Principles of Corporate Finance Canadian 2nd Edition Gitman Solutions Manual

Principles of Corporate Finance
Canadian 2nd Edition Gitman Solutions

Manual
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CHAPTER 8
Valuation of Financial Securities
INSTRUCTOR’S RESOURCES
Overview
The topic of Chapter 8 is the valuation of financial securities. The interest rate, or
required return, is very important in the financial markets. The nominal or actual interest
rate is the sum of the risk-free rate and a risk premium reflecting issue and issuer
characteristics. The term structure of interest rates depicts the relationship between the
interest rate and the time to maturity. The yield curve, the graphical depiction of the term
structure of interest rates, can be upward sloping, downward sloping, or flat. The shape
of the yield curve is generally described by three theories: the expectations hypothesis,
the liquidity preference theory, and market segmentation theory.
Key inputs to the valuation process include cash flows, timing, and the required
return. The value of any asset is equal to the present value of all future cash flows it is
expected to provide over its useful life. Therefore, the value of a bond is the present
value of its coupon payments plus the present value of its par value. The discount rate
used to determine value is the required return. Yield to maturity is the rate of return
investors earn if they buy a bond at a specific price and hold it until maturity, assuming
that all scheduled interest and principal payments are made.
The efficient market hypothesis suggests that securities are fairly priced, they
reflect all publicly available information, and investors should not waste time trying to
find and capitalize on mis-priced securities. The value of a common share is the present
value of all future dividends it is expected to provide over an infinite time horizon. There
are four methods to determine the value of common shares: the dividend valuation
model, book value, liquidation value, and the price earnings multiple. Each of these
methods is discussed in the chapter.
Changes in expected cash flows, return, and risk can impact the value of an asset.
An increase in the expected cash flows should increase share value, all else remaining the
same. Similarly, a decrease in risk will increase the share value, and vice versa. Most
financial decisions affect both return and risk so an assessment of their combined effect
on value must be part of the financial decision-making process.
The value of preferred shares can also be determined. Preferred shares are
assumed to be perpetuities, paying a constant dividend over an infinite period. Although
preferred shares are similar to debt, the yield on preferred shares is higher than that of
debt due to the greater risk associated with preferred shares.
© 2008 Pearson Education Canada 1

ANSWERS TO REVIEW QUESTIONS
8-1 The real rate of interest is the rate that creates an equilibrium between the supply
of savings and demand for investment funds. The nominal rate of interest is the
actual rate of interest charged by the supplier and paid by the demander. The
nominal rate of interest differs from the real rate of interest due to two factors: (1)
a premium due to inflationary expectations (IP) and (2) a premium due to issuer
and issue characteristic risks (RP). The nominal rate of interest for a security can
be defined as kj = k* + IP + RP. For a three-month Government of Canada
Treasury bill, the nominal rate of interest can be stated as kj = k* + IP. The default
risk premium, RP, is assumed to be zero since the security is backed by the
Canadian government; this security is commonly considered the risk-free asset.
8-2 The term structure of interest rates is the relationship of the rate of return to the
time to maturity for any class of similar-risk securities. The graphic presentation
of this relationship is the yield curve. For a given class of securities, the slope of
the curve reflects an expectation about the movement of interest rates over time.
The most common form is an upward-sloping yield curve.
a. Downward sloping: long-term borrowing costs are lower than short-term

borrowing costs.
b. Upward sloping: Short-term borrowing costs are lower than long-term

borrowing costs.
c. Flat: Borrowing costs are relatively similar for short- and long-term loans.
The upward-sloping yield curve has been the most prevalent historically.
8-3 a. According to the expectations hypothesis, the yield curve reflects investor
expectations about future interest rates, with the differences based on inflation
expectations. The curve can take any of the three forms. An upward-sloping
curve is the result of increasing inflationary expectations, and vice versa.
b. The liquidity preference theory is an explanation for the upward-sloping yield

curve. This theory states that long-term rates are generally higher than short-
term rates due to the desire of investors for greater liquidity, and thus a
premium must be offered to attract adequate long-term investment.

c. The market segmentation theory is another theory that can explain any of the
three curve shapes. Since the market for loans can be segmented based on
maturity, sources of supply and demand for loans within each segment
determine the prevailing interest rate. If supply is greater than demand for
short-term funds at a time when demand for long-term loans is higher than the
supply of funding, the yield curve would be upward-sloping. Obviously, the
reverse also holds true.
8-4 In the Fisher Equation, k = k* + IP + RP, the risk premium, RP, consists of the
following issuer- and issue-related components:
¾ Default risk. The possibility that the issuer will not pay the contractual interest
or principal as scheduled.
¾ Maturity (interest rate) risk: The possibility that changes in the interest rates
on similar securities will cause the value of the security to change by a greater
amount the longer its maturity, and vice versa.
¾ Liquidity risk: The ease with which securities can be converted to cash
without a loss in value.
¾ Contractual provisions: Covenants included in a debt agreement or share
issue defining the rights and restrictions of the issuer and the purchaser. These
can increase or reduce the risk of a security.
¾ Tax risk: Certain securities issued by agencies of state and local governments
are exempt from federal, and in some cases state and local, taxes, thereby
reducing the nominal rate of interest by an amount that brings the return into
line with the after-tax return on a taxable issue of similar risk.
The risk-return trade-off is the premise that investors must be compensated for
accepting greater risk with greater expected returns. Financial managers must
balance risk with return to maximize share value.
8-5 Valuation is the process that links risk and return in order to determine the worth
of assets. A financial manager must understand the valuation process in order to
judge the value of benefits received from shares, bonds, and other assets in view
of their risk, return, and combined impact on share value.
8-6 Three key inputs to the valuation process are:
1. Cash flows - the cash generated from ownership of the asset;

2. Timing - the time period(s) in which cash flows are received; and
3. Required return - the interest rate used to discount the future cash flows to a
present value. The selection of the required return allows the level of risk to
be adjusted; the higher the risk, the higher the required return (discount rate).
The valuation process applies to assets that provide an intermittent cash flow or
even a single cash flow over the period.
8-7 The value of any asset is the present value of future cash flows expected from the
asset over the relevant time period. The three key inputs in the valuation process
are cash flows, the required rate of return, and the timing of cash flows. The
equation for value is:
CF1 CF2 CFn

V0 = + + ⋅⋅⋅⋅⋅
(1 + k ) (1 + k )
1 2
(1 + k ) n
where:
V0 = value of the asset at time zero
CFI = cash flow expected at the end of year t
k = appropriate required return (discount rate)
n = relevant time period
8-8 The basic bond valuation equation for a bond that pays annual interest is:
⎡n 1 ⎤ ⎡ 1 ⎤
V 0 = I × ⎢∑ t ⎥
+ M×⎢ n ⎥
⎣ t =1 (1 + kd ) ⎦ ⎣ (1 + kd ) ⎦
or V0 = [I × PVIFa (n per, kd%)] + [M × PVIF (n per, kd%)]
where:
V0 = value of the bond at time zero
I = coupon payment per period in dollars
n = number of periods to maturity
M = par value in dollars
kd = required rate of return on a bond of similar risk
To find the value of bonds paying interest semi-annually, the basic bond valuation
equation is adjusted as follows to account for the more frequent payment of
interest:
1. The annual coupon rate must be converted to semi-annual interest by dividing
by two.
2. The number of years to maturity must be multiplied by two.
3. The required return must be converted to a semi-annual rate by dividing it by
2.
8-9 a. A bond sells at a discount when the required return exceeds the coupon rate.
b. A bond sells at a premium when the required return is less than the coupon
rate.

