<<

. 2
( 2)



balance sheet data. It ignores the firm™s expected earnings potential and generally
after paying all liabilities (includ-
ing preferred stock) were divided lacks any true relationship to the firm™s value in the marketplace. Let us look at
among the common stockholders.
an example.

At year-end 2003, Lamar Company™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 firm™s liabilities are understated.
The actual amount per share
of common stock that would
be received if all of the firm™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 firm™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, creditors™ claims must be satisfied first, then those of the preferred stockholders.
Anything left goes to common stockholders.
287
CHAPTER 7 Stock Valuation


value”because it is based on the current market value of the firm™s assets”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 firm™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 firm™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 firm™s value”if it is assumed that
investors value the earnings of that firm in the same way they do the “average”
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 firm™s share value; it is calculated by multiplying the firm™s
estimate the firm™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
firm™s expected earnings per
such as Standard & Poor™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 firm™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 Lamar™s expected earnings
per share (EPS) of $2.60 by this ratio gives us a value for the firm™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 Company™s stock really worth? That™s a trick ques-
tion, because there™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 firm™s estimated liqui-
dation value per share exceed its “going concern” 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 “worth more dead
than alive.” 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

7“13 What does the efficient-market hypothesis say about (a) securities prices,
(b) their reaction to new information, and (c) investor opportunities to
profit?
7“14 Describe, compare, and contrast the following common stock dividend
valuation models: (a) zero-growth and (b) constant-growth.
7“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?
7“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 firm™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 owners™ 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, ¦, Dn,
Action by Stock Value
D1
Financial and Expected Dividend
risk, and stock value
P0 =
Growth, g.
Manager ks “ 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 Company™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 firm™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 firm™s stock value to decline. Clearly, the
financial manager™s action was not in the owners™ 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 firm™s
owners, because it increases their wealth.



Review Questions

7“17 Explain the linkages among financial decisions, return, risk, and stock
value.
7“18 Assuming that all other variables remain unchanged, what impact would
each of the following have on stock price? (a) The firm™s beta increases.
(b) The firm™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 firm™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 stockholders™
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 firm™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 firm™s common stock is therefore driven by its
expected cash flows (returns) and risk (certainty of the expected cash flows).
In pursuing the firm™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 firm™s cash flows and risk, the financial manager should be
able to achieve the firm™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 firm™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 firm™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 banker™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 firm™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 firm™s debt
VP market value of preferred stock
VS value of common stock

Valuation formulas

Basic stock value:
D∞
D1 D2 ...
P0 [Eq. 7.1]
ks)∞
(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:
FCF∞
FCF1 FCF2 ...
VC [Eq. 7.5]
ka)∞
(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 firm™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 firm™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
firm™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-
firm™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 firm™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 7“1 Common stock valuation Perry Motors™ 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 7“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 Division™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 Erwin™s
Active Shoe Division.
b. Use your finding in part a along with the data provided above to find this
division™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
7“1 Authorized and available shares Aspin Corporation™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?

7“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?

7“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



7“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


7“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 stock™s last price since the begin-
ning of the calendar year?
d. What is the firm™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?

7“6 Common stock valuation”Zero growth Scotto Manufacturing is a mature
LG4
firm in the machine tool component industry. The firm™s most recent common
stock dividend was $2.40 per share. Because of its maturity as well as its stable
sales and earnings, the firm™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 Scotto™s common
stock?
b. If the firm™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.

7“7 Common stock value”Zero growth Kelsey Drums, Inc., is a well-established
LG4
supplier of fine percussion instruments to orchestras all over the United States.
The company™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?

7“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


7“9 Common stock value”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



7“10 Common stock value”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?

7“11 Common stock value”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 firm™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.

7“12 Common stock value”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 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 0% from now to infinity?
b. What is the firm™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


7“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 firm™s common stock value. The firm™s CFO
has gathered data for performing the valuation using the free cash flow valua-
tion model.
The firm™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 Industries™ 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
Industries™ common stock value.
c. If the firm plans to issue 200,000 shares of common sock, what is its esti-
mated value per share?

7“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 firm™s financial data that you™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 CoolTech™s common stock
value per share.
b. Judging on the basis of your finding in part a and the stock™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?

7“15 Book and liquidation value The balance sheet for Gallinas Industries is as
LG5
follows.


Gallinas Industries
Balance Sheet
December 31

Assets Liabilities and Stockholders™ 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 stockholders™ 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 Industries™ 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.

7“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


7“17 Management action and stock value REH Corporation™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 firm™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%.

7“18 Integrative”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%

7“19 Integrative”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 1997“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 Giant™s stock.
b. Using the constant-growth model and your finding in part a, estimate the
value of Giant™s stock.
c. Explain what effect, if any, a decrease in beta would have on the value of
Giant™s stock.
300 PART 2 Important Financial Concepts


7“20 Integrative”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. Craft™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 Craft™s stock would be 1.25. The risk-free rate is currently 9%, and the mar-
ket return is 13%. Craft™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
1998“2003 period.
(2) A decrease in its beta to 1.



CHAPTER 7 CASE Assessing the Impact of Suarez Manufacturing™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 firm™s stock value. To perform the necessary analysis, Inez gathered the fol-
lowing information on the firm™s stock.
During the immediate past 5 years (1999“2003), the annual dividends paid
on the firm™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%. Inez™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 Suarez™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 Manufacturing™s common
stock.
b. Find the value of Suarez™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 firm™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 firm™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 company™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 year™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 book™s Web site at
www.aw.com/gitman
for additional resources, including additional Web exercises.

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