Case Study #$2-$ Common Sources and Forms of Financing $($Chapter $7)$

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 $7\mathrm{.}8$ shows earnings, dividends, and book asset values for the past $5$ years.$)$ Most of the company's supermarkets had been modernized and its brand name was well known.

Financial data for Prairie Home Stores, $2016-2020($$ millions$)$

$\backslash$table$[[,2016,2017,2018,2019,2020],[$Book value, start of year,$$62\mathrm{.}7,$$$66\mathrm{.}1,$$$69\mathrm{.}0,$$$73\mathrm{.}9,$$$76\mathrm{.}5$

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 low a 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 did not just depend on its current book value or earnings, but on its future prospects, which were

good. One financial projection $($shown in the top panel of $[$ Table $7\mathrm{.}9)$ called for growth in earnings of over $100\%$ by $2027.$

Unfortunately this plan would require reinvestment of all Prairie Home's earnings from $2021$ to $2024.$ After that the

company could resume its normal dividend payout and growth rate. Mr$.$ Breezeway believed this plan was feasible.

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Financial projections for Prairie Home Stores, $2021-2026($$ millions$)$

Notes:

Notes:

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

The top panel assumes all earnings are reinvested from the start of $2021$ to the end of $2024.$ At the end of $2025$ and later years, two$-$thirds of earnings are paid out as dividends and

one$-$third reinvested.

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

He was determined to step aside for the next generation of top management. But before retiring he had to decide

whether to recommend that Prairie Home Stores $"$go public"$-$and before that decision, he had to know what the

company was worth.

The next morning he rode to work thoughtfully. 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 shareholders, valuing the company on the assumption

that its shares were publicly 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 $7\mathrm{.}9)$ and

another just projecting past growth $($as in the bottom panel$).$

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.