c. A bond sells at par value when the required return equals the coupon rate.
The coupon rate is generally a fixed rate of interest, whereas the required
return fluctuates with shifts in the cost of long-term funds due to economic
conditions and/or risk of the issuing firm. The disparity between the required
rate and the coupon rate will cause the bond to be sold at a discount or
premium.
8-10 If the required return on a bond is constant until maturity and different from the
coupon interest rate, the bond's value approaches its $1,000 par value as the time
to maturity declines.
8-11 To protect against the impact of rising interest rates, a risk-averse investor would
prefer bonds with short periods until maturity. The responsiveness of the bond's
market value to interest rate fluctuations is an increasing function of the time to
maturity.
8-12 The yield-to-maturity (YTM) on a bond is the rate investors earn if they buy the
bond at a specific price and hold it until maturity.
The YTM can be found precisely by using a hand-held financial calculator and
using the time value functions. The V0 is the present value, “PV”, the annual (or
semi-annual) payment is the “PMT”, the number of periods until maturity is “N,”
the par value is the future value, “FV.” Solve for the interest rate, by pressing
CPT (compute) “I/Y” or “i%”. This interest value is the YTM. If the bond in
question pays semi-annually, this answer will have to be multiplied by 2 to get the
annual rate. Many calculators are already programmed to solve for the Internal
Rate of Return (IRR). Using this feature will also obtain the YTM since the YTM
and IRR are determined the same way.
8-13 In an efficient market, investors would buy an asset if the expected return exceeds
the current return, thereby increasing its price (market value) and decreasing the
expected return, until expected and required returns are equal.
8-14 According to the efficient market hypothesis:
a. Securities prices are in equilibrium (fairly priced with expected returns equal to
required returns);
b. Securities prices fully reflect all public information available and will react
quickly to new information; and
c. Investors should therefore not waste time searching for mispriced (over- or
undervalued) securities.

The efficient market hypothesis is generally accepted as being reasonable for
securities traded on major exchanges; this is supported by research on the
subject.
8-15
a. The zero growth model of common share valuation assumes a constant,
nongrowing dividend stream. The share is valued as a perpetuity and discounted
at a rate ks:
V0
V0 =
ks
b. The constant growth model of common share valuation, also called the Gordon
model, assumes that dividends will grow at a constant rate, g. The share is
valued as the present value of the constantly growing cash flow stream:
D1
V0 =
ks − g
c. The variable growth model of common share valuation assumes that dividends
grow at a variable rate. The share with a single shift in the growth rate is valued
as the present value of the dividend stream during the initial growth phase plus
the present value of the price of shares at the end of the initial growth phase:
N D 0 × (1 + g 1) t ⎛ 1 DN + 1 ⎞
V0 = ∑ + ⎜⎜ × ⎟
t = 1 (1 + ks )
t
⎝ (1 + ks )
N
( ks − g 2) ⎟⎠
8-16
a. Book value is the value of the shares in the event all assets are liquidated for
their book value and the proceeds remaining after paying all liabilities are
divided among the common shareholders.
b. Liquidation value is the actual amount each common shareholder would expect
to receive if the firm's assets are sold, creditors and preferred shareholders are
paid, and any remaining money is divided among the common shareholders.
c. Price earnings multiples are another way to estimate common share value. The
share value is estimated by multiplying expected earnings per share by the
average price/earnings ratio for the industry.
Both the book value and liquidation value approaches ignore the earning power of
a firm's assets and lack a relationship to the firm's value in the marketplace. The
price/earnings multiples approach is considered the best approach to valuation
since it considers expected earnings. The P/E ratio also has the strongest
theoretical roots. One divided by the P/E ratio can be viewed as the rate at which
investors discount the firm's earnings. If the projected earnings per share is
assumed to be earned indefinitely, the P/E multiple approach can be looked on as
a method of finding the present value of a perpetuity of projected EPS at a rate
equal to the P/E ratio.
8-17 The price/earnings ratio assumes that investors will continue to value the firm’s
earnings in the same way as they did in the past, or that the firm is like the
average firm in the industry. If these assumptions are not valid, the price/earnings
ratio will yield an inaccurate estimate
8-18 A decision or action by the financial manager can have an effect on the expected
return and risk of the stock, both of which determine share value. The CAPM
determines the appropriate level of return for a given level of risk. This required
return can then be substituted into the Gordon Model to determine share price.
8-19 CAPM: ks = RF + [bj x (km - RF)] and bj > 1.00:
a. As beta (risk) increases, required return increases and share price falls.
b. As the risk-free rate declines, the required return would also decline. Substituting
ks into the Gordon model Vo = D1 ÷ (ks - g), as ks declines, Vo increases.
c. As D1 decreases, the Vo also decreases since the numerator in the dividend

valuation models will decline.
d. As g increases, the Vo also increases. In the Gordon growth model the value of
(k-g) in the denominator will become smaller resulting in a higher value.
8-20 To value preferred shares, the assumption is made that the preferred share is a
perpetuity paying a constant dividend over an infinite period.
D1
V0 =
kp
where
V0 = value of a company’s preferred shares
D1 = yearly dividend per preferred share
Kp= required return on the company’s preferred shares
Restating the formula to determine the yield:
D1
kp =
P0
8-21 The interest equivalent factor is a tax-related adjustment that must be used to
adjust the before-tax dividend yield on equity securities so it can be compared to
the before-tax return on debt securities.
SOLUTIONS TO PROBLEMS
8-1 LG 1: Interest Rate Fundamentals: The Real Rate of Return
Real rate of return = 5.5% - 2.0% = 3.5%
8-2 LG 1: Real Rate of Interest
a.
Supply and Demand Curve
Current
9 Suppliers
8
7
6
Interest Rate 5
Required 4 Demanders
Demanders/ 3 after new
Supplier 2 law
(%) 1 Current
0 demanders
1 5 10 20 50 100
Amount of Funds
Supplied/Demanded ($ billion)
b. The real rate of interest creates an equilibrium between the supply of savings and
the demand for funds, which is shown on the graph as the intersection of lines for
current suppliers and current demanders. K0 = 4%
c. See graph.
d. A change in the tax law causes an upward shift in the demand curve, causing the
equilibrium point between the supply curve and the demand curve (the real rate of
interest) to rise from ko = 4% to k0 = 6% (intersection of lines for current
suppliers and demanders after new law).
8-3 LG 1: Real and Nominal Rates of Interest
a. 4 shirts

b. $300 + ($300 x .09) = $327
c. $75 + ($75 x .05) = $78.75
d. The number of polo shirts in one year = $327 ÷ $78.75 = 4.1524. He can buy
3.8% more shirts (4.1524 ÷ 4 = .0381).
e. The real rate of return is 9% - 5% = 4%. The change in the number of shirts that
can be purchased is determined by the real rate of return since the portion of the
nominal return for expected inflation (5%) is available just to maintain the ability
to purchase the same number of shirts.
8-4 LG 1: Yield Curve
a.
Yield Curve of Government of Canada Securities
14
12
10
8
6
Yield %
4
2
0
0 5 10 15 20
Time to Maturity (years)
b. The yield curve is slightly downward sloping, reflecting lower expected future
rates of interest. The curve may reflect a general expectation for an economic
recovery due to inflation coming under control and a stimulating impact on the
economy from the lower rates.

