Chapter 7, Solutions

Cornett, Adair, and Nofsinger

CHAPTER 7 Valuing Stocks Questions LG1 1. As owners, what rights and advantages do shareholders obtain? They are able to participate in the econo ic growth o! publicly traded !ir s without having to anage business entities directly. They have the right to residual cash !lows o! corporate pro!its and o!ten receive so e o! these cash !lows through dividends. "n addition, shareholders vote on the e bers !or board o! directors and other proposals !or the co pany. Shareholder capital losses are capped in that they can only lose their initial invest ent. Stoc#s are very li$uid and investors can en%oy this li$uidity in both their entrance into the stoc# ar#et and their e&it !ro it. LG1 '. (escribe how being a residual clai ant can be very valuable. )esidual clai ant*s are able to delegate the operations o! the !ir to pro!essional anagers, en%oying the possibly vast gains in value that can be created by so e !ir s over ti e. LG' +. ,btain a current $uote o! -c(onald*s .-C(/ !ro changed since the $uote in 0igure 1.1. the "nternet. (escribe what has

As o! 2ove ber '+, '337, -C(*s stoc# price had increased in value to 457.7' per share. -C( e&perienced a odest loss !ro 6uly 11, '337 reaching a trough in id7August '337 at appro&i ately 487.53 per share. Since that ti e, it has generally trended upward through the 0all o! '337. LG' 8. Get the trading statistics !or the three activity to that o! Table 1.1. ain 9.S. stoc# e&changes. Co pare the trading

The table below re!lects trading activity on the three ain 9.S. stoc# e&changes !or 2ove ber ':, '337. Trading volu e was particularly high this day co pared to the 6uly 11, '337 activity re!lected in Table 1.1. Continued concerns over the ho e ortgage crises built into a selling !ren;y in the ar#ets with the (6"A plu eting '83 points on this day. <olu e was also up due to this trading day i ediately !ollowing the Than#sgiving holiday wee#end, since ar#ets were closed the previous Thursday and only light trading volu e was e&perienced in the lightly attended trading session the day a!ter Than#sgiving.

771

Chapter 7, Solutions

Cornett, Adair, and Nofsinger

ADVANCES & DECLINES NYSE Advancing "ssues (eclining "ssues 9nchanged "ssues Total Issues Ne' Hig(s Ne' Lo's 9p <olu e (own <olu e -nc(ange. Volu/e Total Volu/e 1+8 .'8=/ ',5:5 .78=/ :8 .'=/ "#$%" $) "$+ 8:+,1+1,17+ .1+=/ +,18>,:51,1'+ .1:=/ +1,:8:,318 .1=/ "#%),#&,0#7*+& A E! 851 .++=/ 1'8 .:3=/ >: .7=/ &#"7& $* &,* 13',17+,18: .1+=/ ::7,>:',5'8 .1:=/ 1,1+1,'>: .1=/ 77*#,7"#0%%& NASDAQ 71' .'5=/ ','81 .7'=/ 138 .+=/ "#&"$ )$ ,*% ++>,>81,35: .17=/ 1,5>>,:71,7'7 .1'=/ 1,>81,:8' .3=/ &#0$*#)7)#$,)&

LG+

5. ?hy ight the Standard @ Aoor*s 533 "nde& be a better easure o! stoc# ar#et per!or ance than the (ow 6ones "ndustrial Average? ?hy is the (6"A ore popular than the S@A 533? The S@A 533 is a broad ar#et inde& that includes stoc#s o! the 533 largest 9S !ir s !ro ten sectors o! the econo y. "t captures 13= o! the overall stoc# ar#et capitali;ation and is a good pro&y !or what is occurring in the overall stoc# ar#et. The (6"A has been used !or a longer period, since the id71113*s, and represents the activity o! the +3 largest corporations in the 9S, covering +3= o! the stoc# ar#et. "ts popularity arises !ro it being the !irst inde& used by the edia.

LG+

:. B&plain how it is possible !or the (6"A to increase one day while the 2asda$ Co posite decreases during the sa e day. The co ponents o! the (6"A and the 2asda$ Co posite inde& are ostly di!!erent co panies. The (6"A includes the +3 industry leaders across all sectors o! the econo y. The 2asda$ is co prised o! predo inantly technology related !ir s and e its a noisy signal o! technology per!or ance on any given day.

LG8

7. ?hich is higher, the as# $uote or the bid $uote? ?hy?

77'

Chapter 7, Solutions

Cornett, Adair, and Nofsinger

The ar#et a#er*s as# price is the lowest price o!!ered !or stoc# sale and the bid price is the highest price a ar#et a#er will pay !or stoc# purchase. Thus, the as# price is higher than the bid price. The di!!erence is the bid7as# spread and it represents the gain a ar#et a#er achieves by ta#ing the ris# position and providing the needed li$uidity !or the stoc# in $uestion. LG8 1. "llustrate through e&a ples how trading co ission costs i pact an investor*s return.

