Individual Assignmnet Corporate Finance
Tenyearsago,in 2003, GeorgeReebyfounded a smallmail-?order companysellinghigh-? quality sportsequipment.SincethoseearlydaysReebySportshas grownsteadilyand been consistently profitable.
The companyhas issued2millionshares, all of whichareowned byGeorgeReebyand his five children.Thecompany doesnot useanydebtin its capitalstructure.Forsomemonths George has been wonderingwhetherthetimehas come to takethecompany public.This wouldallowhimto cash in on partof his investmentand would makeit easierforthefirmto raise capital should it wish to expand in the future.
But how much are the shares worth? George’s first instinct is to look at the firm’s balance
sheet, which shows that the book value of the equity is $26.34 million, or $13.17 per share.
A share price of 13.17 would put the stock on a P/E ratio of 6.6. That is quite a bit lower than
the 13.1 P/E ratio of Reeby’s larger the rival, Molly Sports.
Georgesuspects that bookvalueis not necessarilya goodguideto a share’smarketvalue. Hethinks of his daughterJenny,whoworksin an investmentbank.Shewouldundoubtedly knowwhatthesharesareworth.Hedecidesto phone heraftershefinishesworkthat evening at 9 o’clock or before she starts the next day at 6.00 a.m.
Beforephoning, Georgejots downsomebasicdata on thecompany’sprofitability.After recoveringfromits earlylosses, thecompanyhas earneda returnthat is higherthan its estimated10%costof capital.Georgeis fairlyconfident that thecompanycouldcontinueto grow steadilyforthenextthree to fiveyears.In fact, hefeelsthat the company’sgrowthhas been somewhatheldbackin thelast fewyearsbythedemandsfromtwoof the childrenfor the company to make large dividend payments. Perhaps, if the company went public, it
could hold back on dividends and plow more money back into the business.
Therearesomeclouds on thehorizon.Competitionis increasingand onlythat morning MollySports announcedplans to forma mail-?order division. Georgeis worriedthat beyond thenextthreeorso yearsit mightbecomedifficultto find worthwhileinvestment opportunities.
Georgerealizes thatJennywillneedto know muchmoreabouttheprospectsforthe businessbefore shecanputa final figureon thevalueof ReebySports,buthehopes that
theinformationbelowis sufficientforherto give a preliminaryindicationof the valueof the
shares.
Column1
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013E
earningspershare,$
-?0.70
-?0.23
0.81
1.10
1.30
1.52
1.64
2.00
2.03
2.33
2.68
Dividend,$
0.00
0.00
0.20
0.20
0.30
0.30
0.60
0.60
0.80
0.80
1.00
Bookvaluepershare,$
7.70
7.00
7.61
8.51
9.51
10.73
11.77
13.17
14.40
15.93
17.62
ROE,%
-?7.14
-?2.99
11.57
14.45
15.28
15.98
15.28
16.99
15.41
16.21
16.85
a) HelpJenny to forecastdividendpayments forReebySports and to estimatethevalue of thestock.You do notneedto providea singlefigure.Forexample,youmaywishto calculatetwofigures,oneon the assumptionthattheopportunityforfurther profitableinvestmentis reducedin year3and anotheron theassumptionthatitis reducedin year5.You can assumea costof equity of 12%forthecalculation.
(21points)
OnceReebyoperatesas a marketlistedfirm,George willhaveto justifythefirmscapital structuretowardsshareholders.Hehas heardfromhis daughterthatmostfirmsshould use atleastsomedegree of debtif thegoalis themaximizationof shareholdervalue.Jenny mentioneda debttax shieldas thereasonforherclaim. George,on theotherhand is worriedabouttheincreasedriskthatdebtmightbringforequity holders.
b) Brieflyexplain theleverageeffectand howitis relatedto theexpected riskfor shareholders.Also,explainthebalancing(ortrade-?off) theoryof capitalstructure. Whatarethetwoeffects thatneedto bebalancedand what doesthetheory implyfor thedebt/equitychoiceof Reeby?(13 points)
Georgeis increasinglyconfidentto takethefirmpublic. However,therearestill someissues aroundtheIPOprocess thathehas notyetfigured out. Hehas writtendownthesequestions and asksforyourhelp:
c) Please explainwhata Greenshoeoption is and underwhatcircumstancesitis used.
(4points)
d) WithintheIPOprocess underwritersplayan importantrole.Definetheterms underwriterand syndicateand explaintheirrole/purpose.(4points)
e) In 2003, prosecutorschargedseveral investmentbankersforwhatis called spinning.
Brieflyexplaintheunderlyingprinciple and rationalizetheuseof spinningby investmentbanks. (8points)