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Chapter 4: Q4DQ (page 436)
Explain how the concept of risk can be incorporated into the capital budgeting process
The risk can be introduced to the capital budgeting process when higher returns are required for risky investments.
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If, as an investor, you had a choice of daily, monthly, or quarterly compounding, which would you choose? Why?
Why might investors demand a lower rate of return for an investment in Microsoft as compared to United Airlines?
Mel Thomas, the chief financial officer of Preston 91影视, has been asked to do an evaluation of Dunning Chemical Company by the president and chair of the board, Sarah Reynolds. Preston 91影视 was planning a joint venture with Dunning (which was privately traded), and Sarah and Mel needed a better feel for what Dunning鈥檚 stock was worth because they might be interested in buying the firm in the future.
Dunning Chemical paid a dividend at the end of year one of \(1.30, the anticipated growth rate was 10 percent, and the required rate of return was 14 percent.
a. What is the value of the stock based on the dividend valuation model (Formula 10-8)?
b. Indicate that the value you computed in part a is correct by showing the value of D1, D2, and D3 and by discounting each back to the present at 14 percent. D1 is \)1.30, and it increases by 10 percent (g) each year. Also discount the anticipated stock price at the end of year three back to the present and add it to the present value of the three dividend payments.
The value of the stock at the end of year three is: P3 5 D4 _____ Ke 2 g D4 5 D3 (1 1 g)
If you have done all these steps correctly, you should get an answer approximately equal to the answer in part a.
c. As an alternative measure, you also examine the value of the firm based on the price-earnings (P/E) ratio times earnings per share. Since the company is privately traded (not in the public stock market), you will get your anticipated P/E ratio by taking the average value of five publiclytraded chemical companies. The P/E ratios were as follows during the time period under analysis:
P/E Ratio
Dow Chemical .................. 15
DuPont ............................. 18
Georgia Gulf ..................... 7
3M .................................... 19
Olin Corp .......................... 21
Assume Dunning Chemical has earnings per share of \(2.10. What is the stock value based on the P/E ratio approach? Multiply the average P/E ratio you computed times earnings per share. How does this value compare to the dividend valuation model values that you computed in parts a and b?
d. If in computing the industry average P/E, you decide to weight Olin Corp. by 40 percent and the other four firms by 15 percent, what would be the new weighted average industry P/E? (Note: You decided to weight Olin Corp. more heavily because it is similar to Dunning Chemical.) What will the new stock price be? Earnings per share will stay at \)2.10.
e. By what percent will the stock price change as a result of using the weighted average industry P/E ratio in part d as opposed to that in part c?
Question:Masco Oil and Gas Company is a very large company with common stock listed on the New York Stock Exchange and bonds traded over the counter. As of the current balance sheet, it has three bond issues outstanding:
\(150 million of 10 percent series ....... 2026
\)50 million of 7 percent series ........... 2020
\(75 million of 5 percent series ........... 2016
The vice president of finance is planning to sell \)75 million of bonds next year to replace the debt due to expire in 2016. Present market yields on similar Baa-rated bonds are 12.1 percent. Masco also has \(90 million of 7.5 percent noncallable preferred stock outstanding, and it has no intentions of selling any preferred stock at any time in the future. The preferred stock is currently priced at \)80 per share, and its dividend per share is \(7.80.
The company has had very volatile earnings, but its dividends per share have had a very stable growth rate of 8 percent and this will continue. The expected dividend (D1) is \)1.90 per share, and the common stock is selling for \(40 per share. The company鈥檚 investment banker has quoted the following flotation costs to Masco: \)2.50 per share for preferred stock and $2.20 per share for common stock.
On the advice of its investment banker, Masco has kept its debt at 50 percent of assets and its equity at 50 percent. Masco sees no need to sell either common or preferred stock in the foreseeable future as it has generated enough internal funds for its investment needs when these funds are combined with debt financing. Masco鈥檚 corporate tax rate is 40 percent. Compute the cost of capital for the following:
a. Bond (debt) (Kd).
b. Preferred stock (Kp).
c. Common equity in the form of retained earnings (Ke).
d. New common stock (Kn).
e. Weighted average cost of capital.
Why is the cost of debt less than the cost of preferred stock if both securities are priced to yield 10 percent in the market? (LO11-3)
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