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FI 389 Spring 2016 Cooper FI 389 Homework 4 1. A company has a dividend payout ratio of 40%. It is expected to earn $4.20 per share next year and have a return on equity (ROE) of 19%. The rate of return that investors require for the company's stock is 13%. A. Calculate the growth rate for the company's earnings per share (EPS). The growth rate can be estimated using the following equation. g = ROE(Retention ratio) B. Using the earnings model, what is the value of the company's stock? The equation for the earnings model is Payout ROE EPS1 EPS1 (1 ratio ) ( R 1) V= + . R Rg C. Construct a data table that shows how the growth rate and value of the stock will change if ROE ranges from 10% to 30%, in 1% increments. Using the data, create a scatter chart to show the relationship between the value of the stock and ROE. At what point does the model break down? D. What is the value of the company's stock when calculated using the constant growth dividend discount model? 2. As an analyst for a securities firm, you are responsible for making recommendations to your firm's clients regarding investments in common stocks. After gathering data on Apogee Technologies, Inc., you have found that its dividend has been growing at a rate of 6% per year. The most recent dividend, D0, was $1.95 per share. Apogee Technologies, Inc.'s stock is now selling for $27 per share, and you believe that an appropriate discount rate for the company's stock is 14%. A. If you expect Apogee Technologies, Inc. to increase its dividend by 6% annually for the foreseeable future, above what price would you recommend that your clients not purchase the company's stock? Based on your valuation, is the stock undervalued or overvalued in the market? B. Suppose now that you believe that Apogee Technologies, Inc.'s new product line will produce much higher growth in the near future. Your revised forecast assumes a four-year period of 15% annual growth to be followed by a lower growth rate of 6%. Under this new assumption, what is the value of the stock using the two-stage dividend growth model? Based on your valuation, is the Apogee Technologies, Inc.'s stock undervalued or overvalued in the market? Use an IF function to indicate whether the stock is undervalued or overvalued. 1 FI 389 Spring 2016 Cooper 3. The Apex Company has new products that are expected to produce significant growth in earnings in the near future. Apex Company's management has given analysts the following forecasts for the next three years. 2016 2017 2018 Depreciation $21,000 $30,000 $35,000 EBIT 150,000 180,000 216,000 Investment in Operating Assets 47,000 31,000 19,000 The firm's debt has a current market value of $750,000, and the firm has $50,000 in marketable securities. There are 100,000 common shares outstanding. The tax rate is 35%, and the WACC is estimated to be 13%. A. Calculate Apex Company's estimated free cash flow for each of the next three years (2016-2018). B. After 2018, free-cash-flow growth is expected to slow to 7% per year and remain at the level permanently. Based on this assumption and the information given above, what is the value of Apex Company's stock today? Use the following equations to estimate the value of the company's stock. VFIRM = FCF1 + Nonoperating assets WACC g VCS = VFIRM VD 4. You are considering investing in callable bonds that were issued one year ago. The bonds pay interest semiannually, mature in 14 years on 4/30/2030, and have a coupon rate of 9.0%. The face value of the bonds is $1,000. Currently the bonds are selling for $1,047. The first call date is five years after the issue date. The call premium is $90. A. If your required rate of return is 8.50% for bonds in this risk class, what is the highest price that you would be willing to pay for the bonds? Use the PV function to answer this question. B. What is the current yield of the bonds? C. What is the yield to maturity on the bonds if you purchase them at the current price? Use the RATE function to answer this question. D. Assume that the settlement date for your purchase would be 4/30/2016. Using the PRICE and YIELD functions, recalculate your answers to parts A and C. E. What are the bonds' yield to call? 2 FI 389 Spring 2016 Cooper 5. You have decided to add some bonds to your investment portfolio. You have narrowed your choice down to the following semiannual-coupon bonds. Bond A Bond B Issue Date 7/31/2015 6/30/2015 Settlement Date 4/15/2016 4/15/2016 Maturity Date 7/31/2020 6/30/2030 Coupon Rate 6.00% 10.00% Market Price $950 $1,100 Face Value $1,000 $1,000 Required rate of return 7.00% 9.00% A. Using the PRICE function, calculate the intrinsic value of each bond. Relative to the intrinsic values that you calculate, is either bond undervalued? Use an IF function to identify whether a bond is undervalued or overvalued. B. How much accrued interest would you have to pay for each