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Chapter 7, Solutions

CHAPTER 7 Valuing Stocks Questions LG1 1. As owners, what rights and advantages do shareholders obtain? They are able to participate in the economic growth of publicly traded firms without having to manage business entities directly. They have the right to residual cash flows of corporate profits and often receive some of these cash flows through dividends. In addition, shareholders vote on the members for board of directors and other proposals for the company. Shareholder capital losses are capped in that they can only lose their initial investment. Stocks are very liquid and investors can enjoy this liquidity in both their entrance into the stock market and their exit from it. LG1 2. Describe how being a residual claimant can be very valuable. Residual claimants are able to delegate the operations of the firm to professional managers, enjoying the possibly vast gains in value that can be created by some firms over time. LG2 3. Obtain a current quote of McDonalds (MCD) from the Internet. Describe what has changed since the quote in Figure 8.1. As of November 23, 2007, MCDs stock price had increased in value to $57.72 per share. MCD experienced a modest loss from July 11, 2007 reaching a trough in mid-August 2007 at approximately $47.50 per share. Since that time, it has generally trended upward through the Fall of 2007. LG2 4. Get the trading statistics for the three main U.S. stock exchanges. Compare the trading activity to that of Table 8.1. The table below reflects trading activity on the three main U.S. stock exchanges for November 26, 2007. Trading volume was particularly high this day compared to the July 11, 2007 activity reflected in Table 8.1. Continued concerns over the home mortgage crises built into a selling frenzy in the markets with the DJIA plummeting 240 points on this day. Volume was also up due to this trading day immediately following the Thanksgiving holiday weekend, since markets were closed the previous Thursday and only light trading volume was experienced in the lightly attended trading session the day after Thanksgiving.

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Chapter 7, Solutions

ADVANCES & DECLINES NYSE Advancing Issues Declining Issues Unchanged Issues Total Issues New Highs New Lows Up Volume Down Volume Unchanged Volume Total Volume 834 (24%) 2,565 (74%) 64 (2%) 3,463 45 340 463,831,873 (13%) 3,149,651,823 (86%) 38,646,084 (1%) 3,652,129,7801 AMEX 451 (33%) 824 (60%) 96 (7%) 1,371 48 128 102,173,146 (13%) 667,962,524 (86%) 8,138,296 (1%) 778,273,9661 NASDAQ 782 (25%) 2,248 (72%) 104 (3%) 3,134 54 286 339,948,056 (17%) 1,599,678,727 (82%) 8,948,642 (0%) 1,948,575,4251

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5. Why might the Standard & Poors 500 Index be a better measure of stock market performance than the Dow Jones Industrial Average? Why is the DJIA more popular than the S&P 500? The S&P 500 is a broad market index that includes stocks of the 500 largest US firms from ten sectors of the economy. It captures 80% of the overall stock market capitalization and is a good proxy for what is occurring in the overall stock market. The DJIA has been used for a longer period, since the mid-1880s, and represents the activity of the 30 largest corporations in the US, covering 30% of the stock market. Its popularity arises from it being the first index used by the media.

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6. Explain how it is possible for the DJIA to increase one day while the Nasdaq Composite decreases during the same day. The components of the DJIA and the Nasdaq Composite index are mostly different companies. The DJIA includes the 30 industry leaders across all sectors of the economy. The Nasdaq is comprised of predominantly technology related firms and emits a noisy signal of technology performance on any given day.

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7. Which is higher, the ask quote or the bid quote? Why?

