Solutions to Chapter 7 Valuing Stocks 1. No, this does not invalidate the dividend discount model.

The dividend discount model allows for the fact that firms may not currently pay dividends. As the market matures, and Amazons growth opportunities moderate, investors may justifia ly elieve that Amazon will enjoy high future earnings and will then pay dividends. The stock price today can still reflect the present value of the e!pected per share stream of dividends. #ividend yield $ #ividend%&rice $ #'(1%&) ).)* $ ".+)%&) &) $ ,-) -. The preferred stock pays a level perpetuity of dividends. The e!pected dividend ne!t year is the same as this years dividend .,*/. a. . c. ,*.))%).1" $ ,00.01 ,*.))%).1" $ ,00.01 #ividend yield $ ,*%,00.01 $ ).1" $1"2 3apital gains yield $ ) 4!pected rate of return $ 1"2 +. r $ #'(1%&) 5 g $ *2 5 62 $ 1-2 6. The value of a share of common stock e7uals the present value of dividends received out to the investment horizon, plus the present value of the forecast stock price at the horizon. 8ut the stock price at the horizon date depends on e!pectations of dividends from that date forward. 9o, even if an investor plans to hold a stock for only a year or two, the price ultimately received from another investor depends on dividends to e paid after the date of purchase. Therefore, the stocks present value is the same for investors with different time horizons. a. &) $ #'(1%.r g/ ,-) $ ,-%.r ).)+/ r $).1+ $ 1+2 . &) $ ,-%.).106 ).)+/ $ ,"+

".

0.

1:1

1.

The annual dividend is; ," + $ ,* #'(1%&) $ ).)+* ,*%&) $ ).)+* &) $ ,*%).)+* $ ,100.01

*. <.

weak, semistrong, strong, fundamental, technical The statement is correct. The search for information and insightful analysis makes investor assessments of stock values as relia le as possi le. 9ince the rewards accrue to the investors who uncover relevant information before it is reflected in stock prices, competition among these investors means that there is always an active search for mispriced stocks. The two road areas of investors ehavioral iases are in their attitudes towards risk and their assessments of pro a ilities. 'nvestors appear to e less averse to losses following su stantial gains than they are to losses that follow other losses. 3onse7uently, the early gains of the =dot:com u le> may have led investors to increase their investments in dot:com stocks, leading to the tremendous gains leading up to ?arch "))). 'n addition, psychologists elieve that investors make two mistakes in their assessment of stock market pro a ilities. @irst, when assessing the future of stock market performance, investors attach too much importance to the recent past, largely ignoring events of the more distant past. 9econd, investors suffer from overconfidence, elieving that they are etter stock pickers than they are in reality. These two iases reinforced the u le prior to ?arch "))); overconfident investors attached too much importance to their e!periences during the preceding five years.

1).

11.

a.

#'(1 $ ,1 1.)+ $ ,1.)+ #'(" $ ,1 1.)+" $ ,1.)*10 #'(- $ ,1 1.)+- $ ,1.1"+<

. c. d.

&) $ &- $

#'(1 ,1.)+ = = ,1-.)) r g ).1" ).)+ #'(+ ,1.1"+< 1.)+ = = ,1+.0"-1 r g ).1" ).)+

Aour payments will e; Aear 1 Aear " Aear #'( ,1.)+ ,1.)*10 ,1.1"+< 9elling &rice 1+.0"-1 Total 3ash @low ,1.)+ ,1.)*10 ,16.1+*0 &( of 3ash @low ,).<"*0 ,).*0"" ,11.")<6 9um of &( $ ,1-.)), the same as the answer to part . /. 1:"

1".

g $ return on e7uity plow ack ratio $ ).16 ).+) $ ).)0 $ 0.)2

+) = + + r = + ).)0 = ).10 = 10.)2 r ).)0 +)
#'(1 ,- 1.)6 = = ,-1.6) r g ).16 ).)6

1-.

a.

&) =

&) =

,- 1.)6 = ,+6 ).1" ).)6

The lower discount rate makes the present value of future dividends higher.
,6) = ,6 ,6 g = ).1+ = ).)+ = +.)2 ).1+ g ,6)

1+.

