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Negative Growth

Horse and Buggy Inc. is in a declining industry. Sales, earnings, and dividends are all shrinking at a rate of 10 percent per year.

a. If r = 15 percent and DIV1 = $3, what is the value of a share?

b. What price do you forecast for the stock next year?

c. What is the expected rate of return on the stock?

d. Can you distinguish between bad stocks and bad companies ? Does the fact that the industry is declining mean that the stock is a bad buy?

15. Constant-Growth Model. Metatrend s stock will generate earnings of $5 per share this year. The discount rate for the stock is 15 percent and the rate of return on reinvested earnings also is 15 percent.

a. Find both the growth rate of dividends and the price of the stock if the company reinvests the following fraction of its earnings in the firm: (i) 0 percent; (ii) 40 percent; (iii) 60 percent.

b. Redo part (a) now assuming that the rate of return on reinvested earnings is 20 percent. What is the present value of growth opportunities for each reinvestment rate?

c. Considering your answers to parts (a) and (b), can you briefly state the difference between companies experiencing growth versus companies with growth opportunities?

16. Nonconstant Growth. You expect a share of stock to pay dividends of $1.00, $1.25, and $1.50 in each of the next 3 years. You believe the stock will sell for $20 at the end of the third year.

a. What is the stock price if the discount rate for the stock is 10 percent?

b. What is the dividend yield?

17. Constant-Growth Model. Here are data on two stocks, both of which have discount rates of 15 percent:

Stock A Stock B

Return on equity 15% 10%

Earnings per share $2.00 $1.50

Dividends per share $1.00 $1.00

a. What are the dividend payout ratios for each firm?

b. What are the expected dividend growth rates for each firm?

c. What is the proper stock price for each firm?

18. P/E Ratios. Web Cites Research projects a rate of return of 20 percent on new projects. Management plans to plow back 30 percent of all earnings into the firm. Earnings this year will be $2 per share, and investors expect a 12 percent rate of return on the stock.

a. What is the sustainable growth rate?

b. What is the stock price?

c. What is the present value of growth opportunities?

d. What is the P/E ratio?

e. What would the price and P/E ratio be if the firm paid out all earnings as dividends?

f. What do you conclude about the relationship between growth opportunities and P/E ratios?

19. Constant-Growth Model. Fincorp will pay a year-end dividend of $4.80 per share, which is expected to grow at a 4 percent rate for the indefinite future. The discount rate is 12 percent.

a. What is the stock selling for?

b. If earnings are $6.20 a share, what is the implied value of the firm s growth opportunities?

20. P/E Ratios. No-Growth Industries pays out all of its earnings as dividends. It will pay its next $4 per share dividend in a year. The discount rate is 12 percent.

a. What is the price-earnings ratio of the company?

b. What would the P/E ratio be if the discount rate were 10 percent?

21. Growth Opportunities. Stormy Weather has no attractive investment opportunities. Its return on equity equals the discount rate, which is 10 percent. Its expected earnings this year are $3 per share. Find the stock price, P/E ratio, and growth rate of dividends for plowback ratios of

a. zero

b. .40

c. .80

22. Growth Opportunities. Trend-line Inc. has been growing at a rate of 6 percent per year and is expected to continue to do so indefinitely. The next dividend is expected to be $5 per share.

a. If the market expects a 10 percent rate of return on Trend-line, at what price must it be selling?

b. If Trend-line s earnings per share will be $8, what part of Trend-line s value is due to assets in place, and what part to growth opportunities?