The Value of Common Stocks
Problems 18, 23, 24
For requirements of the course
Financial Markets (2011-2012)
To
Prof. Vineet Virmani
By
Easwara Ananth A T
Roll No 11117, Section A
Date 26st August 2011
INDIAN INSTITUTE OF MANAGEMENT, AHMEDABAD
18)
Given:
Company Qs current ROE = 14%
Cash dividends = (Revenue) [Payout Ratio = .5]
Current book value per share = $50
ROE and Payout ratio = Constant for the next 4 years
After 4 years, ROE -11.5% and Payout ratio = 0.8
Cost of capital = 11.5%
Formulae:
Payout Ratio = Dividend/EPS Dividend = Payout Ratio * EPS
ROE = EPS / Book equity per share EPS = ROE * Book Equity per share
Plowback Ratio = 1 Payout Ratio
Dividend Growth Rate (g) = Plowback Ratio * ROE
18a) EPS and Dividends
Year 0 EPS (ROE * Book equity per share) 0.14 * $50= $7.00
Dividend (Payout Ratio * EPS) 0.5 * $7 = $3.50
Plowback ratio = 1-0.5 = 0.5; Dividend Growth Rate (g) = 0.5 * 0.14 = 0.07
Year
EPS =
[ EPS0 * (1+g) ^ year ]
Dividend = [ (Payout Ratio * EPS) * (1+g) ]
OR Dividend = [ DIV0 * (1+g) ^ year ]
$7.00 * 1.07 = $7.490
$7.490 0.5 = $3.745; $3.50 1.07 = $3.745
$7.00 * (1.07)2 = $8.014
$8.014 0.5 = $4.007; $3.50 1.072 = $4.007
$7.00 * (1.07)3 = $8.575
$8.575 0.5 = $4.288; $3.50 1.073 = $4.288
$7.00 * (1.07)4 = $9.176
$9.176 0.5 = $4.588; $3.50 1.074 = $4.588
Year 5
Payout Ratio = 0.08;
Plowback Ratio = 1-0.08 = 0.02
Dividend Growth Rate (g) = Plowback Ratio * ROE = 0.02 * 0.115 = 0.023
EPS5 = EPS4 * (1+g) = $9.176 1.023 = $9.387
Dividend5 = Dividend4 * (1+g) = $4.588 * 1.023 = $4.693
EPS and Dividend after year 5 will grow at 2.3% per year.
18b) Formula:
Stock Price P0
P0 = [Div1/(1+r)] + [Div2 / (1+r)2 ] +. . + [ DivH / (1+r)H] + [ DivH+1 / (r-g)(1+r)H+1 ]
Solution
P0 = [$3.745/1.115] + [$4.007/1.1152] + [$4.288/1.1153] + [$4.588/1.1154] + X
X = [ $4.693/ ( 0.115 0.023 ) ] * [ 1 / 1.154 ] = 51.011 * 0.647 = $33.004
P0 = $3.359 + $3.223 + $3.093 + $2.968 + $33.004
P0 = $45.647
In the last term, the Dividend growth rate (g) depends on the Plowback ratio
which in turn depends on the Payout Ratio. Hence the stock price P0 is
dependent on the payout ratio after year 4.
23)
Formula:
Stock Price P0
P0 = [Div1/(1+r)] + [Div2 / (1+r)2 ] +. . + [ DivH / (1+r)H] + [ DivH+1 / (r-g)(1+r)H+1 ]
23a)
Stock Price P0 = [ $0.50 / 1.12 ] + [ $0.60 / 1.122 ] + [$1.15 / 1.123] + [ PH ]
PH = { [ $1.24 / (0.12 0.08) ] * [ 1/1.123] } = $ 22.065
P0 = $0.446 + $0.478 + $0.819 + $22.065 = $23.808
23b)
Horizon Value
Discounted Value of free cash flows out to a Valuation horizon (H),
plus the forecasted value of the business at the horizon, also
discounted back to present value.
PH = { [ $1.24 / (0.12 0.08) ] * [ 1/1.123] } = $ 22.065
Horizon value is $22.065 in the stock price $23.808
23c) Formula
P0 = ( EPS1 / r ) +PVGO
PVGO = P0 - ( EPS1 / r )
Solution
PVGO = P3 - ( EPS4 / r )
= [ $1.24 / (0.12 0.08) ] [ $2.49 / 0.12 ]
= $31 - $20.75
PVGO = $10.25
23d)
Since the PVGO of $10.25 is lost at year 3, the current stock price of $23.81 will
be reduced by $7.30 (as shown below).
$10.25 / (1.12)3 = $7.30
New stock price will be $23.81 - $7.30 = $16.51
24)
Given
P0 = $100;
Dividend Growth Rate (g) = 0.04
Dividend = $4;
Payout Ratio = 0.6
Formula
P0 = Div1 / (r g)
r = g + (Div1 / P0)
P0 = ( EPS1 / r ) +PVGO
PVGO = P0 - ( EPS1 / r )
EPS = Dividend / Payout Ratio
P0 = [Div1/(1+r)] + [Div2 / (1+r)2 ] +. . + [ DivH+1 / (r-g)(1+r)H+1 ]
24a) Solution
Expected long-run rate of return: (r) = 0.04 + (4/100) = 0.08 = 8%
EPS = $4/0.6 = $6.67
PVGO (Present Value of Growth Opportunities) = $100 ($6.6.7/0.08)
PVGO = $16.625
24b) Solution
EPS1 = $6.67
Dividend1 = $6.6.7 * 0.2 = $1.33
EPS2 = EPS1 * 1.08 = $6.67 * 0.08 = $7.20
Dividend2 = $7.20 * 0.2 = $1.44
Similarly
Year
EPS
Dividend
1
6.67
1.33
2
7.20
1.44
3
7.78
1.55
4
8.40
1.68
5
9.07
1.81
6
9.80
5.88
P5 = Dividend6/(r-g) 5.88/ (0.08-0.04) = $147
Stock Price P0 = $106.2
P0 = 1.33/1.08 + 1.44/1.082 + 1.55 / 1.083 + 1.68 / 1.084 + (1.81 + 147)/1.085 =
$106.2