Chapter 7

Stock Valuation

Warm Up Exercises
E7-1. Using debt ratio to calculate a firm’s total liabilities
Answer: Debt ratio = total liabilities  total assets
Total liabilities = debt ratio  total assets
= 0.75  $5,200,000 = $3,900,000

E7-2. Determining net proceeds from the sale of stock

Answer: Net proceeds = (1,000,000  $20  0.95) + (250,000  $20  0.90)
= $19,000,000 + $4,500,000 = $23,500,000

E7-3. Preferred and common stock dividends

Answer: 1. The holders of preferred share do not have voting power while the common stock holders have.
2. Dividends must be paid to preferred stock holders before dividends can be paid to common
stockholders.

E7-4. Price/earning ratios

Answer: Earnings per share (EPS) = $11,200,000  4,600,000 = $2.43 per share
Today’s P/E ratio = $24.60  $2.43 = 10.12
Yesterday’s P/E ratio = $24.95  $2.43 = 10.27

E7-5. Using the zero-growth model to value stock

Answer: P0 = [$1.20 (1.05)]  0.08 = $1.26  0.08 = $15.75 per share

E7-6. Capital asset pricing model

Answer: Step 1: Calculate the required rate of return.
rs = 4.5% + 10.8% = 15.3%
Step 2: Calculate the value of the stock using the zero-growth model.
P0 = $2.25  0.153 = $14.71 per share

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128 Gitman/Zutter • Principles of Managerial Finance, Fourteenth Edition, Global Edition

◼ Solutions to Problems
P7-1. Authorized and available shares
LG 2; Basic
a. Maximum shares available for sale
Authorized shares 2,000,000
Less: Shares outstanding 1,400,000
Available shares 600,000
$48,000,000
b. Total shares needed = = 800,000 shares
$60
The firm requires an additional 200,000 authorized shares to raise the necessary funds at
$60 per share.
c. Aspin must amend its corporate charter to authorize the issuance of additional shares.

P7-2. Preferred dividends

LG 2; Intermediate
a. $8.80 per year or $2.20 per quarter.
b. $2.20. For a noncumulative preferred only the latest dividend has to be paid before dividends can be
paid on common stock.
c. $8.80. For cumulative preferred all dividends in arrears must be paid before dividends can be paid on
common stock. In this case the board must pay the three dividends missed plus the current dividend.

P7-3. Preferred dividends

LG 2; Intermediate
Case Answer Explanation
A $16 Three quarters of passed dividends plus the current quarter
(4 quarters × $4 per quarter = $16)
B $2.20 The dividend is 2% of $110 per quarter, or $2.20 per quarter. Only the
current quarter must be paid because the stock is noncumulative.
C $3 Only the current dividend of $3 must be paid because the stock is
noncumulative.
D $4.50 The quarterly dividend is 1.5% of $60 or $0.90 per quarter. The
dividends to be paid equal the four quarters passed plus the current
dividend (5 × $0.90 = $4.50).
E $2.10 The quarterly dividend is 3% of $70 or $2.10 per quarter. No dividends
have been passed, so only the current $2.10 dividend is due.

P7-4. Convertible preferred stock

LG 2; Challenge
a. Conversion value = conversion ratio  stock price = 5  $20 = $100
b. Based on comparison 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 ownership of the
preferred stock.

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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 have a cumulative provision.

P7-5. Preferred stock valuation

LG 4; Basic
a.

b.

c. Stock A is undervalued. The intrinsic value calculated in part (a) is $120 while the market price is
$100. The stock undervalued $20.

P7-6. Personal finance: common stock valuation—zero growth

LG 4; Intermediate

P7-7. Preferred stock valuation: PS0 = Dp  rp

LG 4; Intermediate
a.

b.

