Finance assignment – corporate finance

Individual Assignmnet Corporate Finance

Tenyearsago,in 2003,GeorgeReebyfoundeda smallmail-­‐order companysellinghigh-­‐ qualitysportsequipment.SincethoseearlydaysReebySportshas grownsteadilyand been consistently profitable. 

The companyhas issued2millionshares,all of whichareownedbyGeorgeReebyand his five children.Thecompanydoesnot useanydebtin its capitalstructure.Forsomemonths George has beenwonderingwhetherthetimehas cometo takethecompanypublic.This wouldallowhimto cashin on partof his investmentand wouldmakeit 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.

Georgesuspectsthat bookvalueis not necessarilya goodguideto a share’smarketvalue. Hethinksof his daughterJenny,whoworksin an investmentbank.Shewouldundoubtedly knowwhatthesharesareworth.Hedecidesto phoneheraftershefinishesworkthat 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 fairlyconfidentthat thecompanycouldcontinueto growsteadilyforthenextthreeto fiveyears.In fact,hefeelsthat thecompany’sgrowthhas beensomewhatheldbackin thelast fewyearsbythedemandsfromtwoof 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.

Therearesomecloudson thehorizon.Competitionis increasingand onlythat morning MollySportsannouncedplans to forma mail-­‐order division.Georgeis worriedthat beyond thenextthreeorso yearsit mightbecomedifficultto find worthwhileinvestment opportunities.

GeorgerealizesthatJennywillneedto knowmuchmoreabouttheprospectsforthe businessbeforeshecanputa final figureon thevalueof ReebySports,buthehopesthat

theinformationbelowis sufficientforherto givea preliminaryindicationof thevalueof the

shares.

a)      HelpJennyto forecastdividendpaymentsforReebySportsand to estimatethevalue of thestock.You do notneedto providea singlefigure.Forexample,youmaywishto calculatetwofigures,oneon theassumptionthattheopportunityforfurther profitableinvestmentis reducedin year3and anotheron theassumptionthatitis reducedin year5.You canassumea costof equityof 12%forthecalculation.

(21points)

OnceReebyoperatesas a marketlistedfirm,Georgewillhaveto justifythefirm’scapital structuretowardsshareholders.Hehas heardfromhis daughterthatmostfirmsshould use atleastsomedegreeof debtif thegoalis themaximizationof shareholdervalue.Jenny mentioneda “debttax shield”as thereasonforherclaim.George,on theotherhand is worriedabouttheincreasedriskthatdebtmightbringforequityholders.

b)      Brieflyexplaintheleverageeffectand howitis relatedto theexpectedriskfor shareholders.Also,explainthebalancing(ortrade-­‐off) theoryof capitalstructure. Whatarethetwoeffectsthatneedto bebalancedand whatdoesthetheoryimplyfor thedebt/equitychoiceof Reeby?(13points)

Georgeis increasinglyconfidentto takethefirmpublic.However,therearestill someissues aroundtheIPOprocessthathehas notyetfiguredout. Hehas writtendownthesequestions and asksforyourhelp:

c)       Pleaseexplainwhata „Greenshoeoption“ is and underwhatcircumstancesitis used.

(4points)

d)      WithintheIPOprocessunderwritersplayan importantrole.Definetheterms underwriterand syndicateand explaintheirrole/purpose.(4points)

e)      In 2003,prosecutorschargedseveralinvestmentbankersforwhatis called“spinning”.

Brieflyexplaintheunderlyingprincipleand rationalizetheuseof spinningby investmentbanks.(8points)