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Chapter7

StockValuation
Instructors Resources
Overview
ThischaptercontinuesonthevaluationprocessintroducedinChapter6forbonds.Modelsforvaluing
preferredandcommonstockarepresented.Forcommonstock,thezerogrowth,constantgrowth,and
variablegrowthmodelsareexamined.Therelationshipbetweenstockvaluationandefficientmarketsis
presented.Theroleofventurecapitalistsandinvestmentbankersisalsodiscussed.Thefreecashflow
modelisexplainedandcomparedwiththedividenddiscountmodels.Otherapproachestocommonstock
valuationandtheirshortcomingsareexplained.Thechapterendswithadiscussionoftheinterrelationship
betweenfinancialdecisions,expectedreturn,risk,andafirmsvalue.Stockvaluationfromtheperspective
oftheonesprofessionallifeiscontrastedwithstockvaluationfromapersonalperspective.

Suggested Answer to Opener in Review Question


A123shareswereoriginallyofferedforsaleatapriceof$13.50.Threemonthslater,thestock
tradedforabout$18.Whatreturndidinvestorsearnoverthisperiod?OnNovember10,2009,A123
reported3rdquarterfinancialresults.FromNovember9toNovember11,thefirmsstockpricefell
from$17.85to$16.88.GiventhatA123has102millionsharesoutstanding,whatwerethedollarand
percentagelossesthatshareholdersenduredinthedayssurroundingtheearningsrelease?Overthe
samethreedays(November911),theNasdaqstockindexmovedup0.6%.Howdoesthisinfluence
yourthinkingaboutA123sstockperformancearoundthistime?
Thestockpricerose33.33percent[(($18$13.50)/$13.50)1]fromtheofferingpriceto$18.00.From
November911,A123sharesfellby$0.97($17.85$16.88)pershare,or$98,94million($0.97102
millionshares).Inpercentagetermsthelosswas5.43percent($0.97/$17.85).Giventhataninvestor
couldhaveearned0.6%onadiversifiedportfolioofNasdaqshares,onecanconcludethatA123shares
underperformedthemarketbyabout6percent(5.43%0.6%).Thismarketwasobviouslydissatisfied
withtheimplicationsofA123s3rdquarterfinancialresults.

Answers to Review Questions

Chapter7StockValuation125

1. Equitycapitalispermanentcapitalrepresentingownership,whiledebtcapitalrepresentsaloanthat
mustberepaidatsomefuturedate.Theholdersofequitycapitalreceiveaclaimontheincomeand
assetsofthefirmthatissecondarytotheclaimsofthefirmscreditors.Suppliersofdebtmust
receiveallinterestowedpriortoanydistributiontoequityholders,andinliquidationallunpaiddebts
mustbesatisfiedpriortoanydistributiontothefirmsowners.Equitycapitalisperpetualwhiledebt
hasaspecifiedmaturitydate.Couponpayments,theinterestpaymentondebt,arecurrentlytaxedas
ordinaryincome,whiledividendsarecurrentlytaxedatalowerrate.Tothecorporation,debtinterest
isataxdeductibleexpensewhiledividendsarenot.
2. Commonstockholdersarethetrueownersofthefirm,sincetheyinvestinthefirmonlyuponthe
expectationoffuturereturns.Theyarenotguaranteedanyreturn,butmerelygetwhatisleftover
afteralltheotherclaimshavebeensatisfied.Sincethecommonstockholdersreceiveonlywhatis
leftoverafterallotherclaimsaresatisfied,theyareplacedinaquiteuncertainorriskypositionwith
respecttoreturnsoninvestedcapital.Asaresultofthisriskyposition,theyexpecttobecompensated
intermsofbothdividendsandcapitalgainsofsufficientquantitytojustifytherisktheytake.
3. Rightsofferingsprotectagainstdilutionofownershipbyallowingexistingstockholderstopurchase
additionalsharesofanynewstockissues.Withoutthisprotectioncurrentshareholdersmayhavetheir
votingpowerreduced.Rightsarefinancialinstrumentsissuedtocurrentstockholdersthatpermit
thesestockholderstopurchaseadditionalsharesatapricebelowthemarketprice,indirectproportion
totheirnumberofownedshares.
4. Authorizedsharesarestatedinthecompanyscorporatecharterthatspecifiesthemaximum
numberofsharesthefirmcansellwithoutreceivingapprovalfromtheshareholders.
Whenauthorizedsharesaresoldtothepublicandareinthehandsofthepublic,theyarecalled
outstandingshares.
Whenafirmpurchasesbackitsownsharesfromthepublic,theyareclassifiedastreasurystock.
Treasurystockisnotconsideredoutstandingsinceitisnotinthehandsofthepublic.
Issuedsharesarethesharesofcommonstockthathavebeenputintocirculation.Issuedshares
includebothoutstandingsharesandtreasurystock.
5. Issuingstockoutsideoftheirhomemarketscanbenefitcorporationsbybroadeningtheinvestorbase
andalsoallowingthemtobecomebetterintegratedintothelocalbusinessscene.Alocalstocklisting
bothincreaseslocalpresscoverageandservesaseffectivecorporateadvertising.Locallytradedstock
canalsobeusedtomakecorporateacquisitions.
Americandepositoryreceipts(ADRs)representownershipofsharesofaforeigncompanysstock
heldondepositbytheU.S.bankinthecompanieshomecountry.ADRsareissuedindollarsbyan
AmericanbanktoU.S.investorsandaresubjecttoU.S.securitieslaws,yetstillgiveinvestorsthe
opportunitytointernationallydiversifytheirportfolios.Americandepositoryshares(ADSs)arethe
actualsecuritiesthataretradedinU.S.marketsthatrepresentforeigncompanies.ADRsarebacked
upbyADSs.
6. Theclaimsofpreferredstockholdersareseniortothoseofthecommonstockholderswithrespectto
thedistributionofbothearningsandassets.
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Chapter7StockValuation126