8-5 LG 1: Nominal Interest Rates and Yield Curves
a. kl = k* + IP + RP1
For government of Canada debt issues, RP = 0
RF = k* + IP
20-year bond: RF = 2.5 + 9% = 11.5%

3-month bill: RF = 2.5 + 5% = 7.5%
1-year bill: RF = 2.5 + 6% = 8.5%
5-year bond: RF = 2.5 + 8% = 10.5%
b. If the real rate of interest (k*) drops to 2.0%, the nominal interest rate in each case
would decrease by 0.5 percentage point.
c.
Return versus Maturity
14
12
10
8
6
Rate of
4
Return %
2
0
0.25 1 5 10 20
Years to Maturity
The yield curve for the government of Canada debt securities is upward sloping,
reflecting the prevailing expectation of higher future inflation rates.
d. Followers of the liquidity preference theory would state that the upward sloping
shape of the curve is due to the desire by lenders to lend short term and the desire
by business to borrow long term. The dashed line in the part c graph shows what
the curve would look like without the existence of liquidity preference, ignoring
the other yield curve theories.
e. Market segmentation theorists would argue that the upward slope is due to the
fact that under current economic conditions there is greater demand for long-term
loans for items such as real estate than for short-term loans such as seasonal
needs.

8-6 LG 1: Nominal and Real Rates and Yield Curves
Real rate of interest (k*):

ki = k* + IP + RP
RP = 0 for government of Canada debt securities

k* = ki - IP
a.
Nominal Real rate of interest
Security rate (kj) - IP = (k*)
A 12.6% - 9.5% = 3.1%
B 11.2% - 8.2% = 3.0%
C 13.0% - 10.0% = 3.0%
D 11.0% - 8.1% = 2.9%
E 11.4% - 8.3% = 3.1%
b. The real rate of interest decreased from January to March, remained stable from
March through August, and finally increased in December. Forces that may be
responsible for a change in the real rate of interest include changing economic
conditions such as the international trade balance, a federal government budget
deficit, or changes in tax legislation.
c.
Yield Curve of Government of Canada Debt Securities
14
12
10
Yield %
8
6
4
2
0
0 5 10 15 20

d. The yield curve is slightly downward sloping, reflecting lower expected future
rates of interest. The curve may reflect a general expectation for an economic
recovery due to inflation coming under control and a stimulating impact on the
economy from the lower rates.
8-7 LG 1: Term Structure of Interest Rates
a.
Yield Curve of High-Quality Corporate Bonds
15
14
Today
13
12
Yield %
11
2 years ago
10
5 years ago
9
7
0 5 10 15 20 25 30 35

b. and c.
Five years ago, the yield curve was relatively flat, reflecting expectations of stable
interest rates and stable inflation. Two years ago, the yield curve was downward
sloping, reflecting lower expected interest rates due to a decline in the expected
level of inflation. Today, the yield curve is upward sloping, reflecting higher
expected inflation and higher future rates of interest.
8-8 LG 1: Risk-Free Rate and Risk Premiums
a. Risk-free rate: RF = k* + IP
Security k* + IP = RF
A 3% + 6% = 9%
B 3% + 9% = 12%
C 3% + 8% = 11%
D 3% + 5% = 8%
E 3% + 11% = 14%

b. Since the expected inflation rates differ, it is probable that the maturity of each
security differs.
c. Nominal rate: k = k* + IP + RP
Security k* + IP + RP = k
A 3% + 6% + 3% = 12%
B 3% + 9% + 2% = 14%
C 3% + 8% + 2% = 13%
D 3% + 5% + 4% = 12%
E 3% + 11% + 1% = 15%
d.
8-9 LG 1: Risk Premiums
a. RFt = k* + IPt
Security A: RF3 = 2% + 9% = 11%
Security B: RF15 = 2% + 7% = 9%
b. Risk premium:
RP = default risk + interest-rate risk + liquidity risk + other risk
Security A: RP = 1% + 0.5% + 1% + 0.5% = 3%
Security B: RP = 2% + 1.5% + 1% + 1.5% = 6%
c.. ki = k* + IP + RP or k1 = RF + Risk premium

Security A: k1 = 11% + 3% = 14%
Security B: k1 = 9% + 6% = 15%
Security A has a higher risk-free rate of return than Security B due to expectations
of higher near-term inflation rates. The issue characteristics of Security A in
comparison to Security B indicate that Security A is less risky.
8-10 LG 2: Valuation Fundamentals
a. Cash Flows: CF1-5 $1,200

CF5 $5,000
Required return: 6%
CF1 CF2 CF3 CF4 CF5

b. V0 = + + + +
(1 + k ) (1 + k )
1 2
(1 + k ) (1 + k )
3 4
(1 + k ) 5

$1,200 $1,200 $1,200 $1,200 $6,200
V0 = + + + +
(1 + .06) (1 + 06)
1 2
(1 + 06) (1 + 06)
3 4
(1 + 06) 5
V 0 = $8,791
Using PVIF formula:

V0 = [(CF1 x PVIF6%,l) + (CF2 x PVIF6%, 2) ... (CF5 x PVIF6%,5)]
V0 = [($1,200 x .943) + ($1,200 x .890) + ($1,200 x .840) + ($1,200 x .792)
+ ($6,200 x.747)]
V0 = $1,131.60 + $1,068.00 + $1,008 + $950.40 + $4,631.40
V0 = $8,789.40
Calculator solution: $8,791.13
The maximum price you should be willing to pay for the car is $8,789, since if
you paid more than that amount you would be receiving less than your required
6% return.

