Beatrice Peabody Case 78

Case 78 Questions

1. According to ValueLine estimates in Figure 1, James River’s expected annual dividend growth rate from the 91–93 to 97–99 period is 5.50%, and the next dividend (1995) is expected to be $0.60. Assume that the required return for James River was 8.36% on January 1 1995 and that the 5.50% growth rate was expected to continue indefinitely.

a. Based on the Constant Growth Rate or Gordon Model, what was James River’s price at the beginning of 1995?

P0 = D1/r-g

(0.60)/(.0836–0.055)= (0.60)/(0.0286) = $20.98

b. What conditions must hold to use the constant growth model? Do many “real world” stocks satisfy the constant growth assumptions?

There are two assumptions that must hold in order for the constant growth model to be used. First we must assume that earnings will be constant forever. Second, we must assume dividends will continue to grow at a constant rate forever.

No real world stocks satisfy the assumptions of the constant growth model because their earnings may differ from year to year, violating the first assumption.

2. The Wall Street Journal (WSJ) lists the current price of James River common stock at $27.00.

a. Based on this information, the ValueLine 1995 expected dividend, and the annual rate of dividend change for the growth estimate, what is the company’s return on common stock using the constant growth model? What is the expected dividend yield and expected capital gains yield? Explain the difference in the required return estimates from the ValueLine (see question 1a) to the WSJ price data.

Expected return: D1/P0+g

$0.60/$27 + 5.50% = 2.22% + 5.50% = 7.72%.              

Expected Dividend Yield: D1/P0                         

           .60/27=2.22%

Capital Gains Yield = (P1 – P0)/P0

5.5%=g= 5.50%.      

Investors’ expect lower risk because of the decrease of expected return from 8.36% to 7.72%

b. What is the relationship between dividend yield and capital gains yield over time under constant growth...