Principles of Managerial Finance

351

Figure 1

0 .5 1.0 1.5 2.0 2.5 3.0

5

10

15

20

25

30

Nondiversifiable Risk, b

Security Market Line

Required Return,

k

(%) Data Points

bk

0.00

0.25

0.50

0.75

1.00

1.25

1.50

1.75

2.00

6.00%

8.00

10.00

12.00

14.00

16.00

18.00

20.00

22.00

Required

a. What is the firm’s current book value per share?
b. What is the firm’s current P/E ratio?
c. (1) What are the required return and risk premium for Encore stock using
the capital asset pricing model, assuming a beta of 1.10? (Hint:Use the
security market line—with data points noted—given in Figure 1 to find
the market return.)
(2) What are the required return and risk premium for Encore stock using
the capital asset pricing model, assuming a beta of 1.25?
(3) What will be the effect on the required return if the beta rises as
expected?
d. If the securities analysts are correct and there is no growth in future divi-
dends, what will be the value per share of the Encore stock? (Note:Beta
1.25.)
e. (1) If Jordan Ellis’s predictions are correct, what will be the value per share
of Encore stock if the firm maintains a constant annual 6% growth rate
in future dividends? (Note:Beta1.25.)
(2) If Jordan Ellis’s predictions are correct, what will be the value per share
of Encore stock if the firm maintains a constant annual 8% growth rate
in dividends per share over the next 2 years and 6% thereafter? (Note:
Beta1.25.)
f. Compare the current (2003) price of the stock and the stock values found in
parts a, d,and e.Discuss why these values may differ. Which valuation
method do you believe most clearly represents the true value of the Encore
stock?