8-11 LG 2: Valuation of Assets
PVIF or Present Value of
Asset End of Year Amount PVIFa(k%,n) Cash Flow
A 1 $5000
2 $5000 2.174
3 $5000 $10,870.00
B 1-∞ $ 300 1 ÷ .15 $ 2,000
C 1 0
2 0
3 0
4 0
5 $35,000 .476 $16,660.00
D 1-5 $1,500 3.605 $ 5,407.50

6 8,500 .507 4,309.50
$ 9,717.00
Calculator solution: $ 9,713.53
E 1 $2,000 .877 $ 1,754.00

2 3,000 .769 2,307.00
3 5,000 .675 3,375.00
4 7,000 .592 4,144.00
5 4,000 .519 2,076.00
6 1,000 .456 456.00
$14,112.00

8-12 LG 2: Asset Valuation and Risk
a.
10% Low Risk 15% Average Risk 22% High Risk
PVIFa PV of CF PVIFa PV of CF PVIFa PV of CF
CF1-4 $3,000 3.170 $ 9,510 2.855 $ 8,565 2.494 $ 7,482
CF5 15,000 .621 9,315 .497 7,455 .370 5,550
Present Value of CF: $18,825 $ 16,020 $13,032
Calculator solutions: $18,823.42 $16,022.59 $13,030.91
b. The maximum price Laura should pay is $13,030.91. If she were unable to assess
the risk, Laura would use the lowest price. This would ensure she would not
overpay for the asset. But, if the risk of the asset was so high that 22% did not
reflect the risk level, she might still overpay. If it were an extremely high-risk
asset, a 22% required return might still be too low.
c. At higher levels of risk, investors rationally require higher rates of return. The
higher the required rate of return, the lower the amount an investor should pay for
the asset. High required returns result in lower asset values. This is the case
since the lower the value, the greater the chance the asset can generate the higher
return.
8-13 LG 3: Bond Valuation
a. Vo = [I x (PVIFa(kd%,n)] + [M x PVIF(kd%,n)]
Vo = [$60 x PVIFa(5%,32)] + [$1,000 x PVIF(5%,32)]
Vo = $1,158.03
b. Since Complex Systems' bonds were issued, the required returns on comparable
risk bonds have declined, or the company’s default risk has declined.
c. Vo = [I x PVIFa(kd%,n)] + [M x PVIF(kd%,n)]
Vo = [$60 x PVIFa(6%,32)] + [$1,000 x PVIF(6%,32)]
Vo = $1,000
When the required return is equal to the coupon rate, the bond value is equal to
the par value. In contrast, if the required return is less than the coupon rate, the
bond will sell at a premium (its value will be greater than par).
d. Vo = [I x PVIFa(kd%,n)] + [M x PVIF(kd%,n)]
Vo = [$60 x PVIFa(7.5%,32)] + [$1,000 x PVIF(7.5%,32)]
Vo = $819.77

When the required return is greater than the coupon rate, the bond value is less
than the par value. The bond is selling at a discount. There is an inverse
relationship between yield and price.

Vo = [I x PVIFa(kd%,n)] + [M x PVIF(kd%,n)]
Bond Equation Solution

A Vo = [$70 x PVIFa(6%,40)] + [$1,000 x PVIF(6%,40)] $1,150.46
B Vo = [$40 x PVIFa(4%,32)] + [$1,000 x PVIF(4%,32)] $1,000
C Vo = [$5 x PVIFa(6.5%,16)] + [$100 x PVIF(6.5%,16)] $ 85.35
D Vo = [$40 x PVIFa(9%,26)] + [$500 x PVIF(9%,26)] $ 450.36
E Vo = [$60 x PVIFa(5%,20)] + [$1,000 x PVIF(5%,20)] $1,124.62
8-15 LG 3: Bond Value and Required Returns
a. kj Equation Value
7% Vo = $55 x PVIFa(3.5%,24)] + [$1,000 x PVIF(3.5%,24)] $1,321.17
9% Vo = $55 x PVIFa(4.5%,24)] + [$1,000 x PVIF(4.5%,24)] $1,144.95
11% Vo = $55 x PVIFa(5.5%,24)] + [$1,000 x PVIF(5.5%,24)] $1,000
13% Vo = $55 x PVIFa(6.5%,24)] + [$1,000 x PVIF(6.5%,24)] $880.09
15% Vo = $55 x PVIFa(7.5%,24)] + [$1,000 x PVIF(7.5%,24)] $780.34
b.
Bond Value versus Required Return
1,400
1,300
1,200
Bond Value 1,100
($)
1,000
900
800
700
8% 9% 10% 11% 12% 13% 14% 15%
Required Return (%)
c. When the required return is less than the coupon rate, the market value is greater
than the par value and the bond sells at a premium. When the required return is
greater than the coupon rate, the market value is less than the par value; the bond
therefore sells at a discount. When the required return is equal to the coupon rate,
the market value of the bond is equal to the par value; the bond sells at par.
d. The required return on the bond is likely to differ from the coupon interest rate
because either (1) economic conditions have changed, causing a shift in the basic
cost of long-term funds, or (2) the firm's risk has changed.
8-16 LG 3: Bond Value and Time
Vo = [I x PVIFa(kd%,n)] + [M x PVIF(kd%,n)]
a. Bond Equation Solution

(1) Vo = [$33 x PVIFa(5.1%,30)] + [$1,000 x PVIF(5.1%,30)] $726.42
(2) Vo = [$33 x PVIFa(5.1%,24)] + [$1,000 x PVIF(5.1%,24)] $754.02
(3) Vo = [$33 x PVIFa(5.1%,18)] + [$1,000 x PVIF(5.1%,18)] $791.22
(4) Vo = [$33 x PVIFa(5.1%,12)] + [$1,000 x PVIF(5.1%,12)] $841.36
(5) Vo = [$33 x PVIFa(5.1%,6)] + [$1,000 x PVIF(5.1%,6)] $908.93
(6) Vo = [$33 x PVIFa(5.1%,2)] + [$1,000 x PVIF(5.1%,2)] $966.58
b.
Bond Value versus Years to Maturity
1200
1000 1000
967
909
841
800 791
Bond Value 754 726
($) 600
400
200
0
0 2 4 6 8 10 12 14 16
Years to Maturity
c. The value of the bond increases as the time to maturity decreases and the bond
value approaches the par value as it gets closer to maturity.

8-17 LG 3: Bond Value and Time
Vo = I × PVIFa (kd%, n per) + M × PVIF (kd%, n per)
a. b. c.
Value
Required Return Bond A Bond B
8% $1,121.66 $1,259.38
11% 1,000.00 1,000.00
14% 894.65 813.86
The longer the time to maturity, the greater the impact changing yields (required
returns) have on bond values. A long-term bond is much more sensitive to changes in
yields than is a short-term bond due to interest-rate risk. Investors in Bond B take
more risk than those purchasing Bond A since they are locking their money up for
longer time periods. Those investors are rewarded when yields in the market fall, but
they are more severely penalized when yields increase.
d. If Lynn wants to minimize interest-rate risk in the future, she would choose Bond A
with the shorter maturity. As illustrated above, changes in interest rates impact the
market value of Bond A less than if she held Bond B.
8-18 LG 3: Yield to Maturity
Bond A is selling at a price less than par.

