d.
INPUT DATA
WACC 9%
232
Integrated Case
Chapter 9: Stocks and Their Valuation
Integrated Case
9-23
Mutual of Chicago Insurance Company
Stock Valuation
Robert Balik and Carol Kiefer are senior vice presidents of the Mutual of
Chicago Insurance Company. They are codirectors of the company’s 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.
A. Describe briefly the legal rights and privileges of common
stockholders.
Answer: [Show S9-1 and S9-2 here.] The common stockholders are the
owners of a corporation, and as such they have certain rights and
privileges as described below.
Chapter 9: Stocks and Their Valuation
Integrated Case
233
B. (1) Write a formula that can be used to value any stock, regardless of
its dividend pattern.
Answer: [Show S9-3 through S9-6 here.] The value of any stock is the
B. (2) What is a constant growth stock? How are constant growth stocks
valued?
Answer: [Show S9-7 and S9-8 here.] A constant growth stock is one whose
dividends are expected to grow at a constant rate forever.
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Chapter 9: Stocks and Their Valuation
B. (3) What are the implications if a company forecasts a constant g that
exceeds its rs? Will many stocks have expected g > rs in the short
run (that is, for the next few years)? In the long run (that is,
forever)?
C. Assume that Bon Temps has a beta coefficient of 1.2, that the risk-
free rate (the yield on T-bonds) is 7%, and that the required rate of
return on the market is 12%. What is Bon Temps’s required rate of
return?
Answer: [Show S9-10 here.] Here we use the SML to calculate Bon Temps’s
required rate of return:
Chapter 9: Stocks and Their Valuation
Integrated Case
235
D. Assume that Bon Temps 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 firm’s expected dividend stream over the next 3 years?
Answer: [Show S9-11 here.] Bon Temps is a constant growth stock, and its
D. (2) What is its current stock price?
Answer: [Show S9-12 here.] We could extend the time line on out forever,
find the value of Bon Temps’s dividends for every year on out into
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Chapter 9: Stocks and Their Valuation
D. (3) What is the stock’s expected value 1 year from now?
Answer: [Show S9-13 here.] After one year, D1 will have been paid, so the
D. (4) What are the expected dividend yield, capital gains yield, and total
return during the first year?
Answer: [Show S9-14 here.] The expected dividend yield in any Year N is
E. Now assume that the stock is currently selling at $30.29. What is
its expected rate of return?
Chapter 9: Stocks and Their Valuation
Integrated Case
237
Answer: The constant growth model can be rearranged to this form:
F. What would the stock price be if its dividends were expected to have
zero growth?
Answer: [Show S9-15 here.] If Bon Temps’s dividends were not expected to
grow at all, then its dividend stream would be a perpetuity.
Perpetuities are valued as shown below:
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Chapter 9: Stocks and Their Valuation
G. Now assume that Bon Temps is expected to experience nonconstant
growth of 30% for the next 3 years, then return to its long-run
constant growth rate of 6%. What is the stock’s value under these
conditions? What are its expected dividend and capital gains yields
in Year 1? Year 4?
Answer: [Show S9-16 through S9-18 here.] Bon Temps is no longer a
constant growth stock, so the constant growth model is not
Chapter 9: Stocks and Their Valuation
Integrated Case
239
H. Suppose Bon Temps is expected to experience zero growth during
the first 3 years and then resume its steady-state growth of 6% 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?
Answer: [Show S9-19 and S9-20 here.] Now we have this situation:
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Integrated Case
Chapter 9: Stocks and Their Valuation
I. Finally, assume that Bon Temps’s earnings and dividends are
expected to decline at a constant rate of 6% per year, that is,
g = -6%. 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?
Answer: [Show S9-21 and S9-22 here.] The company is earning something
and paying some dividends, so it clearly has a value greater than
Chapter 9: Stocks and Their Valuation
Integrated Case
241
J. 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 10%,
and the projected free cash flows for the next 3 years are
–$5 million, $10 million, and $20 million. After Year 3, free cash
flow is projected to grow at a constant 6%. What is Bon Temps’s
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?
Answer: [Show S9-23 through S9-29 here.]
K. Suppose Bon Temps decided to issue preferred stock that would pay
an annual dividend of $5.00 and that the issue price was $50.00 per
share. What would be the stock’s 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?
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Integrated Case
Chapter 9: Stocks and Their Valuation
Answer: [Show S9-30 and S9-31 here.]
Appendix 9A: Stock Market Equilibrium
Answers and Solutions
243
Appendix 9A
Stock Market Equilibrium
Answers to End-of-Chapter Questions
9A-1 For a stock to be in equilibrium, two related conditions must hold:
9A-2 Some individual investors may believe that
ˆ=
ˆ
and
ˆ
(hence they would invest most of
244
Answers and Solutions
Appendix 9A: Stock Market Equilibrium
Solutions to End–of-Chapter Problems
9A-1 a. ri = rRF + (rM – rRF)bi.
b. In this situation, the expected rate of return is as follows:
9A-2 a. rs = rRF + (rM – rRF)b = 6% + (10% – 6%)1.5 = 12.0%.
Appendix 9A: Stock Market Equilibrium
Answers and Solutions
245
9A-3 a. Old rs = rRF + (rM – rRF)b = 6% + (3%)1.2 = 9.6%.
b. POld = $58.89. PNew =
04.0r
)04.1(2$
s−
.
Solving for rs we have the following:
04.0r