Dwayne sat at his desk wondering what he should do. Having opted for early retirement, six months ago, he knew that he needed to make some changes the way his investment portfolio was structured. However, being primarily focused on science during his career, he had a fairly limited knowledge of stock selection and portfolio management. One thing was certain, though, Dwayne had an eagerness to learn and that's exactly what he planned to do during his appointment with his broker, Jonathan Price. Dwayne Stevenson, aged 58, had joined the Pharmacopia Company approximately thirty years ago, as a post-doctoral researcher in the field of immunology. His strong work ethic and knowledge of science enabled him to progress steadily along the research track of the company. He won a number of awards and earned many promotions along the way. Five years ago, Dwayne earned the coveted title of "Research   5  Scientist"  enjoyed   by  only  4  other  individuals in the corporation. One of the ain advantages of gaining the "Research 5" status was that he .was given stock options as part of h1's remunerati·on package. At that time, shares of Pharmacopia (PCU) were trading at $30 per share. The company had annual sales in excess  of  $5  billion and the sales and earnings growth forecasts for the next few years were good. The company had applied for Food and Drug Administration (FDA) approval for two highly promising drugs and had a number of others in the pipeline. However, as luck would have it, about 3 years later, the firm suffered a few setbacks. The FDA did not approve a couple of its applications and Pharmacopia was being investigated by the Environmental Protection Agency (EPA) for possible dumping violations. Besides, the patents on two of its best selling drugs expired and the generic versions began to flood the market. Needless to say, the firm's sales began to suffer and profits began to shrink sending its stock price into a downward spiral. 'Downsizing' and cost cutting were buzzwords that could be heard throughout the firm and on Wall Street. About a year later, Dwayne was offered the option to take early retirement, primarily because his project was one that had not gained FDA approval. The severance package offered by the company was too good to tum down so Dwayne opted for early retirement. Part of the retirement package included a significant amount of company stock, which was trading at $12 at the time.As a result of having exercised stock options and his early­ retirement package, Dwayne had accumulated over 100,000 shares of PCU's common stock. This caused his investment portfolio to not be  well diversified and Dwayne knew that he needed to restructure it. With PUC's stock price having declined to $8 per share in recent months, Dwayne wondered whether he should sell the stock or hold it until it reached a better price. Having had very little financial and investment training, Dwayne contacted his broker, Jonathan Price, for some advice. His main question  to Jonathan  was, "How low can it go?"Jonathan told him to hold on  to  the   stock   because   his calculations   showed   that   it was  significantly   undervalued at $8 per share and should rise to about $28 per share in a few months.  He felt  that the company was  having  temporary regulato ry   problems should be able to weather the storm quite well. He said that the intnnsic value of the stock, in his opinion, was in the range of $10- $20. Not convinced, Dwayne asked him to explain how he arrived at that range. Jonathan replied that he used alternate fonns of the dividend discount model, to which Dwayne responded, "Dividend what?" Jonathan realized that he would have to give Dwayne a primer on stock valuation and set up an appointment for the following week. In preparation  for the appointment, Jonathan prepared Table 1 showing the sales, net income, earnings per share, and dividend per share data for the prior 10-year period. In addition, he estimated the firm's beta and noted down the risk-free rate, market risk premium, and the expected growth rate of the pharmaceutical industry (shown in Table 2).

 Table 1:Pharmacopia Company

Key Financial Data for Prior 10-year Period (in $ millions except EPS, DPS)

TABLE 2:Systematic Risk, Industry Growth Rate, Interest rates

Questions:

1.What is the rationale of the required rate of return that Jonathan used and how did he estimate it?

2.What other variations of the DDM can one use and why?" asked Dwayne. What should Jonathan's response be?

3."Why are you using dividends and not earnings per share, Jonathan?" asked What do you think Jonathan would have said?