Question

Ragan, Inc. was founded nineteen years ago by brother and sister Carrington and Genevieve Ragan. The company manufactures and installs commercial heating, ventilation, and cooling (HVAC) units. Ragan, Inc. has experienced rapid growth because of a proprietary technology that increases the energy efficiency of its units. The company is equally split between the two siblings. The original partnership agreement between them gave each 500,000 shares of stock. The company has since gone public. At that time, the siblings retained their shares and 1,000,000 shares of new stock were issued.

The firm anticipates needing to raise a large amount of capital $10 million in the coming year to facilitate further expansion and are evaluating several financing options. The first option is to issue zero-coupon bonds that mature in 20 years. Similar zero-coupon bonds currently have a YTM of 4.5%. The second option is to issue 4% coupon bonds that mature in 20 years. Similar bonds have a YTM of 4%. The third option is to issue preferred stock with a fixed dividend of $0.85 per share. These preferred stock would have a required return of 7.5%. The firm currently has no preferred stock outstanding. The fourth option is to issue common stock.

The stock is currently trading on the market for $20 per share. The firm most recently paid a dividend on common stock of $0.50 and plans to increase that dividend by 25% per year for the next five years. After that, the firm will level off at the industry average of 5% per year, indefinitely. Carrington and Genevieve estimate the required return on the stock to be 15%.

1. What would the shares of preferred stock sell for and how many would they have to sell? How would this impact the firm’s dividend expenses going forward?

2. Based on the information about the common stock dividends, what should the value of the stock be today?

3. What do you think about the estimate of a 15% required return? What does the current stock price suggest about the required return?

Please show all steps. Thank You.

Answer 1

1) Value of preferred stock = Dividend / Required Rate = 0.85 / 7.5% = $11.33

No. of stocks to sell = $10 million / $11.33 = 882,353 shares

Annual Dividend to be paid going ahead = $10m x 7.5% = $750,000 (= 882,353 x 0.85)

2) Forecast dividends given the growth rate as shown below

Year	Dividend
0	$         0.50
1	$         0.63
2	$         0.78
3	$         0.98
4	$         1.22
5	$         1.53
6	$         1.60

Value in year 5, P5 = D6 / (r - g) = 1.60 / (15% - 5%) = $16.02

Value today = D1 / (1 + r) + D2 / (1 + r)^2 + ... + (D5 + P5) / (1 + r)^5

= 0.63 / 1.15 + 0.78 / 1.15^2 + 0.98 / 1.15^3 + 1.22 / 1.15^4 + (1.53 + 16.02) / 1.15^5

= $11.20

3) The current stock price is $20, while its value is $11.20 at 15% required return. It means that the required return priced by the market is lower than 15% because lower the required return, higher the stock value.