Chapter 7

Stock Valuation

 Instructor’s Resources
Chapter Overview
This chapter focuses on equity—distinctions between equity and debt, different forms of equity, and
approaches to valuing equity instruments. The basic model for valuing equity is presented as an example of
the asset-valuation framework introduced in Chapter 5 and applied to bonds in Chapter 6. Specifically, the
value of a share or common of preferred stock is the present value of expected future cash flows from that
share, where the cash flows here are dividends, or in some cases, free cash flows. When capital markets are
efficient, the stock price should equal the present value of expected dividends, and news about changes in risk
or expected cash flows will be priced immediately. The discussion then expands the common-stock valuation
framework to accommodate different assumptions about expected dividend growth. Other approaches to
equity-valuation—ranging from variations on dividend-discounting like the free-cash-flow model to models
based on market benchmarks like price/earnings multiples—are also compared and contrasted with the
expected-dividend model. The chapter ends with discussion of interrelationships among financial decisions,
expected return, risk, and firm value.

 Suggested Answer to Opener-in-Review

In the chapter opener you learned that the stock of Darden Restaurants fell from $120.68 to $39 in just 22
days. Prior to the coronavirus outbreak, Darden was on pace to pay a dividend in 2020 of $3.52 per share.
Given that dividend, and assuming that prior to the outbreak investors required a 9% return on Darden stock,
how fast would it appear that investors expected dividends to grow in the very long run? (Hint: According to
the constant growth dividend model, what growth rate would justify a $120.68 stock price if the next dividend
is $3.52 and the required return is 9%?) The virus outbreak probably decreased the dividend growth rate that
investors expected and increased their required return at the same time. Suppose the growth rate fell 1%
(relative to your answer to the previous question), and the required return rose from 9% to 10%. What would
the new stock price be under those assumptions? How did that compare to Darden’s stock price at its low
point? What lessons do you learn by comparing the model’s estimate to the actual market price ?
The assumed growth rate is found by solving the constant-growth dividend model, Equation 7.4, for g: g = r –
(D1  Po) = 0.09 – ($3.52  $120.68) = 0.060831 or 6.083%. The new stock price is found using Equation
7.4: P0 = D1  (r – g) = $3.52  (0.10 – 0.05083) = $71.59. The actual low for the stock price was $39, so the
increase in the required return and/or the decline in the growth rate must have been even larger. Of course, a
more realistic analysis here could take into account that, in the short run, dividends might actually decline
before eventually going back to a new steady state growth rate. Modeling a scenario like that means using the
variable growth rate model.

 Answers to Review Questions

7-1 Equity capital is permanent capital representing ownership, while debt capital is a loan that must be
repaid. Holders of equity capital receive a claim on firm income and assets subordinate to creditor
claims—that is, debt holders must receive all interest and principal owed prior to distributions of firm
income or assets to equity holders. Equity capital is perpetual, while debt has a specified maturity date.

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To investors, interest on debt is currently taxed as ordinary income, but dividends and capital gains on
common stock are taxed but at a lower rate. To the corporation, interest on debt is tax deductible while
dividends are not.

7-2 A corporation’s owners are the common stockholders. As residual claimants, these stockholders are
not guaranteed a return, only what is left after other claims on firm income and assets have been
satisfied. Any funds invested are at risk; the only guarantee is that losses are capped at the purchase
price of the common stock. Given the significant uncertainty about earnings, common stockholders
expect relatively high returns in the form of dividends and capital gains.

7-3 Rights offerings are financial instruments that allow existing stockholders to purchase additional shares
of new stock issues below the market price, in direct proportion to the number of shares they own.
Rights offerings protect current shareholders against dilution of their voting power.

7-4 Authorized shares are the maximum number of shares a firm can sell without approval from existing
shareholders; this limit is stated in the corporate charter. Authorized shares sold to and held by the
public are called outstanding shares. Shares repurchased by the firm from the public are classified as
treasury stock; this stock is not considered outstanding because it is not held by the public. Issued
shares are shares of common stock that have been put into circulation and include both outstanding
shares and treasury stock.

7-5 Issuing stock outside their domestic markets can benefit corporations by broadening the investor base
and facilitating integration into the local economy. Specifically, a local stock listing increases
community press coverage, thereby raising awareness about the firm. Locally traded stock also
facilitates acquisitions. American depository shares (ADSs) are dollar-denominated receipts for stocks
of foreign companies held by U.S. financial institutions overseas. American depository receipts (ADRs)
are securities that permit U.S. investors to hold shares of non-U.S. companies and trade them in U.S.
markets. ADRs are issued in dollars and subject to U.S. securities laws; they offer U.S. investors an
opportunity to diversify internationally.

7-6 Preferred stockholders have a fixed claim on firm income and assets behind creditors but ahead of
common stockholders.

7-7 Cumulative preferred stock gives the holder the right to receive any dividends in arrears prior to
dividend payment to common stockholders. A call feature allows the issuer to retire outstanding
preferred stock within a certain time period at a pre-specified price. The call price is normally set at or
above the initial issuance price but may decrease according to a predefined schedule. Firms use the call
feature to escape the fixed-payment commitment of preferred stock.

