Copyright 1997 by The Dryden Press All rights reserved

Case 49
Beatrice Peabody
Bond and Stock Evaluation




Beatrice Peabody has been a long time valued customer of the First National Bank. Her first account
was opened 65 years ago when her father, an employee of J ames River Corporation, gave her a
savings account for her 6th birthday. Until his death, her father regularly purchased J ames River
stocks and bonds through an employee option and put them into a trust for her. Through his invest-
ments and her successful real-estate dealings, she developed substantial financial assets and became
a leader in the social and economic fabric of the community.
Sandra Gilbert started working for First National Bank 2 years ago as a loan officer with hopes
of working her way into the banks investment division. She loved working with the public and when
the tellers were extremely busy, she would assist customers with their banking needs. On one occa-
sion Sandra helped Ms. Peabody understand the revised statements being produced by the bank.
Since that time Ms. Peabody always asked for Sandras assistance, and a professional friendship was
established.
Beatrice Peabody spoke with Rodney Samuelson, the banks president, and requested that
Sandra Gilbert be assigned to manage her financial affairs. She was interested in understanding the
valuation fundamentals of her stocks and bonds and felt that Sandras explanations would provide
her the background that would allow her to follow her portfolio more effectively. Rodney was
pleased with Sandras performance at the bank and had considered promoting her to the investment
division. He believed that this assignment would provide the opportunity to evaluate her ability to
work with stocks and bonds. He asked Sandra if she would be interested in the added responsibility
of managing Ms. Peabodys assets. He said that a job well done could lead to a promotion. Sandra
was excited with the challenge, and she eagerly accepted it.
Sandra met with Ms. Peabody and determined that Ms. Peabody wanted to maintain a steady
streamof investment income in order to maintain her current standard of living. She was also inter-
ested in growth to provide for her 9 grandchildrens college education. Sandra reviewed Ms.
Peabodys assets and found that except for a savings account, a NOW account, and several sizable
certificate of deposits, all financial assets were concentrated in James River stocks and bonds.
Ms. Peabody was concerned with the portfolio. J ames River had experienced negative earn-
ings in 1992, 1993 and 1994 (see ValueLine Analysis in Figure 1) and had been downgraded by
Standard & Poors in June of 1994. Sandra explained that these events were already factored in pric-
ing the assets, and investors expectations about the company would drive future stock prices. She
explained the need for diversification. Ms. Peabody agreed that some of her stocks and bonds should

be sold and the funds reinvested in assets of other companies. However, before the change in hold-
ings Ms. Peabody wanted Sandra to explain the principles of valuation using her portfolio as an
example.
In general, Ms. Peabody wanted to know how the bonds and stocks were valued and how to
determine what kind of return they were providing. Some areas that perplexed Ms. Peabody were
how different bonds for the same company could have different coupons and different prices. She
noted that preferred stock paid dividends quarterly while her bonds paid interest semi-annually and
wondered how that affected her return. She was particularly interested in the risk of her assets and
wanted to know how changes in interest rates would affect her holdings. They agreed to meet in
two weeks to discuss the current stock and bond holdings with Ms. Peabody and her heirs and to dis-
cuss the principles of valuation using 1995 as a base year.
Sandra was aware that ValueLine contains information about a companys beta, and fore-
casts of dividend amounts, payout ratios, and expected growth rates. Therefore, she began prepar-
ing for the meeting by obtaining a copy of the 1995 ValueLine analysis for J ames River. This
information is reproduced in Figure 1. Fromthis information she determined the companys price
based on the expected next dividend (see divds decls per share for 1995) and the analysts projected
growth rate in dividends from199193 to 199799 (see left column). Through other sources, she
determined that the investors expected return for the companys stock at the beginning of 1995
was 8.36%. Sandra further obtained current June 1, 1995 information on the companys common and
preferred stock fromthe Wall Street Journal. This information, presented in Figure 2, indicated
that the stock price has increased since the ValueLine data was released.
Copyright 1997 by The Dryden Press All rights reserved


FIGURE 1

ValueLine Analysis for James River Corporation



Copyright 1997 by The Dryden Press All rights reserved

FIGURE 2

New York Stock Exchange Composite Transactions
(The Wall Street Journal)




