Minicase: Stock Valuation

Your employer, a midsized human resources management company, is considering expansion into related fields, including the acquisition of Temp Force Company, an employment agency that supplies word processor operators and computer programmers to businesses with temporarily heavy workloads. Your employer is also considering the purchase of Biggerstaff & McDonald (B&M), a privately held company owned by two friends, each with 5 million shares of stock. B&M currently has free cash flow of $24 million, which is expected to grow at a constant rate of 5%. B&Ms financial statements report short-term investments of $100 million, debt of $200 million, and preferred stock of $50 million. B&Ms weighted average cost of capital (WACC) is 11%. Answer the following questions:

1. Describe briefly the legal rights and privileges of common stockholders.
2. What is free cash flow (FCF)? What is the weighted average cost of capital? What is the free cash flow valuation model?
3. Suppose the free cash flow at Time 1 is expected to grow at a constant rate of g_L forever. If g_LL forever (and g_L
4. Use B&Ms data and the free cash flow valuation model to answer the following questions:

(1) What is its estimated value of operations?

(2) What is its estimated total corporate value? (This is the entity value.)

(3) What is its estimated intrinsic value of equity?

(4) What is its estimated intrinsic stock price per share?

5. You have just learned that B&M has undertaken a major expansion that will change its expected free cash flows to -$10 million in 1 year, $20 million in 2 years, and $35 million in 3 years. After 3 years, free cash flow will grow at a rate of 5%. No new debt or preferred stock was added; the investment was financed by equity from the owners. Assume the WACC is unchanged at 11% and that there are still 10 million shares of stock outstanding.

(1) What is the companys horizon value (i.e., its value of operations at Year 3)? What is its current value of operations (i.e., at Time 0)?

(2) What is its estimated intrinsic value of equity on a price-per-share basis?

6. If B&M undertakes the expansion, what percent of B&Ms value of operations at Year 0 is due to cash flows from Years 4 and beyond? (Hint: Use the horizon value at t=3 to help answer this question.)
7. Based on your answer to the previous question, what are two reasons why managers often emphasize short-term earnings?
8. (1) Write out a formula that can be used to value any dividend-paying stock, regardless of its dividend pattern.

(2) What is a constant growth stock? How are constant growth stocks valued?

(3) What happens if a company has a constant g_L that exceeds its r_s? Will many stocks have expected growth greater than the required rate of return in the short run (i.e., for the next few years)? In the long run (i.e., forever)?

9. Assume that Temp Force has a beta coefficient of 1.2, that the risk-free rate (the yield on T-bonds) is 7.0%, and that the market risk premium is 5%. What is the required rate of return on the firms stock?
10. Assume that Temp Force 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) What is the firms current estimated intrinsic stock price?

(2) What is the stocks expected value 1 year from now?

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

11. Now assume that the stock is currently selling at $30.29. What is its expected rate of return?
12. Now assume that Temp Forces dividend is expected to experience nonconstant growth of 30% from Year 0 to Year 1, 25% from Year 1 to Year 2, and 15% from Year 2 to Year 3. After Year 3, dividends will grow at a constant rate of 6%.

(1) What is the stocks intrinsic value under these conditions?

(2) What are the expected dividend yield and capital gains yield during the first year?

(3) What are the expected dividend yield and capital gains yield during the fourth year (from Year 3 to Year 4)?

13. What are the advantages of the free cash flow valuation model relative to the dividend growth model?
14. What is preferred stock?
15. Suppose a share of preferred stock pays a dividend of $2.10 and investors require a return of 7%. What is the estimated value of the preferred stock?