Situation:Your employer, a mid-sized 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 temporary heavy workloads. Your employer is also considering the purchase of a 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 marketable securities 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.

a. Describe briefly the legal rights and privileges of common stockholders.

b. What is free cash flow (FCF)? What is the weighted average cost of capital? What is the free cash flow valuation model?

c. Use a pie chart to illustrate the sources that comprise a hypothetical companys total value. Using another pie chart, show the claims on a companys value. How is equity a residual claim?

d. Suppose the free cash flow at Time 1 is expected to grow at a constant rate of g_L forever. If g_L < WACC, what is a formula for the present value of expected free cash flows when discounted at the WACC? If the most recent free cash flow is expected to grow at a constant rate of g_L forever (and g_L < WACC), what is a formula for the present value of expected free cash flows when discounted at the WACC?

e. 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?

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

*Debt holders have the first claim on corporate value. Preferred stockholders have the next claim and the remaining is left to common stockholders.

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

f. 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 were added, the investment was financed by equity from the owners. Assume the WACC is unchanged at 11% and it that there are still has 10 million shares of stock outstanding.

(1.) What is its horizon value (i.e., its value of operations at year three)? What is its current value of operations (i.e., at time zero)?

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

g. 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.

h. Based on your answer to the previous question, what are two reasons why managers often emphasize short-term earnings?

i. Your employer also is considering the acquistion of Hatfield Medical Supplies. You have gathered the following data regarding Hatfield, with all dollars reported in millions: (1) most recent sales of $2,000; (2) most recent total net operating capital, OpCap = $1,120; (3) most recent operating profitability ratio, OP = NOPAT/Sales = 4.5%; and (4) most recent capital requirement ratio, CR = OpCap/Sales = 56%. You estimate that the growth rate in sales from Year 0 to Year 1 will be 10%, from Year 1 to Year 2 will be 8%, from Year 2 to Year 3 will be 5%, and from Year 3 to Year 4 will be 5%. You also estimate that the long-term growth rate beyond Year 4 will be 5%. Assume the operating profitability and capital requirement ratios will not change. Use this information to forecast Hatfield's sales, net operating profit after taxes (NOPAT), OpCap, free cash flow, and return on invested capital (ROIC) for Years 1 through 4. Also estimate the annual growth in free cash flow for Years 2 through 4. The weighted average cost of capital (WACC) is 9%. How does the ROIC in Year 4 compare with the WACC?

j. What is the horizon value at Year 4? What is the value of operations at Year 4? Which is larger, and what can explain the difference? What is the value of operations at Year 0? How does the value of operations compare with the current total net operating capital?

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

The value of any financial asset is equal to the present value of future cash flows provided by the asset. When an investor buys a share of stock, he or she typically expects to receive cash in the form of dividends and then, eventually, to sell the stock and to receive cash from the sale. Moreover, the price any investor receives is dependent upon the dividends the next investor expects to earn, and so on for different generations of investors. Thus, the stock's value ultimately depends on the cash dividends the company is expected to provide and the discount rate used to find the present value of those dividends.

Here is the basic dividend valuation equation:

D1

+

D2

+

. . . .

DN

( 1 + rs )

( 1 + rs ) 2

( 1 + rs ) N

The dividend stream theoretically extends on out forever, i.e., n = infinity. Obviously, it would not be feasible to deal with an infinite stream of dividends, but fortunately, an equation has been developed that can be used to find the PV of the dividend stream, provided it is growing at a constant rate.

Naturally, trying to estimate an infinite series of dividends and interest rates forever would be a tremendously difficult task. Now, we are charged with the purpose of finding a valuation model that is easier to predict and construct. That simplification comes in the form of valuing stocks on the premise that they have a constant growth rate.

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

In this stock valuation model, we first assume that the dividend and stock will grow forever at a constant growth rate. Naturally, assuming a constant growth rate for the rest of eternity is a rather bold statement. However, considering the implications of imperfect information, information asymmetry, and general uncertainty, perhaps our assumption of constant growth is reasonable. It is reasonable to guess that a given firm will experience ups and downs throughout its life. By assuming constant growth, we are trying to find the average of the good times and the bad times, and we assume that we will see both scenarios over the firm's life. In addition to assuming a constant growth rate, we will be estimating a long-term required return for the stock. By assuming these variables are constant, our price equation for common stock simplifies to the following expression:

D1

( rs gL )

In this equation, the long-run growth rate (g) can be approximated by multiplying the firm's return on assets by the retention ratio. Generally speaking, the long-run growth rate of a firm is likely to fall between 5% and 8% a year.

(c.) What happens if a company has a constant gL which exceeds rs? 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)?

o. 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?

p. 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 stock price?

(2.) What is the stock's expected value 1 year from now?

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

q. Now assume that the stock is currently selling at $30.29. What is its expected rate of return?

r. 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%. What is the stocks intrinsic value under these conditions? What are the expected dividend yield and capital gains yield during the first year? What are the expected dividend yield and capital gains yield during the fourth year (from Year 3 to Year 4)?

s. Compare and contrast the free cash flow valuation model and the dividend growth model.

t. What is market multiple analysis?

u. What is preferred stock? 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?