Question

Integrative -- Risk and Valuation Hamlin Steel Company wishes to determine the value of Craft Foundry, a firm that it is considering acquiring for cash. Hamlin wishes to determine the applicable discount rate to use as an input to the constant-growth valuation model. Craft's stock is not publicly traded. After studying the required returns of firms similar to Craft that are publicly traded, Hamlin believes that an appropriate risk premium on Craft stock is about 8%. The risk-free rate is currently 4%. Craft's dividend per share for each of the past 6 years is shown in the following table:

Year. Dividend Per Share.

2019. $3.52

2018. $3.38

2017. $3.25

2016. $3.13

2015. $3.01

2014. $2.89

a. Given that Craft is expected to pay a dividend of $3.66 next year, determine the maximum cash price that Hamlin should pay for each share of Craft. (Hint: Round the growth rate to the nearest whole percent.)

b. Describe the effect on the resulting value of Craft from:

(1) A decrease in its dividend growth rate of 2% from that exhibited over the 2014-2019 period.

(2) A decrease in its risk premium to 7%.

Answer 1

		Year	Dividend per share	Dividend Growth
		2014	$2.89
		2015	$3.01	0.041522	(3.01/2.89)-1
		2016	$3.13	0.039867	(3.13/3.01)-1
		2017	$3.25	0.038339	(3.25/3.13)-1
		2018	$3.38	0.04	(3.38/3.25)-1
		2019	$3.52	0.04142	(3.52/3.38)-1
		2020	$3.66	0.039773	(3.66/3.52)-1
			SUM	0.240921
		Expected dividend growth rate	0.040154	(0.240921/6)
		g=Expected dividend growth rate	4%
		D1=Next Years Dividend	$3.66
		R=Required rate of return =4+8=	12%
	a	Maximum Cash Price per Share =P0
		P0=D1/(R-g)=3.66/(0.12-0.04)=	$45.75
	b(1)	Decrease in dividend growth rate by 2%
		g= dividend growth rate =4-2=	2%
		Maximum Cash Price Per Share =P0
		P0=3.66/(0.12-0.02)=	$36.60
	b(2)	Decrease in Risk Premium to 7%
		R=Required Return =4+7=	11%
		Maximum Cash Price Per Share =P0
		P0=3.66/(0.11-0.04)=	$52.29