1. Thress Industries just paid a dividend of $1.50 a share (i.e., D0 = $1.50).

The dividend is expected

to grow 5% a year for the next 3 years and then 10% a year thereafter. What is the expected
dividend per share for each of the next 5 years?

Year 1 = $1.50 × 1.05 = $1.58 Year 3 = $1.66 × 1.05 = $1.74 Year 5 = $1.91 × 1.10 = $2.10
Year 2 = $1.58 × 1.05 = $1.66 Year 4 = $1.74 × 1.10 = $1.91

2. Using the following input data for A&Z corporation, estimate the intrinsic stock price:
Constant free cash flow (FCF) = $20 million Debt = $35 million
Weighted average cost of capital (WACC) = 12% Preferred stock = $5 million
Short-term investments = $12 million Number of shares of common stock = 5 million

[Note
The Constant Growth Model: Estimating the Value of Operations when Expected Growth Is Constant
𝐹𝐶𝐹1
𝑉𝑜𝑝 (𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡 𝑔𝑟𝑜𝑤𝑡ℎ) =
𝑊𝐴𝐶𝐶 − 𝑔𝐿
Special Case: Valuation When Expected Free Cash Flow Grows at a Constant Rate (gL=0)
Consider A&Z Corporation generated $20 million in free cash flow in the most recent year. A&Z’s stockholders have
strong local ties and do not wish to expand. Therefore, A&Z expects to have a constant free cash flow (FCF) of $20
million each year for the foreseeable future. A&Z’s estimated weighted average cost of capital is 12%, which is the
rate A&Z must earn on its investments to fairly compensate its investors, a combination of debtholders, preferred
stockholders, and common stockholders.
Therefore, A&Z’s value of operations will be:
𝐹𝐶𝐹1 $20
𝑉𝑜𝑝 (𝑓𝑜𝑟 𝑎 𝑝𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦) = = = $166.67 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
𝑊𝐴𝐶𝐶 . 12
A&Z has $2 million in bank certificates of deposit, earning a little interest while A&Z decides how to use the funds.
Because A&Z does not need the $2 million to run its operations, these should be classified as short-term investments.

Total intrinsic value = Value of operations + Short-term investments= ($166.67 + $12) =$178.67 million
Intrinsic value of equity = Total intrinsic value - All debt - Preferred stock
= ($178.67-$35 - $5) million
= $138.67 million
Intrinsic stock price = Intrinsic value of equity/Number of shares
= $138.67 million/5 million
= $27.73 dollars per share]

Thus, inputs: Valuation Analysis:

Constant free cash flow (FCF) = $20 million Value of operations $166.67 million
Weighted average cost of capital (WACC) = 10% + ST investments $12 million
Short-term investments = $2 Estimated total intrinsic value $178.67 million
Debt = $28 − All debt $35 million
Preferred stock = $4 − Preferred stock $5 million
Number of shares of common stock = 5 Estimated intrinsic value of equity $138.67 million
÷ Number of shares 5 million
Estimated intrinsic stock price $27.73 dollar/share
3. et’s consider Medicare Corporation, a fast-growing company in the health care industry whose
cost of capital is found to be 12%. Medicare’s expected free cash flows (in millions) for the next
4 years are shown here:
Year 0 1 2 3 4 5
FCF (in million) -$40 $60 $90 $99 … …
Growth in FCF 50% 10% 5% 5%

Medicare expects to have a negative FCF in Year 1 due to the company’s rapid expansion. Free cash
flows become positive at Year 2 and grow rapidly for a couple of years. Medicare expects competition
and market saturation to reduce its growth rate after Year 4 to 5% for all years in the foreseeable
future. Estimate value of operations in year 0.
Also, let’s assume the following: Short-term investments = $10, Debt = $400 million, Preferred stock
= $40 million and number of shares of common stock = 50 million. Estimate the intrinsic stock price.

[Note: Medicare expects competition and market saturation to reduce its growth rate after Year 4 to 5% for all years
in the foreseeable future. This is why Medicare ends its explicit forecast period at Year 4. Because growth is constant
after Year 4, we can apply the constant growth formula at Year 4 to find the present value of all the cash flows from
Year 5 to infinity when discounted back to Year 4. This result is the horizon value at Year 4, HV 4. If growth in FCF is
expected to be constant after Year t, the general formula for the horizon value at Year t is:

𝐹𝐶𝐹𝑡 (1 + 𝑔𝐿 )
𝐻𝑉𝑡 = ]
𝑊𝐴𝐶𝐶 − 𝑔𝐿

We can apply this Equation to estimate Medicare’s horizon value at Year 4.

99(1 + .05)
𝐻𝑉4 = = 1485
. 12 − .05

The current value of operations Vop,0 is the present value of all future free cash flows discounted back to
Year 0.
𝐹𝐶𝐹1 𝐹𝐶𝐹2 𝐹𝐶𝐹3 𝐹𝐶𝐹4
𝑃𝑉 𝑜𝑓 𝐹𝐶𝐹 = 1
+ 2
+ 3
+
(1 + 𝑊𝐴𝐶𝐶) (1 + 𝑊𝐴𝐶𝐶) (1 + 𝑊𝐴𝐶𝐶) (1 + 𝑊𝐴𝐶𝐶)4

−$40 $60 $90 $99

= 1
+ 2
+ 3
+
(1 + .12) (1 + .12) (1 + .12) (1 + .12)4

= $139.091

𝐻𝑉4 1485
𝑃𝑉 𝑜𝑓 𝐻𝑉4 = 4
= = $943.43
(1 + 𝑊𝐴𝐶𝐶) (1 + .12)4
4
𝐹𝐶𝐹𝑡 𝐻𝑉4
𝑉𝑜𝑝,0 == ∑ 𝑡
+ = $139.091 + $943.43 = $1082.838
(1 + 𝑊𝐴𝐶𝐶) (1 + 𝑊𝐴𝐶𝐶)4
𝑡=1

Intrinsic stock price = ($1082.838+$.00001-$400-$40)/50 = $12.86

[Short term investment: $10 = .00001 million]
 4. Assume that ToysRus just paid a dividend of $1.50 (that is, D0 =$1.5). Its stock has a required
rate of return, rs, of 12.5%, and investors expect the dividend to grow at a constant 8% rate in
the future. Use Dividend Growth Model to estimate the intrinsic stock price.
Also, show what would happen if ToysRus was not yet in its constant growth phase and dividends
are expected to grow at a 25% rate for the first year, 20% for the second year, and 15% for the
third year, after which the growth rate is expected to fall to 8% and remain there.