7. Cumulativepreferredstockgivestheholdertherighttoreceiveanydividendsinarrearspriortothe
paymentofdividendstocommonstockholders.
Thecallfeatureinapreferredstockissueallowstheissuertoretireoutstandingpreferredstock
withinacertainperiodoftimeataprespecifiedprice.Thisfeatureisnotusuallyexercisableuntila
fewyearsafterissuance.Thecallnormallytakesplaceatapriceabovetheinitialissuancepriceand
maydecreaseaccordingtoapredefinedschedule.Thecallfeatureallowstheissuertoescapethe
fixedpaymentcommitmentofthepreferredstockthatwouldremainonthebooksindefinitely.
Thecallfeatureisalsoneededinordertoforceconversionofconvertiblepreferredstock.
8. Venturecapitalists(VC)aretypicallybusinessentitiesthatareorganizedforthepurposeofinvesting
inattractivegrowthcompanies.Angelcapitalistsaregenerallywealthyindividualswhoprovide
privatefinancingtonewbusinesses.Firmsusuallyobtainangelfinancingfirst,thenastheirfunding
needsgettoolargeforindividualinvestorstheyseekfundsfromventurecapitalists.
9. Therearefourwaysinwhichinstitutionalventurecapitalistsaremostcommonlyorganized.
Smallbusinessinvestmentcompanies(SBICs)arecorporationscharteredbythefederal
government.
FinancialVCfundsaresubsidiariesoffinancialinstitutions,particularlybanks.
CorporateVCfundsarefirms,sometimessubsidiaries,establishedbynonfinancialfirms.
VClimitedpartnershipsarelimitedpartnershipsorganizedbyprofessionalVCfirms,whoserve
asgeneralpartner.
VCinvestmentsaremadeunderalegalcontractthatclearlyallocatesresponsibilitiesandownership
interestbetweenexistingownersandtheVCfundorlimitedpartnership.Thespecificfinancialterms
willdependonfactorssuchasthebusinessstructure,stageofdevelopment,andoutlook.Although
eachVCinvestmentisunique,thetransactionwillbestructuredtoprovidetheVCwithahighrate
ofreturnthatisconsistentwiththetypicallyhighriskofsuchtransactions.
10. ThegeneralstepsthataprivatefirmmustgothroughtogopublicviaanIPOarelistedbelow.
Thefirmmustobtaintheapprovalofitscurrentshareholders.
Thecompanysauditorsandlawyersmustcertifythatalldocumentsforthecompanyare
legitimate.
Thefirmthenfindsaninvestmentbankwillingtounderwritetheoffering.
Aregistrationstatementmustthenbefiledwiththesecuritiesexchangecommission(SEC).
OncetheregistrationstatementisapprovedbytheSECtheinvestmentpubliccanbeginanalyzing
thecompanysprospects.
11. Theinvestmentbankers(IB)mainactivityistounderwritetheissue.Inadditiontounderwritingthe
IBprovidestheissuerwithadviceaboutpricingandotherimportantaspectsoftheissue.
TheIBmayorganizeanunderwritingsyndicatetohelpunderwritetheissueandthustosharepart
oftherisk.TheIBandthesyndicatewillputtogetherasellinggroupwhosharetheresponsibilityof
sellingaportionoftheissue.

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12. Theefficientmarkethypothesissaysthatinanefficientmarket,investorswouldbuyanassetifthe
expectedreturnexceedsthecurrentreturn,therebyincreasingitsprice(marketvalue)anddecreasing
theexpectedreturn,untilexpectedandrequiredreturnsareequal.
13. Accordingtotheefficientmarkethypothesis:
a.

Securitiespricesareinequilibrium(fairlypricedwithexpectedreturnsequaltorequiredreturns);

b. Securitiespricesfullyreflectallpublicinformationavailableandwillreactquicklytonew
information;and
c.

Investorsshouldthereforenotwastetimesearchingformispriced(overorundervalued)
securities.

Theefficientmarkethypothesisisgenerallyacceptedasbeingreasonableforsecuritiestradedon
majorexchanges;thisissupportedbyresearchonthesubject.Thereisanincreasingchallengetothe
efficientmarkethypothesisbeingofferedbythestudyofbehaviorfinance.Thechallengecomes
primarilyfromthefactthattestsoftheefficientmarkethypothesisassumesthatinvestorsare
completelyrational.Agoingbodyofresearchdisputesthisrationalityassumptionandshowsthat
investorsaredrivenbytheirrationalbehaviorsofgreed,fear,andotheremotions.

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Chapter7StockValuation128

14. a.

