Swan Davis Inc
The Industry Is cyclical, and competition Is strong, so profits are some-what unstable. Tables 1, 2, and 3 provide historical balance sheets, Income statements, and ratios for the company for the period 1994-1996, Table 4 provides industry average data for 994-1996, and Table 5 provides one security analyst’s forecasted data for the company based on assumptions set forth later in the case.
Your consulting firm was Just hired to explain to Sad’s managers how the market establishes the values of Its securities?management wants this Information in order to make accurate estimates of capital costs for use in capital budgeting. Your boss, Maria Gonzales, asked you to head up the project, and she set up a meeting for you with Bob Wilkes, Sad’s chief financial officer (CUFF), and Tony Fiddle, a security analyst who follows SD’. Tony Fiddle agreed to help with the project, but due to other commitments, his help will be limited to providing data.
To avoid any potent- tall problem with Illegal disclosure, It was agreed that no confidential company data should be used-the analysis should be based entirely on publicly available data plus the data in Table 5 which Tony developed on his own-After some discussion, it was agreed that you should use the following securities to explain the valuation process: SAID currently has two bond issues outstanding. Bond A has a $1,000 par value and a coupon rate of 10 percent, paid semi-annually.
This bond was Issued 10 years ago, It has 10 years remaining to maturity, and It has 2 years of call protection left, after which it can be called at 104 percent of par. This issue is actively traded and highly liquid, and its most recent closing price was $1 ,092. The second issue, Bond B, is thinly traded, so no valid market quotation is available. This bond had a 25-year maturity when it was issued 2 years ago, a $1 ,OHO par value, 5 years of call protection remaining, a call price of $1 , 100 when It becomes callable, and a 6. Percent coupon paid semi-annually. Bonds A and B have Identical priority with aspect to claims on Sad’s income and assets. One of Tony Fiddle’s customers has been offered some of the B bonds at a price of $850 per bond. Since this bond is illiquid and not actively traded, the customer does not know if $850 is a fair price. It was agreed that you should determine, for each bond, a fair value and a fair rate of return, and then use your analysis to help explain bond valuation to Sad’s executives.
You were also asked to demonstrate how changes In the rate of Inflation and In the capital budgeting decisions. The most recent S;P Bond Guide indicates that Eng-term bonds with varying ratings have the following yields: AAA A EBB 6. 6% 6. 9 7. 6 7. 8 EBB 8. 8 Blip. L The average bond rating for construction equipment firms is single A. Sad’s bonds were rated single A prior to 1994, but then financial problems led to three downgrading, to a current rating of B. B. SAID has perpetual preferred stock which pays a dividend of $8. 5, is traded actively, and last traded at a price of $97. Bob Wilkes, Sad’s Chief Financial Officer (CUFF), wants to know what the return to investors is on the preferred, and how that return compares to the return on Sad’s bonds and common stock. Bob also notes that most of the preferred is owned by non-financial corporations, and he wants you to explain why this is so. It is agreed that in your explanation you will assume that corporations have a state-plus-federal income tax rate of 40 percent, and you will use the top personal tax rate of 39. 6 percent. C.
Sad’s officers have been under pressure from the board of directors to do something to improve the price of the common stock. Management is also concerned about the stock price personally because bonuses are based on the performance of Sad’s stock price relative to other firms in its industry. So, they would like a detailed explanation of how the market price is determined?what do investors look for, and what can management do to provide what investors want? Bob Wilkes also wants you to explain how stock valuation information be used to help estimate the company’s cost of equity.
Tony Fiddle provided some information that can be used in the stock valuation process. First, as background on what investors think about the company, here are some representative quotations taken from analysts’ reports issued during the past few years. August 1992. Deed Thompson, Smyth Barley’s construction analyst: “Sad’s investment in new facilities is paying off in lower costs and higher volumes, and its R&D and marketing programs are paying off in increased sales.
Management is confident that sales and earnings will set new records this year, and the CUFF regards an earnings growth rate of 1 5 to 20 percent over the next 5 to 7 years as ‘reasonable. ‘ report record sales and earnings again this year, and management believes 1995 will be another good year. The order backlog is down, but management regards this as a temporary situation, not something to be concerned about. This is a cyclical industry, o there are ups and downs. However, the long-run trend for well managed companies such as SAID is clearly up.
