Integrative-Risk and Valuation Hamlin Steel Company wishes to determine the valu

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 6%. The risk-free rate is currently 9%. 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 $3.06 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 fromm (1) A decrease in its dividend growth rate of 2% from that exhibited over the 2010-2015 period (2) A decrease in its risk premium to 5% a. The required return on Craft's stock is %. (Round to the nearest whole percentage.)

Explanation / Answer

a) growth rate, g = (D2015 / D2010)^(1/5) - 1 = (2.83 / 1.93)^(1/5) - 1 = 7.96%

Required return, r = risk-free rate + risk premium = 6% + 9% = 15%

Using dividend growth model, P0 = D1 / (r - g) = 3.06 / (15% - 7.96%) = $43.44 is the max cash price

b1) If g = 7.96% - 2% = 5.96%, then P0 = 33.83

b2) if risk premium = 5%, then r = 14% => Compute P0 = $50.63

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