Thezerogrowthmodelofcommonstockvaluationassumesaconstant,nongrowingdividend
stream.Thestockisvaluedasaperpetuityanddiscountedataraters:
P0 D rs

b. Theconstantgrowthmodelofcommonstockvaluation,alsocalledtheGordonmodel,assumes
thatdividendswillgrowataconstantrate,g.ThestockisvaluedasthePVoftheconstantly
growingcashflowstream:
P0
c.

D1
rs g

Thevariablegrowthmodelofcommonstockvaluationassumesthatdividendsgrowatavariable
rate.ThestockwithasingleshiftinthegrowthrateisvaluedasthePVofthedividendstream
duringtheinitialgrowthphaseplusthePVofthepriceofstockattheendoftheinitialgrowth
phase:
N

P0
t 1

D0 (1 g1 )t
1

N 1
t
N
(1 rs )
(rs g2 )
(1 rs )

15. ThefreecashflowvaluationmodeltakesthePVofallfuturefreecashflows.SincethisPVrepresents
thetotalvalueofthefirmthevalueofdebtandpreferredstockmustbesubtractedtogetthefreecash
flowavailabletostockholders.Dividingtheresultingvaluebythenumberofsharesoutstanding
arrivesatthestockprice.
Thefreecashflowmodeldiffersfromthedividendvaluationmodelintwomainways.
a.

Thetotalcashflowsofthecompanyareevaluated,notjustdividends.

b. Thefirmscostofcapitalisusedasthediscountrate,nottherequiredreturnonstock.
16. a.

Bookvalueisthevalueofthestockintheeventallassetsareliquidatedfortheirbookvalueand
theproceedsremainingafterpayingallliabilitiesaredividedamongthecommonstockholders.

b. Liquidationvalueistheactualamounteachcommonstockholderwouldexpecttoreceiveifthe
firmsassetsaresold,creditorsandpreferredstockholdersarepaid,andanyremainingmoneyis
dividedamongthecommonstockholders.
c.

Priceearningsmultiplesareanotherwaytoestimatecommonstockvalue.Thesharevalueis
estimatedbymultiplyingexpectedearningspersharebytheaverageprice/earningsratiofor
theindustry.

Boththebookvalueandliquidationvalueapproachesignoretheearningpowerofafirmsassetsand
lackarelationshiptothefirmsvalueinthemarketplace.Theprice/earningsmultiplesapproachis
consideredthebestapproachtovaluationsinceitconsidersexpectedearnings.Thepriceearnings
(P/E)ratioalsohasthestrongesttheoreticalroots.OnedividedbytheP/Eratiocanbeviewedasthe
rateatwhichinvestorsdiscountthefirmsearnings.Iftheprojectedearningspershareisassumedto
beearnedindefinitely,theP/EmultipleapproachcanbelookedonasamethodoffindingthePVofa
perpetuityofprojectedearningspershare(EPS)atarateequaltotheP/Eratio.
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17. Adecisionoractionbythefinancialmanagercanhaveaneffectontheriskandexpectedreturnof
thestock,bothofwhicharepartofthestockvaluationmodel.

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Chapter7StockValuation130

18. CAPM:rsRF[bj(rmRF)]andbj1.00:
a.

Astheriskpremiumincreases,requiredreturnincreasesandstockpricefalls.

b. Astheriskfreeratedeclines,therequiredreturnwouldalsodecline.Substitutingksintothe
GordonmodelP0D1(rsg),asrsdeclines,P0increases.
c.

AsD1decreases,theP0alsodecreasessincethenumeratorinthedividendvaluationmodelswill
decline.

d. Asgincreases,theP0alsoincreases.IntheGordongrowthmodelthevalueof(rg)inthe
denominatorwillbecomesmallerresultinginahighervalue.

Suggested Answer to Focus on Practice Box: Understanding


Human Behavior Helps Us Understand Investor Behavior
Theoriesofbehavioralfinancecanapplytootherareasofhumanbehaviorinadditiontoinvesting.
Thinkofasituationinwhichyoumayhavedemonstratedoneofthesebehaviors.Sharewithaclassmate.
Studentanswerswillvary.Examples:
Specifically,regrettheorymayholdtrueforsocialandothersituationsinwhichapersonmakesamistake.
Subsequentdecisionsarebasedonavoidingembarrassment.
Fearofregretcansometimesberationalizedawaywiththethoughtthateveryoneelseisdoingit
(herdingtheory).Thisexplainswhysomepeoplewilldosillythingsatparties.
Studentsmayreacttogradesthesamewayaninvestorreactstoinvestmentnews,placingmore
importanceonrecenteventswithoutrecognizingtheoveralltrend.

Suggested Answer to Focus on Ethics Box: Understanding:


PsstHave You Heard Any Good Quarterly Earnings Forecasts
Lately?
Whattemptationsmightmanagersfaceiftheyhaveprovidedearningsguidancetoinvestorsand
laterfinditdifficulttomeettheexpectationsthattheyhelpedcreate?
Therealcostsassociatedwithprovidingquarterlyguidanceincludedirectcostssuchasthetimesenior
managementandfinancepersonnelmustspendpreparingthereportsandtheindirectcostsoftheexcessive
focusitencouragesonmanagingshorttermresultstohitthetargets.Thedifficultyofforecastingearnings
accuratelysoastoprovideguidancecanleadtotheoftenpainfulresultofmissingquarterlyforecasts.That
inturncanbeapowerfulincentiveformanagementtosacrificelongerterm,valuecreatinginvestmentsin
favorofshorttermresults,andinsomecases,tomanageearningsinappropriatelyfromquartertoquarter
tocreatetheillusionofstability.Managersunabletomeetoverlyoptimisticquarterlyexpectationsmightcut
backonnecessaryresearchanddevelopment,maintenance,training,andothersimilarexpensesinorderto
improvequarterlyprofits.Inthelongrun,suchcutbacksarelikelytoreducefirmvalue.

