# DIVIDENDS-BASED VALUATION OF COMMON EQUITY. Problem 10.16 projected financial statements for…

DIVIDENDS-BASED VALUATION OF COMMON EQUITY. Problem 10.16 projected financial statements for Walmart for Years 1 through 5. The following data for Walmart include the actual amounts for 2008 and the projected amounts for Year 1 to Year 5 for comprehensive income and common shareholders’ equity (assuming Walmart will use implied dividends as the financial flexible account to balance the balance sheet; amounts in millions).

The market equity beta for Walmart at the end of 2008 was 0.80. Assume that the riskfree interest rate was 3.5 per cent and the market risk premium was 5.0 per cent. Walmart had 3,925 million shares outstanding at the end of 2008, and share price was \$46.06

Required

a.       Use the CAPM to compute the required rate of return on common equity capital for Walmart.

b.      Compute the weighted average cost of capital for Walmart as of the start of Year 1. At the end of 2008, Walmart had \$42,218 million in outstanding interest-bearing debt on the balance sheet and no preferred stock. Assume that the balance sheet value of Walmart’s debt is approximately equal to the market value of the debt. Assume that at the start of Year 1, Walmart will incur interest expense of 5.0 per cent on debt capital and that Walmart’s average tax rate is 34.2 per cent.

c.       Use the clean surplus accounting approach to derive the projected dividends for Walmart for Years 1 through 5 based on the projected comprehensive income and shareholders’ equity amounts.

d.      Use the clean surplus accounting approach to project the continuing dividend in Year 6. Assume that the steady-state long-run growth rate will be 3 per cent in Year 6 and beyond.

e.       Using the required rate of return on common equity from Part a as a discount rate, compute the sum of the present value of dividends for Walmart for Years 1 through 5. F

f.        Using the required rate of return on common equity from Part a as a discount rate and the long-run growth rate from Part d, compute the continuing value of Walmart as of the beginning of Year 6 based on Walmart’s continuing dividends in Years 6 and beyond. After computing continuing value, bring continuing value back to present value at the start of Year 1.

g.       Compute the value of a share of Walmart common stock. (i) Compute the sum of the present value of dividends including the present value of continuing value. (ii) Adjust the sum of the present value using the midyear discounting adjustment factor. (iii) Compute the per-share value estimate.

h.       Using the same set of forecast assumptions as before, re compute the value of Walmart shares under two alternative scenarios. Scenario 1: Assume that Walmart’s long-run growth will be 2 per cent, not 3 per cent as before, and assume that Walmart’s required rate of return on equity is 1 per centage point higher than the rate you computed using the CAPM in Part a. Scenario 2: Assume that Walmart’s long-run growth will be 4 per cent, not 3 per cent as before, and assume that Walmart’s required rate of return on equity is 1 per centage point lower than the rate you computed using the CAPM in Part a. To quantify the sensitivity of your share value estimate for Walmart to these variations in growth and discount rates, compare (in per centage terms) your value estimates under these two scenarios with your value estimate from Part g.

i.         What reasonable range of share values would you expect for Walmart common stock? Where is the current price for Walmart shares relative to this range? What do you recommend?

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