Chapter 7 Stock Valuation

P7-13
Lawrence Industries’ most recent annual dividend was $1.80 per share (D0 = $1.80), and the
firm’s required return is 11%.
Find the market value of Lawrence’s shares when:

a) Dividends are expected to grow at 8% annually for 3 years, followed by a 5% constant

annual growth rate in years 4 to infinity.
D0 = $1.80; rs = 11%; g1 = 0.08; g2 = 0.05

𝑫𝒕 = 𝑫𝟎 × (𝟏 + 𝒈𝟏 )𝒕
t D0 (1 + g1)t Dt 𝟏 Present Value of
(𝟏 + 𝒓𝒔 )𝒕 dividend
1 $ 1.80 1.80 $ 1.94 0.9009 $ 1.75
2 $ 1.80 1.1664 $ 2.10 0.8116 $ 1.70
3 $ 1.80 1.2597 $ 2.27 0.7312 $ 1.66
$ 5.11

𝟏 𝑫𝑵+𝟏
𝑷𝑵 = ×
(𝟏 + 𝒓𝒔 )𝑵 (𝒓𝒔 − 𝒈𝟐 )
1 𝐷3+1
𝑃3 = 3
×
(1 + 0.11) (0.11 − 0.05)
1 𝐷4
𝑃3 = 3
×
(1 + 0.11) (0.11 − 0.05)
1 𝐷3 × (1 + 𝑔2 )
𝑃3 = ×
(1.11)3 0.06
1 $ 2.27 × (1 + 0.05)
𝑃3 = ×
1.367631 0.06

$ 2.27 × (1.05)
𝑃3 = 0.731191381 ×
0.06
$ 2.38
𝑃3 = 0.731191381 ×
0.06
𝑃3 = 0.731191381 × $ 39.07
𝑃3 = $ 29.01

𝑃0 = $ 5.11 + $ 29.01
𝑃0 = $ 34.12

b) Dividends are expected to grow at 8% annually for 3 years, followed by a 0% constant

annual growth rate in years 4 to infinity.

D0 = $1.80; rs = 11%; g1 = 0.08; g2 = 0

𝑫𝒕 = 𝑫𝟎 × (𝟏 + 𝒈𝟏 )𝒕
 t D0 (1 + g1)t Dt 𝟏 Present Value of
(𝟏 + 𝒓𝒔 )𝒕 dividend
1 $ 1.80 1.80 $ 1.94 0.9009 $ 1.75
2 $ 1.80 1.1664 $ 2.10 0.8116 $ 1.70
3 $ 1.80 1.2597 $ 2.27 0.7312 $ 1.66
$ 5.11

𝟏 𝑫𝑵+𝟏
𝑷𝑵 = 𝑵
×
(𝟏 + 𝒓𝒔 ) (𝒓𝒔 − 𝒈𝟐 )
1 𝐷3+1
𝑃3 = 3
×
(1 + 0.11) (0.11 − 0)
1 𝐷4
𝑃3 = ×
(1 + 0.11)3 0.11
1 𝐷3 × (1 + 𝑔2 )
𝑃3 = 3
×
(1.11) 0.11
1 $ 2.27 × (1 + 0)
𝑃3 = ×
1.367631 0.11

$ 2.27 × (1)
𝑃3 = 0.731191381 ×
0.11
$ 2.27
𝑃3 = 0.731191381 ×
0.11
𝑃3 = 0.731191381 × $ 20.64
𝑃3 = $ 15.09

𝑃0 = $ 5.11 + $ 15.09
𝑃0 = $ 20.20

c) Dividends are expected to grow at 8% annually for 3 years, followed by a 10% constant
annual growth rate in years 4 to infinity.

