CHAPTER 7 STOCK V

Problem 7.1: (Authorized and available shares)

SOLUTION:
Common Stock 2,000,000
Shares Outstanding 1,400,000
Sale of new common stock $ 60.00
$ 48,000,000

a) Maximum shares available for sale :

Authorized shares 2,000,000
less: shares outstanding 1,400,000
Available shares 600,000

b) Total shares needed $ 800,000.00

The firm required an additional 200,000 authorized shares to raise the necessery funds at $60 per share.

c) Aspin must amend its corporate charter to authorized the issuance of additional shares.

Problem 7.2: (Preffered Dividend)

Slater Lamp Manufacturing has an outstanding issue of prefferd stock with an $80 par value and an 11%
annual dividend.
SOLUTION:
a) What is the annual $ dividend? If it is paid quarterly, how much will be paid each quarter?

Par Value $ 80.00

Annual dividend 11%
amount of anuual dividend
per year $ 8.80
amount of anuual dividend
per quarter $ 2.20

The amount of annual dividend is $8.80 per year ($80*11%) or $2.20 ($8.80/4) per quarter.

b) $2.20 For a noncumulative preferred only the latest dividend has to be paid before dividend can be paid on commo

c) $8.80 For cumulative preferred all dividends in arrears must be paid before dividends can be paid on common stoc
the board must pay the three dividends missed plus the current dividend.

Problem 7.3: (Preferred Dividend)

How many $ of preferred dividends per share must be paid to preferred stock holders in current period before
common stock dividend are paid?
 dividen per share
Case Type Par Value
per period
A Cumulative $ 80.00 $ 5.00
B Noncumulative $ 110.00 $ 0.08
C Noncumulative $ 100.00 $ 11.00
D Cumulative $ 60.00 $ 8.50
E Cumulative $ 90.00 $ 0.09
SOLUTION:
A $ 16.00 2 quarters in arrears + the lastest quarter
B $ 8.80 only the latest quarter
C $ 11.00 only the latest quarter
D $ 25.50 4 quarters in arrears + the lastest quarter
E $ 8.10 only the latest quarter

Problem 7.4: (Convertible Preferred stock)

SOLUTION:
Conversion cost 5
Stock price $ 20.00
preferred Dividend $ 10.00

a) Conversion Value $ 100.00

b) If preferred shares are selling at $96.00 each:

Based on comparision of the preferred stock price versus the conversion value, the investor should convert.
If converted ,the investor has $100 of value versus only $96 if she keeps qwnership of the preferred stock.

c) If the investor converts to common stock she will begin receiving $1.00 per share per year of dividends
Conversion will generate $5.00 per year of total dividends. If the investor keeps the preferred they will
receive $10.00 per year of dividends. This additional $5.00 per year in dividends may cause the investor to keep
the preferred until forced to convert through use of the call feature. Furthermore, while common stock dividends
may be cut or eliminated altogether with no protection, preferred dividends are typically fixed and
cumulative provision.

Problem 7.5: (Common Stock Valuation--Zero growth)

SOLUTION:
ZERO GROWT: P0= D1/rs

a) If required return is 12%:

P0 ?
D1 $ 2.40
r 12%
P0=D1/rs $ 20.00
b) If required return rise to 20%:
P0 ?
D1 $ 2.40
r 20%
P0=D1/rs $ 12.00

c) As perceived risk increases, the required rate of return also increases, causing the stock price
to fall.

Problem 7.6: (Common stock value--Zero growth )

SOLUTION:
Zero growth---Po = D1/rs

D1 $ 5.00
rs (when purchased) 16%
rs (when sold) 12%
Total shares purchased 100

Value of stock when

purchased $ 31.25
Value of stock when sold $ 41.67
sally's capital gain (per
share) $ 10.42 per share
sally's total capital gain $ 1,042

Problem 7.7: (Preferred Stock Valuation)

SOLUTION:
PSo = Dp/rp
Do $ 6.40
Par Value $ 80.00
rp 9.30%

a) Pso = Dp/rp $ 68.82

b) when Reruired rate of return rise to 10.5%:

rp 10.50%
PSo = Dp/rp $ 60.95

The investor would lose $7.87 per share ($68.82-$60.95) because as the required rate of return
on preferred stock issues increases above the 9.3% return she receives, the value of her stock
declines.

