Assignment of Chapter 10

Q1. Assume that Ritchey Industries is expected by investors to have a dividend growth rate over the foreseeable
future of 8 percent a year, and that the required rate of return for this stock is 14 percent. The current dividend
being paid is $1.25. What is the estimated value of the stock?

10-1. Using the constant growth version of the Dividend Discount Model:

P0 = D1/(k-g).
= D0(1+g)/(k-g)
= $1.25(1+.08) / (.14-.08)
= $1.35/.06
= $22.50

Q2. Jay Technology is currently selling for $60 a share with an expected dividend in the coming year of $2 per
share. If the growth rate in dividends expected by investors is 5 percent, what is the required rate of return for
Jay?
10-2.
k = D1/P0 + g
= $2.00/$60 + .05
= .0833 or 8.33%
Q3. Dukes Longhorn Steaks is currently selling for $40 per share and pays $1.8 in dividends. Investors require
15 percent return on this stock. What is the expected growth rate of dividends?

10-3. Again using the constant growth version of the Dividend Discount Model, solve for g
k = D1/P0 + g
k-g = D1/P0
-g = D1/P0 - k
g = k - D1/P0
Or: g = k - [(D0(1+g))/P0]

Q4. Zhou Technology pays $1.50 a year in dividends, which is expected to remain unchanged. Investors require
a 12 percent rate of return on this stock. What is the estimated price?

10-4. Po = D0/k = 1.50/.12 = $12.50

Q5. a. Given a preferred stock with an annual dividend of $3.5 per share and a price of $40, what is the required
rate of return?
b. Assume now that interest rates rise, leading investors to demand a required rate of return of 10 percent. What
will the new price of this preferred stock be?

10-5. (a) Kp = D0/P0 = $3.50/$40 = 8.75%

(b) The price will decline because required rates of return rise while dividends remain fixed.
Specifically,
P = $3.50/.1 = $35.0

Q6. An investor purchases the common stock of a well-known company, Toma Inc., for $30 per share. The
expected dividend for the next year is $4 per share, and the investor is confident that the stock can be sold 1
year from now for $35. What is the implied rate of return?

10-6. Given a one year horizon, this problem can be formulated as

D1 P1
P0 = ─────── + ───────
(1+k) (1+k)

$30 = $4.00/(1+k) + $35/(1+k)

(1+k)30 = 4 + 35
1+k = 39/30 =1.30
k = 30%

Q7 a. The current risk-free rate (RF) is 4 percent, and the expected return on the market for the coming year is
15 percent. Calculate the required rate of return for (1) stock A, with a beta of 1.0, (2) stock B, with a beta of
1.6, and (3) stock C, with a beta of 0.7.
b. How would your answers change if RF in part (a) were to increase to 8 percent, with the other variables
unchanged?
c. How would your answers change if the expected return on the market changed to 20 percent, with the other
variables unchanged?

10-7. (a) (1) Stock A kA = RF + ßA (RM-RF)

= .04 + 1.0(.15 -.04)
= .15
 (2) Stock B kB = .04 + 1.6(.15-.04)
= .216

(3) Stock C kC = .04 + .7(.15-.04)

= .117

(b) If RF increases to .08, required rates of return are:

kA = .08 + 1.0(.15-.08) = .15

kB = .08 + 1.6(.15-.08) = .192

kC = .08 + 0.7(.15-.08) = .129

(c) If RM increases to 20%, the required rates of return also rise. The new results are:

kA = .04 + 1.0(.20-.04) = .20

kB = .04 + 1.6(.20-.04) = .296

kC = .04 + 0.7(.20-.04) = .152

Q9. Kendall Consulting Company is currently selling for $30, paying $1.2 in dividends, and investors expect
dividends to grow at a constant rate of 5 percent a year.
a. If an investor requires a rate of return of 14 percent for a stock with the riskiness of Kendall Company, is it a
good buy for this investor?
b. What is the maximum an investor with a 14 percent required return should pay for Kendall Company? What
is the maximum if the required return is 15 percent?

