CHAPTER 8

STOCK VALUATION
Answers to Concepts Review and Critical Thinking Questions
1. The value of any investment depends on the present value of its cash flows; i.e., what
investors will actually receive. The cash flows from a share of stock are the dividends.
2. Investors believe the company will eventually start paying dividends (or be sold to another
company).
3. In general, companies that need the cash will often forgo dividends since dividends are a
cash expense. oung, growing companies with profitable investment opportunities are one
example; another example is a company in financial distress. This !uestion is examined in
depth in a later chapter.
4. The general method for valuing a share of stock is to find the present value of all
expected future dividends. The dividend growth model presented in the text is only
valid (i) if dividends are expected to occur forever, that is, the stock provides
dividends in perpetuity, and (ii) if a constant growth rate of dividends occurs forever.
" violation of the first assumption might be a company that is expected to cease
operations and dissolve itself some finite number of years from now. The stock of
such a company would be valued by applying the general method of valuation
explained in this chapter. " violation of the second assumption might be a start#up
firm that isn$t currently paying any dividends, but is expected to eventually start
making dividend payments some number of years from now. This stock would also
be valued by the general dividend valuation method explained in this chapter.
5. The common stock probably has a higher price because the dividend can grow, whereas it is
fixed on the preferred. %owever, the preferred is less risky because of the dividend and
li!uidation preference, so it is possible the preferred could be worth more, depending on the
circumstances.
6. The two components are the dividend yield and the capital gains yield. &or most companies,
the capital gains yield is larger. This is easy to see for companies that pay no dividends. &or
companies that do pay dividends, the dividend yields are rarely over five percent and are
often much less.
. es. If the dividend grows at a steady rate, so does the stock price. In other words, the
dividend growth rate and the capital gains yield are the same.
!. In a corporate election, you can buy votes (by buying shares), so money can be used to
influence or even determine the outcome. 'any would argue the same is true in political
elections, but, in principle at least, no one has more than one vote.
". It wouldn$t seem to be. Investors who don$t like the voting features of a particular class of
stock are under no obligation to buy it.
1#. Investors buy such stock because they want it, recogni(ing that the shares have no voting
power. )resumably, investors pay a little less for such shares than they would otherwise.
11. )resumably, the current stock value reflects the risk, timing and magnitude of all future cash
flows, both short#term and long#term. If this is correct, then the statement is false.
12. If this assumption is violated, the two#stage dividend growth model is not valid. In other
words, the price calculated will not be correct. *epending on the stock, it may be more
reasonable to assume that the dividends fall from the high growth rate to the low perpetual
growth rate over a period of years, rather than in one year.
$olutions to Questions and %ro&le's
NOTE: All end of chapter problems were solved using a spreadsheet. Many problems
require multiple steps. ue to space and readability constraints! when these intermediate
steps are included in this solutions manual! rounding may appear to have occurred.
"owever! the final answer for each problem is found without rounding during any step in
the problem.
#asic
1. The constant dividend growth model is+
)
t
, *
t
- (. / g) 0 ($ 1 g)
2o the price of the stock today is+
)
3
, *
3

(. / g) 0 ($ 1 g) , 4..56 (..37) 0 (... 1 .37) , 48..98
The dividend at year 8 is the dividend today times the &:I& for the growth rate in
dividends and four years, so+
)
9
, *
9

(. / g) 0 ($ 1 g) , *
3

(. / g)
8

0 ($ 1 g) , 4..56 (..37)
8

0 (... 1 .37) , 485.;8
<e can do the same thing to find the dividend in ear .7, which gives us the price in
ear .6, so+
)
.6
, *
.6

