Question #87

of 135 If an asset was fairly priced from an investor's point of view, the holding period return (HPR) would be: A) lower than the required return. B) the same as the required return. C) equal to the alpha returns. Flyaweight Foods is a vertically integrated producer and distributor of low-calorie food products operating on a consumer club model. They have enjoyed rapid growth in the southwest United States during their 5-year history and are planning rapid expansion throughout the rest of the country. To fund their expansion, they are soliciting investments from a variety of venture capital groups. One of the groups considering a bid for Flyaweight is Angelcap Investors, a private equity fund run by Harry Moskowitz. Angelcap is interested in acquiring a 10% interest in Flyaweight. Moskowitz' partner, Bill Sharpless, runs the group doing due diligence on Flyaweight. He provides Moskowitz with financial data on the firm: Table 1: Flyaweight Foods Historical Data (Dollars per share) FY1 FY2 FY3 FY4 FY5 Sales per share 4.25 5.60 6.40 7.35 8.05 EPS 1.20 1.85 2.30 2.79 3.10 Dividends 0 0 0.10 0.20 0.35 Free Cash Flow –2.50 –2.10 –1.85 –1.60 –1.25 They ask Merle Muller, an analyst at the firm, to calculate an appropriate required return on Flyaweight. Muller collects the following market consensus information: Table 2: Current Market Conditions (Consensus estimates) Expected 5-year EPS growth 8.0% Expected 1-year Dividend yield 2.2% Current Treasury yield (10-year note) 4.8% Food industry beta (specialty segment) 0.95 Sharpless argues in favor of using the Gordon Growth Model (GGM). "We know what the company growth rate is, we know what the dividend is, and we can decide what our required rate of return is. The GGM will give us the most accurate valuation because it uses the inputs we can measure most accurately." Moskowitz points out, "An H-model would be more appropriate because it assumes a linear slowdown in growth to a constant rate in perpetuity." While Sharpless and Moskowitz debate the appropriate valuation approach, Muller prepares forecasts for Flyaweight. Table 3: Forecast Values for Flyaweight Forecast Average total liabilities per share $14.40 Average owners' equity per share $12.70 Profit margin 29% Sales per share $10.70 Dividend payout ratio 10%