Chapter 12 Questions: 1

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Chapter 12 Questions: 1. a. Evaluate the following statement: One of the assumptions of the constant growth model is that the required rate of return must be greater than the expected dividend growth rate. Because of this assumption, the constant growth model is of limited use in the real world.

b. Two investors are evaluating the stock of Beverly Enterprises for possible purchase. They agree on the stock’s risk and on expectations about future dividends. However, one investor plans to hold the stock for five years, while the other plans to hold the stock for 20 years. Which of the two investors would be willing to pay more for the stock? Explain your answer. (5 points each; 10 Points total)

2. California Clinics, an investor-owned chain of ambulatory care clinics, just paid a dividend of $2 per share. The firm’s dividend is expected to grow at a constant rate of 5 percent per year, and investors require a 15 percent rate of return on the stock. a. What is the stock’s value? b. Suppose the riskiness of the stock decreases, which causes the required rate of return to fall to 13 percent. Under these conditions, what is the stock’s value? c. Return to the original 15 percent required rate of return. Assume that the dividend growth rate estimate is increased to a constant 7 percent per year. What is the stock’s value? (5 points each; 15 points total)

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Chapter 13 Questions: 1. What is the economic interpretation of the corporate cost of capital? (5 points)

3. Golden State Home Health, Inc., is a large, California-based for- profit home health agency. Its dividends are expected to grow at a constant rate of 5 percent per year into the foreseeable future. The firm’s last dividend (D₀) was $1, and its current stock price is $10. The firm’s beta coefficient is 1.2; the rate of return on 20-year T-bonds currently is 8 percent; and the expected rate of return on the market, as reported by a large financial services firm, is 14 percent. Golden State’s target capital structure calls for 60 percent debt financing, the interest rate required on its new debt is 9 percent, and the firm’s tax rate is 30 percent. a. What is the fir m’s cost-of-equity estimate according to the DCF method? b. What is the cost-of-equity estimate according to the CAPM? c. On the basis of your answers to parts a and b, what would be your final estimate for the firm’s cost of equity? d. What is your estimate for the fir m’s corporate cost of capital? (5 points each; 20 points total).