(. / g) 0 ($ 1 g) , *
3

(. / g)
.7

0 ($ 1 g) , 4..56 (..37)
.7

0 (... 1 .37) ,
455.3=
There is another feature of the constant dividend growth model+ The stock price
grows at the dividend growth rate. 2o, if we know the stock price today, we can find
the future value for any time in the future we want to calculate the stock price. In this
problem, we want to know the stock price in three years, and we have already
calculated the stock price today. The stock price in three years will be+
)
9
, )
3
(. / g)
9
, 48..98(. / .37)
9
, 485.;8
"nd the stock price in .6 years will be+
)
.6
, )
3
(. / g)
.6
, 48..98(. / .37)
.6
, 455.3=
2. <e need to find the re!uired return of the stock. >sing the constant growth model,
we can solve the e!uation for $. *oing so, we find+
$ , (*
.
0 )
3
) / g , (4;..3 0 48?.33) / .36 , .359? or 5.9?@
3. The dividend yield is the dividend next year divided by the current price, so the
dividend yield is+
*ividend yield , *
.
0 )
3
, 4;..3 0 48?.33 , .389? or 8.9?@
The capital gains yield, or percentage increase in the stock price, is the same as the
dividend growth rate, so+
Aapital gains yield , 6@
4. >sing the constant growth model, we find the price of the stock today is+
)
3
, *
.
0 ($ 1 g) , 49.38 0 (... 1 .39?) , 48;.;;
5. The re!uired return of a stock is made up of two parts+ The dividend yield and the
capital gains yield. 2o, the re!uired return of this stock is+
$ , *ividend yield / Aapital gains yield , .379 / .36; , ...63 or ...63@
6. <e know the stock has a re!uired return of .. percent, and the dividend and capital
gains yield are e!ual, so+
*ividend yield , .0;(...) , .366 , Aapital gains yield
Bow we know both the dividend yield and capital gains yield. The dividend is
simply the stock price times the dividend yield, so+
*
.
, .366(48=) , 4;.65
This is the dividend next year. The !uestion asks for the dividend this year. >sing the
relationship between the dividend this year and the dividend next year+
*
.
, *
3
(. / g)
<e can solve for the dividend that was Cust paid+
4;.65 , *
3
(. / .366)
*
3
, 4;.65 0 ..366 , 4;.86
. The price of any financial instrument is the ): of the future cash flows. The future
dividends of this stock are an annuity for .. years, so the price of the stock is the
):", which will be+
)
3
, 45.=6():I&"
.3@,..
) , 479.99
!. The price a share of preferred stock is the dividend divided by the re!uired return.
This is the same e!uation as the constant growth model, with a dividend growth rate
of (ero percent. Demember, most preferred stock pays a fixed dividend, so the
growth rate is (ero. >sing this e!uation, we find the price per share of the preferred
stock is+
$ , *0)
3
, 46.6304.3? , .3635 or 6.35@
". <e can use the constant dividend growth model, which is+
)
t
, *
t
- (. / g) 0 ($ 1 g)
2o the price of each company$s stock today is+
Ded stock price , 4;.96 0 (.3? 1 .36) , 4=?.99
ellow stock price , 4;.96 0 (... 1 .36) , 495..=
Elue stock price , 4;.96 0 (..8 1 .36) , 4;7...
"s the re!uired return increases, the stock price decreases. This is a function of the
time value of money+ " higher discount rate decreases the present value of cash
flows. It is also important to note that relatively small changes in the re!uired return
can have a dramatic impact on the stock price.
%ntermediate
1#. This stock has a constant growth rate of dividends, but the re!uired return changes
twice. To find the value of the stock today, we will begin by finding the price of the
stock at ear 7, when both the dividend growth rate and the re!uired return are stable
forever. The price of the stock in ear 7 will be the dividend in ear =, divided by the
re!uired return minus the growth rate in dividends. 2o+
)
7
, *
7

(. / g) 0 ($ 1 g) , *
3

(. / g)
=

0 ($ 1 g) , 49.63 (..36)
=

0 (..3 1 .36) , 45?.63
Bow we can find the price of the stock in ear 9. <e need to find the price here since
the re!uired return changes at that time. The price of the stock in ear 9 is the ): of
the dividends in ears 8, 6, and 7, plus the ): of the stock price in ear 7. The price
of the stock in ear 9 is+
)
9

, 49.63(..36)
8

0 ...; / 49.63(..36)
6

0 ...;
;
/ 49.63(..36)
7

0 ...;
9
/ 45?.63 0 ...;
9

)
9
, 4?3.?.
&inally, we can find the price of the stock today. The price today will be the ): of
the dividends in ears ., ;, and 9, plus the ): of the stock in ear 9. The price of the
stock today is+
)
3
, 49.63(..36) 0 ...8 / 49.63(..36)
;
0 (...8)
;
/ 49.63(..36)
9
0 (...8)
9
/ 4?3.?. 0
(...8)
9

)
3
, 479.8=
11. %ere we have a stock that pays no dividends for .3 years. Fnce the stock begins
paying dividends, it will have a constant growth rate of dividends. <e can use the
constant growth model at that point. It is important to remember that general
constant dividend growth formula is+
)
t
, G*
t
- (. / g)H 0 ($ 1 g)
This means that since we will use the dividend in ear .3, we will be finding the
stock price in ear 5. The dividend growth model is similar to the ):" and the ): of
a perpetuity+ The e!uation gives you the ): one period before the first payment. 2o,
the price of the stock in ear 5 will be+
)
5
, *
.3