Assu e an investor wishes to purchase a stoc# at a stri#e price o! 4>3. Two scenarios to consider, at their e&tre es, would be the purchase o! 13 shares versus the purchase o! 133 shares. The costs to purchase through a discount bro#er, assu ing the bro#er charges 4'3 per trade would be 4>'3 .4>33 C 4'3/ and 4>3'3, respectively. The co ission !or the trades in percentages would be '.''= and 3.''=, respectively. 0or the investor who owns only 13 shares, the price would have to rise by 4' per share to recoup the co ission cost. "t would only have to rise '3D !or the investor who owns 133 shares. "t is evident that the percentage o! trading co issions is lower on larger volu e trades and the e!!ect would be even ore pronounced i! the trades had been placed through a retail bro#er. LG8 >. (escribe the di!!erence in the ti ing o! trade e&ecution and the certainty o! trade price between ar#et orders and li it orders. -ar#et a#ers !ill ar#et orders i ediately at the current stoc# price. This provides the li$uidity an investor needs to buy and sell stoc#s $uic#ly. Eowever, the price at which the stoc# will !ill cannot be guaranteed. ?ith li it orders, the ar#et a#er will only !ill the order when the stated price is reached. This eans that you can count on the e&ecution only a!ter your target buy or sell price is reached, but you cannot guarantee your trade will e&ecute with a li it order. LG5 13. ?hat are the di!!erences between co on stoc# and pre!erred stoc#?

Co on stoc# dividends change over ti e, hope!ully increasing in the long7ter . Are!erred stoc# pays a constant dividend. Are!erred stoc#holders have higher precedence !or pay ent in the event o! !ir li$uidation !ro ban#ruptcy. Eowever, pre!erred stoc#holders do not have voting rights that co on stoc# holders en%oy. Are!erred stoc# prices !luctuate with ar#et interest rates and behave li#e corporate bond prices. Co on stoc# price changes with the value o! the co pany*s underlying business. LG5 11. Eow i portant is growth to a stoc#*s value? "llustrate with e&a ples. Consider two !ir s with a co on ne&t period dividend o! 41, a co on ar#et discount rate o! 1=, but di!!ering growth rates o! += and 5=, respectively. The i plied current prices o! these stoc#s are 4'3 FG41H.3.3173.3+/I and 4++.++ FG41H.3.3173.35/I respectively. The !ir with higher growth prospects .5=/ is valued ore highly than the !ir with lower growth rate prospects .+=/.

77+

Chapter 7, Solutions

Cornett, Adair, and Nofsinger

LG5

1'. 9nder what conditions would the constant growth rate

odel not be appropriate?

?hen the growth rate e&ceeds the discount rate, the constant growth rate odel cannot be e ployed. "t is also not appropriate when the growth rate cannot reasonably be e&pected to be constant into the !uture. LG5 1+. The e&pected return derived !ro the constant growth rate odel relies on dividend yield and capital gain. ?here do these two parts o! the return co e !ro ? )earranging the ter s and solving !or the i !ro the constant growth odel yields the e&pected return odel. The co ponents are the dividend yield and the capital gain. The dividend yield re!lects the percentage return !ro current !ir operations. The capital gain captures the !ir *s !uture growth prospects. Joth co ponents are i portant !ro an investor point o! view, with dividends providing inco e to an investor over the stoc# holding period and the capital gain being reali;ed at the ti e o! stoc# sale. LG: 18. (escribe, in words, how to use the variable growth rate techni$ue to value a stoc#. ?hen the !ir is growing at a very !ast pace in its in!ancy, the e&pected growth rate will initially be very large. This rate should be used !or the high growth period, but a ter inal growth rate should be e ployed !or valuation when the !ir atures. Bssentially, a !ir cannot grow !aster than the general econo y inde!initely and ust be capped in the long ter by its ature growth rate. LG: 15. Can the variable growth rate odel be used to value a !ir that has a negative growth rate in Stage 1 and a stable and positive growth in Stage '? B&plain. "n this case, the !ir would be contracting over a short period and then reaching a stable, positive growth rate. "nso!ar as the initial rate during contraction does not do inate the later ature growth rate, this is possible. "t would suggest that a !ir *s dividends in the short ter decreased, !ollowed by a positive dividend strea in the longer ter . LG7 1:. B&plain why using the AHB relative value approach do not pay dividends. ay be use!ul !or co panies that

Since dividends are non7e&istent, the !orecast stoc# price is si ply a !unction o! current price and the discount rate. "n isolation, it is hard to deter ine i! the !ir is under or overvalued based on this in!or ation only. 9sing the AHB relative value approach, the trailing AHB can be calculated and co pared to a !ir *s co petitors. LG7 17. Eow is a !ir *s changing AHB ratio re!lected in the stoc# price? Give e&a ples. The AHB ratio ultiplied by a !ir *s earnings result in the stoc# price. 0or e&a ple, i! a !ir is e&periencing high growth and all other !actors are held constant, this will lead to a

778

Chapter 7, Solutions

Cornett, Adair, and Nofsinger

higher AHB ratio re!lecting the growth prospects. Stoc# prices can change si ply because the ar#et changes the AHB ratio appropriate !or that stoc#. LG7 11. (i!!erentiate the characteristics o! growth stoc#s and value stoc#s? Ta#en in tande , AHB ratios and growth rates illustrate the type o! stoc# the !ir is characteri;ed by, growth or inco e. 0ir s with high AHB and high growth rates are growth stoc#s. A co parison across an industry o! AHB ratios can be an aid to investors in selecting the best growth stoc# to purchase. Jy contrast, !ir s with low AHB ratios and low growth rates tend to be value stoc#s. LG7 1>. ?hat*s the relationship between the AHB ratio and a !ir *s growth rate? The price o! a stoc# can be odeled with the constant growth rate e$uation. 2ote that the deno inator is .i K g/. So the price relative to earnings is i pacted by the growth rate o! the !ir . A high growth rate will cause a high price and AHB. Thus, high growth !ir s should have high AHB ratios while low growth rate !ir s should have low AHB ratios. LG7 '3. (escribe the process !or using the AHB ratio to esti ate a !uture stoc# price. 9sing current earnings and an e&pected growth rate !or these earnings, the current AHB ratio can be ultiplied by the esti ate o! !uture earnings to produce a price esti ate !or the !uture stoc# value. That is, the current AHB ratio acts as a guide !or the stoc#*s !uture price. This approach should be e ployed cautiously by co paring the AHB ratios to si ilar !ir s to ensure that the !ir you have selected has a reasonable AHB ratio. P1o2le/s Jasic Aroble s LG+ 771 Stock In.e3 Pe14o1/ance ,n 6anuary 1:, '337, the (ow 6ones "ndustrial Average set a new high. The inde& closed at 1',51'.5>, which was up ':.51 that day. ?hat was the return .in percent/ o! the stoc# ar#et that day? 0< G A< L .1 C i/ 1',51'.5> G .1',51'.5>7':.51/ L .1 C i/ i G .1',51'.5>H1',55:.31/71 G 3.'111= LG+ 77' Stock In.e3 Pe14o1/ance ,n 6anuary 1:, '337, the Standard @ Aoor*s 533 "nde& reached the highest it had been since '333. The inde& closed at 1,8+1.>3, which was up 1.17 that day. ?hat was the return .in percent/ o! the stoc# ar#et that day? 0< G A< L .1 C i/ 1,8+1.>3 G .1,8+1.>71.17/ L .1 C i/ i G .1.8+1.>3H1,8+3.7+/71 G 3.31171=

