B.

A (H) BUSINESS ECONOMICS- SEMESTER V

SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT

UNIT IV:
CLASS ASSIGNMENT # 1

DIVIDEND DISCOUNT MODELS & PE MODEL

SET #1

Question 1: A firm pays a dividend of 15% on the equity share of face value of Rs. 1000. Find out the value of the
equity share given that the dividend is expected to remain same and the required rate of return of the
investor is 10%.

Question 2: Assume GBM Corporation is currently paying a dividend of $1 per share and investors expect dividends to
grow at the rate of 7% a year for the foreseeable future. For investments at this level of risk, investors
require a return of 15% in a year. Find the estimated intrinsic value of a GBM stock.

Question 3: Current dividend is $1 and is expected to grow at a higher growth rate of 12% for five years at the end of
which, the new growth rate is expected to be constant at 6% a year. The required rate of return is 10%.
Find the estimated intrinsic worth of the stock.

Question 4: ABC Pharmaceuticals is currently paying a dividend of $2 per share, which is not expected to change.
Investors require a rate of return of 20% to invest in a stock with the riskiness of that of an ABC stock.
Calculate the intrinsic value of stock.

Question 5: XYZ Construction Company is currently paying a dividend of $2 per share, which is expected to grow at a
constant growth rate of 7% per year. Investors require a rate of return of 16% to invest in stocks with this
degree of riskiness. Calculate the implied price of an XYZ stock

Question 6: Suppose that Steady State Electronics wins a major contract for its new computer chip. The very profitable
contract enabled it to increase the growth rate in dividends from the current 5% to 6% without changing
the current dividend from the projected value of $4 per share. What will happen to the stock price?

If the investor’s required rate of return is 12% for the level of risk associated with this stock,
what is the difference between post announcement price and the pre announcement price? What will
happen to the future rates of return?

Question 7: Sam Limited’s stock dividend at the end of this year is expected to be $2.15 and is expected to grow at a
rate of 11.2 %per year forever. If the required rate of return on Sam’s stock is 15.2% per year, what is its
intrinsic value?

a. If Sam Limited’s stock’s current market price is equal to its intrinsic value, what is the next year’s
expected price?

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 b. If an investor were to buy Sam’s stock now and sell it after receiving the $2.15 dividend a year
from now, what is the expected capital gain in % terms? What is the dividend yield and what be
the holding period return?

Question 8: Gourmet Foods has been undergoing rapid growth for the last few years. The current dividend of $2 per
share is expected to grow at the rapid rate of 20% a year for the next 3 years. After that time, the
company is expected to slow down with the dividend growing at a normal rate of 7% a year for the
indefinite future. The required rate of return of this stock is 22%. Find the intrinsic value of the stock.

Question 9: GT services is currently selling for $ 60 per share and is expected to pay a dividend of $3 per share. The
expected growth rate in dividends is 8% for the foreseeable future. Calculate the required rate of return
for this stock.

Question 10: A company is having a growth rate of 18% p.a. for the first four years; 12% p.a. for the next 4 years and
thereafter 6% p.a. for the foreseeable future. The most recent EPS of the company has been Rs. 4 and DP
ratio is 50%. The investor’s required rate of return is 15%. Calculate the intrinsic value per share.

Question 11: You are given the most recent EPS of the company as $1.89 per share. The annual growth rate in earnings
is 6%, dividend payout ratio is 50%, and required rate of return is 10%. Expected P/E ratio is 12.5. Holding
period is 5 years.

Calculate the fair price of the stock at present by calculating the selling price at the end of fifth
year as well.

Question 12: The current price of a company’s share is Rs. 70. The company is expected to pay a dividend of Rs. 4.20
per share increasing with a n annual growth rate of 5%. If a n investor’s required rate of return is 10%,
should he buy the share?

Question 13: The EPS of XYZ limited is Rs. 2.50. The investors expect that a PE ratio of 30 is appropriate for this
company. What should be the price of the share? If the share is available for Rs 80, should an investor
buy?

Question 14: From the following 3 companies, select the share which an investor should purchase after making a
fundamental analysis. Select an appropriate share on the basis of:

i. Fair Price per share

ii. Dividend Yield iii. Capital gain yield

COMPANY X Y Z
Current price per share Rs. 10 Rs. 15 Rs. 42
Expected Dividend Rs. 2 Rs. 2 Rs. 2
Cost of equity capitalization 20% 20% 20%
Growth rate 5% 10% 15%
Market price after one year Rs. 15 Rs. 25 Rs. 50

Question 15: DAS Auto sells @ $32 per share and Ron, the CEO of the company estimates the latest 12- month earnings
at $ 4 per share with a DP ratio of 50%.

a. What is current PE ratio?

b. If an investor expects earnings to grow by 10% a year, what is the projected price for next year if
the PE ratio remains unchanged?

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 c. Ray, the President of the Company analyzes the data and estimates that the DP ratio will remain
the same. Assume the expected growth rate of dividends to be 10% and an investor has
required rate of return of 16%, would this stock be a good buy? Why or why not?

Question 16: Anchor Industries is expected to maintain a constant dividend payout ratio and a constant growth rate of
earnings for the foreseeable future. Earnings were Rs. 4.50 per share in the recently completed fiscal
year. The DP ratio has been a constant 55% in recent years and is expected to remain so. Anchor’s return
on equity is expected to remain at 10% in future and investors require a 11% return on stock.

a. Calculate the current value of the stock.

b. After an aggressive acquisition and marketing program, it now appears that Anchor’s EPS and ROE
will grow rapidly over the next two years. Calculate the current value of Anchor’s stock assuming
Anchor’s dividend to grow at 15% for the next two years and thereafter at the historical rate for the
foreseeable future.

