Unformatted text preview: Chapter 8 Mini Case (7th Ed.)
3 Investments
Capital Cities ABC, Inc. Bond
Par Value
Maturity
Coupon rate
Payment
Required rate of return
Market Price $1,000
12
8.75%
$87.50
$1,314.00 Southwest Bancorp Preferred Stock
Market price
Dividend
Required rate of return $25.50
$2.50 Emerson Electric Common Stock
Market price
Last Dividend
EPS 5 years ago
EPS currently
Required rate of return
a. $36.75
$1.32 Calculate the value of each security based on your required rate of return.
Capital Cities ABC, Inc. Bond
Value = PV of interest payments + PV of the par value
PV of future interest payments PV = PV of payment of Par Value PV =
Value of bond =
Better/Easier Method Southwest Bancorp Preferred Stock
Value = Preferred dividend/Required rat Value of Preferred Stock = $2.50
Emerson Electric Common Stock
Value = next dividend/(Required rate of return  growth rate)
Growth Rate Just an easy way to determine g
PV =
FV =
N=
Pmt. =
I=
Next dividend = last dividend x (1 + growth rate) Last dividend happened. If you
divident which will be what you
Next dividend = $1.32 x (1 +.1548%) = $1.32 x 1.1548 =
Value = next dividend/(Required rate of return  growth rate) Value of Common Stock = $1.52/(15.00%  15.48%) = $1.52/(=0 This is a very bad example since the growth rate in eps/divid
If the growth rate is 15.48%
N=
Pmt. =
PV =
I=
FV =
This is very ambitious. b. Which investment(s) should you accept? Why?
Two ways of determining whether to buy.
Compare cost with worth to you.
Compare return of investment (%) with your required rate of return (%)
Bond Your Value
$1,230.56 Preferred Stock $35.71 Common Stock $0.00 You would buy the preferred stock. It ie worth more to you
than its cost (market price). c. Emerson expects eps and dividends growth to decrease by 3%.
Growth would decrease from 15.48% Then:
Next dividend = last dividend x (1 + growth rate)
Last dividend happened. If you buy you care about the next
divident which will be what you receive.
Next dividend = $1.32 x (1 +.1671%) = $1.32 x 1.1671 =
Value = next dividend/(Required rate of return  growth rate)
Value of Common Stock = $1.4847/(15.00%  16.71%) = $1.52/(1.671%) =
Your Value
$58.92
d. What required rates of return would make you indifferent to all three options? Really asking which rate of return would neither make or lose money for e
options.
Need to determine what is the Yield to Maturity of each investment.
Capital Cities ABC, Inc. Bond
FV =
PV =
N=
Pmt. =
I= $1,000.00
$1,314.00
12
$87.50
5.17% Southwest Bancorp Preferred Stock
Value = Preferred dividend/Required rat Required rate of return = preferred dividend/value
Required rate of return = 2.50/25.50 = Emerson Electric Common Stock Value of common stock = next dividend/(Required rate of Re Required rate of return = next dividend/value of stock + grow
Rate of return = 19.63% If you invest in each of the three and receive a return (%) equal to your requir
you will receive a rate of return neither higher or lower than what you require
to whether you invest or not. Actually you would invest if the return equales your required rate of return be
the shareholders and creditors happy.
The following are not in the Mini Case but provide more examples.
c.1 If your required rate of return changed to 12% of the bond, 14% for the prefer
and 18% for the common stock, how would your answers change to parts a a Calculate the value of each security based on your new required rate of retur
Bond
Value = PV of future interest payments
PV of future interest payments PV = PV of payment of Par Value PV =
Value of bond =
Alternative Method Preferred Stock
Value = Preferred dividend/Required rat
$2.50/0.14
Value of Preferred Stock = Common Stock
Value = next dividend/(Required rate of return  growth rate)
Growth Rate 15.48% Next dividend = last dividend x (1 + growth rate)
$1.52
Value of Common Stock = $60.49
Your Value Bond
Preferred Stock
Common Stock
c.2 $1,068.11
$17.86
$60.49 Assuming again that your required rate of return for the common stock is 20%
anticipated constant growth rate changes to 12%, how would your answers to
and b change?
Common Stock
Value = next dividend/(Required rate of return  growth rate)
Growth Rate
Given as =
Next dividend = last dividend x (1 + growth rate) = $2.00 x (1
Value = next dividend/(Required rate of return  growth rate)
Value = $1.48/(.2  .12) = $28.00
Value of Common Stock =
Your Value
$18.48 years
6.00% 7.00% $1.49
$3.06
15.00%
r required rate of return. PV of the par value
f future interest payments
FV =
0
PV =
?
N=
12 Maturity
Pmt. =
$87.50 Payment
I=
6.00% Required rate of return
$733.59 f payment of Par Value
FV =
PV =
N=
Pmt. =
I= $1,000 Par Value
?
