Chapter 7

Stock Valuation

„ Instructor’s Resources
Chapter Overview
This chapter focuses on equity—distinctions between equity and debt, different forms of equity, and
approaches to valuing equity instruments. The basic model for valuing equity is presented as an example of
the asset-valuation framework introduced in Chapter 5 and applied to bonds in Chapter 6. Specifically, the
value of a share or common of preferred stock is the present value of expected future cash flows from that
share, where the cash flows here are dividends. When capital markets are efficient, stock price should equal
the present value of expected dividends, and news about changes in risk or expected cash flows will be priced
immediately. The discussion then expands the common-stock valuation framework to accommodate different
assumptions about expected dividend growth. Other approaches to equity-valuation—ranging from variations
on dividend-discounting like the free-cash-flow model to models based on market benchmarks like
price/earnings multiples—are also compared and contrasted with the expected-dividend model. The chapter
ends with discussion of interrelationships among financial decisions, expected return, risk, and firm value.

„ Suggested Answer to Opener-in-Review

Tesla Motors initially sold shares to investors at $17 per share. Seven years later, that price was $360.75.
What was the compound annual return on Tesla stock? Given that Tesla paid no dividends and was not
expected to pay dividends anytime soon, how might analysts have valued company shares in 2017? In the
IPO, the company sold 13.3 million shares with a par value of $0.001 per share. How much paid-in capital
did Tesla record on its balance sheet from the IPO? The price of Telsa stock jumped on a highly favorable
Consumer Reports review of its Model S. Do you think Telsa stock rose primarily because investors expected
lower company risk or higher cash flows?
Compound annual return = ($360.75 ÷ $17)1/7 − 1 = 54.72%. The free cash flow model offers the best
approach to valuing startups or firms with no dividend history (such as Telsa). Paid-in capital = 13.3 million
shares × $0.001 = $13,300. Investors probably expected both lower risk and higher cash flows. The favorable
review meant a lower probability Model S would fail as a product, which would reduce Tesla’s risk, but it
would also increase demand for the car, thereby increasing Tesla’s cash flows.

„ Answers to Review Questions

7-1 Equity capital is permanent capital representing ownership, while debt capital is a loan that must be
repaid. Holders of equity capital receive a claim on firm income and assets subordinate to creditor
claims—that is, debt holders must receive all interest and principal owed prior to distributions of firm
income or assets to equity holders. Equity capital is perpetual, while debt has a specified maturity date.
To investors, interest on debt is currently taxed as ordinary income, but dividends and capital gains on
common stock are taxed but at a lower rate. To the corporation, interest on debt is tax deductible while
dividends are not.

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7-2 A corporation’s owners are the common stockholders. As residual claimants, these stockholders are
not guaranteed a return, only what is left after other claims on firm income and assets have been
satisfied. Any funds invested are at risk; the only guarantee is that losses are capped at the purchase
price of the common stock. Given the significant uncertainty about earnings, common stockholders
expect relatively high returns in the form of dividends and capital gains.

7-3 Rights offerings are financial instruments that allow existing stockholders to purchase additional shares
of new stock issues below market price, in direct proportion to the number of shares they own. Rights
offerings protect current shareholders against dilution of their voting power.

7-4 Authorized shares are the maximum number of shares a firm can sell without approval from existing
shareholders; this limit is stated in the corporate charter. Authorized shares sold to and held by the
public are called outstanding shares. Shares repurchased by the firm from the public are classified as
treasury stock; this stock is not considered outstanding because it is not held by the public. Issued
shares are shares of common stock that have been put into circulation and include both outstanding
shares and treasury stock.

7-5 Issuing stock outside their domestic markets can benefit corporations by broadening the investor base
and facilitating integration into the local economy. Specifically, a local stock listing increases
community press coverage, thereby raising awareness about the firm. Locally traded stock also
facilitates acquisitions. American depository shares (ADSs) are dollar-denominated receipts for stocks
of foreign companies held by U.S. financial institutions overseas. American depository receipts (ADRs)
are securities that permit U.S. investors to hold shares of non-U.S. companies and trade them in U.S.
markets. ADRs are issued in dollars and subject to U.S. securities laws; they offer U.S. investors an
opportunity to diversify internationally.

7-6 Preferred stockholders have a fixed claim on firm income and assets behind creditors but ahead of
common stockholders.

7-7 Cumulative preferred stock gives the holder the right to receive any dividends in arrears prior to
dividend payment to common stockholders. A call feature allows the issuer to retire outstanding
preferred stock within a certain time period at a pre-specified price. Call price is normally set at or
above the initial issuance price but may decrease according to a predefined schedule. Firms use the call
feature to escape the fixed-payment commitment of preferred stock.

7-8. The efficient market hypothesis (EMH) says, in equilibrium, the price of a stock or other security is an
unbiased estimate of its true value. Thus, in equilibrium, security prices are neither overvalued nor
undervalued. For a concrete example of what this means, suppose investors learn new information
about a company that suggests its stock is worth more than its current price. In such a case, the security
is undervalued, and expected return exceeds required return (i.e., “appropriate” return based on the
security’s risk). Increased demand for the security from investors with this new information will bid up
the security’s price (market value) and reduce its expected return until the two are equal. Similarly,
investors will sell overvalued securities (those for which expected return falls short of required return),
causing their prices to fall until expected equals required returns. In an efficient market, this process
takes place very quickly, so misvalued securities are rare. For this reason, the text uses the terms
expected return and required return interchangeably.

