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Case Problem 6.1 Sara Decides to Take the Plunge Sara Thomas is a child psychologist who has built a thriving practice in her hometown of Boise, Idaho. Over the past several years she has been able to accumulate a substantial sum of money. She has worked long and hard to be successful, but she never imagined anything like this. Even so, success has not spoiled Sara. Still single, she keeps to her old circle of friends. One of her closest friends is Terry Jenkins, who happens to be a stockbroker and who acts as Sara's financial advisor. Not long ago Sara attended a seminar on investing in the stock market, and since then she's been doing some reading about the market. She has concluded that keeping all of her money in low-yielding savings accounts doesn't make sense. As a result, Sara has decided to move part of her money to stocks. One evening, Sara told Terry about her decision and explained that she had found several stocks that she thought looked \"sort of interesting.\" She described them as follows: North Atlantic Swim Suit Company.This highly speculative stock pays no dividends. Although the earnings of NASS have been a bit erratic, Sara feels that its growth prospects have never been brighter\"what with more people than ever going to the beaches the way they are these days,\" she says. Town and Country Computer.This is a long-established computer firm that pays a modest dividend yield (of about 1.50%). It is considered a quality growth stock. From one of the stock reports she read, Sara understands that T&C offers excellent long-term growth and capital gains potential. Southeastern Public Utility Company.This income stock pays a dividend yield of around 5%. Although it's a solid company, it has limited growth prospects because of its location. International Gold Mines, Inc.This stock has performed quite well in the past, especially when inflation has become a problem. Sara feels that if it can do so well in inflationary times, it will do even better in a strong economy. Unfortunately, the stock has experienced wide price swings in the past. It pays almost no dividends. Questions a. b. c. What do you think of the idea of Sara keeping \"substantial sums\" of money in savings accounts? Would common stocks make better investments for her than savings accounts? Explain. What is your opinion of the four stocks Sara has described? Do you think they are suitable for her investment needs? Explain. What kind of common stock investment program would you recommend for Sara? What investment objectives do you think she should set for herself, and how can common stocks help her achieve her goals? Case Problem 6.2 Wally Wonders Whether There's a Place for Dividends Wally Wilson is a commercial artist who makes a good living by doing freelance workmostly layouts and illustrationsfor local ad agencies and major institutional clients (such as large department stores). Wally has been investing in the stock market for some time, buying mostly high-quality growth stocks as a way to achieve long-term growth and capital appreciation. He feels that with the limited time he has to devote to his security holdings, highquality issues are his best bet. He has become a bit perplexed lately with the market, disturbed that some of his growth stocks aren't doing even as well as many good-grade income shares. He therefore decides to have a chat with his broker, Al Fried. During their conversation, it becomes clear that both Al and Wally are thinking along the same lines. Al points out that dividend yields on income shares are indeed way up and that, because of the state of the economy, the outlook for growth stocks is not particularly bright. He suggests that Wally seriously consider putting some of his money into income shares to capture the high dividend yields that are available. After all, as Al says, \"the bottom line is not so much where the payoff comes from as how much it amounts to!\" They then talk about a high-yield public utility stock, Hydro-Electric Light and Power. Al digs up some forecast information about Hydro-Electric and presents it to Wally for his consideration: Year Expected EPS ($) Expected Dividend Payout Ratio (%) 2016 $3.25 40% 2017 $3.40 40% 2018 $3.90 45% 2019 $4.40 45% 2020 $5.00 45% The stock currently trades at $60 per share. Al thinks that within five years it should be trading at $75 to $80 a share. Wally realizes that to buy the Hydro-Electric stock, he will have to sell his holdings of CapCo Industriesa highly regarded growth stock that Wally is disenchanted with because of recent substandard performance. Questions a. b. How would you describe Wally's present investment program? How do you think it fits him and his investment objectives? Consider the Hydro-Electric stock. 1. c. Determine the amount of annual dividends Hydro-Electric can be expected to pay over the years 2016 to 2020. 2. Compute the total dollar return that Wally will make from Hydro-Electric if he invests $6,000 in the stock and all the dividend and price expectations are realized. 