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UNIT 4: FINANCIAL MANAGEMENT I 2017/18

UNIT 4
VALUING SHARES

PROBLEM SET

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UNIT 4: FINANCIAL MANAGEMENT I 2017/18

1 SOLVED PROBLEMS
1. Suppose you expect Walgreen Company (a drugstore chain) to pay dividends of 0,44 €
per share and trade for 33 € per share at the end of the year. If investments with
equivalent risk to Walgreen’s stock have an expected return of 8,5%, what is the most you
would pay today for Walgreen’s stock? What dividend yield and capital gain rate would you
expect at this price?
Solution:

Div1 + P1 0,44 +33


P0= = =30,82 €
1+r 1,085
At this price, Walgreen’s dividend yield is Div 1/P0 = 0,44/30,82 = 1,43%. The expected capital gain is
33,00 — 30,82 = 2,18 € per share, for a capital gain rate of 2,18/30,82 = 7,07%. Therefore, at this
price, Walgreen’s expected total return is 1,43% + 7,07% = 8,5%, which is equal to its equity cost of
capital.
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2. Suppose Acap Corporation will pay a dividend of 2,80€ per share at the end of this year
and 3 € per share next year. You expect Acap’s stock price to be 52 € in two years. If
Acap’s equity cost of capital is 10%:
a) What price would you be willing to pay for a share of Acap stock today, if you planned to hold the
stock for two years?

b) if you hold the share for five years and Div 3 = 1,5; Div4 = 1,8; Div5 = 2,3; P5 = 58. What would be
the price now?

Solution:

DIV 1 DIV 2 DIV H + P H


P 0= + +...+
1+r (1+r )2 (1+r )
H

2,80 3+52
a) P 0= + =48
1,1 1,12

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UNIT 4: FINANCIAL MANAGEMENT I 2017/18

2,80 3 1,5 1,8 2,3+58


b) P0= + 2+ 3 + 4+ =44,82
1,1 1,1 1,1 1,1 1,15

3. Assume Evco, Inc., has a current price of 50€ and will pay a 2€ dividend in one year, and
its equity cost of capital is 15%. What price must you expect it to sell for right after paying
the dividend in one year in order to justify its current price?
Solution:

Div1 + P1 2+ P1
P 0= ; 50= → P1=55,50 €
1+r 1,15
4. Anle Corporation has a current price of 20 €, is expected to pay a dividend of 1 € in one
year, and its expected price right after paying that dividend is 22 €.
a) What is Anle’s expected dividend yield?

b) What is Anle’s expected capital gain rate?

c) What is Anle’s equity cost of capital?

Solution:

1
a) Dividend yield= =5 %
20
22−20
b) Capital gainrate= =10 %
20
c) Equity cost of capital=5 %+ 10 %=15 %
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5. Krell Industries has a share price of 22 € today. If Krell is expected to pay a dividend of
0,88 € this year, and its stock price is expected to grow to 23,54 € at the end of the year,
what is Krell’s dividend yield and equity cost of capital?
Solution:

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UNIT 4: FINANCIAL MANAGEMENT I 2017/18

3
0,88 23,54+ 0,88
Dividend yield= =4 % ; Equity cost of capital →22= ; r =11,00 %
22 1+r
6. NoGrowth Corporation currently pays a dividend of 2€ per year, and it will continue to
pay this dividend forever. What is the price per share if its equity cost of capital is 15% per
year?
Solution:

With simplifying assumption that dividends are paid at the end of the year, then the stock pays a total
of 2,00 € in dividends per year. Valuing this dividend as a perpetuity, we have,

DIV 1 2
P0= = =13,33 €
r 0,15
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7. Summit Systems will pay a dividend of 1,50 € this year. If you expect Summit’s dividend
to grow by 6% per year, what is its price per share if its equity cost of capital is 11%?
Solution

