Barton Inc.

Mary Barton is a junior equity analyst for an investment company. She is currently working on two of the companys funds: a large US-based equity fund and a smaller private equity fund.

The large US-based fund uses discount models to estimate the value of stock prices. For this fund, a difference in price of $1 or more between the market and estimated prices indicates that the shares are mispriced for the funds investment purposes. The fund is allowed to take either long or short positions in shares identified as misvalued. Bartons manager, George Eckhart, asks her to evaluate the stocks of two companies for possible inclusion in that fund: XRail Company (XRL) and Z-Tarp Limited (ZTL). Selected data for the stocks is shown in Exhibit 1.

Exhibit 1: Selected Stock Data for XRL and ZTL and Additional Market Information
	XRL		ZTL
	EPS ($)	DPS ($)	EPS ($)	DPS ($)
2015	3.15	1.77	5.62	2.53
2014	3.08	1.52	4.98	2.24
2013	2.99	1.36	4.73	2.13
2012	2.77	1.21	4.5	2.02
2011	2.52	0.9	4.2	1.89
Current market price	$77.23		$93.05
Return on assets	27.40%		25.80%
Return on common equity	31.60%		32.80%
Beta	0.94		1.2
Required rate of return on common equity	8.84%		10.48%
Additional information
Risk-free rate			2.94%
Equity risk premium for common shares			6.28%
US economy real growth rate			3.70%
US inflation rate			2.00%
Note: DPS is dividends per share and EPS is earnings per share.

Barton begins her analysis by looking at XRL. After doing some research, she concludes that a reasonable growth estimate for the company is the sustainable growth rate using the most recent years retention ratio and calculates a price for XRL using this information. She makes the following note:

• It will not be possible to use the Gordon model for the analysis of XRL.

Barton and Eckhart discuss the impact of a companys growth rate on its future stock price. Barton determines XRLs growth rate of earnings for the period from 2011 to 2015 and compares it with the current nominal growth rate of the US economy. She concludes that XRL is likely to be in the transition stage of growth.

Next, Eckhart asks Barton to calculate the intrinsic value of ZTL shares using the Gordon growth model to determine whether it meets the funds investment objectives. He suggests that rather than using the sustainable growth rate, she should use the growth rate of dividends over the past five years.

Eckhart tells Barton that he has heard rumors that ZTL is contemplating selling one of its major manufacturing facilities. If that should happen, he believes that the company would pay a series of special dividends in each of the three years following the sale. Barton asks him how she could best incorporate such a possibility into the valuation of the shares.

Turning to the private equity fund, Eckhart informs Barton that the fund is considering buying a controlling interest in a closely held company, H-Tron (HTR), which pays infrequent dividends that are well below the free cash flows with significant growth potential and holds patents on a key innovation in electronics technology. Eckhart believes the value of these patents is not fully reflected in HTRs balance sheet. He asks Barton how HTRs common equity should be valued given these circumstances. Barton states that she will assess which valuation method will be the most suitable.

Finally, Eckhart asks Barton to value HTRs non-callable perpetual preferred stock as a potential investment for the fund. The stock, currently privately held, pays a fixed annual dividend of $7.50. After performing some industry analysis, Barton decides to use an equity risk premium of 6% in valuing the stock.

ANSWER ALL THE FOLLOWING QUESTIONS ONLY BY WRITING THE CORRECT CHOICE.

Question 1 of 6

Using the data in Exhibit 1, Bartons note about the use of the Gordon growth model to value XRL is most likely:

A. Incorrect because the required return on equity is greater than the US economys growth rate.

B. Correct because the required return on equity is less than the expected growth rate.

C. Incorrect because the sustainable growth rate is greater than the US economys growth rate.

Question 2 of 6

Bartons conclusion that XRL is in the transition phase is best described as:

A. Incorrect, because the company is in the supernormal growth phase.

B. Correct.

C. Incorrect, because the company is in the mature phase.

Question 3 of 6

Using the data in Exhibit 1 and following Eckharts suggestions regarding the valuation of ZTL, the most appropriate conclusion that Barton should make about the ZTL shares is that the fund should:

A. Not add ZTL to the portfolio

B. Take a long position in ZTL

C. Take a short position in ZTL.

Question 4 of 6

Eckharts best response to Bartons question about the valuation of ZTL considering the potential sale of its manufacturing facility would be to use:

A. The Gordon growth model to incorporate the decrease in firm value after the sale.

B. A spreadsheet model that incorporates the special dividends.

C. The H-model to reflect the change in dividends.

Question 5 of 6

Based on the information Eckhart provides to Barton about HTR, the most suitable method for her to use in determining the fair value of its common equity is to discount future:

A. Residual income.

B. Free cash flow to equity.

C. Forecasted future dividends.

Question 6 of 6

Bartons estimate of the fair value for HTRs preferred stock is closest to:

A. $84.

B. $81.

C. $125.