7-8 According to the efficient market hypothesis (EMH):

a. Securities prices are in equilibrium (fairly priced with expected returns equal to required returns);
b. Securities prices reflect all public information and react quickly to new information; so
c. Investors should not waste time searching for mispriced (over or undervalued) securities.
The EMH is generally accepted as holding for securities traded on major exchanges and as framework
for thinking about security pricing. But proponents of behavioral finance, or behaviorists, have
challenged the EMH, arguing the key underlying assumption—investor rationality—is false. They
point to a growing body of research showing markets can be driven by reluctance to recognize losses,
desire to follow the herd, tendency to compartmentalize investments, and overweighting of recent
performance.

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7-9 a. The zero growth model of common-stock valuation assumes constant dividends through time, so a
stock is valued as a perpetuity with today’s value (price), P0, depending on the perpetual dividend,
D1 and required return r as follows:

b. The constant growth model assumes dividends will grow at a constant rate, g, from D1. Again, the
required return is denoted by r:

c. The variable growth model assumes dividends grow at a variable rate. The stock with a single
change in the growth rate is valued as the present value of dividends in during the initial growth
phase plus the present value of the price of stock at the end of the initial growth phase. Specifically,

Present value of Present value of stock

dividends during initial price at end of initial
growth period growth period

where Dn is the expected dividend in year n, g1 is the dividend growth rate in the initial period, g2,
is the dividend growth rate in the second period, and r is the required rate of return.

7-10 The free-cash-flow valuation model discounts future free cash flows rather than expected dividends.
Because this discounted value represents total firm value, the market value of total debt and preferred
stock must be subtracted to obtain the value of the firm’s common stock. Dividing the value of
common stock by outstanding shares gives the stock price. The free-cash-flow model differs from the
dividend-valuation model in two ways (i) total firm cash flows are discounted, not just dividends, and
(ii) the discount rate is the firm’s cost of capital, not the required return on stock. This approach is
appealing when valuing startups, firms with no dividend history, or an operating unit or division of a
larger public company.

7-11 a. Book value per share is the hypothetical amount common shareholders would receive if firm assets
were sold at book (accounting) value, liabilities (including preferred stock) were paid off at book
value, and the remainder divided by shares of common stock outstanding.
b. Liquidation value is the amount each common stockholder would expect to receive if firm assets
were actually sold, creditors and preferred stockholders were actually paid, and any remainder
divided among the common stockholders. Here, market rather than book values of assets and
liabilities are used.
c. Under the price-earnings-multiples approach, share value is estimated by multiplying expected
earnings per share by the average price/earnings ratio for the industry. Of the three approaches to
valuation, the price/earnings multiples approach is considered the best because it considers
expected earnings.

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7-12 A useful way to think about the impact of financial decisions on the firm is with the constant-growth

stock-valuation model: P0 = D1 (r – g). Actions of financial managers affect the stock price (and
hence firm value) through their impact on expected dividends (either the next expected, D1, or the
expected growth of dividends, g) or risk (which shows up in required return). Any action that increases
expected dividends will boost the stock price, and any action that increases risk will depress the stock
price.

7-13 A useful way to analyze the impact of events on stock price is to start with the constant-growth stock-
valuation model and assign hypothetical initial values. Accordingly, let the next expected dividend (D1)
be $5, expected rate of dividend growth (g) be 3%, and required rate of return (r) be 8%:

P0 = D1 (r – g) = $5 (0.08 – 0.03) = $100

a. Now, required return (r) = risk-free rate (RF) + risk premium (RP). So, an increase in RP means an
increase in r. Suppose r rises from 8% to 9%, but expected dividends (D1 and g) do not change:
$5 (0.09 – 0.03) = $83.33. In words, stock price will fall from $100 to $83.33.
b. Suppose r falls from 8% to 7%, but nothing else changes: $5 (0.07 – 0.03) = $125.00. Stock
price will rise from $100 to $125.
c. Suppose the dividend expected next year (D1) rises from $5 to $6, but nothing else changes:
$6 (0.08 – 0.03) = $120.00. Stock price will rise from $100 to $120.
d. Suppose expected dividend growth (g) rises from 3% to 4%, but nothing else changes:
$5 (0.08 – 0.04) = $125.00. Stock price will rise from $100 to $125.

 Suggested Answer to Focus on People/Planet/Profit Box:

“Shrinking and Growing at the Same Time”

Why do you think that profit margins are highest in the industries that have become very concentrated?

One possibility is that industries (product markets) are becoming less competitive. In a perfectly competitive
market, price equals marginal cost and pure economic profits (profits above the cost of capital) are zero. As
markets become less competitive, profits can rise above marginal cost.
Another possibility is that larger firms could be more efficient than smaller ones, benefitting from economies
of scale and/or scope, which could make them more profitable.

 Suggested Answer to Focus on Practice Box:

“Understanding Human Behavior Helps Us Understand Investor
Behavior”
Theories of behavioral finance can apply to other areas of human behavior as well as investing. Think of a
situation in which you may have demonstrated one of these behaviors. Share your situation with a classmate.

Student answers will vary. Examples for discussion: (i) regret theory may hold true for social situations in
which a person makes a mistake and subsequently focuses on avoiding embarrassment at all costs; (ii) fear of
regret can sometimes be rationalized away with “everyone else is doing it” (herding theory), thereby

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explaining why some people do silly things at parties; and (iii) students may react to grades as investors react
to news, placing more importance on recent events without recognizing the overall trend (anchoring).