16.

a. . c.

r $ #'(1%&) 5 g $ B.,1.0+ 1.)-/%"1C 5 ).)- $ ).)<"0 $ <."02 'f r $ ).1), then; ).1) $ B.,1.0+ 1.)-/%"1C 5 g g $ ).)-1+ $ -.1+2 g $ return on e7uity plow ack ratio 62 $ return on e7uity ).+ return on e7uity $ ).1"6 $ 1".62

10. 11.

&) $ #'(1%.r g/ $ ,"%.).1" D ).)0/ $ ,--.-a. . c. &) $ #'(1%.r g/ $ ,-%B).16 D .).1)/C $ ,-%)."6 $ ,1" &1 $ #'("%.r g/ $ ,-.1 ).1)/%)."6 $ ,1).*) e!pected rate of return $
#'(1 + 3apital gain ,- + .,1).*) ,1"/ = = ).16) = 16.)2 &) ,1"

d.

E8ad companies may e declining, ut if the stock price already reflects this fact, the investor can still earn a fair rate of return, as shown in part .c/.

1:-

1*.

a.

.i/ reinvest )2 of earnings; g $ ) and #'(1 $ ,0

&) = #'(1 ,0 = = ,+).)) r g ).16 )

.ii/ reinvest +)2; g $ 162 ).+) $ 02 and #'(1 $ ,0 .1 D ).+)/ $ ,-.0)

&) = #'(1 ,-.0) = = ,+).)) r g ).16 ).)0

.iii/ reinvest 0)2; g $ 162 ).0) $ <2 and #'(1 $ ,0 .1 D ).0)/ $ ,".+)
&) = #'(1 ,".+) = = ,+).)) r g ).16 ).)<

.i/ reinvest )2; .ii/ reinvest +)2;

&) =
&) =

,0 = ,+).)) &(FG $ ,) ).16 )

,-.0) = ,61.+- ).16 .)." ).+)/

&(FG $ ,61.+- D ,+).)) $ ,11.+.iii/ reinvest 0)2;

&) = ,".+) = ,*).)) ).16 .)." ).0)/

&(FG $ ,*).)) D ,+).)) $ ,+).)) c. 'n part .a/, the return on reinvested earnings is e7ual to the discount rate. Therefore, the N&( of the firms new projects is zero, and &(FG is zero in all cases, regardless of the reinvestment rate. Hhile higher reinvestment results in higher growth rates, it does not result in a higher value of growth opportunities. This e!ample illustrates that there is a difference etween growth and growth opportunities. 'n part . /, the return on reinvested earnings is greater than the discount rate. Therefore, the N&( of the firms new projects is positive, and &(FG is positive. 'n this case, &(FG is higher when the reinvestment rate is higher ecause the firm is taking greater advantage of its opportunities to invest in positive N&( projects.
,1.)) ,1."6 ,1.6) + ,") + + = ,1*.1) " 1.1) .1.1)/ .1.1)/ -

1<.

a. .

&) =

#'(1%&) $ ,1%,1*.1) $ ).)66" $ 6.6"2

1:+

"). a. . c. &ayout ratio g $ IG4 plow ack ratio

&r ice = #'(1 r g

9tock A ,1%," $ ).6) 162 ).6 $ 1.62

9tock 8 ,1%,1.6) $ ).01 1)2 ).--- $ -.--2

,1 ,1 = ,1-.-= ,*.61 ).16 ).)16 ).16 ).)---

"1.

a. . c.

g $ IG4 plow ack ratio $ ")2 ).-) $ 02 4 $ ,-, r $ ).1" &) =

,- .1 ).-)/ = ,-6.)) ).1" ).)0

No:growth value $ 4%r $ ,-%).1" $ ,"6.)) &(FG $ &) No:growth value $ ,-6 ,"6 $ ,1)

d. e. f.

&%4 $ ,-6%,- $ 11.001 'f all earnings were paid as dividends, price would e7ual the no:growth value .,"6/ and &%4 would e; ,"6%,- $ *.--Jigh &%4 ratios reflect e!pectations of high &(FG.

"".

a. .