PROBLEM 7.8: Common stock value--Constant growth)

Use the constant growth model to fine the value of each firm shown in the table.
Dividend
Dividend growth
Firm expected next Reruired return
rate
year
A $ 1.20 8% 13%
B $ 4.00 5% 15%
C $ 0.65 10% 14%
D $ 6.00 8% 9%
E $ 2.25 8% 20%

SOLUTION:
Constant growth Po = D1/(rs-g)
Firm Share Price
A $ 24.00
B $ 40.00
C $ 16.25
D $ 600.00
E $ 18.75

Problem 7.9: (Common Stock Value--constant growth)

SOLUTION:
r = D1/Po + g
D1 $ 1.20
g 5%
r ?
price $ 28.00

a) r = D1/Po + g 9.29%

b) when g rise to 10%:

g 10%
rs 14.29%

Problem 7.10: (Common Stock Value--Constant growth)

Elk County Telephone has paid the dividends shown in the following table over the past 6 years.
year Dividend per share
2012 $ 2.87
2011 $ 2.76
2010 $ 2.60
2009 $ 2.46
2008 $ 2.37
2007 $ 2.25
SOLUTION:
Po = D1/(rs-g)
D $ 3.02
N 5
PV $ 2.25
FV $ 2.87
I 5%

a) Value at 13% required rate return:

r 13%
Po $ 37.75

b) Value at 10% required rate of return:

r 10%
Po $ 60.40

c) As risk increases, the required rate of return increases, causing the share price to fall.

Problem 7.11: (Common Stock Value--Variable growth)

SOLUTION:
Do $ 2.55
g 25%
r 15%
STEP 1 & 2:
Value of cash dividends and PV of annual dividend
Dt
t Do (1+g)^t
(Do*(1+g)^t)
1 $ 2.55 1.2500 $ 3.19
2 $ 2.55 1.5625 $ 3.98
3 $ 2.55 1.9531 $ 4.98
sum of present value of dividend

STEP 3: PV of price of stock at end of initial growth period

Dt = Do*(1+g)
D3 $ 4.98
g 10%
D4 ?
D4 $ 5.48

Po = Do/(rs-g)
D4 $ 5.48
r 15%
g 10%
P3 ?

P3 $ 109.57

PV of stock at end year 3:

N 3
i 15%
FV $ 109.57
PV ?

PV $72.04

STEP 4: Sum of PV of dividends during initial growth period and PV price of stock at end of growth period:
Po = PV of dividends during initial growth period + PV of price of stock at end of growth period.

PV ( initial growth period) $ 16.51

PV (end of growth period) $72.04

Po $ 88.55

Problem 7.12: (Common Stock Valuation--Variable growth)

SOLUTION:

Do $ 1.80
r 11%
g 8%
a)
Value of cash dividends and PV of annual dividend
Dt
t Do (1+g)^t
(Do*(1+g)^t)
1 $ 1.80 1.0800 $ 1.94
2 $ 1.80 1.1664 $ 2.10
3 $ 1.80 1.2597 $ 2.27
sum of present value of dividend

D4 ?
P3 ?
g (in year 4) 5%

D4 = D3*(1+g) $ 2.38
P3 = D4/(rs-g) 39.68
PV of Stock at end of year 3:
N 3
i 11%
FV 39.68
PV ?
PV $29.01

PV of dividends and future stock price:

Po = PV of dividends during initial growth period + PV of price of stock at end of growth period.

PV(Initial growth period) $ 7.85

PV(end of growth period) $29.01

Po $ 36.86

b) The PV of the first 3 year’s dividends is the same as in part (a):

D3 $ 2.27
r 11%
g ( in year 4 ) 0%
D4 ?
P3 ?

D4 = D3*(1+g) $ 2.27
P3 = D4/(rs-g) $ 20.61

PV of stock at end of year 3:

N 3
i 11%
FV $ 20.61
PV ?

PV $15.07

PV of dividends and future stock price:

Po = PV of dividends during initial growth period + PV of price of stock at end of growth period.

PV(Initial growth period) $ 7.85

PV(end of growth period) $15.07

Po $ 22.92

c) The PV of the first 3 year’s dividends is the same as in part (a):

D3 $ 2.27
r 11%
g (in year 4) 10%
D4 ?
P3 ?

D4 = D3*(1+g) $ 2.49
P3 = D4/(rs-g) $ 249.42

PV of stock at end of year 3:

N 3
i 11%
FV $ 249.42
PV ?

