Question

Integrated Case - Mutual of Chicago Insurance Company

9-23 Stock Valuation Robert Balik and Carol Kiefer are senior Vice presidents of the mutual of Chicago Insurance Company. They are codirectors of the company;s pension funds management division, with Balik having responsibility for fixed-income securities, (primarily bonds) and Keifer being responsible for equity investments. A major new client, the California League of Cities, has requested that Mutual of Chicago present an investment seminar to the mayors of the represented cities; Balik and Leifer, who will make the actual presentation, have asked you to help them.

To Illustrate the common stock valuation process, Balik and Kiefer 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.

a. Describe briefly the legal rights and privileges to common stockholders.

b.

1. Write a formula that can be used to value stock, regardless of the dividend pattern.

2. What is constant growth stock? How are constant groth stocks valued?

3. What are the implications if a company forecasts a constant g that exceeds its r _s? Will many stocks have expected g>r_s in the short run (i.e. for the next few years)? In the long run (i.e. forever)?

c. Assume that Bon Temps has a Beta coefficient of 1.2, that the risk-free rate (yield on the T bonds) is 3%, and that the required rate of return on the market is 8%. What is Bon Temp's required rate of return?

d. Assume that Bon Temps is a constant growth company whose last dividend (D₀, which was paid yesterday) was $2.00 and whose dividends expected to grow indefinitely at a 4% rate.

1. What is the firms expected dividend stream over the next 3 years?

2. What is the current stock price?

3. What is the stock's expected value 1 year from now?

4. What are the expected dividend yield, capital gains yield, and total return during the first year?

e. Now assume that the stock is currently selling at $40.00. What is the expected rate of return?

f. What would the stock price be if its dividends were expected to have zero growth?

g. Now assume that Bon Temp's dividend is expected to grow 30% the first year, 20% the second year, 10% the third year, and return to its long- run constant growth rate of 4%. What is the stocks value under these conditions? What are its expected dividend and capital gains in year 1? year 4?

h. Suppose Bon Temps is expected to experience zero growth during the first 3 years and the resume its steady-state growth of 4% in the fourth year. What would be its value then? What would its expected dividend and capital gains yields in year 1? year 4?

i. Finally assume that Bon Temp's earnings and dividends are expected to decline at a constant rate of 4% per year that is g+ 4%. Why would anyone be willing to buy such a stock, and at what price should it sell? What would be its dividend and capital gains yield each year?

Answer 1

a.

Ans

The common stockholders are the holders of equity shares issued by the companies, which are typically private limited companies and public limited companies. The legal rights and privileges can be summarized as below

• The right to vote in annual general meeting conducted by the company
• When the companies considers issuing rights issue. the first right to subscribe the equity shares are given to existing common stockholders

b.

Ans

The value of stock is normally determined by calculating the present value all future cash flows. The cash flows for equity stocks are dividends declared and paid to common stockholders. This can be put in following formula

P₀ = [D₁ / (1+r_s)^t] + [D₂ / (1+r_s)^t]—to infinity

Where

P₀ = value of equity stock

D = dividend distributed every year

r _s= required return of equity expected by equity stockholders

t = time period

2.

Ans

The constant growth stock is following features

• The stock declares and distributes dividend every year till infinity
• The rate of dividend declared grows every year at a constant rate

The formula to calculate the value of stock in constant growth rate is as below

P₀ = [D₁ / (r_{s -} g)]

P₀ = value of equity stock

D₁ = dividend distributed next year

R_s = required return of equity expected by equity stockholders

g = growth rate estimated

3.

Ans

The growth rate of stock exceeds expected rate of return on equity by stockholders will decrease the value of equity stock as of now . this is not logical simply because the holders equity stockholder will always expect higher rate of return than risk free instruments

In short run due to product and business life cycle can have super normal profit on its products and in this situation will have growth rate higher required rate of return of equity

In longer run profits will align with expected growth rate and constant growth stock becomes realistic