 Suggested Answer to Focus on Ethics Box:

“Index Funds and Corporate Governance”
If you were the CEO of a publicly traded company, would you want a large bloc of your shares held by index
funds? Why or why not?
A CEO’s chief responsibility is to take all actions that increase shareholder wealth. That said, some CEOs
look for opportunities to pursue personal interests at the expense of shareholders. At first, it might seem an
unethical CEO would like to see the bulk of her firm’s shares in an index fund because, to the extent such
funds are poor monitors, she will have some room to use firm resources to advance her personal agenda. But
recent evidence suggests firms largely owned by index funds have excellent corporate governance practices—
most likely because the costs of organizing to oust management is smaller when the bulk of a firm’s shares
are held by large shareholders. In short, an ethical CEO would see a large ownership stake in the hands of an
index fund as a mechanism for committing to (and signaling that commitment to) shareholder welfare.

Now, suppose you manage a large index fund, what responsibility (if any) do you have for ensuring the
companies in your portfolio maximize shareholder wealth?
As fund manager, your fiduciary duty is to your investors; they gave you money believing you will construct
a portfolio to mimic a market index at the lowest possible fees. So monitoring and disciplining the
management of firms in your portfolio is not your first concern. How much effort you spend monitoring
depends on the availability of good substitutes and expected net benefits of monitoring. Devoting few
resources to monitoring a company makes sense if monitoring costs are high, expected benefits are low
(because firm management is entrenched), and investing in a similar company is easy. Moreover, other
shareholders (or more likely blocks of shareholders) can do the necessary monitoring and alert you to serious
governance issues. As a large shareholder, the threat you might ally with disgruntled shareholders might be
sufficient to keep management focused on stockholder wealth.

 Answers to Warm-Up Exercises

E7-1 Using debt ratio to calculate a firm’s total liabilities (LG 1)
Answer: Debt ratio = Total liabilities ÷ Total assets → Total liabilities = Debt ratio × Total assets=
0.6 × €6.4million = € 3.84 million.

E7-2 Determining net proceeds from the sale of stock (LG 2)

Answer: Net proceeds = (1,000,000 × $15 × 0.97) + (100,000 × $15 × 0.80) = $15,750,000.

E7-3 Preferred and common stock dividends (LG 2)

Answer: Preferred and common stock dividends
1. The owners of preferred shares do not have voting power, unlike those who own common
stock.
2. Dividends must be paid to preferred stock holders before dividends can be paid to common
stockholders.

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E7-4 Price-earnings ratios (LG 3)

Answer: Earnings per share (EPS) = £12,500,000 ÷ 5,000,000 = £2.50 per share. So, today’s P/E when the
share value is £2.40 = £2.40  £2.50 = 0.96 times. The P/E when the share value was £2.60 =
£2.60  £2.50 = 1.04 times

E7-5 Valuing stock with zero dividend growth (LG 4)

Answer: Using the zero-growth model to value stock:
P0 = [€2.50  (1.05)]  0.10 = €26.25 per share.

E7-6 Valuing stock with zero dividend growth (LG 6)

Answer: Using the capital asset pricing model:
Applicable discount rate for Martin International = 3% + 7% = 10%
And the value of stock using the zero-growth model will be:
P0 = £1.40  0.10 = £14.00

 Solutions to Problems
P7-1 Authorized and available shares (LG 2; Basic)
a. Maximum shares = Authorized shares – Shares outstanding = 3,000,000 – 2,200,000 = 800,000
b. Total shares needed = £20,000,000 ÷ £20 = 1,000,000 shares, meaning 200,000 additional shares
must be authorized to raise the needed funds.
c. The firm requires an additional 200,000 authorized shares to raise the necessary funds at £20 per
share. Bruges must amend its corporate charter to authorize the issuance of additional shares.

P7-2 Preferred dividends (LG 2; Intermediate)

a. Annual dividend in GBP = Price of preferred stock  Annual dividend rate =
£20  6% = £1.20 per year or £0.30 per quarter.
b. £0.30, for noncumulative preferred stock, only the current dividend must be paid before any
dividends on common stock.
c. £1.20, for cumulative preferred stock, all dividends in arrears must be paid before paying
dividends on common stock. In this case, the board must pay the missed three dividends and the
current dividends.

P7-3 Preferred dividends (LG 2; Intermediate)

Dividend Periods of
per Share Dividend
Company Type Par Value per Period Passes Answer
A Cumulative £50 £3 3 £12
B Noncumulative £100 2% 2 £2
C Noncumulative £80 £2.50 1 £2.50
D Cumulative £60 3% 4 £9
E Cumulative £40 4% 0 £1.60

Explanation

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A: Three quarters of passed dividends plus current quarter dividend = £3  4 = £12

B: 2% of £100 or £2, so no arrears need to be paid as its noncumulative.
C: £2.50, only current dividend, as it is noncumulative.
D: Four quarters of passed dividends plus current dividend = 3% of £60  5 = £9.
E: Quarterly dividend as there are no arrears, 4% of £40 or £1.60.

P7-4 Convertible preferred stock (LG 2; Challenge)

a. Conversion value = Conversion ratio × Stock price = 4 × £10 = £40
b. Comparing the preferred stock price against the conversion value, it is obvious that that the
investor should not convert, as the preferrede shares have a higher value than the converted stock.
c. The dividend payment is higher for common stock: for four converted shares, investors will get
£5 as dividend every year, while if they hold on to preference shares, they will get only £4 as
dividend per year. However, common stock dividends are risky and may be reduced or
eliminated, while preferred stock dividends are fixed.

