Chapter 07

Chapter7
StockValuation
Instructors Resources
Overview
ThischaptercontinuesonthevaluationprocessintroducedinChapter6forbonds.Modelsforvaluing
preferredandcommonstockarepresented.Forcommonstock,thezerogrowth,constantgrowth,and
variablegrowthmodelsareexamined.Therelationshipbetweenstockvaluationandefficientmarketsis
presented.Theroleofventurecapitalistsandinvestmentbankersisalsodiscussed.Thefreecashflow
modelisexplainedandcomparedwiththedividenddiscountmodels.Otherapproachestocommonstock
valuationandtheirshortcomingsareexplained.Thechapterendswithadiscussionoftheinterrelationship
betweenfinancialdecisions,expectedreturn,risk,andafirmsvalue.Stockvaluationfromtheperspective
oftheonesprofessionallifeiscontrastedwithstockvaluationfromapersonalperspective.
Suggested Answer to Opener in Review Question

A123shareswereoriginallyofferedforsaleatapriceof$13.50.Threemonthslater,thestock
tradedforabout$18.Whatreturndidinvestorsearnoverthisperiod?OnNovember10,2009,A123
reported3rdquarterfinancialresults.FromNovember9toNovember11,thefirmsstockpricefell
from$17.85to$16.88.GiventhatA123has102millionsharesoutstanding,whatwerethedollarand
percentagelossesthatshareholdersenduredinthedayssurroundingtheearningsrelease?Overthe
samethreedays(November911),theNasdaqstockindexmovedup0.6%.Howdoesthisinfluence
yourthinkingaboutA123sstockperformancearoundthistime?
Thestockpricerose33.33percent[(($18$13.50)/$13.50)1]fromtheofferingpriceto$18.00.From
November911,A123sharesfellby$0.97($17.85$16.88)pershare,or$98,94million($0.97102
millionshares).Inpercentagetermsthelosswas5.43percent($0.97/$17.85).Giventhataninvestor
couldhaveearned0.6%onadiversifiedportfolioofNasdaqshares,onecanconcludethatA123shares
underperformedthemarketbyabout6percent(5.43%0.6%).Thismarketwasobviouslydissatisfied
withtheimplicationsofA123s3rdquarterfinancialresults.
Answers to Review Questions
Chapter7StockValuation125
1. Equitycapitalispermanentcapitalrepresentingownership,whiledebtcapitalrepresentsaloanthat
mustberepaidatsomefuturedate.Theholdersofequitycapitalreceiveaclaimontheincomeand
assetsofthefirmthatissecondarytotheclaimsofthefirmscreditors.Suppliersofdebtmust
receiveallinterestowedpriortoanydistributiontoequityholders,andinliquidationallunpaiddebts
mustbesatisfiedpriortoanydistributiontothefirmsowners.Equitycapitalisperpetualwhiledebt
hasaspecifiedmaturitydate.Couponpayments,theinterestpaymentondebt,arecurrentlytaxedas
ordinaryincome,whiledividendsarecurrentlytaxedatalowerrate.Tothecorporation,debtinterest
isataxdeductibleexpensewhiledividendsarenot.
2. Commonstockholdersarethetrueownersofthefirm,sincetheyinvestinthefirmonlyuponthe
expectationoffuturereturns.Theyarenotguaranteedanyreturn,butmerelygetwhatisleftover
afteralltheotherclaimshavebeensatisfied.Sincethecommonstockholdersreceiveonlywhatis
leftoverafterallotherclaimsaresatisfied,theyareplacedinaquiteuncertainorriskypositionwith
respecttoreturnsoninvestedcapital.Asaresultofthisriskyposition,theyexpecttobecompensated
intermsofbothdividendsandcapitalgainsofsufficientquantitytojustifytherisktheytake.
3. Rightsofferingsprotectagainstdilutionofownershipbyallowingexistingstockholderstopurchase
additionalsharesofanynewstockissues.Withoutthisprotectioncurrentshareholdersmayhavetheir
votingpowerreduced.Rightsarefinancialinstrumentsissuedtocurrentstockholdersthatpermit
thesestockholderstopurchaseadditionalsharesatapricebelowthemarketprice,indirectproportion
totheirnumberofownedshares.
4. Authorizedsharesarestatedinthecompanyscorporatecharterthatspecifiesthemaximum
numberofsharesthefirmcansellwithoutreceivingapprovalfromtheshareholders.
Whenauthorizedsharesaresoldtothepublicandareinthehandsofthepublic,theyarecalled
outstandingshares.
Whenafirmpurchasesbackitsownsharesfromthepublic,theyareclassifiedastreasurystock.
Treasurystockisnotconsideredoutstandingsinceitisnotinthehandsofthepublic.
Issuedsharesarethesharesofcommonstockthathavebeenputintocirculation.Issuedshares
includebothoutstandingsharesandtreasurystock.
5. Issuingstockoutsideoftheirhomemarketscanbenefitcorporationsbybroadeningtheinvestorbase
andalsoallowingthemtobecomebetterintegratedintothelocalbusinessscene.Alocalstocklisting
bothincreaseslocalpresscoverageandservesaseffectivecorporateadvertising.Locallytradedstock
canalsobeusedtomakecorporateacquisitions.
Americandepositoryreceipts(ADRs)representownershipofsharesofaforeigncompanysstock
heldondepositbytheU.S.bankinthecompanieshomecountry.ADRsareissuedindollarsbyan
AmericanbanktoU.S.investorsandaresubjecttoU.S.securitieslaws,yetstillgiveinvestorsthe
opportunitytointernationallydiversifytheirportfolios.Americandepositoryshares(ADSs)arethe
actualsecuritiesthataretradedinU.S.marketsthatrepresentforeigncompanies.ADRsarebacked
upbyADSs.
6. Theclaimsofpreferredstockholdersareseniortothoseofthecommonstockholderswithrespectto
thedistributionofbothearningsandassets.
2012PearsonEducation,Inc.PublishingasPrenticeHall
7. Cumulativepreferredstockgivestheholdertherighttoreceiveanydividendsinarrearspriortothe
paymentofdividendstocommonstockholders.
Thecallfeatureinapreferredstockissueallowstheissuertoretireoutstandingpreferredstock
withinacertainperiodoftimeataprespecifiedprice.Thisfeatureisnotusuallyexercisableuntila
fewyearsafterissuance.Thecallnormallytakesplaceatapriceabovetheinitialissuancepriceand
maydecreaseaccordingtoapredefinedschedule.Thecallfeatureallowstheissuertoescapethe
fixedpaymentcommitmentofthepreferredstockthatwouldremainonthebooksindefinitely.
Thecallfeatureisalsoneededinordertoforceconversionofconvertiblepreferredstock.
8. Venturecapitalists(VC)aretypicallybusinessentitiesthatareorganizedforthepurposeofinvesting
inattractivegrowthcompanies.Angelcapitalistsaregenerallywealthyindividualswhoprovide
privatefinancingtonewbusinesses.Firmsusuallyobtainangelfinancingfirst,thenastheirfunding