PV $182.38

PV of dividends and future stock price:

Po = PV of dividends during initial growth period + PV of price of stock at end of growth period.

PV(Initial growth period) $ 7.85

PV(end of growth period) $182.38

Po $ 190.22

Problem 7.14: (Common stock value--All growth model)

SOLUTION:
a)
Do/Cfo $ 42,500.00
r 18%
g 0%
Po ?

Po = Do/(r-g) $ 236,111

b)
Do/Cfo $ 42,500.00
r 18%
g 7%
1+g 1.07
Po ?
*CF1 = Cfo*(1+g) $ 45,475.00
Po = Do/(r-g) $ 413,409.09

c) Steps 1 and 2: Value of cash dividends and PV of annual dividends

Do 42500
r 18%
g 12%
Value of cash dividends and PV of annual dividend
Dt
t Do (1+g)^t
(Do*(1+g)^t)
1 $ 42,500 1.1200 $ 47,600
2 $ 42,500 1.2544 $ 53,312
sum of present value of dividend

Step 3: PV of price of stock at end of initial growth period:

P2 ?
D3 ?
g 7%
D2 $ 53,312
r 18%

D3 = D2*(1+g) $ 57,043.84
P2 = D3/(r-g) $ 518,580.36

PV of stock at end of year 2:

N 2
i 18%
FV $ 518,580.36
PV ?

PV $ 372,436.34

Step 4: Sum of PV of dividends during initial growth period and PV price of stock at end of growth period.

PV (initial growth period) $ 130,399.63

PV (end of growth period) $ 372,436.34

Po $ 502,835.97

Problem 7.18: (Valuation with price/earning multiples)

For each cash flowing table, use the data given to estimate its common stock value employing price/earnings m
Price/Earning
Firm Expected EPS
multiples
 A $ 3.00 6.2
B $ 4.50 10.0
C $ 1.80 12.6
D $ 2.40 8.9
E $ 5.10 15.0

SOLUTION:
Stock Price
Firm
(EPS*P/E)
A $ 18.60
B $ 45.00
C $ 22.68
D $ 21.36
E $ 76.50

Problem 7.19: (Management action and stock value)

SOLUTION:
Po = D1/(rs-g)
a)
Do (per share) $ 3.00
g 5%
r 15%
D1 = Do*(1+g) $ 3.15
Po $ 31.50

b)
g 6%
r 14%
Do $ 3.00
D1 = Do*(1+g) $ 3.18
Po $ 39.75

c)
Do $ 3.00
r 17%
g 7%
D1 = Do*(1+g) $ 3.21
Po $ 32.10

d)
Do $ 3.00
r 16%
g 4%
D1 = Do*(1+g) $ 3.12
Po $ 26.00

e)
Do $ 3.00
r 17%
g 8%
D1 = Do*(1+g) $ 3.24
Po $ 36.00

The best alternative in terms of maximizing share price is b.

Problem 7.20: (Integrative--risk and valuation and CAPM formulas)

SOLUTION:
Current price per share of common = Po $ 50.00
Expected dividend per share next year = D1 $ 3.00
Constant dividend growth rate = g 9%
Risk-free rate of return 7%

Po = D1/(rs-g)
rs = (D1/P) + g 15%

rs = Risk- free rate + Risk premium

rs - risk free rate = Risk premium
Risk premium 6%

Problem 7.21: (Integrative--risk and valuation)

Giant Enterprises has a beta of 1.20, the risk-free rate of return is currently 10%, and the market return is 14.
which plans to pay a dividend of $2.60 per share in the coming year,anticipates that its future dividends will in
consistent with that experienced over the 1997–2003 period, when the following dividendswere paid:
year Dividend per share
2012 2.45
2011 2.28
2010 2.1
2009 1.95
2008 1.82
2007 1.8
2006 1.73
SOLUTION:

a) rs - risk free rate = Risk premium

rs 14.8%
risk-free rate 10%
Risk premium 5%

b)
N 6
PV $ 1.73
FV $ 2.45
Do $ 2.60
I=g 5.97%
r 14.80%
Po = D1/(rs-g)
Po $ 29.45

c) A decrease in the risk premium would decrease the required rate of return, which in turn would increase the price o

Problem 7.22: (Integrative--risk and valuation)