10-9. (a) Solving for k as the expected rate of return,

Ks= rf+(rm-rf)b = 9.2%
k = [$1.2(1.05)]/$30 + .05
= .092 or 9.2%

Since the expected return of 9.2% is less than the required rate of return of 14%, this stock is not a good buy.

(b) P0 = D1/(k-g)
= [$1.2(1.05)]/[.14-.05]
= $14

An investor with a required rate of return of 14% should pay no more than $14.

If the required rate of return is 15%, the maximum an investor should pay is
obviously less than in the previous problem. Specifically,

P0 = [$1.2(1.05)]/[.15-.05] = $12.6
Q10. The Parker Dental Supply Company sells at $32 per share, and Ray Parker, the CEO of this well-known
Research Triangle firm, estimates the latest 12-month earnings are $4 per share with a dividend payout of 50
percent. Dr. Parker’s earnings estimates are very accurate.
a. What is Parker’s current P/E ratio?
b. If an investor expects earnings to grow by 10 percent a year, what is the projected price for next year if the
P/E ratio remains unchanged?
c. Dr. Parker analyzes the data and estimates that the payout ratio will remain the same. Assume the expected
growth rate of dividends is 10 percent, and an investor has a required rate of return of 16 percent, would this
stock be a good buy? Why or why not?
d. If interest rates are expected to decline, what is the likely effect on Parker’s P/E ratio?

10-10.
A) 32/4= 8
B) P0= E1 * P0/E1
E1= 4(1.1)= $4.4
P0= 4.4 *8= $35.2
c) k= (2.2 /35.2)+0.1
= 0.1625 or 16.25%
Or
P0 = D1/(k-g)
= $2.2/(.16 -.10) = $36.6

D1= D0 (1+g)
D0= 0.5*4= 2
D1= 2(1+0.1)= $2.2
This stock is a good buy because the expected return is greater than the required return or, alternatively, the estimated
(fundamental) price of the stock is greater than the current market price. (stock is undervalued)

Stock is undervalued in the following two conditions

i) When realized ROR > Required ROR
ii) When Fundamental Price > Market price

(d) If interest rates are expected to decline, the likely effect is an increase in the P/E ratio
for this stock as well as other stocks.
Q11. The required rate of return for Ola Industries is 15.75 percent. The stock pays a current dividend of $2.30,
and the expected growth rate is 12 percent. Calculate the estimated price.

10-11. $2.30 (1.12)

──────────── = $68.69
.1575 - .12

Q12. In Q11, assume that the growth rate is 16 percent. Calculate the estimated price for this stock.

10-12.
$2.30 (1.16)
──────────── = no solution
.1575 - .16

This problem cannot be solved using this equation because the growth rate is greater than the discount rate
(required rate of return).
Q13. Hernandez Products is a rapidly growing firm. Dividends are expected to grow at the rate of 18 percent
annually for the next 10 years. The growth rate after the first 10 years is expected to be 7 percent annually. The
current dividend is $1.48. Investors require a rate of return of 20 percent on this stock. Calculate the intrinsic
value of this stock.

D.R= 20%

0, 1.75, 2.06,2.43, …………..,6.56, 71.54 = PV=??

10-13. D0 = $1.48. 0
D1 = $1.48 (1.18) = $1.75; 1.75/(1+0.2)1 = PV = $1.46
D2 = $1.48 (1.18)2 = $2.06; 2.06/(1+0.2)2 = PV = $1.43
D3 = $1.48 (1.18)3 = $2.43; 2.43/(1+0.2)3 = PV = $1.41
D4 = $1.48 (1.18)4 = $2.87; PV = $1.38
D5 = $1.48 (1.18)5 = $3.39; PV = $1.36
D6 = $1.48 (1.18)6 = $4.00; PV = $1.34
D7 = $1.48 (1.18)7 = $4.71; PV = $1.31
D8 = $1.48 (1.18)8 = $5.56; PV = $1.29
D9 = $1.48 (1.18)9 = $6.56; PV = $1.27
D10 = $1.48 (1.18)10 = $7.75; 7.75/(1+0.2)10 = PV = $1.25
_______
$13.50
The present value of the first 10 years of dividends is $13.50.
Using the constant growth model to account for years 11 through infinity, we have