needsgettoolargeforindividualinvestorstheyseekfundsfromventurecapitalists.
9. Therearefourwaysinwhichinstitutionalventurecapitalistsaremostcommonlyorganized.
Smallbusinessinvestmentcompanies(SBICs)arecorporationscharteredbythefederal
government.
FinancialVCfundsaresubsidiariesoffinancialinstitutions,particularlybanks.
CorporateVCfundsarefirms,sometimessubsidiaries,establishedbynonfinancialfirms.
VClimitedpartnershipsarelimitedpartnershipsorganizedbyprofessionalVCfirms,whoserve
asgeneralpartner.
VCinvestmentsaremadeunderalegalcontractthatclearlyallocatesresponsibilitiesandownership
interestbetweenexistingownersandtheVCfundorlimitedpartnership.Thespecificfinancialterms
willdependonfactorssuchasthebusinessstructure,stageofdevelopment,andoutlook.Although
eachVCinvestmentisunique,thetransactionwillbestructuredtoprovidetheVCwithahighrate
ofreturnthatisconsistentwiththetypicallyhighriskofsuchtransactions.
10. ThegeneralstepsthataprivatefirmmustgothroughtogopublicviaanIPOarelistedbelow.
Thefirmmustobtaintheapprovalofitscurrentshareholders.
Thecompanysauditorsandlawyersmustcertifythatalldocumentsforthecompanyare
legitimate.
Thefirmthenfindsaninvestmentbankwillingtounderwritetheoffering.
Aregistrationstatementmustthenbefiledwiththesecuritiesexchangecommission(SEC).
OncetheregistrationstatementisapprovedbytheSECtheinvestmentpubliccanbeginanalyzing
thecompanysprospects.
11. Theinvestmentbankers(IB)mainactivityistounderwritetheissue.Inadditiontounderwritingthe
IBprovidestheissuerwithadviceaboutpricingandotherimportantaspectsoftheissue.
TheIBmayorganizeanunderwritingsyndicatetohelpunderwritetheissueandthustosharepart
oftherisk.TheIBandthesyndicatewillputtogetherasellinggroupwhosharetheresponsibilityof
sellingaportionoftheissue.
127Gitman/ZutterPrinciplesofManagerialFinance,Thirteenth Edition
12. Theefficientmarkethypothesissaysthatinanefficientmarket,investorswouldbuyanassetifthe
expectedreturnexceedsthecurrentreturn,therebyincreasingitsprice(marketvalue)anddecreasing
theexpectedreturn,untilexpectedandrequiredreturnsareequal.
13. Accordingtotheefficientmarkethypothesis:
a.
Securitiespricesareinequilibrium(fairlypricedwithexpectedreturnsequaltorequiredreturns);
b. Securitiespricesfullyreflectallpublicinformationavailableandwillreactquicklytonew
information;and
c.
Investorsshouldthereforenotwastetimesearchingformispriced(overorundervalued)
securities.
Theefficientmarkethypothesisisgenerallyacceptedasbeingreasonableforsecuritiestradedon
majorexchanges;thisissupportedbyresearchonthesubject.Thereisanincreasingchallengetothe
efficientmarkethypothesisbeingofferedbythestudyofbehaviorfinance.Thechallengecomes
primarilyfromthefactthattestsoftheefficientmarkethypothesisassumesthatinvestorsare
completelyrational.Agoingbodyofresearchdisputesthisrationalityassumptionandshowsthat
investorsaredrivenbytheirrationalbehaviorsofgreed,fear,andotheremotions.
14. a.
Thezerogrowthmodelofcommonstockvaluationassumesaconstant,nongrowingdividend
stream.Thestockisvaluedasaperpetuityanddiscountedataraters:
P0 D rs
b. Theconstantgrowthmodelofcommonstockvaluation,alsocalledtheGordonmodel,assumes
thatdividendswillgrowataconstantrate,g.ThestockisvaluedasthePVoftheconstantly
growingcashflowstream:
P0
c.
D1
rs g
Thevariablegrowthmodelofcommonstockvaluationassumesthatdividendsgrowatavariable
rate.ThestockwithasingleshiftinthegrowthrateisvaluedasthePVofthedividendstream
duringtheinitialgrowthphaseplusthePVofthepriceofstockattheendoftheinitialgrowth
phase:
N
P0
t 1
D0 (1 g1 )t
1
N 1
t
N
(1 rs )
(rs g2 )
(1 rs )
15. ThefreecashflowvaluationmodeltakesthePVofallfuturefreecashflows.SincethisPVrepresents
thetotalvalueofthefirmthevalueofdebtandpreferredstockmustbesubtractedtogetthefreecash
flowavailabletostockholders.Dividingtheresultingvaluebythenumberofsharesoutstanding
arrivesatthestockprice.
Thefreecashflowmodeldiffersfromthedividendvaluationmodelintwomainways.
a.
Thetotalcashflowsofthecompanyareevaluated,notjustdividends.
b. Thefirmscostofcapitalisusedasthediscountrate,nottherequiredreturnonstock.
16. a.
Bookvalueisthevalueofthestockintheeventallassetsareliquidatedfortheirbookvalueand
theproceedsremainingafterpayingallliabilitiesaredividedamongthecommonstockholders.
b. Liquidationvalueistheactualamounteachcommonstockholderwouldexpecttoreceiveifthe
firmsassetsaresold,creditorsandpreferredstockholdersarepaid,andanyremainingmoneyis
dividedamongthecommonstockholders.
c.
Priceearningsmultiplesareanotherwaytoestimatecommonstockvalue.Thesharevalueis
estimatedbymultiplyingexpectedearningspersharebytheaverageprice/earningsratiofor
theindustry.
Boththebookvalueandliquidationvalueapproachesignoretheearningpowerofafirmsassetsand
lackarelationshiptothefirmsvalueinthemarketplace.Theprice/earningsmultiplesapproachis
consideredthebestapproachtovaluationsinceitconsidersexpectedearnings.Thepriceearnings
(P/E)ratioalsohasthestrongesttheoreticalroots.OnedividedbytheP/Eratiocanbeviewedasthe
rateatwhichinvestorsdiscountthefirmsearnings.Iftheprojectedearningspershareisassumedto
beearnedindefinitely,theP/EmultipleapproachcanbelookedonasamethodoffindingthePVofa
perpetuityofprojectedearningspershare(EPS)atarateequaltotheP/Eratio.
17. Adecisionoractionbythefinancialmanagercanhaveaneffectontheriskandexpectedreturnof
thestock,bothofwhicharepartofthestockvaluationmodel.
18. CAPM:rsRF[bj(rmRF)]andbj1.00:
a.
Astheriskpremiumincreases,requiredreturnincreasesandstockpricefalls.
b. Astheriskfreeratedeclines,therequiredreturnwouldalsodecline.Substitutingksintothe
GordonmodelP0D1(rsg),asrsdeclines,P0increases.
c.
AsD1decreases,theP0alsodecreasessincethenumeratorinthedividendvaluationmodelswill
decline.
d. Asgincreases,theP0alsoincreases.IntheGordongrowthmodelthevalueof(rg)inthe
denominatorwillbecomesmallerresultinginahighervalue.
Suggested Answer to Focus on Practice Box: Understanding

