ńňđ. 2 |

after paying all liabilities (includ-

ing preferred stock) were divided lacks any true relationship to the firmâ™s value in the marketplace. Let us look at

among the common stockholders.

an example.

At year-end 2003, Lamar Companyâ™s balance sheet shows total assets of $6 mil-

EXAMPLE

lion, total liabilities (including preferred stock) of $4.5 million, and 100,000

shares of common stock outstanding. Its book value per share therefore would be

$6,000,000 $4,500,000

$15 per share

100,000 shares

Because this value assumes that assets could be sold for their book value, it may

not represent the minimum price at which shares are valued in the marketplace.

As a matter of fact, although most stocks sell above book value, it is not unusual

to find stocks selling below book value when investors believe either that assets

liquidation value per share are overvalued or that the firmâ™s liabilities are understated.

The actual amount per share

of common stock that would

be received if all of the firmâ™s

Liquidation Value

assets were sold for their market

value, liabilities (including Liquidation value per share is the actual amount per share of common stock that

preferred stock) were paid, and

would be received if all of the firmâ™s assets were sold for their market value, liabili-

any remaining money were

ties (including preferred stock) were paid, and any remaining money were divided

divided among the common

among the common stockholders.5 This measure is more realistic than book

stockholders.

5. In the event of liquidation, creditorsâ™ claims must be satisfied first, then those of the preferred stockholders.

Anything left goes to common stockholders.

287

CHAPTER 7 Stock Valuation

valueâ”because it is based on the current market value of the firmâ™s assetsâ”but it

still fails to consider the earning power of those assets. An example will illustrate.

Lamar Company found upon investigation that it could obtain only $5.25 mil-

EXAMPLE

lion if it sold its assets today. The firmâ™s liquidation value per share therefore

would be

$5,250,000 $4,500,000

$7.50 per share

100,000 shares

Ignoring liquidation expenses, this amount would be the firmâ™s minimum value.

Price/Earnings (P/E) Multiples

The price/earnings (P/E) ratio, introduced in Chapter 2, reflects the amount

investors are willing to pay for each dollar of earnings. The average P/E ratio in a

particular industry can be used as the guide to a firmâ™s valueâ”if it is assumed that

investors value the earnings of that firm in the same way they do the âaverageâ

firm in the industry. The price/earnings multiple approach is a popular technique

price/earnings multiple approach

A popular technique used to used to estimate the firmâ™s share value; it is calculated by multiplying the firmâ™s

estimate the firmâ™s share value; expected earnings per share (EPS) by the average price/earnings (P/E) ratio for the

calculated by multiplying the

industry. The average P/E ratio for the industry can be obtained from a source

firmâ™s expected earnings per

such as Standard & Poorâ™s Industrial Ratios.

share (EPS) by the average

The use of P/E multiples is especially helpful in valuing firms that are not

price/earnings (P/E) ratio for the

industry. publicly traded, whereas market price quotations can be used to value publicly

traded firms. In any case, the price/earnings multiple approach is considered

superior to the use of book or liquidation values because it considers expected

earnings. An example will demonstrate the use of price/earnings multiples.

Lamar Company is expected to earn $2.60 per share next year (2004). This

EXAMPLE

expectation is based on an analysis of the firmâ™s historical earnings trend and of

expected economic and industry conditions. The average price/earnings (P/E)

ratio for firms in the same industry is 7. Multiplying Lamarâ™s expected earnings

per share (EPS) of $2.60 by this ratio gives us a value for the firmâ™s shares of

$18.20, assuming that investors will continue to measure the value of the average

firm at 7 times its earnings.

So how much is Lamar Companyâ™s stock really worth? Thatâ™s a trick ques-

tion, because thereâ™s no one right answer. It is important to recognize that the

answer depends on the assumptions made and the techniques used. Professional

securities analysts typically use a variety of models and techniques to value

stocks. For example, an analyst might use the constant-growth model, liquidation

value, and price/earnings (P/E) multiples to estimate the worth of a given stock. If

the analyst feels comfortable with his or her estimates, the stock would be valued

at no more than the largest estimate. Of course, should the firmâ™s estimated liqui-

dation value per share exceed its âgoing concernâ value per share, estimated by

using one of the valuation models (zero- or constant-growth or free cash flow) or

the P/E multiple approach, the firm would be viewed as being âworth more dead

than alive.â In such an event, the firm would lack sufficient earning power to jus-

tify its existence and should probably be liquidated.

