Chapter 10

Stocks and Their Valuation

Learning Objectives
After reading this chapter, students should be able to:
Discuss the legal rights of stockholders.
Explain the distinction between a stocks price and its intrinsic value.
Identify the two odels that can be used to estiate a stocks intrinsic value: the discounted dividend
odel and the corporate odel.
!ist the key characteristics of preferred stock and explain how to estiate the value of preferred
stock.
Chapter 10: Stocks and Their Valuation Learning Objectives 231
Lecture Suggestions
"his chapter provides iportant and useful inforation on coon and preferred stocks. #oreover, the
valuation of stocks reinforces the concepts covered in $hapters %, &, and ', so $hapter () extends and
reinforces concepts discussed in those chapters.
*e begin our lecture with a discussion of the characteristics of coon stocks and how stocks
are valued in the arket. #odels are presented for valuing constant growth stocks, +ero growth stocks,
and nonconstant growth stocks. *e conclude the lecture with a discussion of preferred stocks.
*hat we cover, and the way we cover it, can be seen by scanning the slides and Integrated $ase
solution for $hapter (), which appears at the end of this chapter solution. ,or other suggestions about
the lecture, please see the -!ecture .uggestions/ in $hapter 0, where we describe how we conduct our
classes.
!"S O# C$!%T&': 3 O( )* !"S +)0,-inute periods.
232 Lecture Suggestions Chapter 10: Stocks and Their Valuation
!ns/ers to &nd,o0,Chapter 1uestions
10,1 a2 "he average investor of a fir traded on the ".E is not really interested in aintaining his or
her proportionate share of ownership and control. If the investor wanted to increase his or
her ownership, the investor could siply buy ore stock on the open arket. $onse1uently,
ost investors are not concerned with whether new shares are sold directly 2at about arket
prices3 or through rights offerings. 4owever, if a rights offering is being used to effect a stock
split, or if it is being used to reduce the underwriting cost of an issue 2by substantial
underpricing3, the preeptive right ay well be beneficial to the fir and to its stockholders.
b2 "he preeptive right is clearly iportant to the stockholders of closely held 2private3 firs
whose owners are interested in aintaining their relative control positions.
10,2 5o. "he correct e1uation has D( in the nuerator and a inus sign in the denoinator.
10,3 6es. If a copany decides to increase its payout ratio, then the dividend yield coponent will
rise, but the expected long7ter capital gains yield will decline.
10,3 6es. "he value of a share of stock is the 89 of its expected future dividends. If the two investors
expect the sae future dividend strea, and they agree on the stocks riskiness, then they should
reach siilar conclusions as to the stocks value.
10,) A perpetual bond is siilar to a no7growth stock and to a share of perpetual preferred stock in the
following ways:
(. All three derive their values fro a series of cash inflows:coupon payents fro the
perpetual bond, and dividends fro both types of stock.
;. All three are assued to have indefinite lives with no aturity value 2#3 for the perpetual
bond and no capital gains yield for the stocks.
4owever, there are preferreds that have a stated aturity. In this situation, the preferred
would be valued uch like a bond with a stated aturity. <oth derive their values fro a
series of cash inflows:coupon payents and a aturity value for the bond and dividends
and a stock price for the preferred.
10,4
1
0
s
D
P
r g
=

(= > ).?0@2()A B g3
g > ).)0C0%(.
D; > ).?0 D2(E).)0C0%(3
> ).?&=&;(.
8( > ).?&=&;(@2()A B ).)0C0%(3
> (=.%0.
10,5 "hose cash flows consist of two eleents: 2(3 the dividends the investor receives each year while
he or she holds the stock, and 2;3 the price received when the stock is sold.
10,* "he aFor assuption is r G g.
10,6
tie 0 1 2 3 3 ) 4
Chapter 10: Stocks and Their Valuation Answers and Solutions 233
earnings ;.0
C.(;
0
C.')?;
0
=.&&;&(C 0.='C(?= ?.(%'&(
dividend
s
) ) ) ;.==(=)? ;.%=?0&; =.?C=&0%
g ).;0 ).;0 ).;0 ).(;0 ).(;0 ).)?;0
8) > ;.==@2( E ((A3
=
E ;.%0@2( E ((A3
0
E H=.?C@2((A B ?.;0A3I@2(E((A3
0

> ?(.(=.
233 Answers and Solutions Chapter 10: Stocks and Their Valuation
Solutions to &nd,o0,Chapter %roble-s
10,1 D) > J(.;0K g(7C > ?AK gn > =AK D( through D0 > L
D( > D)2( E g(3 > J(.;02(.)?3 > J(.C;0).
D; > D)2( E g(32( E g;3 > J(.;02(.)?3
;
> J(.=)=0.
DC > D)2( E g(32( E g;32( E gC3 > J(.;02(.)?3
C
> J(.=&&&.
D= > D)2( E g(32( E g;32( E gC32( E gn3 > J(.;02(.)?3
C
2(.)=3 > J(.0=&C.
D0 > D)2( E g(32( E g;32( E gC32( E gn3
;
> J(.;02(.)?3
C
2(.)=3
;
> J(.?()C.
10,2
g r
D
P
s

