Chapter 11 Problem 4: The Baron Basketball Company

Chapter 11 Problem 4 The Baron Basketball Company

Chapter 11 Problem 4 The Baron Basketball Company (BBC) earned $10 a share last year and paid a dividend of $6 a share. Next year, you expect BBC to earn $11 and continue its payout ratio. Assume that you expect to sell the stock for $132 a year from now. If you require 12 percent on this stock, how much would you be willing to pay for it?

Chapter 11 Problem 5 Given the expected earnings and dividend payments in Problem 4, if you expect a selling price of $110 and require an 8 percent return on this investment, how much would you pay for the BBC stock?

Paper For Above instruction

The valuation of stocks is a crucial aspect of investment analysis, relying on a combination of earnings, dividends, growth prospects, and expected return requirements. In this paper, we analyze the valuation of The Baron Basketball Company (BBC) based on provided financial data and projected future performance, employing foundational valuation methods including the Dividend Discount Model (DDM) and growth assumptions.

Starting with the first problem, we examine how much an investor should be willing to pay for BBC stock given the projected data. Last year's earnings per share (EPS) were $10, with a dividend per share of $6. The company is expected to earn $11 per share next year, and the stock price is projected to be $132 in one year. Since the company is expected to maintain its payout ratio—defined as dividends divided by earnings—the dividend next year can be estimated. The payout ratio last year was $6 / $10 = 0.6, or 60%. Assuming the same payout ratio, the expected dividend next year will be 60% of $11, which equates to $6.60.

To determine the current value of the stock, we use the Gordon Growth Model (a form of the DDM), which assumes dividends grow at a constant rate. The model states:

Price = (Dividend in next year) / (Required rate of return - Growth rate)

Next, the growth rate of dividends (g) can be estimated from earnings growth, assuming constant payout ratio: (EPS in next year - EPS last year) / EPS last year = ($11 - $10)/$10 = 0.10 or 10%. The expected dividend next year is $6.60, and the growth rate g = 10%. Plugging into the Gordon Model:

P = $6.60 / (0.12 - 0.10) = $6.60 / 0.02 = $330

However, this indicates a theoretical price of $330, based on perpetual growth assumptions. Alternatively, considering the expected selling price of $132 in one year, and the required return of 12%, the present value (PV) can be computed using discounted cash flow methods (including dividends and future sale price):

PV = (Dividend next year + Price in one year) / (1 + required return)

PV = ($6.60 + $132) / 1.12 ≈ $138.75

This indicates that an investor should be willing to pay approximately $138.75 today, considering the expected dividend and sale price, higher than the current market valuation implied by the Gordon Model. Given this discrepancy, valuation models and assumptions about growth and sale prices significantly impact the estimated current stock value.

In the second problem, the investor’s expected sale price drops to $110, and the required return is 8%. Using a similar approach, the projected dividend remains $6.60, and the present value is calculated as:

PV = ($6.60 + $110) / 1.08 ≈ $109.26

Therefore, an investor willing to accept an 8% return and expecting a sale price of $110 would value the stock at approximately $109.26 today. This illustrates how changes in expected sale price and required return substantially influence valuation outcomes.

Overall, these analyses demonstrate the importance of growth assumptions, payout ratios, and expected future prices in determining stock value. Investors should carefully consider these factors alongside market conditions and company fundamentals to make informed investment decisions.

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