A B C D E F G H I J

1 12/9/2012
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3 Chapter 7 Mini Case
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6 Situation
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Sam Strother and Shawna Tibbs are senior vice presidents of Mutual of Seattle. They are co-directors of the company's
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pension fund management division, with Strother having responsibility for fixed income securities (primarily bonds) and
10 Tibbs responsible for equity investments. A major new client, the Northwestern Municipal Alliance, has requested that
11 Mutual of Seattle present an investment seminar to the mayors of the cities in the association, and Strother and Tibbs,
12 who will make the actual presentation, have asked you to help them.
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15 To illustrate the common stock valuation process, Strother and Tibbs have asked you to analyze the Temp Force
Company, an employment agency that supplies word processor operators and computer programmers to businesses
16 with temporarily heavy workloads. You are to answer the following questions.
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19 a. Describe briefly the legal rights and privileges of common stockholders.
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21 Features of Common Stock
22 1. Common Stock represents ownership. 2. Ownership implies control. 3. Stockholders elect directors. 4. Directors
23 hire management who attempt to maximize stock price.
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25 Classified Stock
26 Classified Stock carries special provisions. For example, shares could be classified as founders' shares which come
27 with voting rights but dividend restrictions.
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29 b. (1.) Write out a formula that can be used to value any stock, regardless of its dividend pattern.
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31 THE DISCOUNTED DIVIDEND APPROACH
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34 The value of any financial asset is equal to the present value of future cash flows provided by the asset. When an
35 investor buys a share of stock, he or she typically expects to receive cash in the form of dividends and then, eventually,
to sell the stock and to receive cash from the sale. Moreover, the price any investor receives is dependent upon the
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dividends the next investor expects to earn, and so on for different generations of investors. Thus, the stock's value
37 ultimately depends on the cash dividends the company is expected to provide and the discount rate used to find the
38 present value of those dividends.
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41 Here is the basic dividend valuation equation:
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43 D1 D2 DN
𝐏 ̂_𝟎 + + . . . .
44 = ( 1 + rs ) ( 1 + rs ) 2 ( 1 + rs ) N
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47 The dividend stream theoretically extends on out forever, i.e., n = infinity. Obviously, it would not be feasible to deal
with an infinite stream of dividends, but fortunately, an equation has been developed that can be used to find the PV of
48 the dividend stream, provided it is growing at a constant rate.
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52 Naturally, trying to estimate an infinite series of dividends and interest rates forever would be a tremendously difficult
53 task. Now, we are charged with the purpose of finding a valuation model that is easier to predict and construct. That
54 simplification comes in the form of valuing stocks on the premise that they have a constant growth rate.
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 A B C D E F G H I J
56 (2.) What is a constant growth stock? How are constant growth stocks valued?
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58 VALUING STOCKS WITH A CONSTANT GROWTH RATE
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In this stock valuation model, we first assume that the dividend and stock will grow forever at a constant growth rate.
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Naturally, assuming a constant growth rate for the rest of eternity is a rather bold statement. However, considering the
63 implications of imperfect information, information asymmetry, and general uncertainty, perhaps our assumption of
64 constant growth is reasonable. It is reasonable to guess that a given firm will experience ups and downs throughout its
65 life. By assuming constant growth, we are trying to find the average of the good times and the bad times, and we
66 assume that we will see both scenarios over the firm's life. In addition to assuming a constant growth rate, we will be
67 estimating a long-term required return for the stock. By assuming these variables are constant, our price equation for
common stock simplifies to the following expression:
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71 D1
𝐏 ̂_𝟎
72 = ( rs – g )
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75 In this equation, the long-run growth rate (g) can be approximated by multiplying the firm's return on assets by the
76 retention ratio. Generally speaking, the long-run growth rate of a firm is likely to fall between 5% and 8% a year.
 A B C D E F G H I J
77
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79 (c.) What happens if a company has a constant g which exceeds rs? Will many stocks have expected g > rs in the
80 short run (i.e., for the next few years)? In the long run (i.e., forever)? Answer: See Chapter 7 PowerPoint file.