D1 =$1.5(1.08) =$1.62

𝐷0 (1 + 𝑔𝐿 ) 𝐷1 $1.5(1 + .08) $1.62

⏞0 =
𝑃 = = = = 36
𝑟𝑠 − 𝑔𝐿 𝑟𝑠 − 𝑔𝐿 . 125 − .08 . 045

Year 0 1 2 3 →ꚙ
Growth rate 25% 20% 15% 8%
Dt D0 D1=D0(1+g0,1) D2=D1(1+g0,2) D3=D2(1+g0,2) 𝐷3 (1 + 𝑔𝐿 )
1.5 1.875 2.25 2.5875 ⏞
𝑝3 =
(𝑟𝑠 − 𝑔𝐿 )
2.5875(1 + .08)
=
. 125 − .08
2.7945
=
PVs of Dividends . 045
$1.67 = 62.1
PV of D1= D1/(1+rs) =1.875/(1+.125)
$1.78
PV of D2= D2/(1+rs) =2.25/(1+.125)2
$1.82
PV of D3= D3/(1+rs) =2.59/(1+.125)3
$43.62
PV of P3= P3/(1+rs) =62.1/(1+.125)3
$48.88
Vop
5. A company currently pays a dividend of $2 per share (D0 = $2). It is estimated that the company’s
dividend will grow at a rate of 20% per year for the next 2 years, then at a constant rate of 7%
thereafter. The company’s stock has a beta of 1.2, the risk-free rate is 7.5%, and the market risk
premium is 4%. What is your estimate of the stock’s current price?

Stock Required rate of return = rs = 0.075+ 1.2 * 0.04 = 12.3 %

D0 = $2, D1 = 2 * 1.2 = $ 2.40, D2 = 2.4 * 1.2 = $ 2.88, D3 = $ 3.0816
P2 = D3/(rs – g) = 3.0816/(0.123 – 0.07) = $58.14
PV of dividend D1 discounted at rs = 2.4/1.123 = $2.137
PV of dividend D2 discounted at rs = 2.88/(1.123)2 = $ 2.284
PV of Horizon Value = 58.14/(1.123)2 = $ 46.101
Stock’s current price = $2.137 + $ 2.284 + $ 46.101 = $50.53

6. Boehm Incorporated is expected to pay a $1.50 per share dividend at the end of this year (i.e., D1
= $1.50). The dividend is expected to grow at a constant rate of 7% a year. The required rate of
return on the stock, rs, is 15%. What is the value per share of Boehm’s stock?
Price = $1.50 / (0.15 - 0.07) = $18.75

7. Nick’s Enchiladas Incorporated has preferred stock outstanding that pays a dividend of $5 at the
end of each year. The preferred sells for $50 a share. What is the stock’s required rate of return?
Stock’s required rate of return = Dps / Vps Stock’s required rate of return = 5/50 = 10 %

8. Let’s suppose Tapley Products is a privately held firm whose forecasted earnings per share are
$7.50, and suppose the P/E ratio for a set of similar publicly traded companies are as follows.

Company ABC XYZ Patley Tetley

P/E 15 10 8 15

Estimate the intrinsic value of Tapley’s stock using market multiple method.

[Note: The Market Multiple Method

For example, suppose an analyst chooses earnings per share (EPS) as the metric, identifies a comparable group, and
calculates the price/earnings (P/E) ratio for each comparable firm. Multiplying the target company’s EPS by the
comparable group’s average P/E ratio provides an estimate of the target’s intrinsic stock price.]

Average P/E of the industry (similar company) = (15+10+8+15)/4 = 48/4 = 12

Intrinsic value of Tapley’s stock = $7.50 (12) = $90.
9. Woidtke Manufacturing’s stock currently sells for $20 a share. The stock just paid a
dividend of $1.00 a share (i.e., D0 = $1.00), and the dividend is expected to grow forever
at a constant rate of 10% a year. What is the required rate of return on Woidtke’s stock?

Stock price one year from now

The expected price of the stock 1 year from now is determined as follows.
• Expected price=Po(1+g)
where,
• Po = Current price
• g = Growth rate
In the given question:
• Po = $20 a share
• g = 10% a year
Therefore,
• Expected price=$20(1+0.1)
• Expected price=$22

Required rate of return on Woidtke's stock

We will use the constant growth dividend model to determine the required rate of return.
• Current stock price=D0∗(1+g)/(r−g)
where,
• Do = Current dividend
• g = Growth rate
• r = Required rate of return
In the given question, Woidtke Manufacturing has
• Do = $1.00 a share
• g = 10% a year
Therefore,
• $20=$1∗(1+0.1)/(r−0.1)
• $20=$1.1/(r−0.1)
• $20(r−0.1) =$1.1
• 20r−$2=$1.1
• 20r=$1.1+$2
We solve for r:
• r=$3.120
• r=0.155
• r=0.155∗100=15.5%
The required rate of return is 15.5%.