22 Jul WHAT DO PE RATIOS INDICATE?
Palooka is a new cosmetics firm which is about to make an initial public offering. It has no physica Show more Palooka is a new cosmetics firm which is about to make an initial public offering. It has no physical assets and no debt. Palooka is coming out with an equity issue to raise $100 million from the markets. The funds raised will be invested in the commercial production of Stumblebum (a new fragrance for men). There is a 0.8 probability that Stumblebum will catch on with the young and beautiful set. In that case earnings will be $1 million immediately (at date 0) will grow at 50% a year for 15 years and then be constant (zero growth) thereafter. There is a 0.2 probability that Stumblebum will fail in which case all the investment will then be wasted (the company will have no earnings ever). Assume the market discounts cash flows at 10%. For simplicity you can assume that the IPO happens on January 1 the investment occurs on January 2 and the earnings (if any) happen on January 3 of that year. In other words were assuming that the IPO the investment and the initial earnings (if any) will all occur at date 0. (i) What is the value of the equity before the issue? Assume that no one knows whether Stumblebum will succeed. Use the following formula: Value of Equity = Present value of cashflows from existing assets + Net Present Value of cashflows from future investments Present Value of debt (if any). (ii) If there are 1 million Palooka shares before the issue what is the value of each share? (iii) What is the price investors will pay for shares in the new issue? (Hint: What happens if it differs from the price of shares before the issue?) (iv) Assume that the company does the IPO and Stumblebum succeeds (and everyone knows it). What is the PE ratio for the firm? Is this high or low? What do PE ratios indicate? Explain. Show less
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