Tutorial 4 Solutions for Principles of Finance
1. Constant dividend growth model (Problem 9.10 in Berk and DeMarzo
(2011))
We need to first find out the equity cost of capital 𝑟𝐸 for Cooperton Mining. Note that the
constant dividend growth model is:
𝐷1
𝑃0 = (1)
𝑟𝐸 − 𝑔
We can rearrange this equation to get:
𝐷1 $4
𝑟𝐸 = +𝑔 = + 3% = 11%
𝑃0 $50
The company decides to boost the growth rate from 3% to 5% by cutting dividends down
and increasing investment. Then, after the dividend-cut announcement, according to the
constant dividend growth model, the share price should be:
$2.5
𝑃0′ = = $41.67
11% − 5%
This is a negative NPV investment. The stock price goes down after the announcement:
𝑃0′ =$41.67< 𝑃0 =$50, which suggests that value is destroyed.
2. Growth versus payout (Problem 9.14 in Berk and DeMarzo (2011))
The firm’s earnings per share in year 1 is 𝐸1 =$3.00. Future earnings will grow as a result
of the firm’s investments. The earnings growth rate is equal to return on investment 𝑅𝑂𝐼
times the retention ratio 𝑅𝑅:
Δ𝐸/𝐸𝑡−1 = 𝑅𝑂𝐼𝑡−1 × 𝑅𝑅𝑡−1 (2)
In the first year, the firm retains all of its earnings 𝑅𝑅1 =100% and invests them. Conse-
quently, in year 2, earnings grow to:
𝐸2 = (1 + Δ𝐸/𝐸1 ) × 𝐸1 = (1 + 𝑅𝑂𝐼1 × 𝑅𝑅1 ) × 𝐸1 = (1 + 25% × 100%) × $3 = $3.75
Earnings growth rates and earnings figures for the remaining years are presented in Table 1.
The firm pays no dividends in the first two years, since it retains all of its earnings. In year
3, the retention ratio goes down to 𝑅𝑅3 = 50%. Therefore, the firm pays out the remaining
50% of the earnings:
𝐷3 = (1 − 𝑅𝑅3 ) × 𝐸3 = (1 − 50%) × $4.69 = $2.34
Retention ratios and dividend figures for the remaining years are also presented in Table 1.
1
Note that the fall in retention ratio in year 3 increases the dividends significantly in year 2
and decreases the earnings growth rate in year 3. Similarly, the further fall in retention ratio
in year 5 increases the dividends significantly in year 5 and decreases the earnings growth
rate in year 6.
From year 5 on, since the payout ratio becomes constant, the dividends grow at the same
rate as earnings:
𝑔𝑡 = Δ𝐸/𝐸𝑡−1 = 5% 𝑓 𝑜𝑟 𝑎𝑙𝑙 𝑡 > 5 (3)
Therefore, according to constant dividend growth model, the firm’s stock price in year 4 is:
𝐷5 $4.75
𝑃4 = = = $95
𝑟𝐸 − 𝑔 10% − 5%
Then, its current price is:
$2.34 $2.64 + $95
𝑃0 = 3
+ = $68.45
(1 + 10%) (1 + 10%)4
Table 1: Dividend forecast for Halliford Corporation
Year 0 1 2 3 4 5 6
Earnings
1 Δ𝐸/𝐸𝑡−1 25% 25% 12.50% 12.50% 5%
2 𝐸𝑡 $3.00 $3.75 $4.69 $5.27 $5.93 $6.23
Dividends
3 𝑅𝑅𝑡 100% 100% 50% 50% 20% 20%
4 𝐷𝑡 $0 $0 $2.34 $2.64 $4.75 $4.98
3. Valuation based on comparable firms (Problem 9.22 in Berk and De-
Marzo (2011))
First, calculate the price-to-earnings ratio for PepsiCo:
$52.66
𝑃/𝐸𝑝𝑒𝑝𝑠𝑖 = = 16.46
$3.20
Then, use this ratio as a valuation multiple for Coca-Cola Company:
𝑃𝑐𝑜𝑐𝑎−𝑐𝑜𝑙𝑎 = 𝑃/𝐸𝑝𝑒𝑝𝑠𝑖 × 𝐸𝑐𝑜𝑐𝑎−𝑐𝑜𝑙𝑎 = 16.46 × $2.49 = $40.98
2
4. Market efficiency
The present value of the earthquake’s cost to the company is:
£1 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 £1 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
− = £2.72 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
5% 5%(1 + 5%)3
Given that there are 1 million shares outstanding the share price would go down by £2.72
per share (=£2.72 million / 1 million shares).
If you could hear the news before the market and short sell the firm’s shares before its
share price goes down by £2.72 per share, you would make a profit. However, this is difficult,
since the news about the damage caused to the firm by the earthquake is public information,
and in efficient markets prices adjust to public information (almost) instantly.