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Financial plan

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“Erik Satie has just inherited her father’s company. Prior to his death, Mr. Satie was the sole stockholder, and he left the entire company to his only son. Although Erik has worked for the firm for many years as a commercial artist, he does not feel qualified to manage the operation. He has considered selling the firm while it is still a viable operation and before his father’s absence causes the value of the firm to deteriorate. Erik realizes that selling the firm will result in his losing control, but his father granted him a long-term contract that guarantees employment or a generous severance package. Furthermore, if Erik were to sell for cash, he should receive a substantial amount of money, so his financial position would be secure. Even though Erik would like to sell out, he has enough business sense to realize that he does not know how to place an asking price on the firm. The IRS had established a value on his father’s stock of $100 a share, and since he owned 100,000 shares, the value of the company for estate tax purposes was $10,000,000. Erik thought that was a reasonable amount but decided to consult with Sophie Ryer, a CPA who completed the estate tax return. Ryer suggested that the firm could be valuable using a discounted cash flow method in which the current and future dividends are discounted back to the present to determine the value of the firm. She explained to Erik that this technique, the dividend-growth model, is an important theoretical model used for the valuation of companies. In addition, she suggested that the price/earnings ratio of similar firms may be used as a guide to the value of the firm. Erik asked Ryer to prepare a valuation of the stock based on P/E ratios and the dividend-growth model. While Erik realized that he could get only one price, he requested a range of values from an optimistic price to a minimum, rock-bottom value. To aid in the valuation process, Ryer assembled the following information. The firm earned $8.50 a share and distributed 60 percent in cash dividends during its last fiscal year. This payout ratio has been maintained for several years, with 40 percent of the earning being retained to finance future growth. The per-share earnings for the past five years were as follows:Year: 1998; Dividend: $6.70Year 1999; Dividend: $7.40Year 200; Dividend: $7.85Year 2001; Dividend: $8.20Year 2002; Dividend: $8.50Publicly held firms in the industry have an average P/E ratio of 12, with the highest being 17 and the lowest

9. The betas of these firms tend to be less than 1.0, with .85 being typical. While the firm is not publicly held, it is similar in structure to other firms in the industry. It is, however, perceptibly smaller than the publicly held firms. The Treasury bill rate is currently 5.2 percent, and most financial analysts anticipate that the market as a whole will average a return of 6 to 6.5 percent greater than the Treasury bill rate. Satie has come to you to help device a financial plan after the company is sold. Such a plan would encompass the construction of a well-diversified portfolio with sufficient resource to meet temporary needs for cash. You do not want to accept blindly the IRS estate value of $10,000,000. Obviously, if the firm could be sold for more, that would be beneficial to your client. In addition, you want an indication of the value Ryer may place on the firm, so you resolve to answer the following question. 3) What is the highest and lowest value of the stock based on the dividend growth model?

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