Problem Set 1

b) If Olin issues $40 mm in debt to repurchase 2 million shares of equity (i.e. they replace $40 mm of equity with $40 mm of debt in their capital structure), and the interest rate on the debt is 10%, what will be the expected EPS next year?

3. Using the cash flow indicator and investment valuation ratios, discuss which company is more likely to have satisfied stockholders.

• 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 for all future years. • Keeping in mind that income is $1,100 in year 1, increases by 5% in years 2

5. What is the estimate of the market risk premium that should be employed in calculating the cost of capital for Ameritrade?

c. A bond that has a $1,000 par value and a coupon interest rate of 12.7%. A new issue would sell for $1,150 per bond and mature in 20 years. The firm’s tax rate is 34%.

12% and the company just paid a $2.50 annual dividend. What is the current share price?

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

The firm employs about 190,000 people and boasts the 20 million strong consumer base with projected growth 3.5 million within the next three years. The firm’s Price-to-Earnings Ratio (P/E) of about 21 is higher than P/Es of its primary competitors. Hence, CVS reported 21 bps increase and the total gain of $68 million in the last year. At the same time, the forward earning on the CVS stock yielded over 9.3% allowing the firm easily meets its dividend obligations. The EPS proves that the stock has been performing well at over 30%. The revenue has been growing at 15.7% per year during the last three years compare to 14.2% revenue growth within the industry. This stock's forward earnings yield of 7.41% is the annual return it would generate if its profits remained fixed and it paid out all of its earnings as dividends. This is normal compared with the earnings yields of other stocks in the industry, and is healthy in absolute terms. Finally, most companies in the industry have generated very low returns on assets over the past five years. CVS has posted results that are about average for the industry, though its ROA over the most recent 12 months was very high.

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In 2014, the rate of inflation was at an all-time low since 2009 of 1.2% (BBC News, 2014), MW’s revenue increase for that year was 1.36% showing that they remained operating healthily. I have worked out that the number of basic shares for 2014 was 65,192,592 and the total dividends were 10,430,814. With their large amount of shares, MW could be liable to depending on shareholders making decisions about their business. According to The London Stock Exchange (2015), the return on investment in a stock from dividend yield is 3.82% for the fiscal year. This is quite a low return, which may suggest that the share is overpriced or that the dividends are likely to be higher in the future. Return on Equity was 18.3% ((23887000/90969000)*100) in 2014, shareholders earned 18% of their investment in the company back, showing an attractive level of investment quality. The Dividend cover is close to risky at 1.68 (0.27/0.16), the company can just about afford the dividends and the dividend pay-out ratio is low at 0.59(0.16/0.27), but has been stable indicating a solid dividend policy from the company. The cash dividend cover is also low at 1.74 (0.27/1.687).

For Problem 24 we computed the present value of shares of common stock with a constant growth return. Problem 24 breaks down as follows:

1. Why has the stock price fallen despite the fact that net income has increased over the periods under review?

After a low record of P/E ratio of 11.2% in Y2014, we can saw the ratio was high in Y2015 since the stock price dropped to $4.54 at the end of financial year. Earnings per share jumped around $10 in Y2016 while the share price went up as well to reach $6.19. This generated a lower ratio than the previous year. The ratio dropped again in Y2017 with extreme earnings per share level that reached $90.9 and a stock price of $6.16. The ratio reached as low as 7,17% in by the end of Y2017. That means that investors are willing to pay $7.17 for every dollar of earning per share that Bega Cheese Ltd

(b) Consider a zero-coupon bond with the face value of $1,000 and three years to

The EPS of the company is Rs. 15. The market rate of discount applicable to the company is 12%. The dividends are expected to grow at 10% annually. The company retains 70% of its earnings. Calculate the market value of the share using the Gordon’s model.