n the world of trendsetting fashion, instinct and marketing savvy are prerequisi

Question

n the world of trendsetting fashion, instinct and marketing savvy are prerequisites to success. Jordan Ellis had both. During 2012, his international casual-wear company, Encore, rocketed to $300 million in sales after 10 years in business. His fashion line covered the young woman from head to toe with hats, sweaters, dresses, blouses, skirts, pants, sweatshirts, socks, and shoes. In Manhattan, there was an Encore shop every five or six blocks, each featuring a different color. Some shops showed the entire line in mauve, and others featured it in canary yellow. Encore had made it. The company's historical growth was so spectacular that no one could have predicted it . However, securities analysts speculated that Encore could not keep the pace....

AND SO ON

Contrary to the conservative securities analysts, Jordan Ellis felt that the company could maintain a constant annual growth rate in dividends per share of 6% in the future, or possibly 8% for the next 2 years and 6% thereafter. Ellis based his estimates on an established longterm expansion plan into European and Latin American markets. Venturing into these markets was expected to cause the risk of the firm, as measured by risk premium on its stock, to increase immediately from 8.8% to 10%. Currently the risk free rate is 6%...

• Identify the critical issues or problems in the case and analyze the key facts related to the issues or problems. Value differs due to changes in the dividend growth rate

• Discuss a tentative solution that addresses the issues or problems and how you would implement your solution.

Explanation / Answer

Let's make some assumptions to quantify the answers.

Net Profits = 10% of Sales = 10% x $300m = $30m

Dividend = 10% of Net Profits = $30m x 10% = $3m

1) If growth rate is constant at 8% and risk premium is increases from 8.8% to 10%. r = 6% + 10% = 16%.

Gordon Growth Model => P = D1 / (r - g) = $3m x (1.08) / (16% - 8%) = $40.5m

2) If growth is expected to be 8% for 2 years and 6% thereafter, we need to use H-model. gs = 8%, gl = 6%, N =2

H-Model => P = D0 / (r - gl) x[(1 + gl) +(N/2) x (gs - gl)] = $3m / (16%-6%) x [(1.06) + (2/2) x (8% - 6%)] = $40.5m

In this case, the value of the firm remains the same based on our assumptions. Gordon growth model doesn't allow for multiple growth rates for calculating the value of the firm. Hence, a modified version of the Gordon growth model known as H-model is typically used.

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