Question

1. Robert Campbell and Carol Morris are senior vice-presidents of the Mutual of Chicago Insurance Company. They are co-directors of the company’s pension fund management division. A major new client has requested that Mutual of Chicago present an investment seminar to illustrate the stock valuation process. As a result, Campbell and Morris 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.

1. What happens if the growth is constant, and g > r_s? Will many stocks have g > r_s?
2. Assume that Bon Temps’ earnings and dividends are expected to decline by a constant 4% per year—that is, g = -4%. Why might someone be willing to buy such a stock, and at what price should it sell? What would be the dividend yield and capital gains yield in each year? Assume that the required rate of return is 16%. The dividend paid yesterday was $2.00.
3. Assume that Bon Temps is expected to experience supernormal growth of 25% for the next 4 years, then to return to its long-run constant growth rate of 8%. What is the stock’s value under these conditions? What are its expected dividend yield and its capital gains yield in Year 1? In Year 6? Assume that the required rate of return is 16%. The dividend paid yesterday was $2.00.

Answer 1

1.
If growth rate is constant, it becomes
Price=D1/(rs-g)

If g>rs, the formula does not work
No, not many stocks will have g>rs

2.
=2*(1-4%)/(16%-(-4%))
=9.6

3.
=2*1.25/1.16+2*(1.25/1.16)^2+2*(1.25/1.16)^3+2*(1.25/1.16)^4+2*(1.25/1.16)^4*1.08/(16%-8%)
=$46.08277

4.
Expected Dividend yield=2*1.25/46.08277=5.4250%

Expected Capital gains yield=16%-5.4250%=10.5750%