Since the investor bought the stock at $75.71, received $5.3 dividend and sell it at $66.25. His rate of
return is:

P7-8. Common stock value—constant growth: P0 = D1  (rs − g)

LG 4; Basic
Year growth Dividend Present Value of
rate dividends

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130 Gitman/Zutter • Principles of Managerial Finance, Fourteenth Edition, Global Edition

2014 4%

2015 3%

2016 2% =

The present value of dividends after 2017 = $30.58

The present value of the stock = $1.96 + $1.91 + $1.83 + $30.58 = $36.28

P7-9. Common stock value—constant growth

LG 4; Intermediate

a.

b.

c. The constant growth model is sensitive to the required return and growth rate. Even a small error in
required return can lead a big difference (3 times in this case) in the estimation of stock value.

P7-10. Common stock value—constant growth:

LG 4; Intermediate
The price of the stock equals next year’s dividend divided by the difference between the required return
and the dividend growth rate.
P0 = D1 / ( rs – g)
$60 = $3.90 / (0.10 – g)
g = 0.035 or 3.5%

P7-11. Personal finance: Common stock value—constant growth: P0 = D1  (rs − g)

LG 4; Intermediate
a.
Year Dividend per share Growth Rate
2009 $5.00 -
2010 5.15

2011 5.40

2012 5.62

2013 5.72

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b. The average growth rate is

c.

P7-12. Common stock value—variable growth:

LG 4; Challenge
P0 = PV of dividends during initial growth period
+ PV of price of stock at end of growth period.
Steps 1 and 2: Value of cash dividends and PV of annual dividends

PV
t D0 1.25t Dt 1/(1.15)t of Dividends
1 $2.55 1.2500 $3.19 0.8696 $2.77
2 2.55 1.5625 3.98 0.7561 3.01
3 2.55 1.9531 4.98 0.6575 3.27
$9.05

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

D3 + 1 = $4.98  (1 + 0.10)
D4 = $5.48
P3 = [D4  (rs − g2)]
P3 = $5.48  (0.15 − 0.10)
P3 = $109.56
PV of stock at end of year 3
N = 3, I = 15%, FV = $109.60
PV = $72.04
Step 4: Sum of PV of dividends during initial growth period and PV price of stock at end of growth
period
P0 = $9.05 + $72.04
P0 = $81.09

P7-13. Personal finance: Common stock value—variable growth

LG 4; Challenge
N
D0  (1 + g1 )t 1 DN + 1
P0 = 
t =1 (1 + rs ) t
+
(1 + rs ) N

(rs − g2 )

P0 = PV of dividends during initial growth period + PV of price of stock at end of growth period.
Steps 1 and 2: Value of cash dividends and PV of annual dividends
D1 = $3.40  (1.00) = $3.40
D2 = $3.40  (1.05) = $3.57

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D3 = $3.57  (1.05) = $3.75

D4 = $3.75  (1.15) = $4.31
D5 = $4.31  (1.10) = $4.74
PV
t Dt 1/(1.14)t of Dividends
1 $3.40 0.8772 $ 2.98
2 3.57 0.7695 2.75
3 3.75 0.6750 2.53
4 4.31 0.5921 2.55
$10.81
Step 3: PV of price of stock at end of initial growth period
P4 = [D5  (rs − g)]
P4 = $4.74  (0.14 − 0.10)
P4 = $118.50
PV of stock at end of year
N = 4, I = 14, FV = $118.50
Solve for PV = $70.16
Step 4: Sum of PV of dividends during initial growth period and PV price of stock at end of growth
period
P0 = $10.81 + $70.16
P0 = $80.97

P7-14. Common stock value—variable growth

LG 4; Challenge
a.
PV
t D0 1.08t Dt 1/(1.11)t of Dividends
1 $1.80 1.0800 $1.94 0.9009 $1.75
2 1.80 1.1664 2.10 0.8116 1.70
3 1.80 1.2597 2.27 0.7312 1.66
$5.11
D4 = D3(1.05) = $2.27  (1.05) = $2.38
P3 = [D4  (rs − g)]
P3 = $2.38  (0.11 − 0.05)
P3 = $39.67
PV of stock at end of year 3
N = 3, I = 11%, FV = $39.67
Solve for PV = $29.01
PV of dividends and future stock price
$5.11 + $29.01 = $34.12
b. The PV of the first 3 year’s dividends is the same as in part a.
D4 = D3(1.0) = 2.27

