Valuation of a constant growth stock
A stock is expected to pay a dividend of $0.75 at the end of the year (i.e., D1 = $0.75), and it should continue to grow at a constant rate of 5% a year. If its required return is 13%, what is the stock's expected price 4 years from today? Round your answer to two decimal places. Do not round your intermediate calculations.
$ Hughes Energy and Transportation Company
The Company
Hughes Energy and Transportation Company (Hughes) is managed by the three Hughes brothers, and Gorge Woods, son-in-law of the oldest Hughes brother. Hughes through its two divisions produces and markets coal and mineral primarily to utilities and industrial users and operates as a transportation company that provides truck and carrier services in the United States, Mexico, and Canada.
Its energy division which is mainly in coal and mining produces a range of steam coals with varying sulfur and heat contents. The company operates 10 underground mining complexes in Illinois, Indiana, Kentucky, Maryland, and West Virginia. As of December 31, 2015, it had approximately 1.1 billion tons of proven and probable coal reserves. The company also leases land; and operates a coal loading terminal with a capacity of 8.0 million tons with ground storage of approximately 60,000 to 70,000 tons on the Ohio River at Mt. Vernon, Indiana. In addition, it buys and resells coal; and manufactures and sells rock dust. Further, the company offers various products and services, which comprise the design and installation of underground mine hoists for transporting employees and materials in and out of mines; design of systems for automating and controlling various aspects of industrial and mining environments; and design and sale of mine safety equipment, including its miner and equipment tracking and proximity detection systems.
Its transportation division provides services to automotive, steel, oil and gas, alternative energy, and manufacturing industries, as well as other transportation companies who aggregate loads from various shippers. As of December 31, 2015, its fleet consisted of 2,166 in-service tractors and 6,054 in-service trailers.
Capital Budget Committee and Project Selection
The Capital Budget Committee at Hughes is composed of Hughes brothers and Woods. Typically, Woods solicit investment proposal from managing directors and if the project cost exceeds $500,000, it required the approval of CBC. For this year, the directors have recommended 10 projects which exceeded the capital expenditure limits. Table 1 and 2 provide a brief description of the projects and initial cost and the estimated cash flow of each project (after tax profit plus depreciation) over its estimated life.
Financial Information
At the end of 2015, the Company had net income of $79,893 and total asset was $1,017,032; consisting of $711,922, from to energy segment and $305,110 from transportation services.
On the basis of its net income, Woods wants to know how much money is available for capital investments as shown in Table 2. Its established common stock’s dividend payout ratio after the preferred stock dividends payment is 50 percent of the funds. Currently the preferred stock has a 8 percent dividend yield with a par value of $100. A 12 percent cost of capital for funds generated internally has been used in the past, and Woods sees no reason to depart from this figure. Any additional funds used for capital budgeting purposes will have to come from external financing. In discussions with the Hughes brothers, Woods informed them that any additional external funds will have a 14 percent rather than the 12 percent current cost of capital.
1. Determine market value of the capital structures.
2. What is the equity cost of capital of each division?
3. What would be the Company’s weighted average cost of capital before new financing?
4. What is the equity cost of capital after financing?
5. What is the Company’s weighted average cost of capital after new financing?
6. Compare the expected rate of return of each project with each division equity cost of capital. Which projects should CBC recommend?
7. Is there any change in your recommendations if the comparison is made with the Company’s weighted average cost of capital?