Question 1

Klister Corporation currently pays dividends of $2.75.The current market price of one share in Klister Corporation is $38.If the growth rate is thought to be 7.5%,what is the implied cost of equity capital?

Accepted Answer

Rearranging equation 11.9,we can obtain the implied cost of equity capital in the following way: k_e = [2.75(1.075)/38] + 0.075 = 0.152 = 15.2%.

Question 2

The dividend payout ratio of a firm is 40%.If the cost of equity capital for the firm is 10% p.a.and the corporate tax rate is 30%,calculate the plowback ratio.

Accepted Answer

The plowback ratio is simply 1 - payout ratio: 1 - 0.4 = 0.6 or 60%.

Question 3

MSB Ltd has a current share price of $14.55.If MSB has a constant expected growth rate of 5% and is expected to pay a dividend of $0.65 per share,what is MSB's cost of capital?

Accepted Answer

Using equation 11.10,we can estimate the cost of capital as follows:

Question 4

You work for an arm of a major merchant bank specialising in Australian equity stocks.It is company policy to use the earnings capitalisation model for valuation purposes and to calculate EPS forecasts using two approaches;one a random walk (RW)and the other a random walk with $0.05 drift (RWD).The EPS for PF Corporation is currently $0.25,and in the previous year EPS was $0.25.PF Corporation has a current share price of $4.25 and a cost of capital of 12%.Which of the following best represents your recommendation about PF Corporation under each approach?

Accepted Answer

Under the random walk model,the expected next period EPS is simply the most recent EPS figure.In this case,that is $0.25.Using the EPS model (equation 11.21)gives a valuation for PF Corporation of 0.25 / 0.12 = $2.08 (approximately),which suggests that PF Corporation is overvalued at the current price of $4.25.Using the random walk with drift model results in an expected next period EPS of $0.30 gives a valuation for PF Corporation of 0.30/0.12 = $2.50,which also suggests that PF Corporation is overvalued at the current price of $4.25.Therefore,both the random walk (RW)and random walk with drift (RWD)models suggest that the shares in PF Corporation are overpriced.Hence the recommendation is that we should short-sell the stock.

Question 5

You work for an arm of a major merchant bank specialising in Australian equity stocks.It is company policy to use the earnings capitalisation model for valuation purposes and to calculate EPS forecasts using two approaches: a random walk (RW)and a random walk with $0.05 drift (RWD).The EPS for PF Corporation is currently $0.35,and in the previous year the EPS was $0.32.PF Corporation has a current share price of $4.70 and a cost of capital of 7%.Which of the following best represents your recommendation about PF Corporation under each approach?

Accepted Answer

Under the random walk model,the expected next period EPS is simply the most recent EPS figure.In this case,that is $0.30.Using the EPS model (equation 11.21)gives a valuation for PF Corporation of 0.30 / 0.07 = $4.29 (approximately),which suggests that PF Corporation is overvalued at the current price of $4.70.Using the random walk with drift model results in an expected next period EPS of $0.35 gives a valuation for PF Corporation of 0.35/0.07 = $5.00,which suggests that PF Corporation is undervalued at the current price of $4.70.Therefore,the random walk (RW)suggests that shares in PF Corporation are overvalued and hence a short-sell strategy should be adopted,while the random walk with drift (RWD)models suggests that the shares in PF Corporation are underpriced,and hence we should buy the stock.

Question 6

Company ABC currently pays annual dividends of $0.40,and growth of these dividends is expected to be at 5% p.a.Given a cost of equity capital of 10%,what is the estimated current share price of ABC?

Accepted Answer

Using equation 11.9,we can calculate the current share price of ABC as follows: 0.40 (1.05)/(0.1 - 0.05)= 8.40.

Question 7

If Minion Ltd has a price of $47.50 and current EPS of $3.50,what is Minion's cost of capital?

Accepted Answer

Using equation 11.22,we can compute the cost of capital as follows: 3.50/47.50 = 0.073684 = 7.36%.

