Corporate Finance: Winter 2023

Review Questions #2: Solutions

1) Consider a 5-yr bond of the Kraft-Heinz Corporation (Ticker: KHC) with a BBB
rating. Suppose KHC bonds pay annual coupons of 6%. Moreover, you observe
that AAA 5-yr bonds are priced to yield 3.5%, and the AAA-BBB spread is
currently 150 bp. What is the current price of the KHC bond if its face value is
$100?

Yield = 3.5% + 150 bp = 5%

2) Now, suppose AAA yields rise to 4% and the AAA-BBB spread rises to 200 bp.
If this scenario comes to pass, what should have happened to the price of the KHC
bond? What about if AAA yields spiked to 5% and the spread widened to 200
bp?

Yield = 4% + 200 bp = 6%, which is the same as the coupon rate so the bond
will be priced at par

Yield = 5% + 200 bp = 7%:

3) Finally, suppose that when AAA yields are at 4%, and the AAA-BBB spread is at
200 bps, KHC has face (par) value of debt of $25 billion. How much value will
KHC bondholders lose if the yield spread were to widen to 230 bp? Assume the
5-yr bond is representative of all KHC debt.

Yield = 4% + 230 bp = 6.3%, which means each $100 face value of bonds will
fall to:

So if there’s $25 billion of debt, BHs will lose $312.5 million overall, given by
1.25% loss*($25 billion Debt) = $312.5 million
4) You observe KHC is currently paying dividends of $1.60/yr. Assuming an
appropriate discount rate for KHC shares is 9%, what is the value of KHC shares
if you are forecasting its dividends to grow at 4.5% per year indefinitely?

Next year’s dividend will be 1.60(1.045) = 1.672/shr. Constant growth DDM

states the price of a share of KHC stock (assuming r = 9%) should be given
by:

5) Assuming that dividends do grow at 4.5%, what should KHC’s share price be in 1
year? What about in 2 years? What is the capital gains yield expected to be on
KHC shares?

Now, first future (in 2 years) dividend will be 1.60(1.045)2 = 1.747/shr.

Constant growth DDM states the price of a share of KHC stock (assuming r
= 9%) should be given by:

Note that $38.83 is 4.5% higher than $37.155. Similarly, in two years the
price will be $40.57, and the capital gains yield is again 4.5%.

6) Given the share price of KHC is in fact $37/shr, what is the appropriate discount
rate on KHC share if the dividends are expected to grow at 4.5%?

Given the price is $37/shr, this implies the “appropriate” discount rate is:

7) You find a bond in the DowntheStreet Journal with 5 years left to maturity, which
pays an annual coupon of 5% on a face value of $5M. The next coupon payment
occurs precisely in 1 year.

a. What is the value of the bond if the discount rate is 6%?

The annual coupon is: 5*0.05=0.25, therefore, the value of the bond is:

P0 = 0.25/0.06*(1-1/(1+0.06) 5) + 5/1.065 = $4.79 million

 b. What is the value of the bond after paying the first coupon (i.e., 1 year from now),
assuming the discount rate remains at 6%?

P1 = 0.25/0.06*(1-1/(1+0.06) 4) + 5/1.064 = $4.83 million

c. What is the interest received with the 1st coupon and what are the capital gains if
you were to sell the bond after 1 year?

Interest = $0.25 million

Capital Gain = P1 - P0 = 4.83 - 4.79 = $0.04 million

d. What is the total return on your investment after the payment of the 1st coupon?

r = (P1 - P0 + Interest)/ P0 = (0.25+0.04)/4.79 = 6%

or, (0.25 + 4.83)/(1+r) = 4.79 and r = 6%

e. What is the total annual return of your investment after the payment of the 2nd
coupon, assuming the discount remains at 6%?

P2 = 0.25/0.06*(1-1/(1+0.06) 3) + 5/1.063 = 4.87

Your annual return is given by the following expression:

0.25/(1+r) + (0.25 + 4.87) / (1+r) 2 = 4.79

where, r = 6%

8) A stock paid a dividend of 2 dollars yesterday. It is expected that dividends grow

at 8% annually during the next three years, and then at 4% forever. If the
appropriate discount rate is 12%, what is the price of the stock?

The value of the stock corresponds to the present value of an annuity with
growth, plus the present value of a perpetuity with growth. The first
dividend to be paid (D1) is 2*1.08 = 2.16. D4, which is the first dividend of the
perpetuity is: 2*1.083*1.04 = 2.62

Therefore the price of the stock is:

D1=2*(1+8%) = 2.16
D2= 2.16*(1+8%) = 2.3328
D3= 2.3328*(1+8%) = 2.5194
D4= 2.5194*(1+4%) = 2.6202
P0 = 2.16/(1+12%) + 2.3328/(1+12%)2 + 2.5194/(1+12%)3
+ (2.6202/(12%-4%))/(1+12%)3 = 28.89
9) Firm B is currently able to generate $30M per year in annual earnings, there are
10 million shares, and investors require a return of 10%. Firm B pays out all
earnings as dividends.

a. Calculate the price per share of the company based on its current circumstances.

EPS = 30million /10 million = 3 = Dividends per share

P0 = 3/10% = $30

b. Firm B now sees an opportunity to reinvest 25% of its earnings in a perpetual

project starting one year from today at an ROE of 12%. Calculate the company’s
growth rate generated by the new project.
g=(1-payout)*ROE = 25%*12% = 3%

c. Assume the company announces the new project. Estimate the new price of the
shares of company, as of today, after the announcement of the new project.