D0 = $1.80; rs = 11%; g1 = 0.08; g2 = 0.10

𝑫𝒕 = 𝑫𝟎 × (𝟏 + 𝒈𝟏 )𝒕
t D0 (1 + g1)t Dt 𝟏 Present Value of
(𝟏 + 𝒓𝒔 )𝒕 dividend
1 $ 1.80 1.80 $ 1.94 0.9009 $ 1.75
2 $ 1.80 1.1664 $ 2.10 0.8116 $ 1.70
3 $ 1.80 1.2597 $ 2.27 0.7312 $ 1.66
$ 5.11

𝟏 𝑫𝑵+𝟏
𝑷𝑵 = ×
(𝟏 + 𝒓𝒔 )𝑵 (𝒓𝒔 − 𝒈𝟐 )
 1 𝐷3+1
𝑃3 = 3
×
(1 + 0.11) (0.11 − 0.10)
1 𝐷4
𝑃3 = ×
(1 + 0.11)3 0.01
1 𝐷3 × (1 + 𝑔2 )
𝑃3 = 3
×
(1.11) 0.01
1 $ 2.27 × (1 + 0.10)
𝑃3 = ×
1.367631 0.01

$ 2.27 × (1.10)
𝑃3 = 0.731191381 ×
0.01
$ 2.497
𝑃3 = 0.731191381 ×
0.01
𝑃3 = 0.731191381 × $ 249.70
𝑃3 = $ 182.58

𝑃0 = $ 5.11 + $ 182.58
𝑃0 = $ 187.69

Chapter 13 Capital Structure Management

P13-12
Northwestern Savings and Loan has a current capital structure consisting of $250,000 of 16%
(annual interest) debt and 2,000 shares of common stock. The firm pays taxes at the rate of
40%.
a) Using EBIT values of $80,000 and $120,000, determine the associated earnings per share
(EPS).

EBIT $ 80,000 $ 120,000

Less: Interest (I)
$ 40, 000 $ 40,000
($ 𝟐𝟓𝟎, 𝟎𝟎𝟎 × 𝟏𝟔%)
Net profits before taxes $ 40,000 $ 80,000

Less: Taxes (𝑻 = 𝟎. 𝟒𝟎) $ 16,000 $ 32,000

Net profits after taxes $ 24,000 $ 48,000

Less: Preferred stock
$0 $0
dividends (PD)
Earnings available for
$ 24,000 $ 48,000
common (EAC)
 Earnings per share (EPS) $ 24,000 $ 48,000
𝑬𝑨𝑪
𝑬𝑷𝑺 = 𝒔𝒉𝒂𝒓𝒆𝒔 𝒐𝒇 𝒄𝒐𝒎𝒎𝒐𝒏 𝒔𝒕𝒐𝒄𝒌 = $ 2.00 = $ 24.00
2,000 2,000

b) Using $80,000 of EBIT as a base, calculate the degree of financial leverage (DFL).
𝑬𝑩𝑰𝑻
𝑫𝑭𝑳𝒂𝒕 𝒃𝒂𝒔𝒆 𝒍𝒆𝒗𝒆𝒍 𝑬𝑩𝑰𝑻 =
𝟏
𝑬𝑩𝑰𝑻 − 𝑰 − (𝑷𝑫 × 𝟏 − 𝑻)
$ 80,000
=
1
$ 80,000 − $40,000 − ($0 × 1 − 0.40)
$ 80,000
=
1
$ 40,000 − ($0 × 0.60)
$ 80,000
=
$ 40,000 − $0
$ 80,000
=
$ 40,000
=2

c) Rework parts a and b assuming that the firm has $100,000 of 16% (annual interest) debt
and 3,000 shares of common stock.

EBIT $ 80,000 $ 120,000

Less: Interest (I)
$ 16, 000 $ 16,000
($ 𝟏𝟎𝟎, 𝟎𝟎𝟎 × 𝟏𝟔%)
Net profits before taxes $ 64,000 $ 104,000

Less: Taxes (𝑻 = 𝟎. 𝟒𝟎) $ 25,600 $ 41,600

Net profits after taxes $ 38,400 $ 62,400

Less: Preferred stock
$0 $0
dividends (PD)
Earnings available for
$ 38,400 62,400
common (EAC)
Earnings per share (EPS) $ 38,400 $ 62,400
𝑬𝑨𝑪
𝑬𝑷𝑺 = 𝒔𝒉𝒂𝒓𝒆𝒔 𝒐𝒇 𝒄𝒐𝒎𝒎𝒐𝒏 𝒔𝒕𝒐𝒄𝒌 = $ 12.80 = $ 20.80
3,000 3,000