=
1
0
> J(.C0@2(;A B ?A3 > J;;.0)
10,3 D( > J).00K g > ?AK rs > (;AK

)
8
M

> L
1
0
$0.55

$9.17.
0.12 0.06
s
D
P
r g
= = =

10,3 8) > J;;K D) > J(.()K g > %AK
(
8
M
> LK rs > L
(
8
M

> 8)2( E g3 > J;;2(.)%3 > J;C.0=.
s
r M
>
)
(
8
D
E g >
$1.10(1.07)
$22
E ).)%
>
$1.177
$22
E ).)% > (;.C0A. rs > (;.C0A.
10,) a2 "he terinal, or hori+on, date is the date when the growth rate becoes constant. "his occurs
at the end of 6ear ;.
b2 ) ( ; C
N N N N
(.0) (.%% ;.)' ;.('
C(.;' >
2.19
0.12 0.05
"he hori+on, or terinal, value is the value at the hori+on date of all dividends expected
thereafter. In this proble it is calculated as follows:
Chapter 10: Stocks and Their Valuation Answers and Solutions 23)
rs > (;A
gs > (&A gs > (&A gn > 0A
$2.09 (1.05)
$31.29.
0.12 0.05
=

c2 "he firs intrinsic value is calculated as the su of the present value of all dividends during the
supernoral growth period plus the present value of the terinal value. Osing your financial
calculator, enter the following inputs: $,) > ), $,( > (.0), $,; > (.%% E C(.;' > CC.)?, I@6P >
(;7 and then solve for 589 > J;%.?'.
10,4 "he firs free cash flow is expected to grow at a constant rate, hence we can apply a constant
growth forula to deterine the total value of the fir.
,ir value > ,$,(@2*A$$ B g3
> J(=0,))),)))@2).(; B ).)?3
> J;,=(?,???,??%.
"o find the value of an e1uity clai upon the copany 2share of stock3, we ust subtract out the
arket value of debt and preferred stock. "his fir happens to be entirely e1uity funded, and this
step is unnecessary. 4ence, to find the value of a share of stock, we divide e1uity value 2or in this
case, fir value3 by the nuber of shares outstanding.
E1uity value per share > E1uity value@.hares outstanding
> J;,=(?,???,??%@0),))),)))
> J=&.CC.
Each share of coon stock is worth J=&.CC, according to the corporate valuation odel.
10,5 Dp > J?.))K 9p > J?)K rp > L
rp >
p
p
9
D
>
$6.00
$60.00
> ()A.
10,* 9p > Dp@rpK therefore, rp > Dp@9p.
a2 rp > J&@J?) > (C.CCA.
b2 rp > J&@J&) > ().)A.
c2 rp > J&@J()) > &.)A.
d2 rp > J&@J(=) > 0.%(A.
234 Answers and Solutions Chapter 10: Stocks and Their Valuation
10,6 a2
. (;0 J
)& . )
() J
r
D
9
p
p
p
= = =
b2 . CC . &C J
(; . )
() J
9
p
= =
10,10 a2 "he preferred stock pays J& annually in dividends. "herefore, its noinal rate of return would
be:
5oinal rate of return > J&@J&) > ()A.
Qr alternatively, you could deterine the securitys periodic return and ultiply by =.
rate of return > J;@J&) > ;.0A.
5oinal rate of return > ;.0A = > ()A.
b2 EAP> 2( E r5Q#@=3
=
B (
> 2( E ).()@=3
=
B (
> ).()C&(C > ().C&(CA.
10,11

0 1
0
D (1 ) D $6[1 ( 0.06)] $6 (0.94) $5.64

P $25.64.
r g r g 0.16 ( 0.06) 0.16 0.06 0.22
s s
g + +
= = = = = =
+
10,12 ,irst, solve for the current price.
)
8
M
> D(@2rs B g3
> J).0)@2).(; B ).)%3
> J().)).
If the stock is in a constant growth state, the constant dividend growth rate is also the capital gains
yield for the stock and the stock price growth rate. 4ence, to find the price of the stock four years
fro today:
=
8
M
> 8)2( E g3
=
> J().))2(.)%3
=
> J(C.()%'? R J(C.((.
10,13 a2 (. . 0) . ' J
;) . )
') . ( J
)0 . ) (0 . )
3 )0 . ) ( 2 ; J
8
M

)
= =
+

=
;.
)
8
M
> J;@).(0 > J(C.CC.
C. . )) . ;( J
() . )
() . ; J
)0 . ) (0 . )
3 )0 . ( 2 ; J
8
M

)
= =

=
Chapter 10: Stocks and Their Valuation Answers and Solutions 235
=. . )) . == J
)0 . )
;) . ; J
() . ) (0 . )
3 () . ( 2 ; J
8
M

)
= =

=
b2 (.
)
8
M
> J;.C)@) > Ondefined.
;.
)
8
M
> J;.=)@27).)03 > 7J=&, which is nonsense.
"hese results show that the forula does not ake sense if the re1uired rate of return is e1ual
to or less than the expected growth rate.
c2 5o, the results of 8art b show this. It is not reasonable for a fir to grow indefinitely at a rate
higher than its re1uired return. .uch a stock, in theory, would becoe so large that it would
eventually overtake the whole econoy.
10,13 "he proble asks you to deterine the value of
C
8
M
, given the following
facts:

D( > J;, b > ).&&,
rP,
> 0.?A,
P8#
> ?A, and
8)
> J;0. 8roceed as follows:
.tep (: $alculate the re1uired rate of return:
rs > rP, E 2r# B rP,3b > 0.?A E 2?A3).&& > ().&&A.
.tep ;: Ose the constant growth rate forula to calculate g:
%. 88 . 2 0288 . 0
25 $
2 $
1088 . 0

