Chapter 4: 12I (page 476)
Use the DuPont system and the following data to find return on equity.
ROE = 24.20%
Over 30 million students worldwide already upgrade their learning with Vaia!
All the tools & learning materials you need for study success - in one app.
Get started for free
Phoebe Black’s investment club wants to buy the stock of either NewSoft, Inc. or Capital Corp. In this connection, Black prepared the following table. You have been asked to help her interpret the data, based on your forecast for a healthy economy and a strong stock market over the next 12 months.
New soft Inc. | Capital Corp. | S & P 500 index | |
Current Prices | \(30 | \)32 | |
Industry | Computer Software | Capital Goods | |
P/E ratio (current) | 25 | 14 | 16 |
P/E ration (5 yr average) | 27 | 16 | 16 |
Price/book ratio (current) | 10 | 3 | 3 |
Price/book ratio (5-year average) | 12 | 4 | 2 |
beta | 1.5 | 1.1 | 1.0 |
Dividend yield | .3% | 2.7% | 2.8% |
a. Newsoft’s shares have higher price–earnings (P/E) and price–book value (P/B) ratios than those of Capital Corp. (The price–book ratio is the ratio of market value to book value.) Briefly discuss why the disparity in ratios may not indicate that NewSoft’s shares are overvalued relative to the shares of Capital Corp. Answer the question in terms of the two ratios, and assume that there have been no extraordinary events affecting either company.
b. Using a constant-growth dividend discount model, Black estimated the value of NewSoft to be \(28 per share and the value of Capital Corp. to be \)34 per share.
Briefly discuss weaknesses of this dividend discount model, and explain why this model may be less suitable for valuing NewSoft than for valuing Capital Corp.
c. Recommend and justify a more appropriate dividend discount model for valuing New- Soft’s common stock.
Janet Ludlow’s firm requires all its analysts to use a two-stage DDM and the CAPM to value stocks. Using these measures, Ludlow has valued QuickBrush Company at \(63 per share. She now must value SmileWhite Corporation.
a. Calculate the required rate of return for SmileWhite using the information in the following table:
December 2010 | ||
Quick brush | Smile white | |
Beta | 1.35 | 1.15 |
Market price | \)45 | \(30 |
Intrinsic value | \)63 | ? |
b. Ludlow estimates the following EPS and dividend growth rates for SmileWhite:
First three years | 12% per year |
Years thereafter | 9% per year |
Estimate the intrinsic value of SmileWhite using the table above and the two-stage DDM. Dividends per share in 2010 were $1.72.
c. Recommend QuickBrush or SmileWhite stock for purchase by comparing each company’s intrinsic value with its current market price.
d. Describe one strength of the two-stage DDM in comparison with the constant-growth DDM. Describe one weakness inherent in all DDMs.
At Litchfield Chemical Corp. (LCC), a director of the company said that the use of dividend discount models by investors is “proof” that the higher the dividend, the higher the stock price.
a. Using a constant-growth dividend discount model as a basis of reference, evaluate the director’s statement.
b. Explain how an increase in dividend payout would affect each of the following (holding all other factors constant):
i. Sustainable growth rate.
ii. Growth in book value.
Which one of the following firms would be described as having below-average sensitivity to the state of the economy?
a. An asset play firm
b. A cyclical firm
c. A defensive firm
d. A stalwart firm
Which of the following is not a governmental structural policy that supply-side economists believe would promote long-term growth in an economy?
a. A redistributive tax system.
b. A promotion of competition.
c. Minimal government interference in the economy.
What do you think about this solution?
We value your feedback to improve our textbook solutions.