SET #2

Question 1: Assume Evco, Inc., has a current price of $50 and will pay a $2 dividend in one year, and its equity cost of
capital is 15%. What price must you expect it to sell for right after paying the dividend in one year in order
to justify its current price?

Question 2: Anle Corporation has a current price of $20, is expected to pay a dividend of $1 in one year, and its
expected price right after paying that dividend is $22.

a. What is Anle’s expected dividend yield?

b. What is Anle’s expected capital gain rate?

c. What is Anle’s equity cost of capital?

Question 3: Suppose Acap Corporation will pay a dividend of $2.80 per share at the end of this year and $3 per share
next year. You expect Acap’s stock price to be $52 in two years. If Acap’s equity cost of capital is 10%:

a. What price would you be willing to pay for a share of Acap stock today, if you planned to hold the stock
for two years?

b. Suppose instead you plan to hold the stock for one year. What price would you expect to be able to sell
a share of Acap stock for in one year?

c. Given your answer in part (b), what price would you be willing to pay for a share of Acap stock today, if
you planned to hold the stock for one year? How does this compare to you answer in part (a)?

Question 4: Krell Industries has a share price of $22 today. If Krell is expected to pay a dividend of $0.88 this year, and
its stock price is expected to grow to $23.54 at the end of the year, what is Krell’s dividend yield and
equity cost of capital?

Question 5: NoGrowth Corporation currently pays a dividend of $2 per year, and it will continue to pay this dividend
forever. What is the price per share if its equity cost of capital is 15% per year?

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Question 6: Summit Systems will pay a dividend of $1.50 this year. If you expect Summit’s dividend to grow by 6% per
year, what is its price per share if its equity cost of capital is 11%?

Question 7: Dorpac Corporation has a dividend yield of 1.5%. Dorpac’s equity cost of capital is 8%, and its dividends are
expected to grow at a constant rate.

a. What is the expected growth rate of Dorpac’s dividends?

b. What is the expected growth rate of Dorpac’s share price?

Question 8: Kenneth Cole Productions (KCP), suspended its dividend at the start of 2009. Suppose you do not expect
KCP to resume paying dividends until 2011.You expect KCP’s dividend in 2011 to be $0.40 per year (paid at
the end of the year), and you expect it to grow by 5% per year thereafter. If KCP’s equity cost of capital is
11%, what is the value of a share of KCP at the start of 2009?

Question 9: DFB, Inc., expects earnings this year of $5 per share, and it plans to pay a $3 dividend to shareholders. DFB
will retain $2 per share of its earnings to reinvest in new projects with an expected return of 15% per year.
Suppose DFB will maintain the same dividend payout rate, retention rate, and return on new investments
in the future and will not change its number of outstanding shares.

a. What growth rate of earnings would you forecast for DFB?

b. If DFB’s equity cost of capital is 12%, what price would you estimate for DFB stock?

c. Suppose DFB instead paid a dividend of $4 per share this year and retained only $1 per share
in earnings. If DFB maintains this higher payout rate in the future, what stock price would you
estimate now? Should DFB raise its dividend?

Question 10: Cooperton Mining just announced it will cut its dividend from $4 to $2.50 per share and use the extra
funds to expand. Prior to the announcement, Cooperton’s dividends were expected to grow at a 3% rate,
and its share price was $50. With the new expansion, Cooperton’s dividends are expected to grow at a 5%
rate. What share price would you expect after the announcement? (Assume Cooperton’s risk is unchanged
by the new expansion.) Is the expansion a positive NPV investment?

Question 11: Gillette Corporation will pay an annual dividend of $0.65 one year from now. Analysts expect this dividend
to grow at 12% per year thereafter until the fifth year. After then, growth will level off at 2% per year.
According to the dividend-discount model, what is the value of a share of Gillette stock if the firm’s equity
cost of capital is 8%?

Question 12: Colgate-Palmolive Company has just paid an annual dividend of $0.96. Analysts are predicting an 11% per
year growth rate in earnings over the next five years. After then, Colgate’s earnings are expected to grow
at the current industry average of 5.2% per year. If Colgate’s equity cost of capital is 8.5% per year and its
dividend payout ratio remains constant, what price does the dividend-discount model predict Colgate
stock should sell for?

Question 13: Halliford Corporation expects to have earnings this coming year of $3 per share. Halliford plans to retain
all of its earnings for the next two years. For the subsequent two years, the firm will retain 50% of its
earnings. It will then retain 20% of its earnings from that point onward. Each year, retained earnings will
be invested in new projects with an expected return of 25% per year. Any earnings that are not retained
will be paid out as dividends. Assume Halliford’s share count remains constant and all earnings growth
comes from the investment of retained earnings. If Halliford’s equity cost of capital is 10%, what price
would you estimate for Halliford stock?

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Question 14: Suppose Cisco Systems pays no dividends but spent $5 billion on share repurchases last year. If Cisco’s
equity cost of capital is 12%, and if the amount spent on repurchases is expected to grow by 8% per year,
estimate Cisco’s market capitalization. If Cisco has 6 billion shares outstanding, what stock price does this
correspond to?

Question 15: Maynard Steel plans to pay a dividend of $3 this year. The company has an expected earnings growth rate
of 4% per year and an equity cost of capital of 10%.

a. Assuming Maynard’s dividend payout rate and expected growth rate remains constant, and Maynard
does not issue or repurchase shares, estimate Maynard’s share price.

b. Suppose Maynard decides to pay a dividend of $1 this year and use the remaining $2 per share to
repurchase shares. If Maynard’s total payout rate remains constant, estimate Maynard’s share price.

c. If Maynard maintains the dividend and total payout rate given in part (b), at what rate are Maynard’s
dividends and earnings per share expected to grow?