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Answers to Warm-Up Exercises


E71.
Answer:

Usingdebtratiotocalculateafirmstotalliabilities
Debtratio totalliabilities totalassets

Totalliabilities debtratio totalassets


0.75 $5,200,000 $3,900,000

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Chapter7StockValuation132

E72.

Determiningnetproceedsfromthesaleofstock

Netproceeds (1,000,000 $20 0.95) (250,000 $20 0.90)


$19,000,000 $4,500,000 $23,500,000

Answer:
E73.

Preferredandcommonstockdividends

Answer: Commonstockdividend(Cashavailablepreferreddividends)number
ofcommonshares
[$12,000,000(4$2.50750,000)]3,000,000
$1.50pershare
E74.

Price/earningratios

Answer: Earningspershare(EPS)$11,200,0004,600,000$2.43pershare
TodaysP/Eratio$24.60$2.4310.12
YesterdaysP/Eratio$24.95$2.4310.27
E75.

Usingthezerogrowthmodeltovaluestock

Answer: P0[$1.20(1.05)]0.08$1.260.08$15.75pershare
E76.

Capitalassetpricingmodel

Answer: Step1:Calculatetherequiredrateofreturn.
rs4.5%10.8%15.3%
Step2:Calculatethevalueofthestockusingthezerogrowthmodel.
P0$2.250.153$14.71pershare

Solutions to Problems
P71.

Authorizedandavailableshares
LG2;Basic
a.

Maximumsharesavailableforsale
Authorizedshares

2,000,000

Less:Sharesoutstanding

1,400,000

Availableshares

600,000

Totalsharesneeded

$48,000,000
800,000shares
$60

b.
Thefirmrequiresanadditional200,000authorizedsharestoraisethenecessaryfundsat
$60pershare.
c.

Aspinmustamenditscorporatechartertoauthorizetheissuanceofadditionalshares.
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133Gitman/ZutterPrinciplesofManagerialFinance,Thirteenth Edition

P72.

Preferreddividends
LG2;Intermediate

P73.

a.

$8.80peryearor$2.20perquarter.

b.

$2.20.Foranoncumulativepreferredonlythelatestdividendhastobepaidbeforedividends
canbepaidoncommonstock.

c.

$8.80.Forcumulativepreferredalldividendsinarrearsmustbepaidbeforedividendscanbe
paidoncommonstock.Inthiscasetheboardmustpaythethreedividendsmissedplusthe
currentdividend.

Preferreddividends
LG2;Intermediate

P74.

$15.00

quartersinarrearsplusthelatestquarter

$8.80

onlythelatestquarter

$11.00

onlythelatestquarter

$25.50

quartersinarrearsplusthelatestquarter

$8.10

onlythelatestquarter

Convertiblepreferredstock
LG2;Challenge

P75.

a.

Conversionvalueconversionratiostockprice5$20$100

b.

Basedoncomparisonofthepreferredstockpriceversustheconversionvalue,theinvestor
shouldconvert.Ifconverted,theinvestorhas$100ofvalueversusonly$96ifshekeeps
ownershipofthepreferredstock.

c.

Iftheinvestorconvertstocommonstockshewillbeginreceiving$1.00pershareperyear
ofdividends.Conversionwillgenerate$5.00peryearoftotaldividends.Iftheinvestorkeeps
thepreferredtheywillreceive$10.00peryearofdividends.Thisadditional$5.00peryear
individendsmaycausetheinvestortokeepthepreferreduntilforcedtoconvertthrough
useofthecallfeature.Furthermore,whilecommonstockdividendsmaybecutoreliminated
altogetherwithnoprotection,preferreddividendsaretypicallyfixedandcumulativeprovision.

Personalfinance:Commonstockvaluationzerogrowth:P0D1rs
LG4;Basic

P76.

a.

P0$2.400.12$20

b.

P0$2.400.20$12

c.

Asperceivedriskincreases,therequiredrateofreturnalsoincreases,causingthestockprice
tofall.

Personalfinance:commonstockvaluationzerogrowth
LG4;Intermediate

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Chapter7StockValuation134

Valueofstockwhenpurchased

$5.00
$31.25
0.16

$5.00
$41.67
0.12
Sallyscapitalgainis$10.42($41.67 $31.25)pershare.
Sallystotalcapitalgainis100 $1,042.00.
Valueofstockwhensold

P77.

Preferredstockvaluation:PS0Dprp
LG4;Intermediate
a.

PS0$6.400.093
PS0$68.82

b.

PS0$6.400.105
PS0$60.95

Theinvestorwouldlose$7.87pershare($68.82$60.95)becauseastherequiredrateofreturn
onpreferredstockissuesincreasesabovethe9.3%returnshereceives,thevalueofherstock
declines.
P78.

