AFW360 Corporate Finance

Tutorial 3: Problem Sets

Dr. Gary John Rangel

School of Management
 Chapter 9 Concept Question 5
Suppose a company has a preferred stock issue and a common stock issue.
Both have just paid a $2 dividend. Which do you think will have a higher price, a
share of the preferred or a share of the common?
Answer:
The common stock probably has a higher price because the dividend can grow,
whereas it is fixed on the preferred. However, the preferred is less risky
because of the dividend and liquidation preference, so it is possible the
preferred could be worth more, depending on the circumstances.
 Chapter 9 Problem 2
The next dividend by Skippy, Inc., will be $2.95 per share. The dividends are
anticipated to maintain a growth rate of 4.8 percent, forever. If the stock
currently sells for $53.10 per share, what is the required return?
Answer:
𝐷1
𝑅= +𝑔
𝑃0
$2.95
𝑅= + 0.048 = 0.1036 = 10.36%
$53.10
 Chapter 9 Problem 11
Bretton, Inc., just paid a dividend of $3.15 on its stock. The growth rate in
dividends is expected to be a constant 4 percent per year, indefinitely.
Investors require a 15 percent return on the stock for the first three years, a
13 percent return for the next three years, and then a 11 percent thereafter.
What is the current share price of the stock?
Answer:
Step 1: Find the dividend in period 7.
𝐷7 = $3.15 × 1.04 7 = $4.145185105
𝐷7
𝑃6 =
𝑟−𝑔
$4.145185105
𝑃6 = = $59.21693007
0.11 − 0.04
 Chapter 9 Problem 11
Answer:
Step 2: Bring future dividends from period 4 to 6 and price at 𝑃6 to find 𝑃3
$3.15 1.04 4 $3.15 1.04 5 $3.15 1.04 6 + $59.21693007
𝑃3 = + 2
+
1.13 1.13 1.13 3
𝑃3 = $3.261110145 + $3.001375709 + $43.80263108
𝑃3 = $50.06511693

Step 3 Bring future dividends from period 1 to 3 and price at 𝑃3 to find 𝑃0

$3.15 1.04 $3.15 1.04 2 $3.15 1.04 3 + $50. 06511693
𝑃0 = + 2
+
1.15 1.15 1.15 3
𝑃0 = $2.848695652 + $2.57621172 + $35.24841853 = $40.67
 Chapter 9 Problem 13
Stoneworks, Inc., has an odd dividend policy. The company has just paid a
dividend of $15 per share and has announced that it will increase the
dividend by $3 per share for each of the next five years, and then never pay
another dividend. If you require a return of 11 percent on the company’s
stock, how much will you pay for a share today?
Answer:
$18 $21 $24 $27 $30
𝑃0 = + 2
+ 3
+ 4
+
1.11 1.11 1.11 1.11 1.11 5
𝑃0
= $16.21621622 + $17.0440711 + $17.54859315 + $17.7857363
+ $17.80353984 = $86.40
 Chapter 9 Problem 13
Answer:
Alternative answer using Texas Instrument BA II Plus Financial Calculator
Keystrokes Display Description

