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Encore International In the world of trendsetting fashion, instinct and marketing savvy are prerequisites to success. Jordan Ellis had both.
Encore InternationalIn the world of trendsetting fashion, instinct and marketing savvy are prerequisites to success. Jordan Ellishad both. During 2009, his international casual-wear company, Encore, rocketed to $300 million in salesafter 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 everyfive or six blocks, each featuring a different color. Some shops showed the entire line in mauve, and otherfeatured it in canary yellow.Encore had made it. The company’s historical growth was so spectacular that no one could have predictedit. However, securities analysts speculated that Encore could not keep up the pace. They warned thatcompetition is fierce in the fashion industry and that the firm might encounter little or no growth in thefuture. They estimated that stockholders also should expect no growth in future dividends.Contrary to the conservative securities analysts, Jordan Ellis felt that the company could maintain aconstant annual growth rate in dividends per share of 6% in the future, or possibly 8% for the next 2 yearsand 6% thereafter. Ellis based his estimates on an established long-term expansion plan into European andLatin American markets. Venturing into these markets was expected to cause the risk of the firm, asmeasured by beta, to increase immediately from 1.10 to 1.25.In preparing the long-term financial plan, Encore’s chief financial officer has assigned a junior financialanalyst, Marc Scott, to evaluate the firm’s current stock price. He has asked Marc to consider theconservative predictions of the securities analysts and the aggressive predictions of the company founder,Jordan Ellis.Mark has compiled these 2009 financial data to aid his analysis:DATA ITEM 2009 VALUEEarnings per share (EPS) $ 4.40Current market price per share of common stock $ 35.00Book value of common stock equity $ 40,000,000Total common shares outstanding 1,750,000Common stock dividend per share (paid in 2009) $ 3.00A couple of notes/hints: When beta = 0; the return is the risk free rate. When beta = 1; the return is themarket return.Required:A. What is the firm’s current book value per share?B. What is the firm’s current P/E ratio?C. What are the required return and risk premium for Encore stock using the capital asset pricingmodel (CAPM), assuming a beta of 1.10? (Hint: Use the security market line and related data tablegiven in Figure 1 to find the market return.)D. What are the required return and risk premium for Encore stock using the CAPM, assuming a betaof 1.25?E. What will be the effect on the required return if the beta rises as expected?F. If the securities analysts are correct and there is no growth in future dividends, what will be thevalue per share of the Encore stock? (Note: Beta = 1.25.)G. If Jordan Ellis’s predictions are correct, what will be the value per share of Encore stock if the firmmaintains a constant annual 6% growth rate in future dividends? (Note: Beta = 1.25)H. If Jordan Ellis’s predictions are correct, what will be the value per share of Encore stock if the firmmaintains a constant annual 8% growth rate in dividends per share over the next 2 years and 6%thereafter? (Note: Beta = 1.25)I. Compare the current (2009) market price of the stock and the stock values calculated in F, G, andH. Discuss why there values may differ. Which valuation method do you believe most clearlyrepresents the true value of the Encore stock? Please be thorough in your discussion and supportyour answer.J. Is the market predicting the beta to rise from 1.10 to 1.25 as reflected in the P/E ratio and CAPMrequired return comparison? Note that the inverse of the P/E (that is E/P) is the yield (or return) onthe stock.FIGURE 1Data P ointsbeta returnData Points0.00 3.0%Beta Return0.25 5.0%0.00 3%0.50 7.0%0.25 5%0.75 9.0%0.50 7%1.00 11.0%0.75 9%1.25 13.0%1.00 11%1.50 15.0%1.25 13%1.75 17.0%1.50 15%2.00 19.0%1.75 17%2.00 19%0%2%4%6%8%10%12%14%16%18%20%0.00 0.25 0.50 0.75 1.00 1.25 1.50 1.75 2.00FIGURE 1 Security Market Line
