ABMF4024 BUSINESS FINANCE Tutorial 3 (Cont’) Answer November 1, 2010

Question 1
a) An upward shift in interest rates and investors’ required rates of return
would cause (rs) to increase and the price of the firm's stock (Po) to
decrease.
b) A reduction in the future growth potential of the firm's earnings and
dividends due to increased foreign competition would lower the firm's
future dividends (D1, D2,...) and hence decrease the stock price (Po).
c) An increase in the riskiness of the firm's common stock due to larger
South American investments by the firm would increase the (marginal)
investor's required rate of return (rs) and hence decrease the stock
price (Po), unless the growth potential of these investments
outweighed the increase risk.

Question 2
The financial decisions of the firm affect both expected future dividend
payments of the firm (D1, D2...) as well as the (marginal) investor's required
rate of return (rs). Shareholder wealth (stock price) is a function of these
variables and hence is a function of the financial decisions of the firm.

Question 3
Hart Enterprises recently paid a dividend, D 0 of $1.25. It expects to have non-
constant growth of 20 percent for 2 years followed by a constant rate of 5
percent thereafter. The firm’s required return is 10 percent.

Question 4
a) How far away is the terminal, or horizon, date?

The terminal, or horizon, date is the date when the growth rate
becomes constant. This occurs at the end of Year 2.

b) What is the firm’s horizon, or terminal, value?

b. 0 rs = 10%
1 2 3
| gs = 20%
| gs = 20%
| gn = 5%
|
1.25 1.50 1.80 1.89
1 . 89
37.80 = 0. 10−0. 05

The horizon, or terminal, value is the value at the horizon date of all
dividends expected thereafter. In this problem it is calculated as
$ 1 .80 (1 .05 )
=$37 .80 .
follows: 0 .10−0 . 05
ABMF4024 BUSINESS FINANCE Tutorial 3 (Cont’) Answer November 1, 2010

c) What is the firm’s intrinsic value today,

P0 ?

The firm’s intrinsic value is calculated as the sum of the present value
of all dividends during the supernormal growth period plus the present
value of the terminal value. Using your financial calculator, enter the
following inputs: CF0 = 0, CF1 = 1.50, CF2 = 1.80 + 37.80 = 39.60, I/YR
= 10, and then solve for NPV = $34.09.

Question 5
Given P0 = $25; D1 = $1.25; rs = 0.12
Hence rs = D1/P0 + g
0.12 = 1.25/25 + g
g = 0.7 (or 7%)

Question 6
Present Value of First 4-Year's Dividends:

Σ [D0 (1 + g1)t/(1 + rs)t]; D0 = $1.50; g1 = .11; rs = .14; t=1

Year Dividend Interest Factor Present Value

(t) Dt =1.50(1+ 0.11)t PVIF14%,t Dt x PVIF14%,t
1 1.50(1 + .11)1 =$1.6650 0.877 1.460
2 1.50(1 + .11)2 =$1.8482 0.769 1.421
3 1.50(1 + .11)3 =$2.0514 0.675 1.385
4 1.50(1 + .11)4 =$2.2771 0.592 1.348
PV (First 4-Years' Dividends) : $5.614

Value of Stock at End of Year 4:

P4= D5/( rs − g2) g2 = .05
D5= D4(1 + g2) = 2.2771(1 + .05) = $2.391
P4 = 2.391/(.14 − .05) = $26.567

Present Value of P4:

PV(P4) = P4/(1 + rs)4 = $26.567/(1 + .14)4
= $26.567(PVIF.14,4) = $26.567 x 0.592 = $15.728

Value of Common Stock (P0):

P0 = PV(First 4-Years' Dividends) + PV(P4)
= $5.614 + $15.728 = $21.34

Question 7
a) FVn = PVo(1+ g)n
ABMF4024 BUSINESS FINANCE Tutorial 3 (Cont’) Answer November 1, 2010

PVo = $2.00; FV6 = $4.00; n = 6

4.00 = 2.00(1 + g)6
(1 + g)6 = 2.000

The term (1 + g)6 represents the future value interest factor (FVIF g,6) in Table I
at the back of the book. Reading across the Period = 6 row, one finds (1 + g) 6
in the i ≅ 12% column. Therefore g ≅ 0.12 (or 12%).

b) Dt = D0(1 + g)t; D0 = $2.00

Year Dividend*
t Dt = 2.00(1 + g)t
1 2.00(1 + .12)1 = $2.240
2 2.00(1 + .12)2 = $2.509
3 2.00(1 + .12)3 = $2.8l0
4 2.00(1 + .12)4 = $3.147
5 2.00(1 + .12)5 = $3.525
6 2.00(1 + .12)6 = $3.948

*Note: The (1 + 0.12)t factors can be obtained from Table I, i.e.,

(1 + 0.12)t = FVIF.12,t

Earnings per year will be exactly two times the projected dividends.

c) P0 = D1/(rs - g)
rs = 0.18; g = 0.12; D1 = $2.240
P0= 2.240/(0.18 − 0.12) = $37.33

Question 8
The dividend at the end of two years = $1 (FVIF0.20, 2) = $1.44
D3 = $1.44(1.06) = $1.526
D4 = $1.53(1.06) = $1.618
D5 = $1.62(1.06) = $1.715

The price of the stock at the beginning of year 5 is the same as at the end of
year 4, or P4 = $1.715/ (0.15 − 0.06) = $19.06