Solutions to Chapter 6

Valuing Stocks

1. No. The dividend discount model allows for the fact that firms may not currently
pay dividends. As the market matures, and Rogers Wireless Communication’s
growth opportunities moderate, investors may justifiably believe that Rogers
Wireless will enjoy high future earnings and will pay dividends then. The stock
price today can still reflect the present value of the expected per share stream of
dividends.

2. Dividend yield = Expected dividend/Price = DIV1/P0

So: P0 = DIV1/dividend yield

P0 = $2.4/.08 = $30

3. a. The typical preferred stock pays a level perpetuity of dividends. The expected
dividend next year is the same as this year’s dividend, $7. Thus the dividend
growth rate is zero and the price today is:
P0 = D1/r = 7/.12 = $58.33

b. The expected dividend in two years is this year’s dividend, $7.

P1= D2/r = 7/.12 = $58.33

c. Dividend yield = $7/$58.33 = .12 =12%

Expected capital gains = 0
Expected rate of return = 12%

4. r = DIV1/P0 + g = 8% + 5% = 13%

5. The value of a common stock equals the present value of dividends received out
to the investment horizon, plus the present value of the forecast stock price at the
horizon. But the stock price at the horizon date depends on expectations of
dividends from that date forward. So even if an investor plans to hold a stock for
only a year for two, the price ultimately received from another investor depends
on dividends to be paid after the date of purchase. Therefore, the stock’s present
value is the same for investors with different time horizons.

6-1
Copyright © 2006 McGraw-Hill Ryerson Limited
6. a. P0 =  r = + g
r = + .04 = .14 = 14%

b. P0 = 2.50/(.165  .04) = $20

7. The dividend yield is defined as the annual dividend (or the annualized current
dividend) divided by the current price. The current annual dividend is ($2  4) = $8 and
the dividend yield is:

DIV1/P0 = .048  $8/ P0 = .048  P0 = $8/.048 = $166.7

To work with the quarterly dividend, divide the dividend yield by 4 and repeat the
above steps:

Quarterly DIV/P0 = .048/4 = .012  $2/ P0 = .012  P0 = $2/.012 = $166.7

8. Weak, semi-strong, strong, fundamental, technical

9. True. The search for information and insightful analysis is what makes investor
assessments of stock values as reliable as possible. Since the rewards accrue to the
investors who uncover relevant information before it is reflected in stock prices,
competition among these investors means that there is always an active search on for
mispriced stocks.

10. a. DIV1 = $1  1.04 = $1.04

DIV2 = $1  1.042 = $1.0816

DIV3 = $1  1.043 = $1.1249

b. P0 = DIV1/(r  g) = = $13

c. P3 = DIV4/(r  g) = = $14.6237

6-2
Copyright © 2006 McGraw-Hill Ryerson Limited
 d. Your payments are:
Year 1 Year 2 Year 3
DIV 1.04 1.0816 1.1249
Sales Price 14.6237
Total cash flow 1.04 1.0816 15.7486

PV of cash flow .9286 .8622 11.2095

Sum of PV = $13.00, the same as your answer to (b).

11. Dividend growth rate, g = return on equity × plowback ratio:

g = .15  .40 = .06

r = + g = + .06 = .16 = 16%

12. a. P0 = = = $21
P0 = = $30

The lower discount rate makes the present value of future dividends higher,
raising the value of the stock.

13. r = + g  g = r - = .14 – = .04 = 4%

14. a. r = + g = + .03 = .0926 = 9.26%.

b. If r = .10, then .10 = 1.64(1.03)/27 + g. So g = .0374 = 3.74%

c. g = Return on equity  plowback ratio

5% = Return on equity  .4
Return on equity = = = 12.5%

15. P0 = DIV1/(r  g)
= $2/(.12 – .06) = $33.33

16. a. P0 = DIV1/(r  g) = 3/[.15 – (.10)] = 3/.25 = $12

b. P1 = DIV2/(r  g) = 3(1  .10)/.25 = $10.80

6-3
Copyright © 2006 McGraw-Hill Ryerson Limited
 c. return = = = .150 = 15.0%

d. “Bad” companies may be declining, but if the stock price already reflects this fact,
the investor still can earn a fair rate of return, as we saw in part c.