0
1
= =
+ =
+ =
g
g
g
P
D
r
s
.tep C: $alculate
C
8
M
:
C
8
M
> 8)2( E g3
C
> J;02(.);&&3
C
> J;%.;;;& J;%.;;.
Alternatively, you could calculate D= and then use the constant growth rate forula to solve for
C
8
M
:
D= > D(2( E g3
C
> J;.))2(.);&&3
C
> J;.(%%&.
C
8
M
> J;.(%%&@2).()&& B ).);&&3 > J;%.;;;& J;%.;;.
10,1) $alculate the dividend cash flows and place the on a tie line. Also, calculate the stock price at the
end of the supernoral growth period, and include it, along with the dividend to be paid at t > 0, as
$,0. "hen, enter the cash flows as shown on the tie line into the cash flow register, enter the
re1uired rate of return as I@6P > (=, and then find the value of the stock using the 589 calculation. <e
sure to enter $,) > ), or else your answer will be incorrect.
D) > )K D( > )K D; > )K DC > (.))K D= > (.))2(.03 > (.0K D0 > (.))2(.03
;
> ;.;0K D? > (.))2(.03
;
2(.)&3 >
J;.=C.
)
8
M
> L
23* Answers and Solutions Chapter 10: Stocks and Their Valuation
) ( ; C = 0 ?
N N N N N N N
(.)) (.0) ;.;0 ;.=C
).?%0 E=) .0) >
).&&&
;; .;)C =;.%0
J;C .%?? >
)
8
M
0
8
M
> D?@2rs B g3 > J;.=C@2).(= B ).)&3 > J=).0). "his is the stock price at the end of 6ear 0.
$,) > )K $,(7; > )K $,C > (.)K $,= > (.0K $,0 > =).0)K I@6P > (=A.
*ith these cash flows in the $,!Q register, press 589 to get the value of the stock today: 589 >
J;C.%%.
10,14 a2 "erinal value >
)% . ) (C . )
3 )% . ( 2 =) J

>
)? . )
&) . =; J
> J%(C.CC illion.
b2 ) ( ; C =
N N N N N
7;) C) =) =;.&)
2J (%.%)3
;C.='
C
op
9
> %(C .CC
0;; .() %0C .CC
J0;% .&'
Osing a financial calculator, enter the following inputs: $,) > )K $,( > 7;)K $,; > C)K $,C >
%0C.CCK I@6P > (CK and then solve for 589 > J0;%.&' illion.
c2 "otal valuet>) > J0;%.&' illion.
9alue of coon e1uity > J0;%.&' B J()) > J=;%.&' illion.
8rice per share >
)) . ()
&' . =;% J
> J=;.%'.
10,15 "he value of any asset is the present value of all future cash flows expected to be generated fro the
asset. 4ence, if we can find the present value of the dividends during the period preceding long7run
constant growth and subtract that total fro the current stock price, the reaining value would be the
present value of the cash flows to be received during the period of long7run constant growth.
D( > J;.)) 2(.;03
(
> J;.0) 892D(3 > J;.0)@2(.(;3
(
> J;.;C;(
D; > J;.)) 2(.;03
;
> JC.(;0 892D;3 > JC.(;0@2(.(;3
;
> J;.='(C
DC > J;.)) 2(.;03
C
> JC.')?;0 892DC3 > JC.')?;0@2(.(;3
C
> J;.%&)=
892D( to DC3 > J%.0)C&
"herefore, the 89 of the reaining dividends is: J0&.&&)) B J%.0)C& > J0(.C%?;. $opounding
this value forward to 6ear C, we find that the value of all dividends received during constant growth
is J%;.(&. HJ0(.C%?;2(.(;3
C
> J%;.(%'' J%;.(&.I Applying the constant growth forula, we can
Chapter 10: Stocks and Their Valuation Answers and Solutions 236
rs > (=A
gs > 0)A gn > &A
2.43
0.14 0.08
(@2(.(=3
C
(@2(.(=3
=
(@2(.(=3
0
gn > %A
*A$$ > (CA
(@(.(C
(@2(.(C3
;
(@2(.(C3
C
solve for the constant growth rate:
C
8
M
> DC2( E g3@2rs B g3
J%;.(& > JC.')?;02( E g3@2).(; B g3
J&.??(? B J%;.(&g > JC.')?;0 E JC.')?;0g
J=.%00= > J%?.)&?;0g
).)?;0 > g
?.;0A > g.
10,1* ) ( ; C =
N N N N N
D) > ;.)) D( D; DC D=
C
8
M
a2 D( > J;2(.)03 > J;.()K D; > J;2(.)03
;
> J;.;)0)K DC > J;2(.)03
C
> J;.C(0;0.
b2 ,inancial calculator solution: Input ), ;.(), ;.;)0), and ;.C(0;0 into the cash flow register,
input I@6P > (;, 89 > L 89 > J0.;&.
c2 ,inancial calculator solution: Input ), ), ), and C=.%C into the cash flow register, I@6P > (;, 89
> L 89 > J;=.%;.
d2 J;=.%; E J0.;& > JC).)) > #axiu price you should pay for the stock.
e2
. )) . C) J
)0 . ) (; . )
() . ; J
g r
D
g r
3 g ( 2 D
8
M
s
(
s

)
)
=

+
=
02 5o. "he value of the stock is not dependent upon the holding period. "he value calculated in
8arts a through d is the value for a C7year holding period. It is e1ual to the value calculated in
8art e. Any other holding period would produce the sae value of
)
8
M
K that is,
)
8
M
> JC).)).
10,16 a2 8art (: Sraphical representation of the proble:
.upernoral 5oral
growth growth
) ( ; C
N N N N T T T N
D) D( 2D; E
;
8
M
3 DC D

89D(
89D;
;
8
M
89
8 )
D( > D)2( E gs3 > J(.&)2(.;03 > J;.;0.
D; > D)2( E gs3
;
> J(.&)2(.;03
;
> J;.&(;.