Question 8

Assume that the current earnings per share of Uschi Ltd is $0.57.Uschi Ltd is not expected to experience any growth.The company has an estimated cost of capital of 15.75%.What is the PV of Uschi Ltd shares?

Accepted Answer

Using equation 11.22,we can estimate the PV of Uschi Ltd shares as follows: 0.57/0.1575 = 3.61906 = $3.62.

Question 9

You work for an arm of a major merchant bank specialising in Australian equity stocks.It is company policy to use the earnings capitalisation model for valuation purposes and to calculate EPS forecasts using two approaches;a random walk (RW)and a random walk with $0.05 drift (RWD).The EPS for PF Corporation is currently $0.50,and in the previous year EPS was $0.52.PF Corporation has a current share price of $5.60 and a cost of capital of 8%.Which of the following best represents your recommendation about PF Corporation under each approach?

Accepted Answer

Under the random walk model,the expected next period EPS is simply the most recent EPS figure.In this case,that is $0.50.Using the EPS model (equation 11.21)gives a valuation for PF Corporation of 0.50 / 0.08 = $6.25,which suggests that PF Corp.is undervalued at the current price of $5.60.Using the random walk with drift model results in an expected next period EPS of $0.55 gives a valuation for PF Corp.of 0.55 / 0.08 = $6.88 (approximately),which also suggests that PF Corp.is undervalued at the current price of $5.60.Therefore,both the random walk (RW)and random walk with drift (RWD)models suggest that the shares in PF Corp are underpriced.Hence the recommendation is that we should buy the stock.

Question 10

Shares in Anza Ltd are currently trading at a P/E ratio of 17.0.If the current price of Anza Ltd shares is $8.60,what is expected future price of the share?

Accepted Answer

Using equation 11.22,the cost of equity capital for Anza Ltd.is simply the inverse of the P/E ratio;that is,k_e = 1/(P/E)= 1/(17.0)= 0.0588 or 5.9%.The cost of equity capital is also the expected return for the stock.Therefore,the price is expected to increase from $8.60 to 8.60(1.059)= 9.1074 or $9.11.

Question 11

MAB Ltd has just announced its latest dividend at $0.60 per share.If MAB has a constant expected growth rate of 5% and a cost of capital of 7%,which of the following is the best estimate of the value of MAB Ltd's shares?

Accepted Answer

Using equation 11.10,we can estimate the value of MAB Ltd shares as follows: PV = 0.6/(0.07 - 0.05)= $30.

Question 12

A company has revenues of $170 000,expenses of $45 000 and tax of $37 500.If the company also has a working capital level of $25 000 and the corporate tax rate is 30%,estimate the level of free cash flows for the firm.

Accepted Answer

Using the FCF model,we estimate the level of FCF for the firm as follows: revenues - (expenses + tax)+ working capital: 170 000 - (45 000 + 37 500)+ 25 000 = $112 500.

Question 13

If a company with a share price of $6 has earnings per share of $0.15,calculate the cost of capital for the firm.

Accepted Answer

Rearranging equation 11.24,we can compute the cost of capital for the firm as follows: 0.15/6 = 0.025.

Question 14

Grott and Perrin,Inc.has expected earnings of $3 per share for next year.The firm's ROE is 20%,and its earnings retention ratio is 70%.If the firm's cost of capital is 15%,what is the present value of its growth opportunities?

Accepted Answer

Value with no growth = $3/0.15 = $20

Question 15

A firm has a dividend payout ratio of 20%,annual profit of $20 000 and a market value of equity equal to $150 000.Given a corporate tax rate of 30%,estimate the growth rate in dividends.

Accepted Answer

To obtain the growth rate,we need the following inputs: growth rate: plowback ratio F1F1F1S1F1F1F10 ROE;plowback ratio: 1 - payout ratio;ROE: profits/equity;growth rate: plowback ratio F1F1F1S1F1F1F10 ROE.ROE = 20 000/150 000 = 0.133333,growth rate = (1 - 0.2)F1F1F1S1F1F1F10 0.1333 = 0.1067 or 10.67%.