775

Chapter 7, Solutions

Cornett, Adair, and Nofsinger

LG8

77+ 5u6ing Stock 'it( Co//issions At your discount bro#erage !ir , it costs 41.>5 per stoc# trade. Eow uch oney do you need to buy '33 shares o! A!i;er, "nc. .A0B/, which trades at 4'7.''? .4'7.''Hshare L '33 shares/ C 41.>5 G 45,85'.>5

LG8

778 5u6ing Stock 'it( Co//issions At your discount bro#erage !ir , it costs 4>.53 per stoc# trade. Eow uch oney do you need to buy +33 shares o! Ti e ?arner, "nc. .T?M/, which trades at 4''.:'? .4''.:'Hshare L +33 shares/ C 4>.53 G 4:,7>5.53

LG8

775 Selling Stock 'it( Co//issions At your !ull7service bro#erage !ir , it costs 41'3 per stoc# trade. Eow uch oney do you receive a!ter selling 153 shares o! 2o#ia Corporation .2,N/, which trades at 4'3.1+? .4'3.1+Hshare L 153 shares/ 7 41'3 G 4',1>>.53

LG8

77: Selling Stock 'it( Co//issions At your !ull7service bro#erage !ir , it costs 41+5 per stoc# trade. Eow uch oney do you receive a!ter selling '53 shares o! "nternational Jusiness -achines ."J-/, which trades at 4>:.17? .4>:.17Hshare L '53 shares/ 7 41+5 G 4'+,>37.53

LG8

777 5u6ing Stock 'it( a a1ket 71.e1 Oou would li#e to buy shares o! Sirius Satellite )adio .S")"/. The current as# and bid $uotes are 4+.>: and 4+.>+ respectively. Oou place a ar#et buy7order !or 533 shares that e&ecutes at these $uoted prices. Eow uch oney did it cost to buy these shares? .4+.>:Hshare L 533 shares/ G 41,>13.33

LG8

771 5u6ing Stock 'it( a a1ket 71.e1 Oou would li#e to buy shares o! Coldwater Cree#, "nc. .C?T)/. The current as# and bid $uotes are 4'3.73 and 4'3.:: respectively. Oou place a ar#et buy7order !or '33 shares that e&ecutes at these $uoted prices. Eow uch oney did it cost to buy these shares? .4'3.73Hshare L '33 shares/ G 48,183.33

LG8

77> Selling Stock 'it( a Li/it 71.e1 Oou would li#e to sell '33 shares o! ?orldSpace, "nc. .?)SA/. The current as# and bid $uotes are 48.:: and 48.:' respectively. Oou place a li it sell7order at 48.:5. "! the trade e&ecutes, how uch oney do you receive !ro the buyer? .48.:5Hshare L '33 shares/ G 4>+3.33

77:

Chapter 7, Solutions

Cornett, Adair, and Nofsinger

LG8

7713 Selling Stock 'it( a Li/it 71.e1 Oou would li#e to sell 133 shares o! eCollege.co .BCLG/. The current as# and bid $uotes are 415.++ and 415.'1 respectively. Oou place a li it sell7order at 415.+1. "! the trade e&ecutes, how uch oney do you receive !ro the buyer? .415.+1Hshare L133 shares/ G 41,5+1.33

LG5

7711 Value o4 a P1e4e11e. Stock A pre!erred stoc# !ro (u$uesne Light Co pany .(P9A)A/ pays 4'.13 in annual dividends. "! the re$uired return on the pre!erred stoc# is 5.8 percent, what*s the value o! the stoc#? 9se e$uation 77:, noting that !or pre!erred stoc#, the growth rate g e$uals ;eroQ
Constant growth odel = P3 = 4'.13 D3 (1 + g ) = = 4+1.1> i g 3.358 3

LG5

771' Value o4 a P1e4e11e. Stock A pre!erred stoc# !ro Eecla -ining Co. .ELA)J/ pays 4+.53 in annual dividends. "! the re$uired return on the pre!erred stoc# is :.1 percent, what is the value o! the stoc#? 9se e$uation 77:, noting that !or pre!erred stoc#, the growth rate g e$uals ;eroQ
Constant growth odel = P3 = 4+.53 D3 (1 + g ) = = 451.87 ig 3.3:1 3

LG7

771+ P8E Ratio an. Stock P1ice 9ltra Aetroleu .9AL/ has earnings per share o! 41.5: and a AHB ratio o! +'.81. ?hat*s the stoc# price? 9se e$uation 7713Q