Some analysts believed that the company would forma joint venture with a communications
papers company. If this joint venture were enacted, James Rivers expected 1995 dividend of $0.60
would be forecasted to grow at 4.0% each year through 1999. But starting in 2000, growth would
be expected to jump to 8%. Because of the added risk of this joint venture, the required return
would be expected to increase to 9.5%, and Sandra decided to determine how the joint venture would
affect the stock price and return computed at the beginning of 1995.
Sandra was uncomfortable with the ValueLine stated expected return forecast and also decided
to determine the return of the stock using a $27 price and growth rate determined by the company
fundamentals. Using the ValueLine information, she determined the growth based on the retention
ratio and a return on retained earnings of 10.5% (see expected 9799% All Divds to Net Profit and
% Earned Net Worth in ValueLine). As a further analysis, she was interested in the required return
fromthe Capital Asset Pricing Model. She was aware that the long termaverage risk premium of
stocks over Treasuries was 6.20%. For approximations of the risk free rate she looked in The Wall
Street Journal (WSJ) for information on the 10 year Treasury Bond yields (Aug. 05). The WSJ infor-
mation is reproduced in Figure 3.
Copyright 1997 by The Dryden Press All rights reserved


FIGURE 3

Wall Street Journal Treasury Bonds, Notes and Bills
(The Wall Street Journal)





In addition to common stock, Ms. Peabody held shares of J ames River Series K preferred
stock. The transaction information for this stock was found in the WSJ (See Figure 2). Sandra was
aware that some companies issued preferred stock with a mandatory sinking fund provision. She
wanted to find the impact on the yield of the series K preferred stock if 20% of the initial issue was
redeemed annually so that the full issue would be fully redeemed in 5 years.
In order to analyze Ms. Peabodys debt holdings, Sandra obtained a copy of the January 1995
Standard & Poors Bond Guide. A copy of the James River information is reproduced in Figure 4.
Ms. Peabodys portfolio contained issues of long-termbonds maturing in 2021 and 2023 and short-
termnotes maturing in 2003. Since James River stocks were rated BBB, they were considered fairly
risky and had a relatively high rate of return. However, since the time the report was published,
investors required rates for comparable notes dropped to 8.5%, and rates for similar long termbonds
dropped to 9%. For the purpose of this analysis, Sandra decided to make the simplifying assump-
tion that interest payments had just been made and the maturities of the bonds were 8 years, 26 years,
and 28 years for the 2003 notes and the 2021 2023 bonds, respectively. Conversations with a bond
analysts indicated that based on the unique fundamentals of the company the current market prices
for James River bonds were actually closer to $910.20, $1,090.50 and $920.34 for the 8, 26 and 28
year debt, respectively. She felt the change in price would allow a comprehensive analysis of the
impact of changing interest rates on bond prices and returns.
Sandra had heard that James River was considering issuing another 28 year bond with a 12%
yield to maturity. There was some uncertainty as to whether the bond would be issued with a call
provision. If the bond was not callable it would sell for $1,371.73. If callable, the bonds indenture
would have a deferred call provision of 5 years and would require a call premiumof one years inter-
est. The callable bond was expected to sell for $1,225. Sandra knew that Ms. Peabody would be
Copyright 1997 by The Dryden Press All rights reserved

interested in the high coupon payment and decided to compare the callable and non callable bond
in the analysis.
After reviewing all the information, Sandra began a long but hopefully productive week.
Based on the ValueLine analysis and information fromcorporate analysts, Sandra began developing
a worksheet to illustrate the pricing of both the debt and equity investments held by Beatrice
Peabody. Sandra was aware that she would need to explain the dynamics and demonstrate the sen-
sitivity of security prices when the expected growth rate and interest rates changed. She also must
explain how a call and sinking provision would affect the expected return of a bond. With this in
mind, you have been asked to assist with preparing the analysis that is to be presented to Ms.
Peabody and her heirs. The following questions have been provided to guide you in your task.





FIGURE 4

Standard & Poors Bond Guide Information


Copyright 1997 by The Dryden Press All rights reserved

QUESTIONS

1. According to ValueLine estimates in Figure 1, James Rivers expected annual dividend
growth rate fromthe 9193 to 9799 period is 5.50%, and the next dividend (1995) is
expected to be $0.60. Assume that the required return for James River was 8.36% on Jan-
uary 1 1995 and that the 5.50% growth rate was expected to continue indefinitely.
a. Based on the Constant Growth Rate or Gordon Model, what was James Rivers price at
the beginning of 1995?
b. What conditions must hold to use the constant growth model? Do many real world
stocks satisfy the constant growth assumptions?

2. The Wall Street Journal (WSJ) lists the current price of James River common stock at
$27.00.
a. Based on this information, the ValueLine 1995 expected dividend, and the annual rate of
dividend change for the growth estimate, what is the companys return on common stock
using the constant growth model? What is the expected dividend yield and expected capi-
tal gains yield? Explain the difference in the required return estimates fromthe Value-
Line (see question 1a) to the WSJ price data.
b. What is the relationship between dividend yield and capital gains yield over time under
constant growth assumptions?

