INVESTMENT MANAGEMENT

[EFET3714]

TUTORIAL 4 QUESTIONS
EQUITY VALUATION

1. Identify whether the following statements are true or false. Provide a reason for your answer:

a. The liquidation value of a firm is equal to the book value of the firm.

False. Book value is simply the historical values and don’t represent what the assets can actually
be sold for in the market. Liquidation value represents what the assets can be sold for
immediately which may be even lower than the market value.

b. The book value of a firm is equal to the ordinary share equity account on its balance sheet.

True. Book value equals historical value of the assets of the firm less the value of all claims
against those assets. What is left is the nominal value left over for distribution to the ordinary
shareholders.

c. Common stocks that pay no dividends are generally priced lower than dividend-paying stocks.

False. It depends. A company paying no dividends may be reinvesting earnings in profitable

projects that will add value to the firm. This will be reflected in a higher share price

d. Stocks which pay high dividends and have low price/earnings ratios are more likely to come out as
undervalued using the dividend discount model.

True. The model is biased towards these stocks because of its emphasis on dividends.

e. According to the dividend discount model, a share's price today depends on the investor's horizon for
holding the share.

FALSE. The model values the share as the present value of all expected future dividends to infinity. The
investor’s holding period is irrelevant to the value of the share.
2. Wartburg Winery has a statement of financial position which lists R1,400,000,000 in assets,
R900,000,000 in liabilities and R500,000,000 in ordinary shareholders' equity. It has 10,000,000
ordinary shares outstanding. The replacement cost of its assets is R1,700,000,000. Its share price in
the market is R49. Calculate Wartburg Winery’s book value per share.
BVPS = 500 000 000 / 10 000 000 = R50
3. You are told by your investment advisor that Laduma Co. is expected to earn R5 per share next year,
R6 per share the following year and that thereafter earnings are expected to grow by 8 percent per year.
The dividend payout ratio is 60 percent and the required rate of return on Laduma shares is 15 percent.
If the current share price is R40, would you expect your adviser to make a buy, hold or sell
recommendation? If transaction costs are R2,50 per share, would you follow his advice?

D1 = R5(0.6) = R3 D2 = R6(0.6) = R3.6 D3 = D2 (1.08) = R3.89

P2 = 3.89/(0.15 – 0.08) = R55.57
P0 = 3/(1.15) + (3.6 + 55.57)/(1.15)2 = 2.61 + 44.74 = R47.35 Buy recommendation
R47.35 – R40 – R2.50 = R4.85 therefore still buy
4. You are interested in Speculative Holdings which is currently trading at a market price of R4.2 per
share. You expect it to achieve earnings next year of R3,420,000 and project a dividend next year of
R0.137 per share. The firm has 10 million shares in issue and you estimate that you would requires a
return of 12% on this investment. What position would you take on Speculative Holdings?
EPS = R3,420,000/10,000,000 = R0.342 ROE = R3,420,000/(R4.20 x 10,000,000) = 0.08
B = 1 – (R0.137/R0.342) = 0.6 or b = (0.342 – 0.137)/0.342 = 0.6 g = 0.6 x 0.08 = 0.05

P0 = R0.137/(0.12 – 0.05) = R1.96 Share is overvalued, take a short position

5. Kyle Co. achieved net income of R12 million rand last year. The firm has 30 million shares in issue
and a payout ratio of 25%. Historical ROE is 22%. If you require a return of 20% how much would
you be prepared to pay for this share?

