Baines Investments, Inc. Baines Investments, Inc. is a private ships for the U.S. government. It also equity investment company located in produces automatic flight control radar Dallas, Texas. The firm specializes in systems and intercept missiles. It is investing in privately owned firms that it privately traded feels it can sell in the future at a higher price Joel's firm normally took the present or eventually take public. In most cases, the value of future dividends, earnings, or firm engages in leveraged buyouts, in which cash flow to determine value. In Joel's it borrows money to buy a publicly traded first analysis he decided to take the company with the intention of taking it present value of future dividends. private. After restructuring the firm by Because dividends appeared to be selling off unnecessary assets and tightening growing at a constant rate for the 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 (Ps) or value company back to the public market at a was equal to much higher price than they paid to take it private Kg An Upcoming Deal A careful analysis of company data indicated that D. or the next period's Joel Horlen recently received his dividend would be 51.80. The growth rate g MBA from Baylor University and was appeared to be 5.5 percent. Kwas hired by Baines Investment, Inc. In his supposed to represent the cost of common first six months on 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 United Defense Systems (UDS). Investment, Inc., insisted that he use the The firm manufactures warships and cargo capital asset pricing model to compute the cost (or required retum) on common equity. Cari 2017 Merw. dr. Alle re. Ne productions distribute without the powe of Merw-Hillion Po Case 14 The term , in the formula above represents the cost of common equity, but can Case 14 The term K, in the formula above represents the cost of common equity, but can easily be replaced by K, the required return on common equity under the capital asset pricing model. Once K, is computed it is merely substituted for K, in the prior formula Now the formula for K K, is equal to R, +B(K.-R) where: K - Required return on common stock R Risk-free rate K. = Market rate of returnuse 11% B Beta. The volatility of a stock's return relative to the market's return. To be determined. use 6% 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 Horien was evaluating was private and had no publie 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: Company Beta Armour Holdings 1.40 BE Aerospace 1.65 General Dynamics .85 Lockheed Martin .80 Northrop Gruman .80 nts, Inc. 1. Compute the average beta for the five firms in the aerospace/defense industry 2. Now, compute the required rate of return(K) using the capital asset pricing model. R, is equal to 6 percent and K. is equal to 11 percent. Use the formula: K, is equal to R, +B(K.-R,). 3. Next, compute the stock price (Pc) using the formula: D P= K-g Note K (the required return on common stock) is being substituted for K. (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