Corporate Fiance _ PP.pdfVIP

1 CHAPTER 5: Practice questions Exercise 16: Consider the following three stocks: a. Stock A is expected to provide a dividend of $10 a share forever b. Stock B is expected to pay a dividend of $5 next year. Thereafter, dividend growth is expected to be 4% a year forever. c. Stock C is expected to pay a dividend of $5 next year. Thereafter, dividend growth is expected to be 20% a year for 5 years (until year 6) and zero thereafter. If the market capitalization rate for each stock is 10%, which stock is the most valuable? a. 1 $10 $100.00 0.10A DIVP r = = = b. 1 $5 $83.33 0.10 0.04B DIVP r g = = = ? ? c. ? ?= + + + + + + × =? ? ? ? C 1 2 3 4 5 6 6 5.00 6.00 7.20 8.64 10.37 12.44 12.44 1P $104.50 1.10 1.10 1.10 1.10 1.10 1.10 0.10 1.10 At a capitalization rate of 10 percent, Stock C is the most valuable. Exercise 21. See BMA for the question text. Extremely high P/EPS ratios can be misleading for a number of reasons. In the case of Textron, the extremely high P/EPS of 63 resulted from a large one-time loss which reduced EPS below what it would otherwise have been, and (perhaps) below what investors expected Textron’s EPS to be in the future. A somewhat more common scenario resulting in an extremely high P/EPS ratio is a growth stock which investors expect will experience significant increases in earnings in the near term future. Mathematically, this is a result similar to Textron’s, but the cause of the expected increase in future earnings and dividends is different. 2 Exercise 24. See BMA for the question text. gr NPV r EPSprice Share 1 ? += Therefore: 0.15)(r NPV r EPS Ρ αα 1α α ? += α 0.08)(r NPV r EPS Ρ β β β β1 β ? += The statement in the question implies the following: ?? ? ? ?? ? ? ? + ? ? ? ? ? ? ? ? ? ? + ? 0.15)(r NPV r EPS 0.15)(r NPV 0.08)(r NPV r EPS 0.08)(r NPV α α α α1 α α β β β β1 β β 3 Rearranging, we have: β1 β β β α1 α α α EPS r 0.08)(r NPV EPS r 0.15)(r