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 3%. Craft's dividend per share for each of the past 6 years is shown in the following table: a. Given that Craft is expected to pay a dividend of $2.88 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.)

Answer 1

Ans:- (a) The required return on crafts stock will be given by Risk premium + Risk-free rate

= 7% + 3% = 10%

It is given that craft is expected to pay a dividend of $2.88. we need to find the maximum cash price that Hamlin should Pay for each share of Craft. First, we need to find the growth rate of the dividend.

FV = PV * ( 1 + g)^5 , where FV is the future value, PV is the Present value and g is the growth rate.

2.77 = 2.28 * ( 1 + g)^5

( 1 + g)^5 = (2.77 / 2.28)

or Growth rate (g) = (2.77 / 2.28) ^ 1/5 - 1

= 0.0397 = 3.97%.

Now the maximum cash price that Hamlin should pay will be given by if the craft is expected to pay a dividend of $2.88.

[ next years dividend / ( Required return - growth rate)]

= [ $2.88 / ( 0.10 - 0.0397)] = $47.76

(b)(1) If the dividend growth rate is decreased to 2% then the actual growth rate will be 3.97% - 2% = 1.97%.

Now the next year's dividend will be $2.77 *( 1 + 0.0197) = $2.8246.

Now the new price will be [ $2.8246 / ( 0.10 - 0.0197)] = $35.1752 = $35.17. (approx).

(2) If the risk Premium is decrease to 6% then the required return will be 6% + 3% = 9%.

Now the new price will be [ $2.88 / ( 0.09 - 0.0397)] = $57.2564 = $57.25. (approx)

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