East Coast Yachts Case: Background Information

In 1969, Tom Warren founded East Coast Yachts. The companys operations are located near Hilton Head Island, South Carolina, and the company is structured as a sole proprietorship. The company has manufactured custom midsize, high-performance yachts for clients, 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. Occasionally, a yacht is manufactured for purchase by a company for business purposes.

The custom yacht industry is fragmented, with a number of manufacturers. As with any industry, there are market leaders, but the diverse nature of the industry ensures that no manufacturer dominates the market. The competition in the market, as well as the product cost, ensures that attention to detail is a necessity. For instance, East Coast Yachts will spend 80 to 100 hours on hand-buffing the stainless steel stem-iron, which is the metal cap on the yacht's bow that conceivably could collide with a dock or another boat.

Several years ago, Tom retired from day-to-day operations of the company and turned the operations of the company over to his daughter, Larissa. Dan Ervin was recently hired by East Coast Yachts to assist the company with its short-term financial planning and financial analysis. Dan graduated from college five years ago with finance degree and he has been employed in the treasury department of a Fortune 500 company since then.

Chapter 5: Interest Rates and Bond Valuation

FINANCING EAST COAST YACHTS'S EXPANSION PLANS WITH A BOND ISSUE

After EFN analysis, Larissa has decided to expand the company's operations. She has asked Dan to enlist an underwriter to help sell $40 million in new 20-year bonds to finance new construction. Dan has entered into discussions with Renata Harper, 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.

1. You are Renata's assistant, and she has asked you to prepare a memo to Dan describing the effect of each of the following bond features on the coupon rate of the bond. She would also like you to list any advantages or disadvantages of each feature.
   1. The security of the bond, that is, whether or not the bond has collateral.
   2. The seniority of the bond.
   3. The presence of a sinking fund.
   4. A call provision with specified call dates and call prices.
   5. A deferred call accompanying the above call provision.
   6. A make-whole call provision.
   7. Any positive covenants. Also, discuss several possible positive covenants East Coast Yachts might consider.
   8. Any negative covenants. Also, discuss several possible negative covenants East Coast Yachts might consider.
   9. A conversion feature (note that East Coast Yachts is not a publicly traded company).
   10. A floating rate coupon.

Dan is also considering whether to issue coupon bearing bonds or zero coupon bonds. The YTM on either bond issue will be 6.5 percent. The coupon bond would have a 6.5 percent coupon rate. The company's tax rate is 35 percent.

2. How many of the coupon bonds must East Coast Yachts issue to raise the $40 million? How many of the zeroes must it issue?
3. In 20 years, what will be the principal repayment due if East Coast Yachts issues the coupon bonds? What if it issues the zeroes?
4. What are the company's considerations in issuing a coupon bond compared to a zero coupon bond?
5. Suppose East Coast Yachts issues the coupon bonds with a make-whole call provision. The make-whole call rate is the Treasury rate plus .40 percent. If East Coast calls the bonds in 7 years when the Treasury rate is 6 percent, what is the call price of the bond? What if it is 9.1 percent?
6. Are investors really made whole with a make-whole call provision?
7. After considering all the relevant factors, would you recommend a zero coupon issue or a regular coupon issue? Why? Would you recommend an ordinary call feature or a make-whole call feature? Why?

Chapter 6: Stock Valuation

STOCK VALUATION AT RAGAN ENGINES

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. She has asked Dan Ervin to analyze Ragan's value.

Ragan Engines, Inc., was founded nine years ago by a brother and sisterCarrington and Genevieve Raganand 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 125,000 shares of stock.

Larissa has asked Dan to determine a value per share of Ragan stock. To accomplish this, Dan has gathered the following information about some of Ragan's competitors that are publicly traded:

	EPS	DPS	Stock Price	ROE	R
Blue Ribband Motors Corp.	$1.15	$0.34	$18.25	13.00%	15.00%
Bon Voyage Marine, Inc.	1.45	0.42	15.31	16.00	18.00
Nautilus Marine Engines	(0.21)	0.60	28.72	N/A	14.00
Industry average	$0.80	$0.45	$20.76	14.50%	15.67%

Nautilus Marine Engines negative earnings per share (EPS) were the result of an accounting write-off last year. Without the write-off, EPS for the company would have been $1.85. Last year, Ragan had an EPS of $4.20 and paid a dividend to Carrington and Genevieve of $157,500 each. The company also had a return on equity of 20 percent. Larissa tells Dan that a required return for Ragan of 16 percent is appropriate.

1. Assuming the company continues its current growth rate, what is the value per share of the company's stock?
2. Dan has examined the company's financial statements, as well as examining those of its competitors. Although Ragan currently has a technological advantage, Dan's research indicates that Ragan's competitors are investigating other methods to improve efficiency. Given this, Dan believes that Ragan's technological advantage will last only for the next five years. After that period, the company's growth will likely slow to the industry average. Additionally, Dan believes that the required return the company uses is too high. He believes the industry average required return is more appropriate. Under Dan's assumptions, what is the estimated stock price?
3. What is the industry average priceearnings ratio? What is Ragan's priceearnings ratio? Comment on any differences and explain why they may exist.
4. Assume the company's growth rate declines to the industry average after five years. What percentage of the stock's value is attributable to growth opportunities?
5. Assume the company's growth rate slows to the industry average in five years. What future return on equity does this imply?
6. Carrington and Genevieve are not sure if they should sell the company. If they do not sell the company outright to East Coast Yachts, they would like to try and increase the value of the company's stock. In this case, they want to retain control of the company and do not want to sell stock to outside investors. They also feel that the company's debt is at a manageable level and do not want to borrow more money. What steps can they take to try and increase the price of the stock? Are there any conditions under which this strategy would not increase the stock price?