7-9 According to the efficient market hypothesis (EMH):

a. Securities prices are in equilibrium (fairly priced with expected returns equal to required returns);
b. Securities prices reflect all public information and react quickly to new information; so

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c. Investors should not waste time searching for mispriced (over or undervalued) securities.
EMH is generally accepted as holding for securities traded on major exchanges and as framework for
thinking about security pricing. But proponents of behavioral finance, or behaviorists; have challenged
EMH, arguing the key underlying assumption—investor rationality—is false. They point to going body
of research showing markets can be driven by reluctance to recognize losses, desire to follow the herd,
tendency to compartmentalize investments, and overweighting of recent performance.

7-10 a. The zero growth model of common-stock valuation assumes constant dividends through time, so .
stock is valued as a perpetuity with today’s value (price), P0, depending on the perpetual dividend,
D1 and required return r as follows:
∞
1 1 D
P0 = D1 × ∑ = D1 × = 1
t=1 (1+ r )
t
r r

b. The constant growth model assumes dividends will grow at a constant rate, g, from D1. Again,
required return is denoted by r:
D1
P0 =
r−g
c. The variable growth model assumes dividends grow at a variable rate. The stock with a single
change in the growth rate is valued as the present value of dividends in during the initial growth
phase plus the present value of the price of stock at the end of the initial growth phase. Specifically:

Present value of Present value of stock

dividends during initial price at end of initial
growth period growth period
where Dn is expected dividend in year n, g1 is dividend growth in the initial period, g2, is dividend
growth in the second period, and r the required rate of return.

7-11 The free-cash-flow valuation model discounts future free cash flows rather than expected dividends.
Because this discounted value represents total firm value, the market value of total debt and preferred
stock must be subtracted to obtain the value of the firm’s common stock. Dividing the value of
common stock by outstanding shares gives stock price. The free-cash-flow model differs from the
dividend-valuation model in two ways (i) total firm cash flows are discounted, not just dividends, and
(ii) the discount rate is the firm’s cost of capital, not the required return on stock. This approach is
appealing when valuing startups, firms with no dividend history, or an operating unit or division of a
larger public company.

7-12 Book value per share is the hypothetical amount common shareholders would receive if firm assets
were sold at book (accounting) value, liabilities (including preferred stock) were paid off at book value,
and the remainder divided by shares of common stock outstanding. Liquidation value is the amount
each common stockholder would expect to receive if firm assets were actually sold, creditors and
preferred stockholders were actually paid, and any remainder divided among the common stockholders.
Here, market rather than book values of assets and liabilities are used. Under the price-earnings-
multiples approach, share value is estimated by multiplying expected earnings per share by the
average price/earnings ratio for the industry. Of the three approaches to valuation, the price/earnings
multiples approach is considered the best because it considers expected earnings.

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7-13 A useful way to think about the impact of financial decisions on the firm is with the constant-growth
stock-valuation model: P0 = D1 ÷ (r – g). Actions of financial managers affect stock price (and hence
firm value) through their impact on expected dividends (either the next expected, D1, or the expected
growth of dividends, g) or risk (which shows up in required return). Any action that increases expected
dividends will boost stock price, and any action that increases risk will depress stock price.

7-14 A useful way to analyze the impact of events on stock price is to start with the constant-growth stock-
valuation model and assign hypothetical initial values. Accordingly, let the next expected dividend (D1)
be $5, expected rate of dividend growth (g) be 3%, and required rate of return (r)be 8%:
P0 = D1 ÷ (r – g) = $5 ÷ (0.08 – 0.03) = $100
a. Now, required return (r) = risk-free rate (RF) + risk premium (RP). So, an increase in RP means an
increase in r. Suppose r rises from 8% to 9%, but expected dividends (D1 and g) do not change:
$5 ÷ (0.09 – 0.03) = $83.33. In words, stock price will fall from $100 to $83.33.
b. Suppose r falls from 8% to 7%, but nothing else changes: $5 ÷ (0.07 – 0.03) = $125.00. Stock
price will rise from $100 to $125.
c. Suppose the dividend expected next year (D1) rises from $5 to $6, but nothing else changes:
$6 ÷ (0.08 – 0.03) = $120.00. Stock price will rise from $100 to $120.
d. Suppose expected dividend growth (g) rises from 3% to 4%, but nothing else changes:
$5 ÷ (0.08 – 0.04) = $125.00. Stock price will rise from $100 to $125.

„ Suggested Answer to Focus on Practice Box:

“Understanding Human Behavior Helps Understand Investor Behavior”
Theories of behavioral finance can apply to other areas of human behavior in addition to investing. Think of a
situation in which you may have demonstrated one of these behaviors. Share with a classmate.

Student answers will vary. Examples for discussion: (i) regret theory may hold true for social situations in
which a person makes a mistake and subsequently focuses on avoiding embarrassment at all costs; (ii) fear of
regret can sometimes be rationalized away with “everyone else is doing it” (herding theory), thereby
explaining why some people do silly things at parties; and (iii) students may react to grades as investors react
to news, placing more importance on recent events without recognizing the overall trend (anchoring).

„ Suggested Answer to Focus on Ethics Box:

“Index Funds and Corporate Governance”
If you were CEO of a publicly traded company, would you want a large bloc of your shares held by index
funds? Why or why not?
A CEO’s chief responsibility is to take all actions that increase shareholder wealth. That said, some CEOs
look for opportunities to pursue personal interests at the expense of shareholders. At first, it might seem an
unethical CEO would like to see the bulk of her firm’s shares in an index fund because, to the extent such
funds are poor monitors, she will have some room to use firm resources to advance her personal agenda. But
recent evidence suggests firms largely owned by index funds have excellent corporate governance practices—
most likely because the costs of organizing to oust management is smaller when the bulk of a firm’s shares
are held by large shareholders. In short, an ethical CEO would see a large ownership stake in the hands of an
index fund as a mechanism for committing to (and signaling that commitment to) shareholder welfare.

