# Question: A major new client has requested that Mutual of Chicago

A major new client has requested that Mutual of Chicago present an investment seminar to illustrate the stock valuation process. As a result, Campbell and Morris 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. What is the difference between common stock and preferred stock? What are some of the characteristics of each type of stock?

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 do you value a constant growth stock?

(3) What happens if the growth is constant and g > rs? Will many stocks have g > rs?

c. Bon Temps has an issue of preferred stock outstanding that pays stockholders a dividend equal to $10 each year. If the appropriate required rate of return for this stock is 8 percent, what is its market value?

d. Assume that Bon Temps is a constant growth company whose last dividend (D0, which was paid yesterday) was $2 and whose dividend is expected to grow indefinitely at a 6 percent rate. The appropriate rate of return for Bon Temps’ stock is 16 percent.

(1) What is the firm’s expected dividend stream over the next three years?

(2) What is the firm’s current stock price?

(3) What is the stock’s expected value one year from now?

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

e. Assume that Bon Temps’ stock is currently selling at $21.20. What is the expected rate of return on the stock?

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

g. Assume that Bon Temps is expected to experience supernormal growth of 30 percent for the next three 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 yield and its capital gains yield in Year 1? In Year 4?

h. Suppose Bon Temps is expected to experience zero growth during the first three years and then to resume its steady-state growth of 6 percent in the fourth year. What is the stock’s value now? What are its expected dividend yield and its capital gains yield in Year 1? In Year 4?

i. Assume that Bon Temps’ earnings and dividends are expected to decline by a constant 6 percent per year—that is, g = – 6%. Why might someone 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?

a. What is the difference between common stock and preferred stock? What are some of the characteristics of each type of stock?

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 do you value a constant growth stock?

(3) What happens if the growth is constant and g > rs? Will many stocks have g > rs?

c. Bon Temps has an issue of preferred stock outstanding that pays stockholders a dividend equal to $10 each year. If the appropriate required rate of return for this stock is 8 percent, what is its market value?

d. Assume that Bon Temps is a constant growth company whose last dividend (D0, which was paid yesterday) was $2 and whose dividend is expected to grow indefinitely at a 6 percent rate. The appropriate rate of return for Bon Temps’ stock is 16 percent.

(1) What is the firm’s expected dividend stream over the next three years?

(2) What is the firm’s current stock price?

(3) What is the stock’s expected value one year from now?

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

e. Assume that Bon Temps’ stock is currently selling at $21.20. What is the expected rate of return on the stock?

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

g. Assume that Bon Temps is expected to experience supernormal growth of 30 percent for the next three 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 yield and its capital gains yield in Year 1? In Year 4?

h. Suppose Bon Temps is expected to experience zero growth during the first three years and then to resume its steady-state growth of 6 percent in the fourth year. What is the stock’s value now? What are its expected dividend yield and its capital gains yield in Year 1? In Year 4?

i. Assume that Bon Temps’ earnings and dividends are expected to decline by a constant 6 percent per year—that is, g = – 6%. Why might someone 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?

## Answer to relevant Questions

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