d. TTC recently introduced a new line of products that has been wildly successfu
ID: 2615988 • Letter: D
Question
d. TTC recently introduced a new line of products that has been wildly successful. On the basis of this s ce d anticipated future success, the following free cash flows were projected Year 2 3 4 s 6 7 8910 CF $5.5 12.1 $23.8 $44.1 $69.0 $888 $1075 $128.9 $147.1 $161.3 After the tenth year, TTC's financial planners anticipate that its free cash flow will grow at a constant rate of 6%. Also, the firm concluded that the new product caused the WACC to fall o 9%. The market value of TTC's debt is $1,200 million; it uses no preferred stock; and there are 20 million shares of common stock outstanding. Use the corporate valuation model to value the stock. 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 fund management division, with Balik having responsibility for fixed-income securities (primarily bonds) and Kiefer being responsable 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; and Balik and Kiefer, 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 of common stockholders b. 1. Write a formula that can be used to value any stock, regardless of its dividend pattern. 2. What is a constant growth stock? How are constant growth stocks valued? 3. What are the implications if a company forecasts a constant g that exceeds its r,? Will many stocks have expected g > r, in the short run (Gue, for the next few years)? In the long run (le, forever)? c. Assume that Bon Temps has a beta coefficient of 1.2, that the risk-free rate (the yield on T-bonds) is 3%, and that the required rate of return on the market is 8 return? what is Bon Temps's required rate of d. Assume that Bon Temps is a constant growth company whose last dividend (Do. which was paid yesterday) was $2.00 and whose dividend is expected to grow indefinitely at a 4% rate. 1. What is the firm's expected dividend stream over the next 3 years? 2. What is its current stock price?Explanation / Answer
Since, there are multiple parts to the question and some parts having multiple sub-parts, I have answered the first four parts (part a to part d) with all the subparts.
______
Part a)
Shareholders are the owners of the company. They own the company in proportion to the shares held by them. As such they are entitled to following rights and privileges:
1) Right to Appoint Directors
Shareholders are entitled to appoint directors as a result of their ownership control. These directors, in turn, appoint managers who are responsible for managing/conducting the affairs of the business.
2) Right to Purchase Additional Shares
The existing shareholders generally have the first right to purchase any additional shares that may be issued by the company. It is also known as pre-emptive right. Such a right may normally included in the corporate charter.
3) Entitlement to Share in Profitability
The shareholders are entitled to received dividends as and when declared by the company. In the absence of any dividends, they indirectly get rewarded in the form of capital appreciation of their investments. Such a situation may occur when the company decides to retain its income (rather than distribute it as dividends) for undertaking expansion/growth projects or reducing debt in its capital structure.
_____
Part b)
1)
The formula that can be used to value any stock, regardless of its dividend pattern is provided as below:
P0 = D1/(1+rs)^1 + D2/(1+rs)^2 + D3/(1+rs)^3 + D4/(1+rs)^4 + D4/(1+rs)^5.............D/(1+rs)
where P0 = Value of Stock Today, D1 = Dividend Year 1, D2 = Dividend Year 2, D1 = Dividend Year 2 and so on, and rs = Required Return on Stock
The above formula indicates that the value of the stock is equal to the sum of the present value of its dividends expected to be paid in the future.
_____
2)
As the name suggests, a constant growth stock is one, the dividends of which are expected to grow at a constant rate in the future. In other words, the dividends are expected to grow evenly in the near future. The formula for valuing constant growth stocks is given below:
P0 = D1/(rs - g)
where P0 = Value of Stock Today, D1 = Dividend Year 1, rs = Required Return on Stock and g = growth rate (which is constant)
_____
3)
If we use the above model (as mentioned in Part 2), a growth rate (g) which is greater than the required return (rs) will provide us with a negative stock price. Such a situation may hold true in short run with respect to stocks having supernormal growth. However, it is practically impossible for any company to continually have a supernormal growth over a long period of time. Therefore, in the long run the growth rate (g) is not likely to exceed the required rate of return on the stock (rs).
_____
Part c)
In the given case, the required rate of return can be calculated with the use of following formula for CAPM:
Rs = Rf + b*(Rm - Rf)
where Rs = Required Return on Stock, Rf = Risk Free Rate, b = Beta, and Rm = Market Rate of Return
Substituting values in the above formula, we get,
Required Rate of Return = 3% + 1.2*(8% - 3%) = 9%
_____
Part d)
1)
The expected dividend stream over next three years is given as below:
D1 = D0*(1+g) = 2*(1+4%) = $2.08
D2 = D1*(1+g) = 2.08*(1+4%)= $2.16
D3 = D2*(1+g) = 2.16*(1+4%) = $2.25
_____
2)
The current stock price is calculated as follows:
P0 = D0*(1+g)/(Rs - g)
where D0 = $2, g= 4% and Rs = 9% (from part c)
Substituting values in the above formula, we get,
P0 = 2*(1+4%)/(9% - 4%) = $41.60
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.