# Lauren entertainment, inc., has an 18 percent annual growth rate

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CHAPTER 14

QUESTION 6

Lauren Entertainment, Inc., has an 18 percent annual growth rate compared to the market rate of 8 percent. If the market multiple is 18, determine P/E ratios for Lauren Entertainment, Inc., assuming its beta is 1.0 and you feel it can maintain its superior growth rate for:

a.       the next 10 years.

b.      the next 5 years.

QUESTION 7

You are given the following information about two computer software firms and the S&P Industrials:

 COMPANY A COMPANY B S&P Industrials P/E ratio   Expected annual growth rate   Dividend yield 30.00    0.18    0.00 27.00    0.15     0.01 18.00      0.07       0.02

a.       Compute the growth duration of each company stock relative to the S&P Industrials.

b.      Compute the growth duration of Company A relative to Company B.

c.       Given these growth durations, what determines your investment decision?

QUESTION 8

The value of an asset is the present value of the expected returns from the asset during the holding period. An investment will provide a stream of returns during this period, and it is necessary to discount this stream of returns at an appropriate rate to determine the asset’s present value. A dividend valuation model such as the following is frequently used:

Pi =    ­­­­­­­­­­­­­­­­­_______D1_________

( Ki – Gi )

Where;   Pi = the current price of common Stock i

D1 = the expected dividend in Period 1

Ki = the required rate of return on Stock i

Gi = the expected constant-growth rate of dividend for Stock i

a.       Identify the three factors that must be estimated for any valuation model, and explain why these estimates are more difficult to derive for common stocks than for bonds.

b.      Explain the principal problem involved in using a dividend valuation model to value:

(1) companies whose operations are closely correlated with economic cycles.

(2) companies that are of very large and mature.

(3) companies that are quite small and are growing rapidly.

Assume that all companies pay dividends.

QUESTION 10

The constant-growth dividend discount model can be used both for the valuation of companies and for the estimation of the long-term total return of a stock.

Assume      \$20 = Price of a stock today

8% = Expected growth rate of dividends

\$0.60 = annual dividend one year forward

a.       Using only the preceding data, compute the expected long-term total return on the stock using the constant-growth dividend discount model.

b.      Briefly discuss three disadvantages of the constant-growth dividend discount model in its application to investment analysis.

c.       Identify three alternative methods to the dividend discount model for the valuation of companies.

QUESTION 11

An analyst expects a risk-free return of 4.5 percent, a market return of 14.5 percent, and the returns for Stocks A and B that are shown inExhibit 14.24.

Exhibit 14.24 Stock Information

 Stock Beta Analyst’s estimated return A B 1.2 0.8 16% 14%

a. Show on a graph:

(1) where Stocks A and B would plot on the security market line (SML) if they were fairly valued using the capital asset pricing model (CAPM).

(2) where Stocks A and B actually plot on the same graph according to the returns estimated by the analyst and shown in Exhibit 14.24.

b. State whether Stocks A and B are undervalued or overvalued if the analyst uses the SML for strategic investment decisions.

QUESTION 12

Lauren Turk is reviewing Francesca Toy’s financial statements in order to estimate its sustainable growth rate. Using the information presented in Exhibit 14.25:

a.  (1) identify and calculate the three components of the DuPont formula.

(2) calculate the ROE for 2011, using the three components of the DuPont formula.

(3) calculate the sustainable-growth rate for 2011.

b. Turk has calculated actual and sustainable growth for each of the past four years and finds in each year that its calculated sustainable-growth rate substantially exceeds its actual growth rate. Cite two courses of action (other than ignoring the problem) that Turk should encourage Francesca Toy to take, assuming the calculated sustainable-growth rate continues to exceed the actual growth rate.

Exhibit 14.25 Francesca Toy, Inc.: Actual 2010 and Estimated 2011 Financial Statements for Fiscal Year Ending December 31 (\$ Millions, except Per-Share Data)

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