VALUATION OF SHARES (35 MARKS)
A. 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 companyâs 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, Encoreâs chief financial officer has assigned a junior financial analyst, Marc Scott, to evaluate the firmâs 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:
- Earnings per share: $ 6.25 (2015 value)
- Price per ordinary share: $ 40 (2015 value)
- Book value of equity: $ 60,000,000 (2015 value)
- Total ordinary shares outstanding: 2,500,000 (2015 value)
- Ordinary dividend per share: $ 4 (2015 value)
Required:
a. What is the firmâs current book value per share?
b. What is the firmâs current P/E ratio?
c.
(1) What is the current required rate of return for Encoreâs shares?
(2) What will be the new required rate of return for Encoreâs shares assuming that they expand into European and Latin American markets as planned?
d. 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).
e.
(1) If Jordan Ellisâs 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) If Jordan Ellisâs 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)
f. 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 Encoreâs Share?
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.
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?