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P3 = [D4  (rs − g)]

P3 = $2.27  0.11
P3 = $20.64
PV of stock at end of year 3
N = 3, I =11%, FV $20.64
Solve for PV = $15.09
P0 = $5.11 + $15.09 = $20.20
c. The PV of the first 3 year’s dividends is the same as in part a.
D4 = D3(1.10) = 2.50
P3 = [D4  (rs − g)]
P3 = $2.50  (0.11 − 0.10)
P3 = $250.00
PV of stock at end of year 3
N = 3, I =11%, FV = $250.00
PV = $182.80
P0 = $5.11 + $182.80 = $187.91

P7-15. Personal finance: Common stock value—all growth models

LG 4; Challenge
a. P0 = (CF0  r)
P0 = $42,500  0.18
P0 = $236,111
b. P0 = (CF1  (r − g))
P0 = ($45,475*  (0.18 − 0.07)
P0 = $413,409.09
CF1 = $42,500(1.07) = $45,475
*

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

PV
t D0 1.12t Dt 1/(1.18)t of Dividends
1 $42,500 1.1200 $47,600 0.8475 $40,338.98
2 42,500 1.2544 53,312 0.7182 38,287.85
$78,626.83

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

D2 + 1 = $53,312  (1 + 0.07)
D3 = $57,043.84
P2 = [D3  (rs − g)]
P2 = $57,043.84  (0.18 − 0.07)
P2 = $518,580.36
PV of stock at end of year 2
N = 2, I = 18%, FV = $518,580.36

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134 Gitman/Zutter • Principles of Managerial Finance, Fourteenth Edition, Global Edition

Solve for 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
P0 = $78,626.83 + $372,436.34
P0 = $451,063.17

P7-16. Free cash flow (FCF) valuation

LG 5; Challenge
a. The value of the total firm is accomplished in three steps.
(1) Calculate the PV of FCF from 2021 to infinity.
[$390,000 (1.03)]  (0.11 − 0.03) = $401,700  0.08 = $5,021,250
(2) Add the PV of the cash flow obtained in (1) to the cash flow for 2020.
FCF2020 = $5,021,250 + 390,000 = $5,411,250
(3) Find the PV of the cash flows for 2016 through 2020.

Year FCF 1/(1.11)t PV

2016 $200,000 0.9009 $ 180,180
2017 250,000 0.8116 202,900
2018 310,000 0.7312 226,672
2019 350,000 0.6587 230,545
2020 5,411,250 0.5935 3,211,577
Value of entire company, Vc = $ 4,051,874

b. Calculate the value of the common stock.

VS = VC − VD − VP
VS = $4,051,874 − $1,500,000 − $400,000 = $2,151,874
c. Value per share $2,151,874  200,000 shares = $10.76

P7-17. Personal finance: Using the free cash flow valuation model to price an IPO
LG 5; Challenge
a. The value of the firm’s common stock is accomplished in four steps.
(1) Calculate the PV of FCF from 2020 to infinity.
[$1,100,000 (1.02)]  (0.08 − 0.02) = $1,122,000  0.06 = $18,700,000
(2) Add the PV of the cash flow obtained in (1) to the cash flow for 2019.
FCF2019 = $18,700,000 + 1,100,000 = $19,800,000
(3) Find the PV of the cash flows for 2016 through 2019.

