P7–2 Preferred dividends Slater Lamp
Manufacturing has an outstanding issue of preferred

stock with an $80 par value and an 11%
annual dividend.

a. What is the annual dollar dividend? If
it is paid quarterly, how much will be paid

each quarter?

b. If the preferred stock is noncumulative
and the board of directors has passed the

preferred dividend for the last three
quarters, how much must be paid to preferred

stockholders in the current quarter before
dividends are paid to common

stockholders?

c. If the preferred stock is cumulative and
the board of directors has passed the preferred

dividend for the last three quarters, how
much must be paid to preferred

stockholders in the current quarter before
dividends are paid to common stockholders?

P7–8 Common stock value: Constant growth
Use the constant-growth model (Gordon

growth model) to find the value of each
firm shown in the following table.

Firm
/ Dividend expected next
year/Dividend growth rate/Required return

A $1.20 8% 13%

B 4.00 $4.00
5 15

C 0.65 10 14

D 6.00 8 9

E 2.25
8 20

P7–10 Common stock value: Constant growth
The common stock of Denis and Denis

Research, Inc., trades for $60 per share.
Investors expect the company to pay a

$3.90 dividend next year, and they expect
that dividend to grow at a constant rate

forever. If investors require a 10% return
on this stock, what is the dividend growth

rate that they are anticipating?

P7–14 Common stock value: Variable growth
Lawrence Industries’ most recent annual

dividend was $1.80 per share (D0 = $1.80),
and the firm’s required return is 11%.

Find the market value of Lawrence’s shares
when:

a. Dividends are expected to grow at 8%
annually for 3 years, followed by a 5%

constant annual growth rate in years 4 to
infinity.

b. Dividends are expected to grow at 8%
annually for 3 years, followed by a 0%

constant annual growth rate in years 4 to
infinity.

c. Dividends are expected to grow at 8%
annually for 3 years, followed by a 10%

constant annual growth rate in years 4 to
infinity.

P7–17 Using the free cash flow valuation
model to price an IPO Assume that you have an

opportunity to buy the stock of CoolTech,
Inc., an IPO being offered for $12.50 per

share. Although you are very much
interested in owning the company, you are concerned

about whether it is fairly priced. To
determine the value of the shares, you

have decided to apply the free cash flow
valuation model to the firm’s financial data

that you’ve developed from a variety of
data sources. The key values you have compiled

are summarized in the following table.

Free cash flow

Year (t) FCFt Other data

2016 $ 700,000 Growth rate of FCF,
beyond 2019 to infinity 5 2%

2017 800,000 Weighted average cost of capital
5 8%

2018 950,000 Market value of all
debt 5 $2,700,000

2019 1,100,000 Market value of preferred
stock 5 $1,000,000

Number of shares of common
stock outstanding 5 1,100,000

P7–19 Valuation with price/earnings
multiples For each of the firms shown in the following

table, use the data given to estimate its
common stock value employing price/

earnings (P/E) multiples.

Firm Expected EPS Price/earnings multiple

A
$3.00
6.2

B
4.50 10.0

C
1.80
12.6

D
2.40
8.9

E 5.10 15.0

P8–9 Rate of return, standard deviation,
and coefficient of variation Mike is searching

for a stock to include in his current stock
portfolio. He is interested in Hi-Tech,

Inc.; he has been impressed with the
company’s computer products and believes

that Hi-Tech is an innovative market
player. However, Mike realizes that any

time you consider a technology stock, risk
is a major concern. The rule he follows

is to include only securities with a
coefficient of variation of returns below 0.90.

Mike has obtained the following price
information for the period 2012 through

2015. Hi-Tech stock, being growth-oriented,
did not pay any dividends during these

4 years.

Stock price

Year Beginning
End

2012 $14.36
$21.55

2013 21.55 64.78

2014
64.78
72.38

2015 72.38
91.80

P8–14 Portfolio analysis You have been
given the expected return data shown in the first

table on three assets—F, G, and H—over the
period 2016–2019.

Expected return

Year Asset F Asset G Asset H

2016 16% 17% 14%

2017 17 16 15

2018 18 15 16

2019 19 14 17

Using these assets, you have isolated the
three investment alternatives shown in the

following table

Alternative Investment

1 100% of asset F

2 50% of asset F and 50%
of asset G

3 50% of asset F and 50%
of asset H

a. Calculate the expected return over the
4-year period for each of the three

alternatives.

b. Calculate the standard deviation of
returns over the 4-year period for each of the

three alternatives.

c. Use your findings in parts a and b to
calculate the coefficient of variation for

each of the three alternatives.

d. On the basis of your findings, which of
the three investment alternatives do you

recommend? Why?