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Now, suppose you manage a large index fund, what responsibility (if any) do you have for ensuring the
companies in your portfolio maximize shareholder wealth?
As fund manager, your fiduciary duty is to your investors; they gave you money believing you will construct
a portfolio to mimic a market index at the lowest possible fees. So monitoring and disciplining the
management of firms in your portfolio is not your first concern. How much effort you spend monitoring
depends on the availability of good substitutes and expected net benefits of monitoring. Devoting few
resources to monitoring a company makes sense if monitoring costs are high, expected benefits are low
(because firm management is entrenched), and investing in a similar company is easy. Moreover, other
shareholders (or more likely blocks of shareholders) can do the necessary monitoring and alert you to serious
governance issues. As a large shareholder, the threat you might ally with disgruntled shareholders might be
sufficient to keep management focused on stockholder wealth.

„ Answers to Warm-Up Exercises

E7-1 Using debt ratio to calculate a firm’s total liabilities (LG 1)
Answer: Debt ratio = Total liabilities ÷ Total assets → Total liabilities = Debt ratio × Total assets
= 0.75 × $5,200,000 = $3,900,000.

E7-2 Determining net proceeds from the sale of stock (LG 2)

Answer: Net proceeds = (1,000,000 × $20 × 0.95) + (250,000 × $20 × 0.90) = $23,500,000.

E7-3 Preferred and common stock dividends (LG 2)

Answer: Common-stock dividend = (Cash available − Preferred dividends owed) ÷ Common shares
= [$12,000,000 − (4 × $2.50 × 750,000)] ÷ 3,000,000 = $1.50 per share.

E7-4 Price-earnings ratios (LG 3)

Answer: Earnings per share (EPS) = $11,200,000 ÷ 4,600,000 = $2.43 per share. So, today’s P/E ratio is
$24.60 ÷ $2.43 = 10.12, and yesterday’s P/E ratio is $24.95 ÷ $2.43 = 10.27.

E7-5 Valuing stock with zero dividend growth (LG 4)

Answer: P0 = D1 ÷ r, where D1 = $1.20 × (1.05) = $1.26. and r = 8%. So, P0 = $1.26 ÷ 0.08 = $15.75.

E7-6 Valuing stock with zero dividend growth (LG 6)

Answer: Calculate required return, r = RF + RP = 4.5% + 10.8% = 15.3%. Then, calculate value of stock
with zero-growth model, P0 = D1 ÷ r, where D1 = $2.25 and r = 15.3%: $2.25 ÷ 0.153 = $14.71.

„ Solutions to Problems
P7-1 Authorized and available shares (LG 2; Basic)
a. Maximum shares = Authorized shares – Shares outstanding = 2,000,000 – 1,400,000 = 600,000.
b. Total shares needed = $48,000,000 ÷ $60 = 800,000 shares, meaning 200,000 additional shares
must be authorized to raise needed funds.
c. Aspin must seek approval through a vote of current shareholders.

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P7-2 Preferred dividends (LG 2; Intermediate)

a. Annual dividend in dollars = Price of preferred stock × annual dividend rate
= $40 × 8% = $3.20 per year or $0.80 per quarter.
b. $0.80—For noncumulative preferred, only the current dividend must be paid before dividends on
common stock.
c. $3.20—For cumulative preferred, all dividends in arrears must be paid before paying dividends
on common stock. Here, the board must pay the three dividends missed plus the current dividend.

P7-3 Preferred dividends (LG 2; Intermediate)

Case Answer Explanation
Three quarters of passed dividends plus current quarter (4 quarters × $4 per
A $16
quarter)
Dividend is 2% of $110 per quarter, or $2.20 per quarter; only current quarter
B $2.20
must be paid because stock is noncumulative.
C $3 Only current dividend of $3 must be paid because stock is noncumulative.
Quarterly dividend is 1.5% of $60 or $0.90 per quarter. Total dividends owed
D $4.50
equal four quarters passed plus current dividend (5 × $0.90).
Quarterly dividend is 3% of $70 or $2.10 per quarter. No dividends have been
E $2.10
passed, so only current $2.10 dividend is due.

P7-4 Convertible preferred stock (LG 2; Challenge)

a. Conversion value or preferred stock = Conversion ratio × Common stock price = 5 × $20 = $100.
b. The investor should covert because value would be $100 while preferred stock price is only $96.
c. This question is trickier than it first appears. Students might note conversion of one share of
preferred to five shares of common stock will reward an investor with $5 in common dividends
annually ($1.00 per share × 5) while retaining the preferred stock will yield only $10.00 per year
in dividends. This is true but fails to recognize an investor converting preferred into common
shares could immediately sell the common shares for $100, repurchase the preferred shares for
$96, and pocket a $4 profit. Moreover, there is no limit on how often this trade can be repeated as
long as the markets for preferred and common are liquid, and prices do not change. [In general,
however, such trading will bid up the price of preferred stock (because investors are buying it) and
depress the price of the common stock (because investors are selling it) until the profit opportunity
vanishes.] Investors might not convert for other reasons as well. Suppose the preferred stock is
worth $100, so no immediate profit is available from converting. Investors might wish to continue
holding preferred stock because common shares are riskier. Transactions costs or tax implications
could also make conversion unappealing.

P7-5 Preferred stock valuation (LG 4; Basic)

a. Annual dividend = Price of preferred stock × annual dividend rate = $65 × 10% or $6.50.
b. Because the dividend stream is a perpetuity, value of preferred stock is just annual dividend
divided by required return, P0 = D1 ÷ r, where D1 = $6.50 and r = 8%.: $6.50 ÷ 0.08 = $81.25.
c. To find share value, recognize the dividend stream is identical to part (b) except that in one year,
investors will receive an extra $13 for two years of passed dividends. Therefore, value of
preferred stock equals value calculated in part (b) plus the present value of the passed dividends:
$81.25 + ($13 ÷ 1.08) = $81.25 + $12.04 = $93.29.

