Chapter 7 CFIN4 Chapter 7 Solutions 7-1 7-2 7-3 Total dollar return per share = ($19 - $20) + 4($0.20) = -$0.20 a. Rate of $19 - $20 $0.80 -$0.20 = 0.01 1.0% return $20 $20 $20 b. Rate of $19 - $20 $0.80 Capital Dividend = 0.05 0.04 5.0% 4.0% gains yield return $20 $20 a. Rate of $988 - $950 $47.50 $85.50 = 0.09 9.0% return $950 $950 $950 b. Rate of $988 - $950 $47.50 Capital Dividend = 0.04 0.05 4.0% 5.0% gains yield return $950 $950 Dividend = 0.09($110) = $9.90 Pˆ 0 = 7-4 7-6 r ps $110(0.09) $9.90 $66 0.15 0.15 Dividend = $16.50 Pˆ 0 = 7-5 D D r ps $16.50 $150 0.11 Dividend = 0.05($40) = $2 a. rps = 10%: Pˆ 0 = b. rps = 8%: Pˆ 0 = D r ps D r ps $2 $20 0.10 $2 $25 0.08 D̂1 $2(1.05) $2.10 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 7 CFIN4 ˆ1 (1 + g) $2.00(1.05) $2.10 D = D0 $30 Pˆ 0 = 0.12 .05 0.07 rs - g rs - g 7-7 D̂1 $3(1.04) $3.12 ˆ1 (1 + g) $3.00(1.04) $3.12 D = D0 $52 Pˆ 0 = g 0.10 .04 0.06 rs rs - g 7-8 D̂1 $1.20(1.025) $1.23 ˆ1 (1 + g) $1.20(1.025) $1.23 D = D0 $9.84 Pˆ 0 = g 0.15 .025 0.125 rs rs - g 7-9 rs = Dividend yield + Capital gains yield = 8% + 6% = 14% ˆ1 $1.06 D = $13.25 Pˆ 0 = g 0.14 0.06 rs Alternative solution: Dividend D̂1 yield P0 0.08 P0 7-10 $1.06 P0 $1.06 $13.25 0.08 rs = 16% g = ?, but we know the price of the stock is P0 = $19.50 D̂1 $2.34 We can solve for g as follows: © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 7 CFIN4 P0 $19.50 D̂1 rs g $2.34 0.16 g Solving for g, we find the growth rate to be 4 percent: $19.50(0.16 – g) = $2.34 $3.12 – $19.50g = $2.34 g = ($3.12 - $2.34)/$19.50 = 0.04 = 4%. The next step is to use the growth rate to project the stock price five years hence: P̂5 D0 (1 g)6 D1(1 g)5 rs g rs g $2.34(1.04)5 $2.847 $23.72 0.16 0.04 0.12 Therefore, Ocala Company’s expected stock price five years from now, P̂5 , is $23.72. Alternative solution: Because the growth rate will remain constant at 4 percent, the stock price should increase by 4 percent each year. Thus, the stock price in Year 5 can be computed as: P̂5 $19.50(1.04)5 $19.50(1.21665) $23.72 7-11 D0 = D̂1 = $0 D̂ 2 = $0.50; this actually is the first dividend that is affected by constant growth (g norm = 6%), thus it can be used to compute the price of the stock at the end of the non-constant growth period. P̂1 D̂2 $0.50 $6.25 rs gnorm 0.14 0.06 Thus, the current price of the stock is P0 ˆ Pˆ D 1 1 (1 rs ) 1 $0 $6.25 (1.14)1 $6.25(0.87719) $5.4825 $5.48 Cash flow time line for this scenario: © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 7 CFIN4 0 1 2 … 3 rs = 14% gnorm = 6% 0.00 0.50 6.25 Pˆ1 5.4825 6.25 0.53 ∞ 0.50(1.06)∞-2 D̂2 0.50 rs gnorm 0.14 .06 Alternative Solution: Students might solve the problem by computing the price at the end of Year 2, because they believe that the first year of constant growth is in Year 3. The solution in this case would be: D̂ 3 = $0.50(1.06) = $0.53 P̂2 P0 D̂3 $0.53 $6.625 rs gnorm 0.14 0.06 ˆ D 1 (1 rs ) 1 ˆ Pˆ D 2 2 (1 rs ) 2 $0 1 (1.14) $0.50 $6.625 (1.14)2 $0 $7.125(0.76947) $5.4825 $5.48 Cash flow time line for this scenario: 