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Chapter 3 Solutions

The value of a bond depends on the present value of its expected cash flows, which are the coupon payments and principal repayment. The yield, or required rate of return, depends on the bond's riskiness. For a zero coupon bond with no coupon payments, its yield still depends on the risk of default. A stock repurchase reduces future earnings per share less than an equal dividend payment because the repurchase also reduces shares outstanding. However, neither creates value for shareholders, as the change in earnings per share does not affect total firm value. Some shareholders may prefer repurchases if capital gains are taxed at a lower rate than dividends. Paying a dividend reduces share price by the amount of the dividend

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257 views5 pages

Chapter 3 Solutions

The value of a bond depends on the present value of its expected cash flows, which are the coupon payments and principal repayment. The yield, or required rate of return, depends on the bond's riskiness. For a zero coupon bond with no coupon payments, its yield still depends on the risk of default. A stock repurchase reduces future earnings per share less than an equal dividend payment because the repurchase also reduces shares outstanding. However, neither creates value for shareholders, as the change in earnings per share does not affect total firm value. Some shareholders may prefer repurchases if capital gains are taxed at a lower rate than dividends. Paying a dividend reduces share price by the amount of the dividend

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hanh4tran-1
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C3.9. Yes.

The value of a bond depends on the coupon rate because the value of the bond is the
present value of the cash flows (including coupon payments) that the bond pays. But the yield is
the rate at which the cash flows are discounted and this depends on the riskiness of the bond, not
the coupon rate. Consider a zero coupon bond it has no coupon payment, but a yield that
depends on the risk of not receiving payment of principal.
C3.10. Yes. Dividends reduce future eps: with fewer assets in the firm, earnings are lower but
shares outstanding do not change. A stock repurchase for the same amount as the dividend
reduces future earnings by the same amount as the dividend, but also reduces shares outstanding.
But firms should not prefer stock purchases for these reasons because the change in eps
does not amount to a change in value. See the next question. Shareholders may prefer stock
repurchases if capital gains are taxed at a lower rate than dividend income.

C3.11. No. Dividends reduce the price of a firm (and the per-share price). But shareholder
wealth is not changed (at least before the taxes they might have to pay on the dividends) because
they have the dividend in hand to compensate them for the drop in the share price. In a stock
repurchase, total equity value drops by the amount of the share repurchase, as with the dividend.
Shareholders who tender shares in the repurchase are just as well off (as with a dividend)
because they get the cash value of their shares. The wealth of shareholders who did not
participate in the repurchase is also not affected: share repurchases at market price do not affect
the per-share price. So share repurchases do not create value for any shareholders.
Subsequent eps are higher with a stock repurchase than with a dividend (as explained in
the answer to question C3.10). Shareholders who tendered their shares in the repurchase earn
from reinvesting the cash received, as they would had they received a dividend. Shareholders

who did not tender have lower earnings (because assets are taken out of the firm) but higher
earnings per share to compensate them from not getting the dividend to reinvest.

C3.12. No. Paying a dividend actually reduces share value by the amount of the dividend (but
does not affect the cum-dividend value). Shareholders are no better off, cum-dividend. Of course,
it could be that firms that pay higher dividends are also more profitable (and so have higher
prices), but that is due to the profitability, not the dividend.
E3.1. Calculating a Price from Comparables
P/E for the comparable firm = 100/5 = 20
P/B for the comparable firm = 100/50 = 2
Price for target, from earnings = $2.50 20 = $50 per share
Price for target, form book value = $30 2 = $60 per share
Average of the two prices = $55 per share
E3.2. Stock Prices and Share Repurchases
Market value of equity before repurchase = 100 $20 = $2,000 million
Amount of repurchase
= 10 $20 = 200
Market value after repurchase
$1,800 million
Market price per share after repurchase

= $1,800/90 = $20

E3.3 Unlevered (Enterprise) Multiples


Market price of equity = 80 $7 = $560 million
Market value of debt
140
(assumes book value market value)
Market value of enterprise
$700 million
Book value of shareholders equity = $250 - 140 = $110million
a. P/B = 560/110 = 5.09
b. Unlevered P/S = 700/560 = 1.25
c. Enterprise P/B = 700/250 = 2.8

E3.5. Valuing Bonds


For this question, first calculate discount factors for each of five years ahead. You can also get
them from present value tables where the discount factor is given as 1/1.05t. At a 5% required
return, the discount factors are:
Year Ahead (t)
1
2
3
4
5

Discount factor (1.05t)


1.05
1.1025
1.1576
1.2155
1.2763

a. The only cash flow is the $1,000 at maturity


Present value (PV) of $1,000 five years hence = $1,000/1.2763
= $783.51
b. This is easy. If the coupon rate is the required rate of return, the bond is worth its face
value, $1,000. You can show this by working the problem as in part b, but with an annual
coupon of $50.
c. The yearly cash flows and their present value are:
Year Ahead (t)
1
2
3
4
5

Discount factor (1.05t)


1.05
1.1025
1.1576
1.2155
1.2763

Total Present Value

Cash Flow
40
40
40
40
1, 040

PV
38.10
36.28
34.55
32.91
814.86
$956.70

(Your answers might differ by a couple of cents if you use discount factors to 5 or 6 decimal
places.)

E3.6. Applying Present Value Calculations to Value a Building


This is a straight forward present value problem: the required return--the discount rate--is
applied to forecasted net cash receipts to convert the forecast to a valuation:
Present value of net cash receipts of 1.1 million
for 5 years at 12% (annuity factor is 3.6048)

$3.965 million

Present value of $12 million terminal payoff at


end of 5 years (present value factor is 0.5674)
Value of building

E3.7

6.809
$10.774

The Method of Comparables: Dell, Inc.

First calculate the multiples for the comparable firms from the price and accounting numbers:

Hewlett-Packard Co.
Lenovo Group Ltd.

Sales

Earnings

Book
Value

Market
Value

$84,229
14,560

$ 7,264
161

$38,526
1,134

$115,700
6,381

HP:
Price/Sales = 1.37
P/E
= 15.93
P/B
= 3.00
Lenovo:
Price/Sales = 0.44
P/E
= 39.63
P/B
= 5.63
Now apply the multiples to Dell:
Average Multiples
for Comparable

Dells
Number

Dells
Valuation

Sales
Earnings
Book value
Average of valuations

0.91
27.78
4.32

x
x
x

61,133
2,947
3,735

=
=
=

$55,631 million
81,868
16,135
51,211

With 2,060 million shares outstanding, the estimated value per share
= $51,211/2,060 = $24.86
Difficulties:
- The comparables are not exactly like Dell. They have different
aspects in operationsHP has a big printer business, for example. One
firm may be a dominant firm in an industry, and thus not a comparable
for others.
- The calculation assumes the market prices for the comps are
efficient
- Not sure how to weight the three valuation based on sales, earnings
and book values; the valuations differ considerably, depending on the
multiple used
E3.8. Pricing Multiples: General Mills, Inc.

P/E

P S
1
1.6
15.38
S E
0.104

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