Suarez Manufacturing Risky Investment 2007

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a. Given that Craft is expected to pay a dividend of $3.68 next year, determine the maximum cash price that Hamlin should pay for each share of Craft.

b. Discuss the use of the CAPM for estimating the value of common stock, and describe the effect on the resulting value of Craft of:

(1) A decrease in its dividend growth rate of 2% from that exhibited over the 2004-2009 period.

Pra IETHICS PROBLEM Melissa is trying to value Generic Utility, Inc.'s stock, which 4] is clearly not growing at all. Generic declared and paid a $5 dividend last year.

The required rate of return for utility stocks is 11%, but Melissa is unsure about the financial reporting integrity of Generic's finance team. She decides to add an extra 1% "credibility" risk premium to the required return as part of her valuation analysis.

a. What is the value of Generic's stock, assuming that the financials are trustworthy?

b. What is the value of Generic's stock, assuming that Melissa includes the extra 1% "credibility" risk premium?

c. What is the difference between the values found in parts a and b, and how might one interpret that difference?

Chapter 7 Case

Assessing the Impact of Suarez Manufacturing's Proposed Risky Investment on Its Stock Value

Early in 2010, Inez Marcus, the chief financial officer for Suarez Manufacturing, was given the task of assessing the impact of a proposed risky investment on the firm's stock value. To perform the necessary analysis, Inez gathered the following information on the firm's stock.

During the immediate past 5 years (2005-2009), the annual dividends paid on the firm's common stock were as follows:

2009 $1.90

2008 1.70

2007 1.55

2006 1.40

2005 1.30

The firm expects that without the proposed investment, the dividend in 2010 will be $2.09 per share and the historical annual rate of growth (rounded to the nearest whole percent) will continue in the future. Currently, the required return on the common stock is 14%. Inez's research indicates that if the proposed investment is undertaken, the 2010 dividend wili rise to $2.15 per share and the annual rate of dividend growth will increase to 13%. She feels that in the best case, the dividend would continue to grow at this rate each year into the future and that in the worst case, the 13% annual rate of growth in dividends would continue only through 2012, and then, at the beginning of 2013, would return to the rate that was experienced between 2005 and 2009. As a result of the increased risk associated with the proposed risky investment, the required return on the common stock is expected to increase by 2% to an annual rate of 16%, regardless of which dividend growth outcome occurs.

Armed with the preceding information, Inez must now assess the impact of the proposed risky investment on the market value of Suarez's stock. To simplify her calculations, she plans to round the historical growth rate in common stock dividends to the nearest whole percent.

To Do a. Find the current value per share of Suarez Manufacturing's common stock.

b. Find the value of Suarez's common stock in the event that it undertakes the proposed risky investment and assuming that the dividend growth rate stays at 13% forever. Compare this value to that found in part a. What effect would the proposed investment have on the firm's stockholders? Explain.

c. On the basis of your findings in part b, do the stockholders win or lose as a result of undertaking the proposed risky investment? Should the firm do it? Why?

d. Rework parts b and c assuming that at the beginning of 2013 the annual dividend growth rate returns to the rate experienced between 2005 and 2009.

Spreadsheet Exercise

You are interested in purchasing the common stock of Azure Corporation. The firm recenrly paid a dividend of $3 per share. It expects its earnings—and hence its dividends—to grow at a rate of 7% for the foreseeable future. Currently, similar-risk stocks have required returns of 10%.

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Responses

  • Mary
    What is the value of generics stock assuming that the financials are trustworthy?
    3 years ago

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