EPS = R12,000,000/30,000,000 = R0.40 D0 = 0.4 x 0.25 = R0.10

g = 0.75 x 0.22 = 0.165 P0 = D0(1+g)/(ks – g) = R0.10(1.165)/(0.2 – 0.165) = R3.33
6. Sabelo deposits R50,000 into his brokerage account. On the 1st of March 2014 he buys 10,000 shares
of Ngwenya Clothing on margin at a share price of R12 a share. The margin requirement is 20%.
Ngwenya Clothing has 5 million shares in issue and its earnings for its 2013 financial year ending 28
February were R10 million, Ngwenya Clothing maintains a 40% retention ratio and declares its
dividends on the 1st of May. The market capitalisation rate for Ngwenya Clothing is 15%.
a) Do you agree with Sabelo’s decision to purchase Ngwenya Clothing shares at a price of R12? What is
the maximum price you would be prepared to pay for these shares (show all workings)?
b) What would Sabelo’s holding period return be if on the 15th of June 2014 he sells the shares for R13.40?
a) ROE = 10,000,000/(5,000,000 * 12) = 0.1667 = 16.67%
g = b x ROE = 0.4 x 0.1667 = 0.067 = 6.7% EPS = 10,000,000/5,000,000 = R2
DPS = R2(1-0.4) = R1.2
P0 = D1/(ks – g) = 1.2(1.067)/(0.15 – 0.067) = R15.42
Agree, share is undervalued at R12.00, maximum price to pay is R15.42
b) PR = {E(D1) + [E(P1) – P0]}/P0 = {1.28 + (13.4 – 12)}x 10,000/(12 x 10,000 x 0.2)
= 26 800/24 000 = 1.12 = 112%
7. Vagabond Vans has announced earnings for 2012 of R3,000 000. It has 1,000,000 shares in issue
trading at R20 each and paid a dividend per share of R1.80. Your required rate of return for the share
is 15%. Calculate the firm’s present value of growth opportunities.

ROE = 3,000,000/20,000,000 = 0.15 EPS = 3,000,000/1,000,000 = 3

b = (3-1.8)/3 = 0.4 g = b x ROE = 0.4 x 0.15 = 0.06
 P0 = D1/(ks-g) = 1.8(1.06)/(0.15 – 0.06) = R21.2 PVGO = P0 – E1/k = R21.2 –
3/0.15 = R1.2

8. You are estimating the price/earnings multiple to use to value StarCineCo., by looking at the average
price/earnings multiple of comparable firms. The following are the price/earnings ratios of firms in the
entertainment business.

P/E
Firm
Ratio
Disney (Walt) 22.09
Time Warner 36.00
King World
14.10
Productions
New Line Cinema 26.70
CCL 19.12
PLG 23.33
CIR 22.91
GET 97.60
GTK 26.00

a) What is the average P/E ratio?

b) Would you use all the comparable firms in calculating the average? Why or why not?
c) What assumptions are you making when you use the industry-average P/E ratio to value
StarCineCo?
d) What valuation would you give to StarCineCo if its current price is R65 per share and you
project earnings per share next year of R3?

A. Average P/E Ratio = 31.98

B. No. Eliminate the outliers, because they are likely to skew the average. The average P/E ratio
without GET and King World is 25.16.
C. You are assuming that
(1) StarCIneCo. is similar to the average firm in the industry in terms of growth and risk.
(2) The marker is valuing communications firms correctly, on average.
D. R3 x 25 = R75
9. Calabash Co. has a trailing P/E ratio of 15. The firm has 5million shares in issue which are currently
trading at R4,50 each. Based on your analysis of the firm’s fundamentals you forecast earnings next
year of R1.8 million. DPS this year was R0,12. If you assume that the firm will maintain its historical
ROE and payout ratio what rate of return would you estimate for this share if you bought it today at the
prevailing market price?

E0 = P ÷ P/E = 4.5/15 = 0.3 b = (0.3 – 0.12)/0.3 = 0.6 or 1- (0.12/0.3) = 0.6

ROE = 0.3/(4.5) = 0.0667 g = b x ROE = 0.6 x 0.0667 = 0.04
E1 = 1.8/5 = 0.36 D1 = 0.36(1-0.6) = 0.144
 ks = D1/P0 + g = 0.144/4.5 + 0.04 = 0.072

