Question

Integrative long 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 4​%.​ Craft's dividend per share for each of the past 6 years is shown in the following​ table:

Year Dividend per Share

2019 $3.16

2018 $2.92

2017 $2.71

2016 $2.51

2015 $2.32

2014 $2.15

.

a. Given that Craft is expected to pay a dividend of $3.41 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 the

2014​-2019 period.

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

a. The required return on​ Craft's stock is _%

Answer 1

a) Required return Growth rate Stock price 12% 54%+8% 8% =(3.16/2.15)^(1/5)-1 85.25 -3.41/(12%-8%) $ 6% =8%-2% b) 1) New growth rate Stock price $ 55.83 -3.16*(1+6%)/(12%-6%) 2) Required return 11% -4%+7% Stock price $ 113.67 -3.41/(11%-8%)

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