Principles of Managerial Finance

CHAPTER 7 Stock Valuation 347

LG6

LG4 LG6

LG4 LG6

7–20 Management action and stock value REH Corporation’s most recent dividend

was $3 per share, its expected annual rate of dividend growth is 5%, and the

required return is now 15%. A variety of proposals are being considered by

management to redirect the firm’s activities. Determine the impact on share price

for each of the following proposed actions, and indicate the best alternative.

a. Do nothing, which will leave the key financial variables unchanged.

b. Invest in a new machine that will increase the dividend growth rate to 6%

and lower the required return to 14%.

c. Eliminate an unprofitable product line, which will increase the dividend

growth rate to 7% and raise the required return to 17%.

d. Merge with another firm, which will reduce the growth rate to 4% and raise

the required return to 16%.

e. Acquire a subsidiary operation from another manufacturer. The acquisition

should increase the dividend growth rate to 8% and increase the required

return to 17%.

7–21 Integrative—Valuation and CAPM formulas Given the following information

for the stock of Foster Company, calculate its beta.

Current price per share of common $50.00

Expected dividend per share next year $ 3.00

Constant annual dividend growth rate 9%

Risk-free rate of return 7%

Return on market portfolio 10%

7–22 Integrative—Risk and valuation Giant Enterprises has a beta of 1.20, the risk-

free rate of return is currently 10%, and the market return is 14%. The com-

pany, which plans to pay a dividend of $2.60 per share in the coming year,

anticipates that its future dividends will increase at an annual rate consistent

with that experienced over the 1997–2003 period, when the following dividends

were paid:

a. Use the capital asset pricing model (CAPM) to determine the required return

on Giant’s stock.

b. Using the constant-growth model and your finding in part a, estimate the

value of Giant’s stock.

c. Explain what effect, if any, a decrease in beta would have on the value of

Giant’s stock.

Year Dividend per share

2003 $2.45

2002 2.28

2001 2.10

2000 1.95

1999 1.82

1998 1.80

1997 1.73