Department of Finance Teaching Assistants

1F0228 FINANCIAL ECONOMICS I (A) Lucía Lastarria / Victor Córdova

TUTORIAL N° 02

Question 1
Considering Gordon's growth model with constant growth rate for dividends, if there
is an increase in the rate of return required by investors, what happens to the share
price?
a. Increases
b. Decreases
c. Increases or decreases depending on the relationship between the
required return on capital and ROE
Caso 1
D0 D0
P0= + +…
( 1+r ) (1+r )2
D
P0= 0
r

Caso 2
2 3
D ( 1+ g ) D0 ( 1+ g ) D0 (1+ g )
P 0= 0 + + +…
( 1+r ) ( 1+ r )2 (1+ r )3
D0 ( 1+ g )
P0=
r −g

Caso 3

D0 ( 1+ g1 ) D0 ( 1+ g1 )2 D0 ( 1+ g1 )3 D 0 ( 1+ g1 )3 ( 1+ g 2 )
P 0= + + + +…
(1+r ) (1+ r )2 ( 1+r )3 ( 1+ r )4

P0=P A + PB
3
D 0 ( 1+ g1 ) ( 1+ g 1 )
PA= ∗[1− ]
( r−g1 ) ( 1+r )3
3
'
D0 ( 1+ g1 ) ( 1+ g2 )
P B=
( r −g2 )

3
D0 ( 1+ g 1 ) ( 1+ g2 )
'
PB ( r−g 2)
PB = 3
= 3
( 1+ r ) ( 1+ r )
If the required return increases, then the diference between the required return and
the expected growth increases. Therefore, the price decreases as the discount rate
increases.

Question 2
A higher growth rate (g) relates to:
a. A higher dividend payment ratio
b. A lower retention rate
c. A higher ROE

g = retention rate * ROE, o (1- rate on dividend payment)*ROE. Higher ROE.

Question 3
If the price of a stock is $ 30, a dividend of $ 2 is expected in 1 year and a stable
growth rate of 4% (given), what is the market discount rate?

a. 7.5%
b. 10.67%
c. 9%

D1 D1
P 0= → r= + g
r −g P0

2
r= +4 %=10.67 %
30

Question 4
The P/E of a company with endogenous growth can never equal the P/E of a
company without growth. Also, utility company reinvestments always increase the
P/E of a stock.

False.
P (1−b)
with endogenous growth=
E ( r−ROE∗b )

If r=ROE
P (1−b)
=
E ¿¿

Therefore, the P / E of a firm with endogenous growth will be similar to that of a

2
The answer will depend on whether the reinvestment will have higher returns than my
opportunity cost.

Question 5
You are a leading analyst at Foro Capital and are looking for profitable stocks to
recommend. You are analyzing the stock of SEL, an oil company, at the end of
June 30, 2017. The share price is GBP 9.74. The company's dividend per share for
the fiscal year ending June 30, 2017 was £ 0.27. You expect the dividend to grow
10% for the next three years and then increase 8% per year forever. You estimate
that the required SEL return on equity is 12%.

Estimate the value of SEL using a two-stage dividend discount model. Is the stock
correctly valued?

Solution in Excel.

Question 6
Carlos received today as an inheritance 1000 shares of the company B S.A. This
common stock paid a dividend of US $ 10 per year for the last 5 years. It is
expected that at the end of this year the company will pay the same dividend ($ 10)
and this payment will be the same for 3 years, grow 6% during the next 2 years and
then grow at an annual rate of 4% in perpetuity. An effective annual discount rate of
12.5% was estimated. However, Carlos needs cash and today they offer to buy his
shares. How much would be the minimum he should accept per share?

Solution in Excel.

Question 7

Consider a stock that has EPS of $6 at the end of the first year, a dividend-payout
ratio of 40%, a discount rate of 15%, and a return on retained earnings of 18%.
Calculate the price of the stock using i) the dividend growth model and ii) the net
present value of growth opportunities model.

First you must calculate important data to be able to calculate the price of the stock
using the dividend growth model:
- The dividend at year one will be $6 * 40% = $2.4 per share.
- As it is said, the payout ratio is 40% so the retention ratio will be 60% (=1-
40%), which implies a growth rate of dividends of 10.8%=60% * 18%
Using this information, you can calculate the price of the share:
Di v 1 $ 2.4
P 0= = =$ 57.14
r −g 15 %−10.8 %
Now, to calculate the price of the stock using the net present value of growth
opportunities model you must do it in two steps. First you must calculate the value
of the firm as it pays 100% of the earnings in dividend. That is:

3
 Di v 1 EPS $ 6
P0= = = =$ 40
r r 15 %

Then, you must calculate the present value of the growth opportunities:

P 0=
[ $−3.6+
$ 3.6∗18 %
15 %
=
]$ 0.72
=$ 17.14
15 %−10.8 % 4.2 %

Finally, you have to add up these values to find the price of the stock:

P0=$ 40+$ 17.14=$ 57.14