Value of Common Stocks

CHAPTER 4

The Value of Common Stocks

Answers to Problem Sets

1. a. True. This is a condition for equilibrium in well-functioning capital markets. All stocks in a particular risk class must offer the same rate of return. If a certain stock, for example, is priced above others in the equivalent risk class, investors would sell their shares to buy cheaper shares from companies in the same risk class. This would force the price of that higher priced stock down to the equilibrium price. The same happens for a stock priced below equilibrium—investors would rush to buy the stock, sending its price back up.

b. True. When shareholders buy a particular stock, they receive cash from the company in the form of future dividends. The rate of return that investors expect is the expected dividend per share plus the expected price appreciation for the stock: r = DIV + (P1 – P0) / P0.

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 2. Investors who buy stocks may get their return from capital gains as well as dividends. But the future stock price always depends on subsequent dividends. There is no inconsistency.

Est. Time: 01-05

 3. P0 = (5 + 110)/1.08 = $106.48.

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 4. r = 5/40 = .125, or 12.5%.

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 5. P0 = 10/(.08 − .05) = $333.33.

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 6. First we must determine the price based on dividends per share for years 1–4.

Then, we must account for the growth in earnings per share. With next year’s EPS at $15 and EPS growing at 5% per year, the forecasted EPS at year 4 is $15 x (1.05)4 = $18.23. Therefore, the forecasted price per share at year 4 is $18.23/.08 = $227.91. Therefore, the current price is:

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Est. Time: 01-05

 7. Price = EPS1/r + PVGO. Recall that the price = DIV1/(r – g). Therefore, price = $10/(.08 - .05) = $333.333. Therefore, 15/.08 + PVGO = 333.33; therefore PVGO = $145.83.

Est. Time: 01-05

 8. With next year’s dividend at $10/share and next year’s price at...