Individual Assignmnet Corporate Finance
Ten years ago, in 2003,George Reeby foundeda small mail-‐order company selling high-‐ qualitysportsequipment. Since those early days Reeby Sports has grown steadily and been consistently profitable.
The company has issued 2 million shares,all of which are ownedby George Reeby and his five children. Thecompanydoes not use any debt in its capital structure. For some months George has beenwondering whether thetime has cometo take the companypublic. This would allow him to cashin on part of his investment and wouldmakeit easier for the firm to 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 $13.17 per share.
A share price of 13.17 would put the stock on a P/E ratio of 6.6. That is quite a bit lower than
the 13.1 P/E ratio of Reeby’s larger the rival, Molly Sports.
George suspectsthat book value is not necessarily a good guide to a share’s market value. He thinksof his daughter Jenny, who works in an investment bank. She would undoubtedly know what the shares are worth. Hedecides to phoneher after she finishes work that evening at 9 o’clock or before she starts the next day at 6.00 a.m.
Before phoning, George jots downsome basic data on the company’s profitability. After recovering from its earlylosses,the company has earned a return that is higher than its estimated 10% cost of capital. George is fairlyconfidentthat the company could continue to growsteadily for the next threeto five years. In fact,he feels that thecompany’s growth has beensomewhat held back in the last few years by the demands from two of thechildrenfor the company to make large dividend payments. Perhaps, if the company went public, it
could hold back on dividends and plow more money back into the business.
There are some cloudson the horizon. Competition is increasing and only that morning Molly Sportsannouncedplans to form a mail-‐order division.George is worried that beyond the next three or so years it might becomedifficult to find worthwhile investment opportunities.
George realizesthat Jenny will need to knowmuch more about the prospects for the business beforeshecan put a final figure on the value of Reeby Sports, but he hopesthat
the information below is sufficient for her to givea preliminary indication of thevalue of the
shares.
Column1
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013E
earningsper share,$
-‐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
Bookvalue pershare, $
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) Help Jennyto forecast dividend paymentsfor Reeby Sportsand to estimate the value of the stock.You do not need to provide a single figure. For example, you may wish to calculate two figures, one on theassumption that the opportunity for further profitable investment is reduced in year 3 and another on theassumption that it is reduced in year 5. You canassume a cost of equityof 12% for the calculation.
(21 points)
Once Reeby operates as a market listed firm, Georgewill have to justify the firm’s capital structure towardsshareholders. He has heard from his daughter that most firms should use at least some degreeof debt if the goal is the maximization of shareholder value. Jenny mentioned a “debt tax shield” as the reason forher claim.George, on the other hand is worried about the increased risk that debt might bring forequityholders.
b) Briefly explainthe leverage effect and how it is related to the expectedrisk for shareholders. Also,explain the balancing (or trade-‐off) theory of capital structure. What are the two effectsthat need to bebalanced and whatdoes the theoryimply for the debt/equity choice of Reeby? (13points)
George is increasingly confident to take the firm public.However, there are still some issues around the IPOprocessthat he has not yet figuredout. He has written down these questions and asks for your help:
c) Please explain what a „Greenshoe option“ is and under what circumstances it is used.
(4 points)
d) Within the IPO processunderwriters play an important role. Define the terms underwriter and syndicate and explain their role/purpose. (4 points)
e) In 2003, prosecutors chargedseveral investment bankersfor what is called“spinning”.
Briefly explainthe underlying principleand rationalize the use of spinning by investment banks.(8points)
What Students Are Saying About Us
.......... Customer ID: 12*** | Rating: ⭐⭐⭐⭐⭐"Honestly, I was afraid to send my paper to you, but splendidwritings.com proved they are a trustworthy service. My essay was done in less than a day, and I received a brilliant piece. I didn’t even believe it was my essay at first 🙂 Great job, thank you!"
.......... Customer ID: 14***| Rating: ⭐⭐⭐⭐⭐
"The company has some nice prices and good content. I ordered a term paper here and got a very good one. I'll keep ordering from this website."