CF CF0 = 0.00 Select Cash Flow worksheet

0, ENTER CF0 = 0.00 Enter initial cash flow

Down arrow, 18, ENTER C01 = 18.00

Enter dividend for first year
Down arrow F01 = 1.00

Down arrow, 21, ENTER C02 = 21.00

Enter dividend for second year
Down arrow F02 = 1.00

Down arrow, 24, ENTER C03 =24.00

Enter dividend for third year
Down arrow F03 = 1.00

Down arrow, 27, ENTER C04 = 27.00

Enter cash flow for fourth year
Down arrow F04 = 1.00

Down arrow, 30, ENTER C05 = 30.00

Enter cash flow for fifth year
Down arrow F05 = 1.00

NPV I = 0.00 Access interest rate variable

11, ENTER I = 11.00 Enter required rate of return

Down arrow, CPT NPV = 86.40 Compute current stock price

 Chapter 9 Problem 23
Jupiter Satellite Corporation earned $29 million for the fiscal year ended
yesterday. The firm also paid out 30 percent of its earnings as dividends
yesterday. The firm will continue to pay out 30 percent of its earnings as
annual, end-of-year dividends. The remaining 70 of earnings is retained by
the company for use in projects. The company has 2.6 million shares of
common stock outstanding. The current stock price is $105. The historical
return on equity (ROE) of 11 percent is expected to continue in the future.
What is the required rate of return on the stock?
Answer:
Step 1: Find the dividend growth rate by the growth rate equation.
𝑔 = 𝑅𝑂𝐸 × 𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑖𝑜
𝑔 = 0.11 × 0.7 = 0.077 = 7.70%
Step 2: Find the dividend per share
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 × 𝑃𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 =
𝑆ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
$29,000,000 × 0.3
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 = = $3.346 = $3.35
2,600,000
 Chapter 9 Problem 23
Answer:
Step 3: Use the rate of return equation.
𝐷1
𝑅= +𝑔
𝑃0
$3.35 × 1.077
𝑅= + 0.077 = 0.1114 = 11.14%
$105
 Chapter 9 Problem 28
Full Boat Manufacturing has projected sales of $115 million next year. Costs
are expected to be $67 million and net investment is expected to be $12
million. Each of these values is expected to grow at 14 percent the following
year, with the growth rate declining by 2 percent per year until the growth
rate reaches 6 percent, where it is expected to remain indefinitely. There are
5.5 million shares of stock outstanding and investors require a return of 13
percent on the company’s stock. The corporate tax rate is 21 percent.
a. What is your estimate of the current stock price?
b. Suppose instead that you estimate the terminal value of the company
using a PE multiple. The industry PE is 11. What is your new estimate of
the company’s stock price?
 Chapter 9 Problem 28
Answer:
a.
Step 1: Calculate the cash flow of the firm from Year 1 to Year 5
Year 1 Year 2 Year 3 Year 4 Year 5
Growth Rate 1.14 1.12 1.1 1.08
Sales 115,000,000 131,100,000 146,832,000 161,515,200 174,436,416
Costs 67,000,000 76,380,000 85,545,600 94,100,160 101,628,173
EBT 48,000,000 54,720,000 61,286,400 67,415,040 72,808,243
Taxes 10,080,000 11,491,200 12,870,144 14,157,158 15,289,731
Net income 37,920,000 43,228,800 48,416,256 53,257,882 57,518,512
Investment 12,000,000 13,680,000 15,321,600 16,853,760 18,202,061
Cash flow 25,920,000 29,548,800 33,094,656 36,404,122 39,316,451

Step 2: Calculate the terminal value of the firm based on growth rate from Year
6 onwards
$39,316,451(1.06)
𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 = = $595,363,401
0.13 − 0.06
 Chapter 9 Problem 28
Answer:
a.
Step 3: Compute the value of the company today based on the cash flows
received from Year 1 to Year 5 and the terminal value in Year 5.
𝐶𝑜𝑚𝑝𝑎𝑛𝑦 𝑣𝑎𝑙𝑢𝑒 𝑡𝑜𝑑𝑎𝑦
$25,920,000 $29,548,800 $33,094,656 $36,404,122
= + + +
1.13 1.132 1.133 1.134
$39,316,451 + $595,363,401
+
1.135
𝐶𝑜𝑚𝑝𝑎𝑛𝑦 𝑣𝑎𝑙𝑢𝑒 𝑡𝑜𝑑𝑎𝑦
= $22,938,053.1 + $23,141,044.72 + $22,936,256.71 + $22,327,329.79
+ $344,478,795.8 = $435,821,480.2
Step 4: Divide the company value today by the number of outstanding shares
$435,821,480.2
= $79.24
5,500,000
 Chapter 9 Problem 28
Answer:
a. Alternative answer using Texas Instrument BA II Plus Financial Calculator
Keystrokes Display Description