3 2 n
2
s n s n
D D (1 g ) $2.812 (1.05)

P $98.42.
r g r g 0.08-0.05
+
= = = =

230 Answers and Solutions Chapter 10: Stocks and Their Valuation
rs > (;A
g > 0A
)
8
M
> 892D(3 E 892D;3 E 892
;
8
M
3
>
;
s
;
;
s
;
s
(
3 r ( 2
8
M
3 r ( 2
D
3 r ( 2
D
+
+
+
+
+
> J;.;0@(.)& E J;.&(;@2(.)&3
;
E J'&.=;@2(.)&3
;
> J&&.&%.
,inancial calculator solution: Input ), ;.;0, ()(.;C;2;.&(; E '&.=;3 into the cash flow register,
input I@6P > &, 89 > L 89 > J&&.&%.
8art ;: Expected dividend yield:
D(@8) > J;.;0@J&&.&% > ;.0CA.
$apital gains yield: ,irst, find
(
8
M
,
which e1uals the su of the present values of D; and
;
8
M

discounted for one year.
1 1
$2.812 $98.42

P $93.73.
(1.08)
+
= =
,inancial calculator solution: Input ), ()(.;C;2;.&(; E '&.=;3 into the cash flow register, input
I@6P > &, 89 > L 89 > J'C.%C.
.econd, find the capital gains yield:
1 0
0

P P $93.73 $88.87
5.47%.
P $88.87

= =
Dividend yield > ;.0CA
$apital gains yield > 0 .=%
& .))A > rs.
b2 Due to the longer period of supernoral growth, the value of the stock will be higher for each
year. Although the total return will reain the sae, rs > ()A, the distribution between dividend
yield and capital gains yield will differ: "he dividend yield will start off lower and the capital
gains yield will start off higher for the 07year supernoral growth condition, relative to the ;7year
supernoral growth state. "he dividend yield will increase and the capital gains yield will
decline over the 07year period until dividend yield > =A and capital gains yield > ?A.
c2 "hroughout the supernoral growth period, the total yield, rs, will be ()A, but the dividend yield
is relatively low during the early years of the supernoral growth period and the capital gains
yield is relatively high. As we near the end of the supernoral growth period, the capital gains
yield declines and the dividend yield rises. After the supernoral growth period has ended, the
capital gains yield will e1ual gn > ?A. "he total yield ust e1ual rs > ()A, so the dividend yield
ust e1ual ()A B ?A > =A.
d2 .oe investors need cash dividends 2retired people3, while others would prefer growth. Also,
investors ust pay taxes each year on the dividends received during the year, while taxes on
the capital gain can be delayed until the gain is actually reali+ed. $urrently 2;))&3, dividends to
individuals are now taxed at the lower capital gains rate of (0A.
10,20
) ( ; C = 0
Chapter 10: Stocks and Their Valuation Answers and Solutions 231
*A$$ > (;.0A
N N N N N N
(),))),))) (?,))),))) ;),))),))) ;0,))),))) ;?,0)),)))
89 > L 407,692,308>
06 . 0 125 . 0
000 , 500 , 26

Osing your financial calculator, enter the following inputs: $,) > )K $,( >()))))))K
$,; > (?))))))K $,C > ;)))))))K $,= > ;0)))))) E =)%?';C)& > =C;?';C)&K
I@6P > (;.0K and then solve for 589 > JC)0,%)0,(&).'?.
"otal fir value JC)0,%)0,(&(
#arket value of debt ? 0 ,))),))) 2given in proble3
#arket value of e1uity J ;=) ,%)0 ,(&(
Uian 4us expected current price per share is calculated as:
. 52 . 7 $
000 , 000 , 32
181 , 705 , 240 $
=
10,21 a2 ) ( ; C =
N N N N N
C,))),))) ?,))),))) (),))),))) (0,))),)))
Osing a financial calculator, enter the following inputs: $,) > )K $,( > C))))))K $,; > ?))))))K
$,C > ()))))))K $,= > (0))))))K I@6P > (;K and then solve for 589 > J;=,((;,C)&.
b2 "he firs terinal value is calculated as follows:
. ))) , ))) , C;( J
)% . ) (; . )
3 )% . ( 2 ))) , ))) , (0 J
=

c2 "he firs total value is calculated as follows:

) ( ; C = 0
N N N N N N
C,))),))) ?,))),))) (),))),))) (0,))),))) (?,)0),)))
89 > L C;(,))),))) >
)% . ) (; . )
))) , )0) , (?

Osing your financial calculator, enter the following inputs: $,) > )K $,( > C))))))K $,; >
?))))))K $,C > ()))))))K $,= > (0)))))) E C;()))))) > CC?))))))K I@6P > (;K and then
solve for 589 > J;;&,((C,?(;.
d2 "o find <arretts stock price, you need to first find the value of its e1uity. "he value of <arretts
e1uity is e1ual to the value of the total fir less the arket value of its debt and preferred stock.
"otal fir value J;;&,((C,?(;
#arket value, debt E preferred ?),))),))) 2given in proble3
#arket value of e1uity J(?&,((C,?(;
<arretts price per share is calculated as:
232 Answers and Solutions Chapter 10: Stocks and Their Valuation
*A$$ > (;A
gn > %A
*A$$ > (;A
gn > ?A
. &( . (? J
))) , ))) , ()
?(; , ((C , (?& J
=
10,22 ,$, > E<I"2( B "3 E Depreciation B
es expenditur
$apital
B

capital working
operating 5et
> J0)),))),))) E J()),))),))) B J;)),))),))) B J)
> J=)),))),))).
,ir value >
g *A$$
,$,

