Question

Recall that if the economy continues to be strong, Carson Company may need to increase its production capacity by about 50 percent over the next few years to satisfy demand. It would need financing to expand and accommodate the increase in production. Recall that the yield curve is currently upward sloping. Also recall that Carson is concerned about a possible slowing of the economy because of potential Fed actions to reduce inflation. It is also considering issuing stock or bonds to raise funds in the next year. If Carson goes public, it might even consider using its stock as a means of acquiring some target firms. It would also consider engaging in a secondary offering at a future point in time if the IPO is successful and if its growth continues over time. It would also change its compensation system so that most of its managers would receive about 30 percent of their compensation in shares of Carson stock and the remainder as salary.

a. At the present time, the PE ratio (stock price per share divided by earnings per share) of other firms in Carson’s industry is relatively low but should rise in the future. Why might this information affect the time at which Carson issues its stock?

b. Assume that Carson Company believes that issuing stock is an efficient means of circumventing the potential for high interest rates. Even if long- term interest rates have increased by the time it issues stock, Carson thinks that it would be insulated by issuing stock instead of bonds. Is this view correct?

c. Carson Company recognizes the importance of a high stock price at the time it engages in an IPO (if it goes public). But why would its stock price be important to Carson Company even after the IPO?

d. If Carson Company goes public, it may be able to motivate its managers by granting them stock as part of their compensation. Explain why the stock may motivate them to perform well. Then explain why the use of stock as compensation may motivate them to focus on short-term goals even though they are supposed to focus on maximizing shareholder wealth over the long run. How can a firm provide stock as motivation but prevent its managers from using a short-term focus?

Answer 1

a) When any firm goes public its main objective to raise more funds. Future earning of firm reflects expected price of stock. Industry PE ratio is is one of the tools of comparison while valuing the stock price. As PE ratio of other firm in Carson's industry is relatively low but it is going to rise in future, means price of stock will be higher in future there fore it would be favorable to issue stock.

b) Various factors need to be considered while determining to issue stock or bond or to raise from long term loan. It includes cost of financing that is cost of issuing stock, Interest payment and other related cost. After comparison decision can be taken. Ownership right is also important factor. Issue of stock may lead in dilution of ownership.

therefore financial as well as non financial factors must be considered. There fore Carson's view is also correct subject to is has considered financial as well as non financial factors like Ownership right.

c) Stock price of company is always important. in given example it is given that Carson " would also consider engaging in a secondary offering at a future point in time if the IPO is successful". There fore stock price must be favorable in future to raise more fund. Stock price also creates image of company in market.

d) Granting Stock to manages or key employees plays motivational role for they hold stock of company they always in benefit if stock price is rising. Stock price rises if company perform better. therefor it is indirect means of motivation to maximize wealth of company. and Wealth maximization is long tern process there fore manager focus more long term rather than short term goal.