Solutions for Chapter 9: Questions and Problems
CHAPTER 9
COMPANY ANALYSIS AND STOCK VALUATION
Answers to Questions
1. Examples of growth companies would firms that have experienced very high rates of
return on total assets and returns on equity when compared to market values. They retain
2. A cyclical stock would be any stock with a high beta value. Examples of high beta stock
3. The biotechnology firm may be considered a growth company because (1) it has a growth
rate of 21% per year which well exceeds the growth rate of the overall economy, (2) it
4. Student Exercise
5. Student Exercise
8. The DDM assumes that (1) dividends grow at a constant rate, (2) the constant growth rate
will continue for an infinite period, and (3) the required rate of return (k) is greater than
the infinite growth rate (g). Therefore, the infinite period DDM cannot be applied to the
valuation of stock for growth companies because the high growth of earnings for the
Solutions for Chapter 9: Questions and Problems
9. Price/Book Value (P/BV) is used as a measure of relative value because, in theory,
market price (P) should reflect book value (BV). In practice, the two can differ
10. A high P/BV ratio such as 3.0 can result from a large amount of fixed assets being carried
11. The price/cash flow ratio (P/CF) has become more popular because of the increased
emphasis on cash by various analysts and because of the increased availability of cash
12. Price/sales ratio varies dramatically by industry. For example, the sales per share for
retail firms are typically higher than sales per share for technology firms. The reason for
13. The major components of EVA include the firm’s net operating profit less adjusted taxes
14. Absolute EVA makes it difficult to judge whether a firm is succeeding relative to past
15. While the EVA measures a firm’s internal performance, the MVA reflects the market’s
judgment of how well the firm performed in terms of the market value of debt and equity
16. The two factors that determine a firm’s franchise value are (1) the difference between the
expected return on new opportunities and the current cost of equity and (2) the size of
Solutions for Chapter 9: Questions and Problems
17. Above average earnings growth is a characteristic of a growth company. Additionally, a
rather high retention rate of 80% implies that the firm will have the resources to take
18. In a perfectly competitive economy, if other companies see a particular firm achieving
returns consistently above risk-based expectations, it is expected that these other
19. Because the dividend model assumes a constant rate of growth for an infinite time period,
the point is that a true growth company is earning a rate of return above its cost of capital
20. The growth duration model attempts to compute the implied growth duration for a growth
firm given differential past growth rates for the market and for the firm and also
alternative P/E ratios. These major assumptions of the model are: (1) equal risk between
the securities compared; (2) no significant differences in the payout ratio of different
Solutions for Chapter 9: Questions and Problems
21. The projected growth rate for the company (11.3%) is above that of the market and the
growth company also has a higher P/E ratio than the aggregate market. It would be
necessary to investigate the company further to determine if the firm’s stock is a growth
22. Magna in recent years is likely an example of negative growth due to declining market
share and stock price.
Solutions for Chapter 9: Questions and Problems
CHAPTER 9
Answers to Problems
1. Student Exercise
2. Student Exercise
5. Present Value common stock =(2,000 × 3)/(0.10-0.066) × 1/(1.1)3 = $132,584
Present Value of Real Estate Investment
Year Cash Flow PV @ 14%
1 $38,155 33,469
6. $27.86 = $2(1+g)/(0.12-g)
Rearranging g = 4.5%
8. g = RR * R.O.E.
Years one, two, three g = 0.25, RR = 0.25/0.30 = 0.833
Solutions for Chapter 9: Questions and Problems
– 77 –
0
1
2
3
4
5
GROWTH
25
25
25
20
20
EPS
PAYOUT RATIO
DIVIDEND
0.33
PV DIVIDEND
0.29
9(a) ROE = Profit Margin × Asset Turnover × Financial Leverage
ROE = (Net Income/Revenue) × (Revenue/Assets) × (Assets/Equity)
ROE20×1= 447/5750 × 5750/2300 × 2300/1360
9(b) Sustainable Growth = ROE × Retention Ratio (RR)
No mention of new equity issue so dividends paid = old retained earnings + net income –
new retained earnings
9(c). i. Increased leverage to improve production can improve the ROE (leverage ratio
increases as does TATO). Effect on SGR is positive.
Solutions for Chapter 9: Questions and Problems
– 78 –
9(d) FCFF for 20X2:
Earnings after tax = 553 million
Plus: Amortization expense = 134
9(e).
20X3
20X4
20X5
20X6
Growth rate (g)
20%
20%
20%
14%
FCFF
1.019
1.223
1.468
1.674