Problem 19-3 New Stock Issue

The Edelman Gem Company, a small jewelry manufacturer, has been successful and has enjoyed a good growth trend. Now Edelman is planning to go public with an issue of common stock, and it faces the problem of setting an appropriate price on the stock. The company and its investment banks believe that the proper procedure is to select several similar firms with publicity traded common stock and to make relevant comparisons.

Several jewelry manufactures are reasonably similar to Edelman with respect to product mix, asset composition, and debt/equity proportions. Of these companies Kennedy Jewelers and Strasburg Fashions are most similar. When analyzing the following data, assume that 2002 and 2007 were reasonably "normal" years for all three companies-that is, these years were neither especially good nor especially bad in terms of sales, earnings, and dividends. At the time of the analysis, rRF was 8%and RPm was 4%. Kennedy is listed on the AMEX and Strasburg on the NYSE, while Edelman will be traded in the Nasdaq market.

Kennedy Strasburg Edelman (total).

Earning per Share

2007 $4.50 $7.50 $1,200,000

2008 3.00 3.50 816,000

Price per Share

2007 $36.00 $65.00 --------

Dividends per Share

2007 $2.25 $3.75 $ 600,000

2002 1.50 2.75 420,000

Book Value per Share,2007 $30.00 $55.00 $9. million

Market/book ratio 2007 120% 118% ------

Total assets, 2007 $28. million $82. million $20 million

Total debt, 2007 $121. million $30. million $11 million

Sales 2007 $41. million $140 million $37 million

The data are on a per share basis for Kenned and Strasburg, but are totals for Edelman.

A- Assume that /Edelman has 100 shares of stock outstanding. Use this information to calculate earnings per share (EPS), dividends per share (DPS), and book value per share for Edelman. (hint: Edelman's 2007 EPS = $12,000).

B- Calculate earnings and dividends growth rates for the three companies. (Hint: Edelman's EPS growth rate is 8%)

C- On the basis of your answer to part a, do you think Edelman's stock would sell at a price in the same "ballpark" as that of Kennedy and Strasburg, that is, in the range of $25 to $100 per share?.

D- Assuming that Edelman's management can split the stock so that the 100 shares could be changed to 1,000 shares, 100,000 shares, or any other number, would such an action make sense in this case? Why or why not?.

E- Now assume tha Edelman did split its stock and has 400,000 shares. Calculate new values for EPS, DPS, and book value per share. (Hint: Edelman's new 2007 EPS is $3.00)

F- Return on equity (ROE) can be measured as EPS/book value per hare or as total earnings/total equity. Calculate ROEs for the three companies for 2007. (Hint: Edelman's 2007 ROE is 13.3%).

G- Calculate dividend payout ratios for the three companies for both years. (Hint: Edelman's 2007 payout ratio is 50%).

H- Calculate debt/total assets ratios for the three companies for 2007. (Hint: Edelman's 2007 debt ratio 55%).

I- Calculate the P/E ratios for Kennedy and Strasburg for 2007. Are these P/Es reasonable in view of relative growth, payout, and ROE data?. If not what other factors might explain them? (Hint: Kennedy's P/E = 8x.)

J- Now determine a range of values for Edelman's stock price, with 400,000 shares outstanding, by applying Kennedy's and Strasburg's P/E ratios, price/dividends ratios, and price/book value ratios to your data for Edelman. For example, one possible price for Edelman' stock is (P/E Kennedy)(EPS Edelman) = 8($3) = $24 per share. Similar calculations would produce a range of prices based on both Kennedy's and Strasburg's data (Hint: range was $24 to $27.)

K- Using the equation rS =D1/Po + g, find approximate rS values for Kennedy and Strasburg. Then use these values in the constant growth stock price model to find a price for Edelman's stock. (Hint: We averaged the EPS and DPS g's for Edelman.)

