Problem Set # 2 (due 2/17, 4 p.m.)

1.         The Putrovsky Corp. is expected to pay a dividend of $0.68 this year.  It has a dividend yield of 2.55%.  Each year it pays out 35% of its earnings; on the 65% that is reinvested, it earns a return of 13%.

a) What is PC’s growth rate?

b) What is their required return?

c) What is the stock price today?

d) How much of this is the PV of existing assets, and how much is PVGO?

                                                                                                                                                             (15 points)

2.         Newbie Inc. is an all-equity firm with a required return of 16%.  They have invested $55 per share today.  For the first two years, they will earn 24% on all investment, they will pay out 20% of their earnings and reinvest 80%.  However after two years, the payout ratio will increase to 40% and the return on equity will drop to 18% (all investment, old and new).  These new rates will stay constant forever.

a) Make a table showing the firm’s dividend per share for the first 5 years

b) Compute Newbie’s stock price today

c) How much of this is the PV of existing assets, and how much is PVGO?

                                                                                                                                                             (25 points)

(Clarifications and hints: 

·        What is invested at time 0 earns 24% for 2 years and then 18% thereafter.  What is invested at time 1 earns 24% for one year and then 18% thereafter.  What is invested at time 2 and later earns 18% forever.

·        Newbie’s existing assets today consist of the initial investment of $55 per share.  In other words, “today” is time 0, after this investment has been made. 

·        PV of the existing assets is the PV of the expected earnings from the existing assets.  This has to be computed given that the future cashflows from the existing assets are not a perpetuity.)

3.         The White Rabbit Co. has retained Red Queen Consultants to advise then whether to undertake the following project to manufacture looking glasses.  The only investment criterion Red Queen Consultants knows about is IRR.  What will they advise if the required return for the project is 6%?

                                                   C₀              C₁             C₂

                                              +8,800        -4,400       -5,500

(6 points)

4.            Choose among these mutually exclusive projects using IRR alone. The required return for each project is 11.375%.

                                                 C₀             C₁            C₂

            Project A                -173,600    117,950     88,550

            Project B                  -60,000      30,500     39,700

            Project C                  -82,500      52,800     51,150

Would it be a problem if the projects had different required returns?  Explain why or why not.

(15 points)

5.            Choose among these mutually exclusive projects using IRR alone. The required return for both projects is 15%.

            Project              C₀              C₁               C₂             C₃

               A             -145,600        49,280        98,560      60,000

               B              -65,600      -140,320      210,560       60,000

(15 points)