17. a. (i) reinvest 0% of earnings: g = 0 and DIV1 = $5:

P0 = = = $33.33

(ii) reinvest 40%: g = 15%  .40 = 6% and DIV1 = $5  (1 – .40) = $3:

P0 = $3/(.15 – .06) = $33.33

(iii) reinvest 60%: g = 15%  .60 = 9% and DIV1 = $5  (1 – .60) = $2:

P0 = 2/(.15 – .09) = $33.33

b. (i) reinvest 0%: P0 = 5/(.15 – 0) = $33.33

PVGO = $0

(ii) reinvest 40%: P0 = = $42.86

PVGO = $42.86 – $33.33 = $9.53

(iii) reinvest 60%: P0 = = $66.67

PVGO = $66.67 – $33.33 = $33.34

c. In part (a), the return on reinvested earnings is equal to the discount rate.
Therefore, the NPV of the firm’s new projects is zero, and PVGO is zero in all
cases, regardless of the reinvestment rate. While higher reinvestment results in
higher growth rates, it does not result in a higher value of growth
opportunities. This example illustrates that there is a difference between
growth and growth opportunities.

In part (b), the return on reinvested earnings is greater than the discount rate.
Therefore, the NPV of the firm’s new projects is positive, and PVGO is
positive. PVGO is higher when the reinvestment rate is higher in this case,
since the firm is taking greater advantage of its opportunities to invest in
positive NPV projects.

20. a. P0 = + + = 18.10

6-4
Copyright © 2006 McGraw-Hill Ryerson Limited
 b. DIV1/P0 = $1/18.10 = .0552 = 5.52%

21. Stock A Stock B

a. Payout ratio $1/$2 = .50 $1/$1.50 = .67
b. g = ROE  plowback 15%  .5 = 7.5% 10%  .333 = 3.33%
c. Price = DIV1/(r  g) = $14.33 = $8.85
Note: We interpret “recent” to mean in the past. The current stock price
depends on future dividends – so the next dividend must be 1 + g times higher.

22. a. ROE  plowback ratio = 20%  .3 = 6%

b. E = $2, plowback ratio = .3, r = .12, g = .06  P0 = = $23.33
c. No-growth value = E/r = $2/.12 = $16.67
PVGO = P0  no-growth value = $23.33  $16.67 = $6.66
d. P/E = 23.33/2 = 11.665
e. If all earnings were paid as dividends, price would equal the no-growth value,
$16.67, and P/E would be 16.67/2 = 8.335.
f. High P/E ratios reflect expectations of high PVGO.

23. a. =$60

b. No-growth value = E/r = $6.20/.12 = $51.67

PVGO = P0  no-growth value = $60  51.67 = $8.33

24. a. Earnings = DIV1 = $4. Growth rate g = 0.

P0 = = $33.33
P/E = 33.33/4 = 8.33

b. If r = .10, P0 = = 40, and P/E increases to 40/4 = 10

A decrease in the required rate of return, holding dividends constant, raises the
stock price and the P/E ratio.

25. a. Plowback ratio = 0 implies DIV1 = $3 and g = 0.

Therefore, P0 = = $30

and the P/E ratio is 30/3 = 10.

6-5
Copyright © 2006 McGraw-Hill Ryerson Limited
 b. Plowback ratio = .40 implies DIV1 = $3(1 – .40) = $1.80, and g = 10%  .40 = 4%.

Therefore P0 = $1.80/(.10 – .04) = $30

and the P/E ratio is 30/3 = 10.

c. Plowback ratio = .80 implies DIV1 = $3(1 – .80) = $.60, and g = 10%  .80 = 8%.

Therefore P0 = $.60/(.10 – .08) = $30

and the P/E ratio is 30/3 = 10.

Regardless of the plowback ratio, the stock price = $30 because all projects
offer return on equity just equal to the opportunity cost of capital.

26. a. P0 = DIV1/(r  g) = $5/(.10 – .06) = $125

b. If Trendline followed a zero-plowback strategy, it could pay a perpetual

dividend of $8. Its value would be $8/.10 = $80, and therefore, the value of
assets in place is $80. The remainder of its value must be due to growth
opportunities, so PVGO = $125 – $80 = $45.

