Question

Ragan, Inc. was founded nineteen years ago by brother and sister Carrington and Genevieve Ragan. The company manufactures and installs commercial heating, ventilation, and cooling (HVAC) units. Ragan, Inc. has experienced rapid growth because of a proprietary technology that increases the energy efficiency of its units. The company is equally split between the two siblings. The original partnership agreement between them gave each 500,000 shares of stock. The company has since gone public. At that time, the siblings retained their shares and 1,000,000 shares of new stock were issued. The firm anticipates needing to raise a large amount of capital ($10 million) in the coming year to facilitate further expansion and are evaluating several financing options. The first option is to issue zero-coupon bonds that mature in 20 years. Similar zero-coupon bonds currently have a YTM of 4.5%. The second option is to issue 4% coupon bonds that mature in 20 years. Similar bonds have a YTM of 4%. The third option is to issue preferred stock with a fixed dividend of $0.85 per share. These preferred stock would have a required return of 7.5%. The firm currently has no preferred stock outstanding. The fourth option is to issue common stock.The stock is currently trading on the market for $20 per share. The firm most recently paid a dividend on common stock of $0.50 and plans to increase that dividend by 25% per year for the next five years. After that, the firm will level off at the industry average of 5% per year, indefinitely. Carrington and Genevieve estimate the required return on the stock to be 15%.

Based on this information, the firm has hired you to make a recommendation.

1. What would the zero-coupon bonds sell for and how many would have to be issued? What

would the firm have to repay when these bonds mature?

2. How many 4% coupon bonds would the firm have to issue and how would that impact the firm’s

interest expense over the next 15 years. How much would the firm have to repay when these

bonds mature?

3. What would the shares of preferred stock sell for and how many would they have to sell? How

would this impact the firm’s dividend expenses going forward?

4. Based on the information about the common stock dividends, what should the value of the

stock be today?

5. What do you think about the estimate of a 15% required return? What does the current stock

price suggest about the required return?

6. If they can sell new shares of common stock at the current stock price of $20, how many would

they have to issue?

7. Based on your answer above (#6), what would be the increase in the dividend expenses for the

firm in future years?

Additional Considerations:

1. What impact would adding a call provision and call price to the 4% coupon bonds have on your

analysis? Would they have to issue more or less of these bonds?

2. What additional (qualitative) considerations must be made with respect to issuing common

stock? How might existing shareholders feel about this?

3. Are there any additional factors you believe should be considered? If so, what are they and how

might they impact your recommendation?

Based on your discussion above, what is your recommendation and why?

Answer 1