PLEASE USE EXCEL AND SHOW FORMULAS

Problem I. As an alternative to last week's Discussion Question on HMK's method of raising $10M in bonds to fund its capital expansion projects, as an alternative HMK has decided to look at equity financing.

Equity financing can be either the use of retained earnings from the right-hand side of the balance sheet (with the corresponding assets being short-term investments in current assets, or very large amounts in the cash account in current assets, or the disposal of other less efficient longer-term assets), or in the current case, the issuance of new common stock to finance the investment. But, in order to get at the cost of this new common stock equity, you have to review a few fundamentals with Mr. Moneypockets first.

a. you note that HMK has just paid an annual dividend of $1.50. Analysts are predicting the dividend to grow by $0.12 per year over the next five years. After then, HMKs earnings are expected to grow by 6% per year, and its dividend payout rate will remain constant. If HMKs cost of capital (which is what we are eventually seeking for the overall weighted average cost of capital) is assumed to be 8.5% by you, what price will you tell Mr. Moneypockets that HMK stock should be selling for today, using the dividend-discount model as your technique?

b. alternatively, you expect free cash flows to be generated over the next five years as follows for HMK:

Year 1 2 3 4 5

FCF ($M) 53 68 78 75 82

After then, you expect the free cash flows to grow at the industry average of 6% per year (same rate as the growth in dividends after the first five years, per above). If you now switch to the discounted free cash flow model as an alternative, and use the same estimate of 8.5% as the equity cost of capital: --what will you tell Mr. Moneypockets that his enterprise value will be for HMK? --if HMK has no excess cash that can be used for this investment, but already has $300M of debt (none of which includes Option I debt financing above), and 40M shares outstanding of common stock, what will be your estimate of the stock price to Mr. Moneypockets?

c. what conclusions can you give Mr. Moneypockets relative to the differing stock price estimates that might result from these two approaches to stock price estimation? What could account for the differences in the two stock price approaches?

d. If the price of the stock is roughly $62 when issued (and assuming no flotation costs such as paid to an Investment Banker), how many shares of new stock will have to be issued in the primary market to major investors such as CalPERS (California Pension Fund System) and the AFL-CIO Pension Fund, in order to raise the $10M??

Problem 2. You have an option to buy Jack Clothing Corporation stocks. Based on the released financial statements, they have $500 million of debt and 14 million shares of stock outstanding. You expect the Corporation to generate the following cash flows over the next five years:

Year 1 2 3 4 5

FCF($millions) 75 84 96 111 120

Beginning with year six, you estimate that the Corporation's free cash flows will grow at 6% per year and that their weighted average cost of capital is 15%. Would you be willing to buy a share at the price $39? And why or why not?