Case 72

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a. SDI currently has two bond issues outstanding. Bond A has a $1,000 par value and a coupon rate of 10 percent, paid semiannually. This bond was issued 10 years ago, it has 10 years remaining to maturity, and it has 2 years of call protection left, after which it can be called at 104 percent of par. This issue is actively traded and highly liquid, and its most recent closing price was $1,092. The second issue, Bond B, is thinly traded, so no valid market quotation is available. This bond had a 25-year maturity when it was issued 2 years ago, a $1,000 par value, 5 years of call protection remaining, a call price of $1,100 when it becomes callable, and a 6.9 percent coupon paid semiannually. Bonds A and B have identical priority with respect to claims on SDI’s income and assets.

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Copyright © 1994. The Dryden Press. All rights reserved.

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Swan-Davis, Inc. (SDI) manufactures equipment for sale to large contractors. The company was founded in 1976 by Tom Stone, the current chairman, and it went public in 1980 at $1 per share. The stock currently sells for $15, Stone owns 14 percent of the shares, and other officers and directors control another 13 percent. The industry is cyclical, and competition is strong, so profits are somewhat unstable. Tables 1, 2, and 3 provide historical balance sheets, income statements, and ratios for the company for the period 1994–1996, Table 4 provides industry average data for 1994-1996, and Table 5 provides one security analyst’s forecasted data for the company based on assumptions set forth later in the case. Your consulting firm was just hired to explain to SDI’s managers how the market establishes the values of its securities—management wants this information in order to make accurate estimates of capital costs for use in capital budgeting. Your boss, Maria Gonzales, asked you to head up the project, and she set up a meeting for you with Bob Wilkes, SDI’s chief financial officer (CFO), and Tony Biddle, a security analyst who follows SDI. Tony Biddle agreed to help with the project, but due to other commitments, his help will be limited to providing data. To avoid any potential problem with illegal disclosure, it was agreed that no confidential company data should be used-the analysis should be based entirely on publicly available data plus the data in Table 5 which Tony developed on his own. After some discussion, it was agreed that you should use the following securities to explain the valuation process:

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Copyright © 1997 South-Western. All rights reserved.

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Stock and Bond Valuation

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SWAN-DAVIS, INC. Case 72

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SWAN-DAVIS CORPORATION, Fundamental Concepts, CASE 72, Directed

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August 1992. Ed Thompson, Smyth Farley’s construction analyst: “SDI’s investment in new facilities is paying off in lower costs and higher volumes, and its R&D and marketing programs are paying off in increased sales. Management is confident that sales and earnings will set new records this year, and the CFO regards an earnings growth rate of 15 to 20 percent over the next 5 to 7 years as ‘reasonable.’ We rate SDI a strong buy.” November 1994. Again from Ed Thompson: “SDI expects to report record sales and earnings again this year, and management believes 1995 will be another good year. The order backlog is down, but management regards this as a temporary situation, not something to be concerned about. This is a cyclical industry, so there are ups and downs. However, the long-run trend for well managed companies such as SDI is clearly up. We are maintaining our recommendation of a strong buy on SDI.” November 1994. At the same time that Ed Thompson recommended buying SDI, Amy Tucker, Murray Finch’s construction analyst, voiced a contrary opinion: “SDI will probably report record earnings for 1994, and management thinks 1995 will also be...
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