Question

Instruction: Read the case study related to East Coast Yachts and complete the following tasks.

After Dan’s analysis for East Coast Yachts (see the Case study for Module 2), Larissa has decided to expand the company’s operations. She has asked Dan to enlist an underwriter to help sell $50 million(total value of all bonds) in new 20-year(maturity of each bond) bonds to finance new construction. Dan has entered into discussions with Kim McKenzie, an underwriter from the firm of Crowe & Mallard, about which bond features East Coast Yachts should consider and also what coupon rate the issue will likely have. After examining all features of each type of bonds, Dan is considering to issuecoupon bearing bonds or zero coupon bonds. The YTM on either bond issue will be 7.5 percent. The coupon bond would have a 7.5 percent coupon rate.

1. How many of the coupon bonds must East Coast Yachts issue to raise the $50 million? How many of the zeroes must it issue? You must show all your works for the full credits.

2. In 20 years, what will be the principal repayment due if East Coast Yachts issues the coupon bonds? What if it issues the zeroes? You must show all your works for the full credits.

Larissa has been talking with the company’s directors about the future of East Coast Yachts. To this point, the company has used outside suppliers for various key components of the company’s yachts, including engines. Larissa has decided that East Coast Yachts should consider the purchase of an engine manufacturer to allow East Coast Yachts to better integrate its supply chain and get more control over engine features. After investigating several possible companies, Larissa feels that the purchase of Ragan Engines, Inc., is a possibility. Ragan Engines, Inc., was founded nine years ago by a brother and sister—Carrington and Genevieve Ragan—and has remained a privately owned company. The company manufactures marine engines for a variety of applications. Ragan has experienced rapid growth because of a proprietary technology that increases the fuel efficiency of its engines with very little sacrifice in performance. The company is equally owned by Carrington and Genevieve. The original agreement between the siblings gave each 150,000 shares of stock. Last year, Ragan had an EPS of $5.35 and paid a dividend to Carrington and Genevieve of $320,000 each. The company also had a return on equity of 21 percent. Larissa tells Dan that a required return for Ragan of 18 percent is appropriate.

3. Assuming the company continues its current growth rate, what is the value per share of the company’s stock? You must show all your works for the full credits.

Step 1: Find total earnings

Step 2: Find payout ratio

Step 3: Find retention ratio

Step 4: Find growth ratio

Step 5: Find total equity value

Step 6: Find value per share

Answer 1

Since the face value of each bond is not given, it is assumed to be $1000.

Issue price of coupon bond is equal to its face value since the YTM equals the coupon rate. Number of bonds to issue = $50 million / $1000 = 50,000

Issue price of each zero-coupon bond = $1000 / (1 + 7.5%)²⁰ = $235.41. Number of bonds to issue = $50 million / $235.41 = 212,393

In 20 years, repayment on coupon bonds = face value = $50 million

In 20 years, repayment on zero-coupon bonds = face value = $50 million

Total earnings = EPS * number of shares = $5.35 * 300,000 = $1,605,000

Payout ratio = Dividend per share / EPS = ($320,000 / 300,000) / $5.35 = 0.20

Retention ratio = 1 - payout ratio = 0.80

growth ratio = retention ratio * ROE = 0.80 * 21% = 17%

Total equity value = next year earnings / (required return - growth rate)

next year earnings = current year earnings * (1 + growth rate) =  $1,605,000 * (1 + 17%) = $1,877,850

Total equity value = $1,877,850 / (21% - 17%) = $46,946,250

value per share = Total equity value / number of shares = $46,946,250 / 300,000 = $156.49