FINANCIAL MANAGEMENT 2e

Rajiv Srivastava - Dr. Anil Misra

Solutions to Numerical Problems Chapter 7

7-1: Price, Growth & Return Superior Logistics Ltd. had given a dividend of Rs 4.00. According to the analysts in the logistic industry the growth rate of dividend is expected to be 8% for times to come. If the market expectation of return is 14% what should be the price of the stock of Superior Logistics? Also project the price of the stock after one year and verify whether the shareholder gets return of 14%. Solution: Current dividend, D0 Growth in dividend, g Required return, r The value of the share is given by: Rs 4.00 8.00% 14.00%

Value of the Stock, P o =

D o (1 + g) r-g

Value of the common stock = 4 x (1 + 0.08) / (0.14 - 0.08) = Rs 72.00 Value of stock after one year Dividend in Year 1, D 1 = D0 (1+g) = Rs 4.32 Value of the common stock = 4.32 x (1 + 0.08) / (0.14 - 0.08) = Rs 77.76 8.00% Growth in price = (77.76 - 72.00)/72.00 = Return for the shareholder = Gain in price + dividend yield = 0.08 + 4.32/72 = 14.00%

7-2: Historical Growth & Price First Chemicals Ltd. has been consistently performing well over last 8 yeaRs The dividend has grown from Rs 1.00 per share to Rs 10 per share over last 8 yeaRs The growth is likely to be maintained in future too. The investors expect a return of 20%. What is the current market price of the share of First Chemicals. Solution: Compounded annual growth rate of dividend can be found using following equation:

(1+ g)8 =

D8 3 = =3 D1 1

g = 0.1472 = 14.72%
Current dividend, D0 Growth in dividend, g Required return, r Rs 3.00 14.72% 20.00%

Value of the common stock = 3 x (1 + 0.1472) / (0.2 - 0.1472) = Rs 65.18

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FINANCIAL MANAGEMENT 2e
Rajiv Srivastava - Dr. Anil Misra

Solutions to Numerical Problems Chapter 7

7-3: Revised Growth & Price First Chemicals Ltd. has just announced successful development of a new chemical that is expected to propel the growth to 18%. Dividend too would grow proportionately. If investor expectation remain unchanged what would be the new price of the share of First Chemicals? Solution If the growth rate is revised to 18% the new price as per DDM would be: Current dividend, D0 Rs 3.00 Growth in dividend, g 18.00% 20.00% Required return, r Value of the common stock = 3 x (1 + 0.18) / (0.2 - 0.18) = Rs 177.00

7-4: Implied Market Expectation of Return Shares of Reliance Computers are currently trading at Rs 50. The firm had given a dividend of Rs 2.50 per share last year. The growth rate of dividend has been 10% in the past which is likely to remain same. What is the expectations of return on the stock of Reliance Computers?

Solution: The return expected by the market can be arrived using DDM for stock value as below:
Value of the Stock, Po = or D o(1+ g) r-g D r-g= 1 P0 r= D1 +g P0

Current dividend, D0 Growth in dividend, g Current Market Price, P0 Expected dividend next year, D1 = D0 (1+g) = Required Return, r = D1/P0 + g = 2.75/50 + 0.10 = 15.500%

Rs 2.50 10.00% Rs 50.00 Rs 2.75

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FINANCIAL MANAGEMENT 2e
Rajiv Srivastava - Dr. Anil Misra

Solutions to Numerical Problems Chapter 7

7-5: Growth and Expected Return Stock of Modern Technologies is trading at a price of Rs 32.10. It has just given a dividend of Rs 2.40 per share. The expected return on the stock of Modern Technologies consistent with the risk of the business it is in is placed at 15%. What is the expected price of the stock of Modern Technologies three years from now? If an investor buys the stock now and sells after 3 years what return would he obtain? Confirm the calculations. Solution: The value of the stock is governed by following equation
Value of the Stock, Po = D o (1+ g) r -g 2.40(1 + g) 32.10 = 0.15 g Gives = 0.07 = 7%

With growth rate of 7% the price expected after 3 years would be P3 = P0 x (1 + g)3 = 32.10 x 1.073 = Rs 39.32 The expected return of the investor buying today and selling three years later would be 15% as can be confirmed by following cash flows Figures in Rs 0 1 2 3 Year -32.10 Buy stock 2.57 2.75 2.94 Dividend Sell Stock 39.32 Cash flow -32.10 2.57 2.75 42.26 IRR of cash flow = Return for investor = 15.00%

7-6: Multiple Growth Rate & Value A-One Computers has declared a dividend of Rs 2 per share. Due to its innovative products it is likely to register a growth in dividends at 15% for the next four yeaRs Thereafter the growth would coincide with that of industry at 6%. The investors require a return of 16% on the stocks of A-One ComputeRs What is should be the price of the stock of A-One Computers?

