Lahore School of Economics

Financial Management I
Chapter 9
Assignment 13
Stocks and their Valuation - 2

Examples

1. Firm B has a 12% ROE. Other things held constant, what would its expected growth rate be if it paid out 25%
of its earnings as dividends?

2. Snyder Computers Inc. is experiencing rapid growth. Earnings and dividends are expected to grow at a rate of
15% during the next 2 years, at 13% the following year, and at a constant rate of 6% during Year 4 and thereafter.
Its last dividend was $1.15, and its required rate of return is 12%.
a) Calculate the value of the stock today.
b) Calculate ^P1and ^P 2.
c) Calculate the dividend and capital gains yields for Years 1, 2, and 3.

3. For a new Firm M, assume that the stockholders’ required rate of return is 13.4%. The company faces three
years of supernormal growth of 30%, after which it will face a constant growth rate of 8%. The last dividend paid to
the stockholders was $1.15. Calculate the intrinsic value of Firm M’s stock.

4. Mitts Cosmetics Co.’s stock price is $58.88, and it recently paid a $2.00 dividend. This dividend is expected to
grow by 25% for the next 3 years, then grow forever at a constant rate, g; and r s = 12%. At what constant rate is the
stock expected to grow after Year 3?

5. Ezzell Corporation issued perpetual preferred stock with a 10% annual dividend. The stock currently yields 8%,
and its par value is $100.
a) What is the stock’s value?
b) Suppose interest rates rise and pull the preferred stock’s yield up to 12%. What is its new market value?

Problems for Assignment

1. Last year a company gave cash dividends of $10 per share, its ROE was 30%, and it gave 80% of its profits as
cash dividends. The expected ROR from the stock market as a whole is 10%, the risk-free rate is 5% and the beta of
this company’s share is 1.2. It is currently trading in the market at $97 per share. Would you buy this share?

2. Hart Enterprises recently paid a dividend, D0, of $1.25. It expects to have nonconstant growth of 20% for 2
years followed by a constant rate of 5% thereafter. The firm’s required return is 10%.
a) What is the firm’s horizon, or terminal, value?
b) What is the firm’s intrinsic value today, ^P0 ?

3. Microtech Corporation is expanding rapidly and currently needs to retain all of its earnings; hence, it does not
pay dividends. However, investors expect Microtech to begin paying dividends, beginning with a dividend of $1.00
coming 3 years from today. The dividend should grow rapidly—at a rate of 50% per year—during Years 4 and 5;
but after Year 5, growth should be a constant 8% per year. If the required return on Microtech is 15%, what is the
value of the stock today?
4. Fee Founders has perpetual preferred stock outstanding that sells for $60 a share and pays a dividend of $5 at
the end of each year. What is the required rate of return?