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### Essentials Of Investments

Book edition 9th
Author(s) Zvi Bodie, Alex Kane, Alan Marcus, Alan J. Marcus
Pages 748 pages
ISBN 9780078034695

# Phoebe Black’s investment club wants to buy the stock of either NewSoft, Inc. or Capital Corp. In this connection, Black prepared the following table. You have been asked to help her interpret the data, based on your forecast for a healthy economy and a strong stock market over the next 12 months. New soft Inc.Capital Corp.S & P 500 indexCurrent Prices$30$32 IndustryComputer SoftwareCapital Goods P/E ratio (current)251416P/E ration (5 yr average)271616Price/book ratio (current)1033Price/book ratio (5-year average)1242beta1.51.11.0Dividend yield.3%2.7%2.8%a. Newsoft’s shares have higher price–earnings (P/E) and price–book value (P/B) ratios than those of Capital Corp. (The price–book ratio is the ratio of market value to book value.) Briefly discuss why the disparity in ratios may not indicate that NewSoft’s shares are overvalued relative to the shares of Capital Corp. Answer the question in terms of the two ratios, and assume that there have been no extraordinary events affecting either company.b. Using a constant-growth dividend discount model, Black estimated the value of NewSoft to be $28 per share and the value of Capital Corp. to be$34 per share.Briefly discuss weaknesses of this dividend discount model, and explain why this model may be less suitable for valuing NewSoft than for valuing Capital Corp.c. Recommend and justify a more appropriate dividend discount model for valuing New- Soft’s common stock.

a. growing market with abundant opportunities

b. (i) assumes a constant growth rate of dividends (ii) Dividend growth may not be realistic about NewSoft

c. Use a multi-stage DDM

See the step by step solution

## Step 1: Explanation on disparity in ratios ‘a’

Higher selling and earnings of NewSoft is justified by its higher expected growth of earnings and dividends. It is in a growing market with abundant opportunities. Capital has lower growth prospect because of maturing market. Price earning and price book ratio reflect growth opportunity implying that this might not be mispriced.

## Step 2: Explanation on weakness of dividend discount model ‘b’

(i) It assumes a constant growth rate of dividends.

(ii) Dividend may be on the growth path but this may not be realistic about NewSoft.

## Step 3: Recommendation on appropriate dividend discount model ‘c’

Use a multi-stage DDM to value Newsoft to allow rapid growth in initial years. This will also ultimately slow to a sustainable rate.

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