FIN 601: Financial Management and Markets Instructor: Dr. Jinsuk Yang Case Study #3

Instructions:

•The Case Study 3 (CS3) is due by 11:00 pm CST, November 14, 2020.

•To complete the CS3, you must download the Excel file: Case_Study_3_format. o Module 3 > Module 3 Assignments > Case Study 3

•Total scores for the CS3 are 35 points. And, you must submit it through Blackboard to earn credits.

•Any late submission will not be accepted.

•Please read FAQs on the last page of the instruction before you post a thread in the Blackboard forum.

Part 1: Read the following information

East Coast Yachts was founded 10 years ago by Larissa Warren. The company’s operations are located near Hilton Head Island, South Carolina. The company has manufactured custom midsize, high-performance yachts for clients over this period, and its products have received high reviews for safety and reliability. The company’s yachts have also recently received the highest award for customer satisfaction. The yachts are primarily purchased by wealthy individuals for pleasure use.

Dan Ervin was recently hired by East Coast Yachts to assist the company with its short-term financial planning.

After Dan’s EFN (External Finance Needed) analysis for East Coast Yachts, Larissa (the founder of East Coast Yachts) has decided to expand the company’s operations. She has asked Dan to enlist an underwriter to help sell $75 million in new 30-year 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. Although Dan is aware of bond features, he is uncertain as to the costs and benefits of some of them, so he isn’t clear on how each feature would affect the coupon rate of the bond issue.

Please use the following information to complete the Part1 – Q1:

•You are Kim’s assistant, and she has asked you to prepare a memo to Dan describing the effect of each of the bond features on the coupon rate of the bond.

•Complete the tasks provided in the Part1-Q1 instruction below this box.

Please use the following information to complete the Part1 – Q2:

•Dan is also considering whether to issue coupon bearing bonds or zero-coupon bonds. The YTM on either bond issue will be an 8 percent. The coupon bond would have an 8 percent coupon rate, and the coupon will be paid semi-annually. The company’s tax rate is 35 percent. Either bond has the par value of $1,000.

•Complete the tasks provided in the Part1-Q2 instruction below this box.

Please use the following information to complete the Part1 – Q3:

•Suppose East Coast Yachts issues the coupon bonds with a make-whole call provision (which means it is callable bond). The “make-whole call rate” is the “Treasury rate on the call date” plus “0.30%”.

•The make-whole call rate is used to compute the “Make-whole Call Price” instead of the yield to maturity.

•Complete the tasks provided in the Part1-Q3 instruction below this box.

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FIN 601: Financial Management and Markets Instructor: Dr. Jinsuk Yang Case Study #3

Part 1-Q1:

•Requirements (5 points):

a.Read the following articles first:

1.Underwriter

2.What are corporate bonds?

3.What Are Bond Covenants?

4.Understanding Covenants

b.Use the template (Case Study 3, spreadsheet: P1-Q1) posted on the Blackboard to complete CS3.

c.In order to complete the P1-Q1 of CS3, you may want to use sources available to you (I know our textbook does not explain everything). When you use other sources, you must provide the reference.

d.Complete the following tasks for each bond.

1.Describe the characteristics of the bond

2.Determine whether the bond with feature benefits the issuers or investors. In addition, explain why.

3.Effect of the feature on coupon rates: “A rule of thumb with bond provisions is to determine who the provisions benefit. If the company benefits, the bond will have a higher coupon rate. If the bondholders benefit, the bond will have a lower coupon rate. ”

4.Provide the reference information: APA format

Part 1-Q2:

•Requirements (5 points):

a.Use the template (Case Study 3, spreadsheet: P1-Q2) posted on the Blackboard to complete CS3.

b.Complete boxes in Q2-a and find “How many of the coupon bonds must East Coast Yachts issue to raise the $75 million? How many of the zero-coupon bond must it issue?”

For “Q2-a”, you can use one of the following methods to compute the bond price. After finding the bond price in $, divide $75 million dollars by the bond price (of the coupon bond and of the zero-coupon bond).

•Using Excel function

Formula: “=PRICE(settlement, maturity, rate, yld, redemption, frequency,[basis])”

The security’s settlement date. The security settlement date is the

Settlement: date after the issue date when the security is traded to the buyer.

For the Case Study 3, the settlement date is January 1, 2020.

The security’s maturity date. The maturity date is the date when

Maturity: the security expires. The company plans to issue a 30-year bond.

Therefore, the maturity date for our case study is January 1, 2050.

Important: Dates should be entered by using the DATE function. For example, use

“=DATE(2008,5,23)” for the 23rd day of May, 2008.

Rate: The security’s annual coupon rate.

Yld: The security’s annual yield to maturity.

The security’s redemption value per the face value (or par value).

Redemption: For the Case Study 3, the company plans to issue bonds with $1,000 of par value (or face value).

The number of coupon payments per year. For annual payments,

Frequency: frequency = 1; for semiannual, frequency = 2; for quarterly, frequency = 4.

Basis: For our case study, it is “0” (=30/360)

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FIN 601: Financial Management and Markets Instructor: Dr. Jinsuk Yang Case Study #3

•Using Equation: Please Read Chapter 8.

