Chapter 07

Inputs are in Blue Answers are in Red NOTE: Some functions used in these spreadsheets may require that the "Analysis ToolPak" or "Solver Add-In" be installed in Excel. To install these, click on the Office button then "Excel Options," "Add-Ins" and select "Go." Check "Analysis ToolPak" and "Solver Add-In," then click "OK."

2012, The McGraw-Hill Companies

Quiz1. Dividend discount model. Amazon.com has never paid a dividend, but in august 2010 the market value of its stock was $57billion. Does this invalidate the dividend discount model?

Answer: No, this does not invalidate the dividend discount model. The dividend discount model allows for the fact that firms may not currently pay dividends. As the market matures, and Amazons growth opportunities moderate, investors may justifiably believe that Amazon will enjoy high future earnings and will then pay dividends. The stock price today can still reflect the present value of the expected per-share stream of dividends.

Quiz 2 Favored stock will pay a dividend this year of $2.40 per share. Its dividend yield is 8%. At what price is the stock selling? Dividend per share Dividend yield Solution: Stock Price = $ 30.00 $ 2.40 8.00%

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Quiz 3 Preferred Products has issued preferred stock with an $8 annual dividend that will be paid in perpetuity. a. If the discount rate is 12%, at what price should the preferred sell? b. At what price should the stock sell 1 year from now? c. What is the dividend yield, the capital gains yield, and the expected rate of return of the stock? Annual dividend Discount rate Solution: a. b. c. Stock Price Stock Price after 1 year Stock Price Dividend yield Capital gains yield Expected rate of return = $ 66.67 = $ 66.67 $ 66.67 12.00% 0.00 12.00% $ 8.00 12%

= = =

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Quiz 4 Waterworks has a dividend yield of 8%. If its dividend is expected to grow at a constant rate of 5%, what must be the expected rate of return on the companys stock? Dividend yield Constant growth rate Solution: Expected rate of return = 13.00% 8.00% 5.00%

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Quiz 5. How can we say that price equals to the present value of all future cash flows when many actual investors may be seeking capital gains and planing to hold their shares for only a year or two? Explain.

5. The value of a share of common stock equals the present value of dividends received out to the investment horizon plus the present value of the forecast stock price at the horizon. But the stock price at the horizon date depends on expectations of dividends from that date forward. So, even if an investor plans to hold a stock for only a year or two, the price ultimately received from another investor depends on dividends to be paid after the date of purchase. Therefore, the stocks present value is the same for investors with different time horizons.

Quiz 6 Steady As She Goes, Inc., will pay a year-end dividend of $3 per share. Investors expect the dividend to grow at a rate of 4% indefinitely. a. If the stock currently sells for $30 per share, what is the expected rate of return on the stock? b. If the expected rate of return on the stock is 16.5%, what is the stock price? Dividend per share Constant growth rate Current selling price (a) Expected rate of return (b) Solution: a. b. Expected rate of return Stock price = 14.00% = $ 24.00 $ 3.00 4.00% $ 30.00 16.50%

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Quiz 7 BMM Industries pays a dividend of $2 per quarter. The dividend yield on its stock is reported at 4.8%. What price is the stock selling at? Dividend Dividend yield Solution: Annual dividend Stock price = $ 8.00 = $ 166.67 note: 4 times quarterly dividend for a whole year. dividend yield= dividend payment/stock price= Stock price=8/0,048 166.6667 $ 2.00 per quarter 4.80%

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ividend for a whole year. payment/stock price=

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Practice Problem 11 Integrated Potato Chips paid a $1 per share dividend yesterday. You expect the dividend to grow steadily at a rate of 4% per year. a. What is the expected dividend in each of the next 3 years? b. If the discount rate for the stock is 12%, at what price will the stock sell? c. What is the expected stock price 3 years from now? d. If you buy the stock and plan to hold it for 3 years, what payments will you receive? What is the present value of those payments? Compare your answer to (b). Per share dividend Constant growth rate Discount rate (b) Solution: a. Expected dividend: DIV1 DIV2 DIV3 DIV1 Stock price $ 1.00 4.00% 12.00%

= $ 1.0400 = $ 1.0816 = $ 1.1249 $ 1.0400 = $ 13.00

b.

c.