10. Brianna Co. raises equity finance from two sources; ordinary shares, preference shares and debentures.
The firm’s R100 preference shares have no expiry date and pay a non-participating dividend of R13
per share. Brianna Co. has 5,000,000 ordinary shares in issue and a market capitalization of
R12,100,132. The company recently declared a dividend of 30c per share and has a P/E ratio of 6. Its
ROE is 22%.
a) Calculate the expected rate of return for an investment in the firm’s preference shares and ordinary
shares respectively. (10)
b) Explain why your analysis in part a) is not sufficient to enable you to make an investment decision
and how the difference in returns you calculated might be justified. (3)
c) Discuss the advantages and disadvantages of investing in preference shares as opposed to ordinary
shares. (4)
d) List three (3) possible features of a preference share. (3)

a) pref = 0.13 √
P0 = R2,42 √ E = R2,42/6 √ = 0.4 √ g = b x ROE √ = 0.1/0.4 √ x 0.22 √ = 0.055 √
√
Ks = D1/ P0 + g = 0.3(1.055)/2,42 + 0.055 = 0.186√
b) Difference in return might be because of risk √ prefs less risky √because div. set and firm
must pay it before it can pay ordinary shares√ therefore less uncertainty and so lower return

c) Dividend amount is set, firm can’t pay ordinary divs until prefs are paid √ Preference
shareholders get paid out in full in the event of liquidation before ordinary sharehodlers. √
Don’t have a vote √, don’t share in profits √as dividend amount is set
d) 3 of participating, convertible, redeemable, cumulative (√ each)
11. A firm reports EBIT of $100 million. The income statement shows depreciation of $20 million. If the
tax rate is 35% and total capital expenditures and increases in working capital total $10 million, what
is the free cash flow to the firm?
Explanation: FCFF = 100(1 − 0.35) + 20 − 10 = $75 million

12. The free cash flow to the firm is $300 million in perpetuity, the cost of equity equals 14%, and the
WACC is 10%. If the market value of the debt is $1 billion, what is the value of the equity using the
free cash flow valuation approach?
Explanation: Total value = 300/0.10 = $3 billion
Equity value = $3 billion − 1 billion = $2 billion

13. The free cash flow to the firm is reported as $405 million. The interest expense to the firm is $76
million. If the tax rate is 35% and the net debt of the firm increased by $50 million, what is the free
cash flow to the equity holders of the firm?
Explanation: FCFE = 405 − 76(1 − 0.35) + 50 = 405.6
14. The free cash flow to the firm is reported as $198 million. The interest expense to the firm is $15
million. If the tax rate is 35% and the net debt of the firm increased by $20 million, what is the
approximate market value of the firm if the FCFE grows at 3% and the cost of equity is 14%?
Explanation: FCFE = 198 − 15(1 − 0.35) + 20 = 208.25
Value = (208.25 × 1.03)/(0.14 − 0.03) = 1,950
15. John Jones, CFA, is head of the research department of Peninsular Research. One of the
companies he is researching, Mackinac Inc., is a U.S. - based manufacturing company.
Mackinac has released the June 2007 financial statements shown in Exhibits 4 - 3, 4 - 4, and 4
- 5.
EXHIBIT 4 - 3 Mackinac Inc. Annual Income Statement
30 June 2007 (in thousands, except per - share data)
Sales $ 250,000
Cost of goods sold 125,000
Gross operating profit 125,000
Selling, general, and administrative expenses 50,000
EBITDA 75,000
Depreciation and amortization 10,500
EBIT 64,500
Interest expense 11,000
Pretax income 53,500
Income taxes 16,050
Net income $ 37,450
Shares outstanding 13,000
EPS $ 2.88

EXHIBIT 4 - 4 Mackinac Inc. Balance Sheet 30 June 2007 (in thousands)

Current Assets
Cash and equivalents $ 20,000
Receivables 40,000
Inventories 29,000
Other current assets 23,000
Total current assets $ 112,000
Noncurrent Assets
Property, plant, and equipment $ 145,000
Less: Accumulated depreciation 43,000
Net property, plant, and equipment 102,000
Investments 70,000
Other noncurrent assets 36,000
Total noncurrent assets 208,000
Total assets $ 320,000
Current Liabilities
Accounts payable $ 41,000
Short - term debt 12,000
Other current liabilities 17,000
Total current liabilities $ 70,000
Noncurrent Liabilities
Long - term debt 100,000
Total noncurrent liabilities 100,000
Total liabilities 170,000
Shareholders’ Equity
Common equity 40,000
Retained earnings 110,000
Total equity 150,000
Total liabilities and equity $ 320,000