288 PART 2 Important Financial Concepts

Review Questions

7â“13 What does the efficient-market hypothesis say about (a) securities prices,

(b) their reaction to new information, and (c) investor opportunities to

profit?

7â“14 Describe, compare, and contrast the following common stock dividend

valuation models: (a) zero-growth and (b) constant-growth.

7â“15 Describe the free cash flow valuation model and explain how it differs

from the dividend valuation models. What is the appeal of this model?

7â“16 Explain each of the three other approaches to common stock valuation:

(a) book value, (b) liquidation value, and (c) price/earnings (P/E) multi-

ples. Which of these is considered the best?

Decision Making and Common Stock Value

LG6

Valuation equations measure the stock value at a point in time based on expected

return and risk. Any decisions of the financial manager that affect these variables

can cause the value of the firm to change. Figure 7.4 depicts the relationship

among financial decisions, return, risk, and stock value.

Changes in Expected Return

Assuming that economic conditions remain stable, any management action that

would cause current and prospective stockholders to raise their dividend expecta-

tions should increase the firmâ™s value. In Equation 7.4, we can see that P0 will

increase for any increase in D1 or g. Any action of the financial manager that will

increase the level of expected returns without changing risk (the required return)

should be undertaken, because it will positively affect ownersâ™ wealth.

Using the constant-growth model, we found Lamar Company to have a share

EXAMPLE

value of $18.75. On the following day, the firm announced a major technologi-

cal breakthrough that would revolutionize its industry. Current and prospective

stockholders would not be expected to adjust their required return of 15%, but

FIGURE 7.4

Effect on

Decision Making

1. Expected Return

and Stock Value Decision Measured by Expected Effect on

Financial decisions, return, Dividends, D1, D2, â¦, Dn,

Action by Stock Value

D1

Financial and Expected Dividend

risk, and stock value

P0 =

Growth, g.

Manager ks â“ g

2. Risk Measured by the

Required Return, ks.

289

CHAPTER 7 Stock Valuation

they would expect that future dividends will increase. Specifically, they expect

that although the dividend next year, D1, will remain at $1.50, the expected rate

of growth thereafter will increase from 7% to 9%. If we substitute D1 $1.50,

ks 0.15, and g 0.09 into Equation 7.4, the resulting value is $25 [$1.50

(0.15 0.09)]. The increased value therefore resulted from the higher expected

future dividends reflected in the increase in the growth rate.

Changes in Risk

Although ks is defined as the required return, we know from Chapter 5 that it is

directly related to the nondiversifiable risk, which can be measured by beta. The

capital asset pricing model (CAPM) given in Equation 5.7 is restated here as

Equation 7.7:

ks RF [b (km RF)] (7.7)

With the risk-free rate, RF, and the market return, km, held constant, the

required return, ks, depends directly on beta. Any action taken by the financial

manager that increases risk (beta) will also increase the required return. In Equa-

tion 7.4, we can see that with everything else constant, an increase in the required

return, ks, will reduce share value, P0. Likewise, a decrease in the required return

will increase share value. Thus any action of the financial manager that increases

risk contributes to a reduction in value, and any action that decreases risk con-

tributes to an increase in value.

Assume that Lamar Companyâ™s 15% required return resulted from a risk-free

EXAMPLE

rate of 9%, a market return of 13%, and a beta of 1.50. Substituting into the cap-

ital asset pricing model, Equation 7.7, we get a required return, ks, of 15%:

ks 9% [1.50 (13% 9%)] 15%

With this return, the value of the firm was calculated in the example above to be

$18.75.

Now imagine that the financial manager makes a decision that, without

changing expected dividends, causes the firmâ™s beta to increase to 1.75. Assuming

that RF and km remain at 9% and 13%, respectively, the required return will

increase to 16% (9% [1.75 (13% 9%)]) to compensate stockholders for the

increased risk. Substituting D1 $1.50, ks 0.16, and g 0.07 into the valuation

equation, Equation 7.4, results in a share value of $16.67 [$1.50 (0.16

0.07)]. As expected, raising the required return, without any corresponding

increase in expected return, causes the firmâ™s stock value to decline. Clearly, the

financial managerâ™s action was not in the ownersâ™ best interest.

Combined Effect

A financial decision rarely affects return and risk independently; most decisions

affect both factors. In terms of the measures presented, with an increase in risk (b)

one would expect an increase in return (D1 or g, or both), assuming that RF and

km remain unchanged. The net effect on value depends on the size of the changes

in these variables.