,".+) = ,-).)) ).1" ).)+

No:growth value $ 4%r $ ,-.1)%).1" $ ,"6.*&(FG $ &) No:growth value $ ,-) ,"6.*- $ ,+.11

"-. a.

4arnings $ #'(1 $ ,+ Frowth rate $ g $ )

&) = ,+ = ,--.-).1" )

&%4 $ ,--.--%,+ $ *.-. 'f r $ ).1) &) =

,+ = ,+).)) &%4 increases to; ,+)%,+ $ 1) ).1)

1:6

"+.

a.

&low ack ratio $ ) #'(1 $ ,+ and g $ ) Therefore; &) =

,+ = ,+).)) &%4 ratio $ ,+)%,+ $ 1) ).1) )

&low ack ratio $ ).+) #'(1 $ ,+.1 D ).+)/ $ ,".+) and g $ 1)2 ).+) $ +2 Therefore; &) =
,".+) = ,+).)) &%4 ratio $ ,+)%,+ $ 1) ).1) ).)+

c.

&low ack ratio $ ).*) #'(1 $ ,+.1 D ).*)/ $ ,).*) and g $ 1)2 ).*) $ *2 Therefore; &) =
,).*) = ,+).)) &%4 ratio $ ,+)%,+ $ 1) ).1) ).)*

Iegardless of the plow ack ratio, the stock price $ ,+) ecause all projects offer return on e7uity e7ual to the opportunity cost of capital. "6. a. . &) $ #'(1%.r g/ $ ,6%.).1) D ).)0/ $ ,1"6 'f Trendline followed a zero:plow ack strategy, it could pay a perpetual dividend of ,*. 'ts value would e; ,*%).1) $ ,*). Therefore, the value of assets in place is ,*). The remainder of its value must e due to growth opportunities, so that; &(FG $ ,1"6 D ,*) $ ,+6 "0. a. g $ ")2 ).-) $ 02 &) $ ,+.1 D ).-)/%.).1" ).)0/ $ ,+0.01 &%4 $ ,+0.01%,+ $ 11.001 . 'f the plow ack ratio is reduced to ).") g $ ")2 ).") $ +2 &) $ ,+.1 D ).")/%.).1" D ).)+/ $ ,+) &%4 $ ,+)%,+ $ 1) &%4 falls ecause the firms value of growth opportunities is now lower; 't takes less advantage of its attractive investment opportunities. c. 'f the plow ack ratio $ ) g $ ) and #'(1 $ ,+ &) $ ,+%).1" $ ,--.-- and 4%& $ ,+%,--.-- $ ).1" $ 1".)2

1:0

"1.

a.

#'(1 $ ,".)) #'(" $ ,".1.")/ $ ,".+) #'(- $ ,".1.")/" $ ,".**

&( $ ,"%1.1) $ ,1.*1* &( $ ,".+)%1.1)" $ ,1.<*&( $ ,".**%1.1)- $ ,".10+

This could not continue indefinitely. 'f it did, the stock would e worth an infinite amount. 8ook value $ ,")) million 4arnings $ ,")) million )."+ $ ,+* million #ividends $ 4arnings .1 D plow ack ratio/ $ ,+* million .1 D ).6/ $ ,"+ million g $ return on e7uity plow ack ratio $ )."+ ).6) $ ).1" $ 1".)2 ?arket value $
,"+ million = ,*)) million ).16 ).1"

"*.

a.

?arket:to: ook ratio $ ,*))%,")) $ + . Now g falls to .).1) ).6)/ $ ).)6, earnings decline to ,") million, and dividends decline to ,1) million. ?arket value $
,1) million = ,1)) million ).16 ).)6

?arket:to: ook ratio $ K This result makes sense ecause the firm now earns less than the re7uired rate of return on its investments. The project is worth less than it costs.
," ,".6) ,1* + + = ,10.6< " 1.1" .1.1"/ .1.1"/ -

"<.

&) =

-).

a. .

#'(1 $ ," 1.") $ ,".+) #'(1 $ ,".+)

&- =
&) =

#'(" $ ,".**

#'(- $ ,-.+60

,-.+60 1.)+ = ,-".016 ).16 ).)+

,".+) ,".** ,-.+60 + ,-".016 + + = ,"*.)"1 " 1.16 .1.16/ .1.16/ -

1:1

-1.

a.