We are maintaining our recommendation of a strong buy on SAID. “November 1994. At the same time that Deed Thompson recommended buying SD’, Amy Tucker, Murray Finch’s construction analyst, voiced a contrary opinion: “SAID will probably report record earnings for 1994, and management thinks 1995 will also be strong. However, we are less confident. The order backlog is down, and the company’s new products did not elicit excitement at the recent Chicago trade show. We think this is a DOD time to take profits in the stock, so we rate it a SELL. “December 1996.
Two years later, after having been burned by an incorrect forecast in 1994, Deed Thompson had this to say: “SAID will shortly report another bad year. The stock is now at a 6-year low, and all the financial are weak. In a conference call with analysts, the CUFF and other company officials described plans to improve operations and strengthen the company’s financial position. If those plans work out, then SAID could regain some of its former luster. However, investors have been burned by management’s overly optimistic predictions in the past, so we recommend a wait and see attitude. We still regard SAID as a SELL. Tony Fiddle also has growth rate projections from two investment advisory services, IBIS and Sacks, which collect growth rate forecasts on each of several thousand companies from analysts such as Deed Thompson and Amy Tucker. L The median forecast of these analysts gives an idea of what the investment community expects each company to do in the foreseeable future. The range of forecasts, and their standard deviation, is also provided. The wider the range, the larger the tankard deviation, hence the greater the uncertainty about the company’s future. The median forecasted growth rate for SAID is 8 percent.
However, the standard deviation associated with that estimate is 12 percent, which is very high and therefore indicates that there are huge variations in the individual analysts’ forecasts. Indeed, analysts’ forecasts for SAID range from-15 percent to +18 percent. When Tony provided his estimate to the growth rate compilers, he used 1 5 percent, but he admits: (1) That he is more optimistic than most, (2) That he does not have much confidence in his estimate because Sad’s tuition is so fluid, and (3) That the actual growth rate will probably turn out to be much higher or lower than his forecasted 15 percent.
Like most analysts, Tony based his growth rate forecast on projections of Sad’s financial statements which he made, using a spread sheet forecasting model. His results are shown in Table 5. He wants you to use the data with caution and to construct similar models but make different assumptions about sales growth and operating ratios, hence obtain a wide range of growth rate forecasts. Swan-Davis and other companies make forecasts of their own, but they typically keep this information inferential.
Because Sad’s recent financial performance has not been good, Tony and many other analysts expect the company to cut the annual dividend in 1997. In a meeting with analysts, management indicated that such a cut was being considered. Tony thinks the dividend will drop from $0. 52 in 1996 to $0. 20 in 1997. If his forecasts are borne out, then earnings would support a dividend growth rate, after the initial 1997 cut of 20 percent for the period 1998 to 2001. After the Year 2001, Tony expects the company to grow at a rate of about 14. 9 percent, and if it achieves this constant Roth situation, he thinks the PIE ratio will rise to 15.
With a forecasted PEPS of $2. 02 and a PIE ratio of 15, the forecasted Year 2001 stock price is $30. 30. (A rounding difference accounts for the difference between the $30. 30 and the $30. 20 shown in Table 5. With forecasts such as these, such a difference is not significant. ) typically forecast PEPS going out for 5 years, which is about as far as analysts think forecasts are useful for most investors. For purposes of the DC model, it would be better to have forecasts of the average growth rate in dividends going on out to repertory.
However, (1) the analysts’ forecasts generally do represent their best guesses for the long-run growth rate, (2) in the long run, dividends should on average grow at the same rate as earnings, hence (3) we can use analysts’ forecasted earnings growth rates as proxies for expected long-run dividend growth rates. Empirical studies have confirmed the validity of this approach. Note, though, that while the approach may be valid for most companies, it may not be appropriate if the earnings growth rate is expected to be quite different over the next 5 years than in the long run.
This is especially true for small companies and for companies undergoing a major transformation. You can use the data in Table 5 to estimate the rate of return an investor would earn if he or she bought the stock at its current $15 price and Fiddle’s results are actually obtained. You wonder, though if “the marginal investor” has expectations that match those of Tony Fiddle, and what the effects on Sad’s stock price and cost of equity would be if a mismatch exists. Fiddle notes that his model is flexible in the sense that if you don’t like his assumptions, you can run the model with other assumptions.
For example, you could use inputs (I. E. , assumptions) that would produce an PEPS growth rate of 8 percent, which would be closer to the median IBIS forecast. Another approach to estimating the cost of equity is the Capital Asset in the neighborhood of 1. 1 to 1. 3. He does not have a beta for SD’, but in a note Tony stated that you might use the following data to calculate one: Rate of Return on: Yardmaster 210. 347. 70 346. 9710. O 4-34. 962. O 5-28. 3535. 60 Sad’s negative returns were caused by its large stock price declines in recent years which resulted from its poor operating results.
