Question

In: Finance

The value of a share of common stock depends on the cash flows it is expected...

The value of a share of common stock depends on the cash flows it is expected to provide, and those flows consist of the dividends the investor receives each year while holding the stock and the price the investor receives when the stock is sold. The final price includes the original price paid plus an expected capital gain. The actions of the marginal investor determine the equilibrium stock price. Market equilibrium occurs when the stock's price is (-Select- less than, equal to, greater than) its intrinsic value. If the stock market is reasonably efficient, differences between the stock price and intrinsic value should not be very large and they should not persist for very long. When investing in common stocks, an investor's goal is to purchase stocks that are undervalued (the price is (-Select- above, below, equivalent to) the stock's intrinsic value) and avoid stocks that are overvalued.

The value of a stock today can be calculated as the present value of (-Select- a finite, an infinite) stream of dividends:

This is the generalized stock valuation model. We will now look at 3 different situations where we can adapt this generalized model to each of these situations to determine a stock's intrinsic value:
1. Constant Growth Stocks;
2. Zero Growth Stocks;
3. Nonconstant Growth Stocks.

Constant Growth Stocks:

For many companies it is reasonable to predict that dividends will grow at a constant rate, so we can rewrite the generalized model as follows:

This is known as the constant growth model or Gordon model, named after Myron J. Gordon who developed and popularized it. There are several conditions that must exist before this equation can be used. First, the required rate of return, rs, must be greater than the long-run growth rate, g. Second, the constant growth model is not appropriate unless a company's growth rate is expected to remain constant in the future. This condition almost never holds for (-Select- mature, start-up) firms, but it does exist for many (-Select- mature, start-up) companies.

Which of the following assumptions would cause the constant growth stock valuation model to be invalid?

  1. The growth rate is zero.
  2. The growth rate is negative.
  3. The required rate of return is greater than the growth rate.
  4. The required rate of return is more than 50%.
  5. None of the above assumptions would invalidate the model.

(-Select- Statement a, Statement b, Statement c, Statement d, Statement e)

Quantitative Problem 1: Hubbard Industries just paid a common dividend, D0, of $1.80. It expects to grow at a constant rate of 4% per year. If investors require a 10% return on equity, what is the current price of Hubbard's common stock? Do not round intermediate calculations. Round your answer to the nearest cent.  
$ _________ per share

Zero Growth Stocks:

The constant growth model is sufficiently general to handle the case of a zero growth stock, where the dividend is expected to remain constant over time. In this situation, the equation is:

Note that this is the same equation developed in Chapter 5 to value a perpetuity, and it is the same equation used to value a perpetual preferred stock that entitles its owners to regular, fixed dividend payments in perpetuity. The valuation equation is simply the current dividend divided by the required rate of return.

Quantitative Problem 2: Carlysle Corporation has perpetual preferred stock outstanding that pays a constant annual dividend of $1.50 at the end of each year. If investors require an 6% return on the preferred stock, what is the price of the firm's perpetual preferred stock? Round your answer to the nearest cent.
$ _________ per share

Nonconstant Growth Stocks:

For many companies, it is not appropriate to assume that dividends will grow at a constant rate. Most firms go through life cycles where they experience different growth rates during different parts of the cycle. For valuing these firms, the generalized valuation and the constant growth equations are combined to arrive at the nonconstant growth valuation equation:

Basically, this equation calculates the present value of dividends received during the nonconstant growth period and the present value of the stock's horizon value, which is the value at the horizon date of all dividends expected thereafter.

Quantitative Problem 3: Assume today is December 31, 2013. Imagine Works Inc. just paid a dividend of $1.40 per share at the end of 2013. The dividend is expected to grow at 12% per year for 3 years, after which time it is expected to grow at a constant rate of 5.5% annually. The company's cost of equity (rs) is 9%. Using the dividend growth model (allowing for nonconstant growth), what should be the price of the company's stock today (December 31, 2013)? Do not round intermediate calculations. Round your answer to the nearest cent.
$ _________ per share

Solutions

Expert Solution

1.
Market equilibrium occurs when the stock's price is equal to its intrinsic value.

2.
When investing in common stocks, an investor's goal is to purchase stocks that are undervalued (the price is below the stock's intrinsic value) and avoid stocks that are overvalued.