DIV3 $ 1.1249 Expected stock price = $ 14.6237 Year 1 1.04 1.04 0.93 Year 2 1.08 1.08 0.86 Year 3 1.12 14.62 15.75 11.21 13.00

d. DIV Selling price Total cash flow PV of cash flow Sum of PV $ $ $

$ $ $

$ $ $ $ $

Sum of PV = $13.00, the same as the answer to part (b).

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Practice Problem 12 A stock sells for $40. The next dividend will be $4 per share. If the rate of return earned on reinvested funds is a constant 15% and the company reinvests 40% of earnings in the firm, what must be the discount rate? Stock price Next dividend per share Rate of return on reinvested funds Reinvested earnings Solution: g Discount Rate = = 6.00% 16.00% $ 40.00 $ 4.00 15.00% 40.00%

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Practice Problem 13 Gentleman Gym just paid its annual dividend of $3 per share, and it is widely expected that the dividend will increase by 5% per year indefinitely. a. What price should the stock sell at? The discount rate is 15%. b. How would your answer change if the discount rate were only 12%? Why does the answer change? Annual dividend per share $ 3.00 Constant growth rate 5.00% Discount rate (a) 15.00% Discount rate (b) 12.00% Solution: a. b. Stock price (P0) Stock price (P0) = $ 31.50 = $ 45.00

The lower discount rate makes the present value of future dividends higher.

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Practice Problem 14 Arts and Crafts, Inc., will pay a dividend of $5 per share in 1 year. It sells at $50 a share, and firms in the same industry provide an expected rate of return of 14%. What must be the expected growth rate of the companys dividends? Annual dividend per share Stock price Expected rate of return Solution: Expected growth rate = 4.00% $ 5.00 $ 50.00 14.00%

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Practice Problem 15 Eastern Electric currently pays a dividend of about $1.64 per share and sells for $27 a share. a. If investors believe the growth rate of dividends is 3% per year, what rate of return do they expect to earn on the stock? b. If investors required rate of return is 10%, what must be the growth rate they expect of the firm? c. If the sustainable growth rate is 5% and the plowback ratio is .4, what must be the rate of return earned by the firm on its new investments?

Dividend per share Stock price Growth rate of dividends (a) Required rate of return (b) Sustainable growth rate Plowback ratio Solution: a. b. c. Expected rate of return (r ) = Expected growth rate (g) Return on equity = =

$ 1.64 $ 27.00 3.00% 10.00% 5.00% 0.40

9.26% 3.74% 12.50%

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Practice Problem 16 You believe that the Non-stick Gum Factory will pay a dividend of $2 on its common stock next year. Thereafter, you expect dividends to grow at a rate of 6% a year in perpetuity. If you require a return of 12% on your investment, how much should you be prepared to pay for the stock?

Dividend next year Constant growth rate Required rate of return Solution: Stock price (P0)

$ 2.00 6.00% 12.00%

= $ 33.33

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Practice Problem 17 Horse and Buggy Inc. is in a declining industry. Sales, earnings, and dividends are all shrinking at a rate of 10% per year. a. If r = 15% and DIV 1 = $3, what is the value of a share? b. What price do you forecast for the stock next year? c. What is the expected rate of return on the stock? d. Can you distinguish between bad stocks and bad companies? Does the fact that the industry is declining mean that the stock is a bad buy? Shrinking rate Required rate of return Dividend in 1st year Solution: a. b. c. Stock price (P0) Stock price (P1) Stock price (P0) Stock price (P1) Expected rate of return = $ 12.00 = $ 10.80 = $ 12.00 = $ 10.80 = 15.00% 10.00% 15.00% $ 3.00

d. Bad companies may be declining, but if the stock price already reflects this fact, the investor can still earn a fair rate of return.

