IN EACH YEAR?ANSWERSHOW S8-21 AND S8-22 HERE. THE COMPANY IS EARNING SOMETHING AND PAYING SOME DIVIDENDS, SO IT CLEARLY HAS A VALUE GREATER THAN ZERO. THAT VALUE CAN BE FOUND WITH THE CONSTANT GROWTH FORMULA, BUT WHERE g IS NEGATIVE pic = pic = pic = pic = pic = $9. 89. SINCE IT IS A CONSTANT GROWTH STOCK g = CAPITAL GAINS YIELD = -6. 0%, HENCE DIVIDEND YIELD = 13. 0% (-6. 0%) = 19. 0%. AS A CHECK DIVIDEND YIELD = pic = 0. 190 = 19. 0%. THE DIVIDEND AND CAPITAL GAINS YIELDS ARE CONSTANT OVER TIME, BUT A HIGH (19. 0 PERCENT) DIVIDEND YIELD IS NEEDED TO OFFSET THE NEGATIVE CAPITAL GAINS YIELD.J. BON TEMPS EMBARKS ON AN AGGRESSIVE EXPANSION THAT REQUIRES ADDITIONAL CAPITAL. MANAGEMENT DECIDES TO FINANCE THE EXPANSION BY BORROWING $40 MILLION AND BY HALTING DIVIDEND PAYMENTS TO INCREASE RETAINED EARNINGS. THE PROJECTED FREE CASH FLOWS FOR THE NEXT triad YEARS ARE -$5 MILLION, $10 MILLION, AND $20 MILLION. AFTER THE THIRD YEAR, FREE CASH FLOW IS PROJECTED TO GROW AT A CONSTANT 6 PERCENT. THE OVERALL COST OF CAPITAL IS 10 PERCENT. WHAT IS BON TEMPS TOTAL VALUE? IF IT HAS 10 MILLION SHARES OF STOCK AND $40 MILLION TOTAL DEBT, WHAT IS THE PRICE PER SHARE? ANSWERSHOW S8-23 THROUGH S8-28 HERE. 0 1 2 3 4 -5 10 20 21. 20 $ -4. 545 8. 264 15. 026 398. 197 $416. 942 = TOTAL VALUE VALUE OF EQUITY = TOTAL VALUE DEBT = $416. 94 $40 = $376. 94 MILLION. PRICE PER SHARE = $376. 94/10 = $37. 69. K. WHAT DOES MARKET EQUILIBRIUM MEAN? ANSWERSHOW S8-29 AND S8-30 HERE. EQUILIBRIUM MEANS STABLE, NO TENDENCY T O CHANGE. MARKET EQUILIBRIUM MEANS THAT PRICES ARE STABLEAT ITS CURRENT PRICE, THERE IS NO GENERAL TENDENCY FOR PEOPLE TO WANT TO BUY OR TO SELL A SECURITY THAT IS IN EQUILIBRIUM.ALSO, WHEN EQUILIBRIUM EXISTS, THE EXPECTED RATE OF RETURN WILL BE EQUAL TO THE REQUIRED RATE OF RETURN pic = D1/P0 + g = k = kRF + (kM kRF)b. L. IF EQUILIBRIUM DOES NOT EXIST, HOW WILL IT BE ESTABLISHED? ANSWERSHOW S8-31 AND S8-32 HERE. SECURITIES WILL BE BOUGHT AND SOLD UNTIL THE EQUILIBRIUM PRICE IS ESTABLISHED. M. WHAT IS THE EFFICIENT MARKETS HYPOTHESIS, WHAT ARE ITS THREE FORMS, AND WHAT ARE ITS IMPLICATIONS? ANSWERSHOW S8-33 THROUGH S8-37 HERE. THE EMH IN GENERAL IS THE HYPOTHESIS THAT SECURITIES ARE NORMALLY IN EQUILIBRIUM AND ARE PRICED FAIRLY, MAKING IT IMPOSSIBLE TO lave THE MARKET. WEAK-FORM EFFICIENCY SAYS THAT INVESTORS CANNOT PROFIT FROM LOOKING AT PAST MOVEMENTS IN STOCK PRICESTHE FACT THAT STOCKS WENT DOWN FOR THE hold out FEW DAYS IS NO REASON TO THINK THAT THEY WILL GO UP (OR DOWN) I N THE FUTURE. THIS FORM HAS BEEN PROVEN PRETTY WELL BY EMPIRICAL TESTS, EVEN THOUGH PEOPLE STILL EMPLOY TECHNICAL ANALYSIS. SEMISTRONG-FORM EFFICIENCY SAYS THAT ALL PUBLICLY AVAILABLE INFORMATION IS REFLECTED IN STOCK PRICES, HENCE THAT IT winT DO MUCH GOOD TO PORE OVER yearly REPORTS TRYING TO FIND UNDERVALUED STOCKS.THIS ONE IS (WE THINK) LARGELY TRUE, BUT SUPERIOR ANALYSTS CAN STILL OBTAIN AND PROCESS NEW INFORMATION disruptive ENOUGH TO GAIN A SMALL ADVANTAGE. STRONG-FORM EFFICIENCY SAYS THAT ALL INFORMATION, EVEN INSIDE INFORMATION, IS EMBEDDED IN STOCK PRICES. THIS FORM DOES NOT HOLDINSIDERS KNOW MORE, AND COULD TAKE ADVANTAGE OF THAT INFORMATION TO MAKE unnatural PROFITS IN THE MARKETS. TRADING ON THE BASIS OF INSIDER INFORMATION IS ILLEGAL. N. PHYFE COMPANY RECENTLY ISSUED PREFERRED STOCK. IT PAYS AN ANNUAL DIVIDEND OF $5, AND THE ISSUE PRICE WAS $50 PER SHARE. WHAT IS THE EXPECTED RETURN TO AN INVESTOR ON THIS PREFERRED STOCK?ANSWERSHOW S8-38 AND S8-39 HERE. pic= pic = pic = 10%. ks = 15% gn = 6% ( 1/(1. 15)3 ( 1/(1. 13)3 ( 1/(1. 13)2 ( 1/1. 13 gs = 50% gn = 8% pic ks = 12% gs = 15% gn = 5% WACC = 10% pic = 30. 29 = pic g = 0% g = 0% g = 0% gn = 6% ks = 13% pic = $66. 54 = pic gs = 30% gs = 30% gs = 30% gn = 6% ks = 13% g = 0% ks = 13% g = 6% ks = 13% ks = 10% gs = 20% gs = 20% gn = 5% WACC = 12% WACC = 12% gn = 7% pic WACC = 13% gn = 7% 530 = pic ( 1/(1. 15)4 ( 1/(1. 15)5 ks = 12% ( 1/1. 13 ( 1/(1. 13)2 ( 1/(1. 13)3 ( 1/(1. 13)2 ( 1/(1. 13)2 ( 1/1. 13 ( 1/(1. 13)2 ( 1/(1. 13)3 ( 1/(1. 13)3 ( 1/1. 13 ( 1/1. 13 (%89