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P7-6 Personal finance: Common-stock valuation—Zero growth (LG 4; Intermediate)

Using the perpetuity formula (P0 = D1 ÷ r, where D1 = $2.80 and r = 9.25%), Kelsey Drums common
stock is worth $32.27 today. Ten years ago, it was worth $36.84 ($2.80 ÷ 0.076), implying Kim
would lose $6.57 per share ($36.84 – $32.27), and $1,314.37 in toto (200 shares × $6.57).

P7-7 Preferred stock valuation (LG 4; Intermediate)

a. Preferred stock price = Expected perpetual dividend (D1) ÷ Required rate of return (r)
= $6.40 ÷ 0.093 = $68.82.
b. New value of preferred stock is $6.40 ÷ 0.105 = $60.95. The investor would lose $7.87 per share
($68.82 − $60.95) because the rise in required return caused the price of preferred stock to fall.
Now, the same perpetual dividend is discounted at a higher rate.

P7-8 Common stock value: Constant growth (LG 4; Basic)

Let P0 be the current price of the common stock, D1 the next expected dividend, r the required return,
and g the expected constant growth rate of dividends:
Firm P0 = D1 ÷ (r − g) Share Price
A P0 = $1.20 ÷ (0.13 − 0.08) = $ 24.00
B P0 = $4.00 ÷ (0.15 − 0.05) = $ 40.00
C P0 = $0.65 ÷ (0.14 − 0.10) = $ 16.25
D P0 = $6.00 ÷ (0.09 − 0.08) = $600.00
E P0 = $2.25 ÷ (0.20 − 0.08) = $ 18.75

P7-9 Common stock value: Constant growth (LG 4; Intermediate)

a. Let P0 be current price of common stock, D1 the next expected dividend, r the required return,
and g the expected dividend growth rate; stock price is given by P0 = D1 ÷ (r − g). The next
dividend (D1) = $1.20 × 1.05 = $1.26. So, plugging given information in the stock-price equation
and solving for r: $28 = $1.26 ÷ (r – 0.05) → r = 9.50%.
b. The next dividend (D1) = $1.20 × 1.10 = $1.32. So, $28 = $1.32 ÷ (r – 0.10) → r = 14.7%.

P7-10 Common stock value: Constant growth (LG 4; Intermediate)

Let P0 be current price of common stock, D1 the next expected dividend, r the required return, and g
the expected dividend growth; stock price is given by P0 = D1 ÷ (r − g). Historical growth in
dividends from 2015 to 2019 (also expected dividend growth) is ($2.52 ÷ $1.52) – 1 = 13.47%.
The next expected dividend (D2020) is $2.52 × 1.1347 = $2.86. Required return is given as 20%, so P0
= $2.86 ÷ (0.20 – 0.1347) = $43.80.

P7-11 Personal finance: Common stock value- Constant growth (LG 4; Intermediate)
Let P0 be current price of common stock, D1 the next expected dividend, r the required return, and g
the expected dividend growth rate; stock price is given by P0 = D1 ÷ (r − g). In the problem, D1 is
$1.35, today’s share price is $114, and required return is 15.8%. Plugging these values in the stock-
price equation and solving for expected dividend growth (g):
$114 = $1.35 ÷ (0.158 – g) = $43.80 → g = 0.158 – ($1.35 ÷ $114) = 0.1462 = 14.62%.

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P7-12 Personal finance: Common stock value—Constant growth (LG 4; Challenge)

a. Let P0 be current stock price, D1 the next expected dividend, r the required return, and g the
expected dividend growth rate; stock price is given by P0 = D1 ÷ (r − g). Historical growth in
dividends from 2014 to 2019 (also expected dividend growth) is ($2.87 ÷ $2.25) – 1 = 4.99%.
The next expected dividend (D2020) is $2.87 × 1.0499 = $3.01, and required return is given as
13%, so P0 = $3.01 ÷ (0.13 – 0.0499) = $37.61.
b. If required return falls to 10%, P0 = $3.01 ÷ (0.10 – 0.0499) = $60.12.
c. A fall in required return means future dividends are discounted at a lower rate, so stock price rises.

P7-13 Common stock value: Variable growth (LG 4; Challenge)

P0 = Present value of dividends during initial growth period
+ Present value of stock price at end of initial growth period.
Step 1: Present value of cash dividends during initial growth period, given last dividend of $2.55,
expected dividend growth for 3 years of 25%, and required return of 15%:
n D0 × 1.25n = Dn ×1/(1.15)n = Present Value of Dividends
1 $2.55 1.2500 $3.19 0.8696 $2.77
2 $2.55 1.5625 $3.98 0.7561 $3.01
3 $2.55 1.9531 $4.98 0.6575 $3.27
Total = $9.05
Step 2: Present value of price of stock at end of initial growth period—given dividend at the end of
third period of $4.98, expected dividend growth of 10%, and required return of 15%:
At end of year 3, next expected dividend, D4 = $4.98 × (1 + 0.10) = $5.48. So, stock price at
the end of year 3, P3 = [D4 ÷ (r − g)] = $5.48 ÷ (0.15 − 0.10) = $109.56. Finally, the present
value of stock price at end of year 3 is $109.56 ÷ (1 + 0.15)3 = $72.04.
Step 3: Add present value of dividends during initial growth period to present value of stock price at
end of growth period: P0 = $9.05 + $72.04 = $81.09.

