Econ 422 Problem Set 4 Solutions: Capital Budgeting and Stock Valuation - Prof. Eric Zivot, Assignments of Economics

Download Econ 422 Problem Set 4 Solutions: Capital Budgeting and Stock Valuation - Prof. Eric Zivot and more Assignments Economics in PDF only on Docsity! Econ 422 E. Zivot Summer 2008 Problem Set 4 Solutions BM Chapter 5 Practice Questions 5.14, 5.16, 5.18, 5.20 14. Newspaper exercise, answers will vary 16. $100.00 0.10 $10 r DIVP 1A === $83.33 .0400.10 $5 gr DIVP 1B =− = − = ⎟ ⎠ ⎞ ⎜ ⎝ ⎛ ×++++++= 6 7 6 6 5 5 4 4 3 3 2 2 1 1 C 1.10 1 0.10 DIV 1.10 DIV 1.10 DIV 1.10 DIV 1.10 DIV 1.10 DIV 1.10 DIVP $104.50 1.10 1 0.10 12.44 1.10 12.44 1.10 10.37 1.10 8.64 1.10 7.20 1.10 6.00 1.10 5.00P 6654321C =⎟⎠ ⎞ ⎜ ⎝ ⎛ ×++++++= At a capitalization rate of 10%, Stock C is the most valuable. For a capitalization rate of 7%, the calculations are similar. The results are: PA = $142.86 PB = $166.67 PC = $156.48 Therefore, Stock B is the most valuable. 18. a. Plowback ratio = 1 – payout ratio = 1.0 – 0.5 = 0.5 Dividend growth rate = g= Plowback ratio × ROE = 0.5 × 0.14 = 0.07 Next, compute EPS0 as follows: ROE = EPS0 /Book equity per share 0.14 = EPS0 /$50 ⇒ EPS0 = $7.00 Therefore: DIV0 = payout ratio × EPS0 = 0.5 × $7.00 = $3.50 EPS and dividends for subsequent years are: Year EPS DIV 0 $7.00 $7.00 × 0.5 = $3.50 1 $7.00 × 1.07 = $7.4900 $7.4900 × 0.5 = $3.50 × 1.07 = $3.7450 2 $7.00 × 1.072 = $8.0143 $8.0143 × 0.5 = $3.50 × 1.072 = $4.0072 3 $7.00 × 1.073 = $8.5753 $8.5753 × 0.5 = $3.50 × 1.073 = $4.2877 4 $7.00 × 1.074 = $9.1756 $9.1756 × 0.5 = $3.50 × 1.074 = $4.5878 5 $7.00 × 1.074 × 1.023 = $9.3866 $9.3866 × 0.5 = $3.50 × 1.074 × 1.023 = $4.6933 EPS and dividends for year 5 and subsequent years grow at 2.3% per year, as indicated by the following calculation: Dividend growth rate = g = Plowback ratio × ROE = (1 – 0.08) × 0.115 = 0.023 b. ⎟ ⎠ ⎞ ⎜ ⎝ ⎛ ×++++= 4 5 4 4 3 3 2 2 1 1 0 1.115 1 0.115 DIV 1.115 DIV 1.115 DIV 1.115 DIV 1.115 DIVP $45.65 1.10 1 0.023-0.115 4.693 1.115 4.588 1.115 4.288 1.115 4.007 1.115 3.745 44321 =⎟⎠ ⎞ ⎜ ⎝ ⎛ ×++++= The last term in the above calculation is dependent on the payout ratio and the growth rate after year 4. 20. a. If investors expected future oil prices to decline from what were then historically high levels in mid-2006, then investors’ expectations were that future earnings of the major oil companies would be less than earnings being reported at that time. Since stock price is the present value of future cash flows to stockholders, stock prices in mid-2006 were based on lower expected earnings (and dividends) and were therefore low relative to earnings in prior periods. b. Newspaper or Internet exercise; answers will vary BM Chapter 6 Quiz Questions 6. 3, 6.4, 6.5, 6.6, 6.7 See solutions at the back of the textbook.