bond? Assume each month has 30 days. C. Calculate the current yield of each bond D. Using the YIELD function, calculate the yield to maturity of each bond using the current market prices. How do the YTMs compare to the current yields of the bonds? E. Calculate the duration and modified duration of each bond. F. Which of the two bonds would be the preferable investment if you expect market rates to fall by 150 basis points for all maturities? What if rates increase by 150 basis points? Why? 6. A firm currently has the following capital structure: Source of Capital Book Value Common Stock $10,500,000 Preferred Stock $1,000,000 Debt $5,000,000 Quantity 400,000 10,000 5,000 Debt is represented by 5,000 semiannual-coupon bonds that mature in 13 years. The coupon rate, face value, and market price of each bond is 9%, $1,000, and $1,050. Flotation costs on new debt would be 2% of the selling price. The company's marginal tax rate is 34%. The preferred stock pays a $9 dividend annually; it is currently valued at $110 per share. Currently, there are 10,000 shares of preferred stock outstanding. Flotation costs on new preferred equity would be 4%. The share price of the company's common stock is currently $47. The company expects dividends to increase by 8% per year for the foreseeable future. Next year's dividend will be $1.75 per share. There are currently 400,000 shares of common stock outstanding. Flotation costs on new common equity would be 7%. Calculate the A. B. C. D. E. F. G. Book-value weights for each source of capital. Market-value weights for each source of capital. After-tax cost of new debt. Cost of new preferred equity. Cost of new common equity. Weighted average cost of capital using book-value weights. Weighted average cost of capital using market-value weights. 3 EPS1 Payout Ratio ROE Required Return 4.20 40% 19% 13% A) Growth Rate Retained earnings1 Value without Growth Value of Growth Opportunities B) Value of Stock D) Constant Growth DDM Value - C) ROE 10.0% 10.5% 11.0% 11.5% 12.0% 12.5% 13.0% 13.5% 14.0% 14.5% 15.0% 15.5% 16.0% 16.5% 17.0% 17.5% 18.0% 18.5% 19.0% 19.5% 20.0% 20.5% 21.0% 21.5% 22.0% 22.5% 23.0% 23.5% 24.0% 24.5% 25.0% 25.5% 26.0% 26.5% 27.0% 27.5% 28.0% 28.5% 29.0% 29.5% 30.0% Growth Rate Value of Stock We can do the same thing with normal formulas, but you must remember that the ROE affects the growth rate, so the growth rate must be calculated within the formula in G22:G32. This makes it much more complex than using a data table. ROE 10% 11% 11% 12% 12% 13% 13% Value 24.00 25.07 26.25 27.54 28.97 30.55 32.31 14% 14% 15% 15% 34.29 36.52 39.07 42.00 Single-Stage Growth Data $ 27.00 Stock Price D0 $ 1.95 Growth Rate Required Return 6% 14% Two-Stage Growth Data $ 27.00 Stock Price D0 $ 1.95 Growth Rate 1 15% Growth Rate 2 6% Rapid Growth Time 4.00 years Required Return 14% Valuation Single-Stage: A) Two-Stage: B) Undervalued or overavalued? (Use IF function) The Apex Company Free Cash Flow Forecast Depreciation EBIT Investment in Operating Assets Net Operating Profit After Tax Operating Cash Flow After Tax Free Cash Flow Tax Rate Current Market Value of Debt Non-Operating Assets FCF Growth Rate after 2018 WACC Common Shares Outstanding Value of Firm Value of Equity Per Share Value 2016 21,000 190,000 47,000 35% 750,000 50,000 7% 13% 100,000 2017 30,000 237,500 31,000 2018 35,000 285,000 19,000 2019 Price Face Value Call Premium Coupon Rate Frequency Maturity (Years) Years to first call Required Return Value (PV function) A. Current Yield B. Yield to Maturity (RATE function) C. $1,047 $1,000 $90 9.00% 2 14 4 8.50% Settlement Date Maturity Date Call Date Valaue (PRICE function) D. Yield to maturity (YIELD function) D. Yield to call (YIELD function) E. 4/30/2016 4/30/2030 4/30/2020 Bond A 7/31/2015 4/15/2016 7/31/2020 5.00% $ 987.00 $ 1,000.00 5.25% 2 Issue date Settlement Date Maturity Date Coupon Rate Price Face Value Required Return Frequency Intrinsic Value Undervalued or overvalued (Use IF function) Accrued Interest (Basis 30/360) Current Yield Yield to Maturity Duration Modified Duration Change in Yields -1.50% 1.50% Bond B 6/30/2015 4/15/2016 6/30/2030 7.50% $ 1,040.00 $ 1,000.00 7.00% 2 A. A. B. C. D. E. E. % Change in Price Bond A Bond B F. F. Tax Rate 34% Bonds Coupon Rate Frequency Face Value Maturity (years) Price Flotation Costs Yield to Maturity After-tax Cost of Debt Preferred Equity Dividend Face Value Price Flotation Costs Cost of Preferred Equity 9% $ $ 2 1,000 13 1,050 2.00% 8.62% C. 9 100 110 4.00% D. Common Equity Dividend (D1) Growth Rate Price Flotation Costs Cost of New Common Equity E. Source Common Preferred Debt Totals Weighted Average Cost of Capital Book Value Weights F. Market Value Weights G. 1.75 8% $ 47.00 7% Quantity Book Value Market Value 400,000 $ 10,000,000 $ 18,800,000 10,000 $ 1,000,000 $ 1,100,000 5,000 $ 5,000,000 $ 5,250,000 $ 16,000,000 $ 25,150,000 BV Weights A. A. A. MV Weights B. B. B. 0.00% 0.00%