P7-5 Voting rights and dual-class stock (LG 2; Challenge)

a. Co-founders equity investment = (Co-founders Class A shares + Co-founders Class B shares) 
All Class A and B shares = (1,369,182 + 12,779,709)  285,877,300 = 0.049 or 4.9%.
b. Co-founders control rights = (Co-founders Class A votes + Co-founders Class B votes)  All
Class A and B votes = (1,369,182 + 12,779,709 × 20)  (273,097,591 + 12,779,709 × 20) =
0.486 or 48.6%.
c. Co-founders equity investment = (Co-founders Class A shares + Co-founders Class B shares) 
All Class A and B shares = (1,369,182 + 12,779,709)  385,877,300 = 0.037 or 3.7%.
Co-founders control rights = (Co-founders Class A votes + Co-founders Class B votes)  All
Class A and B votes = (1,369,182 + 12,779,709 × 20)  (373,097,591 + 12,779,709 × 20) =
0.409 or 40.9%.
d. Co-founders equity investment = (Co-founders Class A shares + Co-founders Class B shares) 
All Class A and B shares = 12,779,709  385,877,300 = 0.033 or 3.3%.
Co-founders control rights = (Co-founders Class A votes + Co-founders Class B votes)  All
Class A and B votes = (12,779,709 × 20)  (373,097,591 + 12,779,709 × 20) = 0.407 or 40.7%.
e. Co-founders equity investment = (Co-founders Class A shares + Co-founders Class B shares) 
All Class A and B shares = 6,779,709  385,877,300 = 0.018 or 1.8%.
Co-founders control rights = (Co-founders Class A votes + Co-founders Class B votes)  All
Class A and B votes = (6,779,709 × 20)  (379,097,591 + 6,779,709 × 20) = 0.263 or 26.3%.

P7-6 Preferred stock valuation (LG 4; Basic)

a. Annual dividend = Price of preferred stock × annual dividend rate = 5% × $50 = $2.50
b. As the dividend stream is for perpetuity, we can calculate the value of preferred stock as a
perpetuity: P0 D1  r, where D1 = $2.50 and r = 6%. Thus, P0 = $2.50 ÷ 0.06 = $41.60.
c. The value of the preferred stocks will be defined by two separate cash flows:
1. Payment of the deferred dividend next year to the value of (2 × $2.50 = $5.00) for the last
two years.
2. regular dividend stream starting from next year.

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We have already calculated the value of Cash Flow 2 in part (a). The PV of Cash Flow 1 will be:
PV = $5 (1+0.06)1 = $4.716
So, the total value of the preferred share as of now = $41.60 + $4.716 = $46.316

P7-7 Personal finance problem: Common-stock valuation: Zero growth (LG 4; Intermediate)
Using the perpetuity formula (P0 = D1  r, where D1 = £1.20 and r = 8%)
Cost of purchase when expected return was 6% = £1.20/0.06 = £20 per share
Receipt of sale when expected return is 8% = £1.20/0.08 = £15 per share
So, Jake will lose £20-£15 or £5 per share. For 300 shares, the total loss will be 300  5 = £1,500.

P7-8 Preferred stock valuation (LG 4; Intermediate)

a. Preferred stock price = Expected perpetual dividend (D1) ÷ Required rate of return (r) =
£7.50  0.08 = £93.75
b. The new value of the preferred stock is £7.50  0.06 = £125. The said investor will gain a profit
of £125  £93.75 = £31.25. This profit will be on account of the increase in value due to the
reduced applicable discount rate.

P7-9 Common stock value: Constant growth (LG 4; Basic)

Let P0 be the current price of the common stock, D1 the next expected dividend, r the required return,
and g the expected constant growth rate of dividends.
Using, P0=D1 /(r  g)
Expected Dividend Dividend Require
Firm Next Year Growth Rate d Return Share Price
A £0.70 8% 13% £14.00
B £2.10 4% 14% £21.00
C £0.40 10% 15% £8.00
D £6.00 6% 9% £200.00
E £2.25 7% 20% £17.31
P7-10 Common stock value: Constant growth (LG 4; Intermediate)
a. Let P0 be current price of the common stock, D1 the next expected dividend, r the required return,
and g the expected dividend growth rate. The stock price is given by P0  D1  (r  g). So,
plugging the given information in the stock-price equation and solving for P0 = $0.72 ÷ (0.10 –
0.05) → P0 = $24
b. P0 = $0.72 ÷ (0.08 – 0.07) → P0 = $72
c. The constant growth model is sensitive to the required return and the growth rate. Even a small
error in the required return can lead a big difference (3 times in this case) in the estimation of
stock value.

P7-11 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)

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g = 0.035 or 3.5%

P7-12 Common stock value: Constant growth (LG 4; Intermediate)

P0 = D1  (rs − g)
Growth
Dividend per
Year Share Rate
2009 $5.00 –
2010 5.15 0.03
2011 5.40 0.0485
2012 5.62 0.0407
2013 5.72 0.0178

0.03+0.0485+0.0407 +0.0178
The average growth rate is =0.0343
4
D 1 5.72 ×(1+3.43 %)
P= = =$ 90
r −g 10 %−3.43 %

P7-13 Personal finance problem: Common stock value: Constant growth (LG 4; Challenge)
a.
Dividend per
Year Growth Rate
Share (€)
2020 1.87 6.25%
2019 1.76 9.32%
2018 1.61 10.27%
2017 1.46 6.57%
2016 1.37 13.22%
2015 1.21
Average Growth
9.13%
Rate
Value of the share: P = D1/(r g) = 1.87 (1 + 0.0913) / (0.1  0.0913) = £234.57
b. Value of share if expected return is 12%
P = D1/(r g) = 1.87 (1 + 0.0913) / (0.12 0.0913) = £54.10
c. An increase in the required rate of return means that future dividends will be discounted at a higher
rate, so the stock price will fall.

