344 PART 2 Important Financial Concepts
LG4LG4LG4LG4The firm’s dividend per share next year is expected to be $3.02.
a. If you can earn 13% on similar-risk investments, what is the most you would
be willing to pay per share?
b. If you can earn only 10% on similar-risk investments, what is the most you
would be willing to pay per share?
c. Compare and contrast your findings in parts aand b,and discuss the impact
of changing risk on share value.7–12 Common stock value—Variable growth Newman Manufacturing is consider-
ing a cash purchase of the stock of Grips Tool. During the year just completed,
Grips earned $4.25 per share and paid cash dividends of $2.55 per share (D 0
$2.55). Grips’ earnings and dividends are expected to grow at 25% per year for
the next 3 years, after which they are expected to grow at 10% per year to infin-
ity. What is the maximum price per share that Newman should pay for Grips if
it has a required return of 15% on investments with risk characteristics similar
to those of Grips?7–13 Common stock value—Variable growth Home Place Hotels, Inc., is entering
into a 3-year remodeling and expansion project. The construction will have a
limiting effect on earnings during that time, but when it is complete, it should
allow the company to enjoy much improved growth in earnings and dividends.
Last year, the company paid a dividend of $3.40. It expects zero growth in the
next year. In years 2 and 3, 5% growth is expected, and in year 4, 15% growth.
In year 5 and thereafter, growth should be a constant 10% per year. What is the
maximum price per share that an investor who requires a return of 14% should
pay for Home Place Hotels common stock?7–14 Common stock value—Variable growth Lawrence Industries’ most recent
annual dividend was $1.80 per share (D 0 $1.80), and the firm’s required
return is 11%. Find the market value of Lawrence’s shares when:
a. Dividends are expected to grow at 8% annually for 3 years, followed by a
5% constant annual growth rate in years 4 to infinity.
b. Dividends are expected to grow at 8% annually for 3 years, followed by a
0% constant annual growth rate in years 4 to infinity.
c. Dividends are expected to grow at 8% annually for 3 years, followed by a
10% constant annual growth rate in years 4 to infinity.7–15 Common stock value—All growth models You are evaluating the potential
purchase of a small business currently generating $42,500 of after-tax cash flow
(D 0 $42,500). On the basis of a review of similar-risk investment opportuni-
ties, you must earn an 18% rate of return on the proposed purchase. Because
you are relatively uncertain about future cash flows, you decide to estimate the
firm’s value using several possible assumptions about the growth rate of cash
flows.
a. What is the firm’s value if cash flows are expected to grow at an annual rate
of 0% from now to infinity?
b. What is the firm’s value if cash flows are expected to grow at a constant
annual rate of 7% from now to infinity?
c. What is the firm’s value if cash flows are expected to grow at an annual rate
of 12% for the first 2 years, followed by a constant annual rate of 7% from
year 3 to infinity?