EXHIBIT 4 - 5 Mackinac Inc. Cash Flow Statement 30 June 2007

(in thousands)
Cash Flow from Operating Activities
Net income $ 37,450
Depreciation and amortization 10,500
Change in Working Capital
(Increase) decrease in receivables ( $ 5,000)
(Increase) decrease in inventories (8,000)
Increase (decrease) in payables 6,000
Increase (decrease) in other current liabilities 1,500
Net change in working capital (5,500)
Net cash from operating activities $ 42,450
Cash Flow from Investing Activities
Purchase of property, plant, and equipment ( $ 15,000)
Net cash from investing activities ( $ 15,000)
Cash Flow from Financing Activities
Change in debt outstanding $ 4,000
Payment of cash dividends (22,470)
Net cash from financing activities (18,470)
Net change in cash and cash equivalents $ 8,980
Cash at beginning of period 11,020
Cash at end of period $ 20,000

Mackinac has announced that it has finalized an agreement to handle North American production
of a successful product currently marketed by a company headquartered outside North America.
Jones decides to value Mackinac by using the DDM and FCFE models. After reviewing
Mackinac’s financial statements and forecasts related to the new production agreement, Jones
concludes the following:
 Mackinac ’s earnings and FCFE are expected to grow 17 percent a year over the next three
years before stabilizing at an annual growth rate of 9 percent.
 Mackinac will maintain the current payout ratio.
 Mackinac ’s beta is 1.25.
 The government bond yield is 6 percent, and the market equity risk premium is 5 percent.
Required:
A. Calculate the value of a share of Mackinac ’s common stock by using the two - stage DDM.
B. Calculate the value of a share of Mackinac ’s common stock by using the two - stage
FCFE model.
C. Jones is discussing with a corporate client the possibility of that client acquiring a 70
percent interest in Mackinac. Discuss whether the DDM or FCFE model is more
appropriate for this client ’s valuation purposes.
SOLUTION

A. When a two - stage DDM is used, the value of a share of Mackinac, using dividends per
share (DPS), is calculated as follows:

DPS 0 = Cash dividends/Shares outstanding = $ 22,470/13,000 = $ 1.7285

DPS 1 = DPS 0 x 1.17 = $ 2.0223
DPS 2 = DPS 0 x1.17^ 2 = $ 2.3661
DPS 3 = DPS 0 x1.17^ 3 = $ 2.7683
DPS 4 = DPS 0 x 1.17^ 3 x 1.09 = $ 3.0175

When the CAPM is used, the required return on equity, r, is

r= Government bond rate + (Beta x Equity risk premium)

=0.0 6 + (1. 25 x 0.0 5) =0. 1225 or 12. 25 percent
𝐷𝑃𝑆4
𝐷𝑃𝑆 𝐷𝑃𝑆2 𝐷𝑃𝑆3 (𝑟−𝑔𝑠𝑡𝑎𝑏𝑙𝑒 )
Value per share =(1+𝑟)11 + +
(1+𝑟) (1+𝑟)3
2 + (1+𝑟)3

Value per share = $ 2 .0 223 / 1. 1225 + $ 2. 3661 / 1. 1225^ 2 + $ 2. 7683 / 1. 1225^ 3

+ [ $ 3 .0 175 / (0. 1225 – 0.0 9)] / 1. 1225 ^3

= $ 1. 8 0 16 + $ 1. 8778 + $ 1. 9573 + $ 65. 6450 = $ 71. 28

c) When the two - stage FCFE model is used, the value of a share of Mackinac is calculated
as follows (in $ thousands, except per - share data):

