Question

Integrativelong dash

Risk

and Valuation   Hamlin Steel Company wishes to determine the value of Craft​ Foundry, a firm that it is considering acquiring for cash. Hamlin wishes to determine the applicable discount rate to use as an input to the​ constant-growth valuation model. ​ Craft's stock is not publicly traded. After studying the required returns of firms similar to Craft that are publicly​ traded, Hamlin believes that an appropriate risk premium on Craft stock is about

8​%. The​ risk-free rate is currently 5​%. Craft's dividend per share for each of the past 6 years is shown in the following​ table:

Year     Dividend per share

2019   $2.50
2018   $2.38
2017   $2.26
2016   $2.16
2015   $2.05
2014   $1.96

a. Given that Craft is expected to pay a dividend of ​$2.62 next​ year, determine the maximum cash price that Hamlin should pay for each share of Craft. ​(Hint: Round the growth rate to the nearest whole​ percent.)

b. Describe the effect on the resulting value of Craft​ from:

​(1) A decrease in its dividend growth rate of​ 2% from that exhibited over the2014​-2019 period.

​(2) A decrease in its risk premium to 7​%.

Answer 1

a.

Annual average growth rate

=((last value/First value)^(1/Time between 1st and last value)-1)*100

=((2.5/1.96)^(1/5)-1)*100

Annual Growth rate% = 4.99

Cost of equity = risk free rate + risk premium = 5+8 = 13%

As per DDM

Price = Dividend in 1 year/(cost of equity - growth rate)

Price = 2.62/ (0.13 - 0.05)

Price = 32.75

b.

1

growth rate = 5-2 = 3%

As per DDM

Price = Dividend in 1 year/(cost of equity - growth rate)

Price = 2.62/ (0.13 - 0.03)

Price = 26.2

2

Cost of equity = risk free rate + risk premium = 5+7 = 12%

As per DDM

Price = Dividend in 1 year/(cost of equity - growth rate)

Price = 2.62/ (0.12 - 0.05)

Price = 37.43