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Chapter 7, Solutions

The market makers ask price is the lowest price offered for stock sale and the bid price is the highest price a market maker will pay for stock purchase. Thus, the ask price is higher than the bid price. The difference is the bid-ask spread and it represents the gain a market maker achieves by taking the risk position and providing the needed liquidity for the stock in question. LG4 8. Illustrate through examples how trading commission costs impact an investors return. Assume an investor wishes to purchase a stock at a strike price of $90. Two scenarios to consider, at their extremes, would be the purchase of 10 shares versus the purchase of 100 shares. The costs to purchase through a discount broker, assuming the broker charges $20 per trade would be $920 ($900 + $20) and $9020, respectively. The commission for the trades in percentages would be 2.22% and 0.22%, respectively. For the investor who owns only 10 shares, the price would have to rise by $2 per share to recoup the commission cost. It would only have to rise 20 for the investor who owns 100 shares. It is evident that the percentage of trading commissions is lower on larger volume trades and the effect would be even more pronounced if the trades had been placed through a retail broker. LG4 9. Describe the difference in the timing of trade execution and the certainty of trade price between market orders and limit orders. Market makers fill market orders immediately at the current stock price. This provides the liquidity an investor needs to buy and sell stocks quickly. However, the price at which the stock will fill cannot be guaranteed. With limit orders, the market maker will only fill the order when the stated price is reached. This means that you can count on the execution only after your target buy or sell price is reached, but you cannot guarantee your trade will execute with a limit order. LG5 10. What are the differences between common stock and preferred stock? Common stock dividends change over time, hopefully increasing in the long-term. Preferred stock pays a constant dividend. Preferred stockholders have higher precedence for payment in the event of firm liquidation from bankruptcy. However, preferred stockholders do not have voting rights that common stock holders enjoy. Preferred stock prices fluctuate with market interest rates and behave like corporate bond prices. Common stock price changes with the value of the companys underlying business. LG5 11. How important is growth to a stocks value? Illustrate with examples. Consider two firms with a common next period dividend of $1, a common market discount rate of 8%, but differing growth rates of 3% and 5%, respectively. The implied current prices of these stocks are $20 [=$1/(0.08-0.03)] and $33.33 [=$1/(0.08-0.05)] respectively. The firm with higher growth prospects (5%) is valued more highly than the firm with lower growth rate prospects (3%).

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Chapter 7, Solutions

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12. Under what conditions would the constant growth rate model not be appropriate? When the growth rate exceeds the discount rate, the constant growth rate model cannot be employed. It is also not appropriate when the growth rate cannot reasonably be expected to be constant into the future.

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13. The expected return derived from the constant growth rate model relies on dividend yield and capital gain. Where do these two parts of the return come from? Rearranging the terms and solving for the i from the constant growth model yields the expected return model. The components are the dividend yield and the capital gain. The dividend yield reflects the percentage return from current firm operations. The capital gain captures the firms future growth prospects. Both components are important from an investor point of view, with dividends providing income to an investor over the stock holding period and the capital gain being realized at the time of stock sale.

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14. Describe, in words, how to use the variable growth rate technique to value a stock. When the firm is growing at a very fast pace in its infancy, the expected growth rate will initially be very large. This rate should be used for the high growth period, but a terminal growth rate should be employed for valuation when the firm matures. Essentially, a firm cannot grow faster than the general economy indefinitely and must be capped in the long term by its mature growth rate.

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15. Can the variable growth rate model be used to value a firm that has a negative growth rate in Stage 1 and a stable and positive growth in Stage 2? Explain. In this case, the firm would be contracting over a short period and then reaching a stable, positive growth rate. Insofar as the initial rate during contraction does not dominate the later mature growth rate, this is possible. It would suggest that a firms dividends in the short term decreased, followed by a positive dividend stream in the longer term.

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16. Explain why using the P/E relative value approach may be useful for companies that do not pay dividends. Since dividends are non-existent, the forecast stock price is simply a function of current price and the discount rate. In isolation, it is hard to determine if the firm is under or overvalued based on this information only. Using the P/E relative value approach, the trailing P/E can be calculated and compared to a firms competitors.