4
DIV 1 1,5
P0= = =30,00 €
r −g 0,11−0,06
8. Dorpac Corporation has a dividend yield of 1,5%. Dorpac’s equity cost of capital is 8%,
and its dividends are expected to grow at a constant rate. What is the expected growth
rate of Dorpac’s dividends?
Solution

DIV 1 DIV 1
P0= ; r= + g=Dividend yield + g ; g=r −Dividend yield
r −g P0
g=8 %−1,5 %=6,5 %
9. Kenneth Cole Productions (KCP), suspended its dividend at the start of this year.
Suppose you do not expect KCP to resume paying dividends until beginning of year 2. You
expect KCP’s at this year that dividend will be 0,40 € per year, and you expect it to grow by
5% per year thereafter. If KCP’s equity cost of capital is 11%, what is the value of a share
of KCP at the start of this year?
Solution

The timeline of this operation would be:

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UNIT 4: FINANCIAL MANAGEMENT I 2017/18

Div 3 0,40
P 2= = =6,67
r−g 0,11−0,05
6,67
P 0= =5,41 €
1,11²
10. Gillette Corporation will pay an annual dividend as follows:

At year six the dividend will be 1,04 €. After then, analysts expect this dividend to grow at
2% per year. According to the dividend-discount model, what is the value of a share of
Gillette stock if the firm’s equity cost of capital is 8%?
Solution

DIV 1 DIV 2 DIV 5 1 DIV 6


P0= + 2
+...+ 5
+ 5

1+r (1+r ) (1+r ) (1+ r) r −g
0,65 0,73 0,82 0,91 1,02 1 1,04
P 0= + + + + + ∗
1,08 1,08 1,08 1,08 1,08 1,08 0,08−0,02
2 3 4 5 5

11. Halliford Corporation expects to have earnings this coming year of 3€ per share.
Halliford plans to retain all of its earnings for the next two years. For the subsequent two
years, the firm will retain 50% of its earnings. It will then retain 20% of its earnings from
that point onward. Each year, retained earnings will be invested in new projects with an
expected return of 25% per year. Any earnings that are not retained will be paid out as
dividends. Assume Halliford’s share count remains constant and all earnings growth comes
from the investment of retained earnings. From year 5 on, dividends grow at constant rate
of 5%. If Halliford’s equity cost of capital is 10%, what price would you estimate for
Halliford stock?

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UNIT 4: FINANCIAL MANAGEMENT I 2017/18

Solution

Div 6 4,98
P 5= = =99,60 €
r−g 0,10−0,05
2,34 2,64 4,75 99,6
P0= 3
+ 4+ 5+ 5
=68,35 €
1,1 1,1 1,1 1,1
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12. Consider the following three stocks:


a) Stock A is expected to provide a dividend of 10€ a share forever.

b) Stock B is expected to pay a dividend of 5€ next year. Thereafter, dividend growth is expected
to be 4% a year forever.

c) Stock C is expected to pay a dividend of 5€ next year. Thereafter, dividend growth is expected
to be 20% a year for five years (i.e., until year 6) and zero thereafter.

If the market capitalization rate for each stock is 10%, which stock is the most valuable?

What if the capitalization rate is 7%?

Solution

4
DIV 1 10
P A= = =100 €
r 0,10
DIV 1 5
PB= = =83,33 €
r − g 0,10−0,04
DIV 1 DIV 2 DIV 3 DIV 4 DIV 5 DIV 6 DIV 7
PC =
1 ,101
+
1 ,102
+
1 , 103
+
1, 10 4
+
1 ,105
+
1 , 106
+ ( 0 , 10
×
1
1 , 106 )
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UNIT 4: FINANCIAL MANAGEMENT I 2017/18

5 , 00 6 , 00 7 , 20 8 , 64 10 , 37 12, 44 12 , 44 1
PC =
1 ,10 1
+
1 ,10 2
+
1 , 10 3
+
1, 10 4
+
1 , 10 5
+
1 ,10 6(+
0 , 10
× )
1, 106
=104 ,50 €

At a capitalization rate of 10%, Stock C is the most valuable.