P7-14 Personal finance: Common stock value—Variable growth (LG 4; Challenge)

P0 = Present value of dividends during initial growth period
+ Present value of stock price at end of initial growth period.
Step 1: Present value of dividends during initial growth period—given last dividend (D0) of $3.40,
variable dividend growth for 4 years, and required return of 14%:
D1 = $3.40 × (1.00) = $3.40 D3 = $3.57 × (1.05) = $3.75
D2 = $3.40 × (1.05) = $3.57 D4 = $3.75 × (1.15) = $4.31
n Dn × 1/(1.14)n = Present Value of Dividends
1 $3.40 0.8772 $2.98
2 $3.57 0.7695 $2.75
3 $3.75 0.6750 $2.53
4 $4.31 0.5921 $2.55
Total = $10.81

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Step 2: Present value of price of stock at end of initial growth period—given dividend at the end of
year 4 period of $4.31, expected dividend growth of 10%, and required return of 14%:
At end of year 4, next expected dividend, D5, is $4.31 × (1.10) = $4.74. So, stock price at the
end of year 4, P4 = [D5 ÷ (r − g)] = $4.74 ÷ (0.14 − 0.10) = $118.50. Finally, present value of
stock price at end of year 4 is $118.50 ÷ (1 + 0.14)4 = $70.16.
Step 3: Add present value of dividends during initial growth period to present value of stock price at
end of growth period: P0 = $10.81 + $70.16 = $80.97.

P7-15 Common stock value—Variable growth (LG 4; Challenge)

a. P0 = Present value of dividends during initial growth period
+ Present value of stock price at end of initial growth period.
Step 1: Present value of dividends during initial growth period—given last dividend of $1.80,
expected dividend growth for 3 years of 8%, and required return of 11%:
n D0 × 1.08n = Dn × ÷1/(1.11)n = Present Value of Dividends
1 $1.80 1.0800 $1.94 0.9009 $1.75
2 $1.80 1.1664 $2.10 0.8116 $1.70
3 $1.80 1.2597 $2.27 0.7312 $1.66
Total = $5.11
Step 2: Present value of price of stock at end of initial growth period—given dividend at the end
of year 3 period of $2.27, expected dividend growth of 5%, and required return of 11%:
At end of year 3, next expected dividend, D4 = $2.27 × (1 + 0.05) = $2.38. So, stock price
at the end of year 3, P3 = [D4 ÷ (r − g)] = $2.38 ÷ (0.11 − 0.05) = $39.67. Finally, the
present value of stock price at end of year 3 = $39.67 ÷ (1 + 0.11)3 = $29.01.
Step 3: Add present value of dividends during initial growth period to present value of stock
price at end of growth period: P0 = $5.11 + $29.01 = $34.12.
b. The present value of year 1-3 dividends is the same as in part (a). For step 2, dividend growth rate
is now zero after year 3, so D3 = D4 = $2.27. Moreover, now P3 may be found with the perpetuity
formula: P3 = D4 ÷ r = $2.27 ÷ 0.11 = $20.64; present value of stock price at the end of year 3 =
$20.64 ÷ (1 + 0.11)3 = $15.09. For step 3, P0 = $5.11 + $15.09 = $20.20.
c. Present value of year 1-3 dividends is the same as in part (a). For step 2, dividend growth is now
10% after year 3, so D4 = $2.27 × (1.10) = $2.50, and P3 = [D4 ÷ (r − g)] = $2.50 ÷ 0.01 =
$250.00. Present value of stock price at end of year 3 is $250.00 ÷ (1.11)3 = $182.80. For step 3,
P0 = $5.11 + $182.80 = $187.91.

P7-16 Personal finance: Common stock value—Free cash flow models (LG 4; Challenge)
a. Firm has no debt or preferred stock, so firm value (Vc) is present value of expected free cash flow
(FCF). If current FCF is not expected to change (FCF0 = FCF1), and required return (r) is 18%:
VC = FCF1 ÷ r = $42,500 ÷ 0.18 = $236,111
b. Free cash flow next year, FCF1 = $42,500 × 1.07 = $45,475. Now, because FCF is expected to
grow at a constant rate, VC can be found using the stock-valuation framework for constant
dividend growth, where FCF1 is substituted for D1, and g represents constant FCF growth:
VC = FCF1 ÷ (r – g) = $46,750 ÷ (0.18 – 0.07) = $413,409.09
c. VC = Present value of FCF in first growth period + Present value of FCF after first growth period.

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Step 1: Present value of FCF during initial growth period—given FCF0 = $42,500, expected FCF
growth of 12% for two years, and required return of 18%:
n FCF0 × 1.12n = FCFn × 1/(1.18)n = Present Value of FCFn
0 $42,500
1 $42,500 1.1200 $47,600 0.8475 $40,338.98
2 $42,500 1.2554 $53,312 0.7182 $38,287.85
Total = $78,626.83
So, stock price at end of year 2, P2 = [FCF3 ÷ (r − g)] = $53,312 ÷ (0.18 − 0.07) =
$518,580.36. Finally, the present value of P2 = $518,580.36 ÷ (1.18)2 = $372,436.34.
Step 3: Add present value of free cash flow during initial growth period to present value of stock
price at end of growth period: VC = $78,626.83 + $372,436.34 = $451,063.17.
Note: Student answers may vary by a few cents because of rounding.

