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Your task is to value the stock price of Harrington Ltd with theDividend Discount Model (DDM) in stable growth. You have thefollowing information:

Dividends per share DIV0

€1.89

Risk-free rate rF

3.00%

Beta β

1.182

Expected return on stocks

8.50%

Estimated long-term dividends growth rate

2.75%

Required:
(a) Calculate the value of the stock of Harrington Ltd using theDividend Discount Model (DDM) in stable growth;

(b) The stock currently trades at €39.40 in the stock market; wouldyou recommend buying it?

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Collen Von
Collen VonLv2
28 Sep 2019

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Sabrina Gupta, an investment advisor with a major brokerage firm, was examining Wal-Mart Stores, Inc. (Wal-Mart) stock and its valuation. Gupta wondered whether to recommend the stock to any of her new clients or to existing clients who did not currently have Wal-Mart in their portfolios.

Her key task was to use an intrinsic value approach to price the shares and to then compare the resulting price with the price at which the stock was traded in the market. Gupta wanted to use alternative valuation methods and assumptions to produce intrinsic value estimates for Wal-Mart stock.

She was interested in seeing if the alternative methods would point to a consensus regarding the valuation of the stock and to see if the valuations suggested an investment opportunity given the current market price. Methods she contemplated to use were:

Multi-stage growth model

Price Earnings Multiple

Most valuation methods Gupta considered required a common set of inputs:

Future Cash Flows to Wal-Mart Investors

Growth rate of future cash flows

Discount factor or required rate of return by Wal-Mart investors

Gupta gathered data to determine each of the above.

Gupta thought that Dividends to Wal-Mart shareholders would adequately capture the cash flows to Wal-Mart shareholders; she also thought that this approach would simplify her task and she would revisit more complex valuation models if she felt the need.

Gupta thought that CAPM would provide her a relatively reliable estimate of the required rate of return. CAPM based required rate of return can be estimated by using a risk free rate, systematic risk of the firm and equity market risk premium. Gupta thought that in a valuation exercise that involve long term cash flows, 10-year government bond yield would be an appropriate risk free rate of return estimate. She checked the 10 year note rate and found out that it was about 3.68%. Gupta searched for Wal-Mart beta in Bloomberg. Bloomberg estimates betas by regressing the S&P 500 returns on the firm returns over the past two years and arrives at a “raw” beta estimate. Bloomberg makes an adjustment in raw beta based on some academic research. Gupta is confident that Bloomberg adjustment is justified and she uses Wal-Mart beta estimate of 0.66 in her analysis.

While Gupta is aware of the importance of EMRP assumption, she thinks that Bloomberg’s historical estimate of 5.05% is a safe assumption. She is aware of the fact that some studies suggest a larger risk premium of approximately six per cent, while others suggest a much lower forward-looking premium of less than four per cent. She is mindful of the arbitrariness of her assumption, and she takes a note to revisit this issue if her valuations produce unreasonable estimates.

Anticipated dividend growth (g) is often estimated in a variety of ways.

First, observed historical dividend growth can be assumed to continue in a perpetual fashion.

Second, future dividend growth can be estimated on the basis of recent estimates of analysts.

Gupta noted that the consensus annual Wal-Mart dividend for fiscal year 2011 was $1.21, and one respected analyst had estimated the expected constant dividend growth (in perpetuity) at approximately 3%.

As the chart suggests, both earnings and dividend growth rates are declining but they seem to be higher than the “respected analyst’s” estimates. Gupta decides to use several alternative perpetual growth assumptions to see the impact on price. Since Gupta decided to use variants of dividend discount model (DDM), she checked the anticipated earnings for 2011. Analyst’s estimates suggested $4.10 earnings per share. Gupta decided to use 10% growth rate from 2011 to 2012 and assumed a steady decline to 3% in 13 years (until 2024) where the perpetual growth rate of 3% resumes. She also assumed that WalMart will increase its dividend payout ratio from 30% to 55% from years 2012 to 2024. You are asked to reproduce Gupta’s analysis of multi-stage growth model and double check her valuation by using an earnings multiple. You have all the data you need to conduct the multi stage discounted growth model analysis, but you will need to do some research about the multiples valuation.