For a capitalization rate of 7%, the calculations are similar.

The results are: PA = 142,86 €; PB = 166,67 €; PC = 156,48 €

Therefore, Stock B is the most valuable.

13. Pharmecology is about to pay a dividend of 1,35€ per share. It’s a mature company,
but future EPS and dividends are expected to grow with inflation, which is forecasted at
2,75% per year.
a) What is Pharmecology’s current stock price? The nominal cost of capital is 9,5%.

b) Redo part (a) using forecasted real dividends and a real discount rate.

Solution

a)

Div 1 1,35 x 1,0275


P0=Div 0+ =1,35+ =21,90 €
r −g 0,095−0,0275
b) First, compute the real discount rate as follows:

(1+r nominal )=(1+r real ) x (1+inflation rate)

1,095=(1+r real ) x 1,0275

r real =(1,095 /1,0275) – 1=0,0657=6,57


In real terms, g = 0. Therefore:

Div 1 1,35
P0=Div 0+ =1,35+ =21,90 €
r −g 0,0657
14. Company Q’s current return on equity (ROE) is 14%. It pays out one-half of earnings
as cash dividends (payout ratio = 50%). Current book value per share is 50 €. Book value
per share will grow as Q reinvests earnings. Assume that the ROE and payout ratio stay

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UNIT 4: FINANCIAL MANAGEMENT I 2017/18

constant for the next four years. After that, competition forces ROE down to 11,5% and
the payout ratio increases to 0,8. The cost of capital is 11,5%.
a) What are Q’s EPS and dividends next year? How will EPS and dividends grow in years 2, 3, 4,
5, and subsequent years?

b) What is Q’s stock worth per share? How does that value depend on the payout ratio and
growth rate after year 4?

Solution

a)

Plowback ratio 0−4=1 – payout ratio 10−4=1 – 0,5=0,5


Dividend growth rate0−4 =g0−4 =Plowback ratio 0−4 × ROE 0−4=0,5× 0,14=0,07
Next, compute EPS0 as follows:

ROE0 =EPS 0 /Book equity per share

0,14=EPS0 /50→ EPS0=7,00 €

Therefore: DIV 0= payout ratio0 × EPS 0=0,5× 7,00=3,50 €

EPS and dividends for year 5 and subsequent years grow at 2,3% per year, as indicated by the
following calculation:

Dividend growthrate 5-=g5- =Plowback ratio 5- × ROE5- =(1 – 0,8)× 0,115=0,023


EPS and dividends for subsequent years are:

Year EPS DIV


0 7,00 7,00 × 0,5 = 3,50
1 7,00 × 1,07 = 7,4900 7,4900 × 0,5 = 3,50 × 1,07 = 3,7450
2 7,00 × 1,072 = 8,0143 8,0143 × 0,5 = 3,50 × 1,072 = 4,0072
3 7,00 × 1,073 = 8,5753 8,5753 × 0,5 = 3,50 × 1,073 = 4,2877
4 7,00 × 1,074 = 9,1756 9,1756 × 0,5 = 3,50 × 1,074 = 4,5878
5 7,00 × 1,074 × 1,023 = 9,3866 9,3866 × 0,8 = 3,50 × 1,074 × 1,023 = 7,5092

b)

3 , 745 4 , 007 4 , 288 4 , 588 7,5092 1


P0 =
1 , 1151
+
1 , 1152
+
1 .115 3
+
1 ,115 4
+ ( ×
0 , 115-0, 023 1 , 115 4 )
=65 , 45 €

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UNIT 4: FINANCIAL MANAGEMENT I 2017/18

15. Mexican Motors stock sells for 200 € per share and next year’s dividend is 8,5 €.
Security analysts are forecasting earnings growth of 7,5% per year for the next five years.
a) Assume that earnings and dividends are expected to grow at 7,5% in perpetuity. What rate of
return are investors expecting?