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17. How is a firms changing P/E ratio reflected in the stock price? Give examples. The P/E ratio multiplied by a firms earnings result in the stock price. For example, if a firm is experiencing high growth and all other factors are held constant, this will lead to a

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Chapter 7, Solutions

higher P/E ratio reflecting the growth prospects. Stock prices can change simply because the market changes the P/E ratio appropriate for that stock. LG7 18. Differentiate the characteristics of growth stocks and value stocks? Taken in tandem, P/E ratios and growth rates illustrate the type of stock the firm is characterized by, growth or income. Firms with high P/E and high growth rates are growth stocks. A comparison across an industry of P/E ratios can be an aid to investors in selecting the best growth stock to purchase. By contrast, firms with low P/E ratios and low growth rates tend to be value stocks. LG7 19. Whats the relationship between the P/E ratio and a firms growth rate? The price of a stock can be modeled with the constant growth rate equation. Note that the denominator is (i g). So the price relative to earnings is impacted by the growth rate of the firm. A high growth rate will cause a high price and P/E. Thus, high growth firms should have high P/E ratios while low growth rate firms should have low P/E ratios. LG7 20. Describe the process for using the P/E ratio to estimate a future stock price. Using current earnings and an expected growth rate for these earnings, the current P/E ratio can be multiplied by the estimate of future earnings to produce a price estimate for the future stock value. That is, the current P/E ratio acts as a guide for the stocks future price. This approach should be employed cautiously by comparing the P/E ratios to similar firms to ensure that the firm you have selected has a reasonable P/E ratio. Problems Basic Problems LG3 7-1 Stock Index Performance On January 16, 2007, the Dow Jones Industrial Average set a new high. The index closed at 12,582.59, which was up 26.51 that day. What was the return (in percent) of the stock market that day? FV = PV (1 + i) 12,582.59 = (12,582.59-26.51) (1 + i) i = (12,582.59/12,556.08)-1 = 0.2111% LG3 7-2 Stock Index Performance On January 16, 2007, the Standard & Poors 500 Index reached the highest it had been since 2000. The index closed at 1,431.90, which was up 1.17 that day. What was the return (in percent) of the stock market that day? FV = PV (1 + i) 1,431.90 = (1,431.9-1.17) (1 + i) i = (1.431.90/1,430.73)-1 = 0.08178%

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Chapter 7, Solutions

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7-3 Buying Stock with Commissions At your discount brokerage firm, it costs $8.95 per stock trade. How much money do you need to buy 200 shares of Pfizer, Inc. (PFE), which trades at $27.22? ($27.22/share 200 shares) + $8.95 = $5,452.95

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7-4 Buying Stock with Commissions At your discount brokerage firm, it costs $9.50 per stock trade. How much money do you need to buy 300 shares of Time Warner, Inc. (TWX), which trades at $22.62? ($22.62/share 300 shares) + $9.50 = $6,795.50

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7-5 Selling Stock with Commissions At your full-service brokerage firm, it costs $120 per stock trade. How much money do you receive after selling 150 shares of Nokia Corporation (NOK), which trades at $20.13? ($20.13/share 150 shares) - $120 = $2,899.50

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7-6 Selling Stock with Commissions At your full-service brokerage firm, it costs $135 per stock trade. How much money do you receive after selling 250 shares of International Business Machines (IBM), which trades at $96.17? ($96.17/share 250 shares) - $135 = $23,907.50

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7-7 Buying Stock with a Market Order You would like to buy shares of Sirius Satellite Radio (SIRI). The current ask and bid quotes are $3.96 and $3.93 respectively. You place a market buy-order for 500 shares that executes at these quoted prices. How much money did it cost to buy these shares? ($3.96/share 500 shares) = $1,980.00

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7-8 Buying Stock with a Market Order You would like to buy shares of Coldwater Creek, Inc. (CWTR). The current ask and bid quotes are $20.70 and $20.66 respectively. You place a market buy-order for 200 shares that executes at these quoted prices. How much money did it cost to buy these shares? ($20.70/share 200 shares) = $4,140.00

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7-9 Selling Stock with a Limit Order You would like to sell 200 shares of WorldSpace, Inc. (WRSP). The current ask and bid quotes are $4.66 and $4.62 respectively. You place a limit sell-order at $4.65. If the trade executes, how much money do you receive from the buyer? ($4.65/share 200 shares) = $930.00