The Generic Genetic (GG) Corporation pays no cash dividends currently and is not expected to for the next 3 years. Its latest EPS was $10, all of which was reinvested in the company. The firm's expected ROE for the next 3 years is 15% per year, during which time it is expected to reinvest all of its earnings. Starting in year 4, the firm's ROE on new investments is expected to fall to 12%, and the plowback ratio is 1/2, which it will continue to do forever after. The risk-free rate is 5%, the expected market return is 8%, and the stock of GG has a beta coefficient of 1.4. A competitor in the market trades with a price-earnings (PE) ratio of 16 in the market.

a. What is the intrinsic value of a share of GG stock based on DDM?

b. Do you think it is important to use multistage dividend discount model to value a firm? in what circumstances? and does it have any limitations, eg. compared to FCFE model?

c. If a stock is underpriced, what is the relationship between market capitalization rate and its expected rate of return?

d. What is the relative valuation of GG based on the PE ratio?

e. Comment on the differences in the estimated value of GG if any and the merits of each method of valuation. f. Assuming the company is the target of a hostile takeover and the acquirer is offering to pay $165 for a share in GG. On the basis of your two calculations to value the firm, should you accept the offer giving reasons for your recommendation?

1. Which of the following is true?
The corporation model can be used to value divisions and firms that do not pay dividends.
The discounted dividend model can be used to value divisions and firms that do not pay dividends.
For the discounted dividend model, a firm's weighted average cost of capital is used as the discount rate.
For the corporate valuation model, a firm's cost of equity is used as the discount rate.
Question 2.2. Which of the following is false?
For the constant growth model to hold, a firm's cost of equity needs to be smaller than its constant dividend growth rate (i.e., rs < g).
For the constant growth model to hold, a firm's cost of equity needs to be greater than its constant dividend growth rate (i.e., rs > g).
From the constant growth model, if the constant dividend growth rate is equal to zero, a firm's share price is equal to the constant dividend divided by the cost of equity (i.e., g=0).
If a company's constant dividend growth rate is negative, the formula for the constant growth model cannot be applied.
Question 3.3. From the discussion of a firm's capital budgeting problem in chapter 11, which of the following is false? (Points : 3.5)
The net present value method (NPV) assumes that cash flows are reinvested at the weighted average cost of capital (WACC).
The internal rate of return method (IRR) assumes that cash flows are reinvested at the internal rate of return.
The modified internal rate of return method (MIRR) assumes that cash flows are reinvested at the weighted average cost of cpaital.
For mutually exclusive projects, if there is a conflict between NPV and IRR, the project with the highest IRR is chosen.
The IRR is independent of a firm's weighted average cost of capital.
Question 4.4. Which of the following is true? (
As a firm's dividend payout ratio increases, the firm's WACC decreases.
The WACC only represents the "hurdle rate" for a typical project with average risk. Therefore, the project's WACC should be adjusted to reflect the project's risk.
Firms with riskier projects generally have a lower WACC.
Holding all else constant, an increase in the target debt ratio tends to lower the WACC.
Question 5.5. Which of the following is false?
If interest rates rise, the price of the bond will rise and its YTM (yield to maturity) will fall.
Short-term bond prices are less sensitive than long-term bond prices to interest rate changes.
Companies are not likely to call bonds unless interest rates have declined significantly. Thus, the call provision is valuable to firms but detrimental to long term investors.
On balance, bonds that have a sinking fund are regarded as being safer than those without such a provision.
Question 6.6. Which of the following is not true? (Points : 3.5)
According to SML (security market line), the risk premium on a high-beta stock would increase more than that on a low-beta stock.
If beta < 1.0, the security is less risky than average.
