Question

Sally Randolph is a surgical nurse at Wellford Surgery Centers (WSC), a small for-profit ambulatory surgery center owner/operator whose stock is thinly traded in the OTC market.  A few nights ago, Sally received a call from her mother asking for some advice regarding a stock recommendation.  Her mother said that her broker had recommended adding 1,000 shares of WSC stock to the family’s retirement portfolio.  Because Sally worked at WSC, her mother thought that Sally might have some special insights.  Also, Sally’s mother just read a short article in an investment magazine regarding market efficiency and behavioral finance, and she asked what impact these ideas have on the broker’s recommendation.

                  Sally was finishing up her master degree in healthcare administration at a local university, so she thought this would be a good opportunity to apply some of the stock valuation concepts she had learned.  To begin, she looked up some basic data:

WSC beta coefficient= 1.9

Yield on treasury bonds= 4.0%

Market risk premium= 6.0 percentage point

Last dividend paid=$1.40

Expected growth rate= a constant 8.0%, or alternatively, 12% for 4 years and 7% constant growth thereafter.

Current stock price=$22.50

Now, she must use this information to make some judgements about whether or not her mother should follow he broker’s advice.

Part a

Use the Security Market Line (SML) of the capital asset pricing model (CAPM) to estimate the required rate of return on the stock.

Part b

Estimate the current fair value of the stock using the constant growth valuation model.

Part c

Given the actual price of the stock ($22.50), calculate the expected rate of return.

Part d

Use the non-constant growth model to estimate WSC’s fair value.

Part e

Based on parts a – d, should the stock be purchased? Please explain

Answer 1

CAPM Ret = Rf + Beta ( Rp)

= 4.0% + 1.90 ( 6%)

= 4% + 11.4%

= 15.40%

Part B:

P0 = D0 (1+g) / ( Ke - g)

= [ $ 1.40 ( 1 + 0.08) ] / (15.40% - 8%)

= $ 1.512 / 7.40%

= $ 20.43

Part C:

Ke = [ D1 / P0 ] + g

= [ 1.512 / 22.50 ] + 0.08

= 0.0672 + 0.08

= 0.1472 i.e 14.72%

Part D:

Value of stock = PV of Cash Flows from it.

DIv Calc:

P4 = D5 / ( Ke -g)

= 2.357 / ( 15.4% - 7%)

= 2.357 / 8.4%

= 28.06

P0 = PV of Cash Flows from it

Part D:

Fait pair price both cases is 20.43 & 21.02 which is less than 22.50, Thus stock is over priced

Thus not advicable to buy it.