Managerial Finance

Stocks Supplemental Practice Problem Set

1.) As an analyst, you have been tasked to value Altria (NYSE: MO) common stock. MO just
paid a dividend of $1.68 per share for the most recent year. You have estimated a required
return for MO of 12%, and you learn from the firms annual report that MO expects
dividends to grow at a perpetual growth rate of 7%. You believe that the growth estimate is
reasonable. What is your estimate of the per-share value of MO?

2.) BP PLC (NYSE: BP) has a current stock price of $50 and just paid a dividend of $1.50. The
dividend is expected to grow at 5% annually. The required return on stocks of similar risk is
determined to be 9.6%.
a. What is next years projected dividend?
b. Using the constant-growth DDM, what is the value of BP?
c. Based upon your result in part b and the current stock price, would you recommend
purchasing the stock? Explain.
d. Assuming the constant-growth DDM model is valid, what dividend growth rate would
result in a model value equal to its current market price?

3.) NiSource (NYSE: NI-B) currently employs a corporate strategy that includes a 100% payout
ratio. The most recent earnings (net income) was $3.88 per share. If the required rate of
return is 7.88%, what is the value of one share? If the price of this NiSource stock was $46.00,
what would be the required rate of return?

4.) Ford (NYSE: F) is expected to pay a $0.60 dividend next year. The dividend is expected to
grow at a 50% annual rate for years 2 and 3, at 20% annually for years 4 and 5, and at 5%
annually for years 6 and thereafter. If the required rate of return on investments of similar
risk is 12%, what is the value per share?

5.) Google (NASDAQ: GOOG) is currently paying no dividend and is not expected to pay a
dividend for several years. After thorough research, you determine that the companys
prospects suggest that Google will start paying a dividend of $2.00 eight years from now, and
the dividend is expected to grow at 5% thereafter. Assume the required rate of return is 11%.
Calculate the current share price of Google.

6.) Investors in General Electric (NYSE: GE) require a rate of return of 12.2%. GE just paid a
dividend of $2.00 and the dividend is expected to grow at 5% indefinitely.
a. What is the current value of a share of GE?
b. Assuming you observe that GEs stock price is currently $40. What dividend growth rate
would be required to justify a $40 stock price?

7.) In the year just ended, Disney (NYSE: DIS) began the year with total shareholders equity of
$1 million. During the year, Disney earned $250,000 net income and paid dividends of
$100,000.
a. What is Disneys payout ratio?
b. What is Disneys retention ratio?
c. What is Disneys return on equity (ROE) for the recent year?
d. What is Disneys sustainable growth rate?

Now assume that another year elapses at Disney and that Disney earns the same ROE as you
found in part (c) above. Also, assume the firm retained the same payout ratio and retention
ratio as you found in parts (a) and (b) above.
 e. How much will Disney earn in net income?
f. What amount will Disney pay out as dividends?

8.) A start-up company has come out with a new product. As a result, the firm projects growth
of 20% per year for 4 years. By then, other firms will have copycat technology, competition
will drive down profit margins, and the sustainable growth rate will fall to 5% thereafter.
The most recent annual dividend was $1.00 per share. Assume a discount rate of 10%.

a. What is the stock price today?

b. Using your answer from part c, what is the current dividend yield?

9.) Home Depot (NYSE: HD) projects a return on equity of 20% on new projects. Management
plans to retain 30% of all earnings into the firm. Earnings this year will be $3.00 per share,
and investors require a 12% rate of return on the stock.

a. What is Home Depots sustainable growth rate?

b. Using your answer for growth from part a, what is the value of the stock today?
c. Calculate Home Depots P/E ratio.

10.) McDonalds (NYSE: MCD) has been growing at a rate of 6% per year and is expected to
continue to so indefinitely. Earnings per share are expected to be $8.00 per share and the
next dividend is expected to be $5.00 per share.

a. If the market expects a 10% rate of return on McDonalds, at what price must it be selling
currently?
b. Calculate McDonalds retention ratio and payout ratio.

11.) EFS Corporation, a small company in the grocery business, expects to pay out its first
dividend next year in the amount of $2.50 per share. Based upon current cash flow
projections, management has indicated that they plan to increase the annual dividend per
share by 20% for the following 3 years and then increase it by 5% every year thereafter.

Assuming a required return of 13%, calculate the per-share intrinsic value of EFS using the
dividend discount model.

12.) ABC Corporation has been experiencing rapid growth in recent years. As an analyst, you are
attempting to value ABC shares utilizing the dividend discount model. You expect the firms
first ever dividend of $3.50 per share to be paid 6 years from today (end of year 6). Your
growth forecast in dividends for ABC includes growth of 25% in the following three years
(years 7-9) before declining to a perpetual growth rate of 4% (starting in year 10). You have
estimated the required rate of return for ABC to be 10%.

Calculate the per-share intrinsic value of ABC using the multi-stage (two-stage) dividend
discount model.

13.) Goldman Sachs has a preferred stock issue (GS-PB) outstanding with a par value per share of
$25. The stated annual dividend on the preferred stock is 6.20%, or $1.55 per share per year.
The current price per share of the preferred stock is $22.15. Given the current price, what is
the implied return that investors are requiring for their investment in this Goldman Sachs
preferred issue?
 Managerial Finance
Stocks Supplemental Practice Problem Set Solutions

1.) As an analyst, you have been tasked to value Philip Morris (NYSE: MO) common stock. MO
just paid a dividend of $1.68 per share for the most recent year. You have estimated a
required return for MO of 12%, and you learn from the firms annual report that MO expects
dividends to grow at a perpetual growth rate of 7%. You believe that the growth estimate is
reasonable. What is your estimate of the per-share value of MO?

Answer:
Start by using the most recent paid dividend of $1.68 (D0) to calculate next years dividend
(D1) using the 7% growth rate. Using the given discount rate of 12%, value the stock using the
constant-growth DDM formula:
DIV1 DIV0 (1+ g)
P0 = =
(r g) (r g)
$1.68(1.07) $1.7976
P0 = = = $35.95
(0.12 0.07) (0.05)

Thus, the value of MO is $35.95.

2.) BP PLC (NYSE: BP) has a current stock price of $50 and just paid a dividend of $1.50. The
dividend is expected to grow at 5% annually. The required return on stocks of similar risk is
determined to be 9.6%.

a. What is next years projected dividend?

Answer:
Next years dividend is simply the current dividend of $1.50, increased by 5%:
DIV1 = DIV0 (1 + g ) = $1.50(1 + 0.05) = $1.50(1.05) = $1.575

b. Using the constant-growth DDM, what is the value of BP?

Answer:
Using the constant growth DDM formula and the dividend in one year calculated in part
(a) above:
DIV1 $1.575 $1.575
P0 = = = = $34.24 (rounded)
(r g ) (0.096 0.05) (0.046)

c. Based upon your result in part b and the current stock price, would you recommend
purchasing the stock? Explain.

Answer:
Given that BPs stock is currently selling for $50 and we believe that the DDM model
value of $34.24 is correct, it would not be wise to purchase the overvalued stock at $50
since we assume that the stock will eventually gravitate downwards towards the value of
$34.24.

d. Assuming the constant-growth DDM model is valid, what dividend growth rate would
result in a model value equal to its current market price?

Answer:
 Again, we can calculate the growth rate from the constant growth DDM formula by
using the current price as the implied stock value (V0) (solve for g):
DIV0 (1+ g)
P0 =
(r g)
$1.50(1+ g)
$50 =
(0.096 g)
$50(0.096 g) = $1.50(1+ g)
$4.8 50g = $1.50 +1.50g
$3.3 = 51.5g
g = 3.3 / 51.5
g = 0.06408

Therefore, at a current stock price of $50, with a discount rate of 9.6%, the implied
dividend growth is 6.40% (rounded). You can check your answer by plugging the 6.408%
into the constant-growth formula above and solving for V0. You should get $50.

3.) NiSource (NYSE: NI-B) currently employs a corporate strategy that includes a 100% payout
ratio. The most recent earnings (net income) was $3.88 per share. If the required rate of
return is 7.88%, what is the value of one share? If the price of this NiSource stock was $46.00,
what would be the required rate of return?

Answer:
Recall that a company with a 100% payout ratio is a no-growth firm since they are not
retaining any earnings (we assume for now they are not able to grow using outside
financing) within the firm for reinvestment but rather are paying out all earnings as
dividends. So, In this case, the earnings per share of $3.88 also represents the dividend per
share. With a no-growth firm, the companys earnings per share and dividend per share
remain unchanged year after year. We can value the stock as the stream of future dividends
(as a perpetuity, essentially, the same dividend every year forever that does not grow):
DIV $3.88
P0 = = = $49.24
r (0.0788)

If the current price of NiSource was equal to $46.00, we can simply use the same formula, but
in this case, solve for r:
DIV $3.88 $3.88
P0 = $46 = $46 r = $3.88 r = = 0.0843 r = 8.43%
r r $46
If the stock price was equal to $46.00, then the implied required rate of return is equal to
8.43%.

4.) Ford (NYSE: F) is expected to pay a $0.60 dividend next year. The dividend is expected to
grow at a 50% annual rate for years 2 and 3, at 20% annually for years 4 and 5, and at 5%
annually for years 6 and thereafter. If the required rate of return on investments of similar
risk is 12%, what is the value per share?

Answer:
The first step here is to calculate the expected dividends to be received in years 2, 3, 4 and 5:
 DIV1 = $0.60 (given)
DIV2 = DIV1 (1 + g ) = $0.60(1 + 0.50) = $0.60(1.50) = $0.90 (year 2 growth = 50%)
DIV3 = DIV2 (1 + g ) = $0.90(1 + 0.50) = $0.90(1.50) = $1.35 (year 3 growth = 50%)
DIV4 = DIV3 (1 + g ) = $1.35(1 + 0.20) = $1.35(1.20) = $1.62 (year 4 growth = 20%)
DIV5 = DIV4 (1 + g ) = $1.62(1 + 0.20) = $1.62(1.20) = $1.944 (year 5 growth = 20%)

Now, since the dividends grow starting at year 6 at the constant growth rate of 5%, we can
use the constant growth DDM formula to get the stock price in year 5 terms.
DIV6
P5 =
(r g )
We need to calculate the expected dividend in year 6 to use the formula above:
DIV6 = DIV5 (1 + g ) = $1.944(1 + 0.05) = $1.944(1.05) = $2.0412 (year 6 growth = 5%)

Now we can calculate the stock price in year 5 terms:

DIV6 $2.0412 $2.0412
P5 = = = = $29.16
(r g ) (0.12 0.05) (0.07 )

Important Note: Be aware that the stock price in year 5 terms is simply another way of
capturing the value of all future dividends into the indefinite future beyond year 5. That is
why we have this term in our calculation of todays stock price, we can now be calculated as:
DIV1 DIV2 DIV3 DIV4 DIV5 P5
P0 = + 2
+ 3
+ 4
+ 5
+
(1 + r ) (1 + r ) (1 + r ) (1 + r ) (1 + r ) (1 + r ) 5
$0.60 $0.90 $1.35 $1.62 $1.944 $29.16
P0 = + 2
+ 3
+ + +
(1.12) (1.12) (1.12) (1.12) 4 (1.12) 5 (1.12) 5
P0 = $20.89 (rounded)

This problem can be solved with a financial calculator:

Hit CF; then hit 2nd, Clr Work (bottom left key) this clears the CF memory.
Note: All FOi numbers between cash flows should default to 1.

C01 = $0.60
C02 = $0.90
C03 = $1.35
C04 = $1.62
C05 = $1.944 + $29.16 = $31.104
NPV; I = 12; down arrow, CPT NPV = $20.89

Thus, the current price of Ford stock given the expectation about dividends should be $20.89.

5.) Google (NASDAQ: GOOG) is currently paying no dividend and is not expected to pay a
dividend for several years. After thorough research, you determine that the companys
prospects suggest that Google will start paying a dividend of $2.00 eight years from now, and
the dividend is expected to grow at 5% thereafter. Assume the required rate of return is 11%.
Calculate the current share price of Google.

Answer:
 This problem can be solved with the constant-growth DDM, but note that the first dividend
does not come until year 8. Therefore, we can calculate the stock price in year 7 terms:
We know that:
DIV8 = $2.00
DIV8 $2.00 $2.00
P7 = = = = $33.33 (rounded)
(r g ) (0.11 0.05) (0.06)

Since we expect no dividends until year 8, the only present value calculation we have to
perform to find todays stock price is discount the price in year 7 terms to today:
P7 $33.33 $33.33
P0 = 7
= 7
= = $16.06 (rounded)
(1 + r ) (1 + 0.11) (1.11) 7

This problem can be solved with a financial calculator:

We know the value of the stock as of time 7 is $33.33 from first calculation; need to discount
the $33.33 back seven periods to time 0:
N=7
FV = $33.33
I/Y = 11
CPT PV = $16.06

Thus, the price of Google today should be equal to $16.06.

6.) Investors in General Electric (NYSE: GE) require a rate of return of 12.2%. GE just paid a
dividend of $2.00 and the dividend is expected to grow at 5% indefinitely.

a. What is the current value of a share of GE?

Answer:
This problem can be solved with the constant-growth DDM:
We know that:
DIV0 = $2.00
DIV1 = $2.00(1 + g ) = $2.00(1 + 0.05) = $2.00(1.05) = $2.10
DIV1 $2.10 $2.10
P0 = = = = $29.17 (rounded)
(r g ) (0.122 0.05) (0.072)

b. Assuming you observe that GEs stock price is currently $40. What dividend growth rate
would be required to justify a $40 stock price?

Answer:
If the current price of GEs stock was equal to $40.00, we can simply use the same
formula, but in this case, solve for g:

DIV0 (1+ g) $2.00(1+ g)

P0 = $40 = $40(0.122 g) = $2.00(1+ g)
$4.88(r40g
g) = $2 + 2g (0.122
$2.88=g)
42g g = 0.0686 g = 6.86%

Therefore, at a current stock price of $40, the implied dividend growth is 6.86%.
7.) In the year just ended, Disney (NYSE: DIS) began the year with total shareholders equity of
$1 million. During the year, Disney earned $250,000 net income and paid dividends of
$100,000.

a. What is Disneys payout ratio?

Answer:
The payout ratio is simply the proportion of net income paid out as dividends:
Dividends $100,000
Payout _ Ratio = = = 0.40 = 40%
Net _ Income $250,000
b. What is Disneys retention ratio?

Answer:
The retention ratio is simply the proportion of net income retained by the firm for
reinvestment:
Re tained _ Earnings $150,000
Re tention _ Ratio = = = 0.60 = 60%
Net _ Income $250,000

Note that, in any given year, it must be the case that:

DIVIDENDS PAID + AMT OF NET INCOME RETAINED FOR INVESTMENT = NET
INCOME

c. What is Disneys return on equity (ROE) for the recent year?

Answer:
The return on equity is simply calculated as:
Net _ Income $250,000
ROE = = = 0.25 = 25%
Beg _ Total _ Equity $1,000,000

d. What is Disneys sustainable growth rate?

Answer:
The sustainable growth rate is calculated as:

Growth Rate = ROE * Retention Ratio

= 0.25 * 0.60 = 0.15 g = 15%
Thus, the sustainable growth rate is equal to 15%

Now assume that another year elapses at Disney and that Disney earns the same ROE as you
found in part (c) above. Also, assume the firm retained the same payout ratio and retention
ratio as you found in parts (a) and (b) above.

e. How much will Disney earn in net income?

Answer:
Since Disney retained 60% of the $250,000 net income (Disney retains $150,000) at the end
of the first year, total shareholders equity will increase to $1,150,000 as a beginning
balance for year 2. If Disney earns the ROE of 25% like they earned in year 1 (you found
this in part c), then net income will be equal to:

Net Income = $1,150,000 x 25% = $287,500

 As a result of Disney retaining $150,000 for reinvestment from the first years profit, they
will be able to increase net income to $287,500 in year 2 (in comparison to $250,000 in
year 1).

f. What amount will Disney pay out as dividends?

Answer:
If Disney pays dividends in line with the payout ratio of year 1 (40%, you found this in
part a), then dividends at the end of year 2 will be equal to:

$287,500 (net income in year 2) * 40% (payout ratio) = $115,000

Thus, Disney is expected to pay dividends of $115,000 in year 2.

8.) A start-up company has come out with a new product. As a result, the firm projects growth
of 20% per year for 4 years. By then, other firms will have copycat technology, competition
will drive down profit margins, and the sustainable growth rate will fall to 5% thereafter.
The most recent annual dividend was $1.00 per share. Assume a discount rate of 10%.

a. What is the stock price today?

Answer:
DIV0 = $1.00 (given)
DIV1 = DIV0 (1 + g ) = $1.00(1 + 0.20) = $1.00(1.20) = $1.20 (year 1 g = 20%)
DIV 2 = DIV0 (1 + g ) 2 = $1.00(1 + 0.20) 2 = $1.00(1.20) 2 = $1.44 (year 2 g = 20%)
DIV3 = DIV0 (1 + g ) 3 = $1.00(1 + 0.20) 3 = $1.00(1.20) 3 = $1.728 (year 3 g = 20%)
4 4 4
DIV 4 = DIV0 (1 + g ) = $1.00(1 + 0.20) = $1.00(1.20) = $2.0736 (year 4 g = 20%)

Now, since the dividends grow starting at year 5 at the constant growth rate of 5%, we
can use the constant growth DDM formula to get the stock price in year 4 terms.
DIV5
V4 =
(r g)
We need to calculate the expected dividend in year 5 to use the formula above:
DIV5 = DIV4 (1 + g ) = $2.0736(1 + 0.05) = $2.0736(1.05) = $2.1773 (year 6 g = 5%)

Now we can calculate the stock price in year 5 terms:

DIV5 $2.1773 $2.1773
V4 = = = = $43.55 (rounded)
(r g) (0.10 0.05) (0.05)

Important Note: Be aware that the stock price in year 4 terms is simply another way of
capturing the value of all future dividends into the indefinite future beyond year 4.

To find todays stock price, simply calculate the present value of the four years of
dividends plus the price of the stock in year 4 terms:
DIV1 DIV2 DIV3 DIV4 V4
V0 = + + + +
(1+ r) (1+ r) (1+ r) (1+ r) (1+ r)4
2 3 4

$1.20 $1.44 $1.728 $2.0736 $43.55

V0 = + + + +
(1.10) (1.10)2 (1.10)3 (1.10)4 (1.10)4
 V0 = $34.74 (rounded)

This problem can be solved with a financial calculator:

Hit CF; then hit 2nd, Clr Work (bottom left key) this clears the CF memory.
Note: All FOi numbers between cash flows should default to 1.

C01 = $1.20
C02 = $1.44
C03 = $1.728
C04 = $2.0736 + $43.5456 = $45.6192
NPV; I = 10; down arrow, CPT NPV = $34.74

Thus, the price of the stock today given the expectation about dividends should be
$34.74.

b. Using your answer from part c, what is the current dividend yield?

Answer:
The current dividend is the next annual dividend to be received divided by the current
stock price. We calculated the next dividend as $1.20 and the stock price today is $34.74
(you found this in part c).

Dividend Yield = Current Annual Dividend / Current Stock Price

Dividend Yield = $1.20 / $34.74 = 0.0345 = 3.45%

9.) Home Depot (NYSE: HD) projects a return on equity of 20% on new projects. Management
plans to retain 30% of all earnings into the firm. Earnings this year will be $3.00 per share,
and investors require a 12% rate of return on the stock.

a. What is Home Depots sustainable growth rate?

Answer:
The sustainable growth rate is calculated as:
Growth Rate = ROE * Retention Ratio

The retention ratio and return on equity are both given in the problem as 30% and 20%,
respectively.
Growth Rate = 0.30 * 0.20 = 0.06 = 6.0%

Thus, the sustainable growth rate is equal to 6.0%

b. Using your answer for growth from part a, what is the value of the stock today?

Answer:
Assuming the growth rate is constant (perhaps I should have explicitly indicated this in
the question), we can use the constant growth DDM to find the stocks value:
DIV1
P0 =
(r g )
We first need to find the first year dividend. We are given the fact that earnings per
share are $3.00 and its retention ratio is 30%. Given a retention ratio of 30%, we know
 that the payout ratio must be 70%. If the firm pays out 70% of $3.00 in earnings per
share, this will result in a first year dividend of $2.10.

We use the growth rate we calculated in part a, and the 12% required rate of return
given:

DIV1 = $2.10
Now, we can calculate the share price:
DIV1 $2.10 $2.10
P0 = = = = $35.00
(r g ) (0.12 0.06) (0.06)

c. Calculate Home Depots P/E ratio.

Answer:
The price/earnings ratio is simply the current stock price by the expected annual
earnings ($3.00 was given as earnings per share). The stock price of $35.00 was calculated
in part b.

Therefore, the P/E ratio is equal to $35.00 / $3.00 = 11.67

10.) McDonalds (NYSE: MCD) has been growing at a rate of 6% per year and is expected to
continue to so indefinitely. Earnings per share are expected to be $8.00 per share and the
next dividend is expected to be $5.00 per share.

a. If the market expects a 10% rate of return on McDonalds, at what price must it be selling
currently?

Answer:
This problem can be solved with the constant-growth DDM:
We know that:
DIV1 = $5.00
DIV1 $5.00 $5.00
P0 = = = = $125.00
(r g ) (0.10 0.06) (0.04)

b. Calculate McDonalds retention ratio and payout ratio.

Answer:
We are given the fact that McDonalds expects earnings per share of $8.00 and dividends
per share of $5.00. Using the formulas for payout ratio and retention ratio (only
difference is that we are using per share data):

The payout ratio is simply the proportion of net income paid out as dividends:
Dividends $5.00
Payout _ Ratio = = = 0.625 = 62.5%
Net _ Income $8.00
 The retention ratio is simply the proportion of net income retained by the firm for
reinvestment:
Re tained _ Earnings $3.00
Re tention _ Ratio = = = 0.375 = 37.5%
Net _ Income $8.00

11.) EFS Corporation, a small company in the grocery business, expects to pay out its first
dividend next year in the amount of $2.50 per share. Based upon current cash flow
projections, management has indicated that they plan to increase the annual dividend per
share by 20% for the following 3 years and then increase it by 5% every year thereafter.

Assuming a required return of 13%, calculate the per-share intrinsic value of EFS using the
dividend discount model.

Answer:
The first step here is to calculate the expected dividends to be received in years 2-5. Why year
5? Because this is the first year in the constant growth period:

DIV1 = $2.50 (given)

DIV2 = DIV1 (1+ g) = $2.50(1+ 0.20) = $2.50(1.20) = $3.00 (year 2 growth = 20%)
DIV3 = DIV2 (1+ g) = $3.00(1+ 0.20) = $3.00(1.20) = $3.60 (year 3 growth = 20%)
DIV4 = DIV3 (1+ g) = $3.60(1+ 0.20) = $3.60(1.20) = $4.32 (year 4 growth = 20%)
DIV5 = DIV4 (1+ g) = $4.324(1+ 0.05) = $4.32(1.05) = $4.536 (year 5 growth = 5%)

Next, we calculate the present value of all of the dividends from year 5 to infinity (this
present value is in year 4 terms). We do this with the constant-growth model:
DIV5
V4 =
(r g)
DIV5 $4.536 $4.536
V4 = = = = $56.70
(r g) (0.13 0.05) (0.08)

Important Note: Be aware that the stock value in year 4 terms (V4) is simply another way of
calculating the present value of all future dividends into the indefinite from year 5 to infinity,
but in year4 terms.

Now, we need to discount all of the dividends in years 1-4, as well as the V4 value, back to
time zero: In other words, the value of the stock today is calculated as:
DIV1 DIV2 DIV3 DIV4 V4
P0 = + 2 + 3 + 4 +
(1+ r) (1+ r) (1+ r) (1+ r) (1+ r) 4
$2.50 $3.00 $3.60 $4.32 $56.70
P0 = + 2 + 3 + +
(1.13) (1.13) (1.13) (1.13) 4 (1.13) 4
P0 = $44.48 (rounded)

This problem can be solved with a financial calculator:

Hit CF; then hit 2nd, Clr Work (bottom left key) this clears the CF memory.
Note: All FOi numbers between cash flows should default to 1.

C01 = $2.50
 C02 = $3.00
C03 = $3.60
C04 = $4.32 + $56.70 = $61.02
NPV; I = 13; down arrow, CPT NPV = $44.48

Thus, the value of EFS stock given the expectation about dividends should be $44.48.

12.) ABC Corporation has been experiencing rapid growth in recent years. As an analyst, you are
attempting to value ABC shares utilizing the dividend discount model. You expect the firms
first ever dividend of $3.50 per share to be paid 6 years from today (end of year 6). Your
growth forecast in dividends for ABC includes growth of 25% in the following three years
(years 7-9) before declining to a perpetual growth rate of 4% (starting in year 10). You have
estimated the required rate of return for ABC to be 10%.

Calculate the per-share intrinsic value of ABC using the multi-stage (two-stage) dividend
discount model.

Solution:
Step 1. Forecast the dividends through the first year of the constant growth period.

The first step here is to calculate the expected dividends to be received in years 7-10. Why
year 10? Because this is the first year in the constant growth period:

DIV6 = $3.50
DIV7 = $3.50(1.25) = $4.375
DIV8 = $4.375(1.25) = $5.46875
DIV9 = $5.46875(1.25) = $6.835938
DIV10 = $6.835938(1.04) = $7.109375

Step 2. Calculate the terminal value.

Start by calculating the present value of all of the dividends from year 5 to infinity (this
present value is in year 4 terms). We do this with the Gordon growth (constant) growth
model:

DIV9
V9 = =
(r g)
$7.109375 $7.109375
V9 = = = $118.49
(0.10 0.04) (0.06)

Important Note: Be aware that the stock value in year 9 terms (V9) is simply another way of
calculating the present value of all future dividends into the indefinite from year 10 to
infinity, but in a present value as of end of year 9.

Step 3. Calculate the intrinsic value per share.

Now, we need to discount all of the dividends in years 6-9, as well as the V9 value, back to
time zero: In other words, the value of the stock today is calculated as:
 $3.50 $4.375 $5.46875 $6.835938 + $118.49
V0 = + + + = $59.92
(1.10)6 (1.10)7 (1.10)8 (1.10)9

The intrinsic value of EFS on a per share basis is $59.92.

This problem can be solved with a financial calculator (TI BA II Plus):

Hit CF key; then hit 2nd, Clr Work (bottom left key) this clears the CF memory.

C01 = $0
F01 = 5 (There are five consecutive years of zero cash flows, years 1-5)
C02 = $3.50 (This is really year 6)
C03 = $4.375 (This is really year 7)
C04 = $5.46875 (This is really year 8)
C04 = $6.835938 + $118.49 = $125.33 (This is really year 9)

NPV; I = 10; down arrow;

CPT NPV = $59.92 (rounded)

13.) Goldman Sachs has a preferred stock issue (GS-PB) outstanding with a par value per share of
$25. The stated annual dividend on the preferred stock is 6.20%, or $1.55 per share per year.
The current price per share of the preferred stock is $22.15. Given the current price, what is
the implied return that investors are requiring for their investment in this Goldman Sachs
preferred issue?

Solution:
Recall that a preferred stock is a perpetual life security that pays a fixed dividend.
The value of a preferred stock can be valued as the stream of future dividends (as a
perpetuity, essentially, the same dividend every year forever that does not grow):
DIV
V0 =
r
If the current price of the GS-PB is $22.15, we can simply use the same formula, but in this
case, solve for the implied required return (r):

DIV
V0 =
r
$1.55
$22.15 = $22.15r = $1.55
r
$1.55
r= = 0.069977 r = 7.00%
$22.15

Therefore, at the current price of $22.15, investors are demanding a required return of 7% for
the preferred shares.