Solution: Current dividend Rs 2.00 Growth rate for 4 years 15% Required rate of return 16% Present value of dividends for next four years: 1 2 Year 2.65 2.30 Dividend, Rs PV at 20%, Rs 1.98 1.97 PV of Dividends from Year 1 - 4 Steady state growth rate Dividend in Year 5 = 1.06 x 3.30 Price at Year 4 using DDM, P4 PV of Price in Year 4 Price today = PV of Dividend (Year 1-4) + PV of P4

3 3.04 1.95

4 3.50 1.93 7.83 6% Rs 3.71 Rs 37.08 Rs 20.48 Rs 28.31

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FINANCIAL MANAGEMENT 2e
Rajiv Srivastava - Dr. Anil Misra

Solutions to Numerical Problems Chapter 7

7-7: Future Dividend and Growth Intel Semiconductors has been growing at the rate of 8% annually. It recently declared a dividend of Rs 4.00 per share. In order to develop a new chip it announced that henceforth no dividend would be paid for next two yeaRs The dividend in third year is expected to be Rs 5.00 and would grow at 10% per annum instead of current growth of 8%. The required rate of return by investors is 14%. What is the impact on price of the share of Intel Semiconductors?

Solution: Under the present scenario the stock price is Rs 72.00 as worked out below: Current dividend, D0 Growth in dividend, g Required return, r The value of the share is given by: Rs 4.00 8.00% 14.00%

Value of the Stock, P o =

D o (1 + g) r-g

Value of the common stock = 4 x (1 + 0.08) / (0.14 - 0.08) = Rs 72.00 After the announcement of development of new chip the next dividend pay out is in Year 3. With revised parameters of dividend and growth the price is worked out for Year 3 and then discounted back to present. Dividend in Year 3, D 3 Rs 5.00 Growth in dividend, g 10.00% Required return, r 14.00% The value of the share is given by: Value of the common stock (Year 3) = 5 x (1 + 0.1) / (0.14 - 0.1) = Rs 137.50 Value of the Stock now = 137.50/1.143 = Rs 92.81 The increase in price of the share of Intel Semiconductors is Rs 20.81due to the announcement of new chip and consequent revised dividend and its growth rate.

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FINANCIAL MANAGEMENT 2e
Rajiv Srivastava - Dr. Anil Misra

Solutions to Numerical Problems Chapter 7

7-8: Earnings and PE Multiple Apex Motors has earnings of Rs. 4 per share. These earnings have been growing at 8% for the past several years and the trend is expected to continue. The firm has been funding its requirements by retaining 40% of earnings. What is the price of the share and the PE multiple?

Solution: The dividend discount model in terms of earnings and retention ratio is
Price, P0 = D1 E x (1 b) = 1 (r g) (r g)

Current Earnings, E0 Rs 4.00 Growth Rate, g 7.50% Required Return, r 14.00% Expected Earnings, E1 Rs 4.30 Retention Ratio, b 40.00% Price = 4 x (1+ 0.075) x (1 - 0.4) / (0.14 - 0.075) = Rs 39.69 9.92 The PE multiple is = 39.69/4.00 =

7-9: Growth & PE Multiple ABC Corporation is earning Rs. 4 per share currently. These earnings are growing at the rate of 3% annually. The required rate of return is estimated at 10%. Out of the earnings the firm pays 60% as dividend. Due to closure of one of the competing firm the estimates of growth are revised to 6%. What would be the impact on the stock price and the PE multiple?

Solution: The price in terms of earnings and retention is Rs 35.67 as shown below: Current Earnings, E0 Rs 4.04 Growth Rate, g 3.00% Required Return, r 0.1 Expected Earnings, E1 Rs 4.16 Retention Ratio, b 40% Price = 4.04 x (1+ 0.03) x (1 - 0.4) / (0.1 - 0.03) = Rs 35.67 The PE multiple of ABC Corporation = P/E = 35.67/4.04 = 8.83 With revised and increased estimates of growth the PE multiple would rise. Current Earnings, E0 Rs 4.04 Growth Rate, g 6.00% Required Return, r 10% Expected Earnings, E1 Rs 4.28 Retention Ratio, b 40% Price = 4.04 x (1+ 0.06) x (1 - 0.4) / (0.1 - 0.06) = Rs 64.24 The PE multiple of ABC Corporation = P/E = 64.24/4.04 = 15.90

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