Even Better Products has come out with a new and improved product. As a result, the firm projects an ROE of 20 %, and it will maintain a plowback ratio of 0.30. Its earnings this year will be 2 dollars per share. Investors expect a 12 % rate of return on the stock.

a. At what price and P/E ratio would you expect the firm to sell?

b. What is the present value of growth opportunities?

c. What would be the P/E ratio and the present value of growth opportunities if the firm planned to reinvest only 20 % of its earnings?

Christie Johnson, CFA, has been assigned to analyze Sundanci using the constant dividend growth price/earnings (P/E) ratio model. Johnson assumes that Sundanci's earnings and dividends will grow at a constant rate of 13 %.

a. Calculate the P/E ratio based on information in Tables earlier mentioned and on Johnson's assumptions for Sundanci.

b. Identify, within the context of the constant dividend growth model, how each of the following factors would affect the P/E ratio.

• Risk (beta) of Sundanci.

• Estimated growth rate of earnings and dividends.

• Market risk premium.

To continue with Sundanci, Abbey Naylor, CFA, has been directed to determine the value of Sundanci's stock using the Free Cash Flow to Equity (FCFE) model. Naylor believes that Sundanci's FCFE will grow at 27 % for two years and 13 % thereafter. Capital expenditures, depreciation, and working capital are all expected to increase proportionately with FCFE.

a. Calculate the amount of FCFE per share for the year 2000, using the data from Table earlier mentioned.

b. Calculate the current value of a share of Sundanci stock based on the two-stage FCFE model.

c. i. Describe one limitation of the two-stage DDM model that is addressed by using the two-stage FCFE model.

ii. Describe one limitation of the two-stage DDM model that is not addressed by using the two-stage FCFE model.

The risk-free rate of retum is 8 %, the expected rate of return on the market portfolio is 15 %, and the stock of Xyrong Corporation has a beta coefficient of 1.2. Xyrong pays out 40 % of its earnings in dividends, and the latest earnings announced were 10 dollars per share. Dividends were just paid and are expected to be paid annually. You expect that Xyrong will earn an ROE of 20 % per year on all reinvested earnings forever.

a. What is the intrinsic value of a share of Xyrong stock?

b. If the market price of a share is currently 100 dollars, and you expect the market price to be equal to the intrinsic value one year from now, what is your expected one-year holding-period return on Xyrong stock?

The stock of Nogro Corporation is currently selling for 10 dollars per share. Earnings per share in the coming year are expected to be 2 dollars. The company has a policy of paying out 50% of its earnings each year in dividends. The rest is retained and invested in projects that earn a 20% rate of return per year. This situation is expected to continue indefinitely.

a. Assuming the current market price of the stock reflects its intrinsic value as computed using the constant growth rate DDM, what rate of return do Nogro's investors require?

b. By how much does its value exceed what it would be if all earnings were paid as dividends and nothing were reinvested?

c. If Nogro were to cut its dividend payout ratio to 25 %, what would happen to its stock price? What if Nogro eliminated the dividend?

Shaar (from the previous problem) has revised slightly her estimated earnings growth rate for Rio National and, using normalized (underlying trend) EPS, which is adjusted for temporary impacts on earnings, now wants to compare the current value of Rio National's equity to that of the industry, on a growth-adjusted basis. Selected information about Rio National and the industry is given in the following Exhibit.

Rio National

Industry

Compared to the industry, is Rio National's equity overvalued or undervalued on a P/Eto-growth (PEG) basis, using normalized (underlying) earnings per share. Assume that the risk of Rio National is similar to the risk of the industry.

Which of the following assumptions does the constant growth dividend discount model require?

a. Dividends grow at a constant rate.

b. The dividend growth rate continues indefinitely.

c. The required rate of return is less than the dividend growth rate.

Rio National Corp. is a U.S.-based company and the largest competitor in its industry. Exhibits earlier entioned present financial statements and related information for the company. Exhibit earlier mentioned presents relevant industry and market data.

The portfolio manager of a large mutual fund comments to one of the fund's analysts, Katrina Shaar: "We have been considering the purchase of Rio National Corp. equity shares, so I would like you to analyze the value of the company. To begin, based on Rio National's past performance, you can assume that the company will grow at the same rate as the industry."

a. Calculate the value of a share of Rio National equity on December 31, 2002, using the Gordon growth model and the capital asset pricing model.

b. Calculate the sustainable growth rate of Rio National on December 31, 2002. Use 2002 beginning-of-year balance sheet values.