CF CF0 = 0.00 Select Cash Flow worksheet

0, ENTER CF0 = 0.00 Enter initial cash flow

Down arrow, 25,920,000, ENTER C01 = 25,920,000.00

Enter dividend for first year
Down arrow F01 = 1.00

Down arrow, 29,548,800, ENTER C02 = 29,548,800.00

Enter dividend for second year
Down arrow F02 = 1.00

Down arrow, 33,094,656, ENTER C03 = 33,094,656.00

Enter dividend for third year
Down arrow F03 = 1.00

Down arrow, 36,404,122, ENTER C04 = 36,404,122.00

Enter cash flow for fourth year
Down arrow F04 = 1.00

Down arrow, 39,316,451, ENTER C05 = 634,679,852.00

Enter cash flow for fifth year
Down arrow F05 = 1.00
 Chapter 9 Problem 28
Answer:
Alternative answer using Texas Instrument BA II Plus Financial Calculator (continued)
Keystrokes Display Description

NPV I = 0.00 Access interest rate variable

13, ENTER I = 13.00 Enter required rate of return

Down arrow, CPT NPV = 435,821,480.2 Compute current stock price

 Chapter 9 Problem 28
Answer:
b.
Step 1: Use the PE multiple to find the terminal value.
𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 = 11 × $57,518,512 = $632,703,632
Step 2: Calculate the value of the company assuming all Yearly cash flows
except for the terminal value are the same as per a.
𝐶𝑜𝑚𝑝𝑎𝑛𝑦 𝑣𝑎𝑙𝑢𝑒 𝑡𝑜𝑑𝑎𝑦
$25,920,000 $29,548,800 $33,094,656 $36,404,122
= + + +
1.13 1.132 1.133 1.134
$39,316,451 + $632,703,632
+
1.135
𝐶𝑜𝑚𝑝𝑎𝑛𝑦 𝑣𝑎𝑙𝑢𝑒 𝑡𝑜𝑑𝑎𝑦
= $22,938,053.1 + $23,141,044.72 + $22,936,256.71 + $22,327,329.79
+ $364,745,577.2 = $456,088,261.6
Step 3: Divide the company value today by the number of outstanding
shares
$456,088,261.6
= $82.93
5,500,000
 Chapter 9 Problem 28
Answer:
b. Alternative answer using Texas Instrument BA II Plus Financial Calculator
Keystrokes Display Description

CF CF0 = 0.00 Select Cash Flow worksheet

0, ENTER CF0 = 0.00 Enter initial cash flow

Down arrow, 25,920,000, ENTER C01 = 25,920,000.00

Enter dividend for first year
Down arrow F01 = 1.00

Down arrow, 29,548,800, ENTER C02 = 29,548,800.00

Enter dividend for second year
Down arrow F02 = 1.00

Down arrow, 33,094,656, ENTER C03 = 33,094,656.00

Enter dividend for third year
Down arrow F03 = 1.00

Down arrow, 36,404,122, ENTER C04 = 36,404,122.00

Enter cash flow for fourth year
Down arrow F04 = 1.00

Down arrow, 39,316,451, ENTER C05 = 672,020,083.00

Enter cash flow for fifth year
Down arrow F05 = 1.00
 Chapter 9 Problem 28
Answer:
Alternative answer using Texas Instrument BA II Plus Financial Calculator (continued)
Keystrokes Display Description

NPV I = 0.00 Access interest rate variable

13, ENTER I = 13.00 Enter required rate of return

Down arrow, CPT NPV = 456,088,261.6 Compute current stock price

 Chapter 9 Problem 31
Storico Co. just paid a dividend of $2.95 per share. The company will increase
its dividend by 20 percent next year and will then reduce its dividend growth rate
by 5 percentage points per year until it reaches the industry average of 5
percent dividend growth, after which the company will keep a constant growth
rate forever. If the required return on Storico stock is 13 percent, what will a
share of stock sell for today?
Answer:
∞
𝐷𝑖𝑣1 𝐷𝑖𝑣2 𝐷𝑖𝑣3 𝐷𝑖𝑣𝑡
𝑃0 = + + +⋯=෍
1+𝑅 1+𝑅 2 1+𝑅 3 1+𝑅 𝑡
𝑡=1
𝑃0
$2.95 1.2 $2.95 1.2 1.15 $2.95 1.2 1.15 1.1
= + +
1.13 1.13 2 1.13 3
$2.95 1.2 1.15 1.1 1.05
0.13 − 0.05
+
1.13 3
𝑃0 = $3.132743363 + $3.188190148 + $3.103547932 + $40.7340666
= $50.15854805 = $50.16
 Thank You

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