Chapter 11: Stock Return and Valuation

Q. 5. ABC company’s stock is currently selling at Rs 45 per share. The company

has paid Re. 1 per share as dividend in the last year. It has been estimated
that the stock’s dividend would grow at a rate of 10 per cent per annum. It is
anticipated to sell at Rs 50 in the end of the next year. Assume the dividend
and price forecasts are accurate. Would you pay Rs 45 to buy and hold the
stock for a year for a 13 per cent required rate of return?

D1 P
Solution: P0 = + 1
1+ r 1+ r

Po = 45, Dt–1= 1, g = 10 %, r = 13 %, P1 = 50

10
Dt = (Dt–1) × g = 1 × = 1.10
1000
110 50
= +
1.13 1.13

= Rs 45.221

Since the estimated current price and the present price are approximately equal,
the investor can buy it.

Q. 6. Arun has made some forecast regarding Jasmine Company’s dividend and
price. According to him, the company will pay a dividend of Rs 3 per share
in the future and at the end of five years holding period the stock could be
sold at Rs 80. His required rate of return is 12 per cent per annum. What
should be the price of the Jasmine stock?

Solution:
D1 D2 D3 D4 D5 Pn
Po = + + + + 5
+
(1 + r )1 (1 + r )2 (1 + r )3 (1 + r ) 4 (1 + r ) (1 + r )n
D = 3, r = 12 per cent, Pn = 80
(3) (3) 2 (3)3 (3)4 (3)5 (80)5
Po = + + + + +
(1 + 0.12) (1.12)2 (1.12)3 (1.12)4 (1.12)5 (1.12)5
= 2.68 + 2.39 + 2.14 + 1.91 + 1.7 + 45.39
= Rs 56.21

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Q. 7. Rose Company is expected to pay a dividend of Rs 2 per share for the next
year. The earnings and dividends of the company are expected to grow at an
annual rate of 12 per cent indefinitely. Investor’s expected rate of return is
15 per cent. What is the theoretical price for the Rose Company’s share?

Dt 2
Solution: Po = = = Rs 66.67.
r−g 0.15 − 0.12

Q. 8. Joan wants to buy Morning Star Co., shares that have paid a dividend of
Rs 1.50 during the last financial year. Joan traditionally requires 18 per cent
return from his investment. Analyst suggests that earnings and dividends on
the stock will grow at a rate of 15 per cent for the next five years and
thereafter at a rate of 10 per cent. What is the fair price expected by Joan?

Solution:
D0 = 1.50; rs = 18 per cent;
gs = 15 per cent gn = 10 per cent
N
Do (1 + g s )t   DN + 1  1 
Po = ∑ t
+  × N 
n =1 (1 + rs )  rs − g n  (1 + rs ) 
N
Do . (1 + g s )t
∑ (1 + rs )t
n =1

1.50 (1 + 0.15) 1.50 (1 + 0.15)2 1.5 (1.15)3 1.50 (1.15)4 1.50 (1.15)5
= + + + +
(1 + 0.18) (1.18) 2 (1.18)3 (1 + 0.18)4 (1.18)5
= 1.46 + 1.42 + 1.39 + 1.35 + 1.32
= 6.94
DN + 1 1.5(1.15)5 (1.10)
=
rs − g n (0.18 − 0.10)
= 41.48
1 1
= = 0.437
(1 + r ) N (1 + 0.18)5
DN +1 1
× = 41.48 × 0.437 = 18.13
rs − g n (1 + rs ) N
Po = 6.94 + 18.13 = Rs 25.07

