Air University

BS Accounting & Finance 7

Financial Modelling

Assignment 5 – Cost of Equity (Van Horne)

Problem 1.

Delphi Products Corporation currently pays a dividend of $2 per share, and this dividend is expected to
grow at a 15 percent annual rate for three years, and then at a 10 percent rate for the next three years,
after which it is expected to grow at a 5 percent rate forever. What value would you place on the stock if
an 18 percent rate of return was required?

Problem 2.

A share of Buford Baseball Bat Company just sold for $100 and carries an $8 annual dividend.

a. What is the dividend yield on this stock?

b. Now assume that this stock has an intrinsic value of $110 at the end of year 5, what is stock’s
yield (cost of equity) if dividends were $8, $6.2, $4.8, $3.5 and $5.4 respectively for year 1 to 5?

Problem 3.

North Great Timber Company will pay a dividend of $1.50 a share next year. After this, earnings and
dividends are expected to grow at a 9 percent annual rate indefinitely. Investors currently require a rate
of return of 13 percent. The company is considering several business strategies and wishes to determine
the effect of these strategies on the market price per share of its stock.
a. Continuing the present strategy will result in the expected growth rate and required rate of
return stated above.

b. Expanding timber holdings and sales will increase the expected dividend growth rate to 11
percent but will increase the risk of the company. As a result, the rate of return required by
investors will increase to 16 percent.

c. Integrating into retail stores will increase the dividend growth rate to 10 percent and increase
the required rate of return to 14 percent. From the standpoint of market price per share, which
strategy is best?

Problem 4.
Just today, Fawlty Foods, Inc.’s common stock paid a $1.40 annual dividend per share and had a closing
price of $21. Assume that the market’s required return, or capitalization rate, for this investment is 12
percent and that dividends are expected to grow at a constant rate forever.

a. Calculate the implied growth rate in dividends.

Problem 5.

Burp-Cola Company just finished making an annual dividend payment of $2 per share on its common
stock. Its common stock dividend has been growing at an annual rate of 10 percent. Kelly Scott requires
a 16 percent annual return on this stock. What intrinsic value should Kelly place on one share of Burp-
Cola common stock under the following three situations?

a. Dividends are expected to continue growing at a constant 10 percent annual rate.

b. The annual dividend growth rate is expected to decrease to 9 percent and to remain
constant at that level.

c. The annual dividend growth rate is expected to increase to 11 percent and to remain
constant at the level.