290 PART 2 Important Financial Concepts

If we assume that the two changes illustrated for Lamar Company in the preced-

EXAMPLE

ing examples occur simultaneously, key variable values would be D1 $1.50, ks

0.16, and g 0.09. Substituting into the valuation model, we obtain a share

price of $21.43 [$1.50 (0.16 0.09)]. The net result of the decision, which

increased return (g, from 7% to 9%) as well as risk (b, from 1.50 to 1.75 and

therefore ks from 15% to 16%), is positive: The share price increased from

$18.75 to $21.43. The decision appears to be in the best interest of the firmâ™s

owners, because it increases their wealth.

Review Questions

7â“17 Explain the linkages among financial decisions, return, risk, and stock

value.

7â“18 Assuming that all other variables remain unchanged, what impact would

each of the following have on stock price? (a) The firmâ™s beta increases.

(b) The firmâ™s required return decreases. (c) The dividend expected next

year decreases. (d) The rate of growth in dividends is expected to

increase.

SUMMARY

FOCUS ON VALUE

The price of each share of a firmâ™s common stock is the value of each ownership interest.

Although common stockholders typically have voting rights, which indirectly give them a

say in management, their only significant right is their claim on the residual cash flows of

the firm. This claim is subordinate to those of vendors, employees, customers, lenders, the

government (for taxes), and preferred stockholders. The value of the common stockholdersâ™

claim is embodied in the cash flows they are entitled to receive from now to infinity. The

present value of those expected cash flows is the firmâ™s share value.

To determine this present value, cash flows are discounted at a rate that reflects the

riskiness of the forecast cash flows. Riskier cash flows are discounted at higher rates, result-

ing in lower present values. The value of the firmâ™s common stock is therefore driven by its

expected cash flows (returns) and risk (certainty of the expected cash flows).

In pursuing the firmâ™s goal of maximizing the stock price, the financial manager must

carefully consider the balance of return and risk associated with each proposal and must

undertake only those that create value for owners. By focusing on value creation and by

managing and monitoring the firmâ™s cash flows and risk, the financial manager should be

able to achieve the firmâ™s goal of share price maximization.

291

CHAPTER 7 Stock Valuation

REVIEW OF LEARNING GOALS

they hope to take public in order to cash out their

Differentiate between debt and equity capital.

LG1

investments.

Holders of equity capital (common and preferred

The first public issue of a firmâ™s stock is called

stock) are owners of the firm. Typically, only common

an initial public offering (IPO). The company selects

stockholders have a voice in management through their

an investment banker to advise it and to sell the

voting rights. Equity holders have claims on income

securities. The lead investment banker may form a

and assets that are secondary to the claims of creditors,

selling syndicate with other investment bankers to

there is no maturity date, and the firm does not benefit

sell the issue. The IPO process includes filing a reg-

from tax deductibility of dividends paid to stockhold-

istration statement with the Securities and Exchange

ers, as is the case for interest paid to debtholders.

Commission (SEC), getting SEC approval, promot-

ing the offering to investors, pricing the issue, and

Discuss the rights, characteristics, and features

LG2

selling the shares.

of both common and preferred stock. The com-

Stock quotations, published regularly in the

mon stock of a firm can be privately owned, closely

financial media, provide information on stocks, in-

owned, or publicly owned. It can be sold with or

cluding calendar year change in price, 52-week high

without a par value. Preemptive rights allow com-

and low, dividend, dividend yield, P/E ratio, vol-

mon stockholders to avoid dilution of ownership

ume, latest price, and net price change from the

when new shares are issued. Not all shares autho-

prior trading day.

rized in the corporate charter are outstanding. If a

firm has treasury stock, it will have issued more

shares than are outstanding. Some firms have two or Understand the concept of market efficiency

LG4

more classes of common stock that differ mainly in and basic common stock valuation under the

having unequal voting rights. Proxies transfer voting zero-growth and constant-growth models. Market

rights from one party to another. Dividend distribu- efficiency suggests that rational investors react

tions to common stockholders are made at the dis- quickly to new information, causing the market

cretion of the firmâ™s board of directors. Firms can is- value of common stock to adjust quickly upward or

sue stock in foreign markets. The stock of many downward. The efficient-market hypothesis sug-

foreign corporations is traded in the form of Ameri- gests that securities are fairly priced, that they

can depositary receipts (ADRs) in U.S. markets. reflect fully all publicly available information, and