>
)? . ) () . )
))) , ))) , =)) J

>
)= . )
))) , ))) , =)) J
> J(),))),))),))).
"his is the total fir value. 5ow find the arket value of its e1uity.
#9"otal > #9E1uity E #9Debt
J(),))),))),))) > #9E1uity E JC,))),))),)))
#9E1uity > J%,))),))),))).
"his is the arket value of all the e1uity. Divide by the nuber of shares to find the price per share.
J%,))),))),)))@;)),))),))) > JC0.)).
10,23 a2 End of 6ear: )& )' () (( (; (C (=
N N N N N N N
D) > (.%0 D( D; DC D= D0 D?
Dt > D)2( E g3
t
.
D;))' > J(.%02(.(03
(
> J;.)(.
D;)() > J(.%02(.(03
;
> J(.%02(.C;;03 > J;.C(.
D;)(( > J(.%02(.(03
C
> J(.%02(.0;)'3 > J;.??.
D;)(; > J(.%02(.(03
=
> J(.%02(.%=')3 > JC.)?.
D;)(C > J(.%02(.(03
0
> J(.%02;.)((=3 > JC.0;.
b2 .tep (:
89 of dividends >

=
+
0
( t
t
s
t
3 r ( 2
D
.
89 D;))' > J;.)(@2(.(;3 > J(.%'
89 D;)() > J;.C(@2(.(;3
;
> J(.&=
89 D;)(( > J;.??@2(.(;3
C
> J(.&'
Chapter 10: Stocks and Their Valuation Answers and Solutions 233
rs > (;A
gs > (0A gn > 0A
89 D;)(; > JC.)?@2(.(;3
=
> J(.'=
89 D;)(C > JC.0;@2(.(;3
0
> J;.))
89 of dividends > J'.=?
.tep ;:
&) . 0; J
)% . )
%) . C J
)0 . ) (; . )
3 )0 . ( 2 0; . C J
g r
3 g ( 2 D
g r
D
8
M
n s
;)(C
n s
;)(=
;)(C
= =

+
=

=
.
"his is the price of the stock 0 years fro now. "he 89 of this price, discounted back 0 years,
is as follows:
89 of
;)(C
8
M
> J0;.&)@2(.(;3
0
> J;'.'?
.tep C:
"he price of the stock today is as follows:
)
8
M
> 89 dividends 6ears ;))'7;)(C E 89 of
;)(C
8
M
> J'.=? E J;'.'? > JC'.=;.
"his proble could also be solved by substituting the proper values into the following e1uation:
0
0
( t
s n s
?
t
s
t
s )
)
r (
(
g r
D
3 r ( 2
3 g ( 2 D
8
M

