CHAPTER 8

Stock Valuation
 
                                                                                                                                                                                                 
          

ANSWERS TO
END-OF-CHAPTER QUESTIONS
8-1. Preferred stock is often referred to as a hybrid security. This is because preferred
stock has many characteristics of both common stock and bonds. It has
characteristics of common stock, such as no fixed maturity date, nonpayment of
dividends does not force bankruptcy, and the nondeductibility of dividends for tax
purposes. But it is like bonds because the dividends are fixed in amount like interest
payments. From the point of view of the preferred stockholder, this is not the most
advantageous combination. On one hand, the dividends are limited as with bond
interest, but the security of forced payment by the threat of bankruptcy is not there.
Thus, from the point of view of the investor, the worst features of common stock and
bonds are combined.
8-2. To a certain extent, preferred stock dividends can be thought of as a liability. The
major difference between preferred dividends in arrears and normal liabilities is that
nonpayment of them cannot force the firm into bankruptcy. However, since the goal
of the firm is common shareholder wealth maximization, which involves getting
money to the shareholders (dividends), preferred arrearages provide a barrier for
achieving this goal.
8-3. A cumulative feature requires all past unpaid preferred stock dividends be paid before
any common stock dividends are declared. A stockholder would like preferred stock
to have a cumulative dividend feature because without it there would be no reason
why preferred stock dividends would not be omitted or passed when common stock
dividends were passed. Since preferred stock does not have the dividend enforcement
power of interest from bonds, the cumulative feature is necessary to protect the rights
of preferred stockholders.
Other frequent protective features serve to allow for voting rights in the event of
nonpayment of dividends or to restrict the payment of common stock dividend if
sinking-fund payments are not met or if the firm is in financial difficulty. In effect, the
protective features included with preferred stock are similar to the restrictive
provisions included with long-term debt.
8-4. Fixed rate preferred stock has dividends that do not vary from the fixed amount or
from period to period.

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 Adjustable rate preferred stock is preferred stock that has quarterly dividends that
fluctuate with interest rates under a formula that ties the dividend payment at either a
premium or discount to the highest of the three-month Treasury bill rate, the 10-year
Treasury bond constant maturity rate, or the 20-year Treasury bond constant maturity
rate. The rates have maximum and minimum levels called the dividend rate band.
The purpose of allowing the interest rate to fluctuate is to minimize the fluctuation in
the value of the preferred stock. It is also very appealing in times of high and
fluctuating interest rates.
8-5. With PIK (payment-in-kind) preferred stock, investors receive no dividends initially;
they merely get more preferred stock, which in turn pays dividends in even more
preferred stock. Usually after 5 or 6 years, if all goes well for the issuing company,
cash dividends should replace the preferred stock dividends, generally ranging from
12 percent to 18 percent, to entice investors to purchase PIK preferred.
8-6. Convertibility allows a preferred stockholder to convert or exchange preferred stock
for shares of common stock at a predetermined exchange rate. This option gives
preferred stockholders more freedom in investment decisions by allowing them to
convert into common stock at their discretion. It gives the preferred stockholder a
higher cash return then the common stock but allows for sharing in some of the future
appreciation of the common stock.
Preferred stock may be callable by the issuer so that in the event interest rates decline
and cheaper funding becomes available, the stock may be called and new securities
may be issued at a lower cost. To agree to the call feature, the investor requires a
slightly higher rate of return. Call of a convertible preferred stock enables a company
to turn the preferred stock into common equity; i.e., calling it without having to spend
the cash.
8-7. Both values are based on future cash flows to be received by stockholders. Preferred
stock typically has a predetermined constant dividend. For common stock, the
dividend is based on profitability of the firm and on management’s decision to pay
dividends or to retain the profits for reinvestment purposes. Thus, the growth of
future dividends is a prime distinguishing feature of common stock.
8-8. The expected rate of return is the rate of return that may be expected from purchasing
a security at the prevailing market price. Thus, the expected rate of return is the rate
that equates future cash flows with the actual selling price of the security in the
market.

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8-9. The required rate of return is the discount rate that equates the present value of future
cash flows with the value of the security. As with the internal rate of return for a
capital budgeting problem, we have to find the rate of return that sets the future cash
flows equal to the cost of the security. This rate may have to be developed by trial
and error.
8-10. The two types of return are dividend income and capital gains. The dividend income
for common stockholders differs from preferred stockholders, in that no specified
dividend amount is to be received. However, the common stockholders are permitted
to participate in the growth of the company. As a result of this growth, their second
source of return, price appreciation, is realized.