P7-14 Common stock value: Variable growth (LG 4; Challenge)

P0  Present value of dividends during initial growth period
 Present value of stock price at end of initial growth period.
The dividend for the next two years will be:
D1 = £2.30 × 1.20 = £2.76
D2 = £2.76 × 1.20 = £3.312

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For the third year it will be:

D3 = 3.312 × 1.05 = £3.48 and then they will grow at 5% in perpetuity.

Now:
PV of D1 = £2.76 ÷ (1 + 0.12) = £2.46
PV of D2 = £3.312 ÷ (1.12)2 = £2.64

The PV of the price of the stock at the end of Year 2 will be:
P3 = £3.48 ÷ (0.12 – 0.05) = £49.71

This is at the end of Year 3 from now, so we need to discount it for 2 years for its PV as of now: PV =
£49.71 ÷ (1 + 0.12)2 = £39.63

So, the value of the stock now should be the sum of the PV of the first two years’ dividends and the
PV of the growing dividend from Year 3 onwards. P0 = £2.46 + £2.64 + £39.63 = £44.72
So, Moore Tools should not pay more than £44.72 per share for the acquisition of Crooks.

P7-15 Personal finance problem: Common stock value: Variable growth (LG 4; Challenge)
P0 = Present value of all future dividends
Year Dividend PV
1 TL 2.50 2.17
2 TL 2.65 2.00
3 TL 2.81 1.85
4 TL 3.15 1.80
5 and Beyond TL 3.46 39.57
Total 47.40

For Year 5 and beyond:

They will pay TL 3.46 in Year 5 and it will increase by 10% every year, so its PV at the end of Year 4
will be
= TL 3.46/(0.15 – 0.10)
Its present value as of now will be (discounted for 4 years at expected return)
= (TL 3.46 / (0.15 – 0.10))/0.154 = TL 39.57

P7-16 Common stock value: Variable growth (LG 4; Challenge)

The dividend for the next two years and their PV will be:
D1 = 1.50 × (1 + 0.10) = $1.65, and its PV = $1.65 ÷ (1 + 1.09) = $1.51
D2 = 1.65 × (1 + 1.10) = $1.815, and its PV = $1.815 ÷ (1 + 1.09)2 = $1.53
Now –
a. If the dividends grow by 5% in Year 3 and beyond, then the PV of this perpetual dividend at the end
of Year 2 will be:
PV = ($1.815 × 1.05) ÷ (0.09 – 0.05) = $47.64
The PV as of now will be = $47.64 ÷ (1 + 0.09)2 = $40.09
So, the total value of Bach’s share as of now will be = $1.51 + $1.53 + $40.09 = $43.14

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b. If the dividends grow by 0% in Year 3 and beyond, then the PV of this perpetual dividend at the end
of Year 2 will be:
PV = $1.815 ÷ 0.09 = $20.16
The PV as of now will be = $20.16 ÷ (1 + 0.09)2 = $16.97
So, the total value of Bach’s share as of now will be = $1.51 + $1.53 + $16.97 = $20.01
c. If the dividends grow by 8% in Year 3 and beyond, then the PV of this perpetual dividend at the end of
Year 2 will be:
PV = ($1.815 × 1.08) ÷ (0.09 – 0.08) = $196.02
The PV as of now will be = $196.02 ÷ (1+0.09)2 = $164.99
So, the total value of Bach’s share as of now will be = $1.51 + $1.53 + $164.99 = $168.03

P7-17 Personal finance problem: Free cash flow valuation (LG 4; Challenge)
a. As the firm does not have any preferred stock or debt, the value of the firm should be the present value
of all future free cash flow:
VC = FCF1 / r = £32,000/0.18 = £177,777.78
b. Free cash flow next year = £32,000  1.08 = £34,560, and it will be growing in perpetuity so the value
of the firm should be:
VC = £34,560 / (0.18 – 0.08) = £345,600
c. For the first two years, cash flow is:
Year 1 = £32,000  1.1 = £35,200 and its PV as of now = £35,200/1.18 = £29,830.51
Year 2 = £35,200  1.1 = £38,720 and its PV as of now = £38,720/1.182 = £27,808.10

The cash flow at the end of Year 3 = £38,720  1.08 = £41817.60 and this will grow at 8% for
infinity:

So, the PV of this perpetual cash flow at the end of Year 4:

PV = £41817.60 /(0.18 – 0.08) = £418,176
And its present value as of now = £418,176 / 1.184 = £215,690.53

So, the value of the firm as of now =

VC = £29,830.51 + £27,808.10 + £215,690.53 = £273,329.14

P7-18 Free cash flow valuation (LG 5; Challenge)

a. Assuming, 2020 is exactly one year from now, we can map the cash flow till 2024 as follows to
calculate Jackson Ltd.’s present value:
Free Cash Years
Year Flow (£) from now PV @ 10%
2020 £220,000 1 £200,000.00
2021 £250,000 2 £206,611.57
2022 £300,000 3 £225,394.44
2023 £320,000 4 £218,564.31
2024 £350,000 5 £217,322.46
Total = £1,067,892.78