=

+
+
+
= .
$alculator solution: Input ), ;.)(, ;.C(, ;.??, C.)?, 0?.C; 2C.0; E 0;.&)3 into the cash flow
register, input I@6P > (;, 89 > L 89 > JC'.=C.
c2 ;))'
D(@8) > J;.)(@JC'.=C > 0.()A
$apital gains yield > ? .')V
Expected total return > (; .))A
;)(=
D?@80 > JC.%)@J0;.&) > %.))A
$apital gains yield > 0 .))
Expected total return > (; .))A
V*e know that rs is (;A, and the dividend yield is 0.()AK therefore, the capital gains yield ust
be ?.')A.
"he ain points to note here are as follows:
(. "he total yield is always (;A 2except for rounding errors3.
;. "he capital gains yield starts relatively high, then declines as the supernoral growth
period approaches its end. "he dividend yield rises.
C. After (;@C(@(C, the stock will grow at a 0A rate. "he dividend yield will e1ual %A, the capital
gains yield will e1ual 0A, and the total return will be (;A.
d2 8eople in high7incoe tax brackets will be ore inclined to purchase -growth/ stocks to take the
capital gains and thus delay the payent of taxes until a later date. "he firs stock is -ature/
at the end of ;)(C.
233 Answers and Solutions Chapter 10: Stocks and Their Valuation
e2 .ince the firs supernoral and noral growth rates are lower, the dividends and, hence, the
present value of the stock price will be lower. "he total return fro the stock will still be (;A,
but the dividend yield will be larger and the capital gains yield will be saller than they were
with the original growth rates. "his result occurs because we assue the sae last dividend
but a uch lower current stock price.
02 As the re1uired return increases, the price of the stock goes down, but both the capital gains
and dividend yields increase initially. Qf course, the long7ter capital gains yield is still =A, so
the long7ter dividend yield is ()A.
Chapter 10: Stocks and Their Valuation Answers and Solutions 23)
Co-prehensive8Spreadsheet %roble-
Note to Instructors:
"he solutions for 8arts a through c of this proble are provided at the back of the textK however, the solution
to 8art d is not. Instructors can access the Excel file on the textbooks web site or the Instructors Pesource
$D.
10,23 a2 (. ,ind the price today.
;. ,ind the expected dividend yield.
Pecall that the expected dividend yield is e1ual to the next expected annual dividend
divided by the price at the beginning of the period.
C. ,ind the expected capital gains yield.
"he capital gains yield can be calculated by siply subtracting the dividend yield fro the
total expected return.
Alternatively, we can recogni+e that the capital gains yield easures capital appreciation,
hence solve for the price in one year, then divide the change in price fro today to one year
fro now by the current price. "o find the price one year fro now, we will have to find the
present values of the terinal value and second year dividend to tie period one.
234 Comprehensive/Spreadsheet Problem Chapter 10: Stocks and Their Valuation
b2 (. ,ind the price today.
;. ,ind the expected dividend yield.
C.
=. ,ind the expected capital gains yield.
Chapter 10: Stocks and Their Valuation Comprehensive/Spreadsheet Problem 235
c2 *e used the 0 year supernoral growth scenario for this calculation, but ultiately it does not
atter which exaple you use, as they both yield the sae result.
Opon reflection, we see that these calculations were unnecessary because the constant growth
assuption holds that the long7ter growth rate is the dividend growth rate and the capital
gains yield, hence we could have siply subtracted the long7run growth rate fro the re1uired
return to find the dividend yield.
d2
"he price as estiated by the corporate valuation ethod differs fro the discounted dividends
ethod because different assuptions are built into the two situations. If we had proFected
financial stateents, found both dividends and free cash flow fro those proFected stateents,
and applied the two ethods, then the prices produced would have been identical. As it stands,
though, the two prices were based on soewhat different assuptions, hence different prices
were obtained. 5ote especially that in the ,$, odel we assued a *A$$ of 'A versus ()A
for the discounted dividend odel. "hat would obviously tend to raise the price.
23* Comprehensive/Spreadsheet Problem Chapter 10: Stocks and Their Valuation
INPUT DATA
WACC 9%
g
n
6%
Millions of shares 20
MV of debt !"200
9ntegrated Case
10,2)
%ing !n 9nsurance +:roup. Co-pan; o0 China Ltd2
Stoc !aluation
Pobert .u and $arol "so are senior vice presidents of the 8ing An Insurance 2Sroup3
$opany of $hina !td. "hey are codirectors of the copanys pension fund anageent
division, with .u having responsibility for fixed7incoe securities 2priarily bonds3 and
"so being responsible for e1uity investents. A aFor new client, the .ynergis 4oldings
!td., has re1uested that 8ing An Insurance present an investent seinar to their
shareholders and directorsK and .u and "so, who will ake the actual presentation, have
asked you to help the.
"o illustrate the coon stock valuation process, .u and "so have asked you to
analy+e the <au <au Agency $opany, an eployent agency that supplies word
processor operators and coputer prograers to businesses with teporarily heavy
workloads. 6ou are to answer the following 1uestions.
!2 escribe brie0l; the legal rights and privileges o0 co--on
stockholders2
Answer: H.how .()7( and .()7; here.I "he coon stockholders are the owners of
a corporation, and as such they have certain rights and privileges as
described below.
12 Qwnership iplies control. "hus, a firs coon stockholders have
the right to elect its firs directors, who in turn elect the officers who
anage the business.
22 $oon stockholders often have the right, called the preeptive right,
to purchase any additional shares sold by the fir. In soe states in
the O..., the preeptive right is autoatically included in every
Chapter 10: Stocks and Their Valuation Integrated Case 236
corporate charterK in others, it is necessary to insert it specifically into
the charter.
<2 +1. =rite a 0or-ula that can be used to value an; stock7 regardless o0 its
dividend pattern2
Answer: H.how .()7C through .()7? here.I "he value of any stock is the present
value of its expected dividend strea:
0
%
>
?
2
. r 1 +

. r 1 +

. r 1 +

. r 1 +

s
3
s
3
s
2
t
s
1

+
+ +
+
+
+
+
+

4owever, soe stocks have dividend growth patterns that allow the to be
valued using short7cut forulas.
<2 +2. =hat is a constant gro/th stock@ $o/ are constant gro/th stocks
valued@
Answer: H.how .()7% and .()7& here.I A constant growth stock is one whose
dividends are expected to grow at a constant rate forever. -$onstant growth/
eans that the best estiate of the future growth rate is soe constant
nuber, not that we really expect growth to be the sae each and every
year. #any copanies have dividends that are expected to grow steadily
into the foreseeable future, and such copanies are valued as constant
growth stocks.
,or a constant growth stock:
1 ? 0+1 A g.7 2 ? 1+1 A g. ? 0+1 A g.
2
, and so on.
*ith this regular dividend pattern, the general stock valuation odel can be
siplified to the following very iportant e1uation:
0
%
>
?
g r