Solution
a)

Div 1 8,5
r= + g= + 0,075=0,1175=11,75 %
P0 200

16. Phoenix Corp. faltered in the recent recession but has recovered since. EPS and
dividends have grown rapidly since -2.

Year -2 -1 0 1 2
EPS 0,75 2,00 2,50 2,60 2,65
dividends 0,00 1,00 2,00 2,30 2,65
Dividend growth – – 100% 15% 15%

The figures for 1 and 2 are of course forecasts. Phoenix’s stock price today in 0 is 21,75€. Phoenix’s
recovery will be complete in 2, and there will be no further growth in EPS or dividends.

A security analyst forecasts next year’s rate of return on Phoenix stock as follows:

Div 1 2,30
r= + g= + 0,15=0,256=25,6
P0 21,75
What’s wrong with the security analyst’s forecast? What is the actual expected rate of return over the
next year?

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UNIT 4: FINANCIAL MANAGEMENT I 2017/18

Solution
The security analyst’s forecast is wrong because it assumes a perpetual constant growth rate of 15%
when, in fact, growth will continue for two years at this rate and then there will be no further growth
in EPS or dividends.

The value of the company’s stock is the present value of the expected dividend of 2,30 to be paid in 1
plus the present value of the perpetuity of 2,65 beginning in 2. Therefore, the actual expected rate of
return is the solution for r in the following equation:

2,30 2,65
21,75= +
1+r r (1+ r )
Solving algebraically (using the quadratic formula) or by trial and error, we find that: r = 0,1201=
12,01%.

17. Each of the following formulas for determining shareholders’ required rate of return
can be right or wrong depending on the circumstances:
Div 1
a) r= +g
P0
EPS 1
b) r=
P0
For each formula construct a simple numerical example showing that the formula can give wrong
answers and explain why the error occurs. Then construct another simple numerical example for which
the formula gives the right answer.

Solution
a) An Incorrect Application. Hotshot Semiconductor’s earnings and dividends have grown by 30
percent per year since the firm’s founding ten years ago. Current stock price is 100€, and next year’s
dividend is projected at 1,25€. Thus:

Div 1 1,25
r= + g= +0,30=31,25 %
P0 100
This is wrong because the formula assumes perpetual growth; it is not possible for Hotshot to grow at
30 percent per year forever.

A Correct Application. The formula might be correctly applied to the Old Faithful Railroad, which
has been growing at a steady 5 percent rate for decades. Its EPS 1=10€, DIV1 = 5€, and P0 = 100€.
Thus:

Div 1 5
r= + g= + 0,05=10,00 %
P0 100
Even here, you should be careful not to blindly project past growth into the future. If Old Faithful
hauls coal, an energy crisis could turn it into a growth stock.

b) An Incorrect Application. Hotshot has current earnings of 5,00 per share. Thus:

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UNIT 4: FINANCIAL MANAGEMENT I 2017/18

EPS 1 5
r= = =5,00 %
P0 100
This is too low to be realistic. The reason P 0 is so high relative to earnings is not that r is low, but
rather that Hotshot is endowed with valuable growth opportunities. Suppose PVGO = 60 €:

EPS1 5
P 0= + PVGO ; 100= + 60→r=12,5 %
r r
A Correct Application. Unfortunately, Old Faithful has run out of valuable growth opportunities.
Since PVGO = 0:

EPS 1 5
P 0= + PVGO ; 100= +0→r=10,00 %
r r
18. Look again at the financial forecasts for Growth-Tech given in next Table. This time
assume you know that the opportunity cost of capital is r =0.12 (discard the 0,099 figure
calculated in the text). Assume you do not know Growth-Tech’s stock value. Otherwise
follow the assumptions given in the text.
Year
1 2 3 4
Book equity 10,00 12,00 14,40 15,55
Earnings per share, EPS 2,50 3,00 2,30 2,49
Return on equity, ROE 0,25 0,25 0,16 0,16
Payout ratio 0,20 0,20 0,50 0,50
Dividends per share, DIV 0,50 0,60 1,15 1,24
Growth rate of dividens (%) – 0,20 0,92 0,08

a) Calculate the value of Growth-Tech stock.

b) What part of that value reflects the discounted value of P3, the price forecasted for year 3?

c) What part of P3 reflects the present value of growth opportunities (PVGO) after year 3?

d) Suppose that competition will catch up with Growth-Tech by year 4, so that it can earn only its
cost of capital on any investments made in year 4 or subsequently. What is Growth-Tech stock
worth now under this assumption? (Make additional assumptions if necessary.)

Solution

a) Growth-Tech’s stock price should be:

0,50 0,60 1,15 1 1,24


P0= + + +
(x
1,12 1,12² 1,12³ 1,12³ (0,12−0,08) )
b) The horizon value contributes:

1 1,24
PV (PH )= x =22,07 €
1,12³ (0,12−0,08)
c) Without PVGO, P3 would equal earnings for year 4 capitalized at 12,00%:

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UNIT 4: FINANCIAL MANAGEMENT I 2017/18

EPS 4 2,49
P3= + PVGO ; therefore: PVGO=31,00− =10,25
r 0,12
d) The PVGO of 10,25€ is lost at year 3. Therefore, the current stock price of 23,81€ will decrease by:

10,25
=7,30
1,12³
The new stock price will be: 23,81 – 7,30=16,51 €
9

19. Compost Science, Inc. (CSI), is in the business of converting Boston’s sewage sludge
into fertilizer. The business is not in itself very profitable. However, to induce CSI to
remain in business, the Metropolitan District Commission (MDC) has agreed to pay
whatever amount is necessary to yield CSI a 10% book return on equity. At the end of the
year CSI is expected to pay a 4,00€ dividend. It has been reinvesting 40% of earnings and
growing at 4% a year.
a) Suppose CSI continues on this growth trend. What is the expected long-run rate of return from
purchasing the stock at 100€? What part of the 100€ price is attributable to the present value
of growth opportunities?

b) Now the MDC announces a plan for CSI to treat Cambridge sewage. CSI’s plant will, therefore,
be expanded gradually over five years. This means that CSI will have to reinvest 80% of its
earnings for five years. Starting in year 6, however, it will again be able to pay out 60% of
earnings. What will be CSI’s stock price once this announcement is made and its consequences
for CSI are known?

Solution

a) Here we can apply the standard growing perpetuity formula with DIV 1=4,00€, g=0,04 and P0 =
100€:

Div 1 4
r= + g= +0,04=8,00 %
P0 100
The 4€ dividend is 60 percent of earnings. Thus:

4
Div 1=EPS 1 x payout ratio→ EPS 1= =6,67 €
0,6
Also:

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UNIT 4: FINANCIAL MANAGEMENT I 2017/18

EPS1 6,67
P 0= + PVGO ; 100= + PVGO; PVGO=16,63 €
r 0,08
b) DIV1 will decrease to: 0,20 x 6,67 = 1,33€

However, by plowing back 80 percent of earnings, CSI will grow by 8 percent per year for five years.
Thus:

Note that DIV6 increases sharply as the firm switches back to a 60,00% payout policy. Forecasted
stock price in year 5 is:

Div 6 5,88
P5= = =147,00 €
r−g 0,08−0,04
Therefore, CSI’s stock price will increase to:

1,33 1,44 1,56 1,68 5,88+147


P0= + + + + =106,22 €
1,08 1,08² 1,08³ 1,08⁴ 1,08⁵
10

20. Permian Partners (PP) produces from aging oil fields in west Texas. Production is 1,8
million barrels per year in 2009, but production is declining at 7% per year for the
foreseeable future. Costs of production, transportation, and administration add up to 25€
per barrel. The average oil price was 65€ per barrel in 2009.
PP has 7 million shares outstanding. The cost of capital is 9%. All of PP’s net income is
distributed as dividends. For simplicity, assume that the company will stay in business
forever and that costs per barrel are constant at 25€. Also, ignore taxes.
a) What is the PV of a PP share? Assume that oil prices are expected to fall to 60€ per barrel in
2010, 55€ per barrel in 2011, and 50€ per barrel in 2012. After 2012, assume a long-term
trend of oil-price increases at 5% per year.

b) What is PP’s EPS/P ratio?

Solution

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UNIT 4: FINANCIAL MANAGEMENT I 2017/18

a)First, we use the following Open Calc spreadsheet to compute net income (or dividends) for 2009
through 2013:

Next, we compute the present value of the dividends to be paid in 2010, 2011 and 2012:

58.590 46.704,60 36.196,07


PV (Div 10/ 11/12)= + + =121.012,62 €
1,09 1,09² 1,09³
The present value of dividends to be paid in 2013 and subsequent years can be computed by
recognizing that both revenues and expenses can be treated as growing perpetuities. Since
production will decrease 7% per year while costs per barrel remain constant, the growth rate of
expenses is: –7.0%

To compute the growth rate of revenues, we use the fact that production decreases 7% per year while
the price of oil increases 5% per year, so that the growth rate of revenues is:

(1,05) x (1−0,07)−1=−2,35 %
Therefore, the present value (in 2012) of revenues beginning in 2013 is:

70.660,91
PV (Revenues)= =622.827,44 €
0,09−(−0,0235)
Similarly, the present value (in 2012) of expenses beginning in 2013 is:

33.662,34
PV (Expenses)= =210.389,63 €
0,09−(−0,07)
Subtracting these present values gives the present value (in 2012) of net income, and then discounting
back three years to 2009, we find that the present value of dividends paid in 2013 and subsequent
years is:

622.827,44−210.389,63 412.437,82
PV (Dividends2013−∞ ) at 2009= = =318.477,67 €
1,09³ 1,09³
The total value of the company is:

V 0=318.477,67 € +121.012,62 € =439.490,29 €

Since there are 7.000.000 shares outstanding, the present value per share is:

439.490,295
P 0= =62,78 €
7.000
72.000
b) EPS 2009= =10,29 €
7.000

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UNIT 4: FINANCIAL MANAGEMENT I 2017/18

EPS 10,29
= =0,164
P 62,78
11

21. Construct a new version of Concatenator business Table, assuming that competition
drives down profitability (on existing assets as well as new investment) to 11,5% in year
5, 11% in year 6, 10,5% in year 7, and 8% in year 8 and all later years. What is the value
of the Concatenator business?
Solution
1 1,59
PV (horizon value)= (
1,1⁶ 0,10−0,08 )
=44,88 €

0,80 0,96 1,15 1,39 0,38 0,47


PV (cash flows)=− − − − − − =−3,84
1,1 1,1² 1,1³ 1,1⁴ 1,1⁵ 1,1⁶
PV (business)=PV ( free cash flow)+ PV (horizon value)=−3,84+ 44,88=41,04 million €

11

22. Gili Industries has a share price of 65 € today. If Gili is expected to pay a dividend of
2,5 € at the end of this year and if the equity cost of capital is 7%, what is the expected
stock price at the end of the year?
Solution

P1−65+2,5
0,07= →P1=67,05 €
65

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UNIT 4: FINANCIAL MANAGEMENT I 2017/18

14

23. Turkish Airlines Inc. stock is expected to have next year a price of 60€ and will pay a
1,5€ dividend in one year if its capital gain rate is 15%. What price must you expect it to
sell for right now? What is the cost of equity capital?
Solution
60−P0 1,5
0,15= → P0 =52,17 € ; r= +15 %=17,88 %
P0 52,17

