Investment Analysis (FIN 383) Fall Homework 7

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1 Investment Analysis (FIN 383) Fall 28 Homework 7 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 Nov 25, 28. 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

4 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. 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.12

5 12. Calculate the P/E ratio and the present value of growth opportunities if the firm planned to reinvest only 2% of its earning. 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/( ) $18.97

7 17. Which stock would you choose to buy? Which stock would you choose to sell/short sell 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

Investment Analysis (FIN 383) Spring Homework 9

Investment Analysis (FIN 383) Spring 2009 Homework 9 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