CFIN4 - Chapter 7Integrative Problem

Robert Campbell and Carol Morris are senior vice-presidents of the Mutual of Chicago Insurance Company. They are co-directors of the companys pension fund management division. A major new client has requested that Mutual of Chicago present an investment seminar to illustrate the stock valuation process. As a result, Campbell and Morris 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.What is the difference between common stock and preferred stock? What are some of the characteristics of each type of stock?

b.What is the difference between a publicly held company and a privately held company? How can the two types of companies be identified?

c.What is classified stock? When going public, why might a small company designate some stock currently outstanding as founders shares?

d.(1) Write a formula that can be used to value any stock, regardless of its dividend pattern.

(2)What is a constant growth stock? How do you value a constant growth stock?

(3)What happens if the growth is constant, and g > r_s? Will many stocks have g > r_s?

e.Bon Temps has an issue of preferred stock outstanding that pays stockholders a dividend equal to $10 each year. If the appropriate required rate of return for this stock is 8%, what is its market value?

f.Assume that Bon Temps is a constant growth company whose last dividend (D₀, which was paid yesterday) was $2 and whose dividend is expected to grow indefinitely at a 6% rate. The appropriate rate of return for Bon Temps stock is 16%.

(1)What is the firms expected dividend stream over the next 3 years?

(2)What is the firms current stock price?

(3)What is the stocks expected value one year from now?

(4)What are the expected dividend yield, the capital gains yield, and the total return during the first year?

g.Assume that Bon Temps stock is currently selling at $21.20. What is the expected rate of return on the stock?

h.What would the stock price be if its dividends were expected to have zero growth?

i.Assume that Bon Temps is expected to experience supernormal growth of 30% for the next 3 years, then to return to its long-run constant growth rate of 6%. What is the stocks value under these conditions? What are its expected dividend yield and its capital gains yield in Year 1? In Year 4?

j.Suppose Bon Temps is expected to experience zero growth during the first three years and then to resume its steady-state growth of 6% in the fourth year. What is the stocks value now? What are its expected dividend yield and its capital gains yield in Year 1? In Year 4?

k.Assume that Bon Temps earnings and dividends are expected to decline by a constant 6% per yearthat is, g = 26%. Why might someone be willing to buy such a stock, and at what price should it sell? What would be the dividend yield and capital gains yield in each year?

l.Bon Temps financial statements show the following information:

Average cost of funds10.0 %

EBIT$500,000

Total capital$1,250,000

EPS$2.00

Shares outstanding150,000

Marginal tax rate30.0%

(1)Compute the companys economic value added (EVA)

(2)Interpret the value you computed in part l(1).

m.Suppose that normally Bon Temps P/E ratio is 20x. Using the information given in part (l), estimate the market price per share for Bon Temps common stock.