Bond B is selling at par value.
Bond C is selling at a price greater than par.
Bond D is selling at a price less than par.
Bond E is selling at a price greater than par.
a. Vo = [I x PVIFa(kd%,n)] + [M x PVIF(kd%,n)]
$911.50 = [$39.50 x PVIFa(kd%,37)] + [$1,000 x PVIF(kd%,37)]
kd = 4.4415%
Since the coupons are paid semi-annually, this answer must be multiplied by 2 to
get the annual yield on the bond: 4.4415 x 2 = 8.88%
b. If the yield to maturity is greater than the coupon rate, the market value of the
bond will be less than the par value, as is the case here. If the yield to maturity is
less than the coupon rate, the market value of the bond will be greater than the par
value. If the yield and coupon rate are equal, the market value of the bond will
equal the par value.

a.
Bond A B C D E
FV $1,000 $1,000 $500 $1,000 $1,000
PV -820 -1,000 -283.75 -1,128 -901.6
n Years x 2 16 32 24 20 6
Annual
PMT coupon/2 45 60 30 75 25
CPT i 6.32% 6.00% 11.29% 6.35% 4.40%
Yield to maturity (i x 2) 12.64% 12.00% 22.58% 12.70% 8.80%
b. The par value and coupon rate for a bond are set at the time of issue and are
constant for the life of the long-term debt issue. As required rates of return (the
yield to maturity) increase above the coupon rate, the market value of the bond
declines below par (the bond sells at a discount to par). As required rates of return
(the yield to maturity) decrease below the coupon rate, the market value of the
bond increases above par (the bond sells at a premium to par).
8-21 LG 3: Bond Valuation and Yield to Maturity
a. VA = [I x PVIFa(kd%,n)] + [M x PVIF(kd%,n)]
VA = [$30 x PVIFa(6%,10)] + [$1,000 x PVIF(6%,10)]
VA = $779.20
VB = [$70 x PVIFa(6%,10)] + [$1,000 x PVIF(6%,10)]

VB = $1,073.60
b.
$20,000
Number of bonds = = 25.667 of bond A
$779.20
$20,000
Number of bonds = = 18.629 of bond B
$1,073.60
c. Interest income of A = 25.667 bonds x $60 = $1,540.02

Interest income of B = 18.629 bonds x $140 = $2,608.06
d. At the end of the 5 years both bonds mature and will sell for par of $1,000.
Bond A:

Time Invested
Period Payment (in periods) FV
1 $30 9 $46.54
2 $30 8 $44.32
3 $30 7 $42.21
4 $30 6 $40.20
5 $30 5 $38.29
6 $30 4 $36.47
7 $30 3 $34.73
8 $30 2 $33.08
9 $30 1 $31.50
10 $30 0 $30.00
$1,000 0 $1,000.00
Total: $1,377.34
PV $769.10
Bond B:
Time Invested
Period Payment (in periods) FV
1 $70 9 $108.59
2 $70 8 $103.42
3 $70 7 $98.50
4 $70 6 $93.81
5 $70 5 $89.34
6 $70 4 $85.09
7 $70 3 $81.03
8 $70 2 $77.18
9 $70 1 $73.50
10 $70 0 $70.00
$1,000 0 $1,000.00
Total: $1,880.45
PV $1,050.03
e. The difference is due to the differences in the coupon payments received each
year. Bond B’s coupons are the reason why the value of the bond is greater.
With Bond B, the reinvestment of the coupons at a high rate is vital in ensuring
that Mark receives the quoted yield to maturity. With Bond A, the par value is
more important and the return on that is guaranteed given that it is received at the
maturity of the bond.

V0 = [I x PVIFa(kd%,n)] + [M x PVIF(kd%,n)]
V0 = [$50 x PVIFa(7%,12)] + [M x PVIF(7%,12)]
V0 = $397.13+ $444.01
V0 = $841.14
Bond Equation Solution

A V0 = [$50 x PVIFa(4%,24)] + [$1,000 x PVIF(4%,24)] = $1,152.47
B V0 = [$60 x PVIFa(6%,40)] + [$1,000 x PVIF(6%,40)] = $1,000
C V0 = [$30 x PVIFa(7%,10)] + [$500 x PVIF(7%,10)] = $464.88
D V0 = [$70 x PVIFa(5%,20)] + [$1,000 x PVIF(5%,20)] = $1,249.24
E V0 = [$3 x PVIFa(7%,8)] + [$100 x PVIF(7%,8)] = $76.11
8-24 LG 3: Bond Valuation–Quarterly Interest
V0 = [$125 x PVIFa(3%,40)] + [$5,000 x PVIF(3%,40)]
V0 = $2,889.35+ $1,532.78
V0 = $4,422.13
8-25 LG 4: Common Share Valuation–Zero Growth

V0 = D1 ÷ ks
a. V0= $2.40 ÷ .12 b. V0 = $2.40 ÷ .20

V0 = $20 V0 = $12
c. As perceived risk increases, the required rate of return also increases, causing the
share price to fall.
8-26 LG 4: Common Share Valuation–Zero Growth

$5.00
Value of share when purchased = = $31.25
.16
$5.00
Value of share when sold = = $41.67
.12
Sally’s capital gain is $10.42 ($41.67 - $31.25) per share, a total of $1,042.

8-27 LG 4: Common Share Value–Constant Growth
V0 = D1 ÷ (ks - g)
Firm V0 = D1 ÷ (ks - g) Share Price

A V0 = $1.30 ÷ (.13 -.08) = $ 26.00
B V0 = $4.20 ÷ (.15 -.05) = $ 42.00
C V0 = $ .72 ÷ (.14 -.10) = $ 18.00
D V0 = $6.48 ÷ (.09 -.08) = $648.00
E V0 = $2.43 ÷ (.20 -.08) = $ 20.25

a.
D1
ks = +g
V0
$1.20 × (1.05)
ks = + .05
$28
$1.26
ks = + .05 = .045 + .05 = .095 = 9.5%
$28
b.
$1.20 × (1.10)
ks = + .10
$28
$1.32
ks = + .10 = .047 + .10 = .147 = 14.7%
$28

Vo = D1 ÷ (ks - g)
a. Calculate the growth rate in dividends over the six years provided:
PV = $2.25
FV = $2.87
n = 5 (6 years of data, but 5 growth periods)
CPT i% = 4.988%, say 5%
Determine the dividend in 2009:

D2009 = $2.87 x (1 + g)
D2009 = $2.87 x (1 + .05)
D2009 = $3.0135

Value at 13% required rate of return:
Vo = $3.0135 = $37.67
13% - 5%
b. Value at 10% required rate of return:

Vo = $3.0135 = $60.27
10% - 5%
c. At a high required rate of return, the share price is relatively low. As the
perceived risk of the company declines, the required rate of return declines. This
results in a higher share price. To receive a higher rate of return, you must pay
less for the share.
8-30 LG 4: Common Share Value–Variable Growth
Determine the Value of the Common Share using the Variable Growth Model:
V0 = Present value of dividends during initial growth period

