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Question: Amanda Monaco has just inherited her fatherâs company.Prior to his death, Mr. Monaco was the sol...
Amanda Monaco has just inherited her fatherâs company. Prior tohis death, Mr. Monaco was the sole stockholder, and he left theentire company to his only daughter. Although Amanda has worked forthe firm for many years as a commercial artist, she does not feelqualified to manage the operation. She has considered selling thefirm while it is still a viable operation and before her fatherâsabsence causes the value of the firm to deteriorate. Amandarealizes that selling the firm will result in losing control, buther father granted her a long-term contract that guaranteesemployment or a generous severance package. Furthermore, if Amandawere to sell for cash, she should receive a substantial amount ofmoney, so her financial position would be secure.
Even though Amanda would like to sell out, she has enoughbusiness sense to realize that she does not know how to place anasking price (a value) on the firm. The IRS had established a valueon her fatherâs stock of $100 a share, and since he owned 100,000shares, the value of the company for estate tax purposes was$10,000,000. Amanda thought that was a reasonable amount butdecided to consult with Sophie Ryer, the CPA who completed theestate tax return.
Ryer suggested that the firm could be valued using a discountedcash flow method in which the current and future dividends arediscounted back to the present to determine the value of the firm.She explained to Amanda that this technique, the dividend-growthmodel, is an important theoretical model used for the valuation ofcompanies. In addition, she suggested that the price/earnings ratioof similar firms may be used as a guide to the value of the firm.Amanda asked Ryer to prepare a valuation of the stock based on P/Eratios and the dividend-growth model. While Amanda realized thatshe could get only one price, she requested range of values from anoptimistic price to a mini mum, rock-bottom value.
To aid the valuation process Ryer assembled the followinginformation. The firm earned $8.50 a share and distributed 60percent in cash dividends during its last fiscal year. This payoutratio had been maintained for several years, with 40 percent of theearnings being retained to finance future growth.The per-shareearnings for the past five years were as follows:
Year
20X1 20X2 20X3 20X4 20X5
Earnings per share
$6.70 7.40 7.85 8.20 8.50
Publicly held firms in the industry have an average P/E ratio of12, with the highest being 17 and the lowest 9. The betas of thesefirms tend to be less than 1.0, with 0.85 being typical. While thefirm is not publicly held, it is similar in structure to otherfirms in the industry. It is, however, perceptible smaller than thepublicly held firms. The Treasury bill rate is currently 5.2percent, and most financial analysts anticipate that the market asa whole will average a return of 6 to 6.5 percent greater than theTreasury bill rate.
Amanda has come to you to help devise a financial plan after thecompany is sold. Such a plan would encompasses the construction ofa well diversified diversified portfolio with sufficient resourcesto meet temporary needs for cash. You do not want to blindly acceptthe IRS estate value of $10,000,000. Obviously, if the firm couldbe sold for more, that would be beneficial to your client. Inaddition, you want an indication of the value Ryer may place on thefirm, so you resolve to answer the following questions
If the estate tax rate is 35%, what is the implication ofvaluation if less than $100 per share?
