# Acct

1713 Words Oct 28th, 2012 7 Pages
Solutions to Valuation Questions 1. Assume you expect a company’s net income to remain stable at \$1,100 for all future years, and you expect all earnings to be distributed to stockholders at the end of each year, so that common equity also remains stable for all future years (assumes clean surplus). Also, assume the company’s β = 1.5, the market risk premium is 4% and the 20-30 year yield on risk free treasury bonds is 5%. Finally, assume the company has 1,000 shares of common stock outstanding. a. Use the CAPM to estimate the company’s equity cost of capital. • re = RF + β * (RM – RF) = 0.05 + 1.5 * 0.04 = 11% b. Compute the expected net distributions to stockholders for each future year. • D = NI – ΔCE = \$1,100 – 0 = \$1,100 c. Use the …show more content…
b. Use the dividend discount (i.e., free cash flow to equity investors) valuation model to estimate the company’s current stock price. • Pe = D1/(re – g) = 700 / (0.11 – 0.05) = \$11,667 • price per share = \$11,667 / 1,000 = \$11.67 3. Same facts as (2) above, except the 5% income growth rate (and beginning of year common equity to support it) are only expected for years 2 and 3. Then growth is expected to be zero and all income is expected to be distributed to shareholders for all future years. a. Compute D1, D2, D3, and Dt for all future years. • Keeping in mind that income is \$1,100 in year 1, increases by 5% in years 2 and 3, and then remains constant for all future years; and keeping in mind that beginning of year 1 common equity is \$8,000, increases by 5% at the beginning of year 2 and at the beginning of year 3, but does not increase at the beginning of year 4 and remains constant from that point forward, you should be able to compute: D1 = \$700, D2 = \$735, and Dt = 1,212.75 for D3 and all future years. b. Use the dividend discount (i.e., free cash flow to equity investors) valuation model to estimate the company’s current stock price. Pe = 700/(1+ 0.11) + 735/(1+ 0.11)2 + [1,212.75/0.11]/(1+ 0.11)2 = \$10,175.31 and the price per share of common stock = \$10,175.31 / 1,000 = \$10.18. 4. Same facts as (3) above, except the growth rates are 5% for years 2 and 3 and then 3% perpetually for all future years. a. Compute D1, D2, D3 and the growth in D…