Human Behavior Helps Us Understand Investor Behavior
Theoriesofbehavioralfinancecanapplytootherareasofhumanbehaviorinadditiontoinvesting.
Thinkofasituationinwhichyoumayhavedemonstratedoneofthesebehaviors.Sharewithaclassmate.
Studentanswerswillvary.Examples:
Specifically,regrettheorymayholdtrueforsocialandothersituationsinwhichapersonmakesamistake.
Subsequentdecisionsarebasedonavoidingembarrassment.
Fearofregretcansometimesberationalizedawaywiththethoughtthateveryoneelseisdoingit
(herdingtheory).Thisexplainswhysomepeoplewilldosillythingsatparties.
Studentsmayreacttogradesthesamewayaninvestorreactstoinvestmentnews,placingmore
importanceonrecenteventswithoutrecognizingtheoveralltrend.
Suggested Answer to Focus on Ethics Box: Understanding:

PsstHave You Heard Any Good Quarterly Earnings Forecasts
Lately?
Whattemptationsmightmanagersfaceiftheyhaveprovidedearningsguidancetoinvestorsand
laterfinditdifficulttomeettheexpectationsthattheyhelpedcreate?
Therealcostsassociatedwithprovidingquarterlyguidanceincludedirectcostssuchasthetimesenior
managementandfinancepersonnelmustspendpreparingthereportsandtheindirectcostsoftheexcessive
focusitencouragesonmanagingshorttermresultstohitthetargets.Thedifficultyofforecastingearnings
accuratelysoastoprovideguidancecanleadtotheoftenpainfulresultofmissingquarterlyforecasts.That
inturncanbeapowerfulincentiveformanagementtosacrificelongerterm,valuecreatinginvestmentsin
favorofshorttermresults,andinsomecases,tomanageearningsinappropriatelyfromquartertoquarter
tocreatetheillusionofstability.Managersunabletomeetoverlyoptimisticquarterlyexpectationsmightcut
backonnecessaryresearchanddevelopment,maintenance,training,andothersimilarexpensesinorderto
improvequarterlyprofits.Inthelongrun,suchcutbacksarelikelytoreducefirmvalue.
Answers to Warm-Up Exercises

E71.
Answer:
Usingdebtratiotocalculateafirmstotalliabilities
Debtratio totalliabilities totalassets
Totalliabilities debtratio totalassets

0.75 $5,200,000 $3,900,000
E72.
Determiningnetproceedsfromthesaleofstock
Netproceeds (1,000,000 $20 0.95) (250,000 $20 0.90)