Preferred stockholders have preference over that investors should therefore not waste time try-

common stockholders with respect to the distribu- ing to find and capitalize on mispriced securities.

tion of earnings and assets and so are normally not The value of a share of common stock is the present

given voting privileges. Preferred stock issues may value of all future dividends it is expected to pro-

have certain restrictive covenants, cumulative divi- vide over an infinite time horizon. The basic stock

dends, a call feature, and a conversion feature. valuation equation and the zero-growth and

constant-growth valuation models are summarized

Describe the process of issuing common stock, in Table 7.5. The most widely cited model is the

LG3

including in your discussion venture capital, constant-growth model.

going public, the investment bankerâ™s role, and

stock quotations. The initial nonfounder financing Discuss the free cash flow valuation model and

LG5

for business startups with attractive growth the use of book value, liquidation value, and

prospects typically comes from private equity in- price/earnings (P/E) multiples to estimate common

vestors. These investors can be either angel capital- stock values. The free cash flow valuation model is

ists or venture capitalists (VCs), which are more appealing when one is valuing firms that have no

formal business entities. Institutional VCs can be dividend history, startups, or operating units or di-

organized in a number of ways, but the VC limited visions of a larger public company. The model finds

partnership is the most common. VCs usually invest the value of the entire company by discounting the

in both early-stage and later-stage companies that firmâ™s expected free cash flow at its weighted

292 PART 2 Important Financial Concepts

TABLE 7.5 Summary of Key Valuation Definitions and

Formulas for Common Stock

Definitions of variables

Dt per-share dividend expected at the end of year t

FCFt free cash flow expected at the end of year t

g constant rate of growth in dividends

ka weighted average cost of capital

ks required return on common stock

P0 value of common stock

VC value of the entire company

VD market value of all the firmâ™s debt

VP market value of preferred stock

VS value of common stock

Valuation formulas

Basic stock value:

Dâ

D1 D2 ...

P0 [Eq. 7.1]

ks)â

(1 ks)1 (1 ks)2 (1

Common stock value:

Zero-growth:

D1

P0 (also used to value preferred stock) [Eq. 7.2]

ks

Constant-growth:

D1

P0 [Eq. 7.4]

ks g

FCF value of entire company:

FCFâ

FCF1 FCF2 ...

VC [Eq. 7.5]

ka)â

(1 ka)1 (1 ka)2 (1

FCF common stock value:

VS VC VD VP [Eq. 7.6]

value and the proceeds remaining after paying all

average cost of capital. The common stock value is

liabilities (including preferred stock) were divided

found by subtracting the market values of the firmâ™s

among the common stockholders. Liquidation value

debt and preferred stock from the value of the entire

per share is the actual amount per share of common

company. The two equations involved in this model

stock that would be received if all of the firmâ™s

are summarized in Table 7.5.

assets were sold for their market value, liabilities

Book value per share is the amount per share of

(including preferred stock) were paid, and the

common stock that would be received if all of the

remaining money were divided among the common

firmâ™s assets were sold for their book (accounting)

293

CHAPTER 7 Stock Valuation

stockholders. The price/earnings (P/E) multiples changing risk should increase share value, and any

approach estimates stock value by multiplying the action that reduces the level of expected return with-

firmâ™s expected earnings per share (EPS) by the out changing risk should reduce share value. Simi-

average price/earnings (P/E) ratio for the industry. larly, any action that increases risk (required return)

will reduce share value, and any action that reduces

Explain the relationships among financial deci- risk will increase share value. Because most financial

LG6

sions, return, risk, and the firmâ™s value. In a sta- decisions affect both return and risk, an assessment

ble economy, any action of the financial manager of their combined effect on stock value must be part

that increases the level of expected return without of the financial decision-making process.

SELF-TEST PROBLEMS (Solutions in Appendix B)

ST 7â“1 Common stock valuation Perry Motorsâ™ common stock currently pays an

LG4

annual dividend of $1.80 per share. The required return on the common stock is

12%. Estimate the value of the common stock under each of the following

assumptions about the dividend.

a. Dividends are expected to grow at an annual rate of 0% to infinity.

b. Dividends are expected to grow at a constant annual rate of 5% to infinity.