According to the Security Market Line (SML), in general, a company’s expected return will double when its beta doubles.
According to the Security Market Line (SML), if a portfolio of real world stocks has a beta of zero, the required rate of return for the portfolio is equal to the risk-free rate.
Question 7.7. P&G Industries bonds have a maturity of 15 years with a $1,000 face value, have an 8% semiannual coupon, are callable in 10 years at $1,125, and currently sell at a price of $1,105. What is their nominal annual yield to call?
6.87%.
7.37%.
11.05%.
8.32%.
Question 8.8. Which of the following is not the flaw (weakness) of the discounted payback method? (Points : 3.5)
It does not tells us by how much the project should increase shareholder wealth, or by how much a project yields over the cost of capital; it merely tells us when we recover our investment.
It ignores cash flows occurring after the payback period.
It ignores the time value of money, that is, dollars received in different years are all given the same weight.
Question 9.9. Jermey Lin has $52,500 invested a stock with a beta of 0.80 and another $47,500 invested in a stock with a beta of 3.2. If these are the only two investments in his portfolio, what is his portfolio's beta?
1.56.
1.82.
2.00.
1.94
Question 10.10. According to CAPM, if the required rate of the return of Stock A obtained from the security market line (SML) is less than the expected rate of the return of stock A from the capital market transaction, then stock A is
fairly priced.
undervalued.
overvalued.
Question 11.11. Determine the yield-to-call (to nearest 0.1 of a percent) of an LTV bond with a 12 percent coupon, that pays interest annually. The bond can be called in 5 years, has a call premium of $114, and is currently selling for $912.50. The bond has a face value of $1,000.
14.58%.
13.92%.
16.34%.
12.17%.
Question 12.12. Project M costs $1,000, its expected cash inflows are $500 per year for 3 years, and its WACC is 11%. What is the project's NPV? (Points : 3.5)
$259.57.
$221.86.
$195.23.
$257.35.
Question 13.13. Project J costs $1,025, its expected cash inflows are $425 per year for 3 years, and its WACC is 10%. What is the project's IRR?
12.58%.
10.82%.
11.76%.
9.64%.
Question 14.14. Project X costs $6,750, its expected cash inflows are $1250 per year for 10 years, and its WACC is 10%. What is the project's payback?(Note, the regular payback is asked in this question, not the discounted payback.) (Points : 3.5)
5.40 years.
10 years.
4.58 years.
6.12 years.
Question 15.15. Project S costs $800, its expected cash inflows are $350 per year for 3 years, and its WACC is 7%. What is the project's MIRR?
13.97%.
12.04%.
14.93%.
9.15%.
Question 16.16. Project Y costs $650, its expected cash inflows are $500 per year for 5 years, and its WACC is 10%. What is the project's discounted payback?
1.47 years.
1.24 years.
1.62 years.
1.15 years.
1. Which of the following is true?
The corporation model can be used to value divisions and firms that do not pay dividends.
The discounted dividend model can be used to value divisions and firms that do not pay dividends.
For the discounted dividend model, a firm's weighted average cost of capital is used as the discount rate.
For the corporate valuation model, a firm's cost of equity is used as the discount rate.
Question 2.2. Which of the following is false?
For the constant growth model to hold, a firm's cost of equity needs to be smaller than its constant dividend growth rate (i.e., rs < g).
For the constant growth model to hold, a firm's cost of equity needs to be greater than its constant dividend growth rate (i.e., rs > g).
From the constant growth model, if the constant dividend growth rate is equal to zero, a firm's share price is equal to the constant dividend divided by the cost of equity (i.e., g=0).
If a company's constant dividend growth rate is negative, the formula for the constant growth model cannot be applied.
Question 3.3. From the discussion of a firm's capital budgeting problem in chapter 11, which of the following is false?
The net present value method (NPV) assumes that cash flows are reinvested at the weighted average cost of capital (WACC).
The internal rate of return method (IRR) assumes that cash flows are reinvested at the internal rate of return.
The modified internal rate of return method (MIRR) assumes that cash flows are reinvested at the weighted average cost of cpaital.