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Q. 9. Modern Foods, a manufacturer of fast food is expected to earn Rs 4 per
share next year and pay a dividend of Re 1 per share. Earnings and
dividends are expected to grow into the foreseeable future at 9 per cent per
annum on the company’s stock. If the required rate of return is 12 per cent,
what would be the theoretical value of the stock?
Dt
Solution: P0 =
r−g
D = Re 1; r = 12 per cent; g = 9 per cent
1
Po =
0.12 − 0.09
1
=
.03
= Rs 33.33
Q. 10. The Sun Corporation recently paid a dividend of Rs 3 per share. Dividends
have been growing at an annual rate of 9 per cent and this growth rate is
expected to continue in the foreseeable future. If the required rate of return
for Sun Corp., is 13 per cent, what is the value of the stock?
Solution: Dt = 3; g = 9 per cent; r = 13 per cent
D1 = Do (1 + g)
= 3 (1 + 0.09) = 3.27
Dt 3.27
Po = =
r−g 0.13 − 0.09
3.27
=
0.04
= Rs 81.75
Q. 11. The Big Brother Corp. has a required rate of return of 15 per cent and its
current dividend is Rs 2.50 per share. If the current price of the Big
Brother Corp. stock is Rs 53 per share what is the growth rate of dividend?

Solution: r = 15 per cent; Dt = 2.50; Po = 53; g =?

Dt
Po =
r−g
2.50
53 =
(0.15 − g )

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 7.95 – 53g = 2.50
– 53g = 2.50 – 7.95
− 5.45
g=
− 53
g = 0.1028
g = 10.28 per cent

Q. 12. The share of ABC Company is currently selling for Rs 65 per share,
dividend per share has grown from Rs 2 to the current level of Rs 5 over
the past 10 years, and this dividend growth is expected to continue in the
future. What is the required rate of return of ABC Company?
1/ n
 Face value 
Solution: g=   −1 Future value instead of face value
 Present value 
1/10
5
=  –1
2
= 1.096 – 1
= 9.6

Do = Rs 10; r = K = ?; Po = 65; g = 0.096

Do (1 + g )
Po =
K−g
5 (1 + 0.096)
65 =
K − 0.096
65 K = 5.48 + 6.24
11.72
K=
65
= 0.1803
= 0.18 × 100
= 18 per cent
Q. 13. The Well Wish Drug Company has been experiencing 5 per cent decline
per year in its cash dividend growth rate for the past few years and this
decline is expected to continue. The company has a current dividend of
Rs 4 per share. If the required rate of return is 15 per cent what is the value
of the stock?
Solution: g = – 0.05; Dt = 4; r = 0.15

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 Dt 4
Po = = = Rs 20
(r − g ) 0.15 − (− 0.05)
Q. 14. The Visual Computer Corp., has been experiencing and above normal
dividend growth rate of 25 per cent per year for the past 5 years. The
above normal growth rate is expected to continue for another 5 years
before it levels off at a normal rate of 7 per cent. The last dividend paid by
the company is Re 1 per share. Determine the current value of the stock if
its required rate of return is 20 per cent.
Solution: gs = 25; N = 5 years; gn = 7 per cent; rs = 20
D (1 + g s )t  DN + 1 1 
Po = t
+ × t
(1 + rs )  (rs − g n ) (1 + rs ) 
N
Do . (1 + g s )t
Step 1: ∑ (1 + rs )t
n =1

1(1 + 0.25) 1(1.25) 2 1(1.25)3 1(1.25)4 1(1.25)5

= + + + +
(1 + 0.2) (1.2) 2 (1.25)3 (1.2)4 (1.2)5
= 1.042 + 1.09 + 1.13 + 1.18 + 1.23
= 5.67
Step 2: DN = 5th year dividend
DN +1 = 6th year dividend
DN +1 1
= ×
rs − g n (1 + rs ) N
3.27 1
= ×
0.2 − 0.07 (1 + .2)5
= 25.15 × .40
= 10.06
Po = 5.67 + 10.06
= 15.73

Q. 15. Mr. Vijay is trying to determine the value of River Valley Corporation’s
common stock. He wants to hold the stock for five years and the estimated
earnings growth rate is 10 per cent. The dividend payout ratio is 50 per
cent. The ending P/E ratio is expected to be 20 and the current earnings
per share is Rs 5. If the required rate of return is 16 per cent, what should
be the price of the River Valley Crop. stock?