ST 7â“2 Free cash flow valuation Erwin Footwear wishes to assess the value of its

LG5

Active Shoe Division. This division has debt with a market value of $12,500,000

and no preferred stock. Its weighted average cost of capital is 10%. The Active

Shoe Divisionâ™s estimated free cash flow each year from 2004 through 2007 is

given in the accompanying table. Beyond 2007 to infinity, the firm expects its

free cash flow to grow at 4% annually.

Year (t) Free cash flow (FCFt)

2004 $ 800,000

2005 1,200,000

2006 1,400,000

2007 1,500,000

a. Use the free cash flow valuation model to estimate the value of Erwinâ™s

Active Shoe Division.

b. Use your finding in part a along with the data provided above to find this

divisionâ™s common stock value.

c. If the Active Shoe Division as a public company will have 500,000 shares

outstanding, use your finding in part b to calculate its value per share.

PROBLEMS

7â“1 Authorized and available shares Aspin Corporationâ™s charter authorizes

LG2

issuance of 2,000,000 shares of common stock. Currently, 1,400,000 shares

are outstanding and 100,000 shares are being held as treasury stock. The firm

wishes to raise $48,000,000 for a plant expansion. Discussions with its investment

294 PART 2 Important Financial Concepts

bankers indicate that the sale of new common stock will net the firm $60

per share.

a. What is the maximum number of new shares of common stock that

the firm can sell without receiving further authorization from

shareholders?

b. Judging on the basis of the data given and your finding in part a, will

the firm be able to raise the needed funds without receiving further

authorization?

c. What must the firm do to obtain authorization to issue more than the num-

ber of shares found in part a?

7â“2 Preferred dividends Slater Lamp Manufacturing has an outstanding issue of

LG2

preferred stock with an $80 par value and an 11% annual dividend.

a. What is the annual dollar dividend? If it is paid quarterly, how much will be

paid each quarter?

b. If the preferred stock is noncumulative and the board of directors has

passed the preferred dividend for the last 3 quarters, how much must be

paid to preferred stockholders before dividends are paid to common

stockholders?

c. If the preferred stock is cumulative and the board of directors has

passed the preferred dividend for the last 3 quarters, how much must

be paid to preferred stockholders before dividends are paid to common

stockholders?

7â“3 Preferred dividends In each case in the following table, how many dollars of

LG2

preferred dividends per share must be paid to preferred stockholders before com-

mon stock dividends are paid?

Dividend per Periods of

Case Type Par value share per period dividends passed

A Cumulative $ 80 $5 2

B Noncumulative 110 8% 3

C Noncumulative 100 $11 1

D Cumulative 60 8.5% 4

E Cumulative 90 9% 0

7â“4 Convertible preferred stock Valerian Corp. convertible preferred stock has a

LG2

fixed conversion ratio of 5 common shares per 1 share of preferred stock. The

preferred stock pays a dividend of $10.00 per share per year. The common

stock currently sells for $20.00 per share and pays a dividend of $1.00 per share

per year.

a. Judging on the basis of the conversion ratio and the price of the

common shares, what is the current conversion value of each preferred

share?

b. If the preferred shares are selling at $96.00 each, should an investor convert

the preferred shares to common shares?

c. What factors might cause an investor not to convert from preferred to

common?

295

CHAPTER 7 Stock Valuation

7â“5 Stock quotation Assume that the following quote for the Advanced Business

LG2

Machines stock (traded on the NYSE) was found in the Thursday, December 14,

issue of the Wall Street Journal.

3.2 84.13 51.25 AdvBusMach ABM 1.32 1.6 23 12432 81.75 1.63

Given this information, answer the following questions:

a. On what day did the trading activity occur?

b. At what price did the stock sell at the end of the day on Wednesday,

December 13?

c. What percentage change has occurred in the stockâ™s last price since the begin-

ning of the calendar year?

d. What is the firmâ™s price/earnings ratio? What does it indicate?

e. What is the last price at which the stock traded on the day quoted?

f. How large a dividend is expected in the current year?

g. What are the highest and the lowest price at which the stock traded during

the latest 52-week period?

h. How many shares of stock were traded on the day quoted?

i. How much, if any, of a change in stock price took place between the day

quoted and the day before? At what price did the stock close on the day before?

