STOCK VALUATION Robert Balik and Carol Kiefer are senior vice presidents of the Mutual of Chicago Insurance Company. They are codirectors of the companys pension fund management division, with Balik having responsibility for fixed-income securities (primarily bonds) and Kiefer being responsible for equity investments. A major new client, the California League of Cities, has requested that Mutual of Chicago present an investment seminar to the mayors of the represented cities; and Balik and Kiefer, who will make the actual presentation, have asked you to help them.

To illustrate the common stock valuation process, Balik and Kiefer 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:

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

   2. What is its current stock price?

   3. What is the stocks expected value 1 year from now?

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

2. Now assume that the stock is currently selling at $40.00. What is its expected rate of return?

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

   1. Now assume that Bon Tempss dividend is expected to grow 30% the first year, 20% the second year, 10% the third year, and return to its long-run constant growth rate of 4%. What is the stocks value under these conditions? What are its expected dividend and capital gains yields in Year 1? Year 4?

   2. Suppose Bon Temps is expected to experience zero growth during the first 3 years and then resume its steady-state growth of 4% in the fourth year. What would be its value then? What would be its expected dividend and capital gains yields in Year 1? In Year 4?

   3. Finally, assume that Bon Tempss earnings and dividends are expected to decline at a constant rate of 4% per year, that is, . Why would anyone be willing to buy such a stock, and at what price should it sell? What would be its dividend and capital gains yields in each year?

   4. Suppose Bon Temps embarked on an aggressive expansion that requires additional capital. Management decided to finance the expansion by borrowing $40 million and by halting dividend payments to increase retained earnings. Its WACC is now 7%, and the projected free cash flows for the next three years are $5 million, $10 million, and $20 million. After Year 3, free cash flow is projected to grow at a constant 5%. What is Bon Tempss total value? If it has 10 million shares of stock and $40 million of debt and preferred stock combined, what is the price per share?

   5. Suppose Bon Temps decided to issue preferred stock that would pay an annual dividend of $5.00 and that the issue price was $100.00 per share. What would be the stocks expected return? Would the expected rate of return be the same if the preferred was a perpetual issue or if it had a 20-year maturity?