The MoMi Corporation's cash flow from operations before interest and taxes was 2 million dollars in the year just ended, and it expects that this will grow by 5 % per year forever. To make this happen, the firm will have to invest an amount equal to 20 % of pretax cash flow each year. The tax rate is 35%. Depreciation was 200,000 dollars in the year just ended and is expected to grow at the same rate as the operating cash flow. The appropriate market capitalization rate for the unleveraged cash flow is 12% per year, and the firm currently has debt of 4 million dollars outstanding. Use the free cash flow approach to value the firm's equity.

Janet Ludlow's firm requires all its analysts to use a two-stage DDM and the CAPM to value stocks. Using these measures, Ludlow has valued QuickBrush Company at 63 dollars per share. She now must value SmileWhite Corporation.

a. Calculate the required rate of return for SmileWhite using the information in the following table:

Note: Rusk-free rate =4.50 %; expected market retum =14.50 %

b. Ludlow estimates the following EPS and dividend growth rates for SmileWhite:

Estimate the intrinsic value of SmileWhite using the table above, and the two-stage DDM. Dividends per share in 2007 were 1.72 dollars.

c. Recommend QuickBrush or SmileWhite stock for purchase by comparing each company's intrinsic value with its current market price.

d. Describe one strength of the two-stage DDM in comparison with the constant growth DDM. Describe one weakness inherent in all DDMs.

Peninsular Research is initiating coverage of a mature manufacturing industry. John Jones, CFA, head of the research department, gathered the following fundamental industry and market data to help in his analysis:

a. Compute the price-to-earnings $\left(P_0 / E_1\right)$ ratio for the industry based on this fundamental data.

b. Jones wants to analyze how fundamental P/E ratios might differ among countries. He gathered the following economic and market data:

Determine whether each of these fundamental factors would cause P/E ratios to be generally higher for Country A or higher for Country B.

Phoebe Black's investment club wants to buy the stock of elther NewSoft, Inc, or Capital Corp. In this connection, Black prepared the following table. You have been asked to help her interpret the data, based on your forecast for a healthy economy and a strong stock market over the next 12 months.

a. Newsoft's shares have higher price-earnings (P/E) and price-book value (P/B) ratios than those of Capital Corp. (The price-book ratio is the ratio of market value to book value.) Briefly discuss why the disparity in ratios may not indicate that NewSoft's shares are overvalued relative to the shares of Capital Corp. Answer the question in terms of the two ratios, and assume that there have been no extraordinary events affecting elther company.

b. Using a constant growth dividend discount model, Black estimated the value of NewSoft to be $28 per share and the value of Capital Corp. to be$34 per share. Briefly discuss weaknesses of this dividend discount model and explain why this model may be less suitable for valuing NewSoft than for valuing Capital Corp.

c. Recommend and justify a more appropriate dividend discount model for valuing NewSoft's common stock.

The risk-free rate of return is 10 %, the required rate of return on the market is 15 %, and High-Flyer stock has a beta coefficient of 1.5. If the dividend per share expected during the coming year, D1, is 2.50 dollars and g=5 %, at what price should a share sell?

Chiptech, Inc., is an established computer chip firm with several profitable existing products as well as some promising new products in development. The company earned 1 dollar a share last year, and just paid out a dividend of .50 dollar per share. Investors believe the company plans to maintain its dividend payout ratio at 50 %. ROE equals 20 %. Everyone in the market expects this situation to persist indefinitely.

a. What is the market price of Chiptech stock? The required return for the computer chip industry is 15 %, and the company has just gone ex-dividend (i.e., the next dividend will be paid a year from now, at t=1 ).

b. Suppose you discover that Chiptech's competitor has developed a new chip that will eliminate Chiptech's current technological advantage in this market. This new product, which will be ready to come to the market in 2 years, will force Chiptech to reduce the prices of its chips to remain competitive. This will decrease ROE to 15 %, and, because of falling demand for its product, Chiptech will decrease the plowback ratio to .40. The plowback ratio will be decreased at the end of the second year, at t=2 : The annual year-end dividend for the second year (paid at t=2 ) will be 60 % of that year's earnings. What is your estimate of Chiptech's intrinsic value per share? (Hint: Carefully prepare a table of Chiptech's earnings and dividends for each of the next 3 years. Pay close attention to the change in the payout ratio in t=2.)

c. No one else in the market perceives the threat to Chiptech's market. In fact, you are confident that no one else will become aware of the change in Chiptech's competitive status until the competitor firm publicly announces its discovery near the end of year 2. What will be the rate of return on Chiptech stock in the coming year (i.e., between t=0 and t=1 )? In the second year (between t=1 and t=2 )? The third year (between t=2 and t=3 )? (Hint: Pay attention to when the market catches on to the new situation. A table of dividends and market prices over time might help.)