Pn = P
LG7

( E) ( E)

E n = +'.81 1.5: = 453.:7

7718 P8E Ratio an. Stock P1ice 6A -organ Chase Co. .6A-/ has earnings per share o! 4+.5+ and a AHB ratio o! 1+.11. ?hat is the price o! the stoc#? 9se e$uation 7713Q

Pn = P

E n = 1+.11 +.5+ = 481.75

"nter ediate Aroble s 7715 Value o4 Di9i.en.s an. :utu1e P1ice A !ir

is e&pected to pay a dividend o! 41.+5

777

Chapter 7, Solutions

Cornett, Adair, and Nofsinger

LG5

ne&t year and 41.53 the !ollowing year. 0inancial Analysts believe the stoc# will be at their price target o! 475 in two years. Co pute the value o! this stoc# with a re$uired return o! 11.5 percent. 9se e$uation 77+Q LG5
P3 = D1 1+ i + D' + P'

(1 + i )

'

1.+5 1.53 + 75.33 + = 4:'.78 1 + 3.115 (1 + 3.115) '

771: Value o4 Di9i.en.s an. :utu1e P1ice A !ir is e&pected to pay a dividend o! 4'.35 ne&t year and 4'.+5 the !ollowing year. 0inancial Analysts believe the stoc# will be at their price target o! 4113 in two years. Co pute the value o! this stoc# with a re$uired return o! 1' percent. 9se e$uation 77+Q P3 = D1 D' + P' '.35 '.+5 + 113.33 + = + = 4>1.83 ' 1 + i (1 + i ) 1 + 3.1' (1 + 3.1') ' 43.>: in '333 to

LG5

7717 Di9i.en. ;1o't( Annual dividends o! AT@T Corp .T/ grew !ro 41.++ in '33:. ?hat was the annual growth rate? 9se e$uation 87'Q
0uture value in : years = 1.++ = 3.>: (1 + g ) g = 5.51=
:

LG5

7711 Di9i.en. ;1o't( Annual dividends o! General Blectric .GB/ grew !ro '331 to 41.3+ in '33:. ?hat was the annual growth rate? 9se e$uation 87'Q
0uture value in 5 years = 1.3+ = 3.:: (1 + g ) g = >.+1=
5

43.:: in

LG5

771> Value a Constant ;1o't( Stock 0inancial analysts !orecast Sa!eco Corp. .SA0/ growth !or the !uture to be 13 percent. Sa!eco*s recent dividend was 41.'3. ?hat is the value o! Sa!eco stoc# when the re$uired return is 1' percent? 9se e$uation 77:Q
Constant growth odel = P3 = D3 (1 + g ) 41.'3(1 + 3.13 ) = = 4::.33 i g 3.1' 3.13

LG5

77'3 Value a Constant ;1o't( Stock 0inancial analysts !orecast Li ited Jrands .LT(/ growth !or the !uture to be 1'.5 percent. LT(*s recent dividend was 43.:3. ?hat is the value o! Li ited Jrands stoc# when the re$uired return is 18.5 percent? 9se e$uation 77:Q

771

Chapter 7, Solutions

Cornett, Adair, and Nofsinger

Constant growth

odel = P3 =

D3 (1 + g ) 43.:3(1 + 3.1'5) = = 4++.75 i g 3.185 3.1'5

LG5

77'1 E3<ecte. Retu1n Bcolap "nc. .BCL/ recently paid a 43.8: dividend. The dividend is e&pected to grow at a 18.5 percent rate. At a current stoc# price o! 488.1', what is the return shareholders are e&pecting? 0irst convert (3 to (1 by 43.8:L.1C3.185/ G 43.5'7. Then use e$uation 777Q
B&pected return = i = D1 + g = .3.5'7 H 88.1'/ + 3.185 = 15.:>= P3

LG5

77'' E3<ecte. Retu1n Aayche& "nc. .AAOM/ recently paid a 43.18 dividend. The dividend is e&pected to grow at a 15 percent rate. At a current stoc# price o! 483.11, what is the return shareholders are e&pecting? 0irst convert (3 to (1 by 43.18L.1C3.15/ G 43.>::. Then use e$uation 777Q
B&pected return = i = D1 + g = .3.>:: H 83.11/ + 3.15 = 17.81= P3

LG:

77'+ Di9i.en. Initiation an. Stock Value A !ir does not pay a dividend. "t is e&pected to pay its !irst dividend o! 43.'3 per share in + years. This dividend will grow at 11 percent inde!initely. 9sing a 1' percent discount rate, co pute the value o! this stoc#. 0irst co pute the year ' value o! the stoc# using e$uation 77: and then discount this bac# two years to get the present value o! the stoc# priceQ
Constant growth odel = P' = D+ = 43.'3 H.3.1' 3.11/ = 4'3.33 i g

P3 = .'3 H 1.1' ' / = 415.>8

LG:

77'8 Di9i.en. Initiation an. Stock Value A !ir does not pay a dividend. "t is e&pected to pay its !irst dividend o! 43.'5 per share in ' years. This dividend will grow at 13 percent inde!initely. 9sing a 11.5 percent discount rate, co pute the value o! this stoc#. 0irst co pute the year 1 value o! the stoc# using e$uation 77: and then discount this bac# one year to get the present value o! the stoc# priceQ