Commonstockvalueconstantgrowth:P0D1(rsg)
LG4;Basic
Firm

P0D1(rsg)

A
B
C
D
E

P0$1.20(0.130.08)
P0$4.00(0.150.05)
P0$0.65(0.140.10)
P0$6.00(0.090.08)
P0$2.25(0.200.08)

SharePrice

$24.00
$40.00
$16.25
$600.00
$18.75

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P79.

Commonstockvalueconstantgrowth
LG4;Intermediate
rs

D1
g
P0

$1.20 (1.05)
0.05
$28
$1.26
rs
0.05 0.045 0.05 0.095 9.5%
$28
rs

a.

$1.20 (1.10)
0.10
$28
$1.32
rs
0.10 0.047 0.10 0.147 14.7%
$28
rs

b.
P710. Personalfinance:Commonstockvalueconstantgrowth:P0D1(rsg)
LG4;Intermediate
Computationofgrowthrate:
N5,PV$2.25,FV$2.87
SolveforI5%
a.

Valueat13%requiredrateofreturn:
P0

$3.02
$37.75
0.13 0.05

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Chapter7StockValuation136

b.

Valueat10%requiredrateofreturn:
P0

c.

$3.02
$60.40
0.10 0.05

Asriskincreases,therequiredrateofreturnincreases,causingthesharepricetofall.

P711. Commonstockvaluevariablegrowth:
LG4;Challenge
P0PVofdividendsduringinitialgrowthperiod
PVofpriceofstockatendofgrowthperiod.
Steps1and2:ValueofcashdividendsandPVofannualdividends
t

D0

1.25t

Dt

1
2
3

$2.55
2.55
2.55

1.2500
1.5625
1.9531

$3.19
3.98
4.98

1/(1.15)t

PV
ofDividends

0.8696
0.7561
0.6575

$2.77
3.01
3.27
$9.05

Step3:PVofpriceofstockatendofinitialgrowthperiod
D31$4.98(10.10)
D4$5.48
P3[D4(rsg2)]
P3$5.48(0.150.10)
P3$109.56
PVofstockatendofyear3
N3,I15%,FV$109.60
PV$72.04
Step4:SumofPVofdividendsduringinitialgrowthperiodandPVpriceofstockatendof
growthperiod
P0$9.05$72.04
P0$81.09
P712. Personalfinance:Commonstockvaluevariablegrowth
LG4;Challenge
D0 (1 g1 )t
(1 rs )t
t 1
N

P0

DN 1
1

(1 rs ) N (rs g2 )

P0PVofdividendsduringinitialgrowthperiodPVofpriceofstockatendofgrowthperiod.
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Steps1and2:ValueofcashdividendsandPVofannualdividends
D1$3.40(1.00)$3.40
D2$3.40(1.05)$3.57
D3$3.57(1.05)$3.75
D4$3.75(1.15)$4.31
D5$4.31(1.10)$4.74
PV
ofDividends
$2.98

t
1

Dt
$3.40

1/(1.14)t
0.8772

3.57

0.7695

2.75

3.75

0.6750

2.53

4.31

0.5921

2.55
$10.81

Step3:PVofpriceofstockatendofinitialgrowthperiod
P4[D5(rsg)]
P4$4.74(0.140.10)
P4$118.50
PVofstockatendofyear
N4,I14,FV$118.50
SolveforPV$70.16
Step4:SumofPVofdividendsduringinitialgrowthperiodandPVpriceofstockatendof
growthperiod
P0$10.81$70.16
P0$80.97
P713. Commonstockvaluevariablegrowth
LG4;Challenge
a.
PV
ofDividends
$1.75

t
1

D0
$1.80

1.08t
1.0800

Dt
$1.94

1/(1.11)t
0.9009

1.80

1.1664

2.10

0.8116

1.70

1.80

1.2597

2.27

0.7312

1.66
$5.11

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Chapter7StockValuation138

D4D3(1.05)$2.27(1.05)$2.38
P3[D4(rsg)]
P3$2.38(0.110.05)
P3$39.67
PVofstockatendofyear3
N3,I11%,FV$39.67
SolveforPV$29.01
PVofdividendsandfuturestockprice
$5.11$29.01$34.12
b. ThePVofthefirst3yearsdividendsisthesameasinparta.
D4D3(1.0)2.27
P3[D4(rsg)]
P3$2.270.11
P3$20.64
PVofstockatendofyear3
N3,I11%,FV$20.64
SolveforPV$15.09
P0$5.11$15.09$20.20
c.

ThePVofthefirst3yearsdividendsisthesameasinparta.
D4D3(1.10)2.50
P3[D4(rsg)]
P3$2.50(0.110.10)
P3$250.00
PVofstockatendofyear3
N3,I11%,FV$250.00
PV$182.80
P0$5.11$182.80$187.91

P714. Personalfinance:Commonstockvalueallgrowthmodels
LG4;Challenge
a.

P0(CF0r)
P0$42,5000.18
P0$236,111

b. P0(CF1(rg))
P0($45,475*(0.180.07)
P0$413,409.09

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139Gitman/ZutterPrinciplesofManagerialFinance,Thirteenth Edition

CF1$42,500(1.07)$45,475

c.

