204 ANSWERS: Some downward adjustment seems appropriate. The DOL affects the market or systematic risk of the firm and beta is, of course, a measure of such risk. Thus if the DOL decreases, then so does the firm’s market risk, and consequently, its beta. Stated differently, the .8-1.2 beta range is apparently based on information obtained when Taylor’s market risk was higher than it is now. Though some downward adjustment seems appropriate, it is another question how much the beta estimate should be decreased. The CAPT can be used as follows: K = B(Ka ~ Kp) where K, is the risk-free rate and K, - K, is the risk premium investors require to purchase the stock of a company with average market risk. The risk-free (long-term government bond) rate is 7% (Exhibit Four), and the risk-premium on the average risk stock is 7.2% based on the information in Exhibit Two. Beta estimates are .8 to 1.2, but appear a bit high (see Question 1) and we will, therefore, use the lower limit of this range. K, = -07 + .8 (.072) = .1276 The dividend valuation model (DVM) is another technique for estimating K,. Assuming continuous growth, a K, estimate is based on D K=P, +g where D, is the expected dividend in one year, P, is the current market price, and g is the expected growth in future dividends. We will estimate P, using the average of the high and low price shown in Exhibit Four: P, = (36 + 28)/2 = $32. Estimates of D, and g are a bit more difficult. Note that “a look backwards" is no help. Based on information in the case, DPS growth will increase and should become more in line with EPS growth. But past EPS growth has been quite high and is not expected to continue (the arithmetic average of the annual EPS increases in Exhibit Three is 32% and the geometric mean is 31%). We can, however, use the Gordon model to obtainan estimate of g using b x R = g, where b is the proportion of earnings retained and R is the return on retained earnings. Using West’s estimates of .3 (one minus the estimated payout ratio of .7) and 12% we obtain g = 63% .12 = .036 our DVM K, estimate is K, = 27 x 2.83(1.036) + .036 32 2.05 + .036 = .100 = 10.0% 32 K Note that this estimate is 200 basis points above the current yield on Taylor’s long-term debt (see Exhibit Four). in our view this is uncomfortably close, and we choose to ignore the DVM estimate. It is interesting to speculate (and discuss with students) why the DVM gave us a low figure. Perhaps West has underestimated ROE and/or the retained earnings proportion. Or maybe his estimates are more short-term forecasts and it is inappropriate to apply a "continuous growth" model. Another possibility--inconsistent with efficient markets--is that West is right. If so, a market price of $32 is too high. We admit, however, that this $32 is not the current market price. If the stock is selling at $28 a share (the low end of the range given in Exhibit Four) the DVM K, estimate becomes 10.9%. This is more reasonable, but still seems a bit low. c. We like 12.76%--or thereabouts--an estimate based on the CAPM. The calculation of capital structure at book values yields: a Source $ Amount 4 of Total Notes 7 Bonds 38 Equity 35 100 The required return on the short term debt K,, is .07 (1-.4) = 4.2%. The required return on the bonds, K,, is -08(1-.4) = 4.8%. Assuming a K, of 12.76%, then the required return, K, is estimated by: K = .07(4.2%) + .38(4.8%) + .55(12.76%) 29% + 1.82% + 7.02% 9.13% K The key here is that most preferred stock is purchased by 205Wd 206 corporations and the dividends they receive are largely tax exempt. Thus, many firms view the purchase of preferred stock the way investors view tax exempt municipal bonds. What is relevant is the after-tax return investors receive from preferred stock and bonds. If the yields on these investments were adjusted for taxes, the after-tax return on preferred would be higher. a. Let’s start by using the information in Exhibit Six. Eizn super Foods 7.5% Easton 7.3% Weston 6.7% The average of these estimates is 7.2%. Taylor’s is certainly higher since Taylor is considered riskier than all three of these firms. It is tempting to raise this average above Taylor’s (before-tax) cost of debt since preferred stock is a riskier investment than bonds. As explained in Question 4, however, it is quite possible that the yield on a firm’s bonds exceeds the yield on its preferred. Since the yield differences on preferred stock of firms in roughly the same industry tend to be 75-100 basis points, let’s adjust by 80 basis points, to 8% (a nice round number!). Using the target weights given in the question, K is calculated as follows: K = .05(4.2%) + .40(4.8%) + .05 (8%) + .50(12.76%) K = .218 + 1.92% + .40% + 6.38% K = 8.91% To make a more informed estimate of K,, it would be helpful to know more about Taylor’s projected EPS growth and current market price in order to more intelligently apply the dividend valuation model. It would also be useful to have a beta estimate based on Taylor’s new (and lower) degree of operating leverage in order to get a more precise risk premium. Regarding the required return on preferred stock, it would be useful to know in quantifiable terms how much riskier Taylor is than its competitors. a. It is reasonable to assume that the market value of the notes payable is somewhere near its book value. These securities have relatively short maturities, and thus, narket prices are not likely to be significantly affected by interest rate changes. b. From Exhibit Five, the book value of Taylor’s bonds is