Bond and Stock Valuation
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 some-what 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 poten-
tial 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:
SDI currently has two bond issues outstanding. Bond A has a $1,000 par value and a coupon rate of 10 percent, paid semi-annually. 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 semi-annually. Bonds A and B have identical priority with respect to claims on SDI’s income and assets. One of Tony Biddle’s customers has been offered some of the B bonds at a price of $850 per bond. Since this bond is illiquid and not actively traded, the customer does not know if $850 is a fair price. It was agreed that you should determine, for each bond, a fair value and a fair rate of return, and then use your analysis to help explain bond valuation to SDI’s executives. You were also asked to demonstrate how changes in the rate of inﬂation and in the company’s risk would affect yields and prices of SDI’s debt, and how that would affect capital budgeting decisions. The most recent S&P Bond Guide indicates that long-term bonds with varying ratings have the following yields:
The average bond rating for construction equipment ﬁrms is single A. SDI’s bonds were rated single A prior to 1994, but then ﬁnancial problems led to three downgradings, to a current rating of BB.
b. SDI has perpetual preferred stock which pays a dividend of $8.25, is traded actively, and last traded at a price of $97. Bob Wilkes, SDI’s Chief Financial Ofﬁcer (CFO), wants to know what the return to investors is on the preferred, and how that...
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