P7-17 Free cash flow (FCF) valuation (LG 5; Challenge)

a. Assumes 2020 is one year in the future. Firm value (VC) may be found in three steps:
Step 1: Present value of FCF from 2025 to infinity: FCF2025 = $390,000 × (1.03) = $401,700,
and present value of FCF2025 to infinity in 2024= $401,700 ÷ (0.11 − 0.03) = $5,021,250.
Step 2: Add step 1 to given FCF2024: $5,021,250 + $390,000 = $5,411,250.
Step 3: Discount FCF from 2020 through 2024 back to today:
Year Years from Now (n) FCFn × 1/(1.11)n = Present Value
2020 1 $200,000 0.900901 $ 180,180.18
2021 2 250,000 0.811622 $ 202,905.61
2022 3 310,000 0.731191 $ 226,669.33
2023 4 350,000 0.658731 $ 230,555.84
2024 5 $5,411,250 0.593451 $3,211,313.50
Total Firm Value (VC) = $4,051,624.46
b. Total value of common stock (VS) = VC – Total debt (VD)– Total value of preferred stock ((VP)
= $4,051,624.46 − $1,500,000 − $400,000 = $2,151,624.46.
c. Value per share of common stock = VS ÷ Common shares = $2,151,624.46 ÷ 200,000 = $10.76.

P7-18 Personal finance: Using the free-cash-flow valuation model to price an IPO (LG 5; Challenge)
a. The value of the firm’s common stock may be found in four steps:
Step 1: Find present value in 2023 of free cash flow (FCF) from 2024 to infinity:
FCF2024 = $1,100,000 × (1.02) = $1,122,000.
Present value of FCF2024 to infinity in 2023= $1,100,000 ÷ (0.08 − 0.02) = $18,700,000.
Step 2: Add step 1 to given FCF2023: $18,700,000 + $1,100,000 = $19,800,000.

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Step 3: Discount FCF from 2020 through 2024 to today to obtain total value of the firm (VC):
Year Years from Now (n) FCFn × 1/(1.08)n = Present Value
2020 1 $ 700,000 0.925926 $648,148.15
2021 2 $ 800,000 0.857339 $685,871.06
2022 3 $ 950,000 0.793832 $754,140.63
2023 4 $19,800,000 0.735030 $14,553,591.09
Total Value of Firm = $16,641,750.92
Step 4: Find value of common stock per share:
VS = VC – VD – VP = $16,641,750.92 – $2,700,000 - $1,000,000 = $12,941,750.92.
Value per share of common stock = Total value of common stock ÷ Common shares
= $12,941,750.92 ÷ 1,100,000 = $11.77.
b. IPO is overvalued by $0.73 ($12.50 − $11.77), so you should not buy the stock.
c. New value of common stock may be found in four steps:
Step 1: Present value in 2023 of FCF from 2024 to infinity:
FCF2024 = $1,100,000 × (1.03) = $1,133,000.
Present value of FCF2024 to infinity-in 2023 = $1,133,000 ÷ (0.08 − 0.03) = $22,660,000.
Step 2: Add step 1 to given FCF2023: $22,660,000 + $1,100,000 = $23,760,000.
Step 3: Discount FCF from 2020 through 2024 back to today.
Year Years from Now (n) FCFn × 1/(1.08)n = Present Value
2020 1 $ 700,000 0.925926 $648,148.15
2021 2 $ 800,000 0.857339 $685,871.06
2022 3 $ 950,000 0.793832 $754,140.63
2023 4 $23,760,000 0.735030 $17,464,309.30
Total Firm Value (VC) = $19,552,469.14
Step 4: Find value of common stock per share:
VS = VC – VD – VP = $19,552,469.14 − $2,700,000 − $1,000,000 = $15,852,469.14.
Value per share of common stock =VS ÷ Common shares
= $15,852,469.14 ÷ 1,100,000 = $14.41.
The IPO is undervalued by $1.91 ($14.41 − $11.77), so you should buy the stock.

P7-19 Book and liquidation value (LG 5; Intermediate)

a. Book value per share =
Book value of assets—Book value of liabilities – Book value of preferred stock
Outstanding Shares
= ($780,000 – $340,000 – $80,000) ÷ 10,000 = $36 per share.

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b. Liquidation value:
Assets Liquidation Value for Common Stock
Cash $40,000 Liquidation Value–Assets $722,000
Marketable Securities 60,000 Less:
Accounts Receivable (0.90 × $120,000) 108,000 Current Liabilities (160,000)
Inventory (0.90 × $160,000) 144,000 Long-Term Debt (180,000)
Land and Buildings (1.30 × $150,000) 195,000 Preferred Stock (80,000)
Machinery & Equipment (0.70 × $250,000) 175,000 Available for
Liquidation Value of Assets $722,000 Common Stockholders $302,000
Liquidation value per share = Value available for common stockholders ÷ common shares
= $302,000 ÷ 10,000 = $30.20.
c. Book values reflect historical prices/costs, not current market value, so it is no surprise
liquidation and book value differ for Gallinas Industries. Here, book exceeds liquidation value (as
is the norm), so estimated value of common shares based on book value exceeds the estimate
based on liquidation value.

P7-20 Valuation with price/earnings multiples (LG 5; Basic)

To estimate stock price given earnings per share (EPS) and the average industry price-earnings
multiple (P/E):
Firm EPS × P/E = Stock Price
A 3.0 × 6.2 = $18.60
B 4.5 × 10.0 = $45.00
C 1.8 × 12.6 = $22.68
D 2.4 × 8.9 = $21.36
E 5.1 × 15.0 = $76.50

P7-21 Management action and stock value (LG 6; Intermediate)

a. Last dividend (D0) was $3, expected dividend growth (g) is 5% per year, and required return (r) is
15%. Hence, the next expected dividend (D1) is $3.15 and stock price, P0 = D1 ÷ (r – g)
= $3.15 ÷ (0.15 − 0.05) = $31.50.
b. If g rises to 6% and r dips to 14%, P0 = $3.18 ÷ (0.14 − 0.06) = $39.75.
c. If g rises to 7% and r rises to 17%, P0 = $3.21 ÷ (0.17 − 0.07) = $32.10.
d. If g falls to 4% and r rises to 16%, P0 = $3.12 ÷ (0.16 − 0.04) = $26.00.
e. If g rises to 8% and r rises to 17%, P0 = $3.24 ÷ (0.17 − 0.08) = $36.00.
The best alternative is the one producing the highest share price, namely (b).