P8–27 Portfolio return and beta Jamie
Peters invested $100,000 to set up the following

portfolio 1 year ago.

Asset
Cost Beta at purchase Yearly income Value today

A
$20,000 0.80 $1,600 $20,000

B
35,000 0.95 1,400 36,000

C
30,000 1.50 — 34,500

D
15,000 1.25 375 16,500

a. Calculate the portfolio beta on the
basis of the original cost figures.

b. Calculate the percentage return of each
asset in the portfolio for the year.

c. Calculate the percentage return of the
portfolio on the basis of original cost,

using income and gains during the year.

d. At the time Jamie made his investments,
investors were estimating that the market

return for the coming year would be 10%.
The estimate of the risk-free rate of return

averaged 4% for the coming year. Calculate
an expected rate of return for each stock

on the basis of its beta and the
expectations of market and risk-free returns.

e. On the basis of the actual results,
explain how each stock in the portfolio performed

relative to those CAPM-generated
expectations of performance. What

factors could explain these differences?

P9-5 The cost of debt Gronseth Drywall
Systems, Inc., is in discussions with its investment bankers regarding the
issuance of new bonds. The investment banker has informedthe firm that
different maturities will carry different coupon rates and sell at different
prices. The firm must choose among several alternatives. In each case, the bonds
will have a $1,000 par value and flotation costs will be $30 per bond. The company
is taxed at a rate of 40%. Calculate the after-tax cost of financing with

each of the following alternatives.

Alternative Coupon Rate Time
to Maturity (years) Premium or
Discount

A 9% 16
$250

B 7 5 50

C 6 7 par

D 5 10 – 75

P9–7 Cost of preferred stock Taylor Systems
has just issued preferred stock. The stock

has a 12% annual dividend and a $100 par
value and was sold at $97.50 per share.

In addition, flotation costs of $2.50 per
share must be paid.

a. Calculate the cost of the preferred
stock.

b. If the firm sells the preferred stock
with a 10% annual dividend and nets $90.00

after flotation costs, what is its cost?

P9–9 Cost of common stock equity: CAPM
J&M Corporation common stock has a beta,

b, of 1.2. The risk-free rate is 6%, and
the market return is 11%.

a. Determine the risk premium on J&M
common stock.

b. Determine the required return that
J&M common stock should provide.

c. Determine J&M’s cost of common stock
equity using the CAPM.

P9–10 Cost of common stock equity Ross
Textiles wishes to measure its cost of common

stock equity. The firm’s stock is currently
selling for $57.50. The firm expects to pay

a $3.40 dividend at the end of the year
(2016). The dividends for the past 5 years

are shown in the following table.

Year
Dividend

2015
$3.10

2014
2.92

2013
2.60

2012
2.30

2011
2.12

After underpricing and flotation costs, the
firm expects to net $52 per share on a

new issue.

a. Determine the growth rate of dividends
from 2011 to 2015.

b. Determine the net proceeds, Nn, that the
firm will actually receive.

c. Using the constant-growth valuation
model, determine the cost of retained earnings, rr.

d. Using the constant-growth valuation
model, determine the cost of new common stock, rn.

P9–17 Calculation of individual costs and
WACC Dillon Labs has asked its financial manager

to measure the cost of each specific type
of capital as well as the weighted average

cost of capital. The weighted average cost
is to be measured by using the following

weights: 40% long-term debt, 10% preferred
stock, and 50% common stock equity

(retained earnings, new common stock, or
both). The firm’s tax rate is 40%.

Debt The firm can sell for $980 a 10-year,
$1,000-par-value bond paying annual

interest at a 10% coupon rate. A flotation
cost of 3% of the par value is required

in addition to the discount of $20 per
bond.

Preferred stock Eight percent (annual
dividend) preferred stock having a par

value of $100 can be sold for $65. An
additional fee of $2 per share must be paid

to the underwriters.

Common stock The firm’s common stock is
currently selling for $50 per share.

The dividend expected to be paid at the end
of the coming year (2016) is $4. Its

dividend payments, which have been
approximately 60% of earnings per share in

each of the past 5 years, were as shown in
the following table.

Year
Dividend

2015
$3.75

2014
3.50

2013
3.30

2012
3.15

2011
2.85

It is expected that to attract buyers, new
common stock must be underpriced

$5 per share, and the firm must also pay $3
per share in flotation costs. Dividend

payments are expected to continue at 60% of
earnings. (Assume that rr = rs.)

a. Calculate the after-tax cost of debt.

b. Calculate the cost of preferred stock.

c. Calculate the cost of common stock.

d. Calculate the WACC for Dillon Labs.