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Practice Problem 18 Metatrends stock will generate earnings of $6 per share this year. The discount rate for the stock is 15%, and the rate of return on reinvested earnings also is 15%. a. Find both the growth rate of dividends and the price of the stock if the company reinvests the following fraction of its earnings in the firm: (i) 0%; (ii) 40%; (iii) 60% b. Redo part (a) now assuming that the rate of return on reinvested earnings is 20%. What is the present value of growth opportunities for each reinvestment rate? Earnings Discount rate Rate of return on reinvested earnings Reinvestment: (a) (i) (ii) (iii) Rate of return on reinvestment (b) Solution: a. (i) Reinvest 0% of earnings: Growth Rate Dividend Stock price (P0) (ii) Reinvest 40% of earnings: Growth Rate Dividend Stock price (P0) (iii) Reinvest 60% of earnings: Growth Rate Dividend Stock price (P0) b. (i) Reinvest 0% of earnings: Stock price with 15% rate of return Stock price (P0) PVGO (ii) Reinvest 40% of earnings: Stock price with 15% rate of return Stock price (P0) PVGO (iii) Reinvest 60% of earnings: Stock price with 15% rate of return Stock price (P0) PVGO $ 6.00 15.00% 15.00% 0.00% 40.00% 60.00% 20.00%

= 0% = $ 6.00 = $ 40.00

= 6.00% = $ 3.60 = $ 40.00

= 9.00% = $ 2.40 = $ 40.00

= $ 40.00 = $ 40.00 = $ -

= $ 40.00 = $ 51.43 = $ 11.43

= $ 40.00 = $ 80.00 = $ 40.00

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Practice Problem 19 You expect a share of stock to pay dividends of $1.00, $1.25, and $1.50 in each of the next 3 years. You believe the stock will sell for $20 at the end of the third year. a. What is the stock price if the discount rate for the stock is 10%? b. What is the dividend yield? Dividends: Year 1 Year 2 Year 3 Discount rate Stock price after 3 years Solution: a. b. Stock price (P0) Stock price (P0) Dividend yield = $ 18.10 $ 18.10 5.52%

$ 1.00 $ 1.25 $ 1.50 10.00% $ 20.00

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Practice Problem 20 Here are data on two stocks, both of which have discount rates of 15%: Stock A 15.00% $ 2.00 $ 1.00 15.00% Stock B 10.00% $ 1.50 $ 1.00 15.00%

Return on equity Earnings per share Dividends per share Discount Rates

a. What are the dividend payout ratios for each firm? b. What are the expected dividend growth rates for each firm? c. What is the proper stock price for each firm? Solution: Stock A Stock B 0.50 0.67 7.50% $ 13.33 3.33% $ 8.57

a. b. c.

Payout ratio Growth rate (g) Stock price

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Practice Problem 21 Web Cites Research projects a rate of return of 20% on new projects. Management plans to plow back 30% of all earnings into the firm. Earnings this year will be $3 per share, and investors expect a 12% rate of return on stocks facing the same risks as Web Cites. a. What is the sustainable growth rate? b. What is the stock price? c. What is the present value of growth opportunities? d. What is the P/E ratio? e. What would the price and P/E ratio be if the firm paid out all earnings as dividends? f. What do you conclude about the relationship between growth opportunities and P/E ratios? Projected Rate of return Plow back ratio Earnings per share Rate of return on stocks Solution: a. b. Sustainable growth rate Sustainable growth rate Stock price No-growth value Sustainable growth rate Stock price PVGO Sustainable growth rate Stock price P/E ratio = 6.00% 20.00% 30.00% $ 3.00 12.00%

= 6.00% = $ 35.00 = $ 25.00 = 6.00% = $ 35.00 = $ 10.00 = 6.00% = $ 35.00 = 11.667

c.

d.

e.

If all earnings were paid as dividends: Price = $ 25.00 P/E ratio 8.333 = High P/E ratios reflect expectations of high PVGO.

f.