Steps1and2:ValueofcashdividendsandPVofannualdividends
t
1
2

D0
$42,500
42,500

1.12t
1.1200
1.2544

Dt
$47,600
53,312

1/(1.18)t
0.8475
0.7182

PV
ofDividends
$40,338.98
38,287.85
$78,626.83

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Chapter7StockValuation140

Step3:PVofpriceofstockatendofinitialgrowthperiod
D21$53,312(10.07)
D3$57,043.84
P2[D3(rsg)]
P2$57,043.84(0.180.07)
P2$518,580.36
PVofstockatendofyear2
N2,I18%,FV$518,580.36
SolveforPV$372,436.34
Step4:SumofPVofdividendsduringinitialgrowthperiodandPVpriceofstockatendof
growthperiod
P0$78,626.83$372,436.34
P0$451,063.17
P715. Freecashflow(FCF)valuation
LG5;Challenge
a.

Thevalueofthetotalfirmisaccomplishedinthreesteps.
(1) CalculatethePVofFCFfrom2018toinfinity.
[$390,000(1.03)](0.110.03)$401,7000.08$5,021,250
(2) AddthePVofthecashflowobtainedin(1)tothecashflowfor2017.
FCF2017$5,021,250390,000$5,411,250
(3) FindthePVofthecashflowsfor2013through2017.
Year
2013
2014
2015
2016
2017

FCF

1/(1.11)t

$200,000
0.9009
250,000
0.8116
310,000
0.7312
350,000
0.6587
5,411,250
0.5935
Valueofentirecompany,Vc

PV
$180,180
202,900
226,672
230,545
3,211,577
$4,051,874

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b. Calculatethevalueofthecommonstock.
VSVCVDVP
VS$4,051,874$1,500,000$400,000$2,151,874
c.

Valuepershare$2,151,874200,000shares$10.76

P716. Personalfinance:UsingthefreecashflowvaluationmodeltopriceanIPO
LG5;Challenge
a.

Thevalueofthefirmscommonstockisaccomplishedinfoursteps.
(1) CalculatethePVofFCFfrom2017toinfinity.
[$1,100,000(1.02)](0.080.02)$1,122,0000.06$18,700,000
(2) AddthePVofthecashflowobtainedin(1)tothecashflowfor2016.
FCF2016$18,700,0001,100,000$19,800,000
(3) FindthePVofthecashflowsfor2010through2016.
Year
2013
2014
2015
2016

FCF
$700,000

1/(1.08)t
0.9259

800,000 0.8573
950,000 0.7938
19,800,00 0.7350
0
Valueofentirecompany,Vc

PV
$
648,060
685,840
754,110
14,533,00
0
$16,641,01
0

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Chapter7StockValuation142

(4) CalculatethevalueofthecommonstockusingEquation7.8.
VSVCVDVP
VS$16,641,010$2,700,000$1,000,000$12,941,010
Valuepershare$12,941,0101,100,000shares$10.76
b. BasedonthisanalysistheIPOpriceofthestockisovervaluedby$0.74($12.50$11.76)
andyoushouldnotbuythestock.
c.

Therevisedvalueofthefirmscommonstockiscalculatedinfoursteps.
(1) CalculatethePVofFCFfrom2017toinfinity.
[$1,100,000(1.03)](0.080.03)$1,133,0000.05$22,660,000
(2) AddthePVofthecashflowobtainedin(1)tothecashflowfor2016.
FCF2016$22,660,0001,100,000$23,760,000
(3) FindthePVofthecashflowsfor2010through2016.
Year
2013
2014
2015
2016

FCF
$700,000

1/(1.08)t
0.9259

800,000 0.8573
950,000 0.7938
23,760,00 0.7350
0
Valueofentirecompany,Vc

PV
$
648,060
685,840
754,110
17,463,60
0
$19,551,61
0

(4) CalculatethevalueofthecommonstockusingEquation7.8.
VSVCVDVP
VS$19,551,610$2,700,000$1,000,000$15,851,610
Valuepershare$15,851,6101,100,000shares$14.41
Ifthegrowthrateischangedto3%theIPOpriceofthestockisundervaluedby$1.91
($14.41$12.50)andyoushouldbuythestock.

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P717. Bookandliquidationvalue
LG5;Intermediate
a.

Bookvaluepershare:
Bookvalueofassets (liabilities+preferredstockatbookvalue)
numberofsharesoutstanding

Bookvaluepershare

$780,000 $420,000
$36pershare
10,000

b. Liquidationvalue:
Cash

$40,000

LiquidationValueofAssets

722,000

Marketable
Securities

60,000

AccountsRec.
(0.90$120,000)

108,000

Inventory
(0.90$160,000)

Less:CurrentLiabilities

(160,000)

LongTermDebt

(180,000)

PreferredStock

(80,000)

AvailableforCS

$302,000

144,000

LandandBuildings
(1.30$150,000)

195,000

Machinery&Equip.
(0.70$250,000)

175,000

Liq.ValueofAssets

$722,000

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Chapter7StockValuation144

c.

Liquidationvaluepershare

Liquidationvalueofassets
Numberofsharesoutstanding

Liquidationvaluepershare

$302,000
$30.20pershare
10,000

Liquidationvalueisbelowbookvaluepershareandrepresentstheminimumvaluefor
thefirm.Itispossibleforliquidationvaluetobegreaterthanbookvalueifassetsare
undervalued.Generally,theyareovervaluedonabookvaluebasis,asisthecasehere.