7â“6 Common stock valuationâ”Zero growth Scotto Manufacturing is a mature

LG4

firm in the machine tool component industry. The firmâ™s most recent common

stock dividend was $2.40 per share. Because of its maturity as well as its stable

sales and earnings, the firmâ™s management feels that dividends will remain at the

current level for the foreseeable future.

a. If the required return is 12%, what will be the value of Scottoâ™s common

stock?

b. If the firmâ™s risk as perceived by market participants suddenly increases,

causing the required return to rise to 20%, what will be the common stock

value?

c. Judging on the basis of your findings in parts a and b, what impact does risk

have on value? Explain.

7â“7 Common stock valueâ”Zero growth Kelsey Drums, Inc., is a well-established

LG4

supplier of fine percussion instruments to orchestras all over the United States.

The companyâ™s class A common stock has paid a dividend of $5.00 per share per

year for the last 15 years. Management expects to continue to pay at that rate

for the foreseeable future. Sally Talbot purchased 100 shares of Kelsey class A

common 10 years ago at a time when the required rate of return for the stock

was 16%. She wants to sell her shares today. The current required rate of return

for the stock is 12%. How much capital gain or loss will she have on her shares?

7â“8 Preferred stock valuation Jones Design wishes to estimate the value of its out-

LG4

standing preferred stock. The preferred issue has an $80 par value and pays an

annual dividend of $6.40 per share. Similar-risk preferred stocks are currently

earning a 9.3% annual rate of return.

a. What is the market value of the outstanding preferred stock?

b. If an investor purchases the preferred stock at the value calculated in part a,

how much does she gain or lose per share if she sells the stock when the

required return on similar-risk preferreds has risen to 10.5%? Explain.

296 PART 2 Important Financial Concepts

7â“9 Common stock valueâ”Constant growth Use the constant-growth model

LG4

(Gordon model) to find the value of each firm shown in the following table.

Firm Dividend expected next year Dividend growth rate Required return

A $1.20 8% 13%

B 4.00 5 15

C 0.65 10 14

D 6.00 8 9

E 2.25 8 20

7â“10 Common stock valueâ”Constant growth McCracken Roofing, Inc., common

LG4

stock paid a dividend of $1.20 per share last year. The company expects earn-

ings and dividends to grow at a rate of 5% per year for the foreseeable future.

a. What required rate of return for this stock would result in a price per share

of $28?

b. If McCracken had both earnings growth and dividend growth at a rate of

10%, what required rate of return would result in a price per share of $28?

7â“11 Common stock valueâ”Constant growth Elk County Telephone has paid the

LG4

dividends shown in the following table over the past 6 years.

Year Dividend per share

2003 $2.87

2002 2.76

2001 2.60

2000 2.46

1999 2.37

1998 2.25

The firmâ™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 a and b, and discuss the impact

of changing risk on share value.

7â“12 Common stock valueâ”Both growth models You are evaluating the potential

LG4

purchase of a small business currently generating $42,500 of after-tax cash flow

(D0 $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 firmâ™s

value using two possible assumptions about the growth rate of cash flows.

a. What is the firmâ™s value if cash flows are expected to grow at an annual rate

of 0% from now to infinity?

b. What is the firmâ™s value if cash flows are expected to grow at a constant

annual rate of 7% from now to infinity?

297

CHAPTER 7 Stock Valuation

7â“13 Free cash flow valuation Nabor Industries is considering going public but is

LG5

unsure of a fair offering price for the company. Before hiring an investment

banker to assist in making the public offering, managers at Nabor have decided

to make their own estimate of the firmâ™s common stock value. The firmâ™s CFO

has gathered data for performing the valuation using the free cash flow valua-

tion model.

The firmâ™s weighted average cost of capital is 11%, and it has $1,500,000 of

debt at market value and $400,000 of preferred stock at its assumed market

value. The estimated free cash flows over the next 5 years, 2004 through 2008,

are given below. Beyond 2008 to infinity, the firm expects its free cash flow to

grow by 3% annually.

Year (t) Free cash flow (FCFt)

2004 $200,000

2005 250,000

2006 310,000

2007 350,000

2008 390,000

a. Estimate the value of Nabor Industriesâ™ entire company by using the free cash

flow valuation model.

b. Use your finding in part a, along with the data provided above, to find Nabor

Industriesâ™ common stock value.

c. If the firm plans to issue 200,000 shares of common sock, what is its esti-

mated value per share?