&) =

,".** ,-.+60 + ,-".016 + = ,"<.*"6 1.16 .1.16/ "

3apital gain $ &1 &) $ ,"<.*"6 ,"*.)"1 $ ,1.*)+ .

r= ,".+) + ,1.*)+ = ).16)) = 16.))2 ,"*.)"1

-".

a.

An individual can do crazy things and not affect the efficiency of financial markets. An irrational person can give assets away for free or offer to pay twice the market value. Jowever, when the persons supply of assets or money runs out, the price will adjust ack to its prior level .assuming that there is no new, relevant information released y these actions/. 'f you are lucky enough to trade with such a person you will receive a positive gain at that investors e!pense. Aou had etter not count on this happening very often though. @ortunately, an efficient market protects irrational investors in cases less e!treme than the a ove. 4ven if they trade in the market in an Eirrational manner, they can e assured of getting a fair price since the price reflects all information. Aes, and how many people have dropped a undleL Gr more to the point, how many people have made a undle only to lose it laterL &eople can e lucky and some people can e very luckyM efficient markets do not preclude this possi ility. 'nvestor psychology is a slippery concept, more often than not used to e!plain price movements that the individual invoking it cannot personally e!plain. 4ven if it e!ists, is there any way to make money from itL 'f investor psychology drives up the price one day, will it do so the ne!t day alsoL Gr will the price drop to a Etrue levelL Almost no one can tell you eforehand what Einvestor psychology will do. Theories ased on it have no content.

c.

--.

'nvestments in financial markets, such as stocks or onds, are availa le to all participants in the marketplace. As a result, the prices of these investments are id up to Efair levels, that is, prices which reflect the present value of e!pected cash flows. 'f the investment werent zero:N&(, investors would uy or sell the asset and there y put pressure on its price until the investment ecomes a zero:N&( prospect. 'n contrast, investments in product markets are made y firms with various forms of protection from full competition. 9uch protection comes from specialized knowledge, name recognition and customer loyalty, and patent protection. 'n these cases, a project may e positive N&( for one firm with the know:how to make it work, ut not positive N&( for other firms. Gr a project may e positive N&(, ut only availa le to one firm ecause it owns a name rand or patent. 'n these cases, competitors are kept out of the market, and the costs of the firms investment opportunities are not id to levels at which N&( is reduced to zero. 1:*

-+.

There are several thousand mutual funds in the Nnited 9tates. Hith so many professional managers, it is no surprise that some managers will demonstrate rilliant performance over various periods of time. As an analogy, consider a contest in which 1),))) people flip a coin ") times. 't would not surprise you if someone managed to flip heads 1* out of ") times. 8ut it would e surprising if he could repeat that performance. 9imilarly, while many investors have shown e!cellent performance over relatively short time horizons, and have received favora le pu licity for their work, far fewer have demonstrated consistency over long periods. 'f the firm is sta le and well run, its price will reflect this information, and the stock may not e a argain. There is a difference etween a Egood company and a Egood stock. The est uys in the stock market are not necessarily the est firmsM instead, you want to identify firms that are better than anyone else realizes. Hhen the market catches up to your assessment and prices adjust, you will profit. Iemem er the first lesson of market efficiency; The market has no memory. Oust ecause long:term interest rates are high relative to past levels does not mean they wont go higher still. Nnless you have special information indicating that long:term rates are too high, issuing long:term onds should e a zero:N&( transaction. 'ssuing short:term de t or common stock should also e a zero:N&( transaction. The stock price will decrease. The original price reflects an anticipation of a "62 increase in earnings. The actual increase is a disappointment compared to original e!pectations. 't seems that ehavioral finance might e!plain anomalies such as the earnings announcement puzzle and the new:issue puzzle. @or e!ample, we e!pect that the announcement of une!pectedly good earnings would initially generate a positive reaction. Jowever, the fact that the announced higher earnings figure is Eune!pected indicates that perhaps investors had een accustomed to lower earnings in the recent past, so that investors under:react initially, out of e!cessive concern a out the risk of loss and also giving too much weight to the lower earnings of the recent past. Jowever, the initial increase in price, coupled with investors attitudes towards risk and their tendency to e overconfident, would produce additional stock price increases in the future.
,".6) ,".6) = ).1) = 1).)2 g = ).16 ).16 g ,6)

-6.