For mutually exclusive projects, if there is a conflict between NPV and IRR, the project with the highest IRR is chosen.
The IRR is independent of a firm's weighted average cost of capital.
Question 4.4. Which of the following is true? (Points : 3.5)
As a firm's dividend payout ratio increases, the firm's WACC decreases.
The WACC only represents the "hurdle rate" for a typical project with average risk. Therefore, the project's WACC should be adjusted to reflect the project's risk.
Firms with riskier projects generally have a lower WACC.
Holding all else constant, an increase in the target debt ratio tends to lower the WACC.
Question 5.5. Which of the following is false? (Points : 3.5)
If interest rates rise, the price of the bond will rise and its YTM (yield to maturity) will fall.
Short-term bond prices are less sensitive than long-term bond prices to interest rate changes.
Companies are not likely to call bonds unless interest rates have declined significantly. Thus, the call provision is valuable to firms but detrimental to long term investors.
On balance, bonds that have a sinking fund are regarded as being safer than those without such a provision.
Question 6.6. Which of the following is not true? (Points : 3.5)
According to SML (security market line), the risk premium on a high-beta stock would increase more than that on a low-beta stock.
If beta < 1.0, the security is less risky than average.
According to the Security Market Line (SML), in general, a company’s expected return will double when its beta doubles.
According to the Security Market Line (SML), if a portfolio of real world stocks has a beta of zero, the required rate of return for the portfolio is equal to the risk-free rate.
Question 7.7. P&G Industries bonds have a maturity of 15 years with a $1,000 face value, have an 8% semiannual coupon, are callable in 10 years at $1,125, and currently sell at a price of $1,105. What is their nominal annual yield to call? (Points : 3.5)
6.87%.
7.37%.
11.05%.
8.32%.
Question 8.8. Which of the following is not the flaw (weakness) of the discounted payback method? (Points : 3.5)
It does not tells us by how much the project should increase shareholder wealth, or by how much a project yields over the cost of capital; it merely tells us when we recover our investment.
It ignores cash flows occurring after the payback period.
It ignores the time value of money, that is, dollars received in different years are all given the same weight.
Question 9.9. Jermey Lin has $52,500 invested a stock with a beta of 0.80 and another $47,500 invested in a stock with a beta of 3.2. If these are the only two investments in his portfolio, what is his portfolio's beta? (Points : 3.5)
1.56.
1.82.
2.00.
1.94
Question 10.10. According to CAPM, if the required rate of the return of Stock A obtained from the security market line (SML) is less than the expected rate of the return of stock A from the capital market transaction, then stock A is (
fairly priced.
undervalued.
overvalued.
Question 11.11. Determine the yield-to-call (to nearest 0.1 of a percent) of an LTV bond with a 12 percent coupon, that pays interest annually. The bond can be called in 5 years, has a call premium of $114, and is currently selling for $912.50. The bond has a face value of $1,000. (Points : 3.5)
14.58%.
13.92%.
16.34%.
12.17%.
Question 12.12. Project M costs $1,000, its expected cash inflows are $500 per year for 3 years, and its WACC is 11%. What is the project's NPV?
$259.57.
$221.86.
$195.23.
$257.35.
Question 13.13. Project J costs $1,025, its expected cash inflows are $425 per year for 3 years, and its WACC is 10%. What is the project's IRR? (
12.58%.
10.82%.
11.76%.
9.64%.
Question 14.14. Project X costs $6,750, its expected cash inflows are $1250 per year for 10 years, and its WACC is 10%. What is the project's payback?(Note, the regular payback is asked in this question, not the discounted payback.) (Points : 3.5)
5.40 years.
10 years.
4.58 years.
6.12 years.
Question 15.15. Project S costs $800, its expected cash inflows are $350 per year for 3 years, and its WACC is 7%. What is the project's MIRR? (
13.97%.
12.04%.
14.93%.
9.15%.
Question 16.16. Project Y costs $650, its expected cash inflows are $500 per year for 5 years, and its WACC is 10%. What is the project's discounted payback?
1.47 years.
1.24 years.
1.62 years.
1.15 years.

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