Year FCF 1/(1.08)t PV

2016 $700,000 0.9259 $ 648,130
2017 800,000 0.8573 685,840
2018 950,000 0.7938 754,110

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 Chapter 7 Stock Valuation 135

2019 19,800,000 0.7350 14,533,000

Value of entire company, Vc = $16,641,080

(4) Calculate the value of the common stock using Equation 7.8.
VS = VC − VD − VP
VS = $16,641,080 − $2,700,000 − $1,000,000 = $12,941,080
Value per share = $12,941,080  1,100,000 shares = $11.76
b. Based on this analysis, the IPO price of the stock is over valued by $0.74 ($12.50 − $11.76), and you
should not buy the stock.
c. The revised value of the firm’s common stock is calculated in four steps.
(1) Calculate the PV of FCF from 2020 to infinity.
[$1,100,000 (1.03)]  (0.08 − 0.03) = $1,133,000  0.05 = $22,660,000
(2) Add the PV of the cash flow obtained in (1) to the cash flow for 2019.
FCF2019 = $22,660,000 + 1,100,000 = $23,760,000
(3) Find the PV of the cash flows for 2016 through 2019.

Year FCF 1/(1.08)t PV

2016 $700,000 0.9259 $ 648,130
2017 800,000 0.8573 685,840
2018 950,000 0.7938 754,110
2019 23,760,000 0.7350 17,463,600
Value of entire company, Vc = $19,551,680

(4) Calculate the value of the common stock using Equation 7.8.
VS = VC − VD − VP
VS = $19,551,680 − $2,700,000 − $1,000,000 = $15,851,680
Value per share = $15,851,680  1,100,000 shares = $14.41
If the growth rate is changed to 3%, the IPO price of the stock is under valued by $1.91 ($14.41 −
$12.50), and you should buy the stock.

P7-18. Book and liquidation value

LG 5; Intermediate
a. Book value per share:
Book value of assets − (liabilities + preferred stock at book value)
number of shares outstanding
$780,000 − $420,000
Book value per share = = $36 per share
10,000

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136 Gitman/Zutter • Principles of Managerial Finance, Fourteenth Edition, Global Edition

b. Liquidation value:

Cash $40,000 Liquidation Value of Assets 722,000

Marketable
Securities 60,000 Less: Current Liabilities (160,000)
Accounts Rec. Long-Term Debt (180,000)
(0.90  $120,000) 108,000 Preferred Stock (80,000)
Inventory Available for CS $302,000
(0.90  $160,000) 144,000
Land and Buildings
(1.30  $150,000) 195,000
Machinery & Equip.
(0.70  $250,000) 175,000
Liq. Value of Assets $722,000

Liquidation value of assets

Liquidation value per share =
Number of shares outstanding

$302,000
Liquidation value per share = = $30.20 per share
10,000
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.

P7-19. Valuation with price/earnings multiples

LG 5; Basic
Firm EPS  P/E = Stock Price
A 3.0  (6.2) = $18.60
B 4.5  (10.0) = $45.00
C 1.8  (12.6) = $22.68
D 2.4  (8.9) = $21.36
E 5.1  (15.0) = $76.50

P7-20. Management action and stock value

LG 6; Intermediate
a. P0 = $3.15  (0.15 − 0.05) = $31.50
b. P0 = $3.18  (0.14 − 0.06) = $39.75
c. P0 = $3.21  (0.17 − 0.07) = $32.10
d. P0 = $3.12  (0.16 − 0.04) = $26.00
e. P0 = $3.24  (0.17 − 0.08) = $36.00
The best alternative in terms of maximizing share price is b.

P7-21. Integrative—risk and valuation and CAPM formulas

LG 4, 6; Intermediate
P0 = D1  (rs − g)

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 Chapter 7 Stock Valuation 137

$50 = $3.00  (rs − 0.09)

rs = 0.15
rs = risk-free rate + risk premium
0.15 = 0.07 + risk premium
0.15 − 0.07 = 0.08 = risk premium

P7-22. Integrative—risk and valuation

LG 4, 6; Challenge
a. 14.8% − 10% = 4%
b. N = 6, PV = −$1.73, FV = $2.45
Solve for g: I = 5.97%
P0 = D1  (rs − g)
P0 = $2.60  (0.148 − 0.0597)
P0 = $29.45
c. A decrease in the risk premium would decrease the required rate of return, which in turn would
increase the price of the stock.