$19,000,000 $4,500,000 $23,500,000
Answer:
E73.
Preferredandcommonstockdividends
Answer: Commonstockdividend(Cashavailablepreferreddividends)number
ofcommonshares
[$12,000,000(4$2.50750,000)]3,000,000
$1.50pershare
E74.
Price/earningratios
Answer: Earningspershare(EPS)$11,200,0004,600,000$2.43pershare
TodaysP/Eratio$24.60$2.4310.12
YesterdaysP/Eratio$24.95$2.4310.27
E75.
Usingthezerogrowthmodeltovaluestock
Answer: P0[$1.20(1.05)]0.08$1.260.08$15.75pershare
E76.
Capitalassetpricingmodel
Answer: Step1:Calculatetherequiredrateofreturn.
rs4.5%10.8%15.3%
Step2:Calculatethevalueofthestockusingthezerogrowthmodel.
P0$2.250.153$14.71pershare
Solutions to Problems
P71.
Authorizedandavailableshares
LG2;Basic
a.
Maximumsharesavailableforsale
Authorizedshares
2,000,000
Less:Sharesoutstanding
1,400,000
Availableshares
600,000
Totalsharesneeded
$48,000,000
800,000shares
$60
b.
Thefirmrequiresanadditional200,000authorizedsharestoraisethenecessaryfundsat
$60pershare.
c.
Aspinmustamenditscorporatechartertoauthorizetheissuanceofadditionalshares.
P72.
Preferreddividends
LG2;Intermediate
P73.
a.
$8.80peryearor$2.20perquarter.
b.
$2.20.Foranoncumulativepreferredonlythelatestdividendhastobepaidbeforedividends
canbepaidoncommonstock.
c.
$8.80.Forcumulativepreferredalldividendsinarrearsmustbepaidbeforedividendscanbe
paidoncommonstock.Inthiscasetheboardmustpaythethreedividendsmissedplusthe
currentdividend.
Preferreddividends
LG2;Intermediate
P74.
$15.00
quartersinarrearsplusthelatestquarter
$8.80
onlythelatestquarter
$11.00
$25.50
quartersinarrearsplusthelatestquarter
$8.10
Convertiblepreferredstock
LG2;Challenge
P75.
a.
Conversionvalueconversionratiostockprice5$20$100
b.
Basedoncomparisonofthepreferredstockpriceversustheconversionvalue,theinvestor
shouldconvert.Ifconverted,theinvestorhas$100ofvalueversusonly$96ifshekeeps
ownershipofthepreferredstock.
c.
Iftheinvestorconvertstocommonstockshewillbeginreceiving$1.00pershareperyear
ofdividends.Conversionwillgenerate$5.00peryearoftotaldividends.Iftheinvestorkeeps
thepreferredtheywillreceive$10.00peryearofdividends.Thisadditional$5.00peryear
individendsmaycausetheinvestortokeepthepreferreduntilforcedtoconvertthrough
useofthecallfeature.Furthermore,whilecommonstockdividendsmaybecutoreliminated
altogetherwithnoprotection,preferreddividendsaretypicallyfixedandcumulativeprovision.
Personalfinance:Commonstockvaluationzerogrowth:P0D1rs
LG4;Basic
P76.
a.
P0$2.400.12$20
b.
P0$2.400.20$12
c.
Asperceivedriskincreases,therequiredrateofreturnalsoincreases,causingthestockprice
tofall.
Personalfinance:commonstockvaluationzerogrowth
LG4;Intermediate
Valueofstockwhenpurchased
$5.00
$31.25
0.16
$5.00
$41.67
0.12
Sallyscapitalgainis$10.42($41.67 $31.25)pershare.
Sallystotalcapitalgainis100 $1,042.00.
Valueofstockwhensold
P77.
Preferredstockvaluation:PS0Dprp
LG4;Intermediate
a.
PS0$6.400.093
PS0$68.82
b.
PS0$6.400.105
PS0$60.95
Theinvestorwouldlose$7.87pershare($68.82$60.95)becauseastherequiredrateofreturn
onpreferredstockissuesincreasesabovethe9.3%returnshereceives,thevalueofherstock
declines.
P78.
Commonstockvalueconstantgrowth:P0D1(rsg)
LG4;Basic
Firm
P0D1(rsg)
A
B
C
D
E
P0$1.20(0.130.08)
P0$4.00(0.150.05)
P0$0.65(0.140.10)
P0$6.00(0.090.08)
P0$2.25(0.200.08)
SharePrice
$24.00
$40.00
$16.25
$600.00
$18.75
P79.
Commonstockvalueconstantgrowth
LG4;Intermediate
rs
D1
g
P0
$1.20 (1.05)
0.05
$28
$1.26
rs
0.05 0.045 0.05 0.095 9.5%
$28
rs
a.
$1.20 (1.10)
0.10
$28
$1.32
rs
0.10 0.047 0.10 0.147 14.7%
$28
rs
b.
P710. Personalfinance:Commonstockvalueconstantgrowth:P0D1(rsg)
LG4;Intermediate
Computationofgrowthrate:
N5,PV$2.25,FV$2.87
SolveforI5%
a.
Valueat13%requiredrateofreturn:
P0
$3.02
$37.75
0.13 0.05
b.
Valueat10%requiredrateofreturn:
P0
c.
$3.02
$60.40
0.10 0.05
Asriskincreases,therequiredrateofreturnincreases,causingthesharepricetofall.
P711. Commonstockvaluevariablegrowth:
LG4;Challenge
P0PVofdividendsduringinitialgrowthperiod
PVofpriceofstockatendofgrowthperiod.
Steps1and2:ValueofcashdividendsandPVofannualdividends
t
D0
1.25t
Dt
1
2
3
$2.55
2.55
2.55
1.2500
1.5625
1.9531
$3.19
3.98
4.98
1/(1.15)t
PV
ofDividends
0.8696
0.7561
0.6575
$2.77
3.01
3.27
$9.05
Step3:PVofpriceofstockatendofinitialgrowthperiod
D31$4.98(10.10)
D4$5.48
P3[D4(rsg2)]
P3$5.48(0.150.10)
P3$109.56
PVofstockatendofyear3
N3,I15%,FV$109.60
PV$72.04
Step4:SumofPVofdividendsduringinitialgrowthperiodandPVpriceofstockatendof
growthperiod
P0$9.05$72.04
P0$81.09
P712. Personalfinance:Commonstockvaluevariablegrowth
LG4;Challenge
D0 (1 g1 )t
(1 rs )t
t 1
N
P0
DN 1
1
(1 rs ) N (rs g2 )
P0PVofdividendsduringinitialgrowthperiodPVofpriceofstockatendofgrowthperiod.
D1$3.40(1.00)$3.40
D2$3.40(1.05)$3.57
D3$3.57(1.05)$3.75
D4$3.75(1.15)$4.31
D5$4.31(1.10)$4.74
PV
ofDividends
$2.98
t
1
Dt
$3.40
1/(1.14)t
0.8772
3.57
0.7695
2.75
3.75
0.6750
2.53
4.31
0.5921
2.55
$10.81
P4[D5(rsg)]
P4$4.74(0.140.10)
P4$118.50
PVofstockatendofyear
N4,I14,FV$118.50
SolveforPV$70.16
growthperiod
P0$10.81$70.16
P0$80.97
P713. Commonstockvaluevariablegrowth
LG4;Challenge
a.
PV
ofDividends
$1.75
t
1
D0
$1.80
1.08t
1.0800
Dt
$1.94
1/(1.11)t
0.9009
1.80
1.1664
2.10
0.8116
1.70
1.80
1.2597
2.27
0.7312
1.66
$5.11
D4D3(1.05)$2.27(1.05)$2.38
P3[D4(rsg)]
P3$2.38(0.110.05)
P3$39.67
N3,I11%,FV$39.67
SolveforPV$29.01
PVofdividendsandfuturestockprice
$5.11$29.01$34.12
b. ThePVofthefirst3yearsdividendsisthesameasinparta.
D4D3(1.0)2.27
P3[D4(rsg)]
P3$2.270.11
P3$20.64
N3,I11%,FV$20.64
SolveforPV$15.09
P0$5.11$15.09$20.20
c.
ThePVofthefirst3yearsdividendsisthesameasinparta.
D4D3(1.10)2.50
P3[D4(rsg)]
P3$2.50(0.110.10)
P3$250.00
N3,I11%,FV$250.00
PV$182.80
P0$5.11$182.80$187.91
P714. Personalfinance:Commonstockvalueallgrowthmodels
LG4;Challenge
a.
P0(CF0r)
P0$42,5000.18
P0$236,111
b. P0(CF1(rg))
P0($45,475*(0.180.07)
P0$413,409.09
CF1$42,500(1.07)$45,475
c.
t
1
2
D0
$42,500
42,500
1.12t
1.1200
1.2544
Dt
$47,600
53,312
1/(1.18)t
0.8475
0.7182
PV
ofDividends
$40,338.98
38,287.85
$78,626.83
D21$53,312(10.07)
D3$57,043.84
P2[D3(rsg)]
P2$57,043.84(0.180.07)
P2$518,580.36
N2,I18%,FV$518,580.36
SolveforPV$372,436.34
growthperiod
P0$78,626.83$372,436.34
P0$451,063.17
P715. Freecashflow(FCF)valuation
LG5;Challenge
a.
Thevalueofthetotalfirmisaccomplishedinthreesteps.
(1) CalculatethePVofFCFfrom2018toinfinity.
[$390,000(1.03)](0.110.03)$401,7000.08$5,021,250
(2) AddthePVofthecashflowobtainedin(1)tothecashflowfor2017.
FCF2017$5,021,250390,000$5,411,250
(3) FindthePVofthecashflowsfor2013through2017.
Year
2013
2014
2015
2016
2017
FCF
1/(1.11)t
$200,000
0.9009
250,000
0.8116
310,000
0.7312
350,000
0.6587
5,411,250
0.5935
Valueofentirecompany,Vc
PV
$180,180
202,900
226,672
230,545
3,211,577
$4,051,874
b. Calculatethevalueofthecommonstock.
VSVCVDVP
VS$4,051,874$1,500,000$400,000$2,151,874
c.
Valuepershare$2,151,874200,000shares$10.76
P716. Personalfinance:UsingthefreecashflowvaluationmodeltopriceanIPO
LG5;Challenge
a.
Thevalueofthefirmscommonstockisaccomplishedinfoursteps.
[$1,100,000(1.02)](0.080.02)$1,122,0000.06$18,700,000
FCF2016$18,700,0001,100,000$19,800,000
Year
2013
2014
2015
2016
FCF
$700,000
1/(1.08)t
0.9259
800,000 0.8573
950,000 0.7938
19,800,00 0.7350
0
PV
$
648,060
685,840
754,110
14,533,00
0
$16,641,01
0
(4) CalculatethevalueofthecommonstockusingEquation7.8.
VSVCVDVP
VS$16,641,010$2,700,000$1,000,000$12,941,010
Valuepershare$12,941,0101,100,000shares$10.76