3.
The value of a stock today can be calculated as the present value of a finite stream of dividends

4.
This condition almost never holds for start-up firms, but it does exist for many mature companies

5.
None of the above assumptions would invalidate the model.

6.
=1.80*1.04/(10%-4%)
=31.2

7.
=1.50/6%
=25

8.
=1.40*(1.12/1.09)+1.40*(1.12/1.09)^2+1.40*(1.12/1.09)^3+1.40*(1.12/1.09)^3*1.055/(9%-5.55%)
=50.88014386


Related Solutions

The value of a share of common stock depends on the cash flows it is expected...
The value of a share of common stock depends on the cash flows it is expected to provide, and those flows consist of the dividends the investor receives each year while holding the stock and the price the investor receives when the stock is sold. The final price includes the original price paid plus an expected capital gain. The actions of the marginal investor determine the equilibrium stock price. Market equilibrium occurs when the stock's price is -Select-less thanequal togreater...
Basic Stock Valuation: Dividend Growth Model The value of a share of common stock depends on...
Basic Stock Valuation: Dividend Growth Model The value of a share of common stock depends on the cash flows it is expected to provide, and those flows consist of the dividends the investor receives each year while holding the stock and the price the investor receives when the stock is sold. The final price includes the original price paid plus an expected capital gain. The actions of themarginal investor determine the equilibrium stock price. Market equilibrium occurs when the stock's...
Stocks and Their Valuation: Discounted Dividend Model The value of a share of common stock depends...
Stocks and Their Valuation: Discounted Dividend Model The value of a share of common stock depends on the cash flows it is expected to provide, and those flows consist of the dividends the investor receives each year while holding the stock and the price the investor receives when the stock is sold. The final price includes the original price paid plus an expected capital gain. The actions of the marginal investor determine the equilibrium stock price. Market equilibrium occurs when...
·         Determine the value of a share of common stock when: (1) dividends are expected to...
·         Determine the value of a share of common stock when: (1) dividends are expected to grow at some constant rate, and (2) dividends are expected to grow at some super-normal, or no constant, growth rate.
Summerdahi Resort’s common stock is currently trading at $37.15 a share. The stock is expected to...
Summerdahi Resort’s common stock is currently trading at $37.15 a share. The stock is expected to pay a dividend of $2.50 a share at the end of the year (D1 = $3.00), and the dividend is expected to grow at a constant rate of 8.25% a year. What is its cost of common equity? 5. Booher Book Stores has a beta of 1.30. The yield on a 3-month T-bill is 4.5%. The market risk premium is 7.5% and the return...
Determine the book value per share of the common stock.
Question: The stockholders’ equity section of Montel Company’s balance sheet follows. This year’s dividends on preferred stock have been paid and no preferred dividends are in arrears. Determine the book value per share of the common stock. Preferred stock 5% cumulative, $10 par value, 20,000 shares authorized, issued, and outstanding . . . . . . . . . . . . $ 200,000 Common stock—$5 par value, 200,000 shares authorized, 150,000 shares issued and outstanding . . . ....
What is the present value of a stream of cash flows expected to grow at a...
What is the present value of a stream of cash flows expected to grow at a 10 percent rate per year for 5 years and then remain constant thereafter until the final payment in 30 years. The payment at the end of the first year is $1,000 and the discount rate is 5.00 percent.
Jarett & Sons's common stock currently trades at $35.00 a share. It is expected to pay...
Jarett & Sons's common stock currently trades at $35.00 a share. It is expected to pay an annual dividend of $2.75 a share at the end of the year (D1 = $2.75), and the constant growth rate is 6% a year. a) What is the company's cost of common equity if all of its equity comes from retained earnings? Round your answer to two decimal places. Do not round your intermediate calculations. % b) If the company issued new stock,...
The common stock of Dayton Repair is expected to pay a $2.28 per share dividend for...
The common stock of Dayton Repair is expected to pay a $2.28 per share dividend for each of the next two years. The company will pay no dividends after that, and is expected to be worth $52 per share at the end of year 3. What is the current price of the stock using a discount rate of 9%? $40.15 $44.16 $45.92 $48.60 $52.00
Jarett & Sons's common stock currently trades at $30.00 a share. It is expected to pay...
Jarett & Sons's common stock currently trades at $30.00 a share. It is expected to pay an annual dividend of $2.75 a share at the end of the year (D1 = $2.75), and the constant growth rate is 8% a year. What is the company's cost of common equity if all of its equity comes from retained earnings? Do not round intermediate calculations. Round your answer to two decimal places. % If the company issued new stock, it would incur...
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT