Investment Analysis (FIN 670) Fall Homework 8

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1 Investment Analysis (FIN 67) Fall 29 Homework 8 Instructions: please read carefully You should show your work how to get the answer for each calculation question to get full credit The due date is Tue Dec 15, 29. Late homework will not be graded. Name(s): Student ID

2 1. A constant-growing stock just paid $2 dividend and has a current market price of $3. Determine the stock's required rate of return if the company's constant growth rate is 5%. a. 5% b. 7% c. 12% d. 14% 1. c R D1/Po + g 2(1+.5)/ Stock analysts just predicted that Hybrid Engine Company's earnings and dividends will grow at 2% each year for the next two years due to its new invention. After that, its growth rate will stabilize at 5% per year indefinitely. Assume that the rate of return on the stock is 14% and its last dividend was $1 per share. Determine the current price of the company's stock. a. $16.8 b. $15.1 c. $16.1 d. $ b Step 1: compute D1, D2 D1 D(1+g*) 1(1+.2) 1.2 D2 D1(1+g*) 1.2(1+1.2) 1.44 Step 2: compute P2 D3/(k-g) D3 D2(1+g) 1.44(1+.5) P /(.14-.5) 16.8 Step 3: Compute P by discounting D1, D2, and P2 to present P 1.2 (1 +.14) (1 +.14) (1 +.14) Southwest Technology's common stock is selling at $3 per share today. Southwest just paid a $2 dividend. Its dividend is expected to grow by 5% in the coming year. The required rate of return on Southwest is 15%. Determine the common stock's dividend yield and capital gain yield for the first year. a. 1%; 5% b. 7%; 8% c. 5%; 1% d. 6.7%; 8.3% 3. b dividend yield D1/P D1 D(1+g) 2(1+.5) 2.1 So dividend yield 2.1/3.7

3 We have total return dividend yield + capital gain yield 15% 7% + capital gain yield So capital gain yield 15% - 7% 8% 4. Heavenly Hotels, Inc. will not pay any dividends for the next three years. Heavenly will pay its first dividend of $2. per share at the end of year four and its dividends will stay the same forever. The required rate of return on the company's common stock is 1%. What price should the stock be selling now? a. $2 b. $16 c. $12 d. $15 Step 1: Compute D1, D2, D3, D4 D1 D2 D3 D4 2 Step 2: compute P4 D5/(k-g) P4 2/(.1-) 2 Step 3: Find P by discounting D1, D2, D3, D4 to present. In this case, D1 D2 D3, so we only need to discount D4 and P P (1 +.1) (1 +.1) 5. If two firms have the same current dividend and the same expected growth rate, their stocks must sell at the same current price or else the market will not be in equilibrium. a. True. b. False. 5.b P D1/(k-g), so the current stock price not only depends on dividend, growth rate, but also on required return k 6. According to the dividend discount model, the current stock price of a company is. a. the sum of all future dividends b. the sum of the present values of all future dividends c. zero if the company does not pay dividends d. All of the above are correct. 6.b 7. If two firms have the same current P/E ratio and the same EPS, their stocks must sell at the same current price or else the market will not be in equilibrium.

4 a. True. b. False. 7. a 8. A company's stock price will rise with an increase of its plowback ratio if. a. the company's ROE its required rate of return b. the company's ROE < its required rate of return c. the company's ROE its growth rate d. the company's ROE > its required rate of return 8. d 9. Which of the following statements is most correct for a zero growth stock? a. The stock's price one year from now should be the same as its current price. b. The stock's dividend yield is larger than the stock's required rate of return. c. The stock pays zero dividends. d. None of the above is correct. 9. a The following information is for question 1-12 Even Better Products has come out with a new and improved product. As a result, the firm projects an ROE of 2%, and it will maintain a plowback ratio of.3. Its earning this year will be $2 per share (E12). Investor expect 12% rate of return on the stock 1. At what price and P/E ratio would you expect the firm to sell e. $ and f. $2. and 11.5 g. $ and h. $22.23 and i. $23.33 and a. g ROE b % D 1 $2(1 b) $2(1.3) $1.4 D1 $1.4 P k g.12.6 P/E $23.33/$ $ What is the present value of growth opportunity a b c d a E PVGO P $2. $23.33 $6. 66 k Calculate the P/E ratio and the present value of growth opportunities if the firm planned to reinvest only 2% of its earning.

