Strictly for course AB1201 internal circulation only.

Nanyang Business School

AB1201 Financial Management
Tutorial 6: Stocks and Their Valuation and Stock Market Efficiency
(Common Questions)
Questions 1 to 5 will be presented by students while Question 6 will be presented by instructors.

1) Constant growth. Investors require a 15% rate of return on Levine Companys stock (that is, rs
= 15%).
a) What is its value if the previous dividend was D0 = $2 and investors expect dividends to grow
at a constant annual rate of (1) -5%, (2) 0%, (3) 5%, or (4) 10%?
b) Is it reasonable to think that a constant growth stock could have g > rs? Explain.

2) Declining growth. Martell Mining Companys ore reserves are being depleted, so its sales are
falling. Also, because its pit is getting deeper each year, its costs are rising. As a result, the
companys earnings and dividends are declining at the constant rate of 5% per year. If D0 = $5
and rs = 15%, would you buy Martell Minings stock? If so, what is the value of the stock? What
is the expected capital gains and dividend yield during the first year, second year, and third year?
Assume the stock is trading at its intrinsic value.

3) Calculation of g and EPS. Sidman Products common stock currently sells for $60.00 a share.
The firm is expected to earn $5.40 per share this year and to pay a year-end dividend of $3.60.
a) If investors require a 9% return and the market is in equilibrium, what is the expected growth
rate, g?
b) If Sidman continues with the same payout ratio, calculate the returns on retained earnings that
Sidman achieves.

4) Preferred stock valuation. Lippo Ltd. has perpetual preferred stock outstanding with a par
value of $100. The stock pays a quarterly dividend of $2, and its current price is $80.
a) What is its nominal annual rate of return?
b) What is its effective rate of return?

5) Firm Multiples Method. Look up the P/E ratio of Google on Yahoo! Finance. Look up the EPS
of Yahoo! Inc. Based on the P/E ratio of Google, estimate the intrinsic value of Yahoo! Inc. Is
the estimated intrinsic value very far from the actual stock price? Why do you think this is so?

6) Nonconstant growth stock valuation. Taussig Technologies Corporation (TTC) has been
growing at a rate of 20% per year in recent years. This same growth rate is expected to last for
another 2 years, then decline to 6% per year forever. Assume the stock is trading at its intrinsic
value.
a) If D0 = $1.60 and rs = 10%, what is TTCs stock worth today? What are its expected dividend
and capital gains yields during Year 1?
b) Now assume that TTCs period of supernormal growth is to last for 5 years rather than 2 years.
How would this affect the stock price, expected dividend yield, and expected capital gains yield?
Answer in words only.
c) What will TTCs expected dividend and capital gains yields be once its period of supernormal
growth ends?
d) Of what interest to investors is the changing relationship between dividend and capital gains
yields over time?
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Self-practice Questions

Question1
John, a stock analyst, is estimating the intrinsic value of Stocks A and B. He estimates that Stock A
will pay a dividend $1.80 per share at the end of Year 1. Stock As dividend is expected to grow
10% per year until the end of Year 4, after that the dividend is expected to grow forever at a
constant rate of 6% per year. Stock A has a required rate of return of 12%. Stock B is expected to
pay dividend of $2.00 per share at the end of Year 1. Stock Bs dividend is expected to grow
forever at a constant rate of 7% per year. Stock B has a required rate of return of 13%.

(i) What are the intrinsic values of Stocks A and B today?

(ii) If John forms a portfolio of these two stocks, the beta of the portfolio is 1.267. Assume that
the market risk premium and the risk-free rate are 6% and 5% respectively. What are the
proportions of Stocks A and B held in the portfolio?

Question 2
Masier Corporation has been growing at a 10% rate, and it just paid a dividend of D0 = $2.50. The
company expects its dividend growth rate to be 20% per year for the next 2 years. After this time,
growth is expected to be constant at 7% forever. The companys equity beta and tax rate are 1.5
and 35%, respectively. The market rate of return is 10%, and the risk-free rate is 6%. Assume the
stock is in equilibrium.