+ present value of price of the share at end of growth period.
Follow the 4-step process: Determine dividends and their present values over the
initial growth period, calculate the value and the present value of the shares at the
end of this period, and then sum the two present values.
Div at Beg
Year of Year Div at end of Year* PV of Div
1 $2.55 D1 = $2.55(1.25) = $3.19 × PVIF(1 per, 15%) = $2.77
2 $3.19 D2 = $3.19(1.25) = $3.99 × PVIF(2 per, 15%) = $3.02
3 $3.99 D3 = $3.99(1.25) = $4.99 × PVIF(3 per, 15%) = $3.28
PV of dividends during first 3 years $9.07
* D1 = D0 × (1 + g)
Price at end of year 3

D4 = $4.99 × (1.10) = $5.49
V4 = $5.49 = $109.80
15% - 10%
Present value = $109.80 × PVIF(3 per, 15%) = $72.20
Value of Grip’s common shares today (at time 0) = $81.27
8-31 LG 4: Common Share Value–Variable Growth

Determine the Value of the Common Share using the Variable Growth Model:
V0 = Present value of dividends during initial growth period

+ present value of price of the share at end of growth period.
Div at Beg
Year of Year Div at end of Year PV of Div
1 $3.40 D1 = $3.40(1.00) = $3.40 × PVIF(1 per, 14%) = $2.98
2 $3.40 D2 = $3.40(1.05) = $3.57 × PVIF(2 per, 14%) = $2.75
3 $3.57 D3 = $3.57(1.05) = $3.75 × PVIF(3 per, 14%) = $2.53
4 $3.75 D4 = $3.75(1.15) = $4.31 × PVIF(4 per, 14%) = $2.55

D5 = $4.31 × (1.10) = $4.74
V4 = $4.74 = $118.50
14% - 10%
Value of Home Place Hotels’common shares today (at time 0) = $80.97
8-32 LG 4: Common Share Value–Variable growth

a.
Div at Beg
1 $1.80 D1 = $1.80(1.08) = $1.94 × PVIF(1 per, 11%) = $1.75
2 $1.94 D2 = $1.94(1.08) = $2.10 × PVIF(2 per, 11%) = $1.70
3 $2.10 D3 = $2.10(1.08) = $2.27 × PVIF(3 per, 11%) = $1.66

D4 = $2.27 × (1.00) = $2.27
V4 = $2.27 = $20.64
11% - 0%
Value of Lawrence Industries’ common shares today (at time 0) =

$20.20

b. The present value of the first 3 years’ dividends is the same as in part a ($5.11).

D4 = $2.27 × (1.05) = $2.38
V4 = $2.38 = $39.67
11% - 5%
Value of Lawrence Industries’ common shares today (at time 0) = $34.12
c. The present value of the first 3 years’ dividends is the same as in part a ($5.11).

D4 = $2.27 × (1.10) = $2.50
V4 = $2.50 = $250
11% - 10%
Present value = $250 × PVIF(3 per, 11%) = $182.80
Value of Lawrence Industries’ common shares today (at time 0) = $187.91
This analysis indicates that as the growth rate increases, the value of the share is
significantly impacted. An increase in growth from 0% to 10% in years 4 to
infinity results in a difference of $167.71 in the value of the shares.
8-33 LG 4: Valuation–All Growth Models
a. V0 = (CF0 ÷ k) b. V0 = (CF1 ÷ (k – g))

V0 = $42,500 ÷ .18 V0 = ($45,475* ÷ (.18 - .07)
V0 = $236,111 V0 = $413,409.10
* CF1 = $42,500(1.07) = $45,475
c. Steps 1 and 2: Value of cash dividends and present value of annual dividends
Year Expected Cash Flow During Year Present Value of Cash Flow
1 CF1 = $42,500 × (1.12) = $47,600 $47,600 ×PVIF (1 per, 18%) = $40,338.98
2 CF2 = $47,600 × (1.12) = $53,312 $53,312 ×PVIF (2 per, 18%) = $38,287.85
3 CF3 = $53,312 × (1.12) = $59,709 $59,709 ×PVIF (3 per, 18%) = $36,341.01
4 CF4 = $59,709 × (1.12) = $66,874 $66,874 ×PVIF (4 per, 18%) = $34,492.91
Total present value of the expected cash flows during the 4 years = $149,460.75
Step 3: Present value of price of shares at end of initial growth period

CF5 = $66,874 × (1.07) = $71,555.18
V4 = $71,555.18 = $650,501.64
18% - 7%
Present value = $650,501.64 × PVIF(4 per, 18%) = $335,521.51
Step 4: Sum of present value of dividends during initial growth period and
present value price of shares at end of growth period
V0 = $149,460.75 + $335,521.51
V0 = $484,982.26
d. The above answers are different because each one assumed a different dividend
growth scenario: zero growth, constant growth, and variable growth. The value
of the common shares will be different depending on the assumptions made.
8-34 LG 4: Book and Liquidation Value
a. Book value per share =

Book value of assets - (book value liabilities + book value preferred shares)
Number of common shares outstanding
Book value per share = $780,000 - $420,000 = $36.00 per share

10,000 common
b. Liquidation value of assets:

Cash (100%) $40,000
Marketable securities (100%) 60,000
Accounts receivable ($120,000 × 90%) 108,000
Inventory ($160,000 × 90%) 144,000
Land and buildings ($150,000 × 130%) 195,000
Machinery and equipment ($250,000 × 60%) 150,000
Liquidation value of assets $697,000
less: Liquidation value of liabilities and preferred equity:

Accounts payable and accruals ($130,000 × 60%) $ 78,000
Line of credit ($ 30,000 × 75%) $ 22,500
Long-term debt ($180,000 × 75%) $135,000
Preferred Shares ($ 80,000 × 50%) $ 40,000
Liquidation value of liabilities and preferred equity $275,500
Liquidation value of company for common shareholders $421,500

Liquidatio n Value of Assets
Liquidatio n value per share =
Number of Shares Outstandin g
Liquidation value per share = $421,500 = $42.15 per share

10,000
c. Liquidation value is a more realistic estimate of the value of a company since it is
based on the market value of each asset and liability, as opposed to the internal
accounting numbers that are based on cost. Surprisingly, for Gallinas Industries,
liquidation value per share is greater than book value per share. It is usual for
liquidation value to be less than book value since in most liquidations, assets are,
generally, overvalued on a book value basis. That is one reason why the firm may
have been having financial problems.
8-35 LG 4: Price/Earnings Multiple Model

Share
Firm EPS1* x P/E = Price
A 3.377 x (6.2) = $20.94
B 5.148 x (10.0) = $51.48
C 2.081 x (12.6) = $26.22
D 2.616 x (8.9) = $23.28
E 6.155 x (15.0) = $92.33
*EPS1 calculated as current EPS x (1 + g)
8-36 LG 4: Calculating Value and Returns
a. EPS1 = $1.40 x (1+ .142)

EPS1 = $1.60
Value = EPS1 x P/E

Value = $1.60 x 13.5
Value = $21.60
b. Expected return = $21.60 = 16.8%

$18.50
The idea is that it is expected the shares will be valued at $21.60 at the end of
year one:
0 1
$18.60 $21.60
c. The shares would not be purchased because the expected return is less than the
investors’ required return of 18%.
d. Expected return = $21.60 + $0.80 = 21.1%
$18.50
The expected return would now be 21.1%, which is greater than the required
return. The shares should be purchased.
8-37 LG 5: Management Action and Share Value