-0.

-1.

-*.

-<.

,6) =

g $ ).1) $ return on e7uity plow ack ratio $ return on e7uity ).0) return on e7uity $ ).1)%).0) $ ).1001 $ 10.012

1:<

+).

a.

&) =

#'(1 #'(" + &" + 1+ r .1 + r / "

#'(1 $ ," #'(" $ ,+

&" =
&) =

#'(" .1 + g / ,+ 1.)6 = = ,0).)) r g ).1" ).)6

," ,+ + ,0) + = ,6".*)0 1.1" .1.1"/ "

Ne!t year; &1 =

#'(" ,+ = = ,61.1+).1" ).)6 ).)1

c.

r=
r=

#'(1 + .&1 &) / ," + .,61.1+- ,6".*)0/ = = ).1")) = 1".))2 &) ,6".*)0
," ,61.1+- ,6".*)0 + = ).1")) ,6".*)0 ,6".*)0

+1.

#'(1 $ ,1 #'(" $ ," #'(- $ ,g $ ).)0 &- $ .,- 1.)0/%.).1+ D ).)0/ $ ,-<.16
&) = ,1 ," ,- + ,-<.16 + + = ,-1."1 " 1.1+ .1.1+/ .1.1+/ -

+". a.

#'(1 $ ,+ and g $ +2 4!pected return $ .#'(1%&)/ 5 g $ .,+%,1))/ 5 +2 $ *2

#'(1 $ 4arnings .1 D plow ack ratio/ Therefore; 4arnings $ #'(1%.1 D plow ack ratio/ $ ,+%.1 D ).+/ $ ,0.0001 'f the discount rate is *2 .the e!pected return on the stock/, then the no:growth value of the stock is; ,0.0001%).)* $ ,*-.-Therefore; &(FG $,1)) D ,*-.-- $ ,10.01

1:1)

c.

@or the first 6 years; g $ 1)2 ).* $ *2 Thereafter; g $ 1)2 ).+ $ +2 Aear 4arnings plow ack #'( g 1 ,0.01 ).*) ,1.-).)* " ,1.") ).*) ,1.++ ).)* ,1.1* ).*) ,1.60 ).)* + ,*.+) ).*) ,1.0* ).)* 6 ,<.)1 ).*) ,1.*1 ).)* 0 ,<.*) ).+) ,6.** ).)+

After year 0, the plow ack ratio falls to ).+) and the growth rate falls to + percent. BHe assume g $ *2 in year 6 .i.e., from t $ 6 to t $ 0/ ecause the plow ack ratio in year 6 is still high at $ ).*). Notice the large jump in the dividends when the plow ack ratio falls.C 8y year 0, the firm enters a steady:growth phase, and the constant:growth dividend discount model can e used to value the stock. The stock price in year 0 will e;
&0 = # 0 .1 + g / ,6.** 1.)+ = = ,16".** k g ).)* ).)+
,1.-,1.++ ,1.60 ,1.0* ,1.*1 ,6.** + ,16".** + + + + + = ,1)0."" " + 6 1.)* .1.)*/ .1.)*/ .1.)*/ .1.)*/ .1.)*/ 0

&) =

+-.

a.

#'(1 $ 1.)) 1.") $ ,1.") #'(" $ 1.)) .1.")/" $ ,1.++ #'(- $ 1.)) .1.")/- $ ,1.1"* #'(+ $ 1.)) .1.")/+ $ ,".)1-0

&+ $ #'(6%.r g/ $ B#'(+ .1 5 g/C%.r g/ $ .,".)1-0 1.)6/%.).1) D ).)6/ $ ,+-.6+60

c. d.

&) =

,1.") ,1.++ ,1.1"* ,".)1-0 + ,+-.6+60 + + + = ,-+.1-* " 1.1) .1.1)/ .1.1)/ .1.1)/ +

#'(1%&) $ ,1.")%,-+.1-* $ ).)-+6 $ -.+62

1:11

e.