15

24. LaCgste Corporation has a current price of 35 €, and its expected price next year is 38
€. If the equity cost of capital is 10%, what dividend should pay LaCgste next year?
Solution
38+DIV 1
35= →DIV 1=0,5 €
1,10

16

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UNIT 4: FINANCIAL MANAGEMENT I 2017/18

25. NoCerBzs Corporation will pay a dividend of 1,80€ per share at the end of this year
and 2,3 € per share in second year. NoCerBzs’s current stock price is 52 €. If NoCerBzs’s
equity cost of capital is 7%. What price would you be willing to pay for a share of
NoCerBzs in two years from now?
Solution

1,8 2,3+ P2
52= + →P 2=55,31 €
1,07 1,072

17

26. MoguerTech, a biotechnology firm, forecasted the following dividends for the next two
years: 0,35€ and 0,48€. MoguerTech’s shares are currently priced at 37,71€ and it is
expected to be 45,60€ in second year. What is it the equity cost of capital?
Solution

0,35 0,48 +45,6


37,71= + →r=11,01 %
1+r (1+r )2
18

27. Calculate EPS, Book Equity per share, Payout ratio, ROE, PlowBack ratio and dividend
growth (g) of next company:

Solution

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UNIT 4: FINANCIAL MANAGEMENT I 2017/18

Earnings 12.000 DIV 2,3


EPS= = =4,8 € ; Payout ratio= = =47,92 %
Outstanding shares 2.500 EPS 4,8
Plowback ratio=1− payout ratio=1−0,4792=52,08 %
Book equity value 84.000
Book equity per share= = =33,60 €
Outstanding shares 2.500
EPS 4,80
ROE= = =14,29 %
book equity per share 33,60
g= plowback ratio x ROE=0,5208 x 0,1429=7,44 %

19

28. Sakarya Corporation will pay an annual dividend as follows:

At year four the dividend will be 1,25 €. After then, analysts expect this dividend to grow
at 4% per year. According to the dividend-discount model, what is the value of a share of
Sakarya stock if the firm’s equity cost of capital is 9%?
Solution

1,25
P3= =25,00 €
0,09−0,04

1,2 1,15 1,35 25,00


P 0= + + + =22,42 €
1,09 1,092 1,093 1,093

20

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UNIT 4: FINANCIAL MANAGEMENT I 2017/18

29. Inntel Hotel, Inc. have earnings per share of 4,00€ in the coming year paid as
dividend. Suppose Inntel Hotel, Inc. cuts its dividend payout ratio to 80% to invest the
cash in an investment project with a rate of return of 7%. What will we be the effect of
this investment in the current price of stock (50,00€)?

Solution

DIV 1 4
r= = =8 %
P0 50

g=PlowBack Ratio∗Returnon New Investment=20 %∗7 %=1,40 %


4∗0,80
P0= =48,48 €
0,8−0,014
21

30. NowGrial, Inc. expects an earnings per share of 2,00 € next year. Security analysts are
forecasting earnings growth of 3,00% per year. NowGrial will invest a percentage of its
earnings to invest every year in a new investment project, the net present value in year 1
is 0,50 €. This net present values will grow equal than earnings. If the equity cost of
capital is 9,00%. What is the present value of growth opportunities? What is the expected
stock’s price?
Solution

NPV 1 0,5 EPS 1 2


PVGO= = =8,33 € ; = =22,22 €
r−g 0,09−0,03 r 0,09
EPS 1
P0= + PVGO=22,22+ 8,33=30,56 €
r
22

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UNIT 4: FINANCIAL MANAGEMENT I 2017/18

2 SELF-STUDY PROBLEMS
1. For the past 15 years, a family has operated the gift shop in a luxury hotel near the Place Vendome
in Paris. The hotel management wants to sell the gift shop to family members rather than paying them
to operate it. The family’s accountant will incorporate the new business and estimates that it will
generate an annual cash dividend of 150.000 € for the new shareholders. The hotel will provide the
family with an infinite guarantee for the space and a generous buyout plan in the event that the hotel
closes its doors. The accountant estimates that a 20% discount rate is appropriate. What is the value
of the shares?

