Question

Sara Smith is a surgical nurse at Orlando Surgery Centers (OSC), a small for-profit ambulatory surgery center whose stock is traded in the OTC market. A few nights ago, Sara received a call from her mother asking for some advice regarding a stock recommendation. Her mother said that her broker had recommended adding 1,000 shares of WSC stock to the family’s retirement portfolio. Because Sara worked at OSC, her mother thought that Sara might have some special insights.

            Sara was finishing up her master’s degree in healthcare administration at AdventHealth University, so she thought this would be a good opportunity to apply some of the stock valuation concepts she had learned. To begin, she looked up some basic data:

• OSC beta coefficient= 1.70
• Yield on treasury bonds (risk-free rate) = 5 percent
• Required rate of return on the market portfolio= 12 percent
• Last dividend paid= $1.60
• Expected growth rate= a constant 8.0%, or alternatively, 12% for 3 years and 7% constant growth thereafter.
• Current stock price= $18.50

Now, she must use this information to make some judgements about whether or not her mother should follow he broker’s advice.

Part a

Use the Security Market Line (SML) of the capital asset pricing model (CAPM) to estimate the required rate of return on the stock.

Required rate of return = Rf + B(Rm – Rf) = 5 + 1.7(12 – 5) = 16.90%

Part b

Estimate the current fair value of the stock using the constant growth valuation model.

Current fair value = P=D0(1 + G)/Ke-G = P=1.60(1 + 0.08)/0.169 – 0.08 = P=$19.42

Part c

Calculate the expected rate of return.

Part d

Use the non-constant growth model to estimate OSC’s fair value.

P = Dividend/cost of equity = P=1.6/0.169 = P=$9.47

Part e

Based on parts a – d, should the stock be purchased? Please explain

I NEED C AND E ANSWERED ONLY PLEASE.

Answer 1

We shall calculate the expected rate of return by using the Constant growth valuation model,

As per constant growth valuation model ,

Fair Value ={ D0(1 + G)/Ke} + G

We shall replace the Fair value by current stock price and Ke by Expected return E(r) ,

Current Price = {D0(1 + G)/E(r) } + G

E(r) ={ D0(1 + G) / Current Price } + G

= 1.60 ( 1 +0.08 ) / 18.50 + 0.08

= 1.728 / 18.50 + 0.08

= 0.1734

Expected return = 17.34%

e) On the basis of b & d , the required rate of return is 16.90% although the expected rate of return is 17.34%, the stock is trading cheap and stock should be bought.

On the basis of part b current stock price is $18.50 versus the fair value which is $19.42 , the stock is trading cheap and stock should be bought.

On the basis d the fair value comes to $9.47 which is less than the current market price of $18.50 hence the stock is trading costly and the investor should not buy the stock.