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Practice Problem 22 Fincorp will pay a year-end dividend of $2.40 per share, which is expected to grow at a 4% rate for the indefinite future. The discount rate is 12%. a. What is the stock selling for? b. If earnings are $3.10 a share, what is the implied value of the firms growth opportunities? Dividend per share Expected growth rate Discount rate Earnings per share (b) Solution: a. b. Stock price Stock price No-growth value PVGO = $ 30.00 = $ 30.00 = $ 25.83 = $ 4.17 $ 2.40 4.00% 12.00% $ 3.10

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Practice Problem 23 No-Growth Industries pays out all of its earnings as dividends. It will pay its next $4 per share dividend in a year. The discount rate is 12%. a. What is the price-earnings ratio of the company? b. What would the P/E ratio be if the discount rate were 10%? Dividend per share Discount rate Discount rate (b) Solution: a. Stock price (P0) Price-earnings ratio Stock price (P0) Price-earnings ratio = $ 33.33 = $ 8.33 = $ 40.00 = $ 10.00 $ 4.00 12.00% 10.00%

b.

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Practice Problem 24 Stormy Weather has no attractive investment opportunities. Its return on equity equals the discount rate, which is 10%. Its expected earnings this year are $4 per share. Find the stock price, P/E ratio, and growth rate of dividends for plowback ratios of a. b. c. 0.00 0.40 0.80 Return on equity Discount rate Expected earnings per share Solution: a. Stock price P/E ratio Growth rate of dividends Stock price P/E ratio Growth rate of dividends Stock price P/E ratio Growth rate of dividends = $ 40.00 = 10.00 = 0.00% = $ 40.00 = 10.00 = 4.00% = $ 40.00 = 10.00 = 8.00% 10.00% 10.00% $ 4.00

b.

c.

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Practice Problem 25 Trend-Line Inc. has been growing at a rate of 6% per year and is expected to continue to do so indefinitely. The next dividend is expected to be $5 per share. a. If the market expects a 10% rate of return on Trend-Line, at what price must it be selling? b. If Trend-Lines earnings per share will be $8, what part of Trend-Lines value is due to assets in place, and what part to growth opportunities? Constant growth rate Dividend per share Expected rate of return (a) Earnings per share (b) Solution: a. b. Stock price (P0) Value of assets in place PVGO = $ 125.00 = $ 80.00 = $ 45.00 6.00% 5.00 10.00% $ 8.00 $

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Practice Problem 26 Construct a market-value balance sheet for FedEx, using the information in Table 7.1 and stock prices reported in Sections 7.1 and 7.2. Assume that market and book values are equal for current assets, current liabilities, and debt and other long-term liabilities. How much extra value shows up on the asset side of the balance sheet? Table 7.1 SIMPLIFIED BALANCE SHEET FOR FEDEX, MAY 31, 2010 (Millions of dollars) Current assets Plant, equipment and other long-term assets $ $ 7,284.00 17,618.00 Current liabilities Debt and other long-term liabilities Shareholders equity Total liabilities and equity $ 4,645.00 $ 6,446.00 $ 13,811.00 $ 24,902.00

$ 24,902.00 Shares of stock outstanding: Table 7.2 Stock Price FedEx Johnson & Johnson Campbell Soup PepsiCo Walmart Dow Chemical Amazon McDonalds American Electric Power GE Solution: $ 83.75 58.29 36.97 64.89 51.20 25.59 132.49 74.54 36.11 15.01

314.00 million

Book Value per $ 43.98 19.19 3.23 12.39 17.49 14.22 13.07 12.34 27.70 10.66

Market-toBook-Value 1.90 3.00 11.40 5.20 2.90 1.80 10.10 6.00 1.30 1.40

SIMPLIFIED MARKET VALUE BALANCE SHEET FOR FEDEX May 31, 2010 (Millions of dollars) Current assets Plant, equipment and other long-term assets Growth opportunities $ $ 7,284.00 17,618.00 Current liabilities Debt and other long-term liabilities Shareholders equity Total liabilities and equity $ 4,645.00 $ 6,446.00 $ 26,297.50 $ 37,388.50

