Question

Pam Alvarez and Shawna Jones are senior vice-presidents of Mutual of Whitewater. They are co-directors of the company’s pension fund management division, with Alvarez having responsibility for fixed income securities (primarily bonds) and Jones being responsible for equity investments. A major new client, the Southwestern Municipal Alliance, has request that Mutual of Whitewater present an investment seminar to the mayors of the represented cities, and Alvarez and Jones, who will make the actual presentation, have asked you to help them.

          To illustrate the common stock valuation process, Alvarez and Jones have asked you to analyze the Temp Que Company, an employment agency that supplies word processor operators and computer programmers to businesses with temporarily heavy workloads. Stocks of companies with similar risk as Temp Que are currently yielding 13%. You are to answer the following questions (Show calculations clearly).

1) Suppose Temp Que is expected to experience zero growth during the first 3 years and then to resume its steady-state growth of 6 percent in the fourth year. What is the stock’s value now?

2) Why do stock prices change? Answer the question by using the following example: Suppose the expected D₁ is $2, the growth rate is 5 percent, and R is 10 percent. Using the constant growth model, what is the price? What is the impact on stock price if g is 4 percent or 6 percent? If R is 9 percent or 11 percent?

Answer 1

Yes. Its value will change.

As per DCF formula, Stock value = D1/(1+R) + D2/(1+R)^2 …. + D/((R-g)*(1+R)^n)

If n is zero, value = D/(R-g)

Since the company does not grow for first three years, its D will remain constant. (Assumed $1). The table below gives the stock value in that case. This would have been $ 14.3 if the steady state has been already reached.

Div	1	1	1	1
Steady state value				14.3
Present Value	0.88	0.78	0.69	8.76
Stock Value	11.12

2. Stock price change based on the expected growth company is expected to achieve. It also varies with the returns expected by the investors which may change as the risk profile of the stock or changes in economic conditions.

As per steady state formula, Stock price = D/(R-g)

                                Where D – dividend.

                                                R – Returns expected

                                                g – Growth rate expected.

Based on the formula, following table gives the value of stock for different R and g.

Dividend >	$2
R (Right)/ g (Down)	9%	10%	11%
4%	40	33	29
5%	50	40	33
6%	67	50	40