Since TFC went public, we have always considered our stockholder risk averse, as they want to see their investment grow but without a lot of risk. Based on the ratio analysis you showed me, it seems we have been doing just that. However, this expansion project is not revealing the same picture.
When Joe talks to our investors, he wants to be able to explain why this project is good for TFC's future even though financially, it may not seem like the best move. With that, I would like you and your intern to come up with the expected rate of return that our investors are currently benefiting from their equity. This will also be our required rate of return for the project, as we have to give the investors a return on their investment.
I just met with Don and he has given us another project. He asked that we calculate TFC's expected rate of return, which is also the required rate of return for our stockholders. In order to do that we are going to use the Capital Asset Pricing Model, or CAPM. With the help of the Security Market Line, or SML, we will use inputs to calculate the required rate of return. In general the required rate of return for TFC will be a risk-free rate plus some additional market premiums. When we put it all together, we will come up with our required rate of return.
Our formula can be thought of as the required rate of return for TFC is equal to the risk-free rate plus a risk premium for TFC's stock.
Our formula can be thought of as the required rate of return for TFC is equal to the risk-free rate plus a risk premium for TFC's stock.
In order for us to calculate the required rate of return, let's go over all the components of the calculation.
FIN534_4_5_Linda-2: First, let's look at the Risk-free rate. This is simply the rate on riskless securities and is commonly measured by the yield on long term U.S. Treasury bonds. It is based in the understanding that the U.S. government will not default on their obligations so the bonds are considered risk free.
FIN534_4_5_Linda-3: Next is the Market Risk Premium, or RP sub M. The Market Risk Premium can be thought of as the additional risk that comes with investing in a non-government security. This is that extra risk premium that is put on any security that is above the risk-free rate. From an investor's standpoint, they want a premium on any investment that is not risk-free because they will be assuming the risk and the trade off is the higher the risk, the higher the return demanded. The RP sub M is the difference between what the market is returning and the risk free rate.
And lastly is Beta, which is a measure of how much TFC's risk would contribute to a well diversified portfolio. Typically stocks have a beta between zero point four and zero point six.
Now that we have our variables, let us determine what the expected value is. Before we do that, we need to call the Accounting Department to get some numbers from them, such as the beta for TFC and the risk free and market rates.
FIN534_4_6_Linda-2: This is Linda who is working on the expansion project and we would like to know the long-term U.S. Treasury bond rate, market portfolio rate, and TFC's beta.
FIN534_4_6_Linda-3: (makes a quick laugh) It is something how once you mention the expansion project everyone stops what they are doing and gives you what you need.
FIN534_4_6_Linda-4: Accounting said that the long term bond rate is three percent, the market rate is eighteen percent and TFC's calculated beta is point eight.
FIN534_4_6_Linda-5: I am going to the Accounting Department to personally thank them. While I am gone, can you calculate the required rate of return based on this data?
Great work! Your calculations show that TFC's required rate of return is fifteen percent, which is also the expected rate of return that investors want. Our investors have been really good to us so it is nice that we are giving them a strong return. The issue is..., can we give them that desired return? As we saw with our financial analysis, this project will really affect our cash basis, so a lot of analysis is needed before rendering a decision.
FIN534_4_8_Linda-2: Also, keep in mind that the CAPM is not perfect. For example, Beta is an estimated number and there can be changes in rates. However, this measurement gives us a benchmark based on the available information.
Hello Don. We calculated fifteen percent for the required rate of return.
Yes, it was the intern who did the terrific analysis.
Another request? Sure what would you like us to do?
FIN34_4_8_Linda-4: Don would like us to go further with this work and calculate TFC's stock price. This is the internal price which may be different from what the market price of TFC's stock price.
Hello again. The required rate of return you calculated is very important to us as it tells what our shareholders can expect to receive as a return on their investment. Using this rate, we can also determine what we feel is TFC's value per share of stock. If we are going to stay competitive in the fitness center industry, we have to make sure our price is valued as it should. There are many ways to value stock. We have decided to use the Constant Growth Model. Note that we have not valued our stock yet because we did not have a required rate of return. Thanks to your hard work we now have that rate and will be using it in the Constant Growth Model.
Don, you are so right about not valuing our stock. We always have done our business work on a small scale, but since we may be undertaking this big expansion
project, we have also decided to revise our business practices. So not only are we reviewing the financial side of the expansion project, we are also reviewing what we are doing as a business in regard to administration. This expansion project will only make TFC stronger.
FIN534_4_9_Don-2: You are correct Linda. We want to become stronger all around. But first, we need to look at the value of TFC. Let us look at some of the variables for determining the share price.
FIN534_4_9_Linda-1: Don, you are so right about not valuing our stock. We always have done our business work on a small scale, but since we may be undertaking this big expansion
As I mentioned before, the Constant Growth Model is the preferred choice for valuing our stock. There are many ways to value a stock but we have chosen this model because of a number of factors. The key to this valuation process is to understand that the value of TFC will be found by taking the present value of all future cash flows.
FIN534_4_10_Don-2: Our first factor for choosing this method centers on dividends. Over the years we have been kind to our investors by providing a flat ten dollar dividend amount. In the financial world this variable is usually labeled D sub zero.
FIN534_4_10_Don-3: Our second factor is our growth rate, signified by "g". This is the rate that we expect dividends to grow. It has been decided that since we are undertaking this big expansion project and considering how loyal our investors have been to us, it is time to increase the dividend rate. We plan to have dividends grow at the rate of ten percent each year. Again, we feel that keeping a strong shareholder base is important. The increase in dividends will enable investors to receive a constant return on their investment.
FIN534_4_10_Don-4: Our third factor has already been completed by you and it is the required rate of return, which you calculated to be fifteen percent.
FIN534_4_10_Don-5: Using the Constant Growth Model, the formula of stock value for TFC equals dividend today times one plus the growth rate all divided by the required rate of return minus the growth rate.
FIN534_4_10_Linda-1: Thanks, Don. I think this is a good formula for our intern to use.
Great job as always. Two hundred and twenty dollars is what the value of TFC's stock should be at today. Don, do you have the most recent trading information on TFCs stock price as of today?
FIN534_4_12_Don-1: Yes. You know I always have my electronic devices tuned into the stock market. As of now, TFC is trading at two hundred twenty dollars and sixty five cents. I guess you can say we are efficient!
FIN534_4_14_Linda-1: Great work again. As you can see, with all else constant the growth rate can really affect the price of a share of stock. That is why it was important for TFC to establish a dividend growth rate. Also, when the stock price calculated is compared to the market price, decisions can be made as to whether or not they are undervalued or overvalued.
FIN534_4_14_Linda-2: Besides the Constant Growth Model, there are other valuation models, but in many of the instances they all are about cash flows. Here we are concerned about cash as that can be the driving force for many business decisions.
This project took us to a different area of our company. We calculated a required rate which can also be thought of as the expected return for our investors. We reviewed how a situational analysis can provide different results and can be used during the decision making process. After the required rate of return calculation, we then calculated TFC's share price under the Constant Growth Model.
We again did some situational analyses to see how input changes can really affect business decisions. That is why it is so important to do a thorough analysis before accepting or rejecting a project. And that is exactly what we are doing with the TFC expansion project.
Please respond to the following:
* From the scenario, value a share of TFC's stock using a growth model method and compare that value to the current trading price of a share of TFC. Determine whether the stock is undervalued or overvalued. Provide a rationale for your response.
In the TFC scenario, growth rate of 10% and the required rate of return $15, the dividends at a flat rate of $10. The Constant growth model is 220. The stated market rate is 220.26. From these data just explain little TFC and the adavanges or risks involved.