Question 3
Besides running his own businesses, Tommy is also an avid stock investor and has a team of professional investment managers overseeing his stock portfolio. He’s trying to determine the fair value of a stock using a simple dividend discount model. Information on the stock is as follows: Macchiato Ltd is a famous coffee retail chain, and its stock traded at $42 at the beginning of
2016. It’s beta estimate by a beta service company is 1 and it’s market risk premium is 6%. The risk-free rate at the end of 2015 was 1.6%. The firm was expected to pay dividends of $1.60 per share at the end of 2016 and 2017.

(a) Using the Capital Asset Pricing Model (CAPM), calculate the required rate of return.

(b) At what price do you expect Macchiato Ltd to sell at the end of 2017 if you forecast it will not pay the dividends as expected?

(c) At what price do you expect Macchiato Ltd to sell at the end of 2017 if you forecast it will pay the dividends as expected?

(d) Assume that Macchiato Ltd’s investors expect it to pay a dividend of $2.50 per share forever. Using the required rate of return calculated in (a) above, determine the value gained or lost per share by buying a share at $42.

(e) Macchiato Ltd traded at 4.5 times sales in 2015. It was reporting a net profit margin of its sales of 14 percent. What was it’s P/E ratio?

(f) Macchiato Ltd had 700,000 shares at the end of 2015. On January 23, 2016, it issued an additional 250,000 shares to the market at the market price of $42 per share. Assess the effect of this share issue on the price per share of the firm.

(g) On March 25, 2016, the directors of Macchiato Ltd decided to issue some new preferred stock. The issue will pay a $20 annual dividend per share, beginning 20 years from the date of issuance. If the market requires a 6% return on this investment, how should the preferred stock be priced on issuance?

(h) It is sometimes assumed in a two-stage dividend growth model that dividend growth drops from a high rate in the first stage to a low perpetual growth rate in the second stage. Comment on the reasonableness of this assumption and discuss what happens if this assumption is violated.

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