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Chapter 7, Solutions

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7-10 Selling Stock with a Limit Order You would like to sell 100 shares of eCollege.com (ECLG). The current ask and bid quotes are $15.33 and $15.28 respectively. You place a limit sell-order at $15.31. If the trade executes, how much money do you receive from the buyer? ($15.31/share 100 shares) = $1,531.00

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7-11 Value of a Preferred Stock A preferred stock from Duquesne Light Company (DQUPRA) pays $2.10 in annual dividends. If the required return on the preferred stock is 5.4 percent, whats the value of the stock? Use equation 7-6, noting that for preferred stock, the growth rate g equals zero:
Constant growth model = P0 = $2.10 D0 (1 + g ) = = $38.89 i g 0.054 0

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7-12 Value of a Preferred Stock A preferred stock from Hecla Mining Co. (HLPRB) pays $3.50 in annual dividends. If the required return on the preferred stock is 6.8 percent, what is the value of the stock? Use equation 7-6, noting that for preferred stock, the growth rate g equals zero:
Constant growth model = P0 = $3.50 D0 (1 + g ) = = $51.47 ig 0.068 0

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7-13 P/E Ratio and Stock Price Ultra Petroleum (UPL) has earnings per share of $1.56 and a P/E ratio of 32.48. Whats the stock price? Use equation 7-10:

Pn = P
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( E) ( E)

E n = 32.48 1.56 = $50.67

7-14 P/E Ratio and Stock Price JP Morgan Chase Co. (JPM) has earnings per share of $3.53 and a P/E ratio of 13.81. What is the price of the stock? Use equation 7-10:

Pn = P

E n = 13.81 3.53 = $48.75

Intermediate Problems 7-15 Value of Dividends and Future Price A firm is expected to pay a dividend of $1.35

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Chapter 7, Solutions

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next year and $1.50 the following year. Financial Analysts believe the stock will be at their price target of $75 in two years. Compute the value of this stock with a required return of 11.5 percent. Use equation 7-3: LG5
P0 = D1 1+ i + D2 + P2

(1 + i )

1.35 1.50 + 75.00 + = $62.74 1 + 0.115 (1 + 0.115) 2

7-16 Value of Dividends and Future Price A firm is expected to pay a dividend of $2.05 next year and $2.35 the following year. Financial Analysts believe the stock will be at their price target of $110 in two years. Compute the value of this stock with a required return of 12 percent. Use equation 7-3: P0 = D1 D2 + P2 2.05 2.35 + 110.00 + = + = $91.40 2 1 + i (1 + i ) 1 + 0.12 (1 + 0.12) 2

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7-17 Dividend Growth Annual dividends of AT&T Corp (T) grew from $0.96 in 2000 to $1.33 in 2006. What was the annual growth rate? Use equation 4-2:
Future value in 6 years = 1.33 = 0.96 (1 + g ) g = 5.58%
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7-18 Dividend Growth Annual dividends of General Electric (GE) grew from $0.66 in 2001 to $1.03 in 2006. What was the annual growth rate? Use equation 4-2:
Future value in 5 years = 1.03 = 0.66 (1 + g ) g = 9.31%
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7-19 Value a Constant Growth Stock Financial analysts forecast Safeco Corp. (SAF) growth for the future to be 10 percent. Safecos recent dividend was $1.20. What is the value of Safeco stock when the required return is 12 percent? Use equation 7-6:
Constant growth model = P0 = D0 (1 + g ) $1.20(1 + 0.10 ) = = $66.00 i g 0.12 0.10

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7-20 Value a Constant Growth Stock Financial analysts forecast Limited Brands (LTD) growth for the future to be 12.5 percent. LTDs recent dividend was $0.60. What is the value of Limited Brands stock when the required return is 14.5 percent? Use equation 7-6:

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Chapter 7, Solutions

Constant growth model = P0 =

D0 (1 + g ) $0.60(1 + 0.125) = = $33.75 i g 0.145 0.125

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