Module Five Mini Case: Corporate Finance - Assignment Example

Running Head: minicase Module Five Mini Case of the of the of the . Module Five Mini Case a. Describe briefly the legal rights and privileges of common stockholders (Ehrhardt & Brigham, 2006). Common stockholders are owners of the company, though of a very small part. As they own the company, they have the right to vote and elect the board of directors. Secondly they have the preemptive right, i.e. the right to buy any additional shares issued by the company. b. (1) Write out a formula that can be used to value any stock, regardless of its dividend pattern (Ehrhardt & Brigham, 2006). = (2) What is a constant growth stock How are constant growth stocks valued (Ehrhardt & Brigham, 2006) Constant growth stocks are stocks whose dividends are expected to grow at a constant rate in the future. They are valued with the following formula: = = . (3) What happens if a company has a constant g that exceeds its rs Will many stocks have expected g > rs in the short run (i.e., for the next few years) In the long run (i.e., forever) (Ehrhardt & Brigham, 2006) The above model can only be used when g is less than rs, otherwise it would give a negative stock value which isn't logical. Therefore the formula can only be used when i. g is less than rs ii. g is expected to be constant iii. g is expected to continue indefinitely. In the short-run, stocks may have super normal growth, in which g > rs However, this isn't sustainable, and therefore in the long-run g < rs. 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 the market risk premium is 5%. What is the required rate of return on the firm's stock (Ehrhardt & Brigham, 2006) rs = rRF + (rM - rRF) Temp Force = 7% + (12% - 7%)(1.2) = 7% + (5%)(1.2) = 7% + 6% = 13%. d. Assume that Temp Force is a constant growth company whose last dividend (D0, which was paid yesterday) was $2.00 and whose dividend is expected to grow indefinitely at a 6% rate. (1) What is the firm's expected dividend stream over the next 3 years (Ehrhardt & Brigham, 2006) 0 1 2 3 4 | | | | | D0 = 2.00 2.12 2.247 2.382 1.88 1.76 1.65 . . . (2) What is the firm's current stock price (Ehrhardt & Brigham, 2006) = = = = $30.29. (3) What is the stock's expected value 1 year from now (Ehrhardt & Brigham, 2006) = = = = $32.10. (4) What are the expected dividend yield, the capital gains yield, and the total return during the first year (Ehrhardt & Brigham, 2006) Total return = 13.0% Dividend yield = $2.12/$30.29 = 7.0% Capital gains yield = 6.0% The dividend yield in the first year is 10 percent, while the capital gains yield is 6 percent. e. Now assume that the stock is currently selling at $30.29. What is the expected rate of return on the stock (Ehrhardt & Brigham, 2006) s= s= $2.12/$30.29 + 0.060 = 0.070 + 0.060 = 13%. f. What would the stock price be if its dividends were expected to have zero growth (Ehrhardt & Brigham, 2006) 0 1 2 3 | | | | 2.00 2.00 2.00 1.77 1.57 1.39 . . . P0 = 15.38 P0 = PMT/r = $2.00/0.13 = $15.38. g. Now assume that Temp Force is expected to experience supernormal growth of 30% for the next 3 years, then to return to its long-run constant growth rate of 6%. What is the stock's value under these conditions What is its expected dividend yield and capital gains yield in Year 1 In Year 4 (Ehrhardt & Brigham, 2006) 0 1 2 3 4 | | | | | 2.600 3.380 4.394 4.658 2.301 2.647 3.045 46.116 54.109 The stock price is $54.109, under these conditions. Dividend yield = = 0.0480 = 4.8%. Capital gains yield = 13.00% - 4.8% = 8.2%. The dividend yield in year 1 is 4.80 percent, and the capital gains yield is 8.2 percent. After year 3, the stock becomes a constant growth stock, with g = capital gains yield = 6.0% and dividend yield = 13.0% - 6.0% = 7.0%. h. Is the stock price based more on long-term or short-term expectations Answer this by finding the percentage of Temp Force's current stock price based on dividends expected more than 3 years in the future (Ehrhardt & Brigham, 2006). = 85.2%. The stock price is based on long-term expectations as around 85 percent of the stock price is determined by the dividends expected more than three years from now. i. Suppose Temp Force is expected to experience zero growth during the first 3 years and then to resume its steady-state growth of 6% in the fourth year. What is the stock's value now What is its expected dividend yield and its capital gains yield in Year 1 In Year 4 (Ehrhardt & Brigham, 2006) 0 1 2 3 4 | | | | | 2.00 2.00 2.00 2.00 2.12 1.77 1.57 1.39 20.99 25.72 = During year 1: Dividend Yield = = 0.0778 = 7.78%. Capital Gains Yield = 13.00% - 7.78% = 5.22%. In year 4 Temp Force becomes a constant growth stock; hence g = capital gains yield = 6.0% and dividend yield = 7.0%. j. Finally, assume that Temp Force's earnings and dividends are expected to decline by a constant 6% per year, that is, g = -6%. Why would anyone 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 (Ehrhardt & Brigham, 2006) As the company is giving out some dividends, therfore it must have a value greater than zero. Therefore, some people buy suc stocks. = = = = = $9.89. Since it is a constant growth stock: g = Capital Gains Yield = -6.0%, hence: Dividend Yield = 13.0% - (-6.0%) = 19.0%. The dividend and capital gains yields are constant over time, but a high (19.0 percent) dividend yield is needed to offset the negative capital gains yield. k. What is market multiple analysis (Ehrhardt & Brigham, 2006) The market multiple analysis is an another way of valuing stocks, in which market-determined multiple is applied to netincome, salaes, book value, or subscribers. For example, if a company's forecasted EPS is $10, and the average price per share to EPS (P/E ratio) is for similar companies is 15, then the estimated stock price per share is $150 ($10 x 15). In the P/E multiple analysis, we take the company's EPS and multiply it with the market multiple to get the stock's value. However, there are some problems in using the market multiple analysis. Firstly, it is hard to find comparable firms. Secondly, the average ratio for the sample of comparable firms often has a wide range. For example, the average P/E ratio might be 20, but the range could be from 10 to 50. Reference Ehrhardt, M. C., & Brigham, E. F. (2006). Financial Management: Theory & Practice. Thomson South-Western. Read More