Robert Balik and Carol Kiefer are senior vice presidents of the Mutual of
Chicago Insurance Company. They are co-directors of the company's pension fund
management division, with Balik having responsibility for fixed income
securities (primarily bonds) and Kiefer being responsible for equity
investments. A major new client, the California League of Cities, has
requested that Mutual of Chicago present an investment seminar to the mayors
of the represented cities, and Balik and Kiefer, who will make the actual
presentation, have asked you to help them. To illustrate the common stock
valuation process, Balik and Kiefer have asked you to analyze the Bon Temps
Company, an employment agency that supplies word-processor operators and
computer programmers to businesses with temporarily heavy workloads. You are
to answer the following questions:
a. Describe briefly the legal rights and privileges of common stockholders.
b. (1) Write out a formula that can be used to value any stock, regardless of
its dividend pattern.
(2) What is a constant growth stock? How are constant growth stocks valued?
(3) What are the implications if a company forecasts a constant \(g\) that
exceeds its \(r_{s} ?\) Will many stocks have expected \(g > r_{s}\) in the short
run (that is, for the next few years)? In the long run (that is, forever)?
c. Assume that Bon Temps has a beta coefficient of \(1.2,\) that the risk-free
rate (the yield on T-bonds) is 7 percent, and that the required rate of return
on the market is 12 percent. What is Bon Temps' required rate of return?
d. Assume that Bon Temps is a constant growth company whose last dividend (D),
which was paid yesterday) was \(\$ 2.00\) and whose dividend is expected to grow
indefinitely at a 6 percent rate.
(1) What is the firm's expected dividend stream over the next 3 years?
(2) What is its current stock price?
(3) What is the stock's expected value 1 year from now?
(4) What are the expected dividend yield, capital gains yield, and total
return during the first year?
e. Now assume that the stock is currently selling at \(\$ 30.29\). What is its
expected rate of return?
f. What would the stock price be if its dividends were expected to have zero
growth?
g. Now assume that Bon Temps is expected to experience nonconstant growth of
30 percent for the next 3 years, then to return to its long-run constant
growth rate of 6 percent. What is the stock's value under these conditions?
What are its expected dividend and capital gains yields in Year 1? Year 4?
h. Suppose Bon Temps is expected to experience zero growth during the first 3
years and then to resume its steady-state growth of 6 percent in the fourth
year. What would its value be then? What would its expected dividend and
capital gains yields be in Year \(1 ?\) In Year \(4 ?\)
i. Finally, assume that Bon Temps' earnings and dividends are expected to
decline at a constant rate of 6 percent per year, that is, \(g=-6 \%\). Why
would anyone be willing to buy such a stock, and at what price should it sell?
What would be its dividend and capital gains yields in each year?
j. Suppose Bon Temps embarked on an aggressive expansion that requires
additional capital. Management decided to finance the expansion by borrowing
\(\$ 40\) million and by halting dividend payments to increase retained
earnings. Its WACC is now 10 percent, and the projected free cash flows for
the next 3 years are \(-\$ 5\) million, \(\$ 10\) million, and \(\$ 20\) million.
After Year \(3,\) free cash flow is projected to grow at a constant 6 percent.
What is Bon Temps' total value? If it has 10 million shares of stock and \(\$
40\) million of total debt, what is the price per share?
k. For Bon Temps' stock to be in equilibrium, what relationship must exist
between its estimated intrinsic value and its current stock price and between
its expected and required rates of return? Are the equilibrium intrinsic value
and expected rate of return the values that management estimates or values as
estimated by some other entity? Explain.
l. If equilibrium does not exist, how will it be established?
m. Suppose Bon Temps decided to issue preferred stock that would pay an annual
dividend of \(\$ 5,\) and the issue price was \(\$ 50\) per share. What would the
expected return be on this stock? Would the expected rate of return be the
same if the preferred was a perpetual issue or if it had a 20 -year maturity?
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