FINC2011 Tutorial 5

BMA Chapter 4 Problems 5, 6, 7, 8, 16, 18, 20, 21, 24, 25, 27

5. Company Z's earnings and dividends per share are expected to grow indefinitely
by 5% a year. If next year's dividend is $10 and the market capitalization rate is
8%, what is the current stock price?

Answer

P0 = 10/(.08 - .05) = $333.33.

6. Company Z-prime is like Z in all respects save one: Its growth will stop after year
4. In year 5 and afterward, it will pay out all earnings as dividends. What is Z-
prime's stock price? Assume next year's EPS is $15.

Answer

P4 = EPS5 / r
P4 = [EPS1 (1 + g1)3 (1 + g2)] / r
P4 = [$15 (1 + .05)3 (1 + 0)] / .08
P4 = $217.05

Note that $15 is the EPS for year 1. The 5 percent growth rate stops after year 4, so
the exponent for the first growth rate must be 3, (Year 4 Year 1). There is no growth
in year 5.

P0 = DIV1 / (1 + r) + [DIV1 (1 + g)] / (1 + r)2 + [DIV1 (1 + g)2] / (1 + r)3 +

[DIV1 (1 + g)3] / (1 + r)4 + P4 / (1 + r)4

P0 = $10 / 1.08 + ($10 1.05) / 1.082 + ($10 1.052) / 1.083 + ($10 1.053) / 1.084
+ $217.05 / 1.084

P0 = $195.06

7. If company Z (see Problem 5) were to distribute all its earnings, it could maintain
a level dividend stream of $15 a share. How much is the market actually paying
per share for growth opportunities?

Answer

Price = EPS1/r + PVGO

Recall that the price = DIV1/(r g). Therefore, price = $10/(.08 - .05) = $333.333.
Therefore, 15/.08 + PVGO = 333.33; therefore PVGO = $145.83.
8. Consider three investors:

a. Mr. Single invests for one year.

b. Ms. Double invests for two years.

c. Mrs. Triple invests for three years.

Assume each invests in company Z (see Problem 5). Show that each expects to
earn a rate of return of 8% per year.

Answer

With next years dividend at $10/share and next years price at $350/share (calculated
by taking the current years price of $333.33 x a 5% growth rate), Zs forecasted
dividends and prices grow as follows:

DIV1 = $10
DIV2 = DIV1 (1 + g) = $10 1.05 = $10.50
DIV3 = DIV2 (1 + g) = $10.50 1.05 = $11.03

P0 = DIV1 / (r g) = $10 / (.08 .05) = $333.33

P1 = P0 (1 + g) = $333.33 1.05 = $350.00
P2 = P1 (1 + g) = $350.00 1.05 = $367.50
P3 = P2 (1 + g) = $367.50 1.05 = $385.88

r1 = (DIV1 + P1 P0) / P0 = ($10 + 350.00 333.33) / $333.33 = .08, or 8%

r2 = (DIV2 + P2 P1) / P1 = ($10.50 + 367.50 350.00) / $350.00 = .08, or 8%
r3 = (DIV3 + P3 P2) / P2 = ($11.03 + 385.88 367.50) / $367.50 = .08, or 8%

Since the rate of return each year is 8 percent, each investor should expect to earn
8%.

16. Look up P/E and P/B ratios for Entergy (ticker symbol ETR), using Yahoo!
Finance or another Internet source. Calculate the same ratios for the following
potential comparables: American Electric Power (AEP), CenterPoint Energy (CNP),
and Southern Company (SO). Set out the ratios in the same format as Table 4.1. Are
the ratios for these electric companies tightly grouped or scattered? If you didnt know
Entergys stock price, would the comparables give a good estimate?
Answer

Internet exercise; answers will vary.

18. 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%?
Answer

10 percent capitalization rate:

P0 Stock A = DIV1 / r = $10 / .1 = $100

P0 Stock B = DIV1 / (r g) = $5 / (.1 .04) = $83.33

[ 1(1+ g)5 (1+ g2 )]/r
(1+ r)6
1 1 (1+ g) 1 (1+ g)2 1 (1+ g)3 1 (1+ g)4 1 (1+ g)5
P0 Stock C = + + + + + +
1+r (1+ r)2 (1+ r)3 (1+ r)4 (1+r )5 (1+ r)6

P0 Stock C = $5 / 1.1 + ($5 1.2) / 1.12 + ($5 1.22) / 1.13 + ($5 1.23) / 1.14 +
($5 1.24) / 1.15 + ($5 1.25) / 1.16 + {[$5 1.25 (1 + 0)] / .1} /1.16
P0 Stock C = $104.51

At a 10% capitalization rate, Stock C has the largest present value.