SOLUTIONS TO
END-OF-CHAPTER PROBLEMS

Solutions to Problem Set A

$6
8-1A. Value (Vps) =
.12
= $50.00
8-2A. Growth rate = return on equity x retention rate
= (16%)  (60%) = 9.6%
14  $100
8-3A. Value (Vps) =
.12
$14
=
.12
= $116.67
8-4A. Expected Rate of Return
Dividend
kps = = $1.95 = or .0463, or 4.63%
Price $42.16
Dividend $3.40
8-5A. (a) Expected return = = = .085 = 8.5%
Price $40
(b) Given your 8 percent required rate of return, the stock is worth $42.50 to you.
Dividend $3.40
Value = = = $42.50
Required Rate of Return .08
Since the expected rate of return (8.5%) is greater than your required rate of
return (8%), or since the current market price ($40) is less than the value
($42.50), the stock is undervalued and you should buy.

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 Dividend in Year 1 Price in Year 1
8-6A. Value (Vcs) = +
(1  Required Rate) (1  Required Rate)

$6 P1
$50 = +
(1  .15) (1  .15)
Rearranging and solving for P1:
P1 = $50 (1.15) - $6
P1 = $51.50
The stock would have to increase $1.50 ($51.50 - $50) or 3 percent
($1.50/$50) to earn a 15% rate of return.
Expected rate Dividend in Year 1 growth
8-7A. (a) = + rate
of return (k cs ) Market Price
$2.00
kcs = + .10
$22.50
kcs = .1889, or 18.9%
$2.00
(b) Vcs = = $28.57
17  .10
Yes, purchase the stock. The expected return is greater than your required
rate of return. Also, the stock is selling for only $22.50, while it is worth
$28.57 to you.
Last Year Dividend (1  Growth Rate)
8-8A. Value (Vcs) =
(Required Rate  Growth Rate)
Vcs =
Vcs = $24.50
8-9A. Growth rate = return on equity x retention rate
= (18%)  (40%) = 7.2%
Last Year Dividend (1  Growth Rate)
8-10A. Expected Rate of Return ( k cs ) = + Growth
Price
Rate
k cs = + 0.095

k cs = 0.193, or 19.3%

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 Dividend in Year 1 Price in Year 1
8-11A. Value (Vcs) = +
(1  Required Rate) (1  Required Rate)

$1.85 $42.50
Vcs = +
(1.11) (1.11)
Vcs = $39.96
8-12A. If the expected rate of return is represented by k cs :
Dividend in Year 1 Price in Year 1
Current Price = +
(1  k cs ) (1  k cs )
Dividend in Year 1  Price in Year 1
k cs = - 1
Growth Price
$2.84  $48.00
k cs = - 1
$43.00

k cs = 0.1823, or 18.23%

8-13A.
Dividend $3.60
(a) k ps = =
Price $33.00
k ps = 0.1091, or 10.91%

= $3.60 = $36
Dividend
(b) Value (Vps) =
Required Rate of Return 0.10
(c) The investor's required rate of return (10 percent) is less than the expected
rate of return for the investment (10.91 percent). Also, the value of the stock
to the investor ($36) exceeds the existing market price ($33), so buy the
stock.

Dividend in Year 1 Growth

8-14A.(a) Expected Rate of Return = + Rate
Market Price
$1.32(1.08)
= + 0.08
$23.50
= 0.1407, or 14.07%

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 Dividend in Year 1
(b) Investor's Value =
Required Rate of Return - Growth Rate

$1.32(1.08)
=
0.105  0.08
= $57.02
(c) Yes, the expected rate of return (14.07%) is greater than your required rate of
return (10.5 percent). Also, your value of the stock ($57.02) is greater than
the current market price ($23.50).
$1.12
8-15A (a) Dividend yield: Dividend  stock price = = 0.0229, or 2.29%
$49

Expected risk  free  market risk  free 

(b) = + beta   return - 
rate of return rate  rate 
= 3.8% + 1.10  (13.3% - 3.8%) = 14.25%
Expected Dividend in Year 1 Growth
(c) = + Rate
rate of return Market Price
$1.12
14.25% = + g
$49
.1425 = .0229 + g
g = .1196, or 11.96%

8-16A
Johnson & Johnson

2000 1999 1998 1997 1996

EPS $3.39 $2.94 $2.23 $2.47 $2.12
Dividend $1.24 $1.09 $0.97 $0.85 $0.74

Stock Price (2/20/01): $96.03

Growth rate: $3.39 = $2.12 (1 + i)4

i = .1245, or 12.45%

D1
k  = 
cs
g
P0
$1.24 (1.1245)
k  = 
cs  .1245
$96.03
k  = .1390, or 13.90%
cs

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Solution to Integrative Problem
1. Value (Vb) based upon your required rate of return:
Bond:
12 $140 $1,000
Vb =  t
+
t 1 (1  .12) (1  .12)12

= $140(6.194) + $1,000(.257)
= $867.16 + $257
= $1,124.16
Preferred Stock:
 $12
Vps = 
t 1 (1  .14) t
However, since the dividend is a constant amount each year with no maturity
date (infinity), the equation can be reduced to
Dividend
Vps =
Required Rate of Return
$12
=
.14
= $85.71

Common Stock:
Step 1: Estimate Growth Rate
Company's earnings have doubled ($4 to $8) in ten years. What annual
compound growth rate would cause an investment to double in ten years?
Looking in Appendix B (Compound sum of $1) an interest factor of 2.000 for
ten years is closest to seven percent (1.967). Thus, at about seven percent,
money would double in ten years. (The same conclusion could have been
reached by using Appendix C but by using a .500 present value interest
factor.)

