Question

Integrative—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 7%. 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: E a. Given that Craft is expected to pay a dividend of $3.76 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 6%. a. The required return on Craft's stock is %. (Round to the nearest whole percentage.) The maximum cash price that Hamlin should pay for each share of Craft is $ - (Round to the nearest cent.) b. (1) If the dividend growth rate decreases by 2%, the maximum cash price that Hamlin should pay for each share of Craft is $ . (Round to the nearest cent.) (2) If the risk premium decreases to 6%, the required return on Craft's stock is %. (Round to the nearest whole percentage.) With a 10% required return, the maximum cash price that Hamlin should pay for each share of Craft is $ (Round to the nearest cent.) V, and the risk-free rate, and the company-specific . For Craft, the lowering of the dividend growth rate future cash flows resulting in in share price. The decrease in the risk premium reflected in risk leading to Price is a function of the current dividend, price. (Select the best answers from the drop-down menus.) in share Data Table in order to copy the contents of the data table below (Click on the icon here into a spreadsheet.) Year 2019 2018 2017 2016 2015 2014 Dividend per Share $3.62 $3.48 $3.34 $3.21 $3.09 $2.97 Print Done

Answer 1

a) Required Return on Craft's Stock = Risk free return+ risk premium of similar stocks

=4%+7%= 11%   

The average growth rate of dividends of the firm is as calculated in the table below

Year	Dividend	Growth rate
2014	2.97
2015	3.09	0.040404
2016	3.21	0.038835
2017	3.34	0.040498
2018	3.48	0.041916
2019	3.62	0.04023
		0.040377

Rounding off to the nearest whole percent, we can say that the dividends are growing by 4% per year

By Gordon's model,

Maximum cash price = Next year dividend/ (required rate - dividend's growth rate)

= 3.76/ (0.11-0.04)

= $53.71

b1. If the dividend growth rate decreases by 2%. new dividend growth rate = 4%-2%= 2%

Maximum cash price = Next year dividend/ (required rate - dividend's growth rate)

= 3.76/ (0.11-0.02)

= $41.78

b2. If the risk premium decreases to 6%

Required Return on Craft's Stock = Risk free return+ risk premium of similar stocks

=4%+6%= 10%

So, If growth rate =4%

Maximum cash price = Next year dividend/ (required rate - dividend's growth rate)

= 3.76/ (0.10-0.04)

= $62.67

If growth rate =2%

Maximum cash price = Next year dividend/ (required rate - dividend's growth rate)

= 3.76/ (0.10-0.02)

= $47.00

Price is a function of the current dividend, dividend growth rate , and the risk free rate and the company specific risk premium. For Craft, lowering of the dividend growth rate decreases future cash flows, resulting in decrease in share price. The decrease in risk premium reflected decrease in risk leading to increase in share price.