P10–4 Long-term investment decision,
payback method Bill Williams has the opportunity

to invest in project A that costs $9,000
today and promises to pay annual end-ofyear

payments of $2,200, $2,500, $2,500, $2,000,
and $1,800 over the next 5 years.

Or, Bill can invest $9,000 in project B
that promises to pay annual end-of-year payments

of $1,500, $1,500, $1,500, $3,500, and
$4,000 over the next 5 years.

a. How long will it take for Bill to recoup
his initial investment in project A?

b. How long will it take for Bill to recoup
his initial investment in project B?

c. Using the payback period, which project
should Bill choose?

d. Do you see any problems with his choice?

P10–10 NPV: Mutually exclusive projects
Hook Industries is considering the replacement of

one of its old drill presses. Three
alternative replacement presses are under consideration.

The relevant cash flows associated with each
are shown in the following table.

The firm’s cost of capital is 15%.

LG 3

LG 2 LG 3

LG 3

Press A Press B Press C

Initial investment (CF0) $85,000 $60,000 $130,000

Year (t) Cash inflows (CFt)

1 $18,000 $12,000 $50,000

2 18,000
14,000 30,000

3 18,000 16,000 20,000

4 18,000 18,000 20,000

5 18,000 20,000 20,000

6 18,000 25,000 30,000

7 18,000 — 40,000

8 18,000 — 50,000

a. Calculate the net present value (NPV) of
each press.

b. Using NPV, evaluate the acceptability of
each press.

c. Rank the presses from best to worst
using NPV.

d. Calculate the profitability index (PI)
for each press.

e. Rank the presses from best to worst
using PI.

P10–11 Long-term investment decision, NPV
method Jenny Jenks has researched the financial

pros and cons of entering into a 1-year MBA
program at her state university. The

tuition and books for the master’s program
will have an up-front cost of $50,000. If

she enrolls in an MBA program, Jenny will
quit her current job, which pays $50,000

per year after taxes (for simplicity, treat
any lost earnings as part of the up-front

cost). On average, a person with an MBA
degree earns an extra $20,000 per year (after

taxes) over a business career of 40 years.
Jenny believes that her opportunity cost

of capital is 6%. Given her estimates, find
the net present value (NPV) of entering

this MBA program. Are the benefits of
further education worth the associated costs?

P10–15 Internal rate of return Peace of
Mind, Inc. (PMI), sells extended warranties for durable

consumer goods such as washing machines and
refrigerators. When PMI sells an extended

warranty, it receives cash up front from
the customer, but later PMI must cover any repair

costs that arise. An analyst working for PMI
is considering a warranty for a new line

of big-screen TVs. A consumer who purchases
the 2-year warranty will pay PMI $200.

On average, the repair costs that PMI must
cover will average $106 for each of the warranty’s

2 years. If PMI has a cost of capital of
7%, should it offer this warranty for sale?

P10–21 All techniques, conflicting rankings
Nicholson Roofing Materials, Inc., is considering

two mutually exclusive projects, each with
an initial investment of $150,000.

The company’s board of directors has set a
maximum 4-year payback requirement

and has set its cost of capital at 9%. The
cash inflows associated with the two projects

are shown in the following table.

Cash inflows
(CFt)

Year Project A Project B

1 $45,000 $75,000

2 45,000 60,000

3 45,000 30,000

4 45,000
30,000

5 45,000
30,000

6 45,000 30,000

a. Calculate the payback period for each
project.

b. Calculate the NPV of each project at 0%.

c. Calculate the NPV of each project at 9%.

d. Derive the IRR of each project.

e. Rank the projects by each of the
techniques used. Make and justify a recommendation.

f. Go back one more time and calculate the
NPV of each project using a cost of

capital of 12%. Does the ranking of the two
projects change compared to your

answer in part e? Why?

P10–24 All techniques: Decision among
mutually exclusive investments Pound Industries is

attempting to select the best of three
mutually exclusive projects. The initial investment

and after-tax cash inflows associated with
these projects are shown in the

following table.

Cash flows Project
A Project B Project C

Initial investment (CF0) $60,000 $100,000 $110,000

Cash inflows (CFt), t 5 1 to 5 20,000 31,500 32,500

a. Calculate the payback period for each
project.

b. Calculate the net present value (NPV) of
each project, assuming that the firm has

a cost of capital equal to 13%.

c. Calculate the internal rate of return
(IRR) for each project.

d. Draw the net present value profiles for
both projects on the same set of axes, and

discuss any conflict in ranking that may
exist between NPV and IRR.

e. Summarize the preferences dictated by
each measure, and indicate which project

you would recommend. Explain why.