◦ TV = Last year’s CF (1+g)/Ks - g

$7.75 (1.07)
V10 = __________ = $63.79. 63.69/(1+0.2)10 = $10.3
.20 - .07

The present value of the price at the end of 10 years is $10.30.

The estimated value of the stock today = $13.50 + $10.30 = $23.80.

Computational Problem

10-1. Boni Software Products is currently paying a dividend of $1.20. This dividend is expected to grow at the
rate of 30 percent a year for the next five years, followed by a growth rate of 20 percent a year for the following
five years. After 10 years the dividend is expected to grow at the rate of 6 percent a year. The required rate of
return for this stock is 25 percent. What is its intrinsic value?

10-1. This is a three- stage growth model.

I=25%
0, 1.56 ,……………….,9.25,73.05= $19.88

D0 = $1.20 0 PV in $
D1 = 1.20(1.30) = $1.56 1.25
D2 = 1.20(1.30)2 = 2.03 1.30
D3 = 1.20(1.30)3 = 2.64 1.35
D4 = 1.20(1.30)4 = 3.43 1.40
D5 = 1.20(1.30)5 = 4.46 1.46
D6 = $4.46(1.20) = $5.35 1.40
D7 = 5.35 (1.20) = 6.42 1.35
D8 = 6.42 (1.20) = 7.71 1.29
D9 = 7.71 (1.20) = 9.25 1.24
D10 = 9.25 (1.20) = 11.10 = 1.19
---------
$13.23

◦ TV = Last year’s CF (1+g)/Ks - g

$11.10(1.06) $11.77
P10 = ───────── = ──────────── = $61.95, PV of this price is $6.65
.25 - .06 .19

P0 = $13.23 + $6.65 = $19.88

NOTE: Depending on rounding procedures, answers will vary a few cents.

10-3 Runyon Industries is expected to enjoy a very rapid growth rate in dividends of 30 percent a year for the
next 4 years. This growth rate is then expected to slow to 20 percent a year for the next 5 years. After that time,
the growth rate is expected to be 5 percent a year. D0 is $2. The beta for this stock is 1.5. The expected return
on the market is 11 percent, and the risk-free rate is 5 percent. What is the estimated price of the stock?

Ks=5+(11-5)1.5= 14%

I=14%
0,2.6,………………………….11.83, 14.2+179.87= $

10-3. This is a three stage growth model. It is unusual in that in the second stage of growth, the
growth rate is equal to the discount rate. The process remains the same.

D0 = $2.00 PV in $
D1 = 2.00(1.30) = $2.60 2.25
30% = g D2 = 2.00(1.30)2 = 3.38 2.52
D3 = 2.00(1.30)3 = 4.39 2.83
D4 = 2.00(1.30)4 = 5.71 3.18
---------------------------------------------------------------------------------
D5 = D4(1.20) = $5.71(1.20) = $6.85 3.29
D6 = D5(1.20) = 6.85(1.20) = 8.22 3.41
20% = g D7 = D6(1.20) = 8.22(1.20) = 9.86 3.53
D8 = D7(1.20) = 9.86(1.20) = 11.83 3.66
D9 = D8(1.20) = 11.83(1.20) = 14.20 3.79
──────
$28.46

D9(1.05) $14.20(1.05) $14.91

P9 = ──────── = ─────────── = ────── = $165.67
.14 - .05 .09 .09
Discounting P8 back eight periods, the PV is $36.87

P0 = $28.46+36.87 = $65.33