Common stock value long dash— Variable growth Newman manufacturing is considerin

Question

Common stock

valuelong dash—Variable

growthNewman manufacturing is considering a cash purchase of the stock of Grips Tool. During the year just completed, Grips earned

$4.124.12

per share and paid cash dividends of

$2.422.42

per share

(D0equals=$ 2.42$2.42).

Grips' earnings and dividends are expected to grow at

2525%

per year for the next 3 years, after which they are expected to grow

99%

per year to infinity. What is the maximum price per share that Newman should pay for Grips if it has a required return of

1212%

on investments with risk characteristics similar to those of Grips?

What is the maximum price per share that Newman should pay for Grips?

$nothing

(Round to the nearest cent.)

Common stock

valuelong dash—All

growth modelsPersonal Finance ProblemYou are evaluating the potential purchase of a small business currently generating

$43 comma 50043,500

of after-tax cash flow

(Upper D 0D0equals=$43 comma 50043,500).

On the basis of a review ofsimilar-risk investment opportunities, you must earn a rate of return of

1818%

on the proposed purchase. Because you are relatively uncertain about future cash flows, you decide to estimate the firm's value using two 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

00%

from now to infinity? b.What is the firm's value if cash flows are expected to grow at a constant rate of

66%

from now to infinity? c.What is the firm's value if cash flows are expected to grow at an annual rate of

1111%

for the first 2 years, followed by a constant annual rate of

66%

from year 3 to infinity? a. What is the firm's value if cash flows are expected to grow at an annual rate of

00%

from now to infinity?

$nothing

(Round to the nearest dollar.)

Explanation / Answer

1

D0=2.42

D1=2.42*1.25=3.025

D2=3.025*1.25=3.78125

D3=3.78125*1.25=4.726563

D4=4.726563*1.09=5.151954

Horizon Value=D4/(r-g)=5.151954/(0.12-0.09)=171.7318

Hence, price of share=D1/(1+r)+D2/(1+r)^2+D3/(1+r)^3+Horizon Value/(1+r)^3

=3.025/1.12+3.78125/1.12^2+4.726563/1.12^3+171.7318/1.12^3

=$131.3149

2

r=0.18

D0=43,500

D1=D0*(1+g)

PV of cash flows=D1/(r-g)

a) 0% growth: PV of cash flows=D0*(1+g)/r= 43500/0.18=241666.67

b) 6% growth: PV of cash flows=D0*(1+g)/r= 43500*1.06/0.12=384250

c) 11% for first two years and from year 3 to infinity, 6%: PV of cash flows=43500*1.11/1.18+43500*1.11^2/1.18^2+Horizon value/1.18^2

Horizon Value=43500*1.11^2*1.06/(0.18-0.06)=473434.4

Hence, PV=43500*1.11/1.18+43500*1.11^2/1.18^2+473434.4/1.18^2=419424.8

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