3. A successful joint venture is expected to result in the 4.0% growth rate until 2000 but would
increase the companys normal growth rate to a constant 8.00% after that time. The joint
venture also is expected to increase investors required return to 9.50%.
a. Based on this information, what is the value of the companys stock?
b. What is the value of the stock at the end of the first year assuming that the stock is in
equilibrium?
c. What is the dividend yield, capital gains yield, and total yield of the stock for the year? If
you are using the spreadsheet model for this case, discuss the changes in dividend yields
and capital gains yields over time.
d. Suppose that the dividend was expected to remain constant at $0.60 for the next five years
and then grow at a constant rate of 5.50%. If the required return is the original 8.36%
fromquestion 1,would the stock value be higher or lower than that in part a? If you are
using the spreadsheet model for the case, calculate the dividend yield, capital gains yield,
and total yield from1996 through 2004.

4. One method of determining the companys growth rate is fromthe fundamentals of the
retention ratio and return on retained earnings. How does the growth ratebased on Value-
Lines 19971999 estimated retention ratio (Hint: use 1 - % all dividends to net profit) and
expected return on retained earnings of 10.5%affect the return on the stock as compared
to the initial return found in question 2?

5. Using the yields for the 10 year T-bond fromThe Wall Street Journal, an annual average
risk premium of stock over risk free treasuries of 6.20%, and the beta fromValueLine, what
is the required return on the stock based on the CAPM? How does this return compare to the
return found in question 2?

6. Answer the following questions on preferred stock using The Wall Street Journal stock
information.

a. What is the nominal expected rate of return for James River series K preferred stock? (Hint:
Preferred stock pays a quarterly dividend) What is the effective annual rate?

b. What is the value of the preferred stock if it has a sinking fund in which 20% of the initial
issue of stock was redeemed annually at par ($100) and the required nominal return is
9.76%?

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7. Answer the following questions concerning James River debt using the S&P Bond Guide
Information.
a. Why do the coupon rates of James River debt vary so widely?
b. Based on the required returns of 8.5% and 9% for similar short termand long termbonds
respectively, what are the values of the semiannual coupon bonds and notes held in Ms.
Peabodys portfolio? Are the bonds and notes selling at a discount or a premium?

8. Based on the bond analysts current expected prices of the companys debt, what is the nomi-
nal yield to maturity of each issue in the portfolio? What is the effective annual rate? Would
you expect a semiannual payment bond to sell at a higher or lower price than an otherwise
equivalent annual payment bond? Explain why.

9. Assume that James River Corporations anticipated new 28 year 12% bond is not callable
and sells for $1,371.73.
a. What is the nominal and effective annual YTM on this bond?
b. What is the current yield on this and the original 28 year bond selling for $920.34?
c. What is each bonds expected price after one year, assuming they both have a YTM of
8.50%? What is the capital gains yields for the year for each bond assuming no change in
interest rates?
d. What is the expected total (percentage) return on each bond during the next year?
e. What would happen to the price, current yield, and total return of each bond over time
assuming constant future interest rates?
f. If you were a tax-paying investor, which bond would you prefer? Why? What impact
would this preference have on the prices, hence YTM, of the tow bonds?

10. Assuming the proposed 28 year bond is callable and sells for $1,225, what is the yield to
first call? Do you think it is likely that the bond will be called? Explain how the probability
of call affects the required yield on a bond.

11. Consider the risk of the bonds.
a. Explain the difference between interest rate price risk and coupon reinvestment rate risk.
b. Which of the two long termbonds in Ms. Peabodys portfolio have the greatest price
risk? Why? If you are using the case spreadsheet model, illustrate your answer by calcu-
lating the change in value of each bond assuming the interest rates rose fromthe initial
9% to 12% and dropped from9% to 6%.
c. Assume that you have money to invest in a bond but need the proceeds of the investment
in 10 years. Which type of bonds could you purchase to eliminate interest rate risk?

12. Assume Ms. Peabody sold some of her James River bonds and bought a 5 year 9% coupon
bond selling at par.
a. Immediately after the bond was purchased, market rates fell to 6%. Given she can only
invest her coupons at 6%, what is the actual realized return on her investment? Hint: Find
the terminal (future) value of her coupons and the par value at maturity. Then find the
rate of return that equates the price with the terminal value. How does the actual realized
return compare with the expected rate of return?
b. What would happen if the interest rates increased rather than decreased?
c. How would the results differ if she would have bought a longer termbond?

13. Many bond market participants are speculators as opposed to long-terminvestors. If you
thought interest rates were going to fall fromcurrent levels, what type of bonds would you
advise Ms. Peabody to purchase in order to maximize short-termcapital gains?

Copyright 1997 by The Dryden Press All rights reserved