Finance question – minicase | Business & Finance homework help

Chapter 7 Minicase

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Terence Breezeway, the CEO of Prairie Home Stores, wondered

what retirement would be like. It was almost 20 years to the day

since his uncle Jacob Breezeway, Prairie Home’s founder, had

asked him to take responsibility for managing the company. Now it

was time to spend more time riding and fishing on the old Lazy

Beta Ranch.

 

Under Mr. Breezeway’s leadership Prairie Home had grown

slowly but steadily and was solidly profitable. (Table 7.6 shows

earnings, dividends, and book asset values for the last 5 years.)

Most of the company’s supermarkets had been modernized and its

brand name was well known.

 

Mr. Breezeway was proud of this record, although he wished

that Prairie Home could have grown more rapidly. He had passed

up several opportunities to build new stores in adjacent counties.

Prairie Home was still just a family company. Its common stock

was distributed among 15 grandchildren and nephews of Jacob

Breezeway, most of whom had come to depend on generous regu-

lar dividends. The commitment to high dividend payout” had

reduced the earnings available for reinvestment and thereby con-

strained growth.

 

Mr. Breezeway believed the time had come to take Prairie

Home public. Once its shares were traded in the public market, the

Breezeway descendants who needed (or just wanted) more cash to

spend could sell off part of their holdings. Others with more inter-

est in the business could hold on to their shares and be rewarded by

higher future earnings and stock prices.

 

But if Prairie Home did go public, what should its shares sell

for? Mr. Breezeway worried that shares would be sold, either by

Breezeway family members or by the company itself, at too Iowa

price. One relative was about to accept a private offer for $200, the

current book value per share, but Mr. Breezeway had intervened

and convinced the would-be seller to wait.

Prairie Home’s value depended not just on its current book value

or earnings but on its future prospects, which were good. One finan-

cial projection (shown in the top panel of Table 7.7) called for growth

in earnings of over 100% by 2022. Unfortunately, this plan would

require reinvestment of all of Prairie Home’s earnings from 2016 to

2019. After that the company could resume its normal dividend pay-

out and growth rate. Mr. Breezeway believed this plan was feasible.

He was determined to step aside for the next generation of top

management. But before retiring, he had to decide whether to rec-

ommend that Prairie Home Stores “go public”-and before that

decision he had to know what the company was worth.

The next morning he rode thoughtfully to work. He left his

horse at the south corral and ambled down the dusty street to Mike

Gordon’s Saloon, where Francine Firewater, the company’s CFO,

was having her usual steak-and-beans breakfast. He asked Ms.

Firewater to prepare a formal report to Prairie Home stockholders,

valuing the company on the assumption that its shares were pub-

licly traded.

Ms. Firewater asked two questions immediately. First, what

should she assume about investment and growth? Mr. Breezeway

suggested two valuations, one assuming more rapid expansion (as

in the top panel of Table 7.7) and another just projecting past

growth (as in the bottom panel of Table 7.7).

Second, what rate of return should she use? Mr. Breezeway said

that 15%, Prairie Home’s usual return on book equity, sounded

right to him, but he referred her to an article in the Journal of

Finance indicating that investors in rural supermarket chains, with

risks similar to Prairie Home Stores, expected to ‘earn about 11 %

on average.

16 The company traditionally paid out cash dividends equal to 10% of start-

of-period book value. See Table 7.6.

TABLE 7.6 Financial data for Prairie Home Stores. 2011-2015 (figures in millions)

2011 2012 2013 2014 2015

Book value, start of year $62.7 $66.1 $69.0 $73.9 $76.5

Earnings 9.7 9.5 11.8 11.0 11.2

Dividends 6.3 6.6 6.9 7.4 7.7

Retained earnings 3.4 2:9 4.9 2.6 3.5

Book value, end of year 66.1 69.0 73.9 76.5 80.0

Notes:

1. Prairie Home Stores has 400,000 common shares.

2. The company’s policy is to pay cash dividends equal to 10% 01 start-of-year book value.

 

TABLE 7.7 Financial projections for Prairie Home Stores, 2016-2021 (figures in millions)

 

2016 2017 2018 2019 2020 2021

1- Rapid-Growth Scenario

Book value, start of year $80 $ 92 $105.8 $121.7 $139.9 $146.9

Earnings 12 13.8 15.9 18.3 21.0 22.0

Dividends 0 0 0 0 14 14.7

Retained earnings 12 13.8 15.9 18.3 7.0 7.4

Book value, end of year 92 105.8 121.7 139.9 146.9 154.3

Constant-Growth Scenario

Book value, start of year $80 $84 $88.2 $92.6 $ 97.2 $102.1

Earnings 12 12.6 13.2 13.9 14.6 15.3

Dividends 8 8.4 8.8 9.3 9.7 10.2

Retained earnings 4 4.2 4.4 4.6 4.9 5.1

Book value, end of year 84 88.2 92.6 97.2 102.1 107.2

 

Notes:

1. Both panels assume earnings equal to 15% of start-of-year book value. This profitability rate is constant.

2. The top panel assumes all earnings are reinvested from 2016 to 2019. In 2020 and later years, two-thirds of earnings are paid

out as dividends and one-third reinvested.

3. The bottom panel assumes two-thirds of earnings are paid out as dividends in all years.

4. Columns may not add up because of rounding.

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