Earnings per Share Payout Ratio 10% 20% 30% 40% 45%

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1 Money & Capital Markets Fall 2011 Homework #3 Due: Friday, Nov. 11 th 1. An analyst has made the following forecasts for a corporation s earnings and payout ratio. The analyst believes that after 2016, the corporation will experience a stable 3% growth in earnings and continue a 45% payout ratio Earnings per Share Payout Ratio 10% 20% 30% 40% 45% Using the dividend discount model (DDM) value the corporation s stock based upon a cost of equity capital (i.e., appropriate discount rate) of (i) 12% and (ii) 8%. 2. Use the following information in per share terms to conduct a Discounted Cash Flow (DCF) valuation. Period Earnings Net Capital Expenditures Change in Non-Cash WC Net Debt Issued FCFE a. Assuming a 10% cost of capital, what is the value per share if after period 3 the firm makes $4 per share in FCFE forever? b. Assuming a 10% cost of capital, what is the value per share if after period 3 the firm s FCFE grows at a constant rate of 4% forever? 3. Use the following information to conduct an Abnormal Earnings () Valuation. For each of the following assume a dividend payout rate of 40%. Period Book Value per Share (BPS) Earnings per Share (EPS) a. Assuming a 14% cost of capital, what is the value per share if competitive equilibrium is reached after period 3?

2 b. Assuming a 14% cost of capital, what is the value per share if Abnormal Earnings per share are $1.40 annually forever after period 3. c. Assuming a 14% cost of capital, what is the value per share if Abnormal Earnings per share grow at a constant 2% annually forever after period 3? 4. An analyst will use the comparables (or, relative) method to value XYZ. The stock has the following characteristics. Ticker EPS BPS Growth (%) Risk (beta) Payout (%) ROE (%) XYZ The following regression results were obtained by running a regression using the price-book ratio as the dependent variable. Determine the value per share of XYZ. Coefficients Intercept Payout (%) 0.10 ROE (%) 0.20 Growth (%) 0.50 Beta An analyst will use the comparables (or, relative) method to value Pepsi. The stock has the following characteristics. Ticker EPS BPS Growth (%) Risk (beta) Payout (%) ROE (%) PEP The following regression results were obtained by running a regression using the price-earnings ratio as the dependent variable. Coefficients Intercept -0.9 Growth 1.04 Beta 7.21 Payout 0.13 Determine the value of Pepsi.

3 6..Suppose an analyst uses a valuation model (either DDM, DCF, or ) in order to arrive at her Buy-Sell-Hold recommendations. Would it be inconsistent of her to also believe in the Efficient Market Hypothesis? Explain. 7. Suppose an analyst uses a valuation model (either DDM, DCF, or ) in order to arrive at her Buy-Sell-Hold recommendations. Would it be inconsistent of her to also believe that investor psychology explains much of the movement in stock prices (thus, for example, reading charts might be helpful)? Explain. 8. How might an investor s choice of valuation model (e.g., DDM, DCF, or ) be influenced by the type of corporation (e.g., young, mature, high-tech, consumer staples, etc.)? That is, when might the valuation model be preferable to other valuation models? When would DCF? 9. In your opinion and in terms of a critique of the efficient markets hypothesis, what are two of the most important anomalies that researchers have found? Briefly explain why the anomalies present a critique of the efficient markets hypothesis. 10. In your opinion and in terms of behavioral finance, what sort of behaviors have been identified that might lead one to reject (or, at least question) the efficient markets hypothesis?

4 Example of Valuation The following table shows the present value calculations for an incomplete valuation. Retention Ratio 60% Payout Ratio 40% Cost of Capital 10% Year Book Value per share Earnings per share ROE Present Value of Dividend per share Retained Earnings per share % % % % % The analyst has forecasted earnings and the payout ratio for 5 years into the future. She must now close the modeling process. Suppose she looks at three possible closures. 1. What happens if the analyst assumes that competitive equilibrium will be reached after the 5 th year? Remember, competitive equilibrium is defined in this case as a situation in which the return on equity just equals the cost of (equity) capital. Under this assumption, the value per share will simply be the initial book value plus the sum of the present value of column. V What happens if the analyst assumes that will remain at a constant dollar amount after the 5 th year? Now, the analyst will need to decide what constant to assume. Suppose she decides upon $1.15. Now, split up the terminal valuation process into two steps. First, place yourself in year 5 and calculate the present value of receiving $1.15 every year forever. T k Second, remember that you live and breathe in year 0, so find the present value of $11.50 five years from today (1 +.10)

5 The analyst can now complete the valuation by simply adding the beginning book value, present value of the column, and present value of the terminal value. V What happens if the analyst assumes that will grow at a constant rate after year 5? She must first settle on a particular growth rate of. Suppose she assumes that will grow at a constant 2.5% after year 5. Again, we can break things up into two steps. First, place yourself in year 5 and ask what would the present value of a dollar amount that grew at 2.5% forever? T 6 k g 5 (1 + g) k g 3.49(1.025) Second, calculate the present value of $47.73 five years from today (1 +.10) The value per share will be the sum of the book value, present value of the forecasted for the next 5 years, and the present value of the terminal value. V