The cash flow in 2025 will be: £350,000*1.04 = £364,000

So, the PV of this perpetual cash flow at the end of 2024 (Year 5) will be:

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157 Zutter/Smart • Principles of Managerial Finance, Sixteenth Edition, Global Edition

£364,000 / (0.1 – 0.04) = £6,066,666.67

And its present value as of now (Year 0) will be:
£6,066,666.67 / 1.15 = £3,766,922.69
So, the total value of the firm:
£1,067,892.78 + £3,766,922.69 = £ 4,834,815.47
b. Total value of common stock (VS) = VC – Total Debt (VD) – Total value of preferred stock (VP)
= £4,834,815.47 – £200,000 – £500,000 = £4,134,815.47
c. Value per common share = VS / Common shares = £4,134,815.47/200,000 = £20.674

P7-19 Personal finance problem: Using the free cash flow valuation model to price an IPO (LG 5;
Challenge)
a. We can calculate the value of Alumina Tech’s common stock by calculating the present value of
the cash flows from 2020 to 2023 and then the present value of the future cash flow beyond 2023
to infinity.
The present value of cash flow from 2020 to 2023 (assuming 2020 is exactly one year from now):
Free Cash Flow
Year FCF Years from Now PV @ 6%
2020 450,000 1 424528.30
2021 400,000 2 355998.58
2022 425,000 3 356838.20
2023 550,000 4 435651.51
Total 1573016.59
Now, the cash flow for 2024 = 550000 × 1.03 = £566500
PV of perpetual cash flow at the end of 2023 = 566500/(0.06-0.03) = £18,883,333.33
PV of this value as of now in Y0 = £18,883,333.33 / 1.064 = £14,957,368.67
Total value of cash flow = 1,573,016.59 + 14,957,368.67 = £16,530,385.26
We can calculate the value of common stock by deducting the present value of debt and any
preferred stock
Total value of common stock (VS)= VC – Total Debt (VD) – Total value of preferred stock (Vp) =
£16,530,385.26 – £1,350,000 – £500,000 = £14,680,385.26
Now as they have 550,000 shares in common stock, the value of each share should be:
= £14,680,385.26 / 550,000 = £26.69
b. As the issue price of £14.20 is well below the value that we have calculated for a share, it seems
this IPO is quite underpriced and hence is good value for money. Therefore, we should invest in
it.
c. If the growth rate beyond 2023 changes from 3% to 4%, only the PV of the perpetual cash flow in
2024 and beyond will change.
Now, the cash flow for 2024 = 550000 × 1.04 = £572,000
The PV of the perpetual cash flow at the end of 2023 = 572,000/(0.06 – 0.0) = £28,600,000
The PV of this value as of now in Y0 = £28,600,000 / 1.064 = £22,653,878.77
The difference between the PV of the perpetual cash flow beyond 2023 at 3% and at 4% growth
rate = £22,653,878.77 – £14,957,368.67 = £7,696,510.10
Additional value added to each share = £7,696,510.10/550,000 = £13.99

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So, the new value of the common share = £26.99 + £13.99 = £40.98
This means the issue price under IPO is now even more attractive than before.

P7-20 Book and liquidation value (LG 5; Intermediate)

a. Book value per share =
Book value of assets—Book value of liabilities – Book value of preferred stock
Outstanding Shares
= (£1,560,000 – £680,000 – £160,000)  10000 = £72 per share.
b. Liquidation Value
Macadamia Industries
Assets (£) Liquidation Value for Common Stock (£)
Cash 80,000 Liquidation Value Assets = 1,560,000
Marketable Securities 120,000 Less:
Accounts Receivable (95% of
228,000 Current Liabilities 320,000
240,000)
Inventories 320,000 Long-Term Debt 360,000
Total Current Assets 760,000 Preference Share Capital 160,000
Land and Buildings (Net) (150% of Available for
450,000
300,000) Common Shareholders 720,000
Machinery and Equipment (80% of
400,000
500,000)
Total Fixed Assets (Net) 800,000
Total Liquidation Value of Assets 1,560,000
Liquidation value per share = Value available for common shareholder/common shares
= £720,000/10,000 = £72 per share.
c. The values calculated in Parts (a) and (b) are similar. However, this is likely to be a rare case
where the book value and the liquidation value are the same. Normally, due to historical cost
conventions, the book value is likely to be higher than the liquidation value.

P7-21 Valuation with price/earnings multiples (LG 5; Basic)

To estimate stock price given earnings per share (EPS) and the average industry price-earnings
multiple (P/E):
Firm EPS  P/E  Stock Price
A 3.0  6.30  £18.90
B 0.75  15.2  £11.40
C 1.80  5.70  £10.26
D 2.50  11.20  £28.00
E 3.20  8.40  £26.88

P7-22 Management action and stock value (LG 6; Intermediate)

a. P0 = [€2.20 × (1 + 0.05)]  (0.12 – 0.05) = €33.
b. P0 = [€2.20 × (1 + 0.08)]  (0.15 – 0.08) = €33.94
c. P0 = [€2.20 × (1 + 0.07)]  (0.14 – 0.07) = €33.62
d. P0 = [€2.20 × (1 + 0.08)]  (0.10 – 0.08) = €118.80
e. P0 = [€2.20 × (1 + 0.04)]  (0.08 – 0.04) = €57.20