Growth Rate (g) = 7%

Step 2: Solve for Value

$3(1  .07) t
Vcs = 
t 1 (1  .20) t

If the seven percent growth rate (g) is assumed constant, the equation may be
reduced to

Dividend at Year End

Vcs =
Required Rate of Return  Growth Rate

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 D1
=
k cs  g
$3(1  .07)
=
.20  .07
$3.21
=
.13
= $24.69

2. Your Value Selling Price

Bond $1,124.16 $1,200.00
Preferred Stock 85.71 90.00
Common Stock 24.69 25.00

Purchase none of the investments as their market values are selling above
their value to you.

3. Bond:
12 $140 $1000
Vb =  t
+
t 1 (1  .14) (1  .14)12

= $140(5.660) + $1,000(.208)
= $792.40 + $208.00
= $1,000.00
You would not buy the bond; it is not worth $1,200.00.
Preferred Stock:
$12
Vps =
.16
= $75.00
Do not buy. Your value is less than what you would have to pay for the
stock.
Common Stock:
$3.21
Vcs =
.18  .07
= $29.18
Buy. Your value is greater than what you would have to pay for the stock.

205
 4. Assuming a growth rate of 12 percent:
3(1  .12)
Vcs   $42.00
.20  .12
Buy the stock. Because of the expected increase in future dividends, the
stock is now worth more to you ($42) than you would have to pay for it
($25) –assuming that the selling price did not increase also.

Solutions to Problem Set B

$7
8-1B. Value (Vps) =
.10
= $70.00
8-2B. Growth rate = return on equity x retention rate
= (24%) × (70%) = 16.8%
.16  $100
8-3B. Value (Vps) =
.12
$16
=
.12
= $133.33
8-4B. Expected Rate of Return
Dividend
kps = = $2.35 = .0426, or 4.26%
Price $55.16
Dividend $3.25
8-5B. (a) Expected return = = = .0844 , or 8.44%
Price $38.50
(b) Given your 8 percent required rate of return, the stock is worth $40.62 to you
Dividend $3.25
Value = = = $40.625
Required Rate of Return $.08
Since the expected rate of return (8.44%) is greater than your required rate of
return (8%) or since the current market price ($38.50) is less than the value
($40.62), the stock is undervalued and you should buy.

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 Dividend in Year 1 Price in Year 1
8-6B. Value (Vcs) = +
(1  Required Rate) (1  Required Rate)

$6.50 P1
$52.75 = +
(1  .16 (1  .16)
Rearranging and solving for P1:
P1 = $52.75 (1.16) - $6.50
P1 = $54.69
The stock would have to increase $1.94 ($54.69 - $52.75), or 3.68 percent,
($1.94/$52.75) to earn a 16% rate of return.
8-7B.
Expected rate Dividend in Year 1 Growth
(a) = + Rate
of return (k cs ) Market Price
$2.50
k cs = + .105
$23.00

k cs = 0.2137, or 21.37%
$2.50
(b) Vcs = = $38.46
.17  .105
The expected rate of return exceeds your required rate of return, which means
that the value of the security to you is greater than the current market price.
Thus, you should buy the stock.
Last Year Dividend (1  Growth Rate)
8-8B. Value (Vcs) =
(Required Rate  Growth Rate)

Vcs = $3.75(1  .06)

.20  .06
Vcs = $28.39
8-9B. Growth rate = return on equity x retention rate
= (24%)  (60%) = 14.4%
Last Year Dividend (1  Growth Rate)
8-10B. Expected Rate of Return ( k cs ) = + Growth
Price
Rate
$3.00(1.085)
k cs = + 0.085 = 0.181, or
$33.84
18.1%

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 Dividend in Year 1 Price in Year 1
8-11B. Value (Vcs) = +
(1  Required Rate) (1  Required Rate)
$1.85 $40.00
Vcs = +
(1.12) (1.12)
Vcs = $37.37
8-12B. If the expected rate of return is represented by k cs :
Dividend in Year 1 Price in Year 1
Current Price = +
(1  k cs ) (1  k cs )
Dividend in Year 1  Price in Year 1
k cs = - 1
Current Price
$2.00  $47.00
k cs = - 1
$44.00

k cs = 0.1136, or 11.36%
Dividend $4.00
8-13B. (a) k ps = = = 11.43%
Price $35.00