s
1

?
g r
. g 1 +
s
0

+
2
"his is the well7known -Sordon,/ or -constant7growth/ odel for valuing
2)0 Integrated Case Chapter 10: Stocks and Their Valuation
stocks. 4ere 1 is the next expected dividend, which is assued to be paid (
year fro now, rs is the re1uired rate of return on the stock, and g is the
constant growth rate.
<2 +3. =hat are the i-plications i0 a co-pan; 0orecasts a constant g that
eBceeds its rs@ =ill -an; stocks have eBpected g C rs in the short run
+that is7 0or the neBt 0e/ ;ears.@ 9n the long run +that is7 0orever.@
Answer: H.how .()7' here.I "he odel is derived atheatically, and the derivation
re1uires that rs C g. If g is greater than rs, the odel gives a negative stock
price, which is nonsensical. "he odel siply cannot be used unless 2(3 rs C
g, 2;3 g is expected to be constant, and 2C3 g can reasonably be expected to
continue indefinitely.
.tocks ay have periods of supernoral growth, where gs C rsK
however, this growth rate cannot be sustained indefinitely. In the long7run, g
D rs.
C2 !ssu-e that <au <au !genc; has a beta coe00icient o0 1227 that the risk,
0ree rate +the ;ield on T,bonds. is 5E7 and that the reFuired rate o0
return on the -arket is 12E2 =hat is <au <au !genc;Gs reFuired rate o0
return@
Answer: H.how .()7() here.I 4ere we use the .#! to calculate <au <au Agencys
re1uired rate of return:
rs ? r'( A +rH I r'(.b<on Te-ps ? 5E A +12E I 5E.+122.
? 5E A +)E.+122. ? 5E A 4E ? 13E2
Chapter 10: Stocks and Their Valuation Integrated Case 2)1
2 !ssu-e that <au <au !genc; is a constant gro/th co-pan; /hose
last dividend +07 /hich /as paid ;esterda;. /as J2200 and /hose
dividend is eBpected to gro/ inde0initel; at a 4E rate2
+1. =hat is the 0ir-Gs eBpected dividend strea- over the neBt 3 ;ears@
Answer: H.how .()7(( here.I <au <au Agency is a constant growth stock, and its
dividend is expected to grow at a constant rate of ?A per year. Expressed as
a tie line, we have the following setup. Wust enter ; in your calculatorK then
keep ultiplying by 1 A g ? 1204 to get 17 2, and 3:
0 1 2 3
K K K K
0 ? 2200 2212 22235 223*2
12**
1254
124)
2
2
2
2 +2. =hat is its current stock price@
Answer: H.how .()7(; here.I *e could extend the tie line on out forever, find the
value of <au <au Agencys dividends for every year on out into the future,
and then the 89 of each dividend discounted at rs ? 13E. ,or exaple, the
89 of 1 is J(.&%?(K the 89 of 2 is J(.%0''K and so forth. 5ote that the
dividend payents increase with tie, but as long as rs C g, the present
values decrease with tie. If we extended the graph on out forever and then
sued the 89s of the dividends, we would have the value of the stock.
4owever, since the stock is growing at a constant rate, its value can be
estiated using the constant growth odel:
0
%
>
?
g r

s
1

?
04 2 0 13 2 0
12 2 2 J

?
05 2 0
12 2 2 J
? J302262
2)2 Integrated Case Chapter 10: Stocks and Their Valuation
rs ? 13E
g ? 4E
181213
18+1213.
2
18+1213.
3
2 +3. =hat is the stockGs eBpected value 1 ;ear 0ro- no/@
Answer: H.how .()7(C here.I After one year, 1 will have been paid, so the expected
dividend strea will then be 27 37 3, and so on. "hus, the expected value
one year fro now is JC;.():
1
%
>
?
g r

s
2

?
04 2 0 13 2 0
235 2 2 J

?
05 2 0
235 2 2 J
? J322102
2 +3. =hat are the eBpected dividend ;ield7 capital gains ;ield7 and total
return during the 0irst ;ear@
Answer: H.how .()7(= here.I "he expected dividend yield in any 6ear # is
ividend ;ield ?
1 #
#
%
>

7
*hile the expected capital gains yield is
Capital gains ;ield ?
1 #
1 # #
%
>
. %
>
%
>
+

? rs I
1 #
#
%

2
"hus, the dividend yield in the first year is %A, while the capital gains yield is
?A:
Total return ? 1320E
ividend ;ield ? J22128J30226 ? 520E
Capital gains ;ield ? 420E
Chapter 10: Stocks and Their Valuation Integrated Case 2)3
&2 #o/ assu-e that the stock is currentl; selling at J302262 =hat is its
eBpected rate o0 return@
Answer: "he constant growth odel can be rearranged to this for:
s
r >
?
g
%

0
1
+
2
4ere the current price of the stock is known, and we solve for the expected
return. ,or <au <au Agency:
s
r >
? J22128J30226 A 02040 ? 02050 A 02040 ? 13E2
(2 =hat /ould the stock price be i0 its dividends /ere eBpected to have Lero
gro/th@
Answer: H.how .()7(0 here.I If <au <au Agencys dividends were not expected to
grow at all, then its dividend strea would be a perpetuity. 8erpetuities are
valued as shown below:
0 1 2 3
K K K K
2200 2200 2200
1255
12)5
1236
2
2
2
0
%
>
?1) 23*
0
%
>
? 8rs ? J220080213 ? J1)23*2
5ote that if a preferred stock is a perpetuity, it ay be valued with this
forula.
2)3 Integrated Case Chapter 10: Stocks and Their Valuation
rs ? 13E
g ? 0E
18+1213.
2
18+1213.
3
181213
:2 #o/ assu-e that <au <au !genc; is eBpected to eBperience
nonconstant gro/th o0 30E 0or the neBt 3 ;ears7 then return to its long,
run constant gro/th rate o0 4E2 =hat is the stockGs value under these
conditions@ =hat are its eBpected dividend and capital gains ;ields in
"ear 1@ "ear 3@
Answer: H.how .()7(? through .()7(& here.I <au <au Agency is no longer a
constant growth stock, so the constant growth odel is not applicable. 5ote,
however, that the stock is expected to becoe a constant growth stock in C
years. "hus, it has a nonconstant growth period followed by constant growth.
"he easiest way to value such nonconstant growth stocks is to set the
situation up on a tie line as shown below:
0 1 2 3 3
K K K K K
22400 323*0 32363 324)543
22301
22435
3203)
34 2113
3
%
>
? 442)3 ?
)3 2105 ?
0
%
>
.iply enter J; and ultiply by 2(.C)3 to get 1 > J;.?)K ultiply that result
by (.C to get 2 > JC.C&, and so forth. "hen recogni+e that after 6ear C, <au
<au Agency becoes a constant growth stock, and at that point
3
%
>
can be
found using the constant growth odel.
3
%
>
is the present value as of t > C
of the dividends in 6ear = and beyond and is also called the terinal value.
*ith the cash flows for 17 27 3, and
3
%
>
shown on the tie line, we
discount each value back to 6ear ), and the su of these four 89s is the
value of the stock today, %0 > J0=.()%.
"he dividend yield in 6ear ( is =.&)A, and the capital gains yield is
&.;A:
Chapter 10: Stocks and Their Valuation Integrated Case 2))
rs ? 13E
gs ? 30E gs ? 30E gs ? 30E gn ? 4E
04 2 0 13 2 0
4)543 2 3

