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Answers to End-of-Chapter Questions

Q5-1. How is preferred stock different from common stock?

A5-1. Common stock usually...
130     Instructor’s Manual

Solutions to End-of-Chapter Problems

P5-1.     The equity section of the balance sheet for H...
Chapter 5 Stock Valuation   131

        c. Verizon was up 0.04/34.13 (remember, we are calculating the increase relative ...
132   Instructor’s Manual

        f.   P = 2.804/(0.16 − 0.04) = $23.37

        g. The return is (23.37 + 2.696 − 22.47)...
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HW5 Solutions.doc

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HW5 Solutions.doc

  1. 1. Answers to End-of-Chapter Questions Q5-1. How is preferred stock different from common stock? A5-1. Common stock usually grants the investor to vote on important corporate decisions. Preferred stock does not. Preferred shareholders have a higher priority claim than common shareholders do because common shareholders cannot receive dividends unless all dividends owed to preferred stockholders have been paid. Both common and preferred stock have a lower priority claim than debt, however. Finally, preferred dividends are usually set at a fixed percentage of par value, while common dividends vary with the profitability of the company. Q5-3. Describe the role of the underwriting syndicate in a firm-commitment offering. A5-3. In a firm-commitment offering, the investment bank agrees to buy the securities from the issuing firm and resell them to investors. Because the investment bank takes possession of the securities, they bear some risk that the value of the securities can change. The underwriting syndicate shares responsibility for selling the issue. In general the syndicate tries to oversubscribe the issue. This should mean that the issue is easier to sell and that the risk to the investment banker of holding a security that is dropping in value is low. Q5-7. The value of common stocks cannot be tied to the present value of future dividends because most firms don’t pay dividends. Comment on the validity, or lack thereof, of this statement. A5-7. It is true that most stocks don’t pay dividends, and forecasting when those stocks will begin pay- ing dividends is very difficult, so in that sense the statement has some validity. However, the val- ue of a stock depends not just on dividends, but on other forms of cash distributions such as share purchases and cash takeover payments. Regardless of what form a stock distributes its cash, in- vestors must have some expectation that at some point the stock will distribute cash to investors; otherwise the stock would have no value. Q5-10. The book value of a firm’s common equity is usually lower than the market value of the common stock. Why? Can you describe a situation in which the liquidation value of a firm’s equity might exceed its market value? A5-10. Market values are forward looking, while book values are backward looking. If the market is op- timistic about a firm’s future, it will almost always place a higher value on the firm’s stock than book value. However, the opposite could be true. Suppose a firm is in the business of producing a product that suddenly becomes technically obsolete. The book value of the firm’s assets might still be considerable, but the market will see problems ahead and assign a very low market value to the firm’s stock. If the firm cannot replace the technically obsolete product with a more com- petitive one, it could be the case that the firm’s shareholders would be better off selling the firm’s remaining assets in a liquidation rather than letting the firm continue to operate. Allowing the firm to continue operations might only result in losses going forward. Given that shutting down a firm is a very difficult decision, the market might anticipate that the firm will not shut down as quickly as it should, so the stock price reflects not what the firm might be worth today if it were liquidated, but a lower value that reflects a continued period of losses. 129
  2. 2. 130 Instructor’s Manual Solutions to End-of-Chapter Problems P5-1. The equity section of the balance sheet for Hilton Web-Cams looks like this: Common stock, $0.25 par $400,000 Paid-in capital surplus $4,500,000 Retained earnings $1,100,000 a. How many shares has the company issued? b. What is the book value per share? c. Suppose that Hilton Web-Cams has made only one offering of common stock. At what price did it sell shares to the market? A5-1. a. 400,000/0.25 = 1.6 million shares a. (400,000+4,500,000+1,100,000)/1.6 million shares = $3.75 per share b. (4,500,000+400,000)/1.6 million shares = $3.0625 P5-3. Owners of the Internet bargain site FROOGLE.com have decided to take their company pubic by conducting an initial public offering of common stock. They have agreed with their investment banker to sell 3.3 million shares to investors at an offer price of $14 per share. The underwriting spread is seven percent. a. What is the net price that FROOGLE.com will receive for their shares? b. How much money