Chapter 4: Q5B (page 436)
Jand, Inc., currently pays a dividend of \(1.22, which is expected to grow indefinitely at 5%. If the current value of Jand’s shares based on the constant-growth dividend discount model is \)32.03, what is the required rate of return?
8.9994%
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Use the following case in answering Problems 26 – 28:
Institutional Advisors for All Inc., or IAAI, is a consulting firm that primarily advises all types of institutions such as foundations, endowments, pension plans, and insurance companies. IAAI also provides advice to a select group of individual investors with large portfolios. One of the claims the firm makes in its advertising is that IAAI devotes considerable resources to forecasting and determining long-term trends; then it uses commonly accepted investment models to determine how these trends should affect the performance of various investments. The members of the research department
of IAAI recently reached some conclusions concerning some important macroeconomic trends. For instance, they have seen an upward trend in job creation and consumer confidence and predict that this should continue for the next few years. Other domestic leading indicators that the research department at IAAI wishes to consider are industrial production, average weekly hours in manufacturing, S&P 500 stock prices, M2 money supply, and the index of consumer expectations.
In light of the predictions for job creation and consumer confidence, the investment advisers at IAAI want to make recommendations for their clients. They use established theories that relate job creation and consumer confidence to inflation and interest rates and then incorporate the forecast movements in inflation and interest rates into established models for explaining asset prices. Their primary concern is to forecast how the trends in job creation and consumer confidence should affect bond prices and how those trends should affect stock prices.
The members of the research department at IAAI also note that stocks have been trending up in the past year, and this information is factored into the forecasts of the overall economy that they deliver. The researchers consider an upward-trending stock market a positive economic indicator in itself; however, they disagree as to the reason this should be the case.
Stock prices are useful as a leading indicator. To explain this phenomenon, which of the following is most accurate?
Stock prices:
a. Predict future interest rates and reflect the trends in other indicators.
b. Do not predict future interest rates, nor are they correlated with other leading indicators; the usefulness of stock prices as a leading indicator is a mystery.
c. Reflect the trends in other leading indicators only and do not have predictive power of their own.
Chiptech, Inc., is an established computer chip firm with several profitable existing products as well as some promising new products in development. The company earned \(1 per share last year and just paid out a dividend of \).50 per share. Investors believe the company plans to maintain its dividend payout ratio at 50%. ROE equals 20%. Everyone in the market expects this situation to persist indefinitely
a. What is the market price of Chiptech stock? The required return for the computer chip industry is 15%, and the company has just gone ex-dividend (i.e., the next dividend will be paid a year from now, at t = 1).
b. Suppose you discover that Chiptech’s competitor has developed a new chip that will eliminate Chiptech’s current technological advantage in this market. This new product, which will be ready to come to the market in two years, will force Chiptech to reduce the prices of its chips to remain competitive. This will decrease ROE to 15%, and, because of falling demand for its product, Chiptech will decrease the plowback ratio to .40. The plowback ratio will be decreased at the end of the second year, at t = 2: The annual year-end dividend for the second year (paid at t = 2) will be 60% of that year’s earnings. What is your estimate of Chiptech’s intrinsic value per share?
( Hint: Carefully prepare a table of Chiptech’s earnings and dividends for each of the next three years. Pay close attention to the change in the payout ratio in t = 2.)
c. No one else in the market perceives the threat to Chiptech’s market. In fact, you are confident that no one else will become aware of the change in Chiptech’s competitive status until the competitor firm publicly announces its discovery near the end of year 2. What will be the rate of return on Chiptech stock in the coming year (i.e., between t = 0 and t = 1)? In the second year (between t = 1 and t = 2)? The third year (between t = 2 and t = 3)? ( Hint: Pay attention to when the market catches on to the new situation. A table of dividends and market prices over time might help.)
A company’s current ratio is 2. If the company uses cash to retire notes payable due within one year, would this transaction increase or decrease the current ratio? What about the asset turnover ratio?
Cash flow from operating activities includes:
a. Inventory increases resulting from acquisitions.
b. Inventory changes due to changing exchange rates.
c. Interest paid to bondholders.
d. Dividends paid to stockholders.
Use the DuPont system and the following data to find return on equity.
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