Using the same formulas as above with a 7% capitalization rate, the values are:
 P0 Stock A = $10 / .07 = $142.86
P0 Stock B = $5 / (.07 - .04) = $166.67
P0 Stock C = $5 / 1.07 + ($5 1.2) / 1.072 + ($5 1.22) / 1.073 + ($5 1.23) / 1.074 +
($5 1.24) / 1.075 + ($5 1.25) / 1.076 + {[$5 1.25 (1 + 0)] / .07} / 1.076
P0 Stock C = $156.50

At a 7% capitalization rate, Stock B has the largest present value.

20. Company Q's current return on equity (ROE) is 14%. It pays out one-half of
earnings as cash dividends (payout ratio = .5). 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 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?

Answer

a. Plowback ratio = 1 payout ratio = 1.0 0.5 = 0.5

Dividend growth rate = g= Plowback ratio ROE = 0.5 0.14 = 0.07
Next, compute EPS0 as follows:
ROE = EPS0 /Book equity per share
0.14 = EPS0 /$50 EPS0 = $7.00
Therefore: DIV0 = payout ratio EPS0 = 0.5 $7.00 = $3.50
EPS and dividends for subsequent years are:
Year EPS DIV
0 $7.00 $7.00 0.5 = $3.50
1 $7.00 1.07 = $7.49 $7.49 0.5 = $3.50 1.07 = $3.75
2 $7.00 1.072 = $8.01 $8.01 0.5 = $3.50 1.072 = $4.01
3 $7.00 1.073 = $8.58 $8.58 0.5 = $3.50 1.073 = $4.29
4 $7.00 1.074 = $9.18 $9.18 0.5 = $3.50 1.074 = $4.59
5 $7.00 1.074 1.023 = $9.39 $9.39 0.8 = $7.51
EPS and dividends for year 5 and subsequent years grow at 2.3% per year,
as indicated by the following calculation:
Dividend growth rate = g = Plowback ratio ROE = (1 0.08) 0.115 = 0.023

DIV1 DIV 2 DIV3 DIV 4 DIV5 1

P0 1
2
3
4
4
1.115 1.115 1.115 1.115 0.115 - 0.023 1.115
b.

3.745 4.007 4.288 4.588 7.5093 1

1
2
3
4
4
$65.453
1.115 1.115 1.115 1.115 0.115 - 0.023 1.115

The last term in the above calculation is dependent on the payout ratio and the
growth rate after year 4.
21. Each of the following formulas for determining shareholders' required rate of
return can be right or wrong depending on the circumstances:

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.

Answer

a. An Incorrect Application. Hotshot Semiconductors earnings and dividends have

grown by 30% per year since the firms founding 10 years ago. Current stock
price is $100, and next years dividend is projected at $1.25. Thus:
DIV1 1.25
r g 0 .30 0 .3125 31.25%
P0 100

This is wrong because the formula assumes perpetual growth; it is not possible
for Hotshot to grow at 30% 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% rate for decades. Its
EPS1 = $10, DIV1 = $5, and P0 = $100. Thus:
DIV1 5
r g 0 .05 0 .10 10.0%
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:
EPS1 5
r 0 .05 5.0%
P0 100

This is too low to be realistic. The reason P0 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
P0 PVGO
r

5
100 60
r

Therefore, r = 12.5%.

A Correct Application. Unfortunately, Old Faithful has run out of valuable

growth opportunities. Since PVGO = 0:
EPS1
P0 PVGO
r

10
100 0
r

Therefore, r = 10.0%.

24. 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 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?

Answer

a.
r = DIV1 / P0 + g
r = $4 / $100 + .04
r = .08, or 8%

EPS1 = Div1 / (1 reinvestment rate)

EPS1 = $4 / (1 .40)
EPS1 = $6.67

P0 = EPS1 / r + PVGO
PVGO = P0 EPS1 / r
PVGO = $100 $6.67 / .08
PVGO = $16.67

b.
DIV1 will decrease to: .20 $6.67 = $1.33.
By plowing back 80% of earnings, CSI will grow by 8% per year for five years before
returning to its long-run growth rate of 4%. The dividend will be 20% of earnings for
years 1-5 and 60% of earnings in year 6 and beyond.