V0 = D1 ÷ (ks - g)
a. V0 = $3.15 ÷ (.15 - .05) = $31.50
b. V0 = $3.18 ÷ (.14 - .06) = $39.75

c. V0 = $3.21 ÷ (.17 - .07) = $32.10
d. V0 = $3.12 ÷ (.16 - .04) = $26.00
e. V0 = $3.24 ÷ (.17 - .08) = $36.00
The best alternative in terms of maximizing share price is b.
8-38 LG 4, 5: Integrative–Valuation and CAPM Formulas
V0 = D1 ÷ (ks - g) ks = RF + [b x (km - RF)]

$50 = $3.00 ÷ (ks - .09) .15 = .07 + [b x (.10 - .07)]
ks = .15 b = 2.67
8-39 LG 4, 5: Integrative–Risk and Valuation

a. ks = RF + [b x (km - RF)]
ks = .10 + [1.20 x (.14 - .10)]
ks = .148 = 14.8%

b. Calculate the growth rate in dividends over the six years provided:
PV = $1.73
FV = $2.45
n = 6 (7 years of data, but 6 growth periods)
CPT i% = 5.9709%, say 6%
D2009 = $2.45 x (1 + .06)

D2009 = $2.60
Vo = D1 ÷ (ks - g)
Vo = $2.60 ÷ (.148 - .06)
Vo = $29.55
c. A decrease in beta would decrease the required rate of return, which in turn would
increase the price of the share.
8-40 LG 4, 5: Integrative–Valuation and CAPM
a. g: FV = PV x (1 + k)n
$3.44 = $2.45 x (1 + k)5
$3.44 = $2.45 x (1 + k)5
$3.44 ÷ $2.45 = FVIFk%,5
1.404 = FVIF7%,5
k = approximately 7%
Calculator solution = 7.02%, use 7%
ks = .09 + [1.25 x (0.066)]

ks = .1725
D1 = ($3.44 x 1.07) = $3.68
V0 = $3.68 ÷ (.1725 - .07)

V0 = $35.90 per share
b. (1) ks = .09 + [1.25 x (0.066)]
D1 = $3.61 ($3.44 x 1.05)
V0 = $3.61 ÷ (.1725 -.05)


(2) ks = .09 + [1.00 x (0.066)]
ks = .156 = 15.6%
D1 = $3.68
V0 = $3.68 ÷ (.156 -.07)

The CAPM supplies an estimate of the required rate of return for common shares.
The dividend valuation model requires an estimate for the required rate of return
and the expected growth rate in earnings per share, dividends per share, and share
price.
The resulting price per share is a result of the interaction of the risk-free rate, the
risk level of the security, and the required rate of return on the market. For Craft,
the lowering of the dividend growth rate reduced future cash flows resulting in a
reduction in share price. The decrease in the beta reflected a reduction in risk
leading to an increase in share price.
8-41 LG 6: Preferred Share Valuation

V0 = Dp ÷ kp
a. V0 = $6.40 ÷ .093
V0 = $68.82
b. V0 = $6.40 ÷ .105
V0 = $60.95
The investor would lose $7.87 per share ($68.82 - $60.95) because, as the required rate of
return on preferred share issues increases above the 9.3% return she receives, the value of
her shares declines.

Issue 1:
V0 = Annual dividends
kp
= $2.20
0.052
= $42.31
Issue 2:
V0 = Annual dividends
kp
= $3.10
0.052
= $59.62
Yield = Annual dividends

P0
= $25.00 × 0.11
$27.25
= 0.1009 or 10.09%
a. Yield = Annual dividends

P0
= $25.00 × 0.08
$24.10
= 0.0830 or 8.30%
b. $24.10 = $0.50 × PVIFa(12 periods, kp) + $25.50 × PVIF(12 periods, kp)

kp = 2.50% × 4 = 10.00%
8-45 LG 6: Interest Equivalent Factor
a. In order to compare the yields earned on the two investments, Lori must
determine the after-tax income that she would receive from both the bond and the
preferred share.
b. Assuming Lori received $1,000 of before-tax dividend income and $1,000 of

before-tax interest income, we can make the following calculations to determine
the yields that Lori should use to make her comparison:
Interest Dividend
Income received $1,000.00 $1,000.00
Tax adjustment 0.00 450.00
Taxable income $1,000.00 $1,450.00
Federal tax (29%) $ 290.00 $ 420.50

Federal dividend tax credit (27.5%) 0.00 275.00
Net federal tax payable $ 290.00 $ 145.50
Provincial tax (15.4%) $ 154.00 $ 223.30
Provincial dividend tax credit (12.4%) 0.00 124.00
Net provincial tax $ 154.00 $ 99.30
Total taxes payable $ 444.00 $ 244.80
After-tax return $ 556.00 $ 755.20

Interest equivalent factor = After-tax dividend income = $755.20 = 1.358
After-tax interest income $556.00
After-tax yield on preferred shares = 7.09% × 1.358 = 9.628%

Therefore, Lori should use yields of 8.35% for the bond and 9.63% for the
preferred share.
CHAPTER 8 CASE
Assessing the Impact of Suarez Manufacturing's Proposed Risky Investment on Its
Bond and Share Values
This case demonstrates how a risky investment can affect a firm's value. First, students
must calculate the current value of Suarez's bonds and shares, rework the calculations
assuming that the firm makes the risky investment, and then draw some conclusions
about the value of the firm in this situation. In addition to gaining experience in
valuation of bonds and shares, students will see the relationship between risk and
valuation.
a. Current value of bonds

Bond
FV -$1,000
n years x 2 36
annual
PMT coupon/2 -45
i annual rate/2 4.00%
CPT PV $1,094.54
b. Current per share value of common shares

Growth rate of dividends:
g can be solved for by: (1) using the geometric growth equation as shown below;
or (2) by solving for i on the calculator also as shown below.
(1)
− 1 = (1.4615) − 1 = 1.0995 − 1 = .0995 = 9.95%

$1.90
g=4
1/ 4
$1.30
(2)
PV -1.3
FV 1.9
n 4
CPT i 9.95%

D1 $1.90(1.10) $2.09
V0 = = = = $52.25
ks − g .14 − .10 .04
c. Value of bonds if Suarez makes risky investment:

Bond
FV -$1,000
n years x 2 36
annual
PMT coupon/2 -45
i annual rate/2 5.00%
CPT PV $917.27
The value of the bonds drops by $177.27 ($1,094.54 - $917.27) if the risky investment is
made. Higher risk increases the required return. The increase in the required return
lowers the present value interest factors resulting in a lower valuation. There may be no
immediate impact on the company if this risky investment is made. This will impact the
company only when they raise more debt financing in the future. The cost of the new
debt financing will be higher than it might have been if the investment was not made.
d. Value of common shares if risky investment is made:
D1 $1.90(1.13) $2.15
V0 = = = = $71.67
ks − g .16 − .13 .03
For shareholders, the risky investment would be very positive. The value of the
company’s common shares will increase $19.42 (from $52.25 to $71.67).
Although risk increased and increased the required return, the higher dividend
growth offsets this higher risk resulting in an increase in value.
e. If Suarez Manufacturing undertakes the risky investment, the shareholders benefit