0 ($ 1 g) , 4.3.33 0 (..8 1 .36) , 4......
The price of the stock today is simply the ): of the stock price in the future. <e
simply discount the future stock price at the re!uired return. The price of the stock
today will be+
)
3
, 4...... 0 ...8
5
, 498..=
12. The price of a stock is the ): of the future dividends. This stock is paying four
dividends, so the price of the stock is the ): of these dividends using the re!uired
return. The price of the stock is+
)
3
, 4.3 0 .... / 4.8 0 ....
;
/ 4.? 0 ....
9
/ 4;; 0 ....
8
/ 4;7 0 ....
6
, 479.86
13. <ith supernormal dividends, we find the price of the stock when the dividends level
off at a constant growth rate, and then find the ): of the future stock price, plus the
): of all dividends during the supernormal growth period. The stock begins constant
growth in ear 8, so we can find the price of the stock in ear 8, at the beginning of
the constant dividend growth, as+
)
8
, *
8

(. / g) 0 ($ 1 g) , 4;.33(..36) 0 (..; 1 .36) , 493.33
The price of the stock today is the ): of the first four dividends, plus the ): of the
ear 9 stock price. 2o, the price of the stock today will be+
)
3
, 4...33 0 .... / 4?.33 0 ....
;
/ 46.33 0 ....
9
/ 4;.33 0 ....
8
/ 493.33 0 ....
8
,
483.35
14. <ith supernormal dividends, we find the price of the stock when the dividends level
off at a constant growth rate, and then find the ): of the futures stock price, plus the
): of all dividends during the supernormal growth period. The stock begins constant
growth in ear 8, so we can find the price of the stock in ear 9, one year before the
constant dividend growth begins as+
)
9
, *
9

(. / g) 0 ($ 1 g) , *
3

(. / g
&
)
9

(. / g
'
) 0 ($ 1 g)
)
9
, 4..?3(..93)
9
(..37) 0 (..9 1 .37)
)
9
, 465.??
The price of the stock today is the ): of the first three dividends, plus the ): of the
ear 9 stock price. The price of the stock today will be+
)
3
, 4..?3(..93) 0 ...9 / 4..?3(..93)
;

0 ...9
;
/ 4..?3(..93)
9

0 ...9
9
/ 465.?? 0 ...9
9

)
3
, 48?.=3
<e could also use the two#stage dividend growth model for this problem, which is+
)
3
, G*
3
(. / g
.
)0(D 1 g
.
)HI. 1 G(. / g
.
)0(. / D)H
T
J/ G(. / g
.
)0(. / D)H
T
G*
3
(. / g
.
)0(D 1
g
.
)H
)
3
( G4..?3(..93)0(..9 1 .93)HG. 1 (..930...9)
9
H / G(. / .93)0(. / ..9)H
9
G4..?3(..37)0
(..9 1 .37)H
)
3
( 48?.=3
15. %ere we need to find the dividend next year for a stock experiencing supernormal
growth. <e know the stock price, the dividend growth rates, and the re!uired return,
but not the dividend. &irst, we need to reali(e that the dividend in ear 9 is the
current dividend times the &:I&. The dividend in ear 9 will be+
*
9
, *
3

(..;6)
9

"nd the dividend in ear 8 will be the dividend in ear 9 times one plus the growth
rate, or+
*
8
, *
3

(..;6)
9

(...6)
The stock begins constant growth in ear 8, so we can find the price of the stock in
ear 8 as the dividend in ear 6, divided by the re!uired return minus the growth
rate. The e!uation for the price of the stock in ear 8 is+
)
8
, *
8

(. / g) 0 ($ 1 g)
Bow we can substitute the previous dividend in ear 8 into this e!uation as follows+
)
8
, *
3

(. / g
&
)
9

(. / g
'
) (. / g
(
) 0 ($ 1 g)
)
8
, *
3

(..;6)
9

(...6) (..3?) 0 (..9 1 .3?) , 8?.6;*
3

<hen we solve this e!uation, we find that the stock price in ear 8 is 8?.6; times as
large as the dividend today. Bow we need to find the e!uation for the stock price
today. The stock price today is the ): of the dividends in ears ., ;, 9, and 8, plus
the ): of the ear 8 price. 2o+
)
3
, *
3
(..;6)0...9 / *
3
(..;6)
;
0...9
;
/ *
3
(..;6)
9
0...9
9
/ *
3
(..;6)
9
(...6)0...9
8
/
8?.6;*
3
0...9
8
<e can factor out *
3
in the e!uation, and combine the last two terms. *oing so, we
get+
)
3
, 4=7 , *
3
I..;60...9 / ..;6
;
0...9
;
/ ..;6
9
0...9
9
/ G(..;6)
9
(...6) / 8?.6;H 0 ...9
8
J
Deducing the e!uation even further by solving all of the terms in the braces, we get+
4=7 , 498.=5*
3
*
3
, 4=7 0 498.=5
*
3
, 4;..?
This is the dividend today, so the proCected dividend for the next year will be+
*
.
, 4;..?(..;6)
*
.
, 4;.=9