19. (Adapted from 2000 CFA Level II exam) The management of Telluride, an international diversified conglomerate based in the United States, believes that the recent strong performance of its wholly owned medical supply subsidiary, Sundanci, has gone unnoticed. In order to realize Sundanci’s full value, Telluride has announced that it will divest Sundanci in a tax-free spin-off.

Sue Carroll, CFA, is Director of Research at Kesson and Associates. In developing an investment recommendation for Sundanci, Carroll has directed four of her analysts to determine a valuation of Sundanci using various valuation disciplines. To assist her analysts, Carroll has gathered the information shown in Tables 2-17 and 2-18 below.

Prior to determining Sundanci’s valuation, Carroll analyzes Sundanci’s return on equity

(ROE) and sustainable growth.

A. i. Calculate the three components of ROE in the DuPont formula for the year 2000.
ii. Calculate ROE for the year 2000.
iii. Calculate the sustainable rate of growth. Show your work.
Carroll learns that Sundanci’s Board of Directors is considering the following policy changes that will affect Sundanci’s sustainable growth rate:
• Director A proposes an increase in the quarterly dividend by $0.15 per share.
• Director B proposes a bond issue of $25 million, the proceeds of which will be used to increase production capacity.
• Director C proposes a 2-for-1 stock split.
TABLE 2-17 Sundanci Actual 1999 and 2000 Financial Statements for FY Ending May 31 ($ millions, except per-share data)
Income Statement 1999 2000 Revenue $474 $598 Depreciation 20 23 Other operating costs 368 460 Income before taxes 86 115 Taxes 26 35 Net income 60 80 Dividends 18 24 Earnings per share $0.714 $0.952 Dividends per share $0.214 $0.286 Common shares outstanding (millions) 84.0 84.0 Balance Sheet 1999 2000 Current assets $201 $326 Net property, plant, and equipment 474 489 Total assets 675 815 Current liabilities 57 141 Long-term debt 0 0 Total liabilities 57 141 Shareholders’ equity 618 674 Total liabilities and equity 675 815 Capital expenditures 34 38 TABLE 2-18 Selected Financial Information Required rate of return on equity 14%
Growth rate of industry 13%
Industry P/E 26 B. Indicate the effect of each of these proposals on Sundanci’s sustainable rate of growth, given that the other factors remain unchanged. Identify which components of the sustainable growth model, if any, are directly affected by each proposal.
Helen Morgan, CFA, has been asked by Carroll to determine the potential valuation for Sundanci using the DDM. Morgan anticipates that Sundanci’s earnings and dividends will grow at 32 percent for two years and 13 percent thereafter.
C. Calculate the current value of a share of Sundanci stock using a two-stage dividend discount model and the data from Tables 2-17 and 2-18. Show your work.