P718. Valuationwithprice/earningsmultiples
LG5;Basic
Firm

EPSP/E

StockPrice

A
B
C
D
E

3.0(6.2)
4.5(10.0)
1.8(12.6)
2.4(8.9)
5.1(15.0)

$18.60
$45.00
$22.68
$21.36
$76.50

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P719. Managementactionandstockvalue:P0D1(rsg)
LG6;Intermediate
a.

P0$3.15(0.150.05)$31.50

b.

P0$3.18(0.140.06)$39.75

c.

P0$3.21(0.170.07)$32.10

d.

P0$3.12(0.160.04)$26.00

e.

P0$3.24(0.170.08)$36.00

Thebestalternativeintermsofmaximizingsharepriceisb.
P720. IntegrativeriskandvaluationandCAPMformulas
LG4,6;Intermediate
P0 D1(rsg)
$50$3.00(rs0.09)
rs 0.15
rs riskfreerateriskpremium
0.150.09riskpremium
0.150.090.06riskpremium
P721.Integrativeriskandvaluation
LG4,6;Challenge
a.

14%10%4%

b.

N6,PV$1.73,FV$2.45
Solveforg:I5.97%
P0D1(rsg)
P0$2.60(0.1480.0597)
P0$29.45

c.

Adecreaseintheriskpremiumwoulddecreasetherequiredrateofreturn,whichinturn
wouldincreasethepriceofthestock.

P722. Integrativeriskandvaluation
LG4,6;Challenge
a.

Estimategrowthrate:
N5,PV$2.45,FV$3.44
SolveforI7.02%
rs0.090.050.14
D1($3.441.0702)$3.68
P0$3.68(0.140.0702)
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Chapter7StockValuation146

P0$52.72

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147Gitman/ZutterPrinciplesofManagerialFinance,Thirteenth Edition

b. (1) rs0.14
D1$3.61($3.441.0502)
P0$3.61(0.140.0502)
P0$40.20pershare
(2) rs
D1$3.68
P0$3.68(0.130.0702)
P0$61.54pershare
Priceisafunctionofthecurrentdividend,expecteddividendgrowthrate,andtheriskfreerate,
andthecompanyspecificriskpremium.ForCraft,theloweringofthedividendgrowthrate
reducedfuturecashflowsresultinginareductioninshareprice.Thedecreaseintherisk
premiumreflectedareductioninriskleadingtoanincreaseinshareprice.
P723. Ethicsproblem
LG4;Intermediate
a.

Thisisazerogrowthdividendvaluationproblem,so:
P0D/r$5/0.11$45.45

b.

Usingthenewdiscountrateof12%(11%1%credibilityriskpremium),wehave:
P0D/r$5/0.12$41.67
Thevaluedeclineisthedifferencebetweenpartsaandb:
Valuedecline$41.67$45.45
$3.78

Thestocksellsforalmost$4lessbecausethecompanysfinancialreportscannotbefullytrusted.
Lackofintegrityisseentohurtstockpricesbecauseofthecredibilitypremium.

Case
Casestudiesareavailableonwww.myfinancelab.com.

Assessing the Impact of Suarez Manufacturings Proposed Risky Investment


on Its Stock Value
Thiscasedemonstrateshowariskyinvestmentcanaffectafirmsvalue.First,studentsmustcalculatethe
currentvalueofSuarezsstock,reworkthecalculationsassumingthatthefirmmakestheriskyinvestment,
andthendrawsomeconclusionsaboutthevalueofthefirminthissituation.Inadditiontogaining
experienceinvaluationofstock,studentswillseetherelationshipbetweenriskandvaluation.
a.

Currentpersharevalueofcommonstockgrowthrateofdividends:

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Chapter7StockValuation148

gcanbesolvedforbyusingthegeometricgrowthequationasshownbelowin(Method1)orby
findingtheinterestfactorterms(i.e.,theI),forthegrowthasshownin(Method2).
g

1.90
(1.46154)1/ 4 1 1.0995 1 0.0995 10.0%
1.30

Method1.

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149Gitman/ZutterPrinciplesofManagerialFinance,Thirteenth Edition

Method2. N4,PV1.30,FV1.90
SolveforI9.95
P0
b.

D1
$1.90(1.10) $2.09

$52.25
rs g 0.14 0.10 0.04

Valueofcommonstockifriskyinvestmentismade:
P0

D1
$1.90(1.13) $2.15

$71.67
rs g 0.16 0.13 0.03

Thehighergrowthrateassociatedwithundertakingtheinvestmentincreasesthemarketvalueof
thestock.
c.

Thefirmshouldundertaketheproposedproject.Thepricepershareincreasesby$19.42(from
$52.25to$71.67).Althoughriskincreasedandincreasedtherequiredreturn,thehigherdividend
growthoffsetsthishigherriskresultinginanetincreaseinvalue.

d.

D20132.15(statedincase)
D20142.15(10.13)2.43
D20152.43(10.13)2.75
D20162.75(10.10)3.02
P2015D2016(rg)
$3.02(0.160.10)$3.020.06$50.33
CF00,CF1$2.15,CF2$2.43,CF3$2.75$50.33
SetI16%
SolveforNPV$37.67
No,thefirmshouldnotundertaketheproposedproject.Thepricepersharedecreasesby$14.58
(from$52.25to$37.67).Nowtheincreaseinriskandincreasedrequiredreturnisnotoffsetby
theincreaseincashflows.Thelongertermofthegrowthisanimportantfactorinthisdecision.

