Nanyang Business School BF3203

Hong Ru

Problem Set 2

Instructions:
• Problem set is not graded. The solution will be posted.
• Please solve the problems by yourself first. Then, check the solutions.
• If you have any questions, email me or stop by my office hours.

1. True or False? Briefly explain (or qualify) your answers.

(a) In principle, the market price of a share of stock equals the discounted value of
the stream of future earnings per share.
(b) The DDM (Dividend Discount Model or the DCF Valuation model) works only
for firms with a dividend history.
2. Consider the following three stocks.

(a) Stock Q is expected to pay a dividend of $2.20 per share forever – no growth or
decline.
(b) Stock R will pay a dividend of $1.40 next year. Dividends are expected to grow
at 3% per year forever.
(c) Stock S is recovering from several years of losses, during which its dividend was cut
to $.50 per year. The now-profitable company is expected to increase dividends
by $.50 per year for four years (DIV1 = $1.00, DIV2 = $1.50, DIV3 = $2.00,
DIV4 = $2.50). Thereafter dividends are not expected to grow or decline.
The cost of capital is 8.5%. How much is each stock worth today (ex-dividend)?

3. SingCar, an electric car company in Singapore, produces net cash flow at a current
rate of $6 million (in real terms) per year, after maintenance, all operating expenses
and taxes. All the cash flow is paid out to the company’s owners. The cash flow (in
nominal terms) is expected to grow at the inflation rate, which is forecasted at 2% per
year. The opportunity cost of capital is 8% (nominal), which is about 6 percentage
points above the long-term Treasury rate in Singapore. (Assume this is an effective
annual rate.)
SingCar will operate for a very long time. Assume for simplicity that it will last forever.

1
 (a) What is the total enterprise value of SingCar today? Assume the first cash flow
is received one year from now. (To clarify further, assume that the first cash flow
is $6 million and the next cash flow is $6 million in real terms, or 6 × 1.02 = $6.12
million, ..., all in nominal terms.)
(b) Now assume that the power station’s cash flow is generated in a constant monthly
stream, starting one month from now. (Thus, the monthly cash flow for this year
is $6/12 = $0.5 million per month (in real terms), etc.) What is its present value?

4. Assume that it is August 2015 and you work at Apple. The company will give you
ownership of 4,000 shares, currently trading at $48 per share. But various legal com-
plications will delay distribution of these shares to you until September 2016.
Apple announced an annual dividend of $1 per share to be paid out in August 2016, just
before you will receive the shares. (Therefore you will not receive the next dividend.)
Assume that an annual dividend for this year is already paid out. In the past Apple’s
dividend has increased by 4% per year. This is a reasonable long-term trend, but
security analysts are pessimistic for the immediate future. They forecast no growth in
earnings and dividends for the next 5 years.
Apple is a relatively safe security. Investors are content with a 8% expected rate of
return per year.
A bank offers to buy the shares from you for $44 per share paid immediately. (The
bank would pay $44 per share now and receive the shares next October.) Is this a fair
offer?

5. Unigene Labs has existing assets that generate an EPS of $5 per year, which is expected
to remain constant if the firm does not invest except to maintain exiting assets. Unigene
is all-equity financed and its stock has a beta of 1.2. You estimate the market risk
premium to be 8% and the risk free rate to be 4%.
Next year (year 1), the firm has the opportunity to invest $3 per share to launch a new
product, which will increase its EPS earnings by $0.80 per year permanently, starting
the year after (year 2). The earnings from this product are highly volatile, with an
annual standard deviation to be 50% and a correlation to the market to be 0.1. The
market’s standard deviation is 20%.

(a) What is the cost of capital for the company’s existing assets?
(b) What would be stock price and the price-to-earnings ratio at time zero if the firm
did not plan to launch the new product?
(c) What is the appropriate discount rate for the new product? Explain your answer.
(d) What would be stock price and the price-to-earnings ratio at time zero if the firm
did plan to launch the new product?