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159 Zutter/Smart • Principles of Managerial Finance, Sixteenth Edition, Global Edition

P7-23 Integrative: Risk and valuation (LG 4 and LG 6; Intermediate)

P0 = D1  (rs − g)
$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

P7-24 Integrative: Risk and valuation (LG 4 and LG 6; Challenge)

a. Given an expected return of 13% and a risk-free rate of 5%, the risk premium on Stable Energy is
Risk Premium = 13% – 5% = 8%
b. Dividend growth rate from 2013 to 2020
Year Dividend per Share (€) Dividend Growth
2020 2.89 22.98%
2019 2.35 3.07%
2018 2.28 8.06%
2017 2.11 9.90%
2016 1.92 10.34%
2015 1.74 –2.79%
2014 1.79 4.07%
2013 1.72
Average Annual Growth 7.95%

So, the expected dividend for 2021 = €2.89 × 1.0795 = €3.12

Now, the annual growth in dividend is 7.95%, the expected return is 13%, and the cash flow for
the next period is €3.12. The PV of this growing perpetuity (value of a share) can be calculated as:

P0 = D1 / (r – g) = €3.12 / (0.13 – 0.0795) = £61.78 per share

c. A reduction in risk premium will reduce the applicable discount rate that is applied to future
discount values to calculate the value of a share. This will increase the present value and hence
the value of the share of Stable Energy.

P7-25 Integrative: Risk and valuation (LG 4 and LG 6; Challenge)

a. The maximum price to pay for Craft stock may be found in three steps:
Step 1: Find the 2017-2022 dividend growth rate (which is expected dividend growth rate) for
Craft stock: g = – 1 = 0.0702 = 7.02%.
Step 2: Find the required return (r) on Craft stock, given a risk-free rate (RF) of 5% and a risk
premium (RP) of 9%: r = RF + RP = 5% + 9% = 14%.
Step 3: Given a next expected dividend (D2023) of $3.68 per share, expected dividend growth (g)
of 7.02%, and a required return (r) of 14%, solve for the maximum price (value) of Craft
stock: P0 D2023 r – g$3.68  (0.14  0.0702) $52.72 per share.

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 Chapter 7 Stock Valuation 160

b. Part (1): The new value of Craft stock with lower dividend growth may be found in two steps:
Step 1: Find new expected dividend for 2020 with expected growth rate two percentage
points lower: D2023 = D2022 (1.0502) = $3.44 (1.0502) = $3.61.
Step 2: Given an expected 2023 dividend (D1) of $3.61 per share, expected dividend
growth (g) of 5.02%, and required return (r) of 14%, solve for new value of
Craft stock:P0 D2023 r – g$3.61  (0.14  0.0502) $40.20 per
share. A two-percentage-point decline in dividend growth reduced share price
by $12.52.
Part (2): To find the new share price, first recognize the smaller risk premium means a smaller
expected return. Specifically, risk premium (RP) falls to 4%, so required return is:
(r) = RF + RP = 5% + 4% = 9%. Given the next expected dividend (D2023) is $3.68 per
share, expected dividend growth (g) is 7.02%, and required return (r) is now 9%, solve
for new value of Craft stock: P0 D2023 r – g$3.68  (0.9  0.0702)
$185.86. A five percentage point decline in the risk premium boosted share price by
$133.14.

P7-26 ETHICS PROBLEM (LG 4; Intermediate)

a. “Clearly not growing” means valuing with the zero-dividend-growth model. Given a next
expected dividend (D1 = D0) of $5 per share and required return (r) of 11%, solve for value of
Generic Utilities stock: P0 D1 r$5  0.11 $45.45 per share.
b. A one-percentage-point “credibility” risk premium means raising required return from 11% to
12%, making the new value of Generic stock: P0 D1  r    $5  0.12 $41.67 per share.
c. The added risk premium reduces the value of Generic stock by $3.79. Uncertainty about the
reliability of the firm’s financials means expected dividends must be discounted at a higher rate.
Put another way, uncertainty makes future dividends worth less to investors.

 Case: Assessing Impact of Proposed Risky Investment on Suarez Stock

Case studies are available on www.pearson.com/mylab/finance.

In this case, students will assess the potential impact of risky project on a hypothetical firm’s stock.
a. To find the current value per share of Suarez common stock, first obtain the dividend growth rate (g),
which is expected to equal recent historical experience:
g = – 1 = – 1 = 0.0995 = 9.95%
Now, given g is 10%, the next expected dividend (D1) is $2.09, and required return is 14%, solve for
stock price: P0 = D1  r – g)   $2.09  (0.14 – 0.0995) $51.63 per share.
Now, given g is 10%, the next expected dividend (D1) is $2.09, and required return is 14%, solve for
stock price: P0 = D1  r – g)   $2.09  (0.14 – 0.0995) $51.63 per share.
b. If Suarez makes the risky investment, next year’s dividend (D1) will rise to $2.15 per share, the dividend
growth rate (g) to 13%., and required return to 16%. The new value of common stock is: P0 = D1  r –
g)   $2.15  (0.16 – 0.13) $71.67 per share. Stock price jumps $20.04 (38.8%).
c. Suarez should undertake the proposed project. Higher dividend growth more than compensates for the
impact of project risk on required return, thereby boosting stock price and shareholder wealth.

