The Webster University Boosters Association has decided to build new bleachers for the football field. Total costs are estimated to be $1 million, and financing will be through a bond issue of the same amount. The bond will have a maturity of 20 years, a coupon rate of 8 percent, and has annual payments. In addition, the Association must set up a reserve to pay off the loan by making 20 equal annual payments into an account which pays 8 percent, annual compounding. The interest-accumulated amount in the reserve will be used to retire the entire issue at its maturity 20 years hence. The Association plans to meet the payment requirements by selling season tickets at a $10 net profit per ticket.
How many tickets must be sold each year to service the debt, i.e., to meet the interest and principal repayment requirements? (Hint: there’s an annual cash outlay consisting of two parts: (1) annual interest on the bond for each of the 20 years, and (2) 20 equal yearly payments which will, when accumulated, equal exactly enough money at that point to pay off the principal (face) amount of the bonds).
Problem 1 – 40 points
You are trying to decide between two different common stock investments:
Oleander Corp.’s expected year-end dividend is D1 = $1.50, its required return is rS = 12.00%, its dividend yield is 8.00%, and its growth rate is expected to be constant in the
future. (Hint: use the dividend yield/capital gain variation of the Gordon model to determine the growth rate)
Webster Manufacturing just paid a dividend of D0 = $1.00. Analysts expect the company's dividend to grow by 30% this year, by 10% in Year 2, and at a constant rate of 5% in Year 3 and thereafter. The required return on Webster's stock is 9.00%.
In this crazy market, you think both stocks are undervalued, as either one can currently be purchased for $10 per share.
REQUIRED: Using the Gordon model to value both stocks, determine which one has the higher intrinsic (calculated) value.
Problem 2 – 30 points
A young couple is planning for the education of their two children. They plan to invest the same amount of money at the end of each of the next 16 years, i.e., the first contribution will be made at the end of the year and the final contribution will be made at the time the oldest child enters college.
The money will be invested in securities that are certain to earn a return of 8 percent each year. The oldest child will begin college in 16 years and the second child will begin college in 18 years. The parents anticipate college costs of $25,000 a year (per child). These costs must be paid at the end of each year.
If each child takes four years to complete their college degrees, then how much money must the couple save each year? (Hint: approach this in two steps: go out to the oldest child’s year of entry and calculate the total funds needed for both children at that point. Then determine an annual contribution which will accumulate from now up to that amount).