b. BasedonthisanalysistheIPOpriceofthestockisovervaluedby$0.74($12.50$11.76)
andyoushouldnotbuythestock.
c.
Therevisedvalueofthefirmscommonstockiscalculatedinfoursteps.
[$1,100,000(1.03)](0.080.03)$1,133,0000.05$22,660,000
FCF2016$22,660,0001,100,000$23,760,000
Year
2013
2014
2015
2016
FCF
$700,000
1/(1.08)t
0.9259
800,000 0.8573
950,000 0.7938
23,760,00 0.7350
0
PV
$
648,060
685,840
754,110
17,463,60
0
$19,551,61
0
(4) CalculatethevalueofthecommonstockusingEquation7.8.
VSVCVDVP
VS$19,551,610$2,700,000$1,000,000$15,851,610
Valuepershare$15,851,6101,100,000shares$14.41
Ifthegrowthrateischangedto3%theIPOpriceofthestockisundervaluedby$1.91
($14.41$12.50)andyoushouldbuythestock.
P717. Bookandliquidationvalue
LG5;Intermediate
a.
Bookvaluepershare:
Bookvalueofassets (liabilities+preferredstockatbookvalue)
numberofsharesoutstanding
Bookvaluepershare
$780,000 $420,000
$36pershare
10,000
b. Liquidationvalue:
Cash
$40,000
LiquidationValueofAssets
722,000
Marketable
Securities
60,000
AccountsRec.
(0.90$120,000)
108,000
Inventory
(0.90$160,000)
Less:CurrentLiabilities
(160,000)
LongTermDebt
(180,000)
PreferredStock
(80,000)
AvailableforCS
$302,000
144,000
LandandBuildings
(1.30$150,000)
195,000
Machinery&Equip.
(0.70$250,000)
175,000
Liq.ValueofAssets
$722,000
c.
Liquidationvaluepershare
Liquidationvalueofassets
Numberofsharesoutstanding
Liquidationvaluepershare
$302,000
$30.20pershare
10,000
Liquidationvalueisbelowbookvaluepershareandrepresentstheminimumvaluefor
thefirm.Itispossibleforliquidationvaluetobegreaterthanbookvalueifassetsare
undervalued.Generally,theyareovervaluedonabookvaluebasis,asisthecasehere.
P718. Valuationwithprice/earningsmultiples
LG5;Basic
Firm
EPSP/E
StockPrice
A
B
C
D
E
3.0(6.2)
4.5(10.0)
1.8(12.6)
2.4(8.9)
5.1(15.0)
$18.60
$45.00
$22.68
$21.36
$76.50
P719. Managementactionandstockvalue:P0D1(rsg)
LG6;Intermediate
a.
P0$3.15(0.150.05)$31.50
b.
P0$3.18(0.140.06)$39.75
c.
P0$3.21(0.170.07)$32.10
d.
P0$3.12(0.160.04)$26.00
e.
P0$3.24(0.170.08)$36.00
Thebestalternativeintermsofmaximizingsharepriceisb.
P720. IntegrativeriskandvaluationandCAPMformulas
LG4,6;Intermediate
P0 D1(rsg)
$50$3.00(rs0.09)
rs 0.15
rs riskfreerateriskpremium
0.150.09riskpremium
0.150.090.06riskpremium
P721.Integrativeriskandvaluation
LG4,6;Challenge
a.
14%10%4%
b.
N6,PV$1.73,FV$2.45
Solveforg:I5.97%
P0D1(rsg)
P0$2.60(0.1480.0597)
P0$29.45
c.
Adecreaseintheriskpremiumwoulddecreasetherequiredrateofreturn,whichinturn
wouldincreasethepriceofthestock.
P722. Integrativeriskandvaluation
LG4,6;Challenge
a.
Estimategrowthrate:
N5,PV$2.45,FV$3.44
SolveforI7.02%
rs0.090.050.14
D1($3.441.0702)$3.68
P0$3.68(0.140.0702)
P0$52.72
b. (1) rs0.14
D1$3.61($3.441.0502)
P0$3.61(0.140.0502)
P0$40.20pershare
(2) rs
D1$3.68
P0$3.68(0.130.0702)
P0$61.54pershare
Priceisafunctionofthecurrentdividend,expecteddividendgrowthrate,andtheriskfreerate,
andthecompanyspecificriskpremium.ForCraft,theloweringofthedividendgrowthrate
reducedfuturecashflowsresultinginareductioninshareprice.Thedecreaseintherisk
premiumreflectedareductioninriskleadingtoanincreaseinshareprice.
P723. Ethicsproblem
LG4;Intermediate
a.
Thisisazerogrowthdividendvaluationproblem,so:
P0D/r$5/0.11$45.45
b.
Usingthenewdiscountrateof12%(11%1%credibilityriskpremium),wehave:
P0D/r$5/0.12$41.67
Thevaluedeclineisthedifferencebetweenpartsaandb:
Valuedecline$41.67$45.45
$3.78
Thestocksellsforalmost$4lessbecausethecompanysfinancialreportscannotbefullytrusted.
Lackofintegrityisseentohurtstockpricesbecauseofthecredibilitypremium.
Case
Casestudiesareavailableonwww.myfinancelab.com.
Assessing the Impact of Suarez Manufacturings Proposed Risky Investment

