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Problem Set - III The Value of Common Stocks

This document contains sample problems from a corporate finance class relating to valuing common stocks. It includes questions about valuing three stocks with different dividend growth rates, valuing a mature company based on forecasted inflation-adjusted dividends and discount rates, calculating the expected rate of return for a stock given dividend growth projections, and explaining why an extremely high price-to-earnings ratio can be misleading.

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486 views

Problem Set - III The Value of Common Stocks

This document contains sample problems from a corporate finance class relating to valuing common stocks. It includes questions about valuing three stocks with different dividend growth rates, valuing a mature company based on forecasted inflation-adjusted dividends and discount rates, calculating the expected rate of return for a stock given dividend growth projections, and explaining why an extremely high price-to-earnings ratio can be misleading.

Uploaded by

Vlipper
Copyright
© © All Rights Reserved
Available Formats
Download as DOC, PDF, TXT or read online on Scribd
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Prof. Thomas J.

Chemmanur
MF807 Corporate Finance

Problem Set - III


The Value of Common Stocks
1. Consider the following three stocks:
a. Stock A is expected to provide a dividend of $10 a share
forever.
b. Stock B is expected to pay a dividend of $5 next year.
Thereafter, dividend growth is expected to be 4% a year
forever.
c. Stock C is expected to pay a dividend of $5 next year.
Thereafter, dividend growth is expected to be 20% a year
for five years (i.e., until year 6) and zero thereafter.
If the market capitalization rate for each stock is 10%, which
stock is the most valuable? What if the capitalization rate is 7%?
2. Pharmecology is about to pay a dividend of $1.35 per share. Its
a mature company, but future EPS and dividends are expected to
grow with inflation, which is forecasted at 2.75% per year.
a. What is Pharmecologys current stock price? The nominal
cost of capital is 9.5%.
b. Redo part (a) using forecasted real dividends and a real
discount rate.
3. Mexican Motors stock sells for 200 pesos per share and next
years dividend is 8.5 pesos. Security analysts are forecasting
earnings growth of 7.5% per year for the next five years.
a. Assume that earnings and dividends are expected to grow
at 7.5% in perpetuity. What rate of return are investors
expecting?
b. Mexican Motors has generally earned about 12% on book
equity (ROE=.12) and paid out 50% of earnings as
dividends. Suppose it maintains the same ROE and payout
ratio in the long-run future. What is the implication for g?
For r? Should you revise your answer to part (a) of this
question?

4. In August 2006, The Wall Street Journal reported a P/E of 63 for


Textron, a mature conglomerate that would not normally be
regarded as a high-growth company. It turns out that Textron had
recently announced a large, one-time loss from discontinued
operations. This loss caused a large, one-time reduction in
reported earnings. Does this example suggest why extremely
high P/EPS ratios can be misleading? Explain briefly.
5. Alpha Corps earnings and dividends are growing at 15% per
year. Beta Corps earnings and dividends are growing at 8% per
year. The companies assets, earnings, and dividends per share
are now (at date 0) exactly the same. Yet PVGO accounts for a
greater fraction of Beta Corps stock price. How is this possible?
Hint: There is more than one possible explanation.
6. Permian Partners (PP) produces from aging oil fields in west
Texas. Production is 1.8 million barrels per year in 2006, but
production is declining at 7% per year for the foreseeable future.
Costs of production, transportation, and administration add up to
$25 per barrel. The average oil price was $65 per barrel in 2006.
PP has 7 million shares outstanding. The cost of capital is 9%.
All of PPs net income is distributed as dividends. For simplicity
assume that the company will stay in business forever and that
costs per barrel are constant at $25. Also, ignore taxes.
a. What is the PV of a PP share? Assume that oil prices are
expected to fall to $60 per barrel in 2007, $55 per barrel in
2008, and $50 per barrel in 2009. After 2009, assume a
long-term trend of oil-price increases at 5% per year.
b. What is PPs EPS/P ratio and why is it not equal to the 9%
cost of capital?

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