Question 16

If shares in Ursula Ltd are currently trading at a P/E ratio of 12.4,what is the implied cost of capital?

Accepted Answer

Using equation 11.22,the cost of equity capital is simply the inverse of the P/E ratio;that is,k_e = 1/(P/E)= 1/(12.4)= 0.0806 or 8.1%.

Question 17

Generally speaking,the higher a firm's ROA (return on assets),the _________ the dividend payout ratio and the _________ the firm's growth rate of earnings.

Accepted Answer

ROA ratio: profits/assets,payout ratio: dividends/profits.So the higher ROA,the higher profits,the lower payout ratio and the higher plowback ratio (1- payout ratio)

Question 18

Assume Luna Ltd pays a mixture of both franked and unfranked dividends.The current dividend just paid is $0.80,of which 40% is franked.The expected constant growth rate is 5% and the estimated cost of capital is 9%.Given a corporate tax rate of 30%,what is the present value of one share in Luna Ltd?

Accepted Answer

Following example 11.10,we can compute the present value of one share in Luna Ltd in the following way: franked dividend: 0.80 F1F1F1S1F1F1F10 0.4 = $0.32.Grossed-up franked dividend: $0.32/(1 - 0.30)= $0.46.Tax credit: $0.46 - $0.32 = $0.14.PV = [(0.80 + 0.14)(1.05)]/[0.09 - 0.05] = $24.68.

Question 19

An investor estimates that a company has a maintainable constant level of EPS of $1.20.The investor also estimates the cost of equity capital to be 14%.New projects adopted for the next three years are expected to generate net returns equal to $4.70,$7.90 and $8.10 in years 1,2 and 3 respectively.What is the present value of one share in this company?

Accepted Answer

Using equation 11.24,we compute the present value of one share as follows: value the maintainable constant earnings: PV_e = 1.20/0.14 = $8.57.Value the growth opportunities: PV (GO)= 4.70/1.14 + 7.90/(1.14)² + 8.10/(1.14)³ = $15.67.Add both components together: 8.57 + 15.67 = $24.24.

Question 20

Annie's Donut Shops,Inc. ,has just paid a dividend of $3.The firm's ROE is 18%,and its earnings retention ratio is 60%.If the firm's cost of capital is 12%,what is the value of the firm excluding any growth opportunities?

Accepted Answer

Value with no growth = $3/0.12 = $25 using equation 11.11

Quiz 11: Equity Valuation Models

Klister Corporation currently pays dividends of $2.75.The current market price of one share in Klister Corporation is $38.If the growth rate is thought to be 7.5%,what is the implied cost of equity capital?

The dividend payout ratio of a firm is 40%.If the cost of equity capital for the firm is 10% p.a.and the corporate tax rate is 30%,calculate the plowback ratio.

MSB Ltd has a current share price of $14.55.If MSB has a constant expected growth rate of 5% and is expected to pay a dividend of $0.65 per share,what is MSB's cost of capital?

Company ABC currently pays annual dividends of $0.40,and growth of these dividends is expected to be at 5% p.a.Given a cost of equity capital of 10%,what is the estimated current share price of ABC?

If Minion Ltd has a price of $47.50 and current EPS of $3.50,what is Minion's cost of capital?

Assume that the current earnings per share of Uschi Ltd is $0.57.Uschi Ltd is not expected to experience any growth.The company has an estimated cost of capital of 15.75%.What is the PV of Uschi Ltd shares?

Shares in Anza Ltd are currently trading at a P/E ratio of 17.0.If the current price of Anza Ltd shares is $8.60,what is expected future price of the share?

MAB Ltd has just announced its latest dividend at $0.60 per share.If MAB has a constant expected growth rate of 5% and a cost of capital of 7%,which of the following is the best estimate of the value of MAB Ltd's shares?

A company has revenues of $170 000,expenses of $45 000 and tax of $37 500.If the company also has a working capital level of $25 000 and the corporate tax rate is 30%,estimate the level of free cash flows for the firm.

If a company with a share price of $6 has earnings per share of $0.15,calculate the cost of capital for the firm.

Grott and Perrin,Inc.has expected earnings of $3 per share for next year.The firm's ROE is 20%,and its earnings retention ratio is 70%.If the firm's cost of capital is 15%,what is the present value of its growth opportunities?

A firm has a dividend payout ratio of 20%,annual profit of $20 000 and a market value of equity equal to $150 000.Given a corporate tax rate of 30%,estimate the growth rate in dividends.

If shares in Ursula Ltd are currently trading at a P/E ratio of 12.4,what is the implied cost of capital?

Generally speaking,the higher a firm's ROA (return on assets) ,the _ the dividend payout ratio and the _ the firm's growth rate of earnings.

Assume Luna Ltd pays a mixture of both franked and unfranked dividends.The current dividend just paid is $0.80,of which 40% is franked.The expected constant growth rate is 5% and the estimated cost of capital is 9%.Given a corporate tax rate of 30%,what is the present value of one share in Luna Ltd?

Annie's Donut Shops,Inc. ,has just paid a dividend of $3.The firm's ROE is 18%,and its earnings retention ratio is 60%.If the firm's cost of capital is 12%,what is the value of the firm excluding any growth opportunities?

Quiz 11: Equity Valuation Models

Klister Corporation currently pays dividends of $2.75.The current market price of one share in Klister Corporation is $38.If the growth rate is thought to be 7.5%,what is the implied cost of equity capital?

The dividend payout ratio of a firm is 40%.If the cost of equity capital for the firm is 10% p.a.and the corporate tax rate is 30%,calculate the plowback ratio.

MSB Ltd has a current share price of $14.55.If MSB has a constant expected growth rate of 5% and is expected to pay a dividend of $0.65 per share,what is MSB's cost of capital?

Company ABC currently pays annual dividends of $0.40,and growth of these dividends is expected to be at 5% p.a.Given a cost of equity capital of 10%,what is the estimated current share price of ABC?

If Minion Ltd has a price of $47.50 and current EPS of $3.50,what is Minion's cost of capital?

Assume that the current earnings per share of Uschi Ltd is $0.57.Uschi Ltd is not expected to experience any growth.The company has an estimated cost of capital of 15.75%.What is the PV of Uschi Ltd shares?

Shares in Anza Ltd are currently trading at a P/E ratio of 17.0.If the current price of Anza Ltd shares is $8.60,what is expected future price of the share?

MAB Ltd has just announced its latest dividend at $0.60 per share.If MAB has a constant expected growth rate of 5% and a cost of capital of 7%,which of the following is the best estimate of the value of MAB Ltd's shares?

A company has revenues of $170 000,expenses of $45 000 and tax of $37 500.If the company also has a working capital level of $25 000 and the corporate tax rate is 30%,estimate the level of free cash flows for the firm.

If a company with a share price of $6 has earnings per share of $0.15,calculate the cost of capital for the firm.

Grott and Perrin,Inc.has expected earnings of $3 per share for next year.The firm's ROE is 20%,and its earnings retention ratio is 70%.If the firm's cost of capital is 15%,what is the present value of its growth opportunities?

A firm has a dividend payout ratio of 20%,annual profit of $20 000 and a market value of equity equal to $150 000.Given a corporate tax rate of 30%,estimate the growth rate in dividends.

If shares in Ursula Ltd are currently trading at a P/E ratio of 12.4,what is the implied cost of capital?

Generally speaking,the higher a firm's ROA (return on assets) ,the _________ the dividend payout ratio and the _________ the firm's growth rate of earnings.

Annie's Donut Shops,Inc. ,has just paid a dividend of $3.The firm's ROE is 18%,and its earnings retention ratio is 60%.If the firm's cost of capital is 12%,what is the value of the firm excluding any growth opportunities?

Generally speaking,the higher a firm's ROA (return on assets) ,the _ the dividend payout ratio and the _ the firm's growth rate of earnings.