Net income = $ 37,450

Depreciation = $ 10,500
Capital expenditures = $ 15,000
Change in working capital = $ 5,500
New debt issuance - Principal repayments = Change in debt outstanding = $ 4,000
FCFE 0 = Net income - Depreciation + Capital expenditures- Change in working Capital - Principal
repayments + New debt issues
FCFE 0 = $ 37,450 + $ 10,500 - $ 15,000 - $ 5,500 + $ 4,000 = $ 31,450
FCFE 0 per share = $ 31,450/13,000 = $ 2.4192
FCFE 1 = FCFE 0 x 1.17 = $ 2.8305
FCFE 2 = FCFE 0 x 1.17 ^2 = $ 3.3117
FCFE 3 = FCFE 0 x 1.17^ 3 = $ 3.8747
FCFE 4 = FCFE 0 x 1.17^ 3 x 1.09 = $ 4.2234

From the answer to A, r = 12.25 percent.

𝐹𝐶𝐹𝐸4
𝐹𝐶𝐹𝐸 𝐹𝐶𝐹𝐸2 𝐹𝐶𝐹𝐸3 (𝑟−𝑔𝑠𝑡𝑎𝑏𝑙𝑒 )
Value per share =(1+𝑟)11 + +
(1+𝑟)2 (1+𝑟)3
+ (1+𝑟)3

Value per share = $ 2. 83 0 5 / 1. 1225 + $ 3. 3117 / 1. 1225^ 2 + $ 3. 8747 / 1. 1225^ 3

+ [ $ 4. 2234 / (0. 1225 – 0.0 9)] / 1. 1225^ 3
= $ 2. 5216 + $ 2. 6283 + $ 2. 7395 + $ 91. 8798 =$ 99. 77

C. The FCFE model is best for valuing companies for takeovers or in situations that have a reasonable
chance of a change in corporate control. Because controlling stockholders can change the dividend
policy, they are interested in estimating the maximum residual cash fl ow after meeting all fi nancial
obligations and investment needs. The DDM is based on the premise that the only cash fl ows received
by stockholders are dividends. FCFE uses a more expansive defi nition to measure what a company
can afford to pay out as dividends.

16. You have been presented with the financial statements of a rapidly growing safari company: Kubanda
Ltd. The most recent financial statements are shown below.

Kubanda Ltd Income Statement for the year ending 31 December 2018

(R 000’s)
Turnover 320 000
Cost of Sales 133 000
Operating Expenses 105 000
PBIT 82 000
Interest paid 22 000
PBT 60 000
Taxation (@ 30%) 18 000
NPAT 42 000
Dividend 21 000
Retained profit 21 000

Kubanda Ltd Balance Sheet as at 31 December 2016

(R 000’s)
Equity & Liabilities
Shareholders’ Equity 100 376
Ordinary share capital @ R0.50 each 50 000
 Retained earnings 50 376

Additional Information:

High growth phase:

1. ROE is 24%.
2. The annual growth rate in dividends in the high growth phase will decline linearly until it reaches
6% in 2021. ( Hint calculate the current g first)
Stable phase:
3. The stable phase growth rate is 5%.
4. Kubanda’s shareholders require a return of 10%.

Required

a) As an investment analyst advise your client Verily, how much must she expect to pay for Kubanda
limited stock. If the current market value is R6, should she purchase the stock?
[19 marks]

b) What are the weaknesses of the Dividend Discount model when applied to equity valuation
[3 marks]

Solution

a)
g=roe*b = 24%*50% = 12%
DPS = div/shares = 21 000/ 100 000 = 0.21
D1 =0.21(1.1) = 0.231
D2 = 0.231(1.08) = 0.2495
D3= 0.2495(1.06) =0.2644
D4=0.2644(1.05) = 0.2777
0.2777
𝑃3 = (0.1−0.05) = 5.554

0.231 0.2495 0.2644 5.554

𝑉0 = + + + 3
1.1 1.12 1.13 1.1

𝑽𝟎 = 𝟒. 𝟒𝟏 Since intrinsic value is greater than the market price, the share is undervalued and she
should purchase the share.

b) Weaknesses of the DDM

It cannot be used to evaluate stocks that do not pay dividends, regardless of the capital gains that could
be realized from investing in the stock.
Flawed assumption that the only value of a stock is the return on investment it provides through
dividends. Only appropriate for firms, which have:
Stable earnings growth rate, Well-established dividend payout policy, a stable pay-out-ratio
model only valid when g<k
It does not take into account non-dividend factors such as brand loyalty, customer retention and the
ownership of intangible assets, all of which increase the value of a company