Tony stated in his note that he used this data to calculate a beta, but his beta was “weird, so perhaps I made a mistake in the calculation. By Weird,’ I mean that I got a lower beta for SAID than the average firm in its industry, yet most analysts think SAID is riskier than average. ” You also remember that your old college textbook stated that analysts often assume that investors’ required return on a given company’s stock exceeds the required return on the company’s bonds by some 2 to 6 percentage points.
Maria also suggests that you consider data provided by Boots Associates, which reports hat the historical risk premium on common stocks over corporate bonds has averaged about 6. 4 percent over the years for which data are available. This number is somewhat above the top of the textbook range. In any event, another estimate of the cost of equity for SAID would be the company’s cost of long-term debt plus either a premium in the 2 to 6 percent range or plus the 6. 4 percent Boots premium. Boots Associates also publishes his topical risk premium on common stocks over long-term government bonds (T-bonds).
A recent report indicates that this risk premium is 7. 5 percent. Tony Fiddle also provided you with the latest issue of Value Line, the most widely followed independent source of financial data and forecasts. Value Line indicates that it expects the average stock in its sample of 1,700 companies to have a dividend yield of approximately 2. 4 percent, and to appreciate in value by 55 percent over the next 4 years. Tony suggested that you can use data to calculate Value Line’s expected return on an average stock, which you could then use as the expected rate of return on the market (km) for your CAMP studies of SD’.
All of this leaves you in something of a quandary. You need to come up with estimates of Sad’s costs of debt and preferred stock, and with an estimate of “the marginal investor’s” expected return to use as the cost of equity. Then you must explain all this to the SAID executives, and give them your estimate of the cost of reasonable estimates of these values, the company will not be able to develop accurate values for EVA or a good cost of capital estimate for evaluating proposed capital expenditures.
Maria Gonzales and Bob Wilkes appreciate the difficulty of your task, but all of you know that the estimates must be made. At the last SAID board meeting, one of the directors suggested to Bob Wilkes that he consider financing with convertible bonds because convertibles carry lower coupon rates than straight, nonconvertible debt. Since SAID needs to cut costs, issuing debt with a lower interest rate would be desirable. However, Bob knows that convertibles have a “true cost” which is different from their coupon rate, so he said he would get back to the director.
Now, he wants you to consider convertibles in your study, explaining how to calculate their true cost and how they should be handled in he WAC calculation. A colleague in your firm’s underwriting group informed you that SD’, with its EBB rating, could probably issue 1 5-year convertible bonds with a 7 percent annual coupon at par, $1 ,OHO. Straight db-rated debt would require a considerably higher coupon. With convertibles, each $1,000 bond could be exchanged, at the option of the bondholder, into 40 shares of SAID stock. The convertible issue would have 10 years of call protection, after which it could be called for $1 ,050.
Companies frequently call to force conversion if the conversion value is 30 recent above the bonds par value, provided the bond has become callable, and SAID would probably follow this policy. The call could only be made on an interest payment date, which in the case of annual coupon bonds such as SAID would issue would be once a year. To help you structure your project, Bob and Maria suggest that you answer the following QUESTIONS If an investor bought some of Sad’s A bonds at the current market price, what would be his or her yield to maturity? 2. Like many other bonds, Sad’s A bonds have a call provision.
What is the yield to call on this issue? Which return old an investor be more likely to receive on this bond if it were purchased today, the YET or the YET? 3. Bond prices and returns vary over time due to changes in a company’s risk situation and in response to market factors such as inflation. How would changes in inflation affect the price and the return required on the A bonds? If Sad’s risk as perceived by investors increases, what would happen to the price and the required return on these bonds? What effect would such changes have on Sad’s capital budgeting decisions? 4. E B bonds are not actively traded, hence they do not have a quoted market price. . From information given in the case, what would be a reasonable interest rate to use in valuing the B bonds? Explain. B. What is a fair price for the B bonds? Does the offered price of $850 seem reasonable Would investors expect these bonds to be called? Explain. Explain the difference between interest rate risk and reinvestment rate risk. 5. Which of the above bonds, A or B, has more interest rate risk? Which has more reinvestment rate risk? 6. Do you think individual investors should buy Sad’s preferred stock? Why or why not?