27. a. g = 20%  .30 = 6%

DIV1 = $2(1 – .30) = $1.40
P0 = DIV1/(r  g) = $1.40/(.12  .06) = $23.33

P/E = 23.33/2 = 11.665

b. If the plowback ratio is reduced to .20, g = 20%  .20 = 4%

DIV1 = $2(1 – .20) = $1.60
P0 = DIV1/(r  g) = $1.60/(.12 – .04) = 20
P/E = 20/2 = 10

P/E falls because the firm’s value of growth opportunities is now lower: It
takes less advantage of its attractive investment opportunities.

c. If the plowback ratio = 0, g = 0, and DIV1 = $2,

P0 = $2/.12 = 16.67 and E/P = 2/16.67 = .12

28. a. DIV1 = 2.00 PV = 2/1.10 = 1.818

DIV2 = 2(1.20) = 2.40 PV = 2.40/1.102 = 1.983

6-6
Copyright © 2006 McGraw-Hill Ryerson Limited
 DIV3 = 2(1.20)2 = 2.88 PV = 2.88/1.103 = 2.164

b. This could not continue indefinitely. If it did, the stock would be worth an
infinite amount. Another way to think about the feasible perpetual growth rate
is to compare the company’s growth rate with the growth rate of the economy.
The economy grows about 3% a year. To grow faster than the economy as a
whole is feasible when the company is small. However, to continue to grow at
20%, the company must take over other companies and eventually become the
entire economy. But in the long run, it still can only grow as quickly as the
entire economy. So it is impossible to grow at 20% in perpetuity. Think about
Microsoft – it has had phenomenal growth partly by acquiring other
companies and partly by growing its own businesses. However, even if it were
to own all of the companies in the world, eventually its growth rate would fall
to the growth rate of the world economy. We are assuming that Bill Gates is
not able to successfully market his software to still to be discovered alien
worlds!! Finally, note too that the constant dividend growth model fails when
the assumed perpetual growth rate is greater than the discount rate.

29. a. Book value = $100 million

First year earnings = $100 million  .24 = $24 million

Dividends = Earnings  (1 – plowback ratio) = $12 million

g = return on equity  plowback ratio = .24  .50 = .12

Market value = = $400 million

Market-to-book ratio = $400/$100 = 4

b. Now g falls to .10  .50 = .05, first year earnings decline to $10 million (=$100
million × .1), and dividends decline to $5 million (=$10 million × .5).

Market value = = $50 million

Market-to-book ratio = ½

This makes sense, because the firm now earns less than the required rate of return
on its investments. Its project is worth less than it costs.

30. P0 = + + = $16.59

31. a. DIV1 = $2  1.20 = $2.40

6-7
Copyright © 2006 McGraw-Hill Ryerson Limited
 b. DIV1 = $2.40 DIV2 = $2.88 DIV3 = $3.456

P3 = = $32.675

P0 = + + = $28.02

c. P1 = + = $29.825

d. Capital gain = P1  P0 = $29.825  $28.02 = 1.805

r = = .15 = 15%

32. a. Note: If students carry at least 4 decimal places, the results will be clearer.
Also, it is easier to solve the prices in reverse order.

DIV1 = $.5 DIV2 = $.5 DIV3 = $.5

DIV4 = $.5 × 1.04 = $.52 DIV5 = $.5 × 1.042 = $.5408
P4 = = = $7.7257
P3 = = = $7.4286
P2 = = = $7.1429
P1 = = = $6.8855
P0 = = = $6.6536

b. Year 0
Dividend yield = = = .07515
Capital gains yield = = = .03485
Dividend yield + capital gains yield = .07515 + .03485 = .11

Year 1
Dividend yield = = = .07262
Capital gains yield = = = .03738
Dividend yield + capital gains yield = .07262 + .03738 = .11

Year 2

6-8
Copyright © 2006 McGraw-Hill Ryerson Limited
 Dividend yield = = = .0700
Capital gains yield = = = .0400
Dividend yield + capital gains yield = .07 + .04 = .11

Year 3
Dividend yield = = = .0700
Capital gains yield = = = .0400
Dividend yield + capital gains yield = .07 + .04 = .11

Yes, each year the sum of the dividend yield and the capital gains yield equal 11
percent, the required rate of return. Once the company hits constant growth rate of
4 percent, both the dividend yield and the capital gains yield also become constant.

