FINM 2416 Asset Pricing Topic 3: Stock Evaluation (1)

FINM2416 ASSET PRICING

PROBLEM SETS (CH18)

9.
a. MF Corp. has an ROE of 16% and a plowback ratio of 50%. If the coming
year's earnings are expected to be $2 per share, at what price will the stock sell?
The market capitalization rate is12%.
b. What price do you expect MF shares to sell for in 3 years?

16. The risk-free rate of return is 8%, the expected rate of return on the market portfolio is 15%,
and the stock of Xyrong Corporation has a beta coefficient of 1.2. Xyrong pays out 40% of its
earnings in dividends, and the latest earnings announced were $10 per share. Dividends were just
paid and are expected to be paid annually. You expect that Xyrong will earn an ROE of 20% per
year on all reinvested earnings forever.
a. What is the intrinsic value of a share of Xyrong stock?
b. If the market price of a share is currently $100, and you expect the market price to be equal
to the intrinsic value 1 year from now, what is your expected 1-year holding-period return
on Xyrong stock?

17. The Digital Electronic Quotation System (DEQS) Corporation pays no cash dividends
currently and is not expected to for the next 5 years. Its latest EPS was $10, all of which was
reinvested in the company. The firm's expected ROE for the next 5 years is 20% per year, and
during this time it is expected to continue to reinvest all of its earnings. Starting in year 6, the firm's
ROE on new investments is expected to fall to 15%, and the company is expected to start paying
out 40% of its earnings in cash dividends, which it will continue to do forever after. DEQS's market
capitalization rate is 15% per year.
a. What is your estimate of DEQS's intrinsic value per share?
b. Assuming its current market price is equal to its intrinsic value, what do you expect to
happen to its price over the next year? The year after?
c. What effect would it have on your estimate of DEQS's intrinsic value if you expected DEQS
to pay out only 20% of earnings starting in year 6?

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FINM 2416 Asset Pricing Topic 3: Stock Evaluation (1)

d. What effect would it have on your estimate of DEQS’s intrinsic value if you expected DEQS
to pay out only 20% of earnings starting in year 6? (This question would be left as a
numerical practice for you to complete after the tutorial)

23. Chiptech, Inc., is an established computer chip firm with several profitable existing products
as well as some promising new products in development. The company earned $1 a share last
year, and just paid out a dividend of $.50 per share. Investors believe the company plans to
maintain its dividend payout ratio at 50%. ROE equals 20%. Everyone in the market expects
this situation to persist indefinitely.
a. What is the market price of Chiptech stock? The required return for the computer chip
industry is 15%, and the company has just gone ex-dividend (i.e., the next dividend will
be paid a year from now, at t = 1).
b. Suppose you discover that Chiptech's competitor has developed a new chip that will
eliminate Chiptech's current technological advantage in this market. This new product,
which will be ready to come to the market in 2 years, will force Chiptech to reduce the
prices of its chips to remain competitive. This will decrease ROE to 15%, and, because
of falling demand for its product, Chiptech will decrease the plowback ratio to .40. The
plowback ratio will be decreased at the end of the second year, at t = 2: The annual year-
end dividend for the second year (paid at t = 2) will be 60% of that year's earnings. What
is your estimate of Chiptech's intrinsic value per share? (Hint: Carefully prepare a table
of Chiptech's earnings and dividends for each of the next 3 years. Pay close attention to
the change in the payout ratio in t = 2.)
c. No one else in the market perceives the threat to Chiptech's market. In fact, you are
confident that no one else will become aware of the change in Chiptech's competitive
status until the competitor firm publicly announces its discovery near the end of year 2.
What will be the rate of return on Chiptech stock in the coming year (i.e., between t = 0
and t = 1)? In the second year (between t = 1 and t = 2)? The third year (between t = 2
and t = 3)? (Hint: Pay attention to when the market catches on to the new situation. A
table of dividends and market prices over time might help.)

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FINM 2416 Asset Pricing Topic 3: Stock Evaluation (1)

CFA PROBLEMS

6. Mike Brandreth, an analyst who specializes in the electronics industry, is preparing a research
report on Dynamic Communication. A colleague suggests to Brandreth that he may be able to
determine Dynamic's implied dividend growth rate from Dynamic's current common stock price,
using the Gordon growth model. Currently company has the policy of paying constant dollar
amount dividend. Brandreth believes that the appropriate required rate of return for Dynamic's
equity is 8%.

a. Assume that the firm’s current stock price of $58.49 equals intrinsic value. What sustatined
rate of dividend growth as of December 2020 is implied by this value? Use the constant growth
dividend discount model (i.e., the Gordon growth model).

b. The management of Dynamic has indicated to Brandreth and other analysts that the company's
current dividend policy will be continued. Is the use of the Gordon growth model to value
Dynamic's common stock appropriate or inappropriate? Justify your response based on the
assumptions of the Gordon growth model.

8. Janet Ludlow's firm requires all its analysts to use a two-stage dividend discount model (DDM)
and the capital asset pricing model (CAPM) to value stocks. Using the CAPM and DDM, Ludlow
has valued QuickBrush Company at $63 per share. She now must value SmileWhite Corporation.
a. Calculate the required rate of return for SmileWhite by using the information in the following
table:

b. Ludlow estimates the following EPS and dividend growth rates for SmileWhite:

Estimate the intrinsic value of SmileWhite by using the table above, and the two-stage DDM.
Dividends per share in the most recent year were $1.72.
c. Recommend QuickBrush or SmileWhite stock for purchase by comparing each company's
intrinsic value with its current market price.

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