L- At what price do you think Edelman's shares should be offered to the public? You will want to select a price that will be low enough to induce investors to bu the stock but not so low that it will rise sharply immediately after it is issued. Think about relative growth rates, ROEs, dividend yields, and total returns (rS = D1/P0 + g)

Problem 19-4 (Refunding Analysis)

Jan Volk, financial manager of Green Sea Transport (GST), has been asked by her boss to review GST's outstanding debt issues for possible bond refunding. Five years ago, GST issued $40,000,000 of 11%, 25 years debt. The issue, with semiannual coupons, is currently callable at a premium of 11%, or $110 for each $1,000 par value bond. Flotation cost on this issue were 6%, or $2,400,000.

Volk believes that GST could issue 20 years debt today with a coupon rate of 8%. The firm has placed many issues in the capital markets during the last 10 years, and its debt flotation cost are currently estimated to be 4% of the issue's value. GST's federal-plus -tax rate is 40%.

Help Volk conduct the refunding analysis by answering the following questions:

A- What is total dollar call premium required to call the old issue? Is it tax deductible? What is the net after tax cost of the call?

B- What is the dollar flotation cost on the new issue? Is it immediately tax deductible? What is the after tax flotation cost?

C- What amounts of old issue flotation costs have not been expensed? Can these deferred cost be expensed immediately if the old issue is refunded? What is the value of the tax savings?

D- What is the net after tax cash outlay required to refund the old issue?

E- What is the semiannual after tax interest savings that arises from amortizing the flotation costs on the new issue? What is the forgone semiannual tax savings on the old issue flotation costs?

F- What is the semiannual after tax interest savings that would result form the refunding?

G- Thus far, Volk has identified two future cash flows: (1) the net of new issue flotation cost tax savings and old issue flotation const tax savings that are lost if refunding occurs and (2) after tax interest savings. What is the sum of these two semiannual cash flows? What is the appropriate discount rate to apply to these future cash flows? What is the present value of these cash flows? (Hint: The PVIFA 24%/40 = 25.5309.)

H- What is the NPV of refunding? Should GST refund now or wait until later?

The Edelman Gem Company, a small jewelry manufacturer, has been successful and has enjoyed a good growth trend. Now Edelman is planning to go public with an issue of common stock, and it faces the problem of setting an appropriate price on the stock. The company and its investment banks believe that the proper procedure is to select several similar firms with publicity traded common stock and to make relevant comparisons.

Several jewelry manufactures are reasonably similar to Edelman with respect to product mix, asset composition, and debt/equity proportions. Of these companies Kennedy Jewelers and Strasburg Fashions are most similar. When analyzing the following data, assume that 2002 and 2007 were reasonably "normal" years for all three companies-that is, these years were neither especially good nor especially bad in terms of sales, earnings, and dividends. At the time of the analysis, rRF was 8%and RPm was 4%. Kennedy is listed on the AMEX and Strasburg on the NYSE, while Edelman will be traded in the Nasdaq market.

Kennedy Strasburg Edelman (total).

Earning per Share

2007 $4.50 $7.50 $1,200,000

2008 3.00 3.50 816,000

Price per Share

2007 $36.00 $65.00 --------

Dividends per Share

2007 $2.25 $3.75 $ 600,000

2002 1.50 2.75 420,000

Book Value per Share,2007 $30.00 $55.00 $9. million

Market/book ratio 2007 120% 118% ------

Total assets, 2007 $28. million $82. million $20 million

Total debt, 2007 $121. million $30. million $11 million

Sales 2007 $41. million $140 million $37 million

The data are on a per share basis for Kenned and Strasburg, but are totals for Edelman.

A- Assume that /Edelman has 100 shares of stock outstanding. Use this information to calculate earnings per share (EPS), dividends per share (DPS), and book value per share for Edelman. (hint: Edelman's 2007 EPS = $12,000).

B- Calculate earnings and dividends growth rates for the three companies. (Hint: Edelman's EPS growth rate is 8%)

C- On the basis of your answer to part a, do you think Edelman's stock would sell at a price in the same "ballpark" as that of Kennedy and Strasburg, that is, in the range of $25 to $100 per share?.