5 g ROE b % D 1 $2(1 b) $2(1.2) $1.6 D1 $1.6 P k g.12.4 P/E $2/$2 1. PVGO P E $2. k $2. $2. $ MF Corp. has an ROE of 16% and a plowback ratio of 5%. If the coming year earning are expected to be $2 per share (E12), required return is 12%. What price will the stock sell today? a. 25 b. 26 c. 27 d. 28 e. 29 a. g ROE b % D 1 $2(1 b) $2(1.5) $1. D1 $1. P k g.12.8 $25.

6 Your preliminary analysis of two stocks has yielded the information set forth below. The required return for both stock A and B is 1% per year Stock A Stock B Expected return on equity, ROE 14% 12% Estimated earnings per share E 1 $2. $1.65 Estimated dividends per share, D Current market price per share, P What are the expected dividend payout ratios for the 2 stocks Stock A Stock B Dividend payout ratio 1 b $1/$2.5 $1/$ What are the expected dividend growth rates of each? Growth rate g ROE b % % 16. What is the intrinsic value of each stock (assume constant growth dividend model) c. Intrinsic value V $1/(.1.7) $33.33 $1/( ) $ Which stock would you choose to buy? Which stock would you choose to sell/short sell

7 You would choose to invest in Stock A since its intrinsic value exceeds its price. You might choose to sell short stock B since its intrinsic value is lower than market price 18. Rio National Corp. is a U.S.-based company and the largest competitor in its industry. Exhibits 18A 18C present financial statements. Exhibit 18D presents relevant industry and market data. a. The portfolio manager of a large mutual fund comments to one of the fund s analysts, Katrina Shaar: We have been considering the purchase of Rio National Corp. equity shares, so I would like you to analyze the value of the company. To begin, based on Rio National s past performance, you can assume that the company will grow at the same rate as the industry. Assume this rate is constant over time, calculate the value of a share of Rio National equity on December 31, 22, using the constant growth model and the capital asset pricing model. a. The value of a share of Rio National equity using the Gordon growth model and the capital asset pricing model is $22.4, as shown below. Calculate the required rate of return using the capital asset pricing model: k r f + β (k M r f ) 4% + 1.8(9% 4%) 13% Calculate the share value using the Gordon growth model: P D (1+ g) $.2 (1 +.12) k g o $22.4 b. Now if Katrina Shaar decides not to use the growth rate of the industry to be the growth rate of Rio National. She decides to calculate the growth rate of the company itself. Calculate the sustainable growth rate of Rio National on December 31, 22. Use 22 beginning-of-year balance sheet values. Assumes this growth rate is constant over time, what should be the intrinsic value of the stock on December 31, 22? The sustainable growth rate of Rio National is 9.97%, calculated as follows: g b ROE Earnings Retention Rate ROE (1 Payout Ratio) ROE 1 DPS Net Income $.2 $ % EPS Average Equity $ ( ) D P (1+ g) $.2 ( ) k g o $6.7

8 EXHIBIT 18A Rio National Corp. Summary year-endbalance sheets (U.S. $ millions) EXHIBIT 18B Rio National Corp. Summary income statement for the year ended December 31, 22 (U.S. $ millions)

9 EXHIBIT 18C Rio National Corp. Common equity data for 22 EXHIBIT 18D Industry and market data December 31, 22

10 19. Shaar (from the previous problem) has revised slightly her estimated earnings growth rate for Rio National and, using normalized (underlying trend) EPS, which is adjusted for temporary impacts on earnings, now wants to compare the current value of Rio National s equity to that of the industry, on a growth-adjusted basis. Selected information about Rio National and the industry is given in Exhibit 19A. EXHIBIT 19A Rio National Corp. vs. industry Compared to the industry, is Rio National s equity overvalued or undervalued on a P/E-to-growth (PEG) basis, using normalized (underlying) earnings per share. Assume that the risk of Rio National is similar to the risk of the industry. Rio National s equity is relatively undervalued compared to the industry on a P/E-togrowth (PEG) basis. Rio National s PEG ratio of 1.33 is below the industry PEG ratio of The lower PEG ratio is attractive because it implies that the growth rate at Rio National is available at a relatively lower price than is the case for the industry. The PEG ratios for Rio National and the industry are calculated below: Rio National Current Price $25. Normalized Earnings per Share $1.71 Price-to-Earnings Ratio $25/$ Growth Rate (as a percentage) 11 PEG Ratio 14.62/ Industry Price-to-Earnings Ratio 19.9 Growth Rate (as a percentage) 12 PEG Ratio 19.9/

11 2. Helen Morgan, CFA, has been asked to use the DDM to determine the value of Sundanci, Inc. Morgan anticipates that Sundanci s earnings and dividends will grow at 32% for two years and 13% thereafter. Assume the current year is the year 2 (year ). Use the data in year 2 as the data in year. Calculate the current value of a share of Sundanci stock by using a two-stage dividend discount model and the data from Tables 2A and 2B. TABLE 2A Sundanci actual 1999 and 2 financial statements for fiscal years ending May 31 ($ million, except pershare data) TABLE 2B Selected financial information