3. If Wally participates in the company's dividend reinvestment plan, how many shares of stock will he have by the end of 2020? What will they be worth if the stock trades at $80 on December 31, 2020? Assume that the stock can be purchased through the dividend reinvestment plan at a net price of $50 a share in 2016, $55 in 2017, $60 in 2018, $65 in 2019, and $70 in 2020. Use fractional shares, to 2 decimals, in your computations. Also, assume that, as in part b, Wally starts with 100 shares of stock and all dividend expectations are realized. Would Wally be going to a different investment strategy if he decided to buy shares in Hydro-Electric? If the switch is made, how would you describe his new investment program? What do you think of this new approach? Is it likely to lead to more trading on Wally's behalf? If so, can you reconcile that with the limited amount of time he has to devote to his portfolio? Case Problem 7.1 Some Financial Ratios Are Real Eye-Openers Jack Arnold is a resident of Lubbock, Texas, where he is a prosperous rancher and businessman. He has also built up a sizable portfolio of common stock, which, he believes, is due to the fact that he thoroughly evaluates each stock he invests in. As Jack says, \"You can't be too careful about these things! Anytime I plan to invest in a stock, you can bet I'm going to learn as much as I can about the company.\" Jack prefers to compute his own ratios even though he could easily obtain analytical reports from his broker at no cost. (In fact, Bob Smith, his broker, has been volunteering such services for years.) Recently Jack has been keeping an eye on a small chemical stock. The firm, South Plains Chemical Company, is big in the fertilizer businesswhich is something Jack knows a lot about. Not long ago, he received a copy of the firm's latest financial statements (summarized here) and decided to take a closer look at the company. Cash $ 1,250 Accounts receivable $ 8,000 Current liabilities $10,000 Inventory $12,000 Long-term debt $ 8,000 Current assets $21,250 Stockholders' equity $12,000 Fixed and other assets $ 8,750 Total liabilities and Total assets $30,000 stockholders' equity $30,000 South Plains Chemical Company Balance Sheet ($ thousands) Sales $50,000 Cost of goods sold $25,000 Operating expenses $15,000 Operating profit $10,000 Interest expense $ 2,500 Taxes $ 2,500 Net profit $ 5,000 Dividends paid to common stockholders ($ in thousands) $ 1,250 Number of common shares outstanding 5 million Recent market price of the common stock $ 25 South Plains Chemical Company Income Statement ($ thousands) Questions a. Using the South Plains Chemical Company figures, compute the following ratios. Latest Industry Averages Liquidity Latest Industry Averages Profitability a. Net working capital N/A h. Net profit margin 8.5% b. Current ratio 1.95 i. Return on assets 22.5% j. ROE 32.2% Activity Latest Industry Averages c. Receivables turnover 5.95 Common-Stock Ratios d. Inventory turnover 4.50 k. Earnings per share $2.00 e. Total asset turnover 2.65 l. Price-to-earnings ratio 20.0 m. Dividends per share $1.00 Leverage b. c. Latest Industry Averages f. Debt-equity ratio 0.45 n. Dividend yield 2.5% g. Times interest earned 6.75 o. Payout ratio 50.0% p. Book value per share $6.25 q. Price-to-book-value ratio 6.4 Compare the company ratios you prepared to the industry figures given in part a. What are the company's strengths? What are its weaknesses? What is your overall assessment of South Plains Chemical? Do you think Jack should continue with his evaluation of the stock? Explain. Case Problem 7.2 Doris Looks at an Auto Issue Doris Wise is a young career woman. She lives in Phoenix, Arizona, where she owns and operates a highly successful modeling agency. Doris manages her modest but rapidly growing investment portfolio, made up mostly of high-grade common stocks. Because she's young and single and has no pressing family requirements, Doris has invested primarily in stocks that offer the potential for attractive capital gains. Her broker recently recommended an auto company stock and sent her some literature and analytical reports to study. One report, prepared by the brokerage house she deals with, provided an up-to-date look at the economy, an extensive study of the auto industry, and an equally extensive review of several auto companies (including the one her broker recommended). She feels strongly about the merits of security analysis and believes it is important to spend time studying a stock before making an investment decision. Questions a. b. c. Doris tries to stay informed about the economy on a regular basis. At the present time, most economists agree that the economy is getting stronger. What information about the economy do you think Doris would find helpful in evaluating an auto stock? Prepare a listand be specific. Which three items of economic information (from your list) do you feel are most important? Explain. In relation to a study of the auto industry, briefly note the importance of each of the following. 1. Auto imports 2. The United Auto Workers union 3. Interest rates 4. The price of a gallon of gas A variety of financial ratios and measures are provided about one of the auto companies and its stock. These are incomplete, however, so some additional information will have to be computed. Specifically, we know the following: Net profit margin 15% Total assets $25 billion Earnings per share $3.00 Total asset turnover 1.5 Net working capital $3.4 billion Payout ratio 40% Current liabilities $5 billion Price-to-earnings ratio 12.5 Case Problem 8.1 Chris Looks for a Way to Invest His Wealth Chris Norton is a young Hollywood writer who is well on his way to television superstardom. After writing several successful television specials, he was recently named the head writer for one of TV's top-rated sitcoms. Chris fully realizes that his business is a fickle one, and on the advice of his dad and manager, he has decided to set up an investment program. Chris will earn about a half-million dollars this year. Because of his age, income level, and desire to get as big a bang as possible from his investment dollars, he has decided to invest in speculative, highgrowth stocks. Chris is currently working with a respected Beverly Hills broker and is in the process of building up a diversified portfolio of speculative stocks. The broker recently sent him information on a hot new issue. She advised Chris to study the numbers and, if he likes them, to buy as many as 1,000 shares of the stock. Among other things, corporate sales for the next three years have been forecasted as follows: Year Sales ($ millions) 1 $22.5 2 $35.0 3 $50.0 The firm has 2.5 million shares of common stock outstanding. They are currently being traded at $70 a share and pay no dividends. The company has a net profit rate of 20%, and its stock has been trading at a P/E of around 40 times earnings. All these operating characteristics are expected to hold in the future. Questions a. b. Looking first at the stock: 1. Compute the company's net profits and EPS for each of the next 3 years. 