Ne!t year the price will e;

&1 = ,1.++ ,1.1"* ,".)1-0 + ,+-.6+60 + + = ,-1.)1" 1.1) .1.1)/ " .1.1)/ -

f.

r=

#'(1 + 3apital Fain ,1.") + .,-1.)1" ,-+.1-*/ = = ).1))) = 1).))2 &) ,-+.1-*

The e!pected return e7uals the discount rate .as it should if the stock is fairly priced/. ++. a, . &+ $ #'(6%.r g/ $ B#'(+ .1 5 g/C%.r g/ $ .,".)1-0 1.)0/%.).1) D ).)0/ $ ,6+.<6
P) = ,1.") ,1.++ ,1.1"* ,".)1-0 + ,6+.<6 + + + = ,+".6" 1.1) .1.1)/ .1.1)/ .1.1)/ +

9ustaina le Frowth Iate 6.))2 0.))2 0.6)2 1.))2 1.6)2 *.))2 *.6)2 <.))2 c.

'ntrinsic (alue .&(/ -+.1+ +".6+*.)< 66.61 06.<) *1.+* 1)1.++ 16<.-1

2 change in &( "".+"2 1-.)*2 16.+-2 1*.112 "-.0+2 -1.*12 +*.--2

The percentage change in the value of the firm increases at a faster rate with each 1 percent increase in the assumed final growth rate, g. The intrinsic value is more sensitivity to changes in g as the sustaina le growth rate approaches the discount rate. The dividend growth model is less relia le as the sustaina le growth rate approaches the discount rate.

+6.

Two important points in the discussion of the yield curve .in 9ection 0.6/ are; first, the yield curve is usually upward sloping .i.e., yields tend to e higher for longer maturity onds/ and, second, an upward sloping yield curve often indicates that future interest rates are e!pected to increase. The relatively unusual case of a downward sloping yield curve often indicates that future interest rates are e!pected to decrease.

1:1"

Solution to Minicase for Chapter 7 The goal is to value the company under oth investment plans and to choose the etter investment plan. The discount rate is the 112 that investors elieve they can earn on similar:risk investments, not the 162 return on ook e7uity. Ieturn on e7uity is useful, however, for computing the growth rate of dividends under the rapid growth scenario. 9tarting in ")1-, in the rapid growth scenario, two:thirds of earnings will e paid out as dividends, and one:third will e reinvested. Therefore, the sustaina le growth rate as of ")1- is; return on e7uity plow ack ratio $ 162 1%- $ 62 (aluation ased on past growth scenario; The firm has een growing at 62 per year. #ividends are proportional to ook value and have grown at 62 annually. #ividends paid in the most recent year .")1"/ were ,1.1 million and are projected to e ,* million ne!t year, in ")1-. The value of the firm is therefore;
(alue ")1) = #'(")11 ,* million = = ,1--.-- million r g ).11 : ).)6

The value per share is; ,1--.-- million%+)),))) $ ,---.-Therefore, it is clear that ?r. 8reezeway was correct in advising his relative not to sell for ook value of ,")) per share. (aluation ased on rapid growth scenario 'f the firm reinvests all income for the ne!t five years .until ")11/, dividends paid in that year will reach ,1+ million, far greater than in the constant growth scenario. Jowever, shareholders will have to give up dividend payments until ")11 in order to achieve this rapid growth. The value of the firm in ")11 will e;
(alue ")16 = #'(")10 ,1+.1 million = = ,"+6 million r g ).11 : ).)6

The value of the firm as of the year ")1" is the present value of this amount plus the present value of the dividend to e paid in ")11, which is projected to e ,1+ million. .Iemem er, there will e no dividend flows in the years leading up to ")11./
(alue ")1) = 1+ + "+6 = ,16-.1) million 1.116

(alue per share is; ,16-.1) million%+)),))) $ ,-*+."6 Thus, it appears that the rapid growth plan is in fact prefera le. 'f the firm follows this plan, it will e a le to go pu lic P that is, sell its shares to the pu lic P at a higher price.

1:1-