17. Shunichi Kobayashi is valuing United Parcel Service (UPS). Kobayashi has made the following
assumptions:
 Book value per share is estimated at $9.62 on 31 December 2007 and expected to grow at 15%
for the next four years.
 EPS will be 22 percent of the book value per share for the next four years.
 Cash dividends paid will be 30 percent of EPS.
 At the end of the four - year period, the market price per share will be three times the book
value per share.
 The beta for UPS is 0.60, the risk - free rate is 5.00 percent, and the equity risk premium is 5.50
percent.
 The current market price of UPS is $59.38, which indicates a current P/B of 6.2.

Required:
a) Estimate the value per share of UPS stock using the dividend discount model. (14)
b) Advise your client on the best investment decision to make based on your estimation. (3)
Solution

Estimate the value per share of UPS stock using the dividend discount model. (14)
Year 0 1 2 3 4
BV * 1.15 9.62 11.063 12.722 14.631 16.825
EPS = 22% OF BV 2.434 2.544 3.2188 3.7016
DPS = 0.3 * EPS 0.73 0.76 0.97 1.11
P4 50.476
PVS @ 8.3 % 0.674 0.648 0.764 37.499
Po + + + 39.58
Ke = 5 + 0.6(5.5) = 8.3%
P4 = 3* BV in year 4 = 3 * 16.8254 = 50.4762
The current market price is 59.38 which is greater than the intrinsic value hence the share is overvalued.
Decision sell or do not buy.
18. BHP Billiton has experienced a significant improvement in operating cash flows due to favorable
macroeconomic and geopolitical factors and due to strong demand by china. The market prices of
resources have risen dramatically in US dollar terms. BHP Billiton has reported significant growth in
earnings for the year ended 30 June 2004 and the company reported an increase in EPS to US$0.55
 (R3.87) as compared to US$0.30 in 2003. The substantial rise in the value of the South African rand
means that the improvement in BHP Billiton’s earnings is less when stated in Rands.
 Earnings and dividends are expected to grow by 18% for the next 5 years in rand terms; thereafter
the growth rate will be 7% per year.
 The dividend in 2004 amounted to R1.73.
 the listed price of BHP Billion in June 2004 was around R59.30.

Required:

Using the dividend discount model, determine the value of each BHP Billiton ordinary share, if the cost of
equity for BHP Billiton is 10%.

SOLUTION

BHP Billiton
Dividend 2004 1.73 1.73 118% 2.04 1
Growth rate during initial period 18% 2.04 118% 2.41 2
Constant growth rate 7% 2.41 118% 2.84 3
Cost of Equity 10% 2.84 118% 3.35 4
3.35 118% 3.96 5

2005 2006 2007 2008 2009

0 1 2 3 4 5
Dividend 2.04 2.41 2.84 3.35 3.96
PV Factors 0.9091 0.8264 0.7513 0.6830 0.6209
PV 1.8558 1.9908 2.1356 2.2909 2.4575
Value - yr 0
Yr1 1.8558
Yr2 1.9908
Yr3 2.1356
Yr4 2.2909
Yr5 2.4575
Present Value of Dividends over next 5 years 10.7306 a
Value of equity at end of Year 5
Dividend in year 6 Yr 5 dividend 1+ growth rate Dividend - yr 6
Dividend in year 6 3.9578 107% 4.2349

Value -Yr5 PVF - Yr5

Dividend in year 4 4.2349
= 141.16228 0.6209 87.651 b
k-g 3%

Total Value 98.381 a+b

98.38
Compare to actual price at yearend. 59.30

Let's evaluate the situation in early 20 07, 2011 and then early 2015
In January 2007 , BHP Billiton was priced at over R130.
However, as we can see, the price was discounting a high growth rate in dividends for the next 5 years.
The dividend paid in 2006 was R2.38, so we were pretty close to the forecast dividend of R2.41.
The price of R130 in the share price is higher than our value in 2004, yet the price then was R59. We would have
made the right investment decision even though we were conservative about earnings growth.