Bond price = Present value of

the coupons

= × 1 × (1 − 1 )

(1 + )

+Present value of the face value

+ × 1

(1 + )

Coupon PMT:

T:

r:

Face value:

Part 1-Q3:

It is the coupon PMT per period. So, if the coupon PMT is distributed semi-annually, you must compute the annual coupon PMT and divide it by 2.

T is “how many periods to maturity. If a 30-year bond is issued and if the coupon PMT is paid semi-annually, T will be “30*2=60”.

r is the yield to maturity per period. YTM is given as the annual YTM. Therefore, if the coupon PMT is paid semi-annually, your r is “YTM/2”.

It is nothing but “Par value”.

•Requirements (5 points):

a.Use the template (Case Study 3, spreadsheet: P1-Q3) posted on the Blackboard to complete CS3.

b.Read the following article: “Make-Whole Call Provisions”

c.Complete either “Q3-a” or “Q3-b,” which asks you to find the call price of the bond if East Coast calls the

bonds in seven years.

o For Q3-a, you can use the Excel function.

Find the make-whole call price if the treasury rate on the call date is 5.0% Use the Excel formula to complete this task.

Formula: “=PRICE(settlement, maturity, rate, yld, redemption, frequency,[basis])”

Here, the settlement date is “Call date” because the issuer buys back the bond on the call date. Here, the “Make-whole call rate” is used for the “yld” in the excel function.

o For Q3-b, you can use the equation.

Find the make-whole call price if the treasury rate on the call date is 5.0% Use the formula listed below

Bond price = Present value of the coupons

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=× × (1 − (1 + ) )

+ Present value of the face value

+ × 1

(1 + )

The bonds in this case study pay “semi-annual coupon”. So, your equation above must be modified as follow.

Bond price = Present value of the coupons + Present value of the face value

= 1 1 + × 1

× × (1 − )

∗2

2 ∗2

( ) (1 + )

2 (1 + ) 2

2

Here, “T” is the number of periods from the call date to the maturity date. If the coupon payment is paid semi-annually and the number of years between the call and maturity dates is 18, “T” is 36 = 18*2.

Here, the “Make-whole call rate” is used for the “yld” in the excel function.

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FIN 601: Financial Management and Markets Instructor: Dr. Jinsuk Yang Case Study #3

d.Complete Q3-c

Find the make-whole call price by using various expected treasury rates (from 5.5% to 9.0%) on the call date given in the spreadsheet. The make-whole call rate is equal to the treasury rates on the call date plus 0.3%. Using the Excel formula can save time to complete this task.

Complete the graph given in the spreadsheet (Once you fill up all the boxes, the graph will appear.)

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FIN 601: Financial Management and Markets Instructor: Dr. Jinsuk Yang Case Study #3

Part 2: Read the following information

Part 2 is still related to the East Coast Yachts.

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 PVC pipes.

Larissa has decided that East Coast Yachts should consider the purchase of a pipe manufacturer to allow East Coast Yachts to better integrate its supply chain and get more control. After investigating several possible companies, Larissa feels that the purchase of HQP (High Quality Pipes), Inc., is a possibility. She has asked Dan Ervin to analyze HQP’s value.

HQP, Inc., was founded nine years ago by a brother and sister— James and Jane —and has remained a privately-owned company. The company manufactures PVC pipes for a variety of applications. HQP has experienced rapid growth. James and Jane equally own the company. The original agreement between the siblings gave each 500,000 shares of stock.

Please use the following information to complete the Part2 – Q1:

•Larissa has asked Dan to determine a value per share of Ragan stock. To accomplish this, Dan must gather the information about the following companies, which are HQP’s competitors that are publicly traded: (Data is given. Look up the values from the financial statements provided: Case_Study_3_Data)

o Omega Flex, Inc (Ticker: OFLX)

o L.B. Foster Company (Ticker: FSTR)

o Westlake Chemical Corp (Ticker: WLK)

•Complete tasks under “Part2-Q1” instruction below this box.

Please use the following information to complete the Part2 – Q2:

•Last year (2019), HQP Inc. had an EPS (Earnings per share) of $8.25 and paid a dividend to James and Jane of $490,000 each. The company also had a return on equity (ROE taken from the ending Balance Sheet) of 20%. Larissa tells Dan that a required return for HQP of 28% is appropriate.

•Complete tasks under “Part2-Q2” instruction below this box.

Please use the following information to complete the Part2 – Q3:

•Dan has examined the company’s financial statements, as well as examining those of its competitors. Although HQP currently has a technological advantage, Dan’s research indicates that HQP’s competitors are investigating other methods to improve efficiency. Given this, Dan believes that HQP’s technological advantage will last only for the next five years. Hence, the HQP will grow at “SGR” rate (the information is in the “Step 1” table). After that period, the company’s growth will likely slow to the industry average (industry SGR1 and SGR2).

•Complete tasks under “Part2-Q3” instruction below this box.

