Question

Integrative-long dashRisk 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 9​%. The​ risk-free rate is currently 5​%. ​ Craft's dividend per share for each of the past 6 years is shown in the following​ table: LOADING.... a. Given that Craft is expected to pay a dividend of ​$3.28 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 8​%. Data: 2019 $3.15 2018 $3.03 2017 $2.92 2016 $2.80 2015 $2.70 2014 $2.59

Answer 1

Answer (a):

Given:

Dividend in year 2014 = $2.59

Dividend in year 2019 = $3.15

Growth rate = (End Value/Start Value) ^ (1/Years)-1

= (3.15 / 2.59) ^ (1/5) - 1

= 3.99%

Rounded off to 4%

Craft is expected to pay a dividend of ​$3.28 next​ year

The​ risk-free rate is currently = 5%

Risk premium on Craft stock is = 9​%

Hence:

Required rate of return = 5% +9% =14%

Share price = Dividend next year / (Required return - Constant growth rate)

= 3.28 / (14% - 4%)

= $32.80

Maximum cash price that Hamlin should pay for each share of Craft = $32.80

Answer (b) (1):

Effect on the resulting value of Craft on decrease in dividend growth rate of​ 2% from that exhibited over the 2014​-2019 period:

Growth rate = 4% - 2% = 2%

Share price = Dividend next year / (Required return - Constant growth rate)

= 3.28 /(14% - 2%)

= $27.33

Share price will decrease to $27.33

Answer (b) (2):

Effect on the resulting value of Craft on decrease in its risk premium to 8​%:

Required rate of return = 5% + 8% =13%

Share price = 3.28 / (13% - 4%) = $36.44

Share price will decrease to $36.44