$ 12,486.50 $ 37,388.50

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n Table 7.1 and stock

ow much extra value

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Practice Problem 27 Castles in the Sand generates a rate of return of 20% on its investments and maintains a plowback ratio of .30. Its earnings this year will be $4 per share. Investors expect a 12% rate of return on the stock. a. Find the price and P/E ratio of the firm. b. What happens to the P/E ratio if the plowback ratio is reduced to .20? c. Show that if plowback equals zero, the earnings-price ratio, E/P, falls to the expected rate of return on the stock. Rate of return Plowback ratio Earnings this year Expected rate of return Plowback ratio (b) Plowback ratio (c) Solution: a. Growth rate (g ) Stock price (P0) P/E ratio Growth rate (g ) Stock price (P0) P/E ratio = 6.00% = $ 46.67 = $ 11.667 = 4.00% = $ 40.00 = $ 10.00 20.00% 0.30 $ 4.00 12.00% 0.20 0.00

b.

c.

Growth rate (g ) = 0.00% Stock price (P0) = $ 33.33 Earnings-price ratio (E/P) = 12.00%

2012, The McGraw-Hill Companies

Practice Problem 28 Grandiose Growth has a dividend growth rate of 20%. The discount rate is 10%. The end-of-year dividend will be $2 per share. a. What is the present value of the dividend to be paid in year 1? Year 2? Year 3? b. Could anyone rationally expect this growth rate to continue indefinitely? Dividend growth rate Discount rate End-of-year dividend Solution: a. DIV 1 PV of DIV 1 DIV 2 PV of DIV 2 DIV 3 PV of DIV 3 b. $ 2.00 = $ 1.818 $ 2.40 = $ 1.983 $ 2.88 = $ 2.164 20.00% 10.00% $ 2.00 g r div.

This could not continue indefinitely. If it did, the stock would be worth an infinite amount.

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Practice Problem 29 Start-Up Industries is a new firm that has raised $200 million by selling shares of stock. Management plans to earn a 24% rate of return on equity, which is more than the 15% rate of return available on comparable-risk investments. Half of all earnings will be reinvested in the firm. a. What will be Start-Ups ratio of market value to book value? b. How would that ratio change if the firm can earn only a 10% rate of return on its investments? Amount raised Return on equity Rate of return Plowback ratio Rate on equity (b) Solution: a. Earnings Dividends Growth rate (g ) Market value Market-to-book ratio Earnings Dividends Growth rate (g ) Market value Market-to-book ratio = $ 48.00 million = $ 24.00 million = 12.00% = $ 800.00 million = 4 = $ 20.00 million = $ 10.00 million = 5.00% = $ 100.00 million = 1/2 $ 200.00 million 24.00% 15.00% 50.00% 10.00%

b.

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Practice Problem 30 Planned Obsolescence has a product that will be in vogue for 3 years, at which point the firm will close up shop and liquidate the assets. As a result, forecast dividends are DIV 1 = $2, DIV 2 = $2.50, and DIV 3 = $18. What is the stock price if the discount rate is 12%? DIV 1 DIV 2 DIV 3 Discount Rate Solution: Stock price (P0) = $ 16.59 $ 2.00 $ 2.50 $ 18.00 12.00%

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Practice Problem 31 Tattletale News Corp. has been growing at a rate of 20% per year, and you expect this growth rate in earnings and dividends to continue for another 3 years. a. If the last dividend paid was $2, what will the next dividend be? b. If the discount rate is 15% and the steady growth rate after 3 years is 4%, what should the stock price be today? Growth rate Last dividend paid Discount rate Steady growth rate (b) Solution: a. b. DIV 1 DIV 1 DIV 2 DIV 3 Stock price (P3) Stock price (P0) = $ = = = = = 2.40 20.00% 2.00 15.00% 4.00%

$ 2.40 $ 2.88 $ 3.456 $ 32.675 $ 28.021

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Practice Problem 32 Tattletale News Corp. has been growing at a rate of 20% per year, and you expect this growth rate in earnings and dividends to continue for another 3 years. The last dividend paid was $2 The discount rate is 15% and the steady growth rate after 3 years is 4% a. What is your prediction for the stock price in 1 year? b. Show that the expected rate of return equals the discount rate. Growth rate Last dividend paid Discount rate Steady growth rate (b) Solution: a. DIV 1 DIV 2 DIV 3 Stock price (P3) Stock price (P0) Stock price (P1) Capital gain b. Expected rate of return = $ = $ = $ = = = = = 2.40 2.88 3.456 20.00% 2.00 15.00% 4.00%

Div1

Div2

$ 32.675 $ 28.021 $ 29.825 $ 1.804

div4 /(r-g) steady growth PV0 discount PV0= (Div. +P1)/(1+r) P1=(1+r)*P0-Div. eller kalkylera diskonterad kassaflde frn period 2 och 29.825 15.00% (dividend+capital gain)/stock price

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PH

Div2

Div3

kassaflde

ller kalkylera diskonterad kassaflde frn period 2 och 3 plus horizon vrde

2012, The McGraw-Hill Companies

Challenge Problem 40 Computer Corp. reinvests 60% of its earnings in the firm. The stock sells for $50, and the next dividend will be $2.50 per share. The discount rate is 15%. What is the rate of return on the companys reinvested funds? Reinvests Stock sells for Next dividend Discount rate Solution: Return on equity = 16.67% 60.00% of earnings $ 50.00 $ 2.50 per share 15.00%

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Challenge Problem 41 A company will pay a $2 per share dividend in 1 year. The dividend in 2 years will be $4 per share, and it is expected that dividends will grow at 5% per year thereafter. The expected rate of return on the stock is 12%. a. What is the current price of the stock? b. What is the expected price of the stock in a year? c. Show that the expected return, 12%, equals dividend yield plus capital appreciation. Dividend per share: Year 1 Year 2 Growth rate Expected rate of return Solution: a. Stock price (P2) Stock price (P0) Stock price (P1) = $ 60.00 = $ 52.806 = $ 57.143

$ $

2.00 4.00 5.00% 12.00%

b. c.

Stock price (P0) = $ 52.806 Stock price (P1) = $ 57.143 Dividend yield plus capital = 12.00% appreciation = r

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Challenge Problem 42 Phoenix Industries has pulled off a miraculous recovery. Four years ago it was near bankruptcy. Today, it announced a $1 per share dividend to be paid a year from now, the first dividend since the crisis. Analysts expect dividends to increase by $1 a year for another 2 years. After the third year (in which dividends are $3 per share) dividend growth is expected to settle down to a more moderate long-term growth rate of 6%. If the firms investors expect to earn a return of 14% on this stock, what must be its price? Dividend per share Expected dividends increase Dividend in third year Long-term growth rate Expected return Solution: Stock price (P3) Stock price (P0) = $ 39.75 = $ 31.27 $ 1.00 $ 1.00 $ 3.00 6.00% 14.00%

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Challenge Problem 43 Compost Science, Inc. (CSI), is in the business of converting Bostons sewage sludge into fertilizer. The business is not in itself very profitable. However, to induce CSI to remain in business, the Metropolitan District Commission (MDC) has agreed to pay whatever amount is necessary to yield CSI a 10% return on investment. At the end of the year, CSI is expected to pay a $4 dividend. It has been reinvesting 40% of earnings and growing at 4% a year. a. Suppose CSI continues on this growth trend. What is the expected rate of return for an investor who purchases the stock at the market price of $100? b. What part of the $100 price is attributable to the present value of growth opportunities? c. Now the MDC announces a plan for CSI to also treat Cambridge sewage. CSIs plant will therefore be expanded gradually over 5 years. This means that CSI will have to reinvest 80% of its earnings for 5 years. Starting in year 6, however, it will again be able to pay out 60% of earnings. What will be CSIs stock price once this announcement is made and its consequences for CSI are known? Return on investment Expected dividend Reinvestment Growth rate Stock price (a) Expansion plan (c) Reinvestment (c) Payout ratio Solution: a. b. Expected rate of return Expected rate of return Earnings No-growth value PVGO = 8.00% 8.00% $ 6.6667 $ 83.33 $ 16.67 Years 3 4 7.78 $ 8.40 $ 0.80 0.80 1.56 $ 1.68 $ 0.08 0.08 10.00% 4.00 40.00% 4.00% $ 100.00 5.00 80.00% 60.00% $

of earnings

years of earnings of earnings

= = =

c. Earnings Plowback DIV g Expected rate of return Stock price (P6) Stock price (P0) 1 $ 6.67 $ 0.80 $ 1.33 $ 0.08 2 7.20 $ 0.80 1.44 $ 0.08