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FIN 601: Financial Management and Markets Instructor: Dr. Jinsuk Yang Case Study #3

Part 2-Q1:

•Requirements (5 points):

a.Use the template (Case Study 3, spreadsheet: P2-Q1) posted on the Blackboard to complete CS3.

b.The cash dividend paid in 2019 Fiscal year is provided in the table. It is collected from Morningstar.

c.Fill the boxes.

Part 2-Q2:

•Requirements (5 points):

a.Use the template (Case Study 3, spreadsheet: P2-Q2) posted on the Blackboard to complete CS3.

b.Fill the boxes

Here, we are trying to answer the following question:

Assuming the company continues its current growth rate, what is the value per share of the company’s stock?

c.To find the value per share of the company’s stock,

a)You need to read Chapter 3: Section 3.5 (Pay attention to “A Note about sustainable growth rate calculations”.)

i.If you compute ROE using the equity at the beginning of the fiscal year, the formula of SGR is

= ×

ii. If you compute ROE using the equity from an ending balance sheet, the formula of SGR is

×

=

b)You also need to use the “Constant Growth Model (Gordon Growth Model)” formula to find out the value of equity. Please, read Chapter 9: Section 9.1 (Case 2: Constant growth). To have a better understanding, please watch the lecture video in the “Business Finance” folder. (Lecture 7: Equity markets and Stock evaluation). https://usi.voicethread.com/share/10591559/

Part 2-Q3:

•Requirements (10 points):

a.Use the template (Case Study 3, spreadsheet: P2-Q3) posted on the Blackboard to complete CS3.

b.Read Chapter 3: Section 3.5 (Pay attention to “A Note about sustainable growth rate calculations”.)

c.Find “the estimated stock price under Dan’s assumptions (the company will grow at the industry average rate after the next five years)”, by completing the boxes from each step (all green boxes will be filled up automatically)

a)Step 1: Once you complete the previous question (P2-Q1 and P2-Q2), all the green boxes will be automatically filled up.

b)Step 2: You are required to find two different payout ratios, two different retention ratios, and two different SGRs. Complete Step 2 Table.

We can find the “Payout ratio” and “Retention ratio” by using “EPS” and “Dividends paid per share.”

= (1)

ℎ

( ) = (2)

ℎ

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FIN 601: Financial Management and Markets Instructor: Dr. Jinsuk Yang Case Study #3

If we divide Equation (1) by Equation (2), we will have the followings:

( )

= ℎ =

( )

ℎ

= −

c)Step 3: You are required to find the expected dividends. Complete Step 3 Table. Please read Chapter 9 – Section 9.1 “The present value of Common Stocks”

i.= −1 × (1 + )

ii.After year 5, we have a different growth rate (the industry SGRs)!

1.“SGR & SGR1” implies that the dividend will grow at “SGR” from the year 1 to 5 and the dividend will grow at “SGR1” from the year 6.

2.“SGR & SGR2” implies that the dividend will grow at “SGR” from the year 1 to 5 and the dividend will grow at “SGR2” from the year 6.

d)Step 4: Find out “PVtoday of each expected dividends” and “Stock Valueyear5”.” Use the “Constant Growth Model (Gordon Growth Model)” formula to find out the “Stock Valueyear5” in Step 4. Please, read Chapter 9: Section 9.1 (Case 2: Constant growth). Complete Step 4 Table.

e)Step 5: Find out the value of total equity and the value per share. Complete Step 5 Table.

Submission Guideline:

oYour financial ratios must be in Excel file format.

a.Your file name must be “CS3-first name-last name”

b.No space between words (don’t forget put the hyphen “ – ” between words)

c.You must save the file as “Save as type: Excel Workbook (.xlsx)”, not “CSV” or any other formats.

oFailure to comply with the “submission guidelines” will result in penalty: – 2 points.

FAQ:

•What is the face value (as % of par)?

Here, “Par” implies “Par value.” Par value is nothing but the face value of the bond. Since these two values are the same, the “as % of par” should be always 100%. Face (par) value is given in the top box.

•What about the bond price (as % of par)?

You should have the bond price computed by following the instruction. So, we simply divide the bond price by the par value. Face (par) value is given in the top box.

•I have different values or % from those in CS3 example when I calculate it. What should I do?

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FIN 601: Financial Management and Markets Instructor: Dr. Jinsuk Yang Case Study #3

Some values in the example are what I made up. So, it is fine if you have different values from what the example shows. For example, Average ROE_end in the example has 15%, which I arbitrary input. But, the correct values for this “Average ROE_end” in the example are 18.34%. As you see the cell function, there is no “Average” function. For your CS3, please watch videos and follow steps.

•Lecture video (CS3 Example): P1-Q3b related to the Make-whole call rate.

In the video example, the YTM is 3.0% and 0.5% is added to get the Make-whole call rate that is

3.5%. However, the formula bar on the video, I made a mistake “YTM + Treasury rate on the call date” and said that it is equal to the Make-whole call rate. Please ignore what is shown in the formula bar. It must be “Treasury rate on the call date + 0.3%” in the CS3 Example.

•Error message?

If you have an error message (or pop-up message) regarding automatic links from the excel file, please ignore it.

•Any question?

Please use the Module 3 Forum Q&As.

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