12 Maturity
0
6.00% Required rate of return $496.97
e of bond =
r/Easier Method
FV =
PV =
N=
Pmt. =
I= $1,230.56
$1,000.00
?
12
$87.50
6.00% rred dividend/Required rate of return
e of Preferred Stock = $2.50/.07 = ate of return  growth rate)
an easy way to determine g.
$1.49
$3.06
5
0
15.48% growth rate
+ growth rate) $1,230.56 (Perpetuity)
$35.71 dividend happened. If you buy you care about the next
ent which will be what you receive.
) = $1.32 x 1.1548 = $1.5243 ate of return  growth rate)
5.00%  15.48%) = $1.52/(=0.48%) = Means nothing. he growth rate in eps/dividends is unreasonable.
the eps in 20 years would increase (in %) as follows:
20
0
1
15.48%
17.79
is very ambitious. required rate of return (%)
Mkt. Price
$1,314.00 don't buy $25.50 value>price buy $36.75
e to you value<price Price>value don't buy rease by 3%.
to 12.48% y you care about the next
$1.4847
wth rate)
%) = $1.52/(1.671%) = Meaningless Mkt. Price
$36.75 prive>value don't buy fferent to all three options?
r make or lose money for each of the three
of each investment. rred dividend/Required rate of return $58.92 dividend/value
9.80% idend/(Required rate of Return Growth Rate)
dend/value of stock + growth rate rn (%) equal to your required rate of return
wer than what you require and will be indifferent
r required rate of return because it would make
xamples.
e bond, 14% for the preferred stock,
nswers change to parts a and b?
r new required rate of return.
f future interest payments + PV of payment of Par Value
f future interest payments
FV =
0
PV =
?
N=
12 Maturity
Pmt. =
$87.50 Payment
I=
12.00% Required rate of return
$885.41 f payment of Par Value
FV =
PV =
?
N=
Pmt. =
I= $1,000 Par Value
12 Maturity
0
12.00% Required rate of return $182.70
e of bond = $1,068.11 native Method
FV =
PV =
N=
Pmt. =
I= $1,000.00
?
12
$87.50
12.00% $798.68 rred dividend/Required rate of return e of Preferred Stock =
ate of return  growth rate) + growth rate) Mkt. Price (Perpetuity) $17.86 $1,314.00 value<cost
$25.50 value<cost
$36.75 value>cost don't buy
don't buy
buy or the common stock is 20%, but the
how would your answers to parts a ate of return  growth rate)
12.00%
+ growth rate) = $2.00 x (1 + .12) = $1.48 ate of return  growth rate)
e = $1.48/(.2  .12) = $28.00
e of Common Stock =
Mkt. Price
$36.75 value<cost $18.48
don't buy Free Cash Flow Model (Table 81), page 246
Most accurate way to value common stock
many stocks do not pay dividends
Can retain and invest with higher return than what
is needed to keep the shareholders happy (Ke).
Assumptions:
Sales last year =
$1,000.00
Anticipated sales growth
Years 12
12.00% per year
Years 35
8.00% per year
Beyond yr. 5 4.00% per year
Operating profit margin (OI/Sales) 12.00%
=
Corporate tax rate = 40.00%
Assets/Sales =
45.00%
Cost of capital =
12.00% Is required rate of return
Number of common shares =
100
Year 1
Sales
1,120.00
Operating Profits 134.40
Taxes
53.76
Profit after Taxes 80.64
 Increase in assets 54.00
Free Cash Flow
26.64 Year 2
1,254.40
150.53
60.21
90.32
60.48
29.84 Year 3
1,354.75
162.57
65.03
97.54
45.16
52.38 Year 4
1,463.13
175.58
70.23
105.35
48.77
56.57 Present value of cash flows for years 1  5. Year 5
1,580.18
189.62
75.85
113.77
52.67
61.10
$155.48 Residual value (as beginning of year 6)
= cash flow (yr. 6)/(cost of capital  growth rate)
= 89.88/(.12  .04) = 89.88/.08 = 1,123.50
It is better to do on financial calculator because growth rate is
rounded off and the most correct answer is actually Present value of residual value
REMEMBER: THIS IS THE VALUE AT THE END OF 5 YEARS.
YOU HAVE TO DISCOUNT IT TO NOW!!!
PV =
FV =
N=
Pmt. =
I=
PV = ?
$637.51
$1,123.51
5
0
12.00% Cost of capital
$637.51 Total Firm Value $792.99 Present value of cash flows for years 1  5.
Present value of residual value
Total Value of Firm =
Less: Debt
Equity Value han what Year 6
1,643.39
197.21
78.88
118.32
28.44
89.88 wth rate is
$1,123.51 YEARS. $155.48
$637.51
$792.99
$250.00
$542.99 ...
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 Spring '07
 Chen

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