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PROBLEMS 6.38

Nonconstant Growth: A company will pay a $2 per share dividend in 1 year. The dividend in 2 years will be $4 per share, and it is expected that dividends will grow at 5 percent per year thereafter. The expected rate of return on the stock is 12 percent.
A. What is the current price of the stock?
B. What is the expected price of the stock in a year?
C. Show that the expected return, 12 percent, equals dividend yield plus capital appreciation

PROBLEM 15.14 (Chapter 15 problem #14)

Earnings and Leverage: Reliable Gearing currently is all-equity financed. It has 10,000 shares of equity outstanding, selling at $100 a share. The firm is considering a capital-restructuring. The low-debt plan calls for a debt issue of $200,000 with the proceeds used to buy back stock. The high-debt plan would exchange $400,000 of debt for equity. The debt will pay an interest rate of 10 percent. The firm pays no taxes.

A. What will be the debt-to-equity ratio after each possible restructuring?
B. If earnings before interest and tax (EBIT ) will be either $90,000 or $130,000, what will be earnings per share for each financing mix for both possible values of EBIT? If both scenarios are equally likely, what is expected(i.e., average) EPS under each financing mix? Is the high-debt mix preferable?
C. Suppose that EBIT is $100,000. What is EPS under each financing mix? Why are they the same in this particular case?

Problem 16.21 (Chapter 16, Problem #21)
Dividend Policy. For each of the following four groups of companies, state whether you would expect them to distribute a relatively high or low proportion of current earnings and whether you would expect them to have a relatively high or low price-earnings ratio.

A. High-risk companies.
B. Companies that have recently experienced a temporary decline in profits.
C. Companies that expect to experience a decline in profits.
D."Growth" companies with valuable future investment opportunities.

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Solution Summary

The solution has 3 questions in financial management relating to stock valuation, financing mix and dividend policy.

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PROBLEMS 6.38

Non constant Growth: A company will pay a $2 per share dividend in 1 year. The dividend in 2 years will be $4 per share, and it is expected that dividends will grow at 5 percent per year thereafter. The expected rate of return on the stock is 12 percent.

A. What is the current price of the stock?

The current price of the stock is the sum of the discounted dividends that would be received. When dividends grow at a constant rate, we can use the dividend discount model to get the price. The growth rate will be constant fro m year 3 onward. We can get the price in year 2 using the dividend discount model. The price would be
Price = Div1/(ke-g), where Div1 would be dividend in year 3, ke is the discounting rate and g is the growth rate.
Price = 4X(1+5%)/(0.12-0.05) = 4.2/0.07 = $60.
The price today would the discounted sum of dividend in year 1, dividend in year 2 and the price is year 2.
Price today = 2/1.12 + 4/(1.12)^2 + 60/(1.12)^2
Price today = $52.80

B. What is the expected price of the stock in a year?

The expected price of the stock in a year would be the discounted cash flows. After a year there would be $4 of dividend and $60 of price in the next year.
The price in a year would be 4/1.12+60/1.12 = $57.14

C. Show that the expected return, 12 percent, equals dividend yield plus capital appreciation

In one year the dividend in $2 and the capital appreciation is $57.14-$52.80=$4.34. The dividend yield is 2/52.80 = 3.79%. The capital ...

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