P = 2.25/(0.10-0.03) = 32.1429

d. Calculate Firm B’s Present Value of Growth Opportunities (PVGO).

PVGO = $32.1429 - $30 = $2.1429

10) You have just purchased a bond priced at par, with a face value of £100. This
bond, with a time to maturity of 5 years, pays £12 annually in coupons. You are
also considering purchasing another bond that pays £6 annually in coupons, with
a maturity of 6 years and face value of £100.

a. What is the yield to maturity of the bond with 5 years to maturity?

Given that the bond was traded at par, the YTM is equal to the coupon
rate, which is 12%.
b. Assume that the 5 year bond and the 6 year bond have the same yield to maturity.
How much would you be willing to pay for the 6 year bond?

B=
6
0.12[1−
1
6
+
]100
(1+0.12) ( 1+0.12 )
6
=75.33
11) COOL THE PLANET is a publicly-listed company that will generate earnings per
share of £10 next year and the payout ratio will be 75%. Shareholders require a
return of 8% and COOL THE WORLD will generate a return on equity of 10%.

a. What is the expected dividend growth rate?

Dividend growth rate=( 1− payout ratio )∗ROE=2.50 %
b. What is the current stock price?
¿1 10 × 0.75
Stock price= = =136.36
r−g 8 %−2.50 %
c. What is the current net present value of growth opportunities (NPVGO)?
Calculate Stock Price of the company with no growth (i.e., value of
assets in place based on paying out all EPS as dividends), and then
NPVGO will be the difference between the ‘asset in place’ price and
current stock price.
¿ 1 $ 10
Value ( assets∈ place )= = =125
r 0.08
NPVGO=136.36−125=11.36

d. What is the dividend yield?

¿ 10× 0.75
Dividend yield = = =5.50 %
Stock price 136.36
e. What will be the current stock price if return on equity increases to 12% in year 3
and thereafter?

From year 3 onwards, the new growth rate is 3%. The following table
illustrates the evolution of dividends for the first 5 years.

1 2 3 4 5

EPS 10 10.25 10.56 10.87 11.2

Div 7.50 7.69 7.92 8.16 8.40
Disc. Div. 6.94 6.59 6.29 5.99 5.72

To calculate the new current price we can use the perpetuity formula from
year 3 onwards and add the discounted dividend for the first two years
individually.
 ¿3
¿ ¿ r−g
Stock price= 1 + 2 2 =¿
( 1+r ) ( 1+r ) ( 1+r )2

12) Consider the stock of the 3M Corp (Ticker: MMM). It is the beginning of 2023.
3M is expecting earnings per share (EPS) of $10.33/shr for 2022, and analysts’
consensus is that EPS should grow to $10.90 for 2023: a growth rate of 5.5%.
3M’s dividends are 58% of earnings at $5.96. Starting in year 4 (2026), 3M will
pay out 80% of EPS as dividends, generating a steady-state growth rate of 2.6% in
dividends based on reinvesting 20% of EPS at the same ROE of 13%.

a) If 3M reinvests 42% of earnings at the firm’s ROE of 13% for each of the next 3
years (2023-2025), how fast will dividends and earnings grow over that time
period?

We know that growth in earnings (& dividends, since the payout ratio, ρ, is
assumed to be constant at 0.58) over the first three years is given by: g = (1-
ρ)*ROE = 0.42*(13%) = 5.5%

b) Additionally, it is anticipated that 3M will start paying out 80% of their EPS as
dividends in year 4 (2026), retaining 20% of EPS to reinvest at 3M’s ROE of
13%, allowing EPS (& dividends) to grow in perpetuity. What growth rate in
dividends/earnings will this imply for the long-term steady state?

Here, as in (a), g = (1-ρ)*ROE = 0.2(13%) = 2.6%, because ρ now equals 0.8.

c) If 3M investors require a return of 10.4% on their shares, and if the market is
anticipating the dividend patterns described in (a) and (b), show that the shares are
approximately fairly valued at $114.83.

Earnings Growth:

10.33 10.90 11.50 12.13 12.80

|------|------|------|------|------|------|-----®
t=0 1 2 3 4 5 6

g = 5.5% g = 2.6%
Earnings Growth:

10.3 10.90 1 .50 12.13 12.80

|- - - |- - - |- - - |- - - |- - - |- - - |- - - 
t= 0 1 2 3 4 5 6

Dividend Growth:

5.96 6.29 6.63 6.99 10.24

|------|------|------|------|------|------|-----®
t=0 1 2 3 4 5 6

$114.94

d) Based on the information given in Parts (a) – (c), what is 3M’s PVGO (use next
year’s anticipated EPS of $10.90 to measure the PV(Assets in Place))?

PVGO = $114.83 – ($10.90/0.104) = $10.02

e) Based on the 2023 EPS forecast of $10.90/shr and a payout ratio of 42%, as well
as the current share price of $114.83, the dividend yield on 3M is expected to be
5.47%. Knowing that, according to the constant growth dividend discount model,
expected return has 2 components: dividend yield and capital gains, and assuming
that investors require a return of 10.4% (as above), show that the constant growth
dividend discount model with g = (10.4% - 5.47%) = 4.93% also gives correct
pricing.

Dividend yield = $6.29/$114.83 = 5.47%

In a constant growth model, r = div yield + g => 9 = 0.104 – 0.0547 = 4.93%

Using this g in a constant growth model gives: P = $6.29/(0.104 – 0.0493) =
$114.99 ~ $114.83