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82 c. Assume that Temp Force has a beta coefficient of 1.2, that the risk-free rate (the yield on T-bonds) is 7.0%, and that
83 the market risk premium is 5%. What is the required rate of return on the firm’s stock?
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86 CAPM = rRF + b (rRF – rM)
87 7% + 1.2(5%) = 13%
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89 d. Assume that Temp Force is a constant growth company whose last dividend (D0, which was paid yesterday) was
90 $2.00 and whose dividend is expected to grow indefinitely at a 6% rate.
91 (1.) What is the firm’s current stock price?
92 (2.) What is the stock's expected value 1 year from now?
93 (3.) What are the expected dividend yield, the capital gains yield, and the total return during the first year?
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96 Constant Growth Model:
97 INPUTS:
98 D0 = $2.00
99 g= 6%
100 rs = 13.0%
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102 D1 D0 (1 + g)
=
103 𝐏 ̂_𝟎= ( rs – g ) ( rs – g )
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105 D1 = D0 (1 + g) = $2.12
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107 D1 $2.12
P0 = =
108 ( rs – g ) 0.07
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111 𝐏 ̂_𝟎 $30.29
=
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113 Stock Price 1 year from now:
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115 D2
P1 =
116 ( rs – g )
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118 D2 = D1 (1+g) = $2.2472
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120 $2.2472
P1 =
121 0.07
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123 P1 = $32.10
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125 Dividend Yield = D1 CG Yield = P1 – P0
126 P0 P0
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128 Dividend Yield = $2.12 CG Yield = $1.82
129 $30.29 $30.29
 A B C D E F G H I J
130
131 Dividend Yield = 7.00% CG Yield = 6.00%
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135 Dividend CG
Total Yield = Yield + Yield
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137 Total Yield = 13.00%
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140 e. Suppose Temp Force’s stock price is selling for $30.29. Is the stock price based more on long-term or short-term
141 expectations? Answer this by finding the percentage of Temp Force’s current stock price that is based on dividends
142 expected during Years 1, 2, and 3.
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Managers often claim that stock prices are "short-term" in nature in the sense that they reflect what is happening in the
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short-term and ignore the long-term. We can use the results for the non-constant model to test this claim.
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148 INPUTS:
149 P0 = $30.29
150 D0 = $2.00
151 g= 6%
152 rs = 13.0%
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The first step is to forecast the dividends for the next 3 years. Then we find the present value of these dividends
155 and compare that PV with the current stock price, which reflects the PV of all future dividends.
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159 Year (t) 0 1 2 3
160 Dt = D0 (1+g)t $2.1200 $2.2472 $2.3820
161 PV(Dt) = Dt/(1+rs)t $1.8761 $1.7599 $1.6509
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163 Sum of PV(Divs.) $5.29
164 P0 $30.29
165 % of P0 due to 3 PV(Divs.) 17%
166 % of P0 due to long-term divs. 83%
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168 For most stocks, the percentage of the current price that is due to long-term cash flows is over 80%.
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171 f. Why are stock prices volatile? Using Temp Force as an example, what is the impact on the estimated stock price if g
172 falls to 5% or rises to 7%? If rs changes to 12% or to 14%?
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175 INPUTS:
176 P0 = $30.29
177 D0 = $2.00
178 g= 6%
179 rs = 13.0%
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181
182 D1 D0 (1 + g)
=
𝐏 ̂_𝟎=
 A B C D E F G H I J
=
183 𝐏 ̂_𝟎= ( rs – g ) ( rs – g )
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186 Estimated Price for Changes in Inputs
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188 Growth Rate: g Required Return: rs
189 11.0% 12.0% 13.0% 14.0% 15.0%
190 5% $35.00 $30.00 $26.25 $23.33 $21.00
191 6% $42.40 $35.33 $30.29 $26.50 $23.56
192 7% $53.50 $42.80 $35.67 $30.57 $26.75
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196 g. Now assume that the stock is currently selling at $30.29. What is its expected rate of return?