77>

Chapter 7, Solutions

Cornett, Adair, and Nofsinger

Constant growth

odel = P1 =

D' = 43.'5 H.3.115 3.13/ = 41:.:7 i g

P3 = .1:.:7 H 1.115/ = 418.>5

LG7

77'5 P8E Ratio o.el an. :utu1e P1ice Nellogg Co. .N/ recently earned a pro!it o! 4'.5' earnings per share and has a AHB ratio o! 1>.1:. The dividend has been growing at a 5 percent rate over the past !ew years. "! this growth rate continues, what would be the stoc# price in !ive years i! the AHB ratio re ained unchanged? ?hat would the price be i! the AHB ratio declined to 15 in !ive years? 9nder these two scenarios, the !uture price esti ates using e$uation 7713 areQ

P5 = P P5 = P
LG7

( E ) E (1 + g )
n 3 n 3

= 1>.1: 4'.5' ( 1 + 3.35) = 4:+.17

5 5

( E ) E (1 + g )

= 15 4'.5' ( 1 + 3.35) = 481.'8

77': P8E Ratio o.el an. :utu1e P1ice 2ew Oor# Ti es Co. .2OT/ recently earned a pro!it o! 41.'1 earnings per share and has a AHB ratio o! 1>.5>. The dividend has been growing at a 7.'5 percent rate over the past si& years. "! this growth rate continues, what would be the stoc# price in !ive years i! the AHB ratio re ained unchanged? ?hat would the price be i! the AHB ratio increased to '' in !ive years? 9nder these two scenarios, the !uture price esti ates using e$uation 7713 areQ

P5 = P P5 = P
Advanced Aroble s LG5

( E ) E (1 + g )
n 3 n 3

= 1>.5> 41.'1 ( 1 + 3.37'5) = 4++.:8

5 5

( E ) E (1 + g )

= '' 41.'1 ( 1 + 3.37'5) = 4+7.77

77'7 Value o4 :utu1e Cas( :lo's A !ir recently paid a 43.85 annual dividend. The dividend is e&pected to increase by 13 percent in each o! the ne&t !our years. "n the !ourth year, the stoc# price is e&pected to be 413. "! the re$uired return !or this stoc# is 1+.5 percent, what is its value? 0ind the dividends in the ne&t !our yearsQ (1 G 43.85 L .1 C 3.13/ G 43.8>5 (' G 43.8>5 L .1 C 3.13/ G 43.5885 (+ G 43.5885 L .1 C 3.13/ G 43.5>> (8 G 43.5>> L .1 C 3.13/ G 43.:5>

7713

Chapter 7, Solutions

Cornett, Adair, and Nofsinger

Then use e$uation 77+ asQ

P3 = D+ D1 D' D + P8 + + + 8 ' + 1 + i (1 + i ) (1 + i ) (1 + i ) 8

= 3.8>5 H 1.1+5 + 3.5885 H 1.1+5 ' + 3.5>> H 1.1+5 + + .3.:5> + 13/ H 1.1+5 8 = 48>.17

LG5

77'1 Value o4 :utu1e Cas( :lo's A !ir recently paid a 43.:3 annual dividend. The dividend is e&pected to increase by 1' percent in each o! the ne&t !our years. "n the !ourth year, the stoc# price is e&pected to be 4113. "! the re$uired return !or this stoc# is 18.5 percent, what is its value? 0ind the dividends in the ne&t !our yearsQ (1 G 43.:3 L .1 C 3.1'/ G 43.:7' (' G 43.:7' L .1 C 3.1'/ G 43.75+ (+ G 43.75+ L .1 C 3.1'/ G 43.18+ (8 G 43.18+ L .1 C 3.1'/ G 43.>88 2ow use e$uation 77+Q
P3 = D+ D1 D' D + P8 + + + 8 ' + 1 + i (1 + i ) (1 + i ) (1 + i ) 8

= 3.:7' H 1.185 + 3.75+ H 1.185 ' + 3.18+ H 1.185 + + .3.>88 + 113/ H 1.185 8 = 4::.'7

LG5

77'> Constant ;1o't( Stock Valuation ?algreen Co. .?AG/ paid a 43.1+7 dividend per share in '333, which grew to 43.'1: in '33:. This growth is e&pected to continue. ?hat is the value o! this stoc# at the beginning o! '337 when the re$uired return is 1+.7 percent? 0irst calculate the growth rate !ro '333 to '33:Q

0< G A< L .1 C g/: 3.'1: G .3.1+7/ L .1 C g/ : g G .3.'1:H3.1+7/1H:71 G 3.1+35 2ow, use this growth rate in e$uation 77: to get obtain the present value o! the stoc#Q
Constant growth odel = P3 = D3 (1 + g ) = 43.'1: .1.1+35/ H.3.1+7 3.1+35/ = 48>.78 i g

LG5

77+3 Constant ;1o't( Stock Valuation Ca pbell Soup Co. .CAJ/ paid a 43.:+' dividend per share in '33+, which grew to 43.7: in '33:. This growth is e&pected to continue. ?hat is the value o! this stoc# at the beginning o! '337 when the re$uired return is 1.7 percent?