P7-22 Integrative: Risk and valuation (LG 4 and LG 6; Intermediate)

The risk premium on Foster stock may be found in two steps:
Step 1: Given stock price (P0) of $50, next expected dividend (D1) of $3 per share, and expected
dividend growth (g) of 6.5%, solve for required return on the stock (r):
P0 = D1 ÷ (r − g)
$50 = $3.00 ÷ (rs − 0.065) → r = 0.125 or 12.5%

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Step 2: Given a 12.5% required return (r) and a 4.5% risk free return (RF), solve for risk premium
(RP) on stock:
r = RF + RP
0.125 = 0.045 + RP → RP = 0.08 or 8.0%

P7-23 Integrative: Risk and valuation (LG 4 and LG 6; Challenge)

a. Given a 14.8% required return (r), and a 4% risk-free rate (RF), solve for risk premium (RP) on
Giant Enterprise stock:
r = RF + RP
0.148 = 0.040 + RP → RP = 0.108 or 10.8%
b. Dividend growth rate from 2013 to 2019 (also expected future growth rate) is

($2.45 ÷ $1.73) – 1 = 0.0597 = 5.97%. Given the next expected dividend (D1) is $2.60 per
share, expected dividend growth (g) is 5.97% per year, and required return (r) is 14.8%, solve the
for value of Giant stock: P0 = D1 ÷ (r – g) = $2.60 ÷ (0.148 − 0.0597) = $29.45.
c. A decline in the risk premium would reduce required return. If expected dividends did not
change, that stream would now be discounted at a lower rate, which means a higher value of (and
market price for) Giant Enterprise stock.

P7-24 Integrative: Risk and valuation (LG 4 and LG 6; Challenge)

a. The maximum price to pay for Craft stock may be found in three steps:
Step 1: Find 2014-2019 dividend growth rate (which is expected dividend growth rate) for Craft
stock: g = ($3.44 ÷ $2.45) – 1 = 0.0702 = 7.02%.
Step 2: Find required return (r) on Craft stock, given a risk-free rate (RF) of 5% risk premium
(RP) of 9%: r = RF + RP = 5% + 9% = 14%.
Step 3: Given a next expected dividend (D2020) of $3.68 per share, expected dividend growth (g)
of 7.02%, and required return (r) of 14%, solve for the maximum price (value) of Craft
stock: P0 = D2020 ÷ (r – g) = $3.68 ÷ (0.14 − 0.0702) = $52.72 per share.
b. Part (1): The new value of Craft stock with lower dividend growth may be found in two steps:
Step 1: Find new expected dividend for 2020 with expected growth rate two percentage
points lower: D2020 = D2019 × (1.0502) = $3.44 × (1.0502) = $3.61.
Step 2: Given an expected 2020 dividend (D1) of $3.61 per share, expected dividend
growth (g) of 5.02%, and required return (r) of 14%, solve for new value of
Craft stock:P0 = D2020 ÷ (r – g) = $3.61 ÷ (0.14 − 0.0502) = $40.20 per share. A
two-percentage-point decline in dividend growth reduced share price by $12.52.
Part (2): To find the new share price, first recognize the smaller risk premium means a smaller
expected return. Specifically, risk premium (RP) falls to 4%, so required return is:
(r) = RF + RP = 5% + 4% = 9%. Given the next expected dividend (D2020) is $3.68 per
share, expected dividend growth (g) is 7.02%, and required return (r) is now 9%, solve
for new value of Craft stock: P0 = D2020 ÷ (r – g) = $3.68 ÷ (0.9 − 0.0702) = $185.86. A
five percentage point decline in the risk premium boosted share price by $133.14.

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P7-25 Ethics problem (LG 4; Intermediate)

a. “Clearly not growing” means valuing with the zero-dividend-growth model. Given a next
expected dividend (D1 = D0) of $5 per share and required return (r) of 11%, solve for value of
Generic Utilities stock: P0 = D1 ÷ r = $5 ÷ 0.11 = $45.45 per share.
b. A one-percentage-point “credibility” risk premium means raising required return from 11% to
12%, making the new value of Generic stock: P0 = D1 ÷ r = $5 ÷ 0.12 = $41.67 per share.
c. The added risk premium reduces the value of Generic stock by $3.79. Uncertainty about the
reliability of the firm’s financials means expected dividends must be discounted at a higher rate.
Put another way, uncertainty makes future dividends worth less to investors.

„ Case: Assessing Impact of Proposed Risky Investment on Suarez Stock

Case studies are available on [Link]/mylab/finance.

In this case, students will assess the potential impact of risky project on a hypothetical firm’s stock.
a. To find the current value per share of Suarez common stock, first obtain the dividend growth rate (g),
which is expected to equal recent historical experience:
𝟒 𝟏.𝟗 𝟒
g=  – 1 = √𝟏. 𝟒𝟔𝟏𝟓𝟒 – 1 = 0.0995 = 9.95%
𝟏.𝟑

