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In the world of trendsetting fashion, instinct and marketing savvy are prerequisites to success. Jordan Ellis had both. During 2015, his international casual-wear company, Encore, rocketed to $300 million in sales after 10 years in business. His fashion line covered the young woman from head to toe with hats, sweaters, dresses, blouses, skirts, pants, sweatshirts, socks, and shoes. The Encore shops are now a standard feature in every town in New Zealand.

Encore had made it. The company’s historical growth was so spectacular that no one could have predicted it. However, securities analysts speculated that Encore could not keep up the pace. They warned that competition is fierce in the fashion industry and that the firm might encounter little or no growth in the future. They estimated that shareholders also should expect no growth in future dividends.

Contrary to the conservative securities analysts, Jordan Ellis felt that the company could maintain a constant annual growth rate in dividends per share of 6% in the future, or possibly 8% for the next 2 years and 6% thereafter. Ellis based his estimates on an established long-term expansion plan into European and Latin American markets. Venturing into these markets was expected to cause the risk of the firm, as measured by risk premium on its share, to increase immediately from 8.8% to 10%. Currently, the risk free rate is 6%.

In preparing the long-term financial plan, Encore’s chief financial officer has assigned a junior financial analyst, Marc Scott, to evaluate the firm’s current share price. He has asked Marc to consider the conservative predictions of the securities analysts and the aggressive predictions of the company founder, Jordan Ellis.

Marc has compiled these 2015 financial data to aid his analysis:

Data item 2015 value Earnings per share $ 6.25 Price per ordinary share $ 40.00 Book value of equity $ 60,000,000 Total ordinary shares outstanding 2,500,000 Ordinary dividend per share $ 4.00

Required:

a. What is the firm’s current book value per share? (2 Marks)

b. What is the firm’s current P/E ratio? (2 Marks)

(1) What is the current required rate of return for Encore’s shares?

(2) What will be the new required rate of return for Encore’s shares assuming that they expand into European and Latin American markets as planned? (6 Marks)

If the securities analysts are correct and there is no growth in future dividends, what will be the value per share? (Use the new required rate of return computed in part [C (2)] above). (2 Marks)

If Jordan Ellis’s predictions are correct, what will be the value per share if the firm maintains a constant annual 6% growth rate in future dividends? (Use the new required rate of return computed in part [C (2)] above). (2 Marks)

If Jordan Ellis’s predictions are correct, what will be the value per share if the firm maintains a constant annual 8% growth rate in dividends per share over the next 2 years and 6% thereafter? (Use the new required rate of return computed in part [C (2)] above)

Compare the current (2015) price of the share and the share values found in parts (a) to (e). Discuss why these values differ. Which valuation method do you believe most clearly represents the true value of Encore’s Share? (7 Marks)

**B. Answer the following questions: **

a. How does a bond issuer decide on the appropriate coupon rate to set on its bonds? Explain the difference between the coupon rate and the required return on a bond. (5 Marks)

b. Companies pay rating agencies such as the Standard and Poor Rating Service, to rate their bonds, and the costs can be substantial. However, companies are not required to have their bonds rated in the first place; doing so is strictly voluntary. Why do you think they do it?

Solved by qualified expert

**Question 1**

a) Total book value of the firm in 2015 = $ 60 million Number of ordinary shares outstanding in 2015 = 2.5 million Hence, book value per share = 60/2.5 = $ 24

b) Price per ordinary share of the company as per the data provided = $ 40 Earnings per share = $ 6.25 Hence, firm’s current P/E = 40/6.25 = 6.4

c)(i) The required rate of return on Encore shares can be estimated using the expected premium that would be given so as to compensate investors for the incremental risk assumed.

It is known that the risk free rate is 6% pa Under the current situation, the share premium required is 8.8% pa Hence, the current required rate on Encore shares = 6 + 8.8 = 14.8% pa

(ii) Due to the expansion of the company in European and Latin American market, the underlying risk would increase and hence the overall risk premium on the stock increases to 10% pa. It is known that the risk free rate is 6% pa Hence, the current required rate on Encore shares = 6 + 10 = 16% pa

d) As per the securities analyst, the future growth in dividend till perpetuity is going to be zero. We deploy the Gordon dividend discount model to estimate the price of the stock.

Price of the stock = Next year dividend /(Expected return – Perpetual dividend growth rate)

Since, dividend growth rate is zero, hence next year dividend is the same as current year dividend i.e. $ 4 per share. Hence, stock price = 4/(0.16-0) = $ 25

e) Now, it is given that the expected growth rate of dividends perpetually is 6%, Hence, dividend per share next year = 4*1.06 = $ 4.244 Price of the stock = Next year dividend /(Expected return – Perpetual dividend growth rate) Hence, stock price = 4.24/(0.16-0.06) = $ 42.4

(2) The current dividend is $ 4 per share. Let us consider this year 0.

Dividend in year 1 = 4*1.08 = $ 4.32

Dividend in year 2 = 4.32*1.08 = $ 4.666

Dividend in year 3 = 4.666*1.06 = $ 4.946

The required rate of return = 16% pa

Hence, stock price = 4.32/1.16 + 4.666/1.162 + 4.946/[(0.16-0.06)*1.162] = $ 43.94

f) In the above parts, the share values have been estimated using the Gordon dividend discount model and thus estimate the intrinsic price or the actual price of the stock. However, the price given in the question is $ 40 which is the market price which is not always equal to the intrinsic price since the markets are not efficient. Further, even theoretical prices keep on changing as per the various inputs as seen in the given question. For instance when the dividend growth rate is altered, the intrinsic price of the stock would change. Hence, by changing the theoretical inputs various different prices are being obtained.

The better pricing mechanism is the market price especially in a stable market as it allows for better price discovery. This is not possible in case of theoretical methods as the final answers are sensitive to changes in the input.