P7-23. Integrative—risk and valuation

LG 4, 6; Challenge
a. Estimate growth rate:
N = 5, PV = $2.45, FV = $3.44
Solve for I = 7.02%
rs = 0.09 + 0.05 = 0.14
D1 = $3.68
P0 = $3.68  (0.14 − 0.0702)
P0 = $52.72
b. (1) rs = 0.14
D1 = $3.61($3.44  1.0502) =
P0 = $3.61  (0.14 − 0.0502)
P0 = $40.20 per share
(2) rs =  +  = 
D1 = $3.68
P0 = $3.68  (0.13 − 0.0702)
P0 = $61.54 per share
Price is a function of the current dividend, expected dividend growth rate, 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 reduction in share price. The decrease in the risk premium reflected a reduction in
risk leading to an increase in share price.

P7-24. Ethics problem

LG 4; Intermediate

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138 Gitman/Zutter • Principles of Managerial Finance, Fourteenth Edition, Global Edition

a. This is a zero-growth dividend valuation problem, so

P0 = D/r = $5/0.11 = $45.45.
b. Using the new discount rate of 12% (11% + 1% credibility risk premium), we have
P0 = D/r = $5/0.12 = $41.67.
The value decline is the difference between parts a and b:
Value decline = $41.67 − $45.45
= −$3.78
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.

◼ Case
Case studies are available on MyFinanceLab.

Assessing the Impact of Suarez Manufacturing’s Proposed Risky Investment on Its

Stock Value
This case demonstrates how a risky investment can affect a firm’s value. First, students must calculate the current
value of Suarez’s stock, rework the calculations assuming that the firm makes the risky investment, and then draw
some conclusions about the value of the firm in this situation. In addition to gaining experience in valuation of
stock, students will see the relationship between risk and valuation.

a. Current per-share value of common stock growth rate of dividends:

g can be solved for by using the geometric growth equation as shown below in (Method 1) or by finding the
interest factor terms (i.e., the I), for the growth as shown in (Method 2).
1.90
Method 1. g = 4 = (1.46154)1/ 4 − 1 = 1.0995 − 1 = 0.0995 = 10.0%
1.30
Method 2. N = 4, PV = −1.30, FV = 1.90
Solve for I = 9.95
D1 $1.90(1.10) $2.09
P0 = = = = $52.25
rs − g 0.14 − 0.10 0.04

b. Value of common stock if risky investment is made:

D $1.90(1.13) $2.15
P0 = 1 = = = $71.67
rs − g 0.16 − 0.13 0.03
The higher growth rate associated with undertaking the investment increases the market value of
the stock.
c. The firm should undertake the proposed project. The price per share increases by $19.42 (from $52.25 to
$71.67). Although risk increased and increased the required return, the higher dividend growth offsets this
higher risk resulting in a net increase in value.
d. D2013 = 2.15(stated in case)
D2014 = 2.15(1 + 0.13) = 2.43
D2015 = 2.43(1 + 0.13) = 2.75
D2016 = 2.75(1 + 0.10) = 3.02

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P2015 = D2016  (r − g)
$3.02  (0.16 − 0.10) = $3.02  0.06 = $50.33
CF0 = 0, CF1 = $2.15, CF2 = $2.43, CF3 = $2.75 + $50.33
Set I = 16%
Solve for NPV = $37.67
No, the firm should not undertake the proposed project. The price per share decreases by $14.58 (from $52.25
to $37.67). Now the increase in risk and increased required return is not offset by the increase in cash flows.
The longer term of the growth is an important factor in this decision.

◼ Spreadsheet Exercise
The answer to Chapter 7’s Azure Corporation spreadsheet problem is located on the Instructor’s Resource Center
at www.pearsonglobaleditions.com/gitman under the Instructor’s Manual.

