Question

1. Ben and Lisa have been called in as consultants for a restaurant.  CaliFlower Cafe moved to a new location on University Blvd., hoping to profit from the cauliflower craze that is sweeping the culinary landscape. Revenues, while modest, are level and enable the corporation to pay out a modest but steady dividend of $0.85 per share.  This dividend is expected to be maintained indefinitely.  CaliFlower Café’s biggest challenge is financing.  Due to increased amounts and costs of loans, they will be subject to higher costs of capital.  Currently their cost of capital is 5%, and they expect that they can lock into that cost for the next three years.  They believe that the cost of capital will increase in year 4 to 6.00% and remain at that level for two years.  In year 6 they will be subject to an 8% cost of capital, which is expected to hold indefinitely.

1. Find the value of CaliFlower Cafe’s stock in years 4 and 6.
2. Find the value of CaliFlower Café’s  stock today.

Answer 1

Solution:

a)Calculation of value of stock:

First we need to calcculate the value of stock for year 6 as the cost of capital is constant after year 5.Thus value of stock in year 6 is:

=Dividend per Share/Cost of capital for year 6

=$0.85/8%

=$10.625

ii)Value of stock in year 4

=Present value of dividend for 2 years+Present value of value of stock in year 6

=[$0.85/(1+0.06)^1]+[$0.85/(1+0.06)^2]+[$10.625/(1+0.06)^2]

=$11.015

b)Value of CaliFlower Café’s  stock today:

Value of stock today=Present value of dividends+Present value of stock in year 4

=$0.85*PVAF(5%,3)+$11.015*PVIF(5%,3)

=$0.85*2.72325+$11.015*0.86384

=$11.83