Hamlin Steel Company wishes to deter-mine the value of Craft Foundry, a firm that it is considering acquiring for cas
wishes to use the capital asset pricing model (CAPM) to determine theapplicable discount rate to use as an input to th
constant-growth valuationmodel Craft’s stock is not publicly traded………..?
Year Dividend per share
2012 $ 3.44
2011 $ 3.28
2010 $ 3.15
2009 $ 2.90
2008 $ 2.75
2007 $ 2.45
SOLUTION:
a)
N 5
PV $ 2.45
FV $ 3.44
I=g 7.02%
Do $ 3.68
Risk premium 5%
Risk-free rate 9%

rs = risk free rate + Risk premium

rs 14%

D1 = Do*(1+g) $ 3.68
Po = D1/(rs-g) $ 52.74

b) (1)
rs 14%
(decrease in g by 2%)
g 5.02%
D1 = Do*(1+g) $ 3.61

Po = D1/(rs-g) $ 40.22 per share

2)
Risk premium 4%
Risk-free rate 9%

rs = risk free rate + Risk premium

rs 13%

D1 $ 3.68
g 7.02%
Po ?
Po = D1/(rs-g) $ 61.54 per share

Price is a function of the current dividend, expected dividend growth rate, and the risk-free rate, and the company
specific risk premium. For Craft, the lowering of the dividend growth rate reduced future cash flows resulting in a red
in share price. the decrease in the risk premium reflected a reduction in risk leading to an increase in share price.

Problem 7.23: (Ethics problems)

SOLUTION:

Do $ 5.00
r 11%

a) This is a zero-growth dividend valuation problem, so:

Po = D/r
Po $ 45.45

b) Using the new discount rate of 12% (11%+ 1% credibility risk premium), we have:
Po = D/r
r 12%
Po $ 41.67

The value decline is the difference between parts a and b:

Value decline $ (3.79)

The stock sells for almost $4 less because the company’s financial reports cannot be fully trusted
Lack of integrity is seen to hurt stock prices because of the credibility premium.
Problem 7.16: (Personal finance: Using the free cash flow valuation model to price an IPO)
Assume that you have an opportunity to buy the stock of CoolTech,Inc.,an IPO being offered for $12.50 persha
Although you are very much interested in owning the company,you are concerned about whether it is fairly pr
Free Cssh flow Other Data:
year FCF^t Growth rate of FCF, beyond 2013 to infinity = 2%
2013 $ 700,000 Weighted average codt of capital = 8%
2014 $ 800,000 Market value of all debt = $2,700,000
2015 $ 950,000 Market value of preferred stock = $1,000,000
2016 $ 1,100,000 Number of shares of common stock outstanding = $1,100,000

SOLUTION:
g 2%
r 8%
Vd $ 2,700,000
Vp $ 1,000,000

a)
The value of the firm’s common stock is accomplished in four steps:
1) Calculate the PV of FCF from 2017 to infinity:
Value of FCF (2016 to infinity) = FCF2018*(1+g)/(r-g)

Value of FCF (2016 to infinity) $ 18,700,000

2) Add the PV of the cash flow obtained in (1) to the cash flow for 2016:
Total FCF(2016) = FCF (2016 to infinity) + FCF(2016)
FCF2016 $ 19,800,000

3) Find the PV of the cash flows for 2010 through 2016:

PV of FCF FCF/
Year FCF 1/(1+r)^t
(1+r)^t
2013 $ 700,000 0.9259 $ 756,000
2014 $ 800,000 0.8573 $ 933,120
2015 $ 950,000 0.7938 $ 1,196,726
2016 $ 19,800,000 0.7350 $ 26,937,681
Value of entire company = Vc $ 29,823,528

4) Calculate the value of the common stock using Equation 7.7:

Vs = Vc - Vd -Vp
Vc $ 29,823,528
Vd $ 2,700,000
Vp $ 1,000,000
No. of outstandingshare $ 1,100,000
IPO offered price 12.50 per
$ 12.50
share

Vs $ 26,123,528
Value per share $ 23.75

b) Based on this analysis the IPO price of the stock is under valued by 11.25 (23.75-12.50)
and you should buy the stock.

c) The revised value of the firm’s common stock is calculated in four steps:

g 3%
r 8%
Vd $ 2,700,000
Vp $ 1,000,000

1) Calculate the PV of FCF from 2017 to infinity:

Value of FCF (2017 to infinity) = FCF2018*(1+g)/(r-g)