on Its Stock Value
Thiscasedemonstrateshowariskyinvestmentcanaffectafirmsvalue.First,studentsmustcalculatethe
currentvalueofSuarezsstock,reworkthecalculationsassumingthatthefirmmakestheriskyinvestment,
andthendrawsomeconclusionsaboutthevalueofthefirminthissituation.Inadditiontogaining
experienceinvaluationofstock,studentswillseetherelationshipbetweenriskandvaluation.
a.
Currentpersharevalueofcommonstockgrowthrateofdividends:
gcanbesolvedforbyusingthegeometricgrowthequationasshownbelowin(Method1)orby
findingtheinterestfactorterms(i.e.,theI),forthegrowthasshownin(Method2).
g
1.90
(1.46154)1/ 4 1 1.0995 1 0.0995 10.0%
1.30
Method1.
Method2. N4,PV1.30,FV1.90
SolveforI9.95
P0
b.
D1
$1.90(1.10) $2.09
$52.25
rs g 0.14 0.10 0.04
Valueofcommonstockifriskyinvestmentismade:
P0
D1
$1.90(1.13) $2.15
$71.67
rs g 0.16 0.13 0.03
Thehighergrowthrateassociatedwithundertakingtheinvestmentincreasesthemarketvalueof
thestock.
c.
Thefirmshouldundertaketheproposedproject.Thepricepershareincreasesby$19.42(from
$52.25to$71.67).Althoughriskincreasedandincreasedtherequiredreturn,thehigherdividend
growthoffsetsthishigherriskresultinginanetincreaseinvalue.
d.
D20132.15(statedincase)
D20142.15(10.13)2.43
D20152.43(10.13)2.75
D20162.75(10.10)3.02
P2015D2016(rg)
$3.02(0.160.10)$3.020.06$50.33
CF00,CF1$2.15,CF2$2.43,CF3$2.75$50.33
SetI16%
SolveforNPV$37.67
No,thefirmshouldnotundertaketheproposedproject.Thepricepersharedecreasesby$14.58
(from$52.25to$37.67).Nowtheincreaseinriskandincreasedrequiredreturnisnotoffsetby
theincreaseincashflows.Thelongertermofthegrowthisanimportantfactorinthisdecision.
Spreadsheet Exercise
TheanswertoChapter7sAzureCorporationspreadsheetproblemislocatedontheInstructorsResource
Centeratwww.pearsonhighered.com/ircundertheInstructorsManual.
Group Exercise
Groupexercisesareavailableonwww.myfinancelab.com.
Thischaptersexercisetakesthegroupsbacktothefuture.Thesemesterbeganwiththefictitiousfirms
havingrecentlybecomepubliclytradedcorporations.Outofnecessitytherewerefewdetailsgiven.The
groupsnowgettorectifythissituation.UsingthedetailsofrecentIPOs,eachgroupisaskedtowritea
detailedprospectusfollowingcloselytheexamplepresentedinthetext.Thisincludesbutisnotlimited
tothepershareprice/quantityoftheoffering.
StudentsshouldquicklyrealizethesimilaritiesofthevariousIPOs.Mostareofferedwithinthe$10$30
range.Theprocessisoftenthesamewithfewsharesavailableattheofferprice,forcingthegeneralpublic
topayapremiumabovethisofferpriceonandaroundtheissuancedate.
Thefinaltaskforthegroupsistogetthemostrecentinformationontheirshadowfirm.Thisincludes
marketnumbersaswellasanyrecentnews/analyses.Oftenthisinformationwillbefairlyinnocuous.
Pointoutthatrecentregulatoryrequirementshaveincreasedthestringentpublicinformationregarding
publiclyheldcorporations.
Integrative Case 3: Encore International