In early 2011 , the share price had risen to R292 per share. Our value in 2004 restated into an equivalent value in
2011 amounts to R192. The role of China can not be underestimated in driving the prices of resources and the
share price of BHP Billiton. The high oil price would also have helped BHP Billiton as well as the tremendous rise
in the aluminium price and the prices of other commodities. The dividend per share in 2009 amounted to $0.82
(about R5.60 per share) which was 40% higher than our forecast.
By early 2015, the outlook for resources was much more challenging due to lower demand from China and greater
supply particularly of iron ore. In February 2015, the share price of BHP Billiton was R268 and this was now only
5% above our adjusted 2004 valuation after 10 years (adjusted to the end of 2014)
Value in 2004 (1.10) n Equivalent value Actual price
2007 98.38 1.331 131 130 1%
2011 98.38 1.949 192 292 -34%
2014 98.38 2.594 255 268 -5%
19. Aling Gas is a major utility, being a provider of gas in the country. The company is expected to
experience solid growth of 12% per year in after tax earnings for the next four years after which
earnings are expected to grow at a sustainable growth rate of 5% per annum. As Alin Gas is a utility
company, it is seen as low risk and the cost of equity of the company is estimated to be 10%.

Alin Gas has just declared a dividend of 33cents per share for the 20x3 financial year and the company
is expected to maintain a constant dividend payout ratio of 70% of after tax earnings in the future. The
listed share price is R6.57 at 31 December 20x3. Assume there is a year until the 20x4 dividend.

Required
Using the dividend discount model, determine the value of each Alin Gas ordinary share, if the cost of
equity for the company is 10%.
SOLUTION

Alin Gas
The long term sustainable growth rate is given as 5%. This is a conservative and prudent growth rate to use.
For example, if the expected inflation rate is 3%, then we are assuming a real growth rate of approximately 2% per year.
Assume Inflation is 3%
Real growth expected to be 2% 5%

Dividend - 20x3 0.33

Dividend(1+g) 0.35
Cost of Equity 10%

Value per share 8.83

Growth rate during the initial period 12%

If high growth is maintained for 4 years
1 2 3 4
20x4 20x5 20x6 20x7
Non-constant growth period 0.370 0.414 0.464 0.519
Value: constant growth D20x7(1+0.05)/(0.10 - 0.05) 10.90
0.37 0.41 0.46 11.42
0.9091 0.8264 0.7513 0.6830
Sum of PVs 8.83 0.34 0.34 0.35 7.80

Value 8.83

Share price at 1 January 20x4 6.57

This is based on an actual company.

The decision to invest in this share would have brought investors sizable gains by investing in 2002 when the share price was R4.20.
At the time we had valued the share at about R7.30.
Even though we were conservative in our estimates of future growth, the investment decision is what matters.
At 1 January, Alin seems to still offer value.

Workings
Dividends during the next 4 years
Prior year
Year 1+growth Dividend
dividend
20x4 0.330 112% 0.370
20x5 0.370 112% 0.414
20x6 0.414 112% 0.464
20x7 0.464 112% 0.519

Valuation at end of Year 4

D6(1+g) 0.545
= = 10.90
k-g 5.0%
20. LaForge Systems, Inc. has net income of $ 285 million for the year 2008. Using information from the
company’ s financial statements given here, show the adjustments to net income that would be required
to find:
A. FCFF.
B. FCFE.
C. In addition, show the adjustments to FCFF that would result in FCFE
Note : The Statement of Cash Flows shows the use of a convention by which the positive numbers of $ 349 and $ 40
for cash used for investing activities and cash used for financing activities, respectively, are understood to be
subtractions, because “ cash used ” is an outflow.
Solution:

21. For LaForge Systems, whose financial statements are given in problem above, show the
adjustments from the current levels of CFO (which is $ 427 million), EBIT ( $ 605 million),
and EBITDA ( $ 785 million) to find
A. FCFF.
B. FCFE.

A)