Question

Your supervisor has asked you to evaluate the relative attractiveness of the stocks of two very similar chemical companies. Litchfield Chemical Corp. (LCC) and Aminochem Company (AOC). Both firms have a June 30 fiscal year end. You have compiled the data in Table 1 for this purpose. Use a 1-year time horizon and assume the following:

Real gross domestic product is expected to rise 5%;

S&P 500 expected total return of 20%;

U.S. Treasury bills yield 5%; and

30 year U.S. Treasury bonds yield 8%.

1. Calculate the value of the common stock of LCC and AOC using the constant growth dividend discount model. Show your work.                                

2. Calculate the expected return over the next year of the common stock of LCC and AOC using the capital asset pricing model, Show your work.                

3. Calculate the internal (implied, normalized, or sustainable) growth rate of LCC and AOC. Show your work.                                                     

4. Recommend LCC or AOC for investment. Justify your choice by using your answers to A, B, C and the information in Table 1.                                 

Table 1
	Litchfield Chemical (LCC)	Aminochem (AOC)
Current stock price	$50	$30
Shares outstanding (millions)	10	20
Projected earnings per share (fiscal 1996)	$4.00	$3.20
Projected dividend per share (fiscal 1996)	$0.90	$1.60
Projected dividend growth ate	8%	7%
Stock beta	1.2	1.4
Investor’s required rate of return	10%	11%
Balance sheet data (millions)
Long-term debt	$100	$130
Stockholders’ equity	$300	$320

Answer 1

Subpart A:

value of the common stock using the constant growth dividend discount model is given by D1/(r-g)

LCC stock valuation :

D1 = Projected dividend per share (fiscal 1996) = $0.90

Investor's required rate of return = r = 10%

Dividend growth rate = g = 8%

Value of stock LCC = D1/(r-g) = 0.90/(10%-8%) = $45

AOC stock valuation :

D1 = Projected dividend per share (fiscal 1996) = $1.6

Investor's required rate of return = r = 11%

Dividend growth rate = g = 7%

Value of stock LCC = D1/(r-g) = 1.6/(11%-7%) = $40

Sub part B:

CAPM formula: Rs - Rf = * (Rm-Rf)

Rm = S&P 500 expected total return = 20%

Rf = U.S. Treasury bills yield = 5%

Stock LCC

= 1.2

substitute the values in CAPM formula:

Rs - 5% = 1.2 ( 20%-5%) = 18%

Rs = 23%

Stock AOC

= 1.4

substitute the values in CAPM formula:

Rs - 5% = 1.4 ( 20%-5%) = 21%

Rs = 26%

Sub part C: Calculate the internal (implied, normalized, or sustainable) growth rate of LCC and AOC. Show your work.     

Internal growth rate is given by the formula: Return on Assets * Retention Ratio

Total asset of the company is given by the formula: Assets = Debt + Equity

Return on Assets = Net Income / Assets

Retention Ratio is the ratio of the amount of earnings retained after paying dividend to the total earnings = (Earnings per share - dividend per share)/(Earnings per share)

Company LCC:

Debt = $100 Mn

Equity = $300 Mn

Assets = Debt + Equity = $100 + $300 = $400 Mn

Net Income = project earnings per share * no of shares = $ 4 * 10 million = $40 Million

Return on Assets = Net Income / Assets = 40/400 = 10%

Retention Ratio = (Earnings per share - dividend per share)/(Earnings per share) = (4-0.9)/4 =0.775

Internal (implied, normalized, or sustainable) growth rate = Return on Assets * Retention Ratio = 10%*0.775 = 7.75%

Company AOC:

Debt = $130 Mn

Equity = $320 Mn

Assets = Debt + Equity = $130 + $320 = $450 Mn

Net Income = project earnings per share * no of shares = $ 3.2 * 20 million = $64 Million

Return on Assets = Net Income / Assets = 64/450 = 14.22%

Retention Ratio = (Earnings per share - dividend per share)/(Earnings per share) = (3.2-1.6)/3.2 =0.5

Internal (implied, normalized, or sustainable) growth rate = Return on Assets * Retention Ratio = 14.22%*0.5= 7.11%

Sub part D: Recommend LCC or AOC for investment. Justify your choice by using your answers to A, B, C and the information in Table 1.

AOC stock is recommended for investment because of following reasons:

1. AOC stock is undervalued as the valuation from sub part A suggests the stock price to be $40 however the stock is trading at $30 whereas LCC stock is overvalued as valuation suggests the stock price to be $45 but the stock trades at $50

2. AOC stock's expected rate of return (26%) as per CAPM is higher than that of LCC (23%)

3. The internal rate of return though higher for LCC as compared to AOC it is marginally higher.