P7-20 Valuation with price/earnings multiples (LG 5; Basic)
To estimate stock price given earnings per share (EPS) and the average industry price-earnings
multiple (P/E): Firm EPS P/EStock Price
A 3.0 6.2 $18.60
B 4.5 10.0 $45.00
P7-21 Management action and stock value (LG 6; Intermediate)
a. Last dividend (D0) was $3, expected dividend growth (g) is 5% per year, and required return (r)
b. If g rises to 6% and r dips to 14%, P0 $3.18 (0.14 0.06) $39.75.
The best alternative is the one producing the highest share price, namely (b).
P7-22 Integrative: Risk and valuation (LG 4 and LG 6; Intermediate)
The risk premium on Foster stock may be found in two steps:
Step 1: Given stock price (P0) of $50, next expected dividend (D1) of $3 per share, and expected
P7-23 Integrative: Risk and valuation (LG 4 and LG 6; Challenge)
a. Given a 14.8% required return (r), and a 4% risk-free rate (RF), solve for risk premium (RP) on
a. Dividend growth rate from 2013 to 2019 (also expected future growth rate) is
b. A decline in the risk premium would reduce required return. If expected dividends did not
P7-24 Integrative: Risk and valuation (LG 4 and LG 6; Challenge)
a. The maximum price to pay for Craft stock may be found in three steps:
Step 1: Find 2014-2019 dividend growth rate (which is expected dividend growth rate) for
Step 2: Find required return (r) on Craft stock, given a risk-free rate (RF) of 5% risk premium
Step 3: Given a next expected dividend (D2020) of $3.68 per share, expected dividend growth
$12.52.
Part (2): To find the new share price, first recognize the smaller risk premium means a smaller
expected return. Specifically, risk premium (RP) falls to 4%, so required return is:
P7-25 Ethics problem (LG 4; Intermediate)
a. “Clearly not growing” means valuing with the zero-dividend-growth model. Given a next
b. A one-percentage-point “credibility” risk premium means raising required return from 11% to
rate. Put another way, uncertainty makes future dividends worth less to investors.
Case: Assessing Impact of Proposed Risky Investment on Suarez
Stock
Case studies are available on www.pearson.com/mylab/finance.
In this case, students will assess the potential impact of risky project on a hypothetical firm’s stock.
a. To find the current value per share of Suarez common stock, first obtain the dividend growth rate (g),
which is expected to equal recent historical experience:
Now, given g is 10%, the next expected dividend (D1) is $2.09, and required return is 14%, solve for
b. If Suarez makes the risky investment, next year’s dividend (D1) will rise to $2.15 per share, the
c. Suarez should undertake the proposed project. Higher dividend growth more than compensates for the
impact of project risk on required return, thereby boosting stock price and shareholder wealth.
d. Now, dividends will grow 13% per year for three years (from the last dividend of $1.90); then, growth
Step 1: Find the present value of dividends during the 13% growth period – given the last dividend
(D0) of $1.90, and required return of 16%:
(1.13) = $2.43
n Dn1/(1.16)n= Present Value of Dividends
0 $1.90
Step 2: Now, find the present value of price of stock at end of 13% growth period (when 9.95%
growth resumes). At the end of year 3, the next expected dividend (D4) is $2.74 1.0995 =
Step 3: Add present value of dividends during 13% growth period to present value of stock price at
Suarez should not undertake the risky project because share price would fall $14.29 (from $51.63 to
return.
Spreadsheet Exercise
Answers to Chapter 7’s Azure Corporation spreadsheet problem are available on
www.pearson.com/mylab/finance.
Group Exercise
Group exercises are available on www.pearson.com/mylab/finance .
The semester began with the fictitious firms about to become public corporations. Out of necessity, few
details were given. Now groups will begin to fill in the blanks. Specifically, using details from recent IPOs,
each group will write a detailed prospectus following the example in the text. Students should quickly see
recent regulation for public companies to disclose more and more information. Class discussion can then
explore the costs and benefits of erring on the side of over-disclosure.
Integrative Case 3: Encore International
In this case, students will explore different methods of valuing a hypothetical firm, including price/earnings
multiples, book value, and traditional dividend-growth models (under varying assumptions about the
patterns of that growth). They will compare stock values generated by the models, discuss the differences,
and select the approach best capturing the firm’s true value.
a. Book value per share = Book value of common equity Common shares outstanding
= $60,000,000 2,500,000 = $24.
(2) Stock price when dividends grow 8% for two years then 6% forever may be found in three steps:
Step 1: Present value of dividends in the 8% growth period, given last dividend (D0) was $4, and
n Dn1/(1.16)n= Present Value of Dividends
0 $4.00
Step 2: Present value of price of stock at end of 8% growth period:
At end of year 2, next expected dividend, D3 = $4.67 (1.06) = $4.95, expected growth is
Step 3: Add present value of dividends during 8% growth period to present value of stock price at
end of 8% growth period: P0 $7.19 $36.79 = $43.98.
f. Comparing value of Suarez stock with different valuation methods:
Valuation Method Share Price
Market value $40.00
Book value 24.00
Book value has no relevance to the true value of the firm. Of the remaining methods, the most
conservative estimate is given by the zero-growth model. Based on this estimate of stock value, wary