7711

Chapter 7, Solutions

Cornett, Adair, and Nofsinger

0irst calculate the growth rate !ro

'33+ to '33:Q

0< G A< L .1 C g/+ 3.7: G .3.:+'/ L .1 C g/ + g G .3.7:H3.:+'/1H+71 G 3.3:+8 2ow, use this growth rate in e$uation 77: to get obtain the present value o! the stoc#Q
Constant growth odel = P3 = D 3 (1 + g ) = 43.7: .1.3:+8/ H.3.317 3.3:+8/ = 4+8.'5 i g

LG5

77+1 C(anges in ;1o't( an. Stock Valuation Consider a !ir that had been priced using a 13 percent growth rate and a 1' percent re$uired return. The !ir recently paid a 41.'3 dividend. The !ir has %ust announced that because o! a new %oint venture, it will li#ely grow at a 13.5 percent rate. Eow uch should the stoc# price change .in dollars and percentage/? 9se e$uation 77: to calculate the !ir *s value prior to the ventureQ
Constant growth odel = P3 = D3 (1 + g ) = 41.'3 .1.13/ H.3.1' 3.13/ = 4::.33 ig

"! the !ir *s growth rate changes to 13.5=, then the new stoc# price isQ
Constant growth odel = P3 = D3 (1 + g ) = 41.'3 .1.135/ H.3.1' 3.135/ = 411.83 ig

The dollar a ount o! this change is 411.83 7 4::.33 G 4''.83 or ++.>+= !or the 3.5= increase to the growth rate. LG5 77+' C(anges in ;1o't( an. Stock Valuation Consider a !ir that had been priced using a 11.5 percent growth rate and a 1+.5 percent re$uired return. The !ir recently paid a 41.53 dividend. The !ir has %ust announced that because o! a new %oint venture, it will li#ely grow at a 1' percent rate. Eow uch should the stoc# price change .in dollars and percentage/? 9se e$uation 77: to calculate the !ir *s value prior to the ventureQ
Constant growth odel = P3 = D3 (1 + g ) = 41.53 .1.115/ H.3.1+5 3.115/ = 41+.:+ ig

"! the !ir *s growth rate changes to 1'=, then the new stoc# price isQ

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Chapter 7, Solutions

Cornett, Adair, and Nofsinger

Constant growth

odel = P3 =

D3 (1 + g ) = 41.53 .1.1'/ H.3.1+5 3.1'/ = 411'.33 ig

The dollar a ount o! this change is 411'.33741+.:+ G 4'1.+7 or ++.>'= !or the 3.5= increase to the growth rate. LG: 77++ Va1ia2le ;1o't( A !ast growing !ir recently paid a dividend o! 43.+5 per share. The dividend is e&pected to increase at a '3 percent rate !or the ne&t + years. A!terwards, a ore stable 1' percent growth rate can be assu ed. "! a 1+ percent discount rate is appropriate !or this stoc#, what is its value? 9se e$uation 771Q
D (1 + g 1 ) D3 (1 + g 1 ) P3 = 3 + + 1+ i (1 + i ) '
'

D3 (1 + g 1 ) +
+

(1 + i ) +
'

D3 (1 + g1 ) (1 + g ' ) i g'
+ +

P3 =

3.+5(1 + 3.'3 ) 3.+5(1 + 3.'3 ) + + 1 + 3.1+ (1 + 3.1+) '

3.+5(1 + 3.'3 )

3.+5(1 + 3.'3 ) (1 + 3.1' ) + 3.1+ 3.1' (1 + 3.1+) +

+

P3 = 3.+7' + 3.+>5 + 87.+: = 481.1+

LG:

77+8 Va1ia2le ;1o't( A !ast growing !ir recently paid a dividend o! 43.83 per share. The dividend is e&pected to increase at a '5 percent rate !or the ne&t 8 years. A!terwards, a ore stable 11 percent growth rate can be assu ed. "! a 1'.5 percent discount rate is appropriate !or this stoc#, what is its value? 9se e$uation 771Q
P3 = D3 (1 + g 1 ) D3 (1 + g 1 ) D (1 + g 1 ) + + 3 + ' 1+i (1 + i ) (1 + i ) +
' + ' +

D3 (1 + g 1 ) +
8

(1 + i ) 8
3.83(1.'5)
8

D3 (1 + g 1 ) (1 + g ' ) i g'
8 8

P3 =

3.83(1 + 3.'5) 3.83(1.'5) 3.83(1.'5) + + + ' 1 + 3.1'5 (1.1'5) (1.1'5) +

3.83(1.'5) (1 + 3.11) + 3.1'5 3.11 (1.1'5) 8

= 3.888 + 3.8>8 + 3.58> + 85.7'5 = 487.'1

LG5 LG7

77+5 P8E o.el an. Cas( :lo' Valuation Suppose that a !ir *s recent earnings per share and dividend per share are 4'.53 and 41.+3, respectively. Joth are e&pected to grow at 1 percent. Eowever, the !ir *s current AHB ratio o! '' see s high !or this growth rate. The AHB ratio is e&pected to !all to 11 within !ive years. Co pute a value !or this stoc# by !irst esti ating the dividends over the ne&t !ive years and the stoc# price in !ive years. Then discount these cash !lows using a 13 percent re$uired rate.

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Chapter 7, Solutions

Cornett, Adair, and Nofsinger

0ind the dividends in the ne&t !our yearsQ (1 G 41.+3 L .1 C 3.31/ G 41.838 (' G 41.838 L .1 C 3.31/ G 41.51: (+ G 41.51: L .1 C 3.31/ G 41.:+1 (8 G 41.:+1 L .1 C 3.31/ G 41.7:> (5 G 41.7:> L .1 C 3.31/ G 41.>13 2e&t, use e$uation 7713 to calculate the stoc# price in year 5Q

P5 = P

( E ) E = ( P E ) E (1 + g )
5 5 5 3

= 11 4'.53 .1.31/ 5 = 4::.1'

2ow !ind the present value o! these cash !lows using a 13= discount rate to get A3Q
P3 = D+ D + P5 D1 D' D8 + + + + 5 ' + 8 1 + i (1 + i ) (1 + i ) (1 + i ) (1 + i ) 5

= 1.838 H 1.13 + 1.51: H 1.13 ' + 1.:+1 H 1.13 + + 1.7:> H 1.13 8 + .1.>13 + ::.1'/ H 1.13 5 = 487.'1

LG5 LG7

77+: P8E o.el an. Cas( :lo' Valuation Suppose that a !ir *s recent earnings per share and dividend per share are 4'.75 and 41.:3, respectively. Joth are e&pected to grow at > percent. Eowever, the !ir *s current AHB ratio o! '+ see s high !or this growth rate. The AHB ratio is e&pected to !all to 1> within !ive years. Co pute a value !or this stoc# by !irst esti ating the dividends over the ne&t !ive years and the stoc# price in !ive years. Then discount these cash !lows using an 11 percent re$uired rate. 0ind the dividends in the ne&t !our yearsQ (1 G 41.:3 L .1 C 3.3>/ G 41.788 (' G 41.788 L .1 C 3.3>/ G 41.>31 (+ G 41.>31 L .1 C 3.3>/ G 4'.37' (8 G 4'.37' L .1 C 3.3>/ G 4'.'51 (5 G 4'.'51 L .1 C 3.3>/ G 4'.8:' 2e&t, use e$uation 7713 to calculate the stoc# price in year 5Q

P5 = P

( E ) E = ( P E ) E (1 + g )
5 5 5 3

= 1> 4'.75 .1.3>/ 5 = 413.+>

2ow !ind the present value o! these cash !lows using an 11= discount rate to get A3Q
P3 = D+ D + P5 D1 D' D8 + + + + 5 ' + 8 1 + i (1 + i ) (1 + i ) (1 + i ) (1 + i ) 5

= 1.788 H 1.11 + 1.>31 H 1.11' + '.37' H 1.11+ + '.'51 H 1.118 + . '.8:' + 13.+>/ H 1.115 = 455.'>

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Chapter 7, Solutions

Cornett, Adair, and Nofsinger

77+7 E3cel P1o2le/ Spreadsheets are especially use!ul !or co puting stoc# value under di!!erent assu ptions. Consider a !ir that is e&pected to pay the !ollowing dividendsQ Oear 1 ' + 8 5 : 41.'3 41.'3 41.53 41.53 41.75 41.>3 and grow at 5= therea!ter A. 9sing an 11 percent discount rate, what would be the value o! this stoc#? J. ?hat is the value o! the stoc# using a 13 percent discount rate? A 1' percent discount rate? C. ?hat would the value be using a := growth rate a!ter Oear : instead o! the 5= rate using each o! these three discount rates? (. ?hat do you conclude about stoc# valuation and its assu ptions? S,L9T",2Q
P1esent Value &&= Discount Rate 41.31 43.>7 41.13 43.>> 41.38 41.3' &+= Discount Rate 41.3> 43.>> 41.1+ 41.3' 41.3> 41.37 &,= Discount Rate 41.37 43.>: 41.37 43.>5 43.>> 43.>:

At 5= growth

Yea1 1 ' + 8 5 :

Di9i.en. 41.'3 41.'3 41.53 41.53 41.75 41.>3 Te1/inal P1ice 4++.'5 4+>.>3 4'1.53 Su/ >

: R 11= : R 13= : R 1'=

417.71 4''.5' 418.88 ?,"@07 ?,*@0, ?,+@$$

At := growth &&= Discount Rate 41.31 43.>7 41.13 43.>> 41.38

P1esent Value &+= Discount Rate 41.3> 43.>> 41.1+ 41.3' 41.3> &,= Discount Rate 41.37 43.>: 41.37 43.>5 43.>>

Yea1 1 ' + 8 5

Di9i.en. 41.'3 41.'3 41.53 41.53 41.75

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Chapter 7, Solutions

Cornett, Adair, and Nofsinger

41.>3 Te1/inal P1ice 483.'1 453.+5 4++.57 Su/ >

41.3'

41.37

43.>:

: R 11= : R 13= : R 1'=

4'1.58 4'1.8' 417.31 ?,7@7" ?"$@*& ?,"@+&

A. 0ro the table calculated in B&cel, the value o! the stoc# based on an 11= discount rate would be 4'+.>7. J. 0ro the table, the value o! the stoc# based on a 13= discount rate would be 4'1.>' and based on a 1'= discount rate would be 4'3.88. C. 0ro the table, the value o! the stoc# that grows at := .rather than 5=/ in year 7 and a!ter causes a higher stoc# value than a !uture 5= growth. (. Assu ptions are crucially i portant in stoc# valuation. -inor changes in either the discount rate or the growth assu ption rate can have big i pact on stoc# valuation. Resea1c( It Stock Sc1eene1 "nvestors can choose !ro any thousands o! stoc#s. The large nu ber to choose !ro can be $uite daunting to new investors. 0ortunately, so e good stoc# screeners are available !or !ree on the "nternet that will !ind only the #inds o! co panies the investor is loo#ing !or. Loo#ing !or s all value co panies? A stoc# screen at OahooS 0inance will show all the stoc#s that eet the three criteria o! .1/ ar#et capitali;ation between 4'53 illion and 41 billion, .'/ AHB ratio less than or e$ual to 13, and .+/ a $uic# ratio greater or e$ual to 1.3. "n 6anuary o! '337, 1: !ir s et all three o! these criteria. OahooS 0inance provides 1> screens li#e this one to choose !ro . Aic# one o! these pre7set screens. (iscuss the #inds o! stoc#s the screen will !ind and report on those co panies. .httpQHHscreener.!inance.yahoo.co Hpresetscreens.ht l/ S,L9T",2Q Consider the preset screen !or Large Cap <alue. description is as !ollowsQ The stoc# screener

Stocks with market capitalizations greater than or equal to $ !illion with a price" earnings ratio less than or equal to # and a quick ratio of greater than or equal to #$% Selecting this prescreen yields any o! the big, ature !ir s you would e&pect, such as B&&on-obil .M,-/, A!i;er, "nc. .A0B/, Gold an Sachs .GS/ and 0ede& Corp .0(M/. These are ature !ir s in their industry that co and very large capitali;ation .4817 billion !or M,-/ and are !avored invest ents !or larger institutional investors. These

771:

Chapter 7, Solutions

Cornett, Adair, and Nofsinger

!ir s tends to be leaders in their industry and o!!er an attractive strea their investors. Integ1ate. ini CaseA Valuing Ca1ni9al Co1<o1ation

o! dividends !or

Carnival Corp. provides cruises to a%or vacation destinations. Carnival operates 7> cruise ships with a total capacity o! 1+:,>:3 passengers in 2orth A erica, Burope, the 9nited Ningdo , Ger any, Australia, and 2ew Tealand. The co pany also operates hotels, sightseeing otor coaches and rail cars, and lu&ury day boats. These activities generated earnings per share o! 4'.7+ !or '33:. The stoc# price in 6anuary o! '337 was 451.>5. The previous stoc# prices and dividends are shown in the !ollowing table.
,+++ 43.8' 483.+3 ,++& 43.8' 4'>.+ 5 ,++, 43.8' 4'8.> : ,++" 43.88 4''.5 > ,++$ 43.5' 5 48'.' : ,++) 43.13 455.8 8 ,++% 41.3'5 453.51

Annual (ividend Stoc# Arice in 6anuary

Carnival is a !ir in the General Bntertain ent industry, which is in the Services sector. The !ollowing table shows so e #ey statistics !or Carnival, the industry, and the sector.
Be6 Statistic AHB ratio (ividend Oield 2e&t 57year Growth Ca1ni9al +3.+7 3.53= 15.3= ;ene1al Ente1tain/ent ':.'3 '.3>= 1+.'1= Se19ices Secto1 '5.:: 1.++= 1+.88=

9se the various valuation odels and relative value easures to assess whether Carnival stoc# is correctly valued. Co pute value esti ates !ro ultiple odels. The appropriate re$uired rate o! return is 15 percent. "t will be use!ul to calculate the stoc# price !or 6anuary o! '337 !ro co pare to the actual value reali;ed at the ti e, 451.>5 per share. various ethods to

2ote that the growth rate is currently the sa e or higher than the discount rate, so the constant growth rate odel cannot be used. .1/ (eter ine the dividends to year 5 with the sa e growth rate that the dividends have been growing and then use a ter inal AHB ratio o! ': .which is a decline !ro the current AHB o! +3/ to co pute the !uture price. Then !ind the A< o! these cash !lows. So !irst, deter ine the historical dividend growth rateQ

7717

Chapter 7, Solutions

Cornett, Adair, and Nofsinger

0uture value in : years = 1.3'5 = 3.8' (1 + g ) g = 1:.3+=

:

2ow use this 1:= growth rate to !ind the ne&t !ive dividendsQ (1 G 41.3'5 L .1 C 3.1:/ G 41.11> (' G 41.11> L .1 C 3.1:/ G 41.+7> (+ G 41.+7> L .1 C 3.1:/ G 41.:33 (8 G 41.:33 L .1 C 3.1:/ G 41.15: (5 G 41.15: L .1 C 3.1:/ G 4'.15+ 2e&t, use e$uation 7713 to calculate the stoc# price in year 5Q

P5 = P

( E ) E = ( P E ) E (1 + g )
5 5 5 3

= ': 4'.7+ .1.1:/ 5 = 418>.31

2ow !ind the present value, A3, o! these cash !lowsQ

P3 = D+ D + P5 D1 D' D8 + + + + 5 ' + 8 1 + i (1 + i ) (1 + i ) (1 + i ) (1 + i ) 5

= 1.11> H 1.15 + 1.+7> H 1.15 ' + 1.:33 H 1.15 + + 1.15: H 1.15 8 + .'.15+ + 18>.31/ H 1.15 5 = 47>.+1

.'/ 2ow, use the variable valuation odel, using e$uation 771. Assu e that the growth rate !or 5 years is 15= and then it scales bac# to a 1+.'1=, the General Bntertain ent industry growth rate, as its constant growth rateQ
D3 ( 1 + g 1 ) D3 ( 1 + g 1 ) D (1 + g 1 ) D (1 + g 1 ) + + 3 + 3 + ' + 1+ i (1 + i ) (1 + i ) (1 + i ) 8
' + 8 ' +

D3 ( 1 + g 1 ) +
5

P3 =

1.3'5(1 + 3.15) (1 + 3.1+'1) 1.3'5(1 + 3.15) + 3.15 3.1+'1 + (1 + 3.15) 5 = 8.13 + :1.5+ = 47'.:+
5 5

1.3'5(1 + 3.15) 1.3'5(1 + 3.15) 1.3'5(1 + 3.15) 1.3'5(1 + 3.15) P3 = + + + ' + 1 + 3.15 (1 + 3.15) (1 + 3.15) (1 + 3.15) 8

(1 + i ) 5
8

D3 ( 1 + g 1 ) ( 1 + g ' ) i g'
5

.+/ 2ote that the e&pected return !ro

B&pected return = i =

e$uation 777 isQ

D1 + g = 3.53= + 15.3= = 15.5= P3

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Chapter 7, Solutions

Cornett, Adair, and Nofsinger

This is higher than the proposed discount rate o! 15=. This suggests that the stoc# is undervalued. Given the results o! .1/, .'/, and .+/, and the current stoc# price o! 451.>5, Carnival appears undervalued.

771>