Spreadsheet Exercise
TheanswertoChapter7sAzureCorporationspreadsheetproblemislocatedontheInstructorsResource
Centeratwww.pearsonhighered.com/ircundertheInstructorsManual.

Group Exercise
Groupexercisesareavailableonwww.myfinancelab.com.

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Chapter7StockValuation150

Thischaptersexercisetakesthegroupsbacktothefuture.Thesemesterbeganwiththefictitiousfirms
havingrecentlybecomepubliclytradedcorporations.Outofnecessitytherewerefewdetailsgiven.The
groupsnowgettorectifythissituation.UsingthedetailsofrecentIPOs,eachgroupisaskedtowritea
detailedprospectusfollowingcloselytheexamplepresentedinthetext.Thisincludesbutisnotlimited
tothepershareprice/quantityoftheoffering.
StudentsshouldquicklyrealizethesimilaritiesofthevariousIPOs.Mostareofferedwithinthe$10$30
range.Theprocessisoftenthesamewithfewsharesavailableattheofferprice,forcingthegeneralpublic
topayapremiumabovethisofferpriceonandaroundtheissuancedate.
Thefinaltaskforthegroupsistogetthemostrecentinformationontheirshadowfirm.Thisincludes
marketnumbersaswellasanyrecentnews/analyses.Oftenthisinformationwillbefairlyinnocuous.
Pointoutthatrecentregulatoryrequirementshaveincreasedthestringentpublicinformationregarding
publiclyheldcorporations.

Integrative Case 3: Encore International


Thiscasefocusesonthevaluationofafirm.Thestudentexploresvariousmethodsofvaluation,including
theprice/earningsmultiple,bookvalue,nogrowth,constantgrowth,andvariablegrowthmodels.Riskand
returnareintegratedintothecasewiththeadditionofthesecuritymarketlineandthecapitalassetpricing
model.Thestudentisaskedtocomparestockvaluesgeneratedbyvariousmodels,discussthedifferences,
andselecttheonethatbestrepresentsthetruevalueofthefirm.

Bookvaluepershare

$60,000,000
$24
2,500,000

a.
P/E ratio

$40
6.4
$6.25

b.
c.

a.

rsRFriskpremiumEncore
rs6%8.8%
rs14.8%
Requiredreturn14.8%

b. rs6%10%
rs16%
Requiredreturn16%
c.

Asriskpremiumsrise,requiredreturnalsorises.

d. Zerogrowth:

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151Gitman/ZutterPrinciplesofManagerialFinance,Thirteenth Edition

e.

P0

D1
rs

P0

$4.00
$25
0.16

a.

Constantgrowth:
P0

D1
(rs g )

P0

($4.00 1.06) $4.24

$42.40
(0.16 0.06)
0.10

b. Variablegrowthmodel:PVofdividends
D0 (1 g1 )t
1
DN 1

(1 rs )t (1 rs ) N (rs g 2 )
t 1
n

P0

PoPVofdividendsduringinitialgrowthperiodPVofpriceofstockatendofgrowthperiod.
Steps1and2:ValueofcashdividendsandPVofannualdividends
Year

D0

1.08t

Dt

1/1.16t

2013
2014

1
2

$4.00
4.00

1.080
1.166

$4.32
4.67

0.8621
0.7432

PV
ofDividends

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$3.72
3.47
$7.19

Chapter7StockValuation152

Step3:PVofpriceofstockatendofinitialgrowthperiod
D2015$4.67(1.06)$4.95
P2014[D2015(rsg2)]
P2014$4.95(0.160.06)
P2014$49.50
PVofstockatendofyear2(2014)
PVP2(1/1.16)2
PV$49.50(0.7432)
PV$36.79
Step4:SumofPVofdividendsduringinitialgrowthperiodandPVpriceofstockatendof
growthperiod
P20012$7.19$36.79
P20012$43.98
f.
ValuationMethod
Marketvalue
Bookvalue
Zerogrowth
Constantgrowth
Variablegrowth

PerShare
$40.00
24.00
25.00
42.40
43.98

Thebookvaluehasnorelevancetothetruevalueofthefirm.Oftheremainingmethods,themost
conservativeestimateofvalueisgivenbythezerogrowthmodel.Waryanalystsmayadvisepaying
nomorethan$25pershare,yetthisishardlymorethanbookvalue.Themostoptimisticprediction,
thevariablegrowthmodel,resultsinavalueof$43.98,whichisnotfarfromthemarketvalue.The
marketisobviouslynotascautiousaboutEncoreInternationalsfutureastheanalysts.
NotealsotheP/Eandrequiredreturnconfirmoneanother.TheinverseoftheP/Eis16.25,or
0.16.Thisisalsoameasureofrequiredreturntotheinvestor.Therefore,theinverseoftheP/E(16%)
andsumoftheriskfreerateandriskpremiumareidentical.Themarketappearstobepricinginthe
expectationthatthecompanywillexpandintoEuropeanandLatinAmericanmarkets.

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