5 9.07 $ 0.80 1.81 $ 0.08

6 9.80 0.40 5.88 0.04

8.00% $ 152.81 $ 106.17

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Challenge Problem 44 Better Mousetraps has come out with an improved product, and the world is beating a path to its door. As a result, the firm projects growth of 20% per year for 4 years. By then, other firms will have copycat technology, competition will drive down profit margins, and the sustainable growth rate will fall to 5%. The most recent annual dividend was DIV0 = 1 per share. a. What are the expected values of DIV1 , DIV2 , DIV3 , and DIV4 ? b. What is the expected stock price 4 years from now? The discount rate is 10%. c. What is the stock price today? d. Find the dividend yield, DIV1 / P0 . e. What will next years stock price, P1, be? f. What is the expected rate of return to an investor who buys the stock now and sells it in 1 year? Projected growth Time Sustainable growth rate Annual dividend (DIV 0) Discount rate (b) Solution: a. DIV1 DIV2 DIV3 DIV4 DIV4 Stock price (P4) c. DIV1 DIV2 DIV3 DIV4 Stock price (P4) Stock price (P0) d. Stock price (P0) Dividend yield Stock price (P1) Stock price (P0) Stock price (P1) Expected rate of return = = = = $ $ $ $ 1.20 1.44 1.728 2.0736 20.00% 4.00 years 5.00% 1.00 per share 10.00%

$ $

b.

= $ 2.0736 = $ 43.5456 = = = = = = $ 1.20 $ 1.44 $ 1.728 $ 2.0736 $ 43.5456 $ 34.738 $ 34.73779 3.45% 37.012 34.738 37.012 10.00%

e. f.

= $ $ $ =

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Challenge Problem 45 Better Mousetraps has come out with an improved product, and the world is beating a path to its door. As a result, the firm projects growth of 20% per year for 4 years. By then, other firms will have copycat technology, competition will drive down profit margins, and the sustainable growth rate will fall to 5%. The most recent annual dividend was DIV0 = 1 per share. a. Compute the value of Better Mousetraps for assumed sustainable growth rates of 6% through 9%, in increments of 5%. b. Compute the percentage change in the value of the firm for each 1-percentage-point increase in the assumed final growth rate, g. c. What happens to the sensitivity of intrinsic value to changes in g? What do you conclude about the reliability of the dividend growth model when the assumed sustainable growth rate begins to approach the discount rate? Projected growth Time Sustainable growth rate Annual dividend (DIV0) Discount Rate (b) Sustainable growth range Solution: a.,b. DIV1 DIV2 DIV3 DIV4 Stock price (P4) Stock price (P0) Sustainable Intrinsic Growth Value (PV) Rates 5.00% 34.74 6.00% 42.53 6.50% 48.09 7.00% 55.51 7.50% 65.90 8.00% 81.48 8.50% 107.44 9.00% 159.37 c. = = = = $ 1.20 $ 1.44 $ 1.728 $ 2.0736 54.95 42.53 20.00% 4.00 years 5.00% $ 1.00 per share 10.00% 6.00% 0.50% $

= $ = $

% Change in PV 22.42% 13.08% 15.43% 18.71% 23.64% 31.87% 48.33%

The percentage change in the value of the firm increases at a faster rate with each 1% increase in the assumed final growth rate, g . The intrinsic value is more sensitive to changes in g as the sustainable growth rate approaches the discount rate. The dividend growth model is less reliable as the sustainable growth rate approaches the discount rate.

2012, The McGraw-Hill Companies