Home Products, Inc. (HPI) is a leading manufacturer of prescription and ethical drugs; specialty foods and candies; and proprietary drugs. Important product names include Advil, Anacin, Dimetapp, Norplant and Robitussin. Total revenues in the last fiscal year were in excess of $9 billion.

Long Term Debt

The company has a capital structure that is made up of 34 percent long-term debt, 3 percent preferred stock, and 63 percent common stock. One of the two largest domestic long-term debt issues is a 9 1/8 percent coupon bond that is due in 26 years. This debenture is currently selling for $930. The bond is callable in seven years and if called will be redeemed at a premium of 104.4375. The other large publicly held bond is a 9 percent coupon bond that is due in nine years. This debenture is selling for $972.50. Both of these bonds are rated A by Moody's.

Preferred Stock

The preferred stock is $2.75 cumulative preferred with a stated value of $30.50, but it is currently selling for $30. More than 5.5 million shares were issued in February 1979 in connection with a merger of FDS Holding Company into a subsidiary of HPL. The preferred stock has no voting rights unless the company is an arrears on six or more quarterly dividends, and then each shareholder is entitled to one- quarter vote per share. In the event of liquidation each share is entitled to $30.50 plus accrued dividends.

Common Stock

Returns from common stock come from the cash dividend payment and/or changes in the price of stock. Investors receiving dividends can expect them to grow over time, but some stocks do not pay dividends, especially during their early growth years. As firms mature, they typically start paying dividends and then management is very reluctant to reduce the dividend. For the firms that do not pay dividends, the normal assumption is that the earnings are being retained by the firm to promote growth; thus, the stock price should grow at a higher rate than firms that have high payment ratios.

Two major factors that affect the price of stock are changes in the required rate of return caused, primarily by changes in the risk, and change in the growth rate of earnings, which is turn create changes in the growth rate of dividends.

The common stock of Home Products currently has over 95 million shares of $ 3.125 par value stock outstanding. A share of common stock presently sells for $405/8 and pays a quarterly dividend of $0.385. A consensus estimate (Zack's and IBES) indicates that earnings and dividends are expected to grow at an annual rate of 9.7 percent for the next five years. The common shares have no preemptive rights. Stock holders of HPI have the opportunity to buy additional shares of common stock through a plan of automatic dividend reinvestment optional cash purchase. This plan allows stock holders to have their dividends reinvested in shares of common stock, and they can purchase additional shares at the market price (with no commission) each month. Shareholders who participate in this plan are limited to a total of $1000 per month that they can use to purchase additional shares.

QUESTIONS

1. Look at the 9 1/8 percent coupon bond. What is the current yield, its yield-to-first call and

its yield-to-maturity?

2. Do you think this bond will be called? Why or why not?

3. What would be the value of the 9 1/8 percent coupon percent if the time of maturity was 10 years rather than 26 years? Can you explain why your answer is correct?

4. What is the required rate of return for the preferred stock? How does this rate compare to the YIM for the HPI 9 1/8 percent bond? Is this difference what would you have expected

from a risk/return standpoint? Why or why not?

5. In the event of liquidation, HPI preferred stockholders are entitled to $30.50 plus accrued

dividends. Does this mean that preferred stockholders will receive that amount?

6. What is the dividend yield and the expected capital gains yield for HPI common stock?

7. Given that HPI selling for $405/8, what is its required rate of return? (Use the constant

growth valuation model.)

8. Assume that the risk-free rate is 7 percent and that the expected return of the market is 12 percent. According to the security market line valuation model, what is the required rate of return for HPI common stock if its beta is 1.10?

9. Using the constant growth valuation model, find the present value of HPI common stock.

Would you buy or sell?

10. The constant growth value is used in text books as a conceptual model to explain changes in stock prices. Is the model also of value for the actual valuation of stocks?