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Calculating fair value of the given securities

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1. A person is considering buying the stock of two home health companies that are similar in all respects except the proportion of earnings paid out as dividends. Both companies are expected to earn $6 per share in the coming year, but Company D (for dividends) is expected to pay out the entire amount as dividends, while Company G ( for growth) is expected to pay out only one-third of its earnings, or $2 per share. The companies are equally risky, and their required rate of return is 15%. D's constant growth rate is zero and G's is 8.33%. What are the intrinsic values of stocks D and G?

2. A broker offers to sell you shares of Bay Area Helthcare, which just paid a dividend of $2 per share. The dividend is expected to grow at a constant rate of 5% per year. The stock's required rate of return is 12%. What is the expected dollar dividend over the next three years? What is the current value of the stock and the expected stock price at the end of each of the next three years? What is the expected dividend yield and capital gains yield for each of the next three years? What is the expected total return for each of the next three years? How does the expected total return compare with the required rate of return on the stock? Does this make sense?

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1.
Company D
Dividend=D=$6
Required rate of return=r=15%
Intrinsic value of stock D=D/r=6/15%=$40

Company G
Current Dividend=Do=$2
Growth rate=g=8.33%
Required rate of return=r=15%
Intrinsic value of stock G=Do*(1+g)/(r-g)=2*(1+8.33%)/(15%-8.33%)=$32.48

2.
What is the expected dollar dividend over the next three years?

Current dividend=Do=$2
Growth rate=g=5%
Required rate of return=r=12%

Expected dividend at the end of Year 1=D1=Do*(1+g)=2*(1+5%)=$2.10
Expected dividend at the end of Year 2=D2=D1*(1+g)=2.10*(1+5%)=$2.205
Expected dividend at the end ...

Solution Summary

There are two problems. Solutions to these problems depict the methodology to estimate the fair value of given securities. Capital gains and dividend yields are also estimated.

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Melissa: Calculate goodwill in acquisition, prepare journal entries under two methods

On July 1 of the current year, Melissa Co. acquired 25% of the outstanding shares of common stock of International Co. at a total cost of $700,000. At the time, the equity (net assets) of International Co. totaled $2,400,000, meaning that the $700,000 purchase price was greater than 25% of net assets. Melissa was willing to pay more than book value for the Internation Co. stock for the following reasons:

a) International owned depreciable plant assets (10-year remaining economic life) with a current fair value of $60,000 more than their carrying amount.
b) International owned land with a current fair value of $300,000 more than its carrying amount.
c) There are no other identifiable tangible or intangible assets with fair value in excess of book value. Accordingly, the remaining excess, if any, is to be allocated to goodwill.

International Co. earned net income of $540,000 evenly over the current year ended December 31. On December 31, International declared and paid a cash dividend of $105,000 to common stockholders. Fair value of Melissa's share of the stock at December 31 is $750,000. Both companies close their accounting records on December 31.

Instructions:

1. Compute the total amount of goodwill of International Co. based on the price paid by Melissa Co.

2. Prepare all journal entries in Melissa's accounting records relating to the investment for year ended December 31 under the cost method of accounting, classifying the securities as available for sale.

3. Prepare all journal entries in Melissa's accounting records relating to the investment for year ended December 31 under the equity method of accounting.

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