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161 Zutter/Smart • Principles of Managerial Finance, Sixteenth Edition, Global Edition

d. Now, dividends will grow 13% per year for three years (from the last dividend of $1.90); then, growth
will slow to the historical growth rate of 9.95%. Stock price will equal the present value of dividends
during 13% growth period plus the present value of stock price at the end of that period.
Step 1: Find the present value of dividends during the 13% growth period – given the last dividend (D0)
of $1.90, and required return of 16%:
D1 = $1.90 (1.13) = $2.15 D3 = $2.43 (1.13) = $2.74 D2 = $2.15 (1.13) = $2.43
n Dn 1/(1.16)n = Present Value of Dividends
0 $1.90
1 $2.15 0.8621 $1.85
2 $2.43 0.7432 $1.80
3 $2.74 0.6407 $1.76
Total = $5.41
Step 2: Now, find the present value of price of stock at end of 13% growth period (when 9.95% growth
resumes). At the end of year 3, the next expected dividend (D4) is $2.74 1.0995 = $3.01,
expected dividend growth is 9.95%, and required return is 14%,, so stock price is:
P3   [D4  (r  g)]   $3.01  (0.16  0.0995) =  $49.84. Finally, present value of stock price
at end of year 3 is $49.84        $31.93
Step 3: Add present value of dividends during 13% growth period to present value of stock price at end
of 13% growth period: P0   $5.41  $31.93 = $37.34.
Suarez should not undertake the risky project because share price would fall $14.29 (from $51.63 to
$37.34). Additional dividends do not compensate for the impact on of additional risk on required return.

 Spreadsheet Exercise

Answers to Chapter 7’s Azure Corporation spreadsheet problem are available on

www.pearson.com/mylab/finance.

 Group Exercise
Group exercises are available on www.pearson.com/mylab/finance.

The semester began with the fictitious firms about to become public corporations. Out of necessity, few
details were given. Now groups will begin to fill in the blanks. Specifically, using details from recent IPOs,
each group will write a detailed prospectus following the example in the text. Students should quickly see
similar patterns. Most IPOs, for example, are priced between $10 and $30 with few shares available at the
offer price, forcing the public to pay a premium on and around the issuance date. The final group task is
obtaining the most recent information on its shadow firm, including current market numbers and any recent
news/analyses. Students will find much of the news fairly innocuous. Instructors can note the tendency in
recent regulation for public companies to disclose more and more information. Class discussion can then
explore the costs and benefits of erring on the side of over-disclosure.

 Integrative Case 3: Encore International

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 Chapter 7 Stock Valuation 162

In this case, students will explore different methods of valuing a hypothetical firm, including price/earnings
multiples, book value, and traditional dividend-growth models (under varying assumptions about the patterns
of that growth). They will compare stock values generated by the models, discuss the differences, and select
the approach best capturing the firm’s true value.
a. Book value per share = Book value of common equity Common shares outstanding
= $60,000,000 2,500,000 = $24.
b. Current price/earnings ratio = Current stock price Earnings per share (EPS) = $40 $6.25 = 6.4.
c. (1) Current required return on common stock (r) = Risk-free rate (RF) + Risk premium (RP)
= 6% + 8.8% = 14.8%.
(2) New required return on common stock = 6% + 10% = 16%.
d. Because no dividend growth is anticipated, the valuation formula for perpetuities will indicate stock
price. Given a constant dividend of $4.00 (D1) and a required return of 16%, stock price, P0 = D1 r = $4
0.16 = $25.
e. (1) Given a 6% constant dividend growth, the next dividend is $4 (1.06) = $4.24. Stock price (P0)
with 6% constant dividend growth (g), 16% required return (r), and $4.24 next dividend (D1) is:
P0 = D1 (r – g) = $4.24 (0.16 – 0.06) = $42.40.
(2) Stock price when dividends grow 8% for two years then 6% forever may be found in three steps:
Step 1: Present value of dividends in the 8% growth period, given last dividend (D0) was $4, and
required return is 16%:
First note: D1 = $4.00 (1.08) = $4.32 and D2 = $4.32 (1.08) = $4.67. So,
n Dn 1/(1.16)n = Present Value of Dividends
0 $4.00
1 $4.32 0.8621 $3.72
2 $4.67 0.7432 $3.47
Total = $7.19
Step 2: Present value of price of stock at end of 8% growth period:
At end of year 2, next expected dividend, D3 = $4.67 (1.06) = $4.95, expected growth is
6%, and required return is 16%, so stock price, P2   [D3  (r  g)]   $4.95  (0.16  .06)
=  49.50. Finally, present value of end-of-year-2 stock price is $49.50     $36.79.
Step 3: Add present value of dividends during 8% growth period to present value of stock price at
end of 8% growth period: P0   $7.19  $36.79 = $43.98.
f. Comparing value of Suarez stock with different valuation methods:
Valuation Method Share Price
Market value $40.00
Book value 24.00
Zero growth 25.00
Constant growth 42.40
Variable growth 43.98

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Book value has no relevance to the true value of the firm. Of the remaining methods, the most
conservative estimate is given by the zero-growth model. Based on this estimate of stock value, wary
analysts may advise paying no more than $25 per share—a figure hardly more than book value. The
most optimistic prediction, the variable-growth model, estimates at $43.98, not far from the market
value. The market appears to be more optimistic about Encore International’s future than wary analysts.

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