Home Products: Stock and Bond Valuation

This case discusses the valuation of stocks and bonds. It says that in textbooks, the
valuation of stocks and bonds is simply stated as the present value of all the future cash
flows expected from the security. The concept is logical, straightforward, and simple.
The valuation of bonds is usually presented first, since the relatively certain cash flows
are broken into an annuity and a payment of the par value at some specific date in the
future. Preferred stock valuation follows bond valuation and the value of preferred stock
is shown to be the present value of perpetual annuity. The cash flows from the constant-
size dividend are fairly certain, and most preferred stocks do not have a maturity date.
Finally, common stock is presented but neither the future cash flows (from dividends)
nor the final value is known with any degree of certainty.
The case describes Home Products, Inc, a leading manufacturer of prescription and
ethical drugs; specialty foods and candies; and proprietary drugs. Total revenues in the
last fiscal year were in excess of $9 billion. Company's capital structure is made up of
34% long-term debt, 3% preferred stock, and 63% common stock. The case describes
the two largest domestic long-term debt, and close this issue disclosing that these two
bonds are rated A by Moody's. Then, it talks about preferred stocks. 5.5 million shares
were issued in Feb. 1979 in connection with the merger of FDS Holding Company onto
a subsidiary of HPI. Finally, it describes the common stock and informed that returns
from common stocks come from the cash dividend payment and /or changes in the
price of the stock. Two major factors that affect the price of stock are changes in the
required rate of return, caused primarily by changes in risk, and change in the growth
rate of earnings, which in return create changes in growth rate dividends

Questions:
1. Look at the 9 1/8 % coupon bond. What is its current yield, its yield-to-first call,
and its yield-to-maturity?

Solution: Current Yield = Annual Coupon Interest / Price = 9.125 / $930 = 9.81%

Yield-to-first call (7 years):

PV = $930; FV = $1,044.375; N = 7 years

Let, L= 7%

VB0 = $91.25 (PVIFA, 7%, 7years) + $1104.4375 (PVIF, 7%, 7years)

= $91.25 (5.3093) + $1104.4375 (0.6227)

= $1179.51

NPVL= $1179.51-$1000

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 = $179.51

H=12%

VB0=$91.25(PVIFA,12%,7years) + $1104.4375(PVIF,12%, 7years)

=$91.25(4.5638)+$1104.4375(0.4523)

=$915.98

NPVH=$915.98 - $1000

= -$84.02

Yield-to-first call = L + (NL /(NL - NH))(H - L)

= 7% + (179.51/ (179.52+84.02))(12%-7%)

= 10.40%

Yield to Maturity (26 years):

Yield to maturity = (I+(M-V)/n)/((M+2V)/3)

=($91.25+($1000-$930)/26)/((1000+(2*930))/3)

=9.85%

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

Solution: No, this bond will not be called by the company because it is better for them to
pay 9.88% YTM rather than 11.023%, for Yield-to-first call.

3. What would be the value of the 9.125 percent coupon bond if the time to
maturity was 10 years rather than 26 years?

Solution: Value of Bond = $91.25 (PVIFA I,n ) + $1000 (PVIF I,n)

= $91.25 (6.1446) + $1000 (0.3855)

=$946.19

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4. What is the required rate of return for the preferred stock? How does this rate
compare to the YTM for the HPI 9.125 percent bond? Is this difference what you
would have expected from risk/return standpoint? Why or why not?

Solution: RRR = Cumulative Preferred Div. / Preferred Stock Price = $2.75 / $30 =
9.17%

The bond 9.88% is more attractive for the investor than a 9.17% preferred stock. This is
contrary to what we would have expected because the bonds should have lower yields
due to lower risks.

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
this amount?

Solution: No, in the event of liquidation, i.e. bankruptcy, the collection hierarchy starts
with creditors and bonds, then stocks. Stockholders, preferred and common will
distribute residual gains. Preferred stock, claims senior to common stock, junior to debt.

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

Solution: PV = 40.625; PMT = .385, g = 9.7%

Dividend yield = Dividend / Price = (.385 *4) / 40.625 = 3.79%

Capital gain = Selling price + PMT1-$3,125

= $40.625 + $(.385 *4) - $3.125
= $39.04
7. Given that HPI is selling for $40.625, what is its required rate of return? (use the
constant growth model)

Solution: P0 = (1+g) D0 / (r g)

Or, 40.625 = 1.6894 / (X 0.097)

Or, X 0.097=1.6894/40.625

So, X = 13.86%

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8. Assume that the risk-free rate is 7% and that the expected return of the market
is 12%. 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?
Solution: Given that,
Rf = 7% Rmkt = 12% =1.10
Required rate of return= Rf + (Rmkt - Rf) = 7 + 1.10 (12 - 7) = 12.5%

9. Using the constant growth valuation model, find the present value of HPI
common stock. Would you buy or sell?
Solution: Given that, RRR = 13.86%, g = 9.7% and Dividend = $0.385
PV = (1 + g) D0 / (r - g) = 4 0.385 (1 + 0.097) = $ 40.61

Current Market Price = $40.625

Decision: Buy
10. The constant growth model is used in textbooks as a conceptual model to
explain changes in stock prices. Is the model also of value for the actual
valuation of stocks?
Solution: Constant growth model is not perfect for the actual valuation of the stock.
Constant growth model has some limitations. Those limitations are overcame by the
Gordon growth model.