Value of FCF (2017 to infinity) $ 22,660,000

2) Add the PV of the cash flow obtained in (1) to the cash flow for 2016:
Total FCF(2016) = FCF (2016 to infinity) + FCF(2016)

FCF2016 $ 23,760,000

3) Find the PV of the cash flows for 2010 through 2016:

PV of FCF FCF/
Year FCF 1/(1+r)^t
(1+r)^t
2013 $ 700,000 0.9259 $ 756,000
2014 $ 800,000 0.8573 $ 933,120
2015 $ 950,000 0.7938 $ 1,196,726
2016 $ 23,760,000 0.7350 $ 32,325,218
Value of entire company = Vc $ 35,211,064

4) Calculate the value of the common stock using Equation 7.7:

Vs = Vc - Vd -Vp
Vc $ 35,211,064
Vd $ 2,700,000
Vp $ 1,000,000
No. of outstandingshare $ 1,100,000
IPO offered price 12.50 per
$ 12.50
share

Vs $ 31,511,064
Value per share $ 28.65

If the growth rate is changed to 3% the IPO price of the stock is over valued by $16.15
($28.65- $12.50) and you should not buy the stock.

Problem 7.17: (Book Liquidation Value)

SOLUTION:

a) Book Value per Share:

Book Value per share = Book Value of assets - (liabilities + preferred stock at book value)
number of shares outstanding

Book Value of assets $ 780,000

Liabilities (160000+180000) $ 340,000
Preferred Stock $ 80,000
No. of shares outstanding $ 10,000
LIabilities + Preferred stock $ 420,000

Book Value per share $ 36 per share

b) Liquidation Value:
Cash $ 40,000 Liquidation of Value of Assets
Marketable Securities $ 60,000 Less:
Accounts receivable
(90%* 120000) $ 108,000 Current Liabilities
Inventory (90%* 160000) $ 144,000 Long-Term Debt
Land and Building
(130%*150000) $ 195,000 Preferred Stock
Machinery & Equipment
(70%*250000) $ 175,000 Total
Liq. Value of Assets $ 722,000 Available for CS

Liquidation value of asstes = Liquidation value of assets

Number of shares outstanding
Liquidation value of assets 30.2 per share

c) Liquidation value is below book value per share and represents the minimum value for
the firm. It is possible for liquidation value to be greater than book value if assets are
undervalued. Generally, they are overvalued on a book value basis, as is the case here.
 CHAPTER 7 STOCK VALUATION

y funds at $60 per share.

h an $80 par value and an 11%

paid each quarter?

per quarter.

before dividend can be paid on common stock.

ividends can be paid on common stock. In this case

ock holders in current period before

 periods of
dividends passed
2
1
3
4 42.5
0

the investor should convert.

ship of the preferred stock.

share per year of dividends

s the preferred they will
ds may cause the investor to keep
e, while common stock dividends
typically fixed and
g the stock price

ed rate of return
e of her stock
over the past 6 years.
l dividend
1/(1+r)^t PV of Dividend
0.8696 $ 3.67
0.7561 $ 5.27
0.6575 $ 7.57
$ 16.51
e of stock at end of growth period:
of growth period.

l dividend
1/(1+r)^t PV of Dividend
0.9009 $ 2.16
0.8116 $ 2.59
0.7312 $ 3.10
$ 7.85
of growth period.

of growth period.
of growth period.
l dividend
1/(1+r)^t PV of Dividend
0.8475 $ 56,168.00
0.7182 $ 74,231.63
$ 130,399.63

of stock at end of growth period.

k value employing price/earnings multiples.

y 10%, and the market return is 14.8%. The company
ates that its future dividends will increase at an annual rate
wing dividendswere paid:
hich in turn would increase the price of the stock.

that it is considering acquiring for cash.Hamlin

le discount rate to use as an input to the
 he risk-free rate, and the company
ced future cash flows resulting in a reduction
ding to an increase in share price.

m), we have:

ot be fully trusted
 ation model to price an IPO)
IPO being offered for $12.50 pershare.
ncerned about whether it is fairly priced……?

2013 to infinity = 2%
pital = 8%

ock = $1,000,000
n stock outstanding = $1,100,000
3.75-12.50)
 stock at book value)
ding

$ 722,000

$ (160,000)
$ (180,000)

$ (80,000)

$ (420,000)
$ 302,000