18+1213.
2
18+1213.
3
18+1213.
3
181213
ividend ;ield ?
105 2 )3 J
400 2 2 J
? 0203*0 ? 32*E2
Capital gains ;ield ? 13200E I 32*E ? *22E2
During the nonconstant growth period, the dividend yields and capital gains
yields are not constant, and the capital gains yield does not e1ual g.
4owever, after 6ear C, the stock becoes a constant growth stock, with g >
capital gains yield > ?.)A and dividend yield > (C.)A B ?.)A > %.)A.
$2 Suppose <au <au !genc; is eBpected to eBperience Lero gro/th during
the 0irst 3 ;ears and then resu-e its stead;,state gro/th o0 4E in the
0ourth ;ear2 =hat /ould be its value then@ =hat /ould be its eBpected
dividend and capital gains ;ields in "ear 1@ 9n "ear 3@
Answer: H.how .()7(' and .()7;) here.I 5ow we have this situation:
0 1 2 3 3
K K K K K
2200 2200 2200 2200 2212
1255
12)5
1236
20 266
3
%
>
? 30226 ?
2) 252 ?
0
%
>
During 6ear (:
ividend ;ield ?
52 2 2) J
00 2 2 J
? 02055* ? 525*E2
Capital gains ;ield ? 13200E I 525*E ? )222E2
Again, in 6ear = <au <au Agency becoes a constant growth stockK hence g
> capital gains yield > ?.)A and dividend yield > %.)A.
92 (inall;7 assu-e that <au <au !genc;Gs earnings and dividends are
eBpected to decline at a constant rate o0 4E per ;ear7 that is7
2)4 Integrated Case Chapter 10: Stocks and Their Valuation
rs ? 13E
g ? 0E g ? 0E g ? 0E gn ? 4E
05 2 0
12 2 2
18+1213.
2
18+1213.
3
18+1213.
3
181213
g ? I4E2 =h; /ould an;one be /illing to bu; such a stock7 and at /hat
price should it sell@ =hat /ould be its dividend and capital gains
;ields in each ;ear@
Answer: H.how .()7;( and .()7;; here.I "he copany is earning soething and
paying soe dividends, so it clearly has a value greater than +ero. "hat value
can be found with the constant growth forula, but where g is negative:
0
%
?
g r

S
1

?
g r
. g 1 +
S
0

+
?
. 04 2 0 + 13 2 0
. 63 2 0 + 00 2 2 J

?
16 2 0
** 2 1 J
? J62*62
.ince it is a constant growth stock:
g ? Capital gains ;ield ? ,420E7
4ence:
ividend ;ield ? 1320E I +,420E. ? 1620E2
As a check:
ividend ;ield ?
*6 2 6 J
** 2 1 J
? 02160 ? 1620E2
"he dividend and capital gains yields are constant over tie, but a high
2('.)A3 dividend yield is needed to offset the negative capital gains yield.
M2 Suppose <au <au !genc; e-barked on an aggressive eBpansion that
reFuires additional capital2 Hanage-ent decided to 0inance the
eBpansion b; borro/ing J30 -illion and b; halting dividend pa;-ents
to increase retained earnings2 9ts =!CC is no/ 10E7 and the projected
0ree cash 0lo/s 0or the neBt 3 ;ears are ,J) -illion7 J10 -illion7 and J20
-illion2 !0ter "ear 37 0ree cash 0lo/ is projected to gro/ at a constant
4E2 =hat is <au <au !genc;Gs total value@ 90 it has 10 -illion shares
o0 stock and J30 -illion o0 debt and pre0erred stock co-bined7 /hat is
the price per share@
Answer: H.how .()7;C through .()7;& here.I
0 1 2 3 3
Chapter 10: Stocks and Their Valuation Integrated Case 2)5
=!CC ? 10E
K K K K K
,) 10 20 21220
,32)3)
*2243
1)2024
36* 2165 )30 ?
314 2632 ? Total value
Value o0 eFuit; ? Total value I ebt
? J314263 I J30 ? J354263 -illion2
%rice per share ? J354263810 ? J352462
2)* Integrated Case Chapter 10: Stocks and Their Valuation
gn ? 4E
04 2 0 10 2 0
20 2 21

18+1210.
2
18+1210.
3
18+1210.
3
181210
N2 Suppose <au <au !genc; decided to issue pre0erred stock that /ould
pa; an annual dividend o0 J) and that the issue price /as J)0 per share2
=hat /ould be the stockGs eBpected return@ =ould the eBpected rate o0
return be the sa-e i0 the pre0erred /as a perpetual issue or i0 it had a
20,;ear -aturit;@
Answer: H.how .()7;' and .()7C) here.I
p
r >
?
p
p
V

?
)0 J
) J
? 10E2
If the preferred has a ;)7year aturity its value would be calculated as
follows:
Enter in your financial calculator: # > ;)K 98"' > ()K %HT > 0K (V > 0)K and
then solve for %V > J0).
4owever, to find the value of the perpetual preferreds dividends after 6ear
;) we can enter the following data: # > ;)K 98"' > ()K %HT > 0K (V > )K and
then solve for %V > J=;.0%. "hus, dividends in 6ears ;( to infinity account
for J0).)) B J=;.0% > J%.=C of the perpetual preferreds value.
Chapter 10: Stocks and Their Valuation Integrated Case 2)6