Question 6
Arshad Khan, CFA, is principal and founding partner of Khan Nolan Beyrout, an asset management firm. Khan and his partner, Christopher Nolan, have concluded that continuing increases in the price of oil are going to make natural gas a more attractive long-term choice as a source of energy. As a result of their analysis, Khan and Nolan have decided to take a position in a natural gas distributor. The Central Texas Energy & Gas Company is one possible choice for investment. The company has been in business for several decades and has a reliable history of paying out 25 percent of its earnings in dividends. Dividend growth at the firm has historically averaged 4.2% per year, with dividends reaching $2.30 per share in the fiscal year just ended. Khan and Nolan agree, however, that the company’s growth rate should increase to 5.0% going forward because of the shift away from oil and towards natural gas. Nolan considers Central Texas Energy & Gas Company a potentially attractive investment because of its very reasonable 6.563 trailing P/E. North Slope Energy Distributors, Inc. is another company that Khan Nolan Beyrout is considering for investment. North Slope is a much younger company than Central Texas and consequently has enjoyed a much higher growth rate in recent years. The company paid out only $1.10 per share in dividends in the most recent fiscal year for a payout ratio of 11%, but dividend growth has been 15% per year. Nolan expects North Slope’s dividend growth rate to decline consistently over the next ten years until it reaches the same long-run growth rate as Central Texas. Because of this rapid dividend growth rate, North Slope trades at a leading P/E of 8.257. Nolan is concerned, however, about the risk in North Slope’s stock if the firm’s dividend growth does not meet his expectations. He tells Khan, “Assuming that the expected rate of return on the stock doesn’t change, if North Slope’s dividend grows 15% for the next three years but the growth rate then suddenly falls to the terminal growth rate of 5%, we would lose over 20% of our investment.” Khan points out, “But even if dividend growth does hit 15% for the next three years and then falls to its terminal value, we’d make nearly 8% on our investment if the terminal growth rate were 5.5% instead of 5%.” Khan argues in favor of investing in Central Texas, saying, “It would only have to earn a 7% ROE in order to fund our expected sustainable growth rate (SGR) of 5%, while maintaining its dividend policy.” Nolan agrees, saying, “If Central Texas’ ROE equals the implied rate of return on equity, the company could more than double the payout ratio and still maintain a 5% growth rate.” Once they complete their analysis, Khan and Nolan decide to invest in Central Texas Energy & Gas. Part 1) In which circumstance is a dividend discount model (DDM) least likely to be an appropriate measure of a stock’s value? A) The investor is a majority shareholder. B) The company has a long history of dividend payments. C) The company has a clear dividend policy that relates to the firm’s earnings. D) The company is a mature firm that generates excess cash flow. Part 2) What is the implied expected rate of return on Central Texas Energy & Gas? A) 5.0%. B) 9.0%. C) 8.2%. D) 4.2%. Part 3) Which statement about a firm’s sustainable growth rate (SGR) is least accurate? A) It assumes that the firm’s debt-to-equity ratio is unchanged. B) The two key variables are the ROA and the retention ratio. C) It tells how quickly a firm can grow using internally generated funds. D) It assumes that the firm does not issue new equity. Part 4) What is the implied expected rate of return on North Slope? A) 7.2%. B) 9.6%. C) 6.8%. D) 10.0%. Part 5) Regarding the statements made by Khan and Nolan about the risk of their potential investment in North Slope if dividend growth varies from their expectations: A) Khan’s statement is incorrect; Nolan’s statement is incorrect. B) Khan’s statement is correct; Nolan’s statement is correct. C) Khan’s statement is correct; Nolan’s statement is incorrect. D) Khan’s statement is incorrect; Nolan’s statement is correct. Part 6) Regarding the statements made by Khan and Nolan about the SGR for Central Texas: A) Khan’s statement is correct; Nolan’s statement is incorrect. B) Khan’s statement is incorrect; Nolan’s statement is incorrect. C) Khan’s statement is correct; Nolan’s statement is correct. D) Khan’s statement is incorrect; Nolan’s statement is correct.
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