1. In March 2004, Fly Paper's stock sold for about $73. Security analysts were forecasting a long-term earnings growth rate of 8.5 percent. The company is expected to pay a dividend of $1.68 per share
a. Assume dividends are expected to grow along with earnings at g 8.5 percent per year in perpetuity. What rate of return r were investors expecting?
b.Fly Paper was expected to earn about 12 percent on book equity and to pay out about 50 percent of earnings as dividends. What do these forecasts imply for g? For r? Use the perpetual-growth DCF formula.
2. The table shows a book balance sheet for the Wishing Well Motel chain. The company's long-term debt is secured by its real estate assets, but it also uses short-term bank financing. It pays 10 percent interest on the bank debt and 9 percent interest on the secured debt. Wishing Well has 10 million shares of stock outstanding, trading at $90 per share. The expected return on Wishing Well's common stock is 18 percent.
Balance sheet for Wishing Well, Inc. (figures in $ millions).
Cash and marketable securities 100 Bank loan 280
Inventory 50 Accounts payable 120
Accounts receivable 200 Current liabilities 400
Current assets 350
Real estate 2,100 Long-term debt 1,800
Other assets 150 Equity 400
Total 2,600 Total 2,600
Calculate Wishing Well's WACC. Assume that the book and market values of Wishing Well's debt are the same. The marginal tax rate is 35 percent.
The solution has two problems - one relating to dividend discount model and the other relating to calculation of WACC