Baines Investments, Inc. Baines Investments, Inc, is a private equity investment company located in ships for the U.S. government. It also Dallas, Texas. The firm specializes in produces automatic flight control radar investing in privately owned firms that it systems and intercept missiles. It is feels it can sell in the future at a higher price privately traded. or eventually take public. In most cases, the - Joel's firm normally took the present firm engages in leveraged buyouts, in which value of future dividends, earnings, or company with the intention of taking it first analysis he decided to take the private. After restructuring the firm by present value of future dividends. selling off unnecessary assets and tightening Because dividends appeared to be budgets to increase profitability, Baines foreseeable future, he decided to use the Investments and other participating constant growth rate dividend valuation investing firms eventually hope to take the model in which the price (P0) or value company back to the public market at a was equal to much higher price than they paid to take it private. P0=KegD1 An Upcoming Deal A careful analysis of company data indicated that D1, or the next period's Joel Horlen recently received his dividend would be $1.80. The growth rate g MBA from Baylor University and was appeared to be 5.5 percent. Ke was hired by Baines Investment, Inc. In his supposed to represent the cost of common first six months on the job, he assisted equity and was normally given to him in other analysts in evaluating companies, his classroom exercises while working on but now he had an assignment of his own. his MBA. However, his employer, Baines The company he was to assess is Investment, Inc., insisted that he use the United Defense Systems (UDS). The capital asset pricing model to compute the firm manufactures warships and cargo cost (or required return) on common equity. Copyright 02017 MeGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. A stock with a beta of one would be as volatile as the market. A stock with a beta of 1.20 would be 20 percent more volatile than the market, and a stock with a beta of .80 would be 20 percent less volatile than the market and so on. The beta was normally computed over a five-year period for a publicly traded company. Because the company (UDS) that Joel Horlen was evaluating was private and had no public stock price, Joel decided to use an alternative method to compute beta. He would take the average beta of five publicly traded companies in the same industry as UDS (Aerospace/defense). The betas for the five companies are as follows: 1. Compute the average beta for the five firms in the aerospace/defense 2. Now, compute the required rate of return (K) ) using the capital asset pricing model. Rf is equal to 6 percent and Km is equal to 11 percent. Use the formula: K, is equal to Rf+(KmRf). 3. Next, compute the stock price (P0) using the formula: P0=KjgD1 Note Kj (the required return on common stock) is being substituted for Ke (the cost of common equity). They both represent the same thing, the return that stockholders demand. 4. Using your answer from question 3 and assuming earnings per share are $2.40, what is the P/E ratio? 5. Because the firm is privately held and thus there is no public market for its securities, there will be a liquidity discount of 20 percent from the stock price computed in question 3 . What will the adjusted stock price be? What will the adjusted P/E be? 6. Assume that Joel Horlen discovers that UDS is about to win a major new defense department contract on combat radar systems and the Company's value will increase by 40 percent. Ignoring the liquidity discount for this calculation, what will the new stock price and P/E ratio be? 7. Discuss the impact of the company deciding to go public sometime in the future on the liquidity discount