1. The common stock of Peachtree Paper, Inc., is currently selling for $40 a sha

Question

1. The common stock of Peachtree Paper, Inc., is currently selling for $40 a share. A dividend of $2.00 per share was just paid. You are estimating that this dividend will grow at a constant rate of 10%.

(a) Using the constant growth DVM model, what is your required rate of return if $40 is a resonable trading price? (show all work)

(b) If Peachtree Papers is a new company that produces a relatively unknown product, is the constant growth model a good valuation method for a potential investor to use? Justify your answer.

2.  Heidi invested $3,000 and purchased shares of a German corporation when the exchange rate was $1,00=1.6 euro. After six months, she sold all of the share for 3,180 euro, when the exchange rate was $1.00=1.12 euro. No dividends were paid during the time Heidi owned the shares of stock. What is the amount of Heidi's gain or loss on this investment?

3. The risk-free rate of return is 4% while the market rate of return is 11%. Delta Company has a historical beta of 1.25. Today, the beta for Delta Company was adjusted to reflect internal changes in the structure of the company. The new beta is 1.38. What is the amount of the change in the expected rate of return for Delta Company based on this revision to beta?

Explanation / Answer

1. a. Using the constant growth model, $ 40 = $ 2 ( 1.10) / (K - 0.10 ), where K is the required rate of return from the stock.

Solving the equation, K = 15.5%

b. If Peachtree Papers is a new company producing a relatively unknown product, the constant growth DVM is not a suitable model for a potential investor, as the growth rate in dividends over a long horizon would be difficult to calculate in the first place, plus whether or not the growth rate so calculated will sustain in the long run would be doubtful.

2. Heidi's cost of acquisition = 3,000 dollars = 4,800 euros

After 6 months, Heidi sells them for 3,180 euros or 3,180 / 1.12 = $ 2,839.29

Heidi's loss on investment = Sale proceeds - Cost of acquisition = $ 2,839.29 - $ 3,000 = $ (160.71)

3. Expected return using old beta = 4 + 1.25 ( 11-4) = 12.75%

Expected return using new beta = 4 + 1.38 (11 -4) = 13.66%

Change in expected return = 13.66% - 12.75% = 0.91% increase

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