𝑬𝑩𝑰𝑻
𝑫𝑭𝑳𝒂𝒕 𝒃𝒂𝒔𝒆 𝒍𝒆𝒗𝒆𝒍 𝑬𝑩𝑰𝑻 =
𝟏
𝑬𝑩𝑰𝑻 − 𝑰 − (𝑷𝑫 × 𝟏 − 𝑻)
$ 80,000
=
1
$ 80,000 − $16,000 − ($0 × 1 − 0.40)
 $ 80,000
=
1
$ 64,000 − ($0 × 0.60)
$ 80,000
=
$ 64,000 − $0
$ 80,000
=
$ 64,000
= 1.25

P13-15

Play-More Toys produces inflatable beach balls, selling 400,000 balls per year. Each ball
produced has a variable operating cost of $0.84 and sells for $1.00. Fixed operating costs are
$28,000. The firm has annual interest charges of $6,000, preferred dividends of $2,000, and
a 40% tax rate.

a) Calculate the operating breakeven point in units.

𝑭𝑪
𝑸=
𝑷 − 𝑽𝑪
$ 28,000
=
$ 1.00 − $ 0.84
$ 28,000
=
$ 0.16
= 175,000 𝑢𝑛𝑖𝑡𝑠

b) Use the degree of operating leverage (DOL) formula to calculate DOL.

𝑸 × (𝑷 − 𝑽𝑪)
𝑫𝑶𝑳𝒂𝒕 𝒃𝒂𝒔𝒆 𝒔𝒂𝒍𝒆𝒔 𝒍𝒆𝒗𝒆𝒍 𝑸 =
𝑸 × (𝑷 − 𝑽𝑪) − 𝑭𝑪
400,000 × ($ 1.00 − $ 0.84)
=
400,000 × ($ 1.00 − $ 0.84) − $ 28,000
400,000 × $ 0.16
=
400,000 × $0.16 − $ 28,000
$ 64,000
=
$ 64,000 − $ 28,000
$ 64,000
=
$ 36,000
= 1.78

c) Use the degree of financial leverage (DFL) formula to calculate DFL.

𝑬𝑩𝑰𝑻 = 𝑸 × (𝑷 − 𝑽𝑪) − 𝑭𝑪
= 400,000 × ($ 1.00 − $ 0.84) − $ 28,000
= 400,000 × $0.16 − $ 28,000
 = $ 64,000 − $ 28,000
= $ 36,000

𝑬𝑩𝑰𝑻
𝑫𝑭𝑳𝒂𝒕 𝒃𝒂𝒔𝒆 𝒍𝒆𝒗𝒆𝒍 𝑬𝑩𝑰𝑻 =
𝟏
𝑬𝑩𝑰𝑻 − 𝑰 − (𝑷𝑫 × 𝟏 − 𝑻)
$ 36,000
=
1
$ 36,000 − $ 6,000 − ($ 2,000 × 1 − 0.40)
$ 36,000
=
$2,000
$ 30,000 − ( )
0.60
$ 36,000
=
$2,000
$ 30,000 − ( 0.60 )
$ 36,000
=
$ 30,000 − $ 3,333.3333
$ 36,000
=
$ 26, 666.6667
= 1.35

d) Use the degree of total leverage (DTL) formula to calculate DTL. Compare this to the
product of DOL and DFL calculated in parts b and c.

𝑸 × (𝑷 − 𝑽𝑪)
𝑫𝑻𝑳𝒂𝒕 𝒃𝒂𝒔𝒆 𝒔𝒂𝒍𝒆𝒔 𝒍𝒆𝒗𝒆𝒍 𝑸 =
𝟏
𝑸 × (𝑷 − 𝑽𝑪) − 𝑭𝑪 − 𝑰 − (𝑷𝑫 × 𝟏 − 𝑻)
400,000 × ($ 1.00 − $ 0.84)
=
400,000 × ($ 1.00 − $ 0.84) − $ 28,000 − $ 6,000
1
− ($ 2,000 × 1 − 0.40)
400,000 × $0.16
=
$2,000
400,000 × $0.16 − $ 28,000 − $ 6,000 − ( 0.60 )
$ 64,000
=
$ 64,000 − $ 28,000 − $ 6,000 − $ 3,333.3333
$ 64,000
=
$ 26,666.6667
= 2.40

𝑫𝑻𝑳 = 𝑫𝑶𝑳 × 𝑫𝑭𝑳

= 1.78 × 1.35
= 2.40
∴ The two formulas give the same result.