Year 1 2 3 4 5 6
EPSt $6.67 $7.20 $7.78 $8.41 $9.07 $9.80

DIVt 1.33 1.44 1.56 1.68 1.81 5.88

P5 = DIV6 / (r g)
P5 = $5.88 / (.08 .04)
P5 = $146.93
 P0 = DIV1 / (1 + r) + DIV2 / (1 + r)2 + DIV3 / (1 + r)3 + DIV4 / (1 + r)4 + DIV5 / (1 +
r)5 + P5 / (1 + r)5
P0 = $1.33 / 1.08 + $1.44 / 1.082 + $1.56 / 1.083 + $1.68 / 1.084 + $1.81 / 1.085 +
$146.93 / 1.085
P0 = $106.17

25. Permian Partners (PP) produces from aging oil fields in west Texas. Production
is 1.8 million barrels per year in 2016, 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 2016.

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 ending 2016 value of one PP share? Assume that oil prices are
expected to fall to $60 per barrel in 2017, $55 per barrel in 2018, and $50
per barrel in 2019. After 2019, assume a long-term trend of oil-price
increases at 5% per year.

b. What is PP's EPS/P ratio and why is it not equal to the 9% cost of capital?

Answer

a.First, compute the dividends, which equal net income, for 2016 through 2020:

2016 2017 2018 2019 2020

Production (million
barrels) 1.8000 1.6740 1.5568 1.4478 1.3465
Price of oil/barrel ($) 65 60 55 50 52.5
Costs per barrel ($) 25 25 25 25 25

117,000,00 100,440,00
Revenue 0 0 85,625,100 72,392,130 70,690,915
Expenses 45,000,000 41,850,000 38,920,500 36,196,065 33,662,340
Net Income (=
Dividends) 72,000,000 58,590,000 46,704,600 36,196,065 37,028,574

Horizon growth rates:

gRevenue = (1+ sales price growth rate) (1 + production growth rate) 1
gRevenue = (1 + .05) [1 + (.07)] 1
gRevenue = .0235, or 2.35%

gCosts = (1+ costs growth rate) (1 + production growth rate) 1

gCosts = (1 + 0) [1 + (.07)] 1
gCosts = .07, or 7%

PV2019 Revenues = revenue2020 / (r g)

PV2019 Revenues = $70,690,915 / [.09 (.0235)]
PV2019 Revenues = $622,827,444

PV2019 Costs = costs2020 / (r g)

PV2019 Costs = $33,662,340 / [.09 (.07)]
PV2019 Costs = $210,389,628

PV2019 = PV2019 revenues PV2019 costs

PV2019 = $622,827,444 210,389,628
PV2019 = $412,437,817

PV2016 = DIV2017 / (1 + r) + DIV2018 / (1 + r)2 + (DIV2019 + P2019) / (1 + r)3

PV2016 = $58,590,000 / 1.09 + $46,704,600 / 1.092 + ($36,196,065 +412,437,817) /
1.093
PV2016 = $439,490,293
Price per share2016 = PV2016 / number of shares
Price per share2016 = $439,490,293 / 7,000,000
Price per share2016 = $62.78

b.
EPS2016 = net income2016 / number of shares
EPS2016 = $72,000,000 / 7,000,000
EPS2016 = $10.29

EPS/P = $10.29 / $62.78

EPS/P = .164, or 16.4%
The EPS/P is greater than the cost of capital because production and earnings are
declining.

27. Mexican Motors market cap is 200 billion pesos. Next year's free cash flow is
8.5 billion pesos. Security analysts are forecasting that free cash flow will grow
by 7.5% per year for the next five years.

a. Assume that the 7.5% growth rate is expected to continue forever. What rate
of return are investors expecting?

b. Mexican Motors has generally earned about 12% on book equity (ROE = .
12) and paid out 50% of earnings as dividends. The remaining 50% of
earnings has gone to free cash flow. Suppose the company maintains the
same ROE and investment rate in the long-run future. What is the
implication for the growth rate of earnings and free cash flow? For the cost
of equity? Should you revise your answer to part (a) of this question?

Answer

a. The constant growth formula P= DIV/(r g) can be used here:

$200 = $8.5/(r-.075)

Solving for r, r = 0.1175. That is, investors expect an 11.75% rate of return.

b. Given the Mexican Motors is plowing back 50% of earnings after earning 12%
on equity, the firm can expect to grow at an annual rate of only 6% (ROE x
plowback = 0.12 x 0.50 = 0.06). Applying the constant growth formula again and
solving for r we get:

$200 = $8.5/(r-.06)

r = 0.1025. That is, investors should expect only a 10.25% rate of return.