Individual Assignmnet Corporate Finance

Ten years ago, in 2003, George Reeby founded a small mail-­-order company selling high-­- quality sports equipment. Since those early days Reeby Sports has grown steadily and been consistently profitable. 

The company has issued 2 million shares, all of which are owned by George Reeby and his five children. The company does not use any debt in its capital structure. For some months George has been wondering whether the time has come to take the company public. This would allow him to cash in on part of his investment and would make it 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 suspects that book value is not necessarily a good guide to a share's market value. He thinks of his daughter Jenny, who works in an investment bank. She would undoubtedly know what the shares are worth. He decides to phone her 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 down some basic data on the company's profitability. After recovering from its early losses, the company has earned a return that is higher than its estimated 10% cost of capital. George is fairly confident that the company could continue to grow steadily for the next three to five years. In fact, he feels that the company's growth has been somewhat held back in the last few years by the demands from two of the children for 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 clouds on the horizon. Competition is increasing and only that morning Molly Sports announced plans to form a mail-­-order division. George is worried that beyond the next three or so years it might become difficult to find worthwhile investment opportunities.

George realizes that Jenny will need to know much more about the prospects for the business before she can put a final figure on the value of Reeby Sports, but he hopes that the information below is sufficient for her to give a preliminary indication of the value of the shares.

a) Help Jenny to forecast dividend payments for Reeby Sports and 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 the assumption that the opportunity for further profitable investment is reduced in year 3 and another on the assumption that it is reduced in year 5. You can assume a cost of equity of 12% for the calculation.

Once Reeby operates as a market listed firm, George will have to justify the firm's capital structure towards shareholders. He has heard from his daughter that most firms should use at least some degree of debt if the goal is the maximization of shareholder value. Jenny mentioned a "debt tax shield" as the reason for her claim. George, on the other hand is worried about the increased risk that debt might bring for equity holders.

b) Briefly explain the leverage effect and how it is related to the expected risk for shareholders. Also, explain the balancing (or trade-­-off) theory of capital structure. What are the two effects that need to be balanced and what does the theory imply for the debt/equity choice of Reeby?

George is increasingly confident to take the firm public. However, there are still some issues around the IPO process that he has not yet figured out. 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.

d) Within the IPO process underwriters play an important role. Define the terms underwriter and syndicate and explain their role/purpose.

e) In 2003, prosecutors charged several investment bankers for what is called "spinning".

Briefly explain the underlying principle and rationalize the use of spinning by investment banks.