0 1 2 3 rs = 14% gnorm = 6% 0.00 P0 7-12 0.50 0.53 6.625 Pˆ2 D̂2 0.53 rs gnorm 0.14 .06 7.125 5.4825 7.125 (1.14)2 … ∞ 0.50(1.06)∞-2 5.4825 D0 = $0 ˆ D ˆ D ˆ $0 D 1 2 3 D̂4 = $3.00; this actually is the first dividend that is affected by constant growth, which equals 0 percent (g = 0%), thus it can be used to compute the price of the stock at the end of the nonconstant growth period. © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 7 CFIN4 P̂3 D̂4 $3.00 $30.00 rs gnorm 0.10 0 Thus, the current price of the stock is P0 P̂3 (1 rs ) 3 $30.00 (1.10)3 $30.00(0.751315) $22.5394 $22.54 Cash flow time line: 0 1 2 3 4 rs = 10% 0.00 0.00 0.0000 0.00 3.00 … gnorm = 0% ∞ 3.00 D̂4 3.00 30.00 Pˆ3 rs gnorm 0.10 0 30.00 22.5394 22.5394 Alternative Solution: Students might solve the problem by computing the price at the end of Year 4, because they believe that the first year of constant growth is in Year 4. The solution in this case would be: D̂4 = $3.00 P̂4 P̂0 7-13 D̂5 $3.00 $30 rs gnorm 0.10 0 ˆ Pˆ D 4 4 (1 rs ) 4 $3.00 $30.00 (1.10)4 $33(0.68301) $22.5394 $22.54 D0 = $1.00 D̂1 = D̂ 2 = $1.00 D̂ 3 = $1.00(1.08) = $1.08; this is the first dividend that is affected by constant growth (g norm = 8%), thus it can be used to compute the price of the stock at the end of the non-constant growth period. P̂2 D̂3 $1.08 $1.08 $12.00 rs gnorm 0.17 0.08 0.09 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 7 CFIN4 Thus, the current price of the stock is P0 ˆ D 1 ˆ Pˆ D $1.00 $1.00 $12.00 2 2 1 2 (1 rs ) (1 rs ) (1.17)1 (1.17)2 $1.00(0.85470) $13.00(0.73051) $0.8547 $9.4966 $10.35 Cash flow time line: 0 1 2 … 3 rs = 17% gnorm = 8% 0.8547 9.4966 1.00 1.00 1.08 12.00 ˆ P 2 13.00 ∞ 1.00(1.08)∞-2 D̂3 1.08 rs gnorm 0.17 .08 10.3513 7-14 D0 = $0 D̂1 = $0 D̂ 2 = $2.00 Because the $2 dividend actually represents the first constant-growth dividend, the constant growth model can be used to compute the value of the stock at the end of Year 1 as follows: P̂1 D̂2 $2.00 $20.00 rs gnorm 0.15 0.05 The PV of $20 one year from today is: PV = P0 = $20/1.15 = $17.39 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 7 CFIN4 Cash flow time line: 0 1 2 … 3 rs = 15% gnorm = 5% 0.00 0.0000 17.3913 2.00 2.10 21.00 Pˆ2 23.00 ∞ 2.00(1.05)∞-2 D̂3 2.10 rs gnorm 0.15 .05 17.3913 Alternative solution: D̂ 3 = $2.00(1.05) = $2.10; Because this is affected by constant growth (g norm = 5%), it can be used to compute the price of the stock at the end of Year 2. P̂2 D̂3 $2.10 $2.10 $21.00 rs gnorm 0.15 0.05 0.10 Thus, the current price of the stock is P0 ˆ D 1 ˆ Pˆ D $0 $2.00 $21.00 2 2 1 2 1 (1 rs ) (1 rs ) (1.15) (1.15)2 $0(0.86957) $23.00(0.75614) $17.39 7-15 D0 = $0 D̂1 = $1.50 D̂ 2 = $2.00 D̂ 3 = $2.00(1.05) = $2.10; Because this is affected by constant growth (g norm = 5%), it can be used to compute the price of the stock at the end of Year 2. P̂2 D̂3 $2.10 $2.10 $35 rs gnorm 0.11 0.05 0.06 Thus, the current price of the stock is P0 ˆ D 1 (1 rs ) 1 ˆ Pˆ D 2 2 (1 rs )2 $1.50 (1.11)1 $2.00 $35.00 (1.11)2 $1.50(0.90090) $37.00(0.81162) $31.38 © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 7 CFIN4 Cash flow time line: 0 1 2 … 3 rs = 11% gnorm = 5% 1.3514 1.50 2.00 2.10 35.00 Pˆ2 30.0300 37.00 ∞ 2.00(1.05)∞-2 D̂3 2.10 rs gnorm 0.11.05 31.3814 Alternative solution: Because the $2 dividend actually represents the first constant-growth dividend (the starting basis for constant growth), the constant growth model can be used to compute the value of the stock at the end of Year 1 as follows: P̂1 D̂2 $2.00 $33.33 rs gnorm 0.11 0.05 Thus, if the stock is sold in one year, the investor would have received one dividend payment equal to $1.50 and the $33.33 stock price. The PV of $34.83 one year from today is: PV = P0 = $34.83/1.11 = $31.38 7-16 D̂1 = $0.60 D̂ 2 = $0.90 D̂ 3 = $2.40 D̂4 = $3.50 D̂ 5 = $3.50(1.04) = $3.64; Because this is affected by constant growth (g norm = 4%), it can be used to compute the price of the stock at the end of Year 4. P̂4 D̂5 $3.64 $3.64 $22.75 rs gnorm 0.20 0.04 0.16 Thus, the current price of the stock is © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 7 CFIN4 P0 ˆ ˆ ˆ Pˆ D D D 3 2 4 4 1 2 3 4 (1 rs ) (1 rs ) (1 rs ) (1 rs ) ˆ D 1 $0.60 1 (1.20) $0.90 2 (1.20) $2.40 3 (1.20) $3.50 $22.75 (1.20)4 $0.60(0.83333) $0.90(0.69444) $2.40(0.57870) $26.25(0.48225) $15.17 Cash flow time line: 0 1 2 3 4 5 rs = 11% gnorm = 4% 0.5000 0.6250 1.3889 0.60 0.90 2.40 3.50 … 3.50(1.05)∞-4 3.64 22.75 Pˆ 4 ∞ D̂5 3.64 rs gnorm 0.20 .04 26.25 12.6591 15.1730 Alternative solution: Because the $3.50 dividend actually represents the first constant-growth dividend (the starting basis for constant growth), the constant growth model can be used to compute the value of the stock at the end of Year 3 as follows: P̂3 D̂4 $3.50 $21.875 rs gnorm 0.20 0.04 Thus, if the stock is sold in three years, the investor would have received three dividend payments equal to $0.60, $0.90, and $2.40, respectively, and the $21.875 stock price at the end of Year 3. The PV of this cash flow stream is: P0 ˆ D 1 (1 rs ) 1 ˆ D 2 (1 rs ) 2 ˆ Pˆ D 3 3 (1 rs ) 3 $0.60 1 (1.20) $0.90 2 (1.20) $2.40 $21.875 (1.20)3 $0.60(0.83333) $0.90(0.69444) $24.275(0.57870) $15.17 7-17 P0 19 x $3.70 = $70.30 7-18 Price range: 28 x $4 = $112 to 30 x 4 = $120 7-19 NI = $65,000 T = 35% © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 7 CFIN4 Interest expense = $40,000 Invested capital = $800,000 Cost of funds = 12% Net income = $65,000 = Taxable income(1 - 0.40) Taxable income = ($65,000)/(1 - 0.35) = $100,000 EBIT = $100,000 + $40,000 = $140,000 EVA = (EBIT)(1 - T) – (Cost of funds)(Invested capital) EVA = $140,000(1 – 0.35) – 0.12($800,000) = $91,000 - $96,000 = -$5,000 7-20 Net income = $1.2 million = Taxable income(1 - 0.40) Taxable income = ($1.2 million)/(1 - 0.40) = $2.0 million EBIT = Taxable income + Interest = $2.0 million + $1.5 million = $3.5 million EVA = EBIT(1 - T) - (WACC x Invested capital) = $3.5 million(1 - 0.40) - (0.10 x $8.0 million) = $2.1 million - $0.8 million = $1.3 million © 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.