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198 Rearrange to rate of return formula
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200 D1
+ g
201 𝐫 ̂_𝐬= P0
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204 $2.12
+ 0.06
205 𝐫 ̂_𝐬= $30.29
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207 13%
𝐫 ̂_𝐬=
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h. Now assume that Temp Force’s dividend is expected to experience nonconstant growth of 30% from Year 0 to Year 1,
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25% from Year 1 to Year 2, and 15% from Year 2 to Year 3. After Year 3, dividends will grow at a constant rate of 6%.
212 What is the stock’s intrinsic value under these conditions? What are the expected dividend yield and capital gains yield
213 during the first year? What are the expected dividend yield and capital gains yield during the fourth year (from Year 3 to
214 Year 4)?
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217 For many companies, it is unreasonable to assume that it grows at a constant growth rate. Hence, valuation for these
218 companies proves a little more complicated. The valuation process, in this case, requires us to estimate the short-run
non-constant growth rate and predict future dividends. Then, we must estimate a constant long-term growth rate at
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which the firm is expected to grow. Generally, we assume that after a certain point of time, all firms begin to grow at a
220 rather constant rate. Of course, the difficulty in this framework is estimating the short-term growth rate, how long the
221 short-term growth will hold, and the long-term growth rate.
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225 Specifically, we will predict as many future dividends as we can and discount them back to the present. Then we will
226 treat all dividends to be received after the convention of constant growth rate with the Gordon constant growth model
described above. The point in time when the dividend begins to grow at a constant rate is called the horizon date.
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When we calculate the constant growth dividends, we solve for a horizon value (also called the terminal value or
228 continuing value) as of the horizon date. We can then find the present value of the dividends in the forecast period and
229 the present value of the horizon value, which gives the current estimated stock price.
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233 Process for Finding the Value of a Nonconstant Growth Stock
234 INPUTS:
235 D0 = $2.00 Last dividend the company paid.
236 rs = 13.0% Stockholders' required return.
 A B C D E F G H I J
237 g0,1 = 30% Growth rate for Year 1 only.
238 g1,2 = 25% Growth rate for Year 2 only.
239 g2,3 = 15% Growth rate for Year 3 only.
240 gL = 6% Constant long-run growth rate for all years after Year 3.
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242 Growth rate 30% 25% 15% 6% 6%
243 Year 0 1 2 3 4
244 Dividends $2.6000 $3.2500 $3.7375
245 ↓ ↓ ↓
246 D1 D2 D3 D4
247 ────── ────── ────── ──── =
(1+rs)1 (1+rs)2 (1+rs)3 (rs− gL) 𝐏 ̂_
248 𝟑
249 ↓
250 D3 (1+gL)
251 $2.301 ────── =
(rs− gL) 𝐏 ̂_
252 PVs of dividends $2.545 𝟑
253 $2.590 ↓
254 PV of HV3 $39.224 $56.596 $3.962
255 = ─────── $56.596 = ──── = 𝐏 ̂_
(1+rs)3 7.00% 𝟑
256 $46.661
𝐏 ̂_𝟎
257 =
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259 Expected Dividend and CG Yields at t = 0
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261 Dividend Yield = 5.6%
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263 CG Yield = 7.4%
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265 Total Return = 13.0%
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268 Expected Dividend and CG Yields at t = 3
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270 Dividend Yield = 0.0%
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272 CG Yield = 13.0%
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274 Total Return = 13.0%
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277 i. What is free cash flow (FCF)? What is the weighted average cost of capital? What is the free cash flow valuation
278 model? Answer: See Chapter 7 Mini Case Show
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282 j. Use a pie chart to illustrate the sources that comprise a hypothetical company’s total value. Using another pie chart,
283 show the claims on a company’s value. How is equity a residual claim? Answer: See Chapter 7 Mini Case Show
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286 k. Use B&B’s data and the free cash flow valuation model to answer the following questions.
