Valuing Stocks Recall that if the economy continues to be strong, Carson Company
ID: 2714988 • Letter: V
Question
Valuing Stocks
Recall that if the economy continues to be strong, Carson Company may need to increase its production capacity by about 50 percent over the next few years to satisfy demand. It would need financing to expand and accommodate the increase in production. Recall that the yield curve is currently upward sloping. Also recall that Carson is concerned about a possible slowing of the economy because of potential Fed actions to reduce inflation. It is also considering issuing stock or bonds to raise funds in the next year. If Carson goes public, it might even consider using its stock as a means of acquiring some target firms. It would also consider engaging in a secondary offering at a future point in time if the IPO is successful and if its growth continues over time. It would also change its compensation system so that most of its managers would receive about 30 percent of their compensation in shares of Carson stock and the remainder as salary.
a. At the present time, the price–earnings ratio (stock price per share divided by earnings per share) of other firms in Carson’s industry is relatively low but should rise in the future. Why might this information affect the time at which Carson issues its stock?
b. Assume that Carson Company believes that issuing stock is an efficient means of circumventing the potential for high interest rates. Even if long-term interest rates have increased by the time it issues stock, Carson thinks that it would be insulated by issuing stock instead of bonds. Is this view correct?
c. Carson Company recognizes the importance of a high stock price at the time it engages in an IPO (if it goes public). But why would its stock price be important to Carson Company even after the IPO?
d. If Carson Company goes public, it may be able to motivate its managers by granting them stock as part of their compensation. Explain why the stock may motivate them to perform well. Then explain why the use of stock as compensation may motivate them to focus on short-term goals even though they are supposed to focus on maximizing shareholder wealth over the long run. How can a firm provide stock as motivation but prevent its managers from using a short-term focus?
Explanation / Answer
a Price Earning Ratio is used to predict the Fair Market value by predicting the future earnings. If the Investors beleive that Future earnings will be higher than they will give the Higher valuation of the Stock so thereby Carson and company can raise money at higher valuation.
b There are certain advantages and disadvantages for issuing the stocks. Carson needs to compare the cost of capital of issuing stocks and Bonds as the Interest paid on bonds is tax deductible whereas the dividend is not tax deductible. Company has to mandatorily pay the interest to the Bondholders if they issue the bonds whereas dividend payment is not compulsory so looking at the cash flow position decision can be made. However issuing stock means giving some ownership right in the company to stockholders so all this factors should be considered before taking decision on issuing stock or issuing bonds. It is not always good to issue stock and it is not always good to issue the bonds as well.
c High Stock price at the time of issuing IPO is important as the company can get higher amount of money through IPO but at the same it also want to go in secondary for target acquisition at that time also if the stock price is higher then Carson can acquire the target firms at a fewer no of issue of stocks and also if the stock prices increases and it gives stock as compensation to Equity shareholders it will fetch more value to employees as well which increases motivation of the employees.
d Stock given as compensation gives the ownership feeling to the employees. They are considered as owners of the company and not employees as they own the Stocks of the company this will motivate them to perform well as higher profit of the company will give more dividends and capital growth in the stock price of the company. Issuing them the shares might shfit the focus of the employee to short term goals as if they do well in the short term the stock price will increase and by selling the stock in the market they will earn more money rather than looking at the Maximising shareholders' wealth. A firm can provide stock as Motivation but prevent its managers from using a short term focus by preventing them to sale the shares for specified period say 3 to 5 years from the date of giving them the shares this will give them motivation as well as to focus on Maximising shareholder wealth rather than using a short term focus.
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