Question

problem8&9

PROBLEM a) DERIVE THE "COST OF EQUITY USING THE GORDON DIVIDEND MODEL FOR THE STOCK PRICE OF 1386, GROWTH IN DIVIDEND OF 3%, AND DIVIDEND OF t36. THEN INDICATE WHETHER IS RETURN ON EQUITY IS A GOOD RETURN RELATIVE TO CURRENT YEAR 2012 RETURNS ON EQUITY WHICH HAVE BEEN RUNNING FROM 4 % TO 7 % FOR THRIVING MANUFACTURING CONGLOME RATES AND EVEN HIGHER FOR SOME VENTURE CAPITAL AND PRIVATE EQUITY FIRMS UPWARD TO OVER 10 %. b) IS THE DISCOUNTING OF INVESTMENT VENTURE CASH FLOWS DEEPER WITH T RATE YOU HAVE DERIVED, OR LESS THAN THE DISCOUNTING OF THRIVING MANUFACTURING CONGLOMERATES? EXPLAIN PROBLEM IF THE PRICE OF A SHARE OF NEWTON INDUSTRIES STOCK IS $261 PER SHARE AND NEWTON'S CURRENT DIVIDEND IS RUNNING AT A LEVEL $15 PER SHARE AND GROWING AT APPROXIMATELY 3%, AND AS WELL NEWTON'S COST OF EQUITY IS y%, wOULD YOU BUY THE STOCK AT THE S 261 PRICE? PROVIDE YOUR ANSWER AND THE INFORMATION TO BACK UP YOUR CHOICE

Answer 1

Problem 8

a.

Gordon Dividend Model

PriceofShare- (Dividend1+g) ar e ke -9

386 =

36(1 0.03)) ke 0.03

K_e = 12.61%

Yes, return on equity is a good return relative, the return is higher than the returns of a Manufacturing Conglomerate and even higher from Venture Capital and Private Equity.

b.

The higher the discount rate, discounted cash flows will be lower. As Manufacturing Conglomerate has a lower discount rate, discounted cash flows will be higher than Venture Capital.

Problem 9

PriceofShare- (Dividend1+g) ar e ke -9

= 257.5

1510.03)) 0,09- 0,03 Priceof Share(

Price of Newton's Share is trading at 261 and fair price is calculated at 257.5, which is lower, therefore share is 'Overvalued'. Recommendation: Sell