7â“14 Using the free cash flow valuation model to price an IPO Assume that you

LG5

have an opportunity to buy the stock of CoolTech, Inc., an IPO being offered

for $12.50 per share. Although you are very much interested in owning the com-

pany, you are concerned about whether it is fairly priced. In order to determine

the value of the shares, you have decided to apply the free cash flow valuation

model to the firmâ™s financial data that youâ™ve developed from a variety of data

sources. The key values you have compiled are summarized in the following

table.

Free cash flow

Year (t) FCFt Other data

2004 $ 700,000 Growth rate of FCF, beyond 2007 to infinity 2%

2005 800,000 Weighted average cost of capital 8%

2006 950,000 Market value of all debt $2,700,000

2007 1,100,000 Market value of preferred stock $1,000,000

Number of shares of common stock outstanding 1,100,000

a. Use the free cash flow valuation model to estimate CoolTechâ™s common stock

value per share.

b. Judging on the basis of your finding in part a and the stockâ™s offering price,

should you buy the stock?

298 PART 2 Important Financial Concepts

c. Upon further analysis, you find that the growth rate in FCF beyond 2007 will

be 3% rather than 2%. What effect would this finding have on your

responses in parts a and b?

7â“15 Book and liquidation value The balance sheet for Gallinas Industries is as

LG5

follows.

Gallinas Industries

Balance Sheet

December 31

Assets Liabilities and Stockholdersâ™ Equity

Cash $ 40,000 Accounts payable $100,000

Marketable securities 60,000 Notes payable 30,000

Accounts receivable 120,000 Accrued wages 30,000

Inventories 160,000 Total current liabilities $160,000

Total current assets $380,000 Long-term debt $180,000

Land and buildings (net) $150,000 Preferred stock $ 80,000

Machinery and equipment 250,000 Common stock (10,000 shares) 360,000

Total fixed assets (net) $400,000 Total liabilities and stockholdersâ™ equity $780,000

Total assets $780,000

Additional information with respect to the firm is available:

(1) Preferred stock can be liquidated at book value.

(2) Accounts receivable and inventories can be liquidated at 90% of book value.

(3) The firm has 10,000 shares of common stock outstanding.

(4) All interest and dividends are currently paid up.

(5) Land and buildings can be liquidated at 130% of book value.

(6) Machinery and equipment can be liquidated at 70% of book value.

(7) Cash and marketable securities can be liquidated at book value.

Given this information, answer the following:

a. What is Gallinas Industriesâ™ book value per share?

b. What is its liquidation value per share?

c. Compare, contrast, and discuss the values found in parts a and b.

7â“16 Valuation with price/earnings multiples For each of the firms shown in the fol-

LG5

lowing table, use the data given to estimate their common stock value employing

price/earnings (P/E) multiples.

Firm Expected EPS Price/earnings multiple

A $3.00 6.2

B 4.50 10.0

C 1.80 12.6

D 2.40 8.9

E 5.10 15.0

299

CHAPTER 7 Stock Valuation

7â“17 Management action and stock value REH Corporationâ™s most recent dividend

LG6

was $3 per share, its expected annual rate of dividend growth is 5%, and the

required return is now 15%. A variety of proposals are being considered by

management to redirect the firmâ™s activities. Determine the impact on share price

for each of the following proposed actions, and indicate the best alternative.

a. Do nothing, which will leave the key financial variables unchanged.

b. Invest in a new machine that will increase the dividend growth rate to 6%

and lower the required return to 14%.

c. Eliminate an unprofitable product line, which will increase the dividend

growth rate to 7% and raise the required return to 17%.

d. Merge with another firm, which will reduce the growth rate to 4% and raise

the required return to 16%.

e. Acquire a subsidiary operation from another manufacturer. The acquisition

should increase the dividend growth rate to 8% and increase the required

return to 17%.

7â“18 Integrativeâ”Valuation and CAPM formulas Given the following information

LG4 LG6

for the stock of Foster Company, calculate its beta.

Current price per share of common $50.00

Expected dividend per share next year $ 3.00

Constant annual dividend growth rate 9%

Risk-free rate of return 7%

Return on market portfolio 10%

7â“19 Integrativeâ”Risk and valuation Giant Enterprises has a beta of 1.20, the risk-

LG4 LG6

free rate of return is currently 10%, and the market return is 14%. The com-

pany, which plans to pay a dividend of $2.60 per share in the coming year,

anticipates that its future dividends will increase at an annual rate consistent

with that experienced over the 1997â“2003 period, when the following dividends

were paid:

Year Dividend per share

2003 $2.45

2002 2.28

2001 2.10

2000 1.95

1999 1.82

1998 1.80

1997 1.73

a. Use the capital asset pricing model (CAPM) to determine the required return

on Giantâ™s stock.

b. Using the constant-growth model and your finding in part a, estimate the

value of Giantâ™s stock.

c. Explain what effect, if any, a decrease in beta would have on the value of

Giantâ™s stock.