33. DIV1 = dividend payout × earnings1 = .4 × $3 = $1.2

DIV2 = dividend payout × earnings2 = .4 × $3 × 1.1 = $1.32
DIV3 = dividend payout × earnings3 = .4 × $3 × 1.12 = $1.452
DIV4 = dividend payout × earnings4 = .4 × $3 × 1.13 = $1.5972
DIV5 = dividend payout × earnings5 = .4 × $3 × 1.14 = $1.75692
P0 = + + + + × = $13.95

37. Before-tax rate of return:

= = = .078 = 7.8%

After-tax rate of return:

= = .0596 = 5.96%
43. 50 =

g = .15 – = .10

g = .10 = return on equity  plowback ratio = return on equity  .60

return on equity = .10/.60 = .1667 = 16.67%

6-9
Copyright © 2006 McGraw-Hill Ryerson Limited
44. a. P0 = +

DIV1 = $1

DIV2 = $2

P2 = = = $30

P0 = + = $26.40

b. Next year, P1 = = = $28.57

c. return = = = .12

= + = .12

45. DIV1 = $1
DIV2 = $2
DIV3 = $3

g = .06 Therefore P3 = 3(1.06)/(.14 – .06) = $39.75

P0 = + + = $31.27

46. a. DIV1 = $4, and g = 4%

Expected return = DIV1/P0 + g = 4/100 + 4% = 8%

b. Since DIV1 = Earnings  (1 – plowback ratio),

Earnings = DIV1/(1 – plowback ratio) = 4/(1 – .4) = $6.667

If the discount rate is 8% (the expected return on the stock), then the no-growth
value of the stock is 6.667/.08 = $83.34. Therefore PVGO =$100 – $83.34 = $16.66

c. For the first 5 years, g = 10%  .8 = 8%. Thereafter, g = 10%  .4 = 4%

Year 1 2 3 4 5 6 ...
Earnings 6.67 7.20 7.78 8.40 9.07 9.80
plowback .80 .80 .80 .80 .80 .40
DIV 1.33 1.44 1.56 1.68 1.81 5.88
g .08 .08 .08 .08 .08 .04

6-10
Copyright © 2006 McGraw-Hill Ryerson Limited
 After year 6, the plowback ratio falls to .4 and the growth rate falls to 4
percent. [We assume g = 8% in year 5 (i.e., from t = 5 to t = 6), since the
plowback ratio in year 5 is still high at b = .80. Notice the big jump in the
dividend when the plowback ratio falls.] By year 6, the firm enters a steady-
growth phase, and the constant-growth dividend discount model can be used
to value the stock.

The stock price in year 6 will be

P6 = = = $152.88

P0 = + + + + + = $106.22

47. a. DIV1 = 1.00  1.20 = $1.20

DIV2 = 1.00  (1.20)2 = $1.44
DIV3 = 1.00  (1.20)3 = $1.728
DIV4 = 1.00  (1.20)4 = $2.0736

b. P4 = DIV5/(r  g) = DIV4(1 + g)/(r  g)

= 2.0736(1.05)/(.10 – .05) = $43.55

c. P0 = + + + = $34.74

d. DIV1/P0 = 1.20/34.74 = .0345 = 3.45%

e. Next year the price will be:

+ + = $37.01

f. return =

= = .10

The expected return equals the discount rate (as it should if the stock is fairly priced).

48. Before-tax rate of return

= = = .1 = 10%
After-tax dividend:
Grossed up dividend = 1.25 × 2 = 2.50
Gross federal tax = .22 × 2.50 = .55

6-11
Copyright © 2006 McGraw-Hill Ryerson Limited
 Federal tax credit = .1333 × 2.50 = .3333
Net federal tax = .55 - .3333 = .2167
Gross provincial tax = .119 × 2.50 = .2975
Provincial tax credit = .066 × 2.50 = .165
Net provincial tax = .2975 - .165 = .1325
Total dividend tax = .2167 + .1325 = .3492

After-tax dividend = 2 – .3492 = 1.6508

Capital gains tax = .5 × (.22 + .119) × (53 – 50) = .5085

After-tax capital gains = 53 – 50 – .5085 = 2.4915

After-tax rate of return

=

= = .0828 = 8.28%

49. Assume taxes do not change. We make the easiest reinvestment assumption: dividends
are spent as they are received and do not earn any interest. Thus, the future value of
dividends received is 2 × 3 = 6. The selling price is $55.