Now, given g is 10%, the next expected dividend (D1) is $2.09, and required return is 14%, solve for
stock price: P0 = D1 ÷ (r – g) = $2.09 ÷ (0.14 – 0.0995) = $51.63 per share.
Now, given g is 10%, the next expected dividend (D1) is $2.09, and required return is 14%, solve for
stock price: P0 = D1 ÷ (r – g) = $2.09 ÷ (0.14 – 0.0995) = $51.63 per share.
b. If Suarez makes the risky investment, next year’s dividend (D1) will rise to $2.15 per share, the dividend
growth rate (g) to 13%., and required return to 16%. The new value of common stock is: P0 = D1 ÷ (r – g)
= $2.15 ÷ (0.16 – 0.13) = $71.67 per share. Stock price jumps $20.04 (38.8%).
c. Suarez should undertake the proposed project. Higher dividend growth more than compensates for the
impact of project risk on required return, thereby boosting stock price and shareholder wealth.
d. Now, dividends will grow 13% per year for three years (from the last dividend of $1.90); then, growth
will slow to the historical growth rate of 9.95%. Stock price will equal the present value of dividends
during 13% growth period plus the present value of stock price at the end of that period.
Step 1: Find the present value of dividends during the 13% growth period – given the last dividend (D0)
of $1.90, and required return of 16%:
D1 = $1.90 × (1.13) = $2.15 D3 = $2.43 × (1.13) = $2.74 D2 = $2.15 × (1.13) = $2.43
n Dn × 1/(1.16)n = Present Value of Dividends
0 $1.90
1 $2.15 0.8621 $1.85
2 $2.43 0.7432 $1.80
3 $2.74 0.6407 $1.76
Total = $5.41

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Step 2: Now, find the present value of price of stock at end of 13% growth period (when 9.95% growth
resumes). At the end of year 3, the next expected dividend (D4) is $2.74 × 1.0995 = $3.01,
expected dividend growth is 9.95%, and required return is 14%,, so stock price is:
P3 = [D4 ÷ (r − g)] = $3.01 ÷ (0.16 − 0.0995) = $49.84. Finally, present value of stock price at
end of year 3 is $49.84 ÷ (1 + 0.16)3 = $31.93
Step 3: Add present value of dividends during 13% growth period to present value of stock price at end
of 13% growth period: P0 = $5.41 + $31.93 = $37.34.
Suarez should not undertake the risky project because share price would fall $14.29 (from $51.63 to
$37.34). Additional dividends do not compensate for the impact on of additional risk on required return.

„ Spreadsheet Exercise
Answers to Chapter 7’s Azure Corporation spreadsheet problem are available on
[Link]/mylab/finance.

„ Group Exercise
Group exercises are available on [Link]/mylab/finance.

The semester began with the fictitious firms about to become public corporations. Out of necessity, few
details were given. Now groups will begin to fill in the blanks. Specifically, using details from recent IPOs,
each group will write a detailed prospectus following the example in the text. Students should quickly see
similar patterns. Most IPOs, for example, are priced between $10 and $30 with few shares available at the
offer price, forcing the public to pay a premium on and around the issuance date. The final group task is
obtaining the most recent information on its shadow firm, including current market numbers and any recent
news/analyses. Students will find much of the news fairly innocuous. Instructors can note the tendency in
recent regulation for public companies to disclose more and more information. Class discussion can then
explore the costs and benefits of erring on the side of over-disclosure.

„ Integrative Case 3: Encore International

In this case, students will explore different methods of valuing a hypothetical firm, including price/earnings
multiples, book value, and traditional dividend-growth models (under varying assumptions about the patterns
of that growth). They will compare stock values generated by the models, discuss the differences, and select
the approach best capturing the firm’s true value.
a. Book value per share = Book value of common equity ÷ Common shares outstanding
= $60,000,000 ÷ 2,500,000 = $24.
b. Current price/earnings ratio = Current stock price÷ Earnings per share (EPS) = $40 ÷ $6.25 = 6.4.
c. (1) Current required return on common stock (r) = Risk-free rate (RF) + Risk premium (RP)
= 6% + 8.8% = 14.8%.
(2) New required return on common stock = 6% + 10% = 16%.
d. Because no dividend growth is anticipated, the valuation formula for perpetuities will indicate stock
price. Given a constant dividend of $4.00 (D1) and a required return of 16%, stock price, P0 = D1 ÷ r =
$4 ÷ 0.16 = $25.

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148 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

e. (1) Given a 6% constant dividend growth, the next dividend is $4 × (1.06) = $4.24. Stock price (P0)
with 6% constant dividend growth (g), 16% required return (r), and $4.24 next dividend (D1) is:
P0 = D1 ÷ (r – g) = $4.24 ÷ (0.16 – 0.06) = $42.40.
(2) Stock price when dividends grow 8% for two years then 6% forever may be found in three steps:
Step 1: Present value of dividends in the 8% growth period, given last dividend (D0) was $4, and
required return is 16%:
First note: D1 = $4.00 × (1.08) = $4.32 and D2 = $4.32 × (1.08) = $4.67. So,
n Dn × 1/(1.16)n = Present Value of Dividends
0 $4.00
1 $4.32 0.8621 $3.72
2 $4.67 0.7432 $3.47
Total = $7.19

Step 2: Present value of price of stock at end of 8% growth period:

At end of year 2, next expected dividend, D3 = $4.67 × (1.06) = $4.95, expected growth is
6%, and required return is 16%, so stock price, P2 = [D3 ÷ (r − g)] = $4.95 ÷ (0.16 − .06)
= 49.50. Finally, present value of end-of-year-2 stock price is $49.50 ÷ (1.16)2 = $36.79.
Step 3: Add present value of dividends during 8% growth period to present value of stock price at
end of 8% growth period: P0 = $7.19 + $36.79 = $43.98.
f. Comparing value of Suarez stock with different valuation methods:
Valuation Method Share Price
Market value $40.00
Book value 24.00
Zero growth 25.00
Constant growth 42.40
Variable growth 43.98

Book value has no relevance to the true value of the firm. Of the remaining methods, the most
conservative estimate is given by the zero-growth model. Based on this estimate of stock value, wary
analysts may advise paying no more than $25 per share—a figure hardly more than book value. The
most optimistic prediction, the variable-growth model, estimates at $43.98, not far from the market
value. The market appears to be more optimistic about Encore International’s future than wary analysts.

© 2015 Pearson Education, Inc.