STOCK VALUATION Case study

Robert Balik and Carol Kiefer are senior vice presidents of theMutual of Chicago Insurance Company. They are co-directors of thecompany’s pension fund management division, with Balik havingresponsibility for fixed-income securities (primarily bonds) andKiefer being responsible for equity investments. A major newclient, the California League of Cities, has requested that Mutualof Chicago present an investment seminar to the mayors of therepresented cities; and Balik and Kiefer, who will make the actualpresentation, have asked you to help them.

To illustrate the common stock valuation process, Balik andKiefer have asked you to analyze the Bon Temps Company, anemployment agency that supplies word-processor operators andcomputer programmers to businesses with temporarily heavyworkloads. You are to answer the following questions:

a. Describe briefly the legal rights and privileges of commonstockholders.

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

2. What is a constant growth stock? How are constant growthstocks valued?

3. What are the implications if a company forecasts a constant gthat exceeds its rs? Will many stocks have expected g rs in theshort run (that is, for the next few years)? In the long run (thatis,

forever)?

c. Assume that Bon Temps has a beta coefficient of 1 2, that therisk-free rate (the yield on T-bonds) is 7%, and that the requiredrate of return on the market is 12%. What is Bon Temps’s requiredrate of return?

d. Assume that Bon Temps is a constant growth company whose lastdividend (D0, which was paid yesterday) was $2 00 and whosedividend is expected to grow indefinitely at a 6% rate.

1. What is the firm’s expected dividend stream over the next 3years?

2. What is its current stock price?

3. What is the stock’s expected value 1 year from now?

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

e. Now assume that the stock is currently selling at $30 29.What is its expected rate of return?

f. What would the stock price be if its dividends were expectedto have zero growth?

g. Now assume that Bon Temps is expected to experiencenonconstant growth of 30% for the next 3 years, then return to itslong-run constant growth rate of 6%. What is the stock’s valueunder these conditions? What are its expected dividend and capitalgains yields in Year 1? Year ?

h. Suppose Bon Temps is expected to experience zero growthduring the first 3 years and then resume its steady-state growth of6% in the fourth year. What would be its value then? What would beits expected dividend and capital gains yields in Year 1? In Year4?

i. Finally, assume that Bon Temps’s earnings and dividends areexpected 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 whatprice should it sell? What would be its dividend and capital gainsyields in each year?