bkmsol_ch18

# bkmsol_ch18 - CHAPTER 18 EQUITY VALUATION MODELS 1 P0 =...

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CHAPTER 18: EQUITY VALUATION MODELS 1. P 0 = D 1 /(k – g) = \$2.10/(0.11 – 0) = \$19.09 2. I and II 3. a. k = D 1 /P 0 + g 0.16 = \$2/\$50 + g g = 0.12 = 12% b. P 0 = D 1 /(k – g) = \$2/(0.16 – 0.05) = \$18.18 The price falls in response to the more pessimistic dividend forecast. The forecast for current year earnings, however, is unchanged. Therefore, the P/E ratio falls. The lower P/E ratio is evidence of the diminished optimism concerning the firm's growth prospects. 4. a. g = ROE × b = 16% × 0.5 = 8% D 1 = \$2(1 – b) = \$2(1 – 0.5) = \$1 P 0 = D 1 /(k – g) = \$1/(0.12 – 0.08) = \$25 b. P 3 = P 0 (1 + g) 3 = \$25(1.08) 3 = \$31.49 5. a. This director is confused. In the context of the constant growth model [i.e., P 0 = D 1 /(k – g)], it is true that price is higher when dividends are higher holding everything else including dividend growth constant . But everything else will not be constant. If the firm increases the dividend payout rate, the growth rate g will fall, and stock price will not necessarily rise. In fact, if ROE > k , price will fall. b. (i) An increase in dividend payout will reduce the sustainable growth rate as less funds are reinvested in the firm. The sustainable growth rate (i.e., ROE × plowback) will fall as plowback ratio falls. (ii) The increased dividend payout rate will reduce the growth rate of book value for the same reason -- less funds are reinvested in the firm. 18-1

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