will FROOGLE.com raise in the offering? c. What do FROOGLE.com’s investment bankers make on this transaction? A5-3. If the underwriting spread is seven percent, then the net price is 0.93 × $14 or $13.02. FROOGLE.com will raise $13.02 × 3.3 million or $42,966,000 in the offering, and the invest- ment bankers will make ($14 - $13.02) × 3.3 million or $3,234,000. P5-4. The following stock quotes were taken from a recent issue of The Wall Street Journal: 52 - Week Vol Net YTD % Chg HI LO Stock (SYM) DIV Yld (%) PE 100s Close Chg 12.7 46.8 33 Smucker SJM 0.92 2.1 20 1349 44.86 0.05 -11.8 44.3 31.1 Verizon VZ 1.54 4.5 15 61517 34.17 0.04 a. Which company had higher earnings per share over the last year? b. What was the closing price of Verizon reported in the paper yesterday? c. Which company’s stock earned a higher percentage return on the day being reported here? A5-4. a. The P/E ratio of Smucker is 20, so earnings must be about 44.86/20 = $2.24 per share over the last year. The same calculation for Verizon reveals last year’s earnings of about 34.17/15 = $2.28 per share, so Verizon had higher earnings per share. b. Verizon’s closing price today increased by $0.04, so yesterday’s close must have been $34.13.
  3. 3. Chapter 5 Stock Valuation 131 c. Verizon was up 0.04/34.13 (remember, we are calculating the increase relative to yesterday’s close or 0.12% on the day, while Smucker was up 0.05/44.81 or 0.11%, so Verizon had a bet- ter day. P5-11. The C. Alice Stone Company’s common stock has paid a $3 dividend for so long that investors are now convinced that the stock will continue to pay that annual dividend forever. If the next dividend is due in one year and investors require an 8% return on the stock, what is its current market price? What will the price be immediately after the next dividend payment? A5-11. P = $3/0.08 = $37.50 is the current price. However, as soon as the next dividend payment is made, another one of $3 is due a year later, so the price at that time is also $37.50. There is no ex- pected appreciation in the stock price. The entire 8% return comes from the stock’s dividend yield. P5-17. Yesterday, September 22, 2009, Wireless Logic Corp. (WLC) paid its annual dividend of $1.25 per share. Because WLC’s financial prospects are particularly bright, investors believe that the company will increase its dividend by 20 percent per year for the next four years. After that, in- vestors believe WLC will increase the dividend at a modest annual rate of 4 percent. Investors re- quire a 16 percent return on WLC stock, and WLC always makes its dividend payment on September 22 of each year. a. What is the price of WLC stock on September 23, 2009? b. What is the price of WLC stock on September 23, 2010? c. Calculate the percentage change in price of WLC stock from September 23, 2009, to Septem- ber 23, 2010. d. For an investor who purchased WLC stock on September 23, 2009, received a dividend on September 22, 2010, and sold the stock on September 23, 2010, what was the total rate of re- turn on the investment? How much of this return came from the dividend, and how much came from the capital gain? e. What is the price of WLC stock on September 23, 2013? f. What is the price of WLC stock on September 23, 2014? g. For an investor who purchased WLC stock on September 23, 2013, received a dividend on September 22, 2014, and sold the stock on September 23, 2014, what was the total rate of re- turn on the investment? How much of this return came from the dividend, and how much came from the capital gain? Comment on the differences between your answers to this ques- tion and your answers to part (d). 1.50 1.80 2.16 2.592 1 2.696 A5-17. a. P= + + + + × = 17.85 1.16 1.16 2 1.16 3 1.16 4 1.16 4 0.16 − 0.04 1.80 2.16 2.592 1 2.696 b. P= + + + × = 19.21 1.16 1 1.16 2 1.16 3 1.16 3 0.16 − 0.04 c. (19.21/17.85)-1 = 0.0762 or 7.62% d. (19.21+1.50-17.85) / 17.85 = 0.1602, or 16.02%. Actually, it would be 16% exactly without rounding errors. Of this about 7.6% is a capital gain and the rest is the dividend yield. e. P = 2.696/(0.16 − 0.04) = $22.47
  4. 4. 132 Instructor’s Manual f. P = 2.804/(0.16 − 0.04) = $23.37 g. The return is (23.37 + 2.696 − 22.47) / 22.47 = 0.16 or 16%. Again we are earning exactly the required return on the stock. However, now that the stock has entered its constant growth pe- riod, the stock price increases by 4 percent per year, just equal to the dividend growth rate, and the remaining 12 percent of our return comes from the dividend. P5-20. Investors expect the following series of dividends from a particular common stock: Next year $1.10 2nd year $1.25 3rd year $1.45 4th year $1.60 5th year $1.75 After the 5th year, dividends will grow at a constant rate. If the required rate of return on this stock is 9 percent and the current market price is $45.64, what is the long-term rate of dividend growth expected by the market? 1.10 1.25 1.45 1.60 1 1.75 A5-20. P = + + + + × = 45.64 1.09 1.09 2 1.09 3 1.09 4 1.09 4 0.09 − g Solve this equation for g and you get 6%.

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