(the per share price rises about 37.2%). On the other hand, the bondholders' lose;
the value of the bonds falls by about 16.2%). The firm should probably proceed
with the investment because there is considerable benefit to its shareholders,
thereby fulfilling the primary goal of maximizing shareholder wealth. However,
this would come at the expense of one stakeholder group (creditors).
f. Value of common shares using variable growth model:
Div at Beg
1 $1.90 D1 = $1.90(1.13) = $2.15 × PVIF(1 per, 16%) = $1.85
2 $2.15 D2 = $2.15(1.13) = $2.43 × PVIF(2 per, 16%) = $1.81
3 $2.43 D3 = $2.43(1.13) = $2.75 × PVIF(3 per, 16%) = $1.76
D4 = $2.75 × (1.10) = $3.03
V4 = $3.03 = $50.42
16% - 10%
Value of Suarez common shares = $37.72
Under this scenario, the price of the shares drops 27.8%, or $14.80 from the current per
share value of $52.25. If Suarez thinks that these growth rates are more likely to occur
than the constant growth projected in part d, it should not undertake this risky
investment. Both shareholders and bondholders lose.
INTEGRATIVE CASE 2
ENCORE INTERNATIONAL
This case focuses on the valuation of a firm. The student explores various methods of
valuation, including the price/earnings multiple, book value, no growth, constant growth,
and variable growth models. Risk and return are integrated into the case with the
addition of the security market line and the capital asset pricing model. The student is
asked to compare stock values generated by various models, discuss the differences, and
select the one which best represents the true value of the firm.
$60,000,000
a. Book value per share = = $24
2,500,000
b. P/E ratio = $52.43 = 8.40

$6.24
c. (1) ks = RF + [bj x (km - RF)]

ks = 6% + [1.10 x (14% - 6%)]
ks = 6% + 8.8%
ks = 14.8%
Required return = 14.8%

Risk premium = 8.8%

(2) ks = 6% + [1.25 x (14% - 6%)]
ks = 6% + 10%
ks = 16%
Required return = 16%

Risk premium = 10%
(3) As beta rises, the risk premium and required return also rise.
D1
d. Zero growth: V0 =
ks
$4.00
V0 = = $27.03
.148
D1
e. (1) Constant growth: V 0 =
( ks − g )
($4.00 × 1.06) $4.24

V0 = = = $42.40
(.16 − .06) .10
(2) Variable Growth Model: Present Value of Dividends
Po = Present value of dividends during initial growth period + present value of

price of stock at end of growth period.
Div at Beg
1 $4.00 D1 = $4.00(1.08) = $4.32 × PVIF(1 per, 16%) = $3.72
2 $4.32 D2 = $4.32(1.08) = $4.67 × PVIF(2 per, 16%) = $3.47

D3 = $4.67 × (1.06) = $4.95
V4 = $4.95 = $49.50
16% - 6%
Present value = $49.50 × PVIF (2 per, 16%) = $36.79
Value of Encore’s common shares = $43.98

f. Value = EPS x P/E
Value = [$6.24 x (1 + 0.05)] x 8
Value = $6.55 x 8
Value = $52.40
g. Valuation Method Per Share

Market value $52.43
Book value 24.00
Zero growth 27.03
Constant growth 42.40
Variable growth 43.98
P/E Multiple 52.40
The book value has no relevance to the true value of the firm. Of the remaining methods,
the most conservative estimate of value is given by the zero growth DVM. Wary
analysts may advise paying no more than $25 per share, yet this is hardly more than book
value, and less than half of the market price of the shares. The most optimistic prediction
is $52.40 using the P/E multiple model approach. But even it is almost exactly the
current market price. The market is obviously not as cautious about Encore
International's future as the analysts, or even the company’s CFO.
It might be argued that the company’s common shares are overvalued in the market if one
believed in the various inputs used for the DVM.

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Principles of Corporate Finance

Canadian 2nd Edition Gitman Solutions

Valuation of Financial Securities

© 2008 Pearson Education Canada 1

a. Downward sloping: long-term borrowing costs are lower than short-term

b. Upward sloping: Short-term borrowing costs are lower than long-term

b. The liquidity preference theory is an explanation for the upward-sloping yield

© 2008 Pearson Education Canada 2

8-6 Three key inputs to the valuation process are:

1. Cash flows - the cash generated from ownership of the asset;

CF1 CF2 CFn

or V0 = [I × PVIFa (n per, kd%)] + [M × PVIF (n per, kd%)]

© 2008 Pearson Education Canada 4

8-14 According to the efficient market hypothesis:

© 2008 Pearson Education Canada 5

8-19 CAPM: ks = RF + [bj x (km - RF)] and bj > 1.00:

c. As D1 decreases, the Vo also decreases since the numerator in the dividend

Restating the formula to determine the yield:

Real rate of return = 5.5% - 2.0% = 3.5%

8-2 LG 1: Real Rate of Interest

Supply and Demand Curve

8-3 LG 1: Real and Nominal Rates of Interest

© 2008 Pearson Education Canada 8

c. $75 + ($75 x .05) = $78.75

8-4 LG 1: Yield Curve

Yield Curve of Government of Canada Securities

Time to Maturity (years)

© 2008 Pearson Education Canada 9

20-year bond: RF = 2.5 + 9% = 11.5%

Return versus Maturity

© 2008 Pearson Education Canada 10

Real rate of interest (k*):

RP = 0 for government of Canada debt securities

Yield Curve of Government of Canada Debt Securities

Time to Maturity (years)

© 2008 Pearson Education Canada 11

8-7 LG 1: Term Structure of Interest Rates

Yield Curve of High-Quality Corporate Bonds

Time to Maturity (years)

8-8 LG 1: Risk-Free Rate and Risk Premiums

© 2008 Pearson Education Canada 12

8-9 LG 1: Risk Premiums

c.. ki = k* + IP + RP or k1 = RF + Risk premium

8-10 LG 2: Valuation Fundamentals

a. Cash Flows: CF1-5 $1,200

CF1 CF2 CF3 CF4 CF5

© 2008 Pearson Education Canada 13

Using PVIF formula:

© 2008 Pearson Education Canada 14

B 1-∞ $ 300 1 ÷ .15 $ 2,000

D 1-5 $1,500 3.605 $ 5,407.50

E 1 $2,000 .877 $ 1,754.00

© 2008 Pearson Education Canada 15

8-13 LG 3: Bond Valuation

© 2008 Pearson Education Canada 16

© 2008 Pearson Education Canada 17

Bond Equation Solution

8-15 LG 3: Bond Value and Required Returns