= $4.00 = $40
Dividend
(b) Value (Vps ) =
Required Rate of Return 0.10
(c) The investor's required rate of return (10 percent) is less than the expected
rate of return for the investment (11.43 percent). Also, the value of the stock
to the investor ($40) exceeds the existing market price ($35). The investor
should buy the stock.
Dividend in Year 1
8-14B. (a) Expected Rate of Return = +
Market Pirce
$1.00(1.08)
= + 0.08
$25.00
= 0.1232, or 12.32%
Dividend in Year 1
(b) Investor's Value =
Required Rate of Return  Growth Rate

$1.00(1.08)
=
0.11  0.08
= $36.00
(c) Yes, the expected rate of return is greater than your required rate of return
(12.32 percent versus 11 percent). Also, your value of the stock ($36.00) is
higher than the current market price ($25.00).

208
 $1.20
8.15B (a) Dividend yield: Dividend  stock price = = 2.22%
$54

Expected risk  free  market risk  free 

(b) rate of return = + beta   return - 
rate  rate 
= 3.8% + 0.90  (13.3% - 3.8%) = 12.35%
Expected Dividend in Year 1 Growth
(c) rate of return = +
Market Price Rate
$1.20
12.35% = + g
$54
.1235 = .0222 + g
g = .1013, or 10.13%

8-16B

First Union Corporation

1999 1998 1997 1996 1995

EPS $3.33 $2.95 $2.99 $2.58 $2.38
Dividend $1.88 $1.58 $0.90 $1.10 $0.98

Stock Price (12/31/99): $32.9375

Growth rate: $3.33 = $2.38 (1 + i)4

i = .0876, or 8.76%
D1
k  = 
cs
g
P0
$1.88 (1.0876)
k  = 
cs  .0876
$32.9375

k  = .1497, or 14.97%
cs

Solutions to Appendix 8A
8A-1. Using the NVDG model,

EPS1 PV1
Vcs = +
k cs k cs  g
where kcs = the investor's required rate of return
EPS1 = the firm's earning per share in year 1

209
 g = the growth rate, which is the firm's earnings retention rate
times its return on equity.
 r x EPS1 x ROE 
PV1 =   - r x EPS1
 k cs 

r = the firm's earnings retention rate

ROE = the firm's return on equity investment
For our problem,

PV1 =  (0.65) x ($5) x (0.20)  - (0.65) x ($5)

 
 0.16 

= $4.0625 - $3.25
= $0.8125
$5 $0.8125
and Pcs = 
.16 .16  (0.65)(0.20)

= $31.25 + $27.08
= $58.33
Using the more traditional dividend-growth model, we get:
D1
Vc =
k cs  g
Since D1 = EPS1(1 - the retention rate), and
g = the retention rate x return on equity
($5)(1  .65)
Pcs = = $1.75 = $58.33
.16  (.65)(.20) .03
8A-2. Given the EPS1 is expected to be $7 and the investor's required rate of return is 18
percent, the value of the stock, assuming no growth opportunities would be:
EPS1 $7
Pcs =  = $38.89
k cs .18
where kcs = the investor's required rate of return
EPS1 = the firm's earning per share in year 1

210
To compute the present value of the growth opportunities, PVDG, for each scenario,
we use the following equation:
PV1
NVDG =
k cs  g

 r x EPS1 x ROE 
where PV1 =   - r x EPS1
 k cs 
g = the growth rate, which is the firm's earnings retention rate
times its return on equity.
r = the firm's earnings retention rate
ROE = the firm's return on equity investment
Given the different possible retention rates and ROEs, we may solve for the respective
PV1s. The results are as follows:
Possible Different Retention Rates
ROEs 0% 30% 60%
16% 0.00 -0.23 -0.47
18% 0.00 0.00 0.00
24% 0.00 0.70 1.40
We next calculate the NVDG for each scenario by dividing the above PV1 values by
kcs - g, which gives the following results:
Possible Different Retention Rates
ROEs 0% 30% 60%
16% 0.00 -1.74 -5.60
18% 0.00 0.00 0.00
24% 0.00 6.48 38.89
Adding the $38.89 price, assuming no growth, to the above NVDGs, we get:
Possible Different Retention Rates
ROEs 0% 30% 60%
16% 38.89 37.15 33.29
18% 38.89 38.89 38.89
24% 38.89 45.37 77.78
Thus, our results show that value is created only when management reinvests at above
the investor's required rate of return. That is, growth may actually decrease the firm's
value if the profitability of the new investments are not adequate enough to satisfy the
investor's required returns.

211