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 A B C D E F G H I J
288 INPUT DATA SECTION: Data used for valuation (in millions)
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290 Free cash flow $24.0
291 WACC 11%
292 Growth 5%
293 Marketable securities $100.0
294 Debt $200.0
295 Preferred stock $50.0
296 Number of shares of stock 10.0
297
298 (1) What is its estimated value of operations?
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300 FCF1
Vop =
301 (WACC-g)
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303 $25.2
Vop =
304 0.06
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306 Vop = $420.00
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308 (2) What is its estimated total corporate value?
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310 Value of Operation $420.0
311 Plus Value of Non-operating Assets $100.0
312 Total Corporate Value $520.0
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314 (3) What is its estimated intrinsic value of equity?
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316 Debt holders have the first claim on corporate value. Preferred stockholders have the next claim and the remaining is
317 left to common stockholders.
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319 Total Corporate Value $520.0
320 Minus Value of Debt $200.0
321 Minus Value of Preferred Stock $50.0
322 Intrinsic Value of Equity $270.0
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325 (4) What is its estimated intrinsic stock price per share?
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327 Intrinsic Value of Equity $270.0
328 Divided by number of shares 10.0
329 Intrinsic price per share $27.00
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331
Estimating the Value of R&R’s Stock Price (Millions, Except for Per
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Share Data)
333 INPUTS:
334 Value of operations = $420.00
335 Value of nonoperating assets = $100.00
336 All debt = $200.00
337 Preferred stock = $50.00
338 Number of shares of common stock = 10.00
339 ESTIMATING PRICE PER SHARE
 A B C D E F G H I J
340 Value of operations $420.00
341 + Value of nonoperating assets 100.00
342 Total estimated value of firm $520.00
343 − Debt 200.00
344 − Preferred stock 50.00
345 Estimated value of equity $270.00
346 ÷ Number of shares 10.00
347 Estimated stock price per share = $27.00
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351 l. You have just learned that B&B has undertaken a major expansion that will change its expected free cash flows to −
$10 million in 1 year, $20 million in 2 years, and $35 million in 3 years. After 3 years, free cash flow will grow at a rate of
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5%. No new debt or preferred stock were added, the investment was financed by equity from the owners. Assume the
353 WACC is unchanged at 11% and it that there are still has 10 million shares of stock outstanding.
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356 (1.) What is its horizon value (i.e., its value of operations at year three)? What is its current value of operations (i.e.,
357 at time zero)?
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359
360 B&B's Value of Operations (Millions of Dollars)
361 INPUTS:
362 gL = 5.00%
363 WACC = 11.00% Projections
364 Year 0 1 2 3 4
365 FCF −$10.00 $20.00 $35.00
366 ↓ ↓ ↓
367 FCF1 FCF2 FCF3
368 ────── ────── ──────
369 (1+WACC)1 (1+WACC)2 (1+WACC)3
370 HV = Vop,3
371 FCF3(1+gL)
372 −$9.009 ─────────
373 PVs of FCFs $16.232 (WACC− gL)
374 $25.592
375 PV of HV $447.855 $612.50 $36.75
376 = ────── = ────
(1+WACC)3 6.00%
377 Vop = $480.67
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379
380 (2.) What is its value of equity on a price per share basis?
381
382
Estimating the Value of R&R’s Stock Price (Millions, Except for Per
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Share Data)
384 INPUTS:
385 Value of operations = $480.67
386 Value of nonoperating assets = $100.00
387 All debt = $200.00
388 Preferred stock = $50.00
389 Number of shares of common stock = 10.00
 A B C D E F G H I J
390 ESTIMATING PRICE PER SHARE
391 Value of operations $480.67
392 + Value of nonoperating assets 100.00
393 Total estimated value of firm $580.67
394 − Debt 200.00
395 − Preferred stock 50.00
396 Estimated value of equity $330.67
397 ÷ Number of shares 10.00
398 Estimated stock price per share = $33.07
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