◼ Group Exercise
Group exercises are available on MyFinanceLab.

This chapter’s exercise takes the groups back to the future. The semester began with the fictitious firms having
recently become publicly traded corporations. Out of necessity, few details were given. The groups now get to
rectify this situation. Using the details of recent IPOs, each group is asked to write a detailed prospectus following
closely the example presented in the text. This includes but is not limited to the per-share price/quantity of the
offering.

Students should quickly realize the similarities of the various IPOs. Most are offered within the $10–$30 range.
The process is often the same with few shares available at the offer price, forcing the general public to pay a
premium above this offer price on and around the issuance date.

The final task for the groups is to get the most recent information on their shadow firm. This includes market
numbers as well as any recent news/analyses. Often this information will be fairly innocuous. Point out that recent
regulatory requirements have increased the stringent public information regarding publicly held corporations.

◼ Integrative Case 3: Encore International

This case focuses on the valuation of a firm. The student explores various methods of valuation, including the
price/earnings multiple, book value, no growth, constant growth, and variable growth models. Risk and return are
integrated into the case with the addition of the security market line and the capital asset pricing model. The
student is asked to compare stock values generated by various models, discuss the differences, and select the one
that best represents the true value of the firm.

$60,000,000
a. Book value per share = = $24
2,500,000

$40
b. P/E ratio = = 6.4
$6.25

c. (1) rs = RF + risk premiumEncore

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140 Gitman/Zutter • Principles of Managerial Finance, Fourteenth Edition, Global Edition

rs = 6% + 8.8%
rs = 14.8%
Required return = 14.8%
(2) rs = 6% + 10%
rs = 16%
Required return = 16%
As risk premiums rise, required return also rises.
d. Zero growth:

D1
P0 =
rs
$4.00
P0 = = $25
0.16
e. (1) Constant growth:
D1
P0 =
(rs − g)
($4.00  1.06) $4.24
P0 = = = $42.40
(0.16 − 0.06) 0.10
(2) Variable growth model: PV of dividends
n
 D  (1 + g1 )t   1 DN+1 
P0 =   0 +  
t =1  (1 + rs )t   (1 + rs ) N
(rs − g2 ) 

Po = PV of dividends during initial growth period + PV of price of stock at end of growth period.
Steps 1 and 2: Value of cash dividends and PV of annual dividends

PV
Year t D0 1.08t Dt 1/1.16t of Dividends
2016 1 $4.00 1.080 $4.32 0.8621 $3.72
2017 2 4.00 1.166 4.67 0.7432 3.47
$7.19

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

D2018 = $4.67  (1 + .06) = $4.95
P2017 = [D2018  (rs − g2)]
P2017 = $4.95  (0.16 − 0.06)
P2017 = $49.50
PV of stock at end of year 2 (2017)
PV = P2  (1/1.16)2
PV = $49.50  (0.7432)
PV = $36.79

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 Chapter 7 Stock Valuation 141

Step 4: Sum of PV of dividends during initial growth period and PV price of stock at end of
growth period
P2015 = $7.19 + $36.79
P2015 = $43.98
f.
Valuation Method Per Share
Market value $40.00
Book value 24.00
Zero growth 25.00
Constant growth 42.40
Variable growth 43.98

The book value has no relevance to the true value of the firm. Of the remaining methods, the most
conservative estimate of value is given by the zero-growth model. Wary analysts may advise paying no more
than $25 per share, yet this is hardly more than book value. The most optimistic prediction, the variable
growth model, results in a value of $43.98, which is not far from the market value. The market is obviously
not as cautious about Encore International’s future as the analysts are.
Note also the P/E and required return confirm one another. The inverse of the P/E is 1  6.25, or 0.16. This is
also a measure of required return to the investor. Therefore, the inverse of the P/E (16%) and sum of the risk-
free rate and risk premium are identical. The market appears to be pricing in the expectation that the company
will expand into European and Latin American markets.

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