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Problem 1 (17) The Big Basketball Company (BBC) earned $10 a share last year and paid a dividend of $6 a share. Next year, you expect BBC to earn $11 and continue its payout ratio. (a) Assume that you expect to sell the stock for $132 a year from now. If you require 12% on this stock, how much would you be willing to pay for it? (b) If you expected a selling price of $110 and required an 8% return on this investment, how much would you pay for the BBC stock? (c) Over the long run, you expect dividends for BBC to grow at 8% and you require an 11% on the stock. Using the infinite period DDM, how much would you pay for this stock? (d) Based on new information regarding the popularity of basketball, you revise your growth estimate for BBC to 9%. What is the P/E ratio you will apply to BBC, and what is the maximum price you will pay for the stock? Your required return is still 11%. Problem 2 (12p) The Shamrock Dogfood Company (SDC) has consistently paid out 40% of its earnings in dividends. (a) The company's return on equity is 16%.What would you estimate as its dividend growth rate? (b) Given the low risk in dog food, your required return on SDC is 13%.What P/E ratio would you apply to the firm's earnings? (c) What P/E ratio would you apply if you learned that SDC had decided to increase its payout to 50%? (Hint: This change in payout has multiple effects.) Problem 3 (9p) Abby Morgan is preparing a valuation of Generic Genetic Corporation. Abby has decided to use a three- stage free cash flow valuation model and the following estimates. The FCFE for year 2019 is $1,500,000. The FCFE is expected to grow at 10 percent in 2020, then at 16 percent annually for the following three years, and then at 6 percent in year 5 and thereafter. Generic Genetic's estimated beta is 2.00, and Abby believes that current market conditions dictate a 2.5 percent risk-free rate of return and a 6.0 percent market risk premium. Generic Genetic has 2 million outstanding common shares. Generic Genetic's any has a capital structure consisting of 45 percent of debt and 55 percent of equity. The tax rate is 35%. Given Abby's assumptions and approach, estimate the value of a share of Generic Genetic. Problem 4 (10p) The Shamrock Vegetable Company has the following results, Net sales 6,000,000 Net total assets 4,000,000 Amortization 160,000 Net income 400,000 Long-term debt 2,000,000 Equity 1,160,000 Dividends 160,000 (a). Compute Shamrock's ROE directly. Confirm this using the three components. (b). Using the ROE computed in part (a), what is the expected sustainable growth rate for Shamrock? (c). Assuming the firm's net profit margin went to 0.04, what would happen to Shamrock's ROE? (d). Using the ROE in part (c), what is the expected sustainable growth rate? What if dividends were only $40,000? 0.10 Net profit margin Total assets turnover Total assets/equity 0.04 2.20 2.40 1.40 1.50 SOBEY SCHOOL OF BUSINESS (a). Derive for each its return on equity based on the three DuPont components (b). Given the following earnings and dividends, compute the estimated sustainable growth rate for each firm. K L M Earnings/share 2.75 3.00 4.50 Dividends/share 1.25 1.00 1.00 Problem 6 lop) Based on DuPont system, discuss three ways a firm can increase its ROE Problem 7 (120 Assume you have a 1-year investment horizon and are trying to choose among three bonds. All have the same degree of default risk and mature in 10 years. The first is a zero-coupon bond that pays $1.000 at maturity. The second has an 8% coupon rate and pays the 580 coupon once per year. The third has a 10% coupon rate and pays the coupon once per year. (a.) If all three bonds are now priced to yield 8% to maturity, what are their prices? b.) If you expect their yields to maturity to be 8% at the beginning of next year, what will their prices be then? What is your before-tax holding period return on each bond? your tax bracket is 30% on ordinary income and 20% on capital gains income, what will be your after-tax rate of return be on each? Ic.) Recalculate your answer to lb) under the assumption that you expect the yields to maturity on each bond to be 7% at the beginning of next year. Problem 5 17p Three companies have the following results during the recent period: 0.10 Net profit margin Total assets turnover Total assets/equity 0.04 2.20 2.40 0.06 2.00 2.20 1.40 1.50 SOBEY SCHOOL OF BUSINESS (a). Derive for each its return on equity based on the three DuPont components. (b). Given the following earnings and dividends, compute the estimated sustainable growth rate for each firm KLM Earnings/share 2.75 3.00 4.50 Dividends/share 1.25 1.00 1.00 Problem 6 lop Based on DuPont system, discuss three ways a firm can increase its ROE. Problem 7 (12) Assume you have a 1-year investment horizon and are trying to choose among three bonds. All have the same degree of default risk and mature in 10 years. The first is a zero-coupon bond that pays $1.000 at maturity. The second has an 8% coupon rate and pays the $80 coupon once per year. The third has a 10% coupon rate and pays the coupon once per year. (a) fall three bonds are now priced to yield 8% to maturity. what are their prices? b.) If you expect their yields to maturity to be at the beginning of next year what will their prices be then? What is your before tax holding period return on each bond? If your tax bracket is 30% on ordinary income and 20% on capital gains income, what will be your after tax rate of return be on each? c.Recalculate your answer to (b) under the assumption that you expect the yields to maturity on each bond to be at the beginning of next year. Problem 8 (8p) You have been reading about the Moncton Computer Company (MCC), which currently retains 90% of its earnings ($5 a share this year). It earns an ROE of almost 30%. Assuming a required return of 14%, how much would you pay for MCC on the basis of the relative valuation model? Discuss your answer. What would you pay for Moncton Computer if its retention rate was 60% and its ROE was 19%? Show your work. Problem 9 (9) Your client has asked you for advice on the following two investments: Purchase 2000 shares of common stock or receive real-estate income as follows. The purchasing cost of both investments are $ 133,000. End of Year Real Estate Cash Flows $38,155 $48,020 $92.100 The common stock pays no dividends for two years; it is anticipating the firm will begin paying a $3 dividend in the third year and the dividend will grow at 6.7%. Investors demand a 10% return from this stock. The real estate investments yields 14%. What is the value of each investments and which investment is better