300 PART 2 Important Financial Concepts

7â“20 Integrativeâ”Valuation and CAPM Hamlin Steel Company wishes to deter-

LG4 LG6

mine the value of Craft Foundry, a firm that it is considering acquiring for cash.

Hamlin wishes to use the capital asset pricing model (CAPM) to determine the

applicable discount rate to use as an input to the constant-growth valuation

model. Craftâ™s stock is not publicly traded. After studying the betas of firms sim-

ilar to Craft that are publicly traded, Hamlin believes that an appropriate beta

for Craftâ™s stock would be 1.25. The risk-free rate is currently 9%, and the mar-

ket return is 13%. Craftâ™s dividend per share for each of the past 6 years is

shown in the following table.

Year Dividend per share

2003 $3.44

2002 3.28

2001 3.15

2000 2.90

1999 2.75

1998 2.45

a. Given that Craft is expected to pay a dividend of $3.68 next year,

determine the maximum cash price that Hamlin should pay for each share

of Craft.

b. Discuss the use of the CAPM for estimating the value of common stock, and

describe the effect on the resulting value of Craft of:

(1) A decrease in its dividend growth rate of 2% from that exhibited over the

1998â“2003 period.

(2) A decrease in its beta to 1.

CHAPTER 7 CASE Assessing the Impact of Suarez Manufacturingâ™s

Proposed Risky Investment on Its Stock Value

E arly in 2004, Inez Marcus, the chief financial officer for Suarez Manufactur-

ing, was given the task of assessing the impact of a proposed risky investment

on the firmâ™s stock value. To perform the necessary analysis, Inez gathered the fol-

lowing information on the firmâ™s stock.

During the immediate past 5 years (1999â“2003), the annual dividends paid

on the firmâ™s common stock were as follows:

Year Dividend per share

2003 $1.90

2002 1.70

2001 1.55

2000 1.40

1999 1.30

The firm expects that without the proposed investment, the dividend in 2004

will be $2.09 per share and the historical annual rate of growth (rounded to the

301

CHAPTER 7 Stock Valuation

nearest whole percent) will continue in the future. Currently, the required return

on the common stock is 14%. Inezâ™s research indicates that if the proposed

investment is undertaken, the 2004 dividend will rise to $2.15 per share and the

annual rate of dividend growth will increase to 13%. As a result of the increased

risk associated with the proposed risky investment, the required return on the

common stock is expected to increase by 2% to an annual rate of 16%.

Armed with the preceding information, Inez must now assess the impact of

the proposed risky investment on the market value of Suarezâ™s stock. To simplify

her calculations, she plans to round the historical growth rate in common stock

dividends to the nearest whole percent.

Required

a. Find the current value per share of Suarez Manufacturingâ™s common

stock.

b. Find the value of Suarezâ™s common stock in the event that it undertakes

the proposed risky investment and assuming that the dividend growth rate

stays at 13% forever. Compare this value to that found in part a. What

effect would the proposed investment have on the firmâ™s stockholders?

Explain.

c. On the basis of your findings in part b, do the stockholders win or lose as a

result of undertaking the proposed risky investment? Should the firm do it?

Why?

WEB EXERCISE To use the price/earnings multiples approach to valuation, you need to find a

WW firmâ™s projected earnings and the P/E multiple. One of the most popular sites to

W

obtain these estimates is Zacks Investment Research, www.zacks.com.

1. At the top of the page, locate the area where you can enter a companyâ™s

ticker symbol and select the desired information.

2. Enter OO for Oakley Inc. and select estimates from the pull-down menu.

a. What is the current mean/consensus estimate for the next fiscal yearâ™s

earnings?

b. Using the indicated price/earnings ratio further down on that page, cal-

culate the stock price.

3. Repeat steps 2a and b for the following stocks:

a. Southwest Airlines: LUV

b. Microsoft: MSFT

c. Weight Watchers: WTW

Remember to check the bookâ™s Web site at

www.aw.com/gitman

for additional resources, including additional Web exercises.

ńňđ. 2 |