Question #107

The required return = [($36.00 + $2.80) / $34.34 ] – 1 = 0.13 or 13%. (Module 20.3, LOS 20.i) Julie Davidson, CFA, has recently been hired by a well-respected hedge fund manager in New York as an investment analyst. Davidson's responsibilities in her new position include presenting investment recommendations to her supervisor, who is a principal in the firm. Davidson's previous position was as a junior analyst at a regional money management firm. In order to prepare for her new position, her supervisor has asked Davidson to spend the next week evaluating the fund's investment policy and current portfolio holdings. At the end of the week, she is to make at least one new investment recommendation based upon her evaluation of the fund's current portfolio. Upon examination of the fund's holdings, Davidson determines that the domestic growth stock sector is currently underrepresented in the portfolio. The fund has stated to its investors that it will aggressively pursue opportunities in this sector, but due to recent profit-taking, the portfolio needs some rebalancing to increase its exposure to this sector. She decides to search for a suitable stock in the pharmaceuticals industry, which, she believes, may be able to provide an above average return for the hedge fund while maintaining the fund's stated risk tolerance parameters. Davidson has narrowed her search down to two companies, and is comparing them to determine which is the more appropriate recommendation. One of the prospects is Samson Corporation, a mid-sized pharmaceuticals corporation that, through a series of acquisitions over the past five years, has captured a large segment of the flu vaccine market. Samson financed the acquisitions largely through the issuance of corporate debt. The company's stock had performed steadily for many years until the acquisitions, at which point both earnings and dividends accelerated rapidly. Davidson wants to determine what impact any additional acquisitions will have on Samson's future earnings potential and stock performance. The other prospect is Wellborn Products, a manufacturer of a variety of over-the-counter pediatric products. Wellborn is a relatively new player in this segment of the market, but industry insiders have confidence in the proven track record of the company's upper management who came from another firm that is a major participant in the industry. The market cap of Wellborn is much smaller than Samson's, and the company differs from Samson because it has grown internally rather than through the acquisition of its competitors. Wellborn currently has no long-term debt outstanding. While the firm does not pay a dividend, it has recently declared that it intends to begin paying one at the end of the current calendar year. Select financial information (year-end 2005) for Samson and Wellborn is outlined below: Samson: Current Price: $36.00 Sales: $75,000,000 Net Income: $5,700,000 Assets: $135,000,000 Liabilities: $95,000,000 Equity: $60,000,000 Wellborn: Current Price: $21.25 Dividends expected to be received at the end of 2006: $1.25 Dividends expected to be received at the end of 2007: $1.45 Price expected at year-end 2007: $27.50 Required return on equity: 9.50% Risk-free rate: 3.75% Other financial information: One-year forecasted dividend yield on market index: 1.75% Consensus long-term earnings growth rate: 5.25% Short-term government bill rate: 3.75% Medium-term government note rate: 4.00% Long-term government bond rate: 4.25% It is the beginning of 2006, and Davidson wants use the above data to identify which will have the greatest expected returns. She must determine which valuation model(s) is most appropriate for these two securities. Also, Davidson must forecast sustainable growth rates for each of the companies to assess whether or not they would fit within the fund's investment parameters.