The before-tax rate of return is

= () 1/3
-1= ()
1/3
- 1 = .0685 = 6.85%

Annual after-tax dividends = 2 – .3492 = 1.6508 (from question 48)

Future value of dividends received = 1.6508 × 3 = 4.9524

Capital gain tax = .5 × (.22 + .119) × (55 – 50) = .8475

The after-tax rate of return is

= () 1/3
-1
= () 1/3
- 1 = .0573 = 5.73%

50. a. Both of these instruments are perpetuities. Recall the price of a perpetuity is
P0 =

Rearranging the equation to find the required rate of return. The consol’s
annual cash flow is its coupon payment and the preferred share’s annual cash
flow is its dividend payment.

6-12
Copyright © 2006 McGraw-Hill Ryerson Limited
 Consol rate of return = bond coupon/P0 = .04 × 1000/800 = .05 = 5%

Preferred share rate of return = preferred dividend/P0 = 6/120 = .05 = 5%

b. Convert the annual cash flows to their after-tax amounts:

After-tax bond coupon = (1 - .35) × .04 × 1000 = .65 × 40 = 26
After-tax preferred dividend = (1 - .29) × 6 = 4.26

Consol after-tax rate of return = after-tax coupon/P0 = 26/800 = .0325 = 3.25%

Preferred after-tax rate of return = after-tax dividend/P0 = 4.26/120 = .0355 = 3.55%

c. With a 35% corporate tax rate, the after-tax rate of return on the consol is the
same as we calculated in (b), 3.25%. However, the corporate tax rate on
dividends received from other Canadian corporations is zero. Thus the rate of
return on the preferred shares is the before-tax rate from (a), 5%.

d. Corporations with spare cash to invest will prefer to purchase dividend-paying

securities of Canadian corporations than corporate bonds to take advantage of
preferential dividend tax treatment.

51. The first dividend comes in 3 years from today and thereafter grows at a constant annual
rate of 6%. Use the constant dividend growth model to calculate the price two years
from today, P2, and then discount that price to today to today’s price, P0:

P2 = = = 12.5

P0 =× P2 = × 12.5 = 10.33

52. The growing annuity formula is × 1 –[ () ] T

Years 1 – 4
r = 12%, g = 10%, T = 4,
C1 = DIV1 = (1 + g) × DIV0 = 1.1 × 1 = 1.1

Present value of Year 1 – 4 dividends

[ () ] = × [1 – () ]= 3.82
= × 1– T 4

Years 5 – 14
r = 12%, g = 8%, T = 10
To get the Year 5 dividend (which is the first cash flow in the second interval of
constant growth), figure out the Year 4 dividend first. Since dividends are
expected to grow 10% a year for 4 years and then grow at 8%:

6-13
Copyright © 2006 McGraw-Hill Ryerson Limited
 DIV4 = 1.14 × DIV0 = 1.14 × 1 = 1.4641
DIV5 = (1 + g) × DIV4 = 1.08 × 1.4641 = 1.581228

Present value of Years 5 – 14 dividends at the end of Year 4

[ () ] = × [1 – () ]= 12.0523
= × 1– 10 10

Present value of Years 5 – 14 dividends today

=× × 1–[ () ] = × 12.0523 = 7.66
10

Year 15 and on
r = 12%, g = 5%

DIV14 = (1.08)10 × DIV4 = (1.08)10 × 1.4641 = 3.1609

DIV15 = (1.05) × DIV14 = 1.05 × 3.1609 = 3.3190

Present value of Year 15 and on dividends at the end of Year 14

= = = 47.41

Present value of Year 15 and on dividends today

= = × 47.41 = 9.70

Price today = present value of all dividends to be received

P0 = 3.82 + 7.66 + 9.70 = 21.18

53.
Event PV of dividends
High quality gold 8 × annuity factor(9%, 20 years) = 73.03
Medium quality gold 2 × annuity factor(9%, 20 years) = 18.26
No gold 0

P0 = .4 × 73.03 + .5 × 18.26 = $38.34

54. a. Price on May 1, 2007 = 2.50/(.1 - .06) = 62.50

b. Price on May 1, 2007 = 1.248/(.1 - .04) = 20.8
c. Price on May 1, 2006 = [1.20 + .3 × 62.50 + .7 × 20.8] = $31.37
d. Rate of return if R&D is successful = - 1 = 1.031 = 103.1%

Rate of return if R&D is unsuccessful = - 1 = -0.299 = -29.9%

Expected rate of return = .3 × 1.031 + .7 × (-.299) = .10 = 10%

6-14
Copyright © 2006 McGraw-Hill Ryerson Limited