Challenge Questions Set 4 Key PDF

Challenge Questions set 4
1. The following are the earnings per share of Thermo Electron, a company that designs
cogeneration and resource recovery plants, from 1987 to 1992:
Year EPS
1987 0.67
1988 0.77
1989 0.90
1990 1.10
1991 1.31
1992 1.51
A. Estimate the arithmetic average growth rate in earnings per share from 1987 to 1992.
B. Estimate the geometric average growth rate in earnings per share from 1987 to 1992.
C. Why are the growth rates different?
Year EPS Growth rate

1987 $0.67
1988 $0.77 14.93%
1989 $0.90 16.88%
1990 $1.10 22.22%
1991 $1.31 19.09%
1992 $1.51 15.27%
A. Arithmetic Average = 17.68%

B. Geometric Average = 17.65%
C. The geometric average considers the compounded effects of growth. The arithmetic average does not.
2. Johnson and Johnson, a leading manufacturer of healthcare products, had a return on equity in
1992 of 31.4%, and paid out 36% of its earnings as dividends. It earned a net income of $1,625
million on a book value of equity of $5,171 million. As a consequence of healthcare reform, it is
expected that the return on equity will drop to 25% in 1993 and that the dividend payout ratio
will remain unchanged.
A. Estimate the growth rate in earnings based upon 1992 numbers.

B. Estimate the growth rate in 1993, when the ROE drops from 31.4% to 25%.
C. Estimate the growth rate after 1993, assuming that 1993 numbers can be sustained.
A. Retention Ratio = 64%

Return on Equity = 1625/5171 = 31.4%
Expected Growth Rate = 0.64 * 31.4% = 20.10%
B. Growth Rate in 1993 = ($5,171 * (.25 -.314)/ $1,625) + 0.64 * 0.25 = -4.37%
C. Growth Rate After 1993 = 0.64 * 0.25 = 16%
3. Computer Associates makes software that enables computers to run more efficiently. It is still
in its high-growth phase and has the following financial characteristics:
Return on Assets = 25%
Dividend Payout Ratio = 7%
Debt/Equity Ratio = 10%
Interest rate on Debt = 8.5%
Corporate tax rate = 40%
It is expected to become a stable firm in ten years.
A. What is the expected growth rate for the high-growth phase?

B. Would you expect the financial characteristics of the firm to change once it reaches a steady
state? What form do you expect the change to take?
C. Assume now that the industry averages for larger, more stable firms in the industry are as
follows:
Industry Average Return on Assets = 14%
Industry Average Debt/Equity Ratio = 40%
Industry Average Interest Rate on Debt = 7%
Industry Average Dividend Payout ratio = 50%
What would you expect the growth rate in the stable growth phase to be?
A. Expected Growth Rate = 0.93 (25% + 0.10 (25% - 8.50% * (1 - 0.4)) = 25.10%
B. The following would be the expected changes:
(1) ROC will decline as the firm gets larger and the marginal projects are no longer as lucrative.
(2) Dividend payout ratio will increase.
(3) Debt/Equity ratio will increase as the firm gets larger and safer.
(4) The interest rate on debt will decline for the same reasons.
C. Expected Growth Rate = 0.5 (0.14 + 0.4 (0.14 - 0.07 * (1 - 0.4)) = 8.96%
4. Respond true or false to the following statements relating to the dividend discount model.
A. The dividend discount model cannot be used to value a high growth company that pays no
dividends.
B. The dividend discount model will undervalue stocks, because it is too conservative.
C. The dividend discount model will find more undervalued stocks, when the overall stock
market is depressed.
D. Stocks that are undervalued using the dividend discount model have generally made
significant positive excess returns over long periods (five years or more).
E. Stocks which pay high dividends and have low price/earnings ratios are more likely to come
out as undervalued using the dividend discount model.
A. False. The dividend discount model can still be used to value the dividends that the company
will pay after the high growth eases.
B. False. It depends upon the assumptions made about expected future growth and risk.
C. False. This will be true only if the stock market falls more than merited by changes in the
fundamentals (such as growth and cash flows).
D. True. Portfolios of stocks that are undervalued using the dividend discount model seem to
earn excess returns over long time periods.
E. True. The model is biased towards these stocks because of its emphasis on dividends.
5. An analyst complains that the Gordon Growth Model yields absurd results. He presents
several problems that he has had with the model. Respond to each of these comments.
A. The model values stocks which do not pay dividends at zero.

B. The model sometimes yields negative values for stocks, when growth rates exceed the
discount rate.
C. The model yields absurdly high values for other stocks, where the discount rate is very close
to the growth rate.
D. No firm raises dividends by a fixed percent every year. The model's assumption is unrealistic
and the values obtained from it will not hold.
E. Since cyclical firms have earnings which go up and down, based upon economic conditions,
the model can never be used to value a cyclical firm.
A. A stock that pays no dividends is not a stable stock. The Gordon Growth model is not
designed to value such a stock. If a company with stable growth insists on not paying dividends,
but retains the FCFE, this FCFE can be used in the Gordon Growth model as the dividend.
B. A stable stock cannot have a growth rate greater than the discount rate, because no company
can grow much faster than the economy in which it operates in the Gordon Growth Model. This
upper limit on how high growth rates can go operates as a constraint in the model.
C. This should not happen for a stable stock, for the same reasons stated above.
D. It is true that the model smooths out growth rates in dividends. In present value terms, though,
this smoothing effect cannot have a large effect on the value estimate obtained from the model.
E. The model requires that, in the long term, the growth rate for a firm is stable (close to the
growth rate in the economy). Thus, cyclical firms, which maintain an average growth rate close
to a stable rate, cyclical ups and downs notwithstanding, can be valued using this model.
6. The following are a number of valuation scenarios, where multiple estimates of growth are
available. Specify how you weight the different growth rates and why.
A. A cyclical firm, whose earnings have dropped significantly (historical growth rate is negative)
as a consequence of a recession, but which you believe has bottomed out and is in the process of
recovering. The firm is heavily followed by analysts, who have a good track record in
forecasting earnings growth.
B. A troubled firm, whose earnings have dropped significantly because of a combination of bad
luck and bad management, but which is now restructuring. You have fairly good information on
the form the restructuring will take and its expected impact. Analysts follow the firm, but their
track record is spotty.
C. A healthy firm, where the estimates of growth from history, analysts, and fundamentals are
fairly close.
D. A firm, which has a long and fairly reliable history of earnings growth, but which has just
sold off three divisions (comprising almost half of the market value of the firm). Analysts follow
the stock, but base forecasts primarily on historical growth.
A. Weight analysts' forecasts the most, and historical growth rates the least (or not at all). In
estimating growth rates from fundamentals, use predicted values for the fundamentals, rather
than current values.
B. Use growth rates from fundamentals, and reflect the expected changes from the restructuring
in these fundamentals.
C. Weight all three growth rates equally.
D. Use fundamentals on the remaining divisions to predict growth.

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Challenge Questions set 4

Year EPS Growth rate

A. Arithmetic Average = 17.68%

A. Estimate the growth rate in earnings based upon 1992 numbers.

A. Retention Ratio = 64%

Return on Assets = 25%

Dividend Payout Ratio = 7%

Debt/Equity Ratio = 10%

Interest rate on Debt = 8.5%

Corporate tax rate = 40%

It is expected to become a stable firm in ten years.

A. What is the expected growth rate for the high-growth phase?

A. The model values stocks which do not pay dividends at zero.

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