Mutual of Chicago Insurance Company
323Chapter 9 Stocks and Their Valuation
a. Describe briefly the legal rights and privileges of common stockholders.
b. (1) Write out 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 rs? Will many stocks
have expected g rs in the short run (that is, for the next few years)? In the long run (that is, forever)?
c. Assume that Bon Temps has a beta coefficient of 1.2, that the risk-free rate (the yield on T-bonds) is 7 per-
cent, and that the required rate of return on the market is 12 percent. What is Bon Temps’ required rate of
return?
d. Assume that Bon Temps is a constant growth company whose last dividend (D0, which was paid yester-
day) was $2.00 and whose dividend is expected to grow indefinitely at a 6 percent rate.
(1) What is the firm’s expected dividend stream over the next 3 years?
(2) What is its 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 $30.29. What is its 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 Temps is expected to experience nonconstant growth of 30 percent for the next 3
years, then to return to its long-run constant growth rate of 6 percent. What is the stock’s value under
these conditions? What are its expected dividend and capital gains yields in Year 1? Year 4?
h. Suppose Bon Temps is expected to experience zero growth during the first 3 years and then to resume its
steady-state growth of 6 percent in the fourth year. What would its value be then? What would its
expected dividend and capital gains yields be in Year 1? In Year 4?
i. Finally, assume that Bon Temps’ earnings and dividends are expected to decline at a constant rate of 6
percent 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 its dividend and capital gains yields in each year?
j. Suppose Bon Temps embarked on an aggressive expansion that requires additional capital. Management
decided to finance the expansion by borrowing $40 million and by halting dividend payments to increase
retained earnings. Its WACC is now 10 percent, and the projected free cash flows for the next 3 years are
$5 million, $10 million, and $20 million. After Year 3, free cash flow is projected to grow at a constant 6
percent. What is Bon Temps’ total value? If it has 10 million shares of stock and $40 million of total debt,
what is the price per share?
k. For Bon Temps’ stock to be in equilibrium, what relationship must exist between its estimated intrinsic
value and its current stock price and between its expected and required rates of return? Are the equilib-
rium intrinsic value and expected rate of return the values that management estimates or values as esti-
mated by some other entity? Explain.
l. If equilibrium does not exist, how will it be established?
m. Suppose Bon Temps decided to issue preferred stock that would pay an annual dividend of $5, and the
issue price was $50 per share. What would the expected return be on this stock? Would the expected rate
of return be the same if the preferred was a perpetual issue or if it had a 20-year maturity?