Thiscasefocusesonthevaluationofafirm.Thestudentexploresvariousmethodsofvaluation,including
theprice/earningsmultiple,bookvalue,nogrowth,constantgrowth,andvariablegrowthmodels.Riskand
returnareintegratedintothecasewiththeadditionofthesecuritymarketlineandthecapitalassetpricing
model.Thestudentisaskedtocomparestockvaluesgeneratedbyvariousmodels,discussthedifferences,
andselecttheonethatbestrepresentsthetruevalueofthefirm.
Bookvaluepershare
$60,000,000
$24
2,500,000
a.
P/E ratio
$40
6.4
$6.25
b.
c.
a.
rsRFriskpremiumEncore
rs6%8.8%
rs14.8%
Requiredreturn14.8%
b. rs6%10%
rs16%
Requiredreturn16%
c.
Asriskpremiumsrise,requiredreturnalsorises.
d. Zerogrowth:
e.
P0
D1
rs
P0
$4.00
$25
0.16
a.
Constantgrowth:
P0
D1
(rs g )
P0
($4.00 1.06) $4.24
$42.40
(0.16 0.06)
0.10
b. Variablegrowthmodel:PVofdividends
D0 (1 g1 )t
1
DN 1
(1 rs )t (1 rs ) N (rs g 2 )
t 1
n
P0
PoPVofdividendsduringinitialgrowthperiodPVofpriceofstockatendofgrowthperiod.
Year
D0
1.08t
Dt
1/1.16t
2013
2014
1
2
$4.00
4.00
1.080
1.166
$4.32
4.67
0.8621
0.7432
PV
ofDividends
$3.72
3.47
$7.19
D2015$4.67(1.06)$4.95
P2014[D2015(rsg2)]
P2014$4.95(0.160.06)
P2014$49.50
PVofstockatendofyear2(2014)
PVP2(1/1.16)2
PV$49.50(0.7432)
PV$36.79
growthperiod
P20012$7.19$36.79
P20012$43.98
f.
ValuationMethod
Marketvalue
Bookvalue
Zerogrowth
Constantgrowth
Variablegrowth
PerShare
$40.00
24.00
25.00
42.40
43.98
Thebookvaluehasnorelevancetothetruevalueofthefirm.Oftheremainingmethods,themost
conservativeestimateofvalueisgivenbythezerogrowthmodel.Waryanalystsmayadvisepaying
nomorethan$25pershare,yetthisishardlymorethanbookvalue.Themostoptimisticprediction,
thevariablegrowthmodel,resultsinavalueof$43.98,whichisnotfarfromthemarketvalue.The
marketisobviouslynotascautiousaboutEncoreInternationalsfutureastheanalysts.
NotealsotheP/Eandrequiredreturnconfirmoneanother.TheinverseoftheP/Eis16.25,or
0.16.Thisisalsoameasureofrequiredreturntotheinvestor.Therefore,theinverseoftheP/E(16%)
andsumoftheriskfreerateandriskpremiumareidentical.Themarketappearstobepricinginthe
expectationthatthecompanywillexpandintoEuropeanandLatinAmericanmarkets.

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Chapter 07

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Chapter7

Suggested Answer to Opener in Review Question

Answers to Review Questions

Suggested Answer to Focus on Practice Box: Understanding

Suggested Answer to Focus on Ethics Box: Understanding:

Answers to Warm-Up Exercises

Totalliabilities debtratio totalassets

Netproceeds (1,000,000 $20 0.95) (250,000 $20 0.90)

Assessing the Impact of Suarez Manufacturings Proposed Risky Investment

Integrative Case 3: Encore International

($4.00 1.06) $4.24

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