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  N (e d / e)(1 + g )n   ( P / E ) (eo ) (1 + g ) N +1 
Solution: Po =  ∑ o  +  
 N =1 (1 + r ) n
  (1 + r ) N 
g = 10; P/E = 20; r = 16; eo = 5; d/e = 50 per cent; N = 5
50
Step 1: eo × d/e = 5 × = 2.5
100
N
(eo × d / e) (1 + g )n
Step 2: ∑ 1 + rn
n =1

2.5 (1 + 0.1)1 2.5 (1.1)2 2.5 (1.1)3 2.5 (1.1)4 2.5 (1.1)5
= + + + +
(1 + 0.16)1 (1.16)2 (1.16)3 (1.16)4 (1.16)5
= 2.371 + 2.248 + 2.132 + 2.022 + 1.917
= 10.69
 P / E (eo ) (1 + g ) N +1 
Step 3: =
(1 + r ) N

20 × 5 (1 + 0.1)5 +1
=
(1 + 0.16)5
177 ⋅ 1501
=
(1.16)5
= 84.35
Po = 10.69 + 84.35 = Rs 95.04.
Q. 16. An investor plans to purchase some common stock from XY Corp. The
Corp has not paid cash dividend since it started its business 5 years ago.
The investor expects to hold the stock for four years. Investor has been
told by several financial analysts that XY Corp. will start paying the cash
dividend in 3 years that will be 20 per cent of its earnings. The required
rate of return is 18 per cent. The ending P/E ratio is 19. If the investor
expects earnings which is currently Rs 2 per share to continue to grow at a
rate of 15 per cent per year what is the present value of the stock?

Solution:
 N (eo d / e)(1 + g )n   P / E (eo ) (1 +g ) N +1 
Po = ∑ +  
 N =1 (1 + r ) n   (1 + r ) N 
N = 5 years; d/e = 0 .20; r = 0 .18; P/E = 19; eo = Rs 2

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 0 0 2 × 2(1.15)2 2 × 2(1.15)4 19 × 2(1.15)5
Po = + + + +
(1 + 0.2) (1.2)2 (1.18)3 (1.18)4 (1.18)5
= 0 + 0 + 0.37 +0 .36 + 39.41
= Rs 40.14

Q. 17. Kayals is considering the Instant Starch Company for possible investment.
The holding period of her investment is 5 years. Instant company’s
earnings per share is Rs 4 and expected to grow at a rate of 10 per cent per
year. The per cent of cash dividend payout ratio is to remain at 50 per
cent. If Instant Company’s current stock price is Rs 50, what is the ending
P/E ratio with 15 per cent required rate of return?
 N (e d / e)(1 + g )n   P / E (eo ) (1 +g ) N +1 
Solution: Po =  ∑ o +  
 N =1 (1 + r ) n
  (1 + r ) N 

g = 10%; eo = 4; d/e = 0.50; r = 15; P(E) = ?

Step 1: (eo) (d/e) = 4 × 0.5 = 2

 N [e d /e] (1 + g ) n 
Step 2:  ∑ o 
 n =1 (1 + r ) n 

2 × (1.1)1 2 × (1.1)2 2 × (1.1)3 2 (1.1) 4 2 × (1.1)5

= + + + +
(1 + 0.15)1 (1.15)2 (1.15)3 (1.15)4 (1.15)5
= 1.913 + 1.829 + 1.750 + 1.6741 + 1.601 = 8.76

(eo ) (1 + g ) N +1 P / E (4) (1 + 0.10)5 +1 ( P / E )7.09

P/E N
= 5
=
(1 + r ) (1 + 0.15) 2.01

= (P/E) 3.53
50 = 8.76 + P/E 3.53
50 – 8.76 = 3.53 P/E
41.24 = 3.53 P/E
P/E = 11.68