D- Assuming that Edelman's management can split the stock so that the 100 shares could be changed to 1,000 shares, 100,000 shares, or any other number, would such an action make sense in this case? Why or why not?.

E- Now assume tha Edelman did split its stock and has 400,000 shares. Calculate new values for EPS, DPS, and book value per share. (Hint: Edelman's new 2007 EPS is $3.00)

F- Return on equity (ROE) can be measured as EPS/book value per hare or as total earnings/total equity. Calculate ROEs for the three companies for 2007. (Hint: Edelman's 2007 ROE is 13.3%).

G- Calculate dividend payout ratios for the three companies for both years. (Hint: Edelman's 2007 payout ratio is 50%).

H- Calculate debt/total assets ratios for the three companies for 2007. (Hint: Edelman's 2007 debt ratio 55%).

I- Calculate the P/E ratios for Kennedy and Strasburg for 2007. Are these P/Es reasonable in view of relative growth, payout, and ROE data?. If not what other factors might explain them? (Hint: Kennedy's P/E = 8x.)

J- Now determine a range of values for Edelman's stock price, with 400,000 shares outstanding, by applying Kennedy's and Strasburg's P/E ratios, price/dividends ratios, and price/book value ratios to your data for Edelman. For example, one possible price for Edelman' stock is (P/E Kennedy)(EPS Edelman) = 8($3) = $24 per share. Similar calculations would produce a range of prices based on both Kennedy's and Strasburg's data (Hint: range was $24 to $27.)

K- Using the equation rS =D1/Po + g, find approximate rS values for Kennedy and Strasburg. Then use these values in the constant growth stock price model to find a price for Edelman's stock. (Hint: We averaged the EPS and DPS g's for Edelman.)

L- At what price do you think Edelman's shares should be offered to the public? You will want to select a price that will be low enough to induce investors to bu the stock but not so low that it will rise sharply immediately after it is issued. Think about relative growth rates, ROEs, dividend yields, and total returns (rS = D1/P0 + g)

Problem 19-4 (Refunding Analysis)

Jan Volk, financial manager of Green Sea Transport (GST), has been asked by her boss to review GST's outstanding debt issues for possible bond refunding. Five years ago, GST issued $40,000,000 of 11%, 25 years debt. The issue, with semiannual coupons, is currently callable at a premium of 11%, or $110 for each $1,000 par value bond. Flotation cost on this issue were 6%, or $2,400,000.

Volk believes that GST could issue 20 years debt today with a coupon rate of 8%. The firm has placed many issues in the capital markets during the last 10 years, and its debt flotation cost are currently estimated to be 4% of the issue's value. GST's federal-plus -tax rate is 40%.

Help Volk conduct the refunding analysis by answering the following questions:

A- What is total dollar call premium required to call the old issue? Is it tax deductible? What is the net after tax cost of the call?

B- What is the dollar flotation cost on the new issue? Is it immediately tax deductible? What is the after tax flotation cost?

C- What amounts of old issue flotation costs have not been expensed? Can these deferred cost be expensed immediately if the old issue is refunded? What is the value of the tax savings?

D- What is the net after tax cash outlay required to refund the old issue?

E- What is the semiannual after tax interest savings that arises from amortizing the flotation costs on the new issue? What is the forgone semiannual tax savings on the old issue flotation costs?

F- What is the semiannual after tax interest savings that would result form the refunding?

G- Thus far, Volk has identified two future cash flows: (1) the net of new issue flotation cost tax savings and old issue flotation const tax savings that are lost if refunding occurs and (2) after tax interest savings. What is the sum of these two semiannual cash flows? What is the appropriate discount rate to apply to these future cash flows? What is the present value of these cash flows? (Hint: The PVIFA 24%/40 = 25.5309.)

H- What is the NPV of refunding? Should GST refund now or wait until later?

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