(i) What is the expected dividend yield today?

(ii) What is the expected price at the end of year 3?

Question 3
Robin Corporation does not expect to pay any dividend for the next 2 years (i.e. end of Year 1 and
Year 2). At the end of Year 3, the company expects to pay dividend of $0.50, and this dividend is
expected to grow at a high growth rate of 35% per annum for 3 years, before achieving a long-run
dividend growth rate of g%. The companys beta coefficient is 1.6. Risk-free rate is 4% per annum
and market return is 8% per annum. If the intrinsic value of Robin Corporations shares is $14,
what is the companys long-run dividend growth rate g?

Answers to Self-practice Questions:

Question 1

(i) Stock A:

Step 1: Find dividend stream

D1 = $1.8, D2 = 1.8 x 1.1 = $1.98, D3 = 1.8 x 1.12 = $2.178, D4 = 1.8 x 1.13 = $2.3958

Step 2: Find terminal value of stock as of t = 4

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D5 2.3958 1.06 2.5395

P4 $42.3258
rs g 0.12 0.06 0.06

Step 3: Find intrinsic value at t = 0

1.8 1.98 2.178 2.3958 42.3258

P0 2
$33.157
1.12 (1.12) (1.12) 3 (1.12) 4 (1.12) 4

Stock B:

D1 2.00
P0 $33.33
rs g 0.13 0.07

(ii) Method 1

Step 1: Find required returns on portfolio given portfolio beta

rP = rRF + RPM (bP) = 5% + 6% (1.267) = 12.60%

Step 2: Since the required return on the portfolio is the weighted required return on Stock A and
Stock B, we can set up the below equation

rP = wA rA + (1 wA) rB

12.6 = wA (12) + (1 wA) (13)

wA = 40%, wB = 60%

Method 2

Step 1: Find the beta of Stocks A and B using the given required returns

rA = rRF + RPM (bA)

12 = 5 + 6 (bA)

bA = 1.1667

rB = rRF + RPM (bB)

13 = 5 + 6 (bB)

bA = 1.3333

Step 2: Since portfolio beta is the weighted average beta of the component stock, we can set up the
below equation:

bP = wA bA + (1 wA) bB

1.267 = wA (1.1667) + (1 wA) (1.3333)

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wA = 40%, wB = 60%

Question 2
(i) rs = 6 + (10-6)1.5 = 12%

D1 = 2.50(1.2) = $3, D2 = 2.5(1.2)2 = $3.60, D3 = 3.60(1.07) = $3.8520

3.8520
P2 $77.04
0.12 0.07

3 3.60 77.04
P0 2
2.6786 2.8699 61.4158
(1.12) (1.12) (1.12) 2
= $66.9643

D1 $3
Dividend yield = 4.48%
P0 $66.9643

(ii) The expected price at the end of year 3

D4 3.8520 (1.07) 4.1216
P3 $82.43
rS g 0.12 0.07 0.05
Question 3

0 rS 1 2 3 4 5 6 7
|------------|------------|------------|------------|------------|-----------|-----------|---- - -
P0=$14 $0.50 35% D4 35% D5 35% D6 g% D7

rS = 4% + (8% - 4%) 1.6 = 10.4%

D3 = 0.50
D4 = 0.50 (1 + 35%) = 0.675
D5 = 0.675 (1 + 35%) = 0.91125
D6 = 0.91125 (1 + 35%) = 1.23019
D7 = 1.23019 (1+g)

PV6 = D7 / (rS g) = 1.23019 (1 + g) / (10.4% - g)

14 = 0.5/(1+10.4%)3 + 0.675/(1+10.4%)4 + 0.91125/(1+10.4%)5

+ 1.23019/(1+10.4%)6 + 1.23019(1+g)/(10.4% - g)/(1+10.4%)6

14 = 2.06107 + 0.67945(1+g)/(0.104 g)

g = 4.46%

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