2. Compute the price of the stock three years from now. 3. Assuming that all expectations hold up and that Chris buys the stock at $70, determine his expected return on this investment. 4. What risks is he facing by buying this stock? Be specific. 5. Should he consider the stock a worthwhile investment candidate? Explain. Looking at Chris's investment program in general: 1. What do you think of his investment program? What do you see as its strengths and weaknesses? 2. Are there any suggestions you would make? 3. Do you think Chris should consider adding foreign stocks to his portfolio? Explain. Case Problem 8.2 An Analysis of a High-Flying Stock Marc Dodier is a recent university graduate and a security analyst with the Kansas City brokerage firm of Lippman, Brickbats, and Shaft. Marc has been following one of the hottest issues on Wall Street, C&I Medical Supplies, a company that has turned in an outstanding performance lately and, even more important, has exhibited excellent growth potential. It has five million shares outstanding and pays a nominal annual dividend of $0.05 per share. Marc has decided to take a closer look at C&I to assess its investment potential. Assume the company's sales for the past five years have been as follows: Year Sales ($ millions) 2012 $10.0 2013 $12.5 2014 $16.2 2015 $22.0 2016 $28.5 Marc is concerned with the future prospects of the company, not its past. As a result, he pores over the numbers and generates the following estimates of future performance: Expected net profit margin 12% Estimated annual dividends per share 5 Number of common shares outstanding No change P/E ratio at the end of 2017 35 P/E ratio at the end of 2018 50 Questions a. b. Determine the average annual rate of growth in sales over the past five years. (Assume sales in 2011 amounted to $7.5 million.) 1. Use this average growth rate to forecast revenues for next year (2017) and the year after that (2018). 2. Now determine the company's net earnings and EPS for each of the next two years (2017 and 2018). 3. Finally, determine the expected future price of the stock at the end of this two-year period. Because of several intrinsic and market factors, Marc feels that 25% is a viable figure to use for a desired rate of return. 1. Using the 25% rate of return and the forecasted figures you came up with in question a, compute the stock's justified price. 2. If C&I is currently trading at $32.50 per share, should Marc consider the stock a worthwhile investment candidate? Explain. Case Problem 9.2 Deb Takes Measure of the Market Several months ago, Deb Forrester received a substantial sum of money from the estate of her late aunt. Deb initially placed the money in a savings account because she was not sure what to do with it. Since then, however, she has taken a course in investments at the local university. The textbook for the course was, in fact, this one, and the class just completed this chapter. Excited about what she has learned in class, Deb has decided that she definitely wants to invest in stocks. But before she does, she wants to use her newfound knowledge in technical analysis to determine whether now would be a good time to enter the market. Deb has decided to use all of the following measures to help her determine if now is, indeed, a good time to start putting money into the stock market: Advance-decline line New highs-new lows indicator (Assume the current 10-day moving average is 0 and the last 10 periods were each 0.) Arms index Mutual fund cash ratio Deb goes to the Internet and, after considerable effort, is able to put together the accompanying table of data. Questions a. b. Based on the data presented in the table, calculate a value (where appropriate) for periods 1 through 5, for each of the four measures listed above. Chart your results, where applicable. Discuss each measure individually and note what it indicates for the market, as it now stands. Taken collectively, what do these four measures indicate about the current state of the market? According to these c. measures, is this a good time for Deb to consider getting into the market, or should she wait a while? Explain. Comment on the time periods used in the table, which are not defined here. What if they were relatively long intervals of time? What if they were relatively short? Explain how the length of the time periods can affect the measures. Period 1 Period 2 Period 3 Period 4 Period 5 Dow Jones Industrial Average 8,300 7,250 8,000 9,000 9,400 Dow Transportation Average 2,375 2,000 2,000 2,850 3,250 New highs $ 68 $ 85 $ 85 $ 120 $ 200 New lows $ 75 $ 60 $ 80 $ 75 $ 20 Volume up 600,000,000 836,254,123 275,637,497 875,365,980 1,159,534,297 Volume down 600,000,000 263,745,877 824,362,503 424,634,020 313,365,599 Mutual fund cash (trillions of dollars) $0.31 $0.32 $0.47 $0.61 $0.74 Total assets managed (trillions of dollars) $6.94 $6.40 $6.78 $6.73 $7.42 Advancing issues (NYSE) 1,120 1,278 1,270 1,916 1,929 Declining issues (NYSE) 2,130 1,972 1,980 1,334 1,321