Take home exercise no.

4
Part A

Assume that Bon Temps has a beta coefficient of 1.4, that the risk-free rate (the
yield on T-bonds) is 3%, and that the required rate of return on the market is 8%.
What is Bon Temps's required rate of return?

𝑅𝐹 = 3%
B=1.4
𝑅𝑀 = 8%
𝑅𝑆 = 3 + 1. 4(8 − 3)=10%

Part B

Part B Assume that Bon Temps is a constant growth company whose last dividend

(D0, which was paid yesterday) was $2.20 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? (3) What is the stock’s expected value one

year from now? (4) What are the expected dividend yield, capital gains yield, and

total return during the first year?

(1) What is the firm's expected dividend stream over the next 3 years?

Formula: 𝐷𝑛 = 𝐷(𝑛−1) * ( 1 + g )

𝐷1 = 𝐷0 * (1 + 𝑔) = 2. 20 * (1 + 4%) = 2.29

𝐷2 = 𝐷1 * (1 + 𝑔) = 2. 29 * (1 + 4%) = 2.38

𝐷3 = 𝐷2 * (1 + 𝑔) = 2. 38 * (1 + 4%) = 2.48
 (2) What is its current stock price?

𝐷1 2.29
𝑃0 = 𝑅−𝑔
= 10% − 4%
= 38. 17
(3) What is the stock’s expected value one year from now?

𝐷2 2.38
𝑃1 = 𝑅−𝑔
= 10% − 4%
= 39. 67
(4) What are the expected dividend yield, capital gains yield, and total return during the first.

year?

𝐷1 2.29
Expected dividend yield = 𝑃0
= 38.17
= 0. 06 = 6%

𝑃1− 𝑃0 39.67 − 38.17

Capital gain yield = 𝑃0
= 38.17
= 0.04 = 4%

Total return = Dividend yield + Capital gain yield = 6% + 4% =10%

Part C
Now assume that the stock is currently selling at $40.00. What is its
expected rate of return?

𝐷1 𝑃1−𝑃0 2.29 39.67−40

Expected rate of return = 𝑃0
+ 𝑃0
= 40
+ 40
= 4. 9%

Part D
What would the stock price be if its dividends were expected to have zero growth?
If Bon Temps' dividends were not expected to grow, its dividend stream would be
perpetuity. So D1=D2=D3=D0=$2.2, g=0
𝐷 2.2
=> P0 = 𝑅
= 10%
= $ 22
Part E
Now assume that Bon Temps's dividend is expected to grow 30% the first year,
20% the second year, 10% the third year, and return to its long-run constant growth
rate of 4%. What is the stock’s value under these conditions? What are its expected
dividend and capital gains yields in Year 1? In Year 4?

Now assume that Bon Temps's dividend is expected to grow 30% the first year, 20% the second
year, 10% the third year, and return to its long-run constant growth rate of 4%. What is the
stock’s value under these conditions? What are its expected dividend and capital gains yields in
Year 1? In Year 4?
a) 𝐷0 = $2.20 r = 10%

𝐷1 = $2.86 𝐷2 = $3.432 𝐷3 = $3.7752 𝐷4 = $3.926208

𝐷4
𝑃3 = 𝑅− 𝑔4
= $65.4368

𝐷1 𝐷2 𝐷3 𝑃3
𝑃0 = 1+𝑟
+ 2 + 3 + 3 = $57.44
(1+𝑟) (1+𝑟) (1+𝑟)

b)
𝐷1
Dividend Yield at Y1 = 𝑃0
= 4.98%

Capital Gains Yield at Y1 = r - Dividend Yield at Y1 = 5.02%

𝐷4
Dividend Yield at Y4 = 𝑃3
= 6%

Capital Gains Yield at Y4 = r - Dividend Yield at Y4 = 4%

Part F
Suppose Bon Temps is expected to experience zero growth during the first 3 years and
then resume its steady-state growth of 4% in the fourth year. What would be its value
then? What would be its expected dividend and capital gains yields in Year 1? In Year 4?
a) 𝐷0 = $2.20 r = 10% 𝐷1 = $2.20 𝐷2 = $2.20 𝐷3 = $2.20 𝐷4 = $2.288

𝐷4
𝑃3 = 𝑅− 𝑔4
= $38.13

𝐷1 𝐷2 𝐷3 𝑃3
𝑃0 = 1+𝑟
+ 2 + 3 + 3 = $34.12
(1+𝑟) (1+𝑟) (1+𝑟)

b)
𝐷1
Dividend Yield at Y1 = 𝑃0
= 6.45%

Capital Gains Yield at Y1 = r - Dividend Yield at Y1 = 3.55%

𝐷4
Dividend Yield at Y4 = 𝑃3
= 6%

Capital Gains Yield at Y4 = r - Dividend Yield at Y4 =4%

Part G
Finally, assume that Bon Temps’s earnings and dividends are expected to decline
at a constant rate of 4% per year, that is, g = -4%. 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?

The current dividend of $2.20 will be decreased -4%, so the value of stock:

𝐷 2.20(1−4%)
𝑃0= (𝑅−𝑔
1
)
= (10%+4%)
= $15. 08

The stock will be acceptable for buying only if it is still undervalued.

2.20(1−4%)
Dividend yield= 15.08
= 14%
Capital gain yield= 10% − dividend yield=10%-14%=-4%
Part H
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 8%, 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 5%. What is Bon
Temps’s market value of operations? If it has 10 million shares of stock, $40 million of
debt and preferred stock combined, and $5 million of non operating assets, what is the
price per share?

𝐷3 × (1+𝑟) 20 × (1+5%)
Value at the end of year 3: 𝑃3= 𝑅−𝑟
= 8%−5%
= $700 M
Market value will be:

𝐷1 𝐷2 𝐷3 𝑃3
P= 1+𝑅
+ 1+𝑅
+ 1+𝑅
+ 1+𝑅
−5 10 20 700
= 1 + 8%
+ 2 + 3 + 3 = $575.5M
(1+8%) (1+8%) (1+8%)

If it has 10 million shares of stock, $40 million of debt and preferred stock combined, and
$5 million of non-operating assets, the price per share will be:

𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦 − 𝐷𝑒𝑏𝑡 $575.5 − $40

Price per share = 𝑆ℎ𝑎𝑟𝑒 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
= $10
= $53.55
Part I
Suppose Bon Temps decided to issue preferred stock that would pay an
annual dividend of $6 and that the issue price was $100 per share. What
would be the stock's expected return? Would the expected rate of return be
the same if the preferred was a perpetual issue or if it had a 20-year maturity?

$6
RP = DP / PP + g = $100
+ 0 = 6%

If the preferred has a 20-year maturity its value would be calculated as follows:
Enter the following inputs into your financial calculator: N=20; I/YR=10; C=6;
FV=100; and then solve for PV=$100
Yes, the expected rate of return will be the same if the preferred stock had a 20-year
maturity.