Solution → 750.000 €

2. Suppose that the current cash dividend on Novartis`ordinary shares is 4,72 €. Financial analysts
expect the dividends to grow at a constant rate of 6% per year and investors require a 10% return on
this class shares. What should be the current price of Novartis’ shares?

Solution → 125,00 €

3. Eduardo Cavallas has just bought the ordinary shares of Regietto SA. The company expects to grow
at the following rates for the next three years: 30 per cent, 25 per cent and 15 per cent. Last year, the
company paid a dividend of €2,50. Assume a required rate of return of 10 per cent. Compute the
expected dividends for the next three years and also the present value of these dividends.

Solution → D1= 3,25; D2 = 4,06; D3 = 4,67; P0 = 9,83

4. Meubles de Montreux SA has been growing at a rate of 6 per cent for the past two years, and the
company’s CEO expects the company to continue to grow at this rate for the next several years. The
company paid a dividend of 1,20€ last year. If your required rate of return was 14 per cent, what is
the maximum price that you would be willing to pay for this company’s shares?

Solution → D1= 1,27; P0 = 15,88

5. Clarion Electrical has been selling electrical supplies for the past 20 years. The company’s product
line has seen very little change in the past five years, and the company does not expect to add any
new items for the foreseeable future. Last year, the company paid a dividend of 4,45€ to its ordinary
shareholders. The company is not expected to grow its revenues for the next several years. If your
required rate of return for such firms is 13 per cent, what is the current value of this company’s
shares?

Solution → P0 = 34,23

6. Brandenburg Infotech AG is a fast-growing communications company. The company did not pay a
dividend last year and is not expected to do so for the next two years. Last year, the company’s
growth accelerated and they expect to grow at a rate of 35 per cent for the next five years before
slowing down to a more stable growth rate of 7 per cent for the next several years. In the third year,
the company has forecasted a dividend payment of €1,10. Calculate the price of the company’s shares
at the end of its rapid growth period (i.e. at the end of five years). Your required rate of return for
such shares is 17 per cent. What is the current price of the shares?

Solution → D1= D2=D3=0; D4=1,485; D5=2,005; D6= 2,145; P5 =21,45; P0 = 12,17

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UNIT 4: FINANCIAL MANAGEMENT I 2017/18

7. Jenny Banks is interested in buying the shares of Breakdancer Productions PLC, which are growing
at a constant rate of 6 per cent. Last year, the firm paid a dividend of €2,65. The required rate of
return is 16 per cent. What is the current price for the shares?

Solution → D1= 2,809; P0 = 28,09

8. ProCor A/S, a biotechnology firm, forecasted the following growth rates for the next three years: 35
per cent, 28 per cent and 22 per cent. The company then expects to grow at a constant rate of 9 per
cent for the next several years. The company paid a dividend of 1,75€ last week. If the required rate
of return is 20 per cent, what is the market value of the shares?

Solution → D1= 2,36; D2 = 3,02; D3 = 3,69; D4 = 4,02; P0 = 27,36

3 BIBLIOGRAPHY
Principles of Corporate Finance 12th edition. Richard A. Brealey, Stewart C. Myers, Franklin Allen.
Mcgraw-hill.

Fundamentals of Corporate Finance. 2014. Jonathan Berk, Peter Demarzo Jarrad Harford. Pearson.

Fundamentals of Corporate Finance. 2017. Robert Parrino, David S. Kidwell, Thomas Bates. Wiley &
Sons Inc.

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