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MUTUAL Of CHICAGO INSURANCE COMPANY 9-23 STOCK VALUATION Retort Balik and Carol Kiefer we 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. 1. Write a formula that can to 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 air 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)? b. Assume that Bon Temps has a beta coefficient of 1.2, that the risk-free rate (the yield on T-bonds) is 7%, and that the required rate of return on the market is 12%. What is Bon Temps’ required rate of return? c. Assume that Bon Temps is a constant growth company whose last dividend (D 0 , which was paid yesterday) was $2.00 and whose dividend is expected to grow indefinitely at a 6% 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? d. Now assume that the stock is currently selling at $30.29. What is its expected rate of return? e. What would the stock price to if its dividends were expected to have zero growth? f. Now assume But Bon Temps is expected to experience nonconstant growth of 30% for the next 3 years, then return to its long-run constant growth rate of 6%. What is the stock’s value under these conditions? What are its expected dividend and capital gains yields in Year 1? Year 4? g. Suppose Bon Temp’s expected to experience zero growth during the first 3 years and then resume its steady-state growth of 6% in the fourth year. What would be its value then?. What would to its expected dividend and capital gains yields in Year 1 In Year 4? h. Finally, assume that Bon Temps’s comings and dividends are expected to decline at a constant rate of 6% 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 to its dividend and capital gains yields in each year? i. 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%, and the protected free cash flows for the next 3 years are −$5 million, $10 million. and $20 million. After Year 3, free cash flow is protected to grow at a constant 6%. What is Bon Temps‘s total value? If it has 10 million shares of stock and $40 million of debt and preferred stock combined, w hat is the price per share? j. Suppose Bon Temps decided to issue preferred stock that would pay an annual dividend of $500 and that the issue price was $50.00 per share What would be the stock’s expected return? Would the expected rate of return he the same if the preffered was a perpetual issue or if it had a 20-year

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Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
Publisher: Cengage Learning
ISBN: 9781285867977
BuyFind

Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
Publisher: Cengage Learning
ISBN: 9781285867977

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Chapter
Section
Chapter 9, Problem 23IC
Textbook Problem

MUTUAL Of CHICAGO INSURANCE COMPANY

9-23 STOCK VALUATION Retort Balik and Carol Kiefer we 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:

  1. a. Describe briefly the legal rights and privileges of common stockholders.
    1. 1. Write a formula that can to used to value any stock, regardless of its dividend pattern.
    2. 2. What is a constant growth stock’ How are constant growth stocks valued?
    3. 3. What air the implications if a company forecasts a constant g that exceeds its rs? Will many stocks have expected g > rs in the short run (that is, for the next few years)? In the long run (that is, forever)?
  2. b. Assume that Bon Temps has a beta coefficient of 1.2, that the risk-free rate (the yield on T-bonds) is 7%, and that the required rate of return on the market is 12%. What is Bon Temps’ required rate of return?
  3. c. Assume that Bon Temps is a constant growth company whose last dividend (D0, which was paid yesterday) was $2.00 and whose dividend is expected to grow indefinitely at a 6% rate.
    1. 1. What is the firm’s expected dividend stream over the next 3 years?
    2. 2. What is its current stock price?
    3. 3. What is the stock’s expected value 1 year from now?
    4. 4. What are the expected dividend yield, capital gains yield, and total return during the first year?
  4. d. Now assume that the stock is currently selling at $30.29. What is its expected rate of return?
  5. e. What would the stock price to if its dividends were expected to have zero growth?
  6. f. Now assume But Bon Temps is expected to experience nonconstant growth of 30% for the next 3 years, then return to its long-run constant growth rate of 6%. What is the stock’s value under these conditions? What are its expected dividend and capital gains yields in Year 1? Year 4?
  7. g. Suppose Bon Temp’s expected to experience zero growth during the first 3 years and then resume its steady-state growth of 6% in the fourth year. What would be its value then?. What would to its expected dividend and capital gains yields in Year 1 In Year 4?
  8. h. Finally, assume that Bon Temps’s comings and dividends are expected to decline at a constant rate of 6% 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 to its dividend and capital gains yields in each year?
  9. i. 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%, and the protected free cash flows for the next 3 years are −$5 million, $10 million. and $20 million. After Year 3, free cash flow is protected to grow at a constant 6%. What is Bon Temps‘s total value? If it has 10 million shares of stock and $40 million of debt and preferred stock combined, w hat is the price per share?
  10. j. Suppose Bon Temps decided to issue preferred stock that would pay an annual dividend of $500 and that the issue price was $50.00 per share What would be the stock’s expected return? Would the expected rate of return he the same if the preffered was a perpetual issue or if it had a 20-year

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Chapter 9 Solutions

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