12 Using a two-stage dividend discount model, the current value of a share of Sundanci is calculated as follows: D3 D1 D 2 (k g) V (1 + k) (1 + k) (1 + k) $.5623 $.377 $.4976 (.14.13) + + $ where: E $.952 D $.286 E 1 E (1.32) 1 $ $ D 1 E 1.3 $ $.377 E 2 E (1.32) 2 $.952 (1.32) 2 $ D 2 E 2.3 $ $.4976 E 3 E (1.32) $.952 (1.32) $ D 3 E 3.3 $ $ Peninsular Research is initiating coverage of a mature manufacturing industry. John Jones, CFA, head of the research department, gathered the following fundamental industry and market data to help in his analysis: a. Compute the price-to-earnings (P /E 1 ) ratio for the industry based on this fundamental data. Use government bond yield to proxy for risk-free rate.

13 The industry s estimated P/E can be computed using the following model: P /E 1 payout ratio/(r g) However, since r and g are not explicitly given, they must be computed using the following formulas: g ind ROE retention rate Therefore: r ind government bond yield + ( industry beta equity risk premium).6 + (1.2.5).12 P /E 1.6/(.12.1) 3. b. Jones wants to analyze how fundamental P/E ratios might differ among countries. He gathered the following economic and market data: Determine whether each of these fundamental factors would cause P/E ratios to be generally higher for Country A or higher for Country B. (i) (ii) (iii) Forecast growth in real GDP would cause P/E ratios to be generally higher for Country A. Higher expected growth in GDP implies higher earnings growth and a higher P/E. ii. Government bond yield would cause P/E ratios to be generally higher for Country B. A lower government bond yield implies a lower risk-free rate and therefore a higher P/E. iii. Equity risk premium would cause P/E ratios to be generally higher for Country B. A lower equity risk premium implies a lower required return and a higher P/E.

14 22. The Stambaugh Corporation currently has earnings per share of $8.25. The company has no growth and pays out all earnings as dividends. It has a new project which will require an investment of $1.6 per share in one year. The project is only a two-year project, and it will increase earnings in the two years following investment by $2.1 and $2.45 per share, respectively. Investors require a 12% return on Stambaugh stock. a. What is the value per share of the company's stock assuming the firm does not undertake the investment opportunity? If the company does not make any new investments, the stock price will be the present value of the constant perpetual dividends. In this case, all earnings are paid dividends, so, applying the perpetuity equation, we get: P Dividend / R P $8.25 /.12 P $68.75 b. If the company does undertake the investment, what is the value per share of the stock now? The investment is a one-time investment that creates an increase in EPS for two years. To calculate the new stock price, we need the no growth price plus the PVGO. In this case, the PVGO is simply the present value of the investment plus the present value of the increases in EPS. So, the PVGO will be: PVGO C 1 / (1 + R) + C 2 / (1 + R) 2 + C 3 / (1 + R) 3 PVGO $1.6 / $2.1 / $2.45 / PVGO $1.99 So, the price of the stock if the company undertakes the investment opportunity will be: P $ P $7.74 c. Again, assume the company undertakes the investment, what will be the price per share 4 years from now? After the project is over, and the earnings increase no longer exists, the price of the stock will revert back to $68.75, the value of the company as a cash cow.

15 23. The stock of Nogro Corporation is currently selling for $1 per share. Earnings per share in the coming year are expected to be $2. The company has a policy of paying out 5% of its earnings each year in dividends. The rest is retained and invested in projects that earn a 2% rate of return per year. This situation is expected to continue indefinitely. a. Assuming the current market price of the stock reflects its intrinsic value as computed using the constant growth rate DDM, what rate of return do Nogro s investors require? a. D 1.5 $2 $1 g b ROE Therefore: D1 $1 k + g % P $1 b. By how much does its value exceed what it would be if all earnings were paid as dividends and nothing were reinvested? Since k ROE, the NPV of future investment opportunities is zero: PVGO P E k $1 $1 $ c. If Nogro were to cut its dividend payout ratio to 25%, what would happen to its stock price? What if Nogro eliminated the dividend? Since k ROE, the stock price would be unaffected if Nogro were to cut its dividend payout ratio to 25%. The additional earnings that would be reinvested would earn the ROE (2%). Again, if Nogro eliminated the dividend, this would have no impact on Nogro s stock price since the NPV of the additional investments would be zero.

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