Question

Problem 18-04
New Stock Issue

Bynum and Crumpton Inc. (B&C), a small jewelry manufacturer, has been successful and has enjoyed a positive growth trend. Now B&C is planning to go public with an issue of common stock, and it faces the problem of setting an appropriate price for the stock. The company and its investment banks believe that the proper procedure is to conduct a valuation and select several similar firms with publicly traded common stock and to make relevant comparisons.
Several jewelry manufacturers are reasonably similar to B&C with respect to product mix, asset composition, and debt/equity proportions. Of these companies, Abercrombe Jewelers and Gunter Fashions are most similar. When analyzing the following data, assume that the most recent year has been reasonably "normal" in the sense that it was neither especially good nor especially bad in terms of sales, earnings, and free cash flows. Abercrombe is listed on the AMEX and Gunter on the NYSE, while B&C will be traded in the Nasdaq market.

Company data	Abercrombe		Gunter		B&C
Shares outstanding	6 million		9 million		500,000
Price per share	$31.00		$49.00		NA
Earnings per share	$2.20		$3.13		$2.60
Free cash flow per share	$1.63		$2.54		$2.00
Book value per share	$14.00		$22.00		$19.00
Total assets	$119 million		$248 million		$11.5 million
Total debt	$35 million		$50 million		$2 million

1. B&C is a closely held corporation with only 500,000 shares outstanding. Free cash flows have been low and in some years negative due to B&C's recent high sales growth rates, but as its expansion phase comes to an end B&C's free cash flows should increase. B&C anticipates the following free cash flows over the next 5 years:

   Year	1	2	3	4	5
   FCF	1,000,000	1,050,000	1,208,000	1,329,000	1,462,000

   
   
   After Year 5, free cash flow growth will be stable at 7% per year. Currently, B&C has no non-operating assets, and its WACC is 12%. Using the free cash flow valuation model (see Chapters 8 and 9), estimate B&C's intrinsic value of equity and intrinsic per share price. Round your answers for the value of equity to the nearest dollar and for the value of equity per share to the nearest cent.

   Value of equity	$
   Per share value of equity	$

2. Calculate debt to total assets, P/E, market to book, P/FCF, and ROE for Abercrombe, Gunter, and B&C. For calculations that require a price for B&C, use the per share price you obtained with the corporate valuation model in Part a.

   	Abercrombe		Gunter		B&C
   D/A	%		%		%
   P/E
   Market/Book
   ROE	%		%		%
   P/FCF

   
   
3. Using Abercrombe's and Gunter's P/E, Market/Book, and Price/FCF ratios, calculate the range of prices for B&C's stock that would be consistent with these ratios. For example, if you multiply B&C's earnings per share by Abercrombe's P/E ratio you get a price. What range of prices do you get? Round your answers to the nearest cent.
   
   The range of prices:
   from $   to $  
   

Answer 1

1. For Calculation of the Value of Equity and Per Share Price under Free Cash Flow Valuation Method, we need to follow following Steps

Step 1: Calculation of Present Value of Future Cash Flows (for 5 Years)

Year	Free Cash Flows	Discount Rate (12%) (1/(1+.12)n where N=no. of Period)	Present Value of Cash flows
1	1,000,000	0.892857	892857
2	1,050,000	0.797194	837054
3	1,208,000	0.71178	859831
4	1,329,000	0.635518	844604
5	1,462,000	0.567427	829578
Total			4263923

Step 2: Calculation of Terminal Value Using Gordan Formula i.e Cash Flow/ (Ke-g) where KE= WACC and g = Growth rate

Cash Flow for the terminal period (beginning of 6^th Year) =1,462,000/(.12-.07)= 29,240,000

Present Value of the Terminal Period= 29,240,000 * (P.V of 1 n=5 r=12%) i.e 0.567427= 16,591,561

Step 3: Add both the PV i.e 42,63,923+16,591,561= 20,855,484. This is the Total Value of the Firm.

Step 4: Equity Value of the Firm= Total Value – Net Debt

                                                         = 20,855,484- 2,000,000= 18,855,484

Step 5: Value Per Share= Equity Value/No. of Equity Shares

                                          = 18,855,484/500,000 = 38

2. Calculation of the below Ratios

	Abercrombe		Gunter		B&C
D/A	%	29.41	%	20.16	%	17.39
P/E		14.09		15.65		14.61
Market/Book		2.21		2.23		2
ROE	%	7.09	%	6.39	%	6.84
P/FCF		19.02		19.29		19

3. Calculation of Range of Prices

	Abercrombe		Gunter
P/E		14.09		15.65
Market/Book		2.21		2.23
P/FCF		19.02		19.29

On basis of aforesaid information, We can take average of the following:

Average PE = 14.87

Average Market/Book= 2.22

Average Price/FCFF= 19.155

Considering the aforesaid ratios, following price per share of B&C may be calculated:

using PE Ratio

EPS of B&C = 2.6

Average PE= 14.87

Price of B&C = Average PE * Earning= 14.87*2.6= 38.7

Using Market/Book Ratio

Book Value per Share of B&C = 19

Average Market/Book= 2.22

Price of B& C= Average Market/Book*Book Value per Share= 2.22*19= 42.18

Using Price/FCFF Ratio

FCFF per Share of B&C= 2

Average Price/FCFF= 19.15

Price of B&C= Average Price/FCFF*FCFF Per Share= 19.15*2= 38.3

Based on the aforesaid Calculation, the range of Price per share for B&C be taken as $42-$38.