Solutions to Valuation Questions Essay

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Solutions to Valuation Questions 1. Assume you expect a company’s net income to remain stable at $1,100 for all future years, and you expect all earnings to be distributed to stockholders at the end of each year, so that common equity also remains stable for all future years (assumes clean surplus). Also, assume the company’s β = 1.5, the market risk premium is 4% and the 20-30 year yield on risk free treasury bonds is 5%. Finally, assume the company has 1,000 shares of common stock outstanding. a. Use the CAPM to estimate the company’s equity cost of capital. • re = RF + β * (RM – RF) = 0.05 + 1.5 * 0.04 = 11% b. Compute the expected net distributions to stockholders for each future year. • D = NI – ΔCE = $1,100 – 0 = $1,100 c. Use the …show more content…
b. Use the dividend discount (i.e., free cash flow to equity investors) valuation model to estimate the company’s current stock price.

Pe = 700 / (1+0.11) + 735 / (1+0.11)2 + 948.15 / (1+0.11)3 + [976.59 / (0.11-0.03)] / (1+0.11)3 = $10,846.42 and the price per share of common stock = $10,846.42 / 1,000 = $10.85. 5. Same facts as (2) above, except derive Pe and the price per common share using the earnings-based valuation model. a. Compute RI1, RI2 and RI3, and verify that residual income is growing at a constant rate. What is that rate? • • • • RI1 = 1,100.00 – 0.11(8000) = 220.00 RI2 = 1,155.00 – 0.11(8400) = 231.00 RI3 = 1,212.75 – 0.11(8820) = 242.55 g = 231/220 – 1 = 242.55/231 – 1 = 5% (same as the dividend growth rate in (2) above)

b. Use the residual income to equity investors model to derive Pe and the price per common share. Compare your answer to the answer you got using the free cash flow to equity investors (dividend discount model) in (2) above. Pe = 8,000 + 220/(0.11 – 0.05) = $11,667 and the price per common share = $11,667 / 1000 = $11.67. 6. Same facts as (4) above, except derive Pe and the price per common share using the earnings-based
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