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Donaldson Lufkin and Jenrette Case Study

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    DLJ was founded in 1959 by William Donaldson, Dan Lufkin, and Richard Jenrette, which whom set out with $100,000 to create an equity research firm that would serve institutional shareholders. The firm went public in 1970 after gradually increasing the services provided to clients and diversifying in the face of competition. DLJ was a member of NYSE and retained their membership by offering shares of itself to the public. DLJ sold itself to Equitable in 1985, after facing capital requirements.

    Equitable was a mutual life insurance company, owned by policyholders. Jenrette joined Equitable as chief investment officer, and he later became chairman of the company in 1990. He initiated a restructuring of Equitable in response to serious problems. This involved cutting $150 million in annual costs and selling 49% of Equitable to AXA, a French holding company. He demutualized Equitable, raising $450 in an initial public offering. By 1995, AXA owned approximately 60% of Equitable.

    DLJ’s strategy was one of patience and involved focusing on building higher margin businesses such as underwriting IPOs and high yield debt, creating specialized issues of mortgage-backed debt and merchant banking, and striving to be a leader in each market it selected. DLJ is ranked as the 11th largest securities firm serving institutional, corporate, government, and individual clients as a leading investment and merchant bank. Its’ businesses included securities underwriting, sales and trading, merchant banking, venture capital, financial advisory services, investment research, correspondent brokerage services, and asset management.

    It operated through Banking Group, Capital Markets Group, and a Financial Services Group. The Banking Group assisted in clients in raising capital through the issuance of debt and equity securities in the public and private markets. It was believed to have a competitive advantage focusing on 17 sectors in the industry. The Merchant Banking group invested capital directly into companies. Since 1992, DLJ had placed $580 million in 20 companies and realized $610 million from seven partial or whole realizations. DLJ had annual returns greater than 90%, making DLJ one of the highest earning companies among principal investors.

    Due to the success in this group, DLJ sought to form four new funds: DLJ Investment Partners, DLJ Real Estate Fund, DLJ Senior Debt Fund, and Global Retail Partners L. P. The Banking Group produced high margins with lower levels of risk in favorable environments, and most of its costs were personnel-related. However, Merchant Banking offered more risk as DLJ put its own capital in with its limited partners in purchasing securities in companies. The Capital Markets Group offered trading, research, and sales services in fixed-income and equity securities focusing on serving its’ clients.

    The Group held large inventories of stocks and bonds, which were financed through repurchase agreements, in order to serve its clients successfully. The Financial Services Group provided services targeting individual investors and the financial intermediaries who represented them. Its’ revenues were earned by charging a fee for services and on the interest made on the money it lent for margin trades. Also, they earned money on the spread between the rate at which it lent and the rate at which it borrowed, much like a bank did.

    Overall, DLJ was a very successful company and due to their desirable position, investors would soon have the opportunity to share DLJ’s success. Its growth was greater than others in the industry over the past 5 years, its’ strategy to compete in higher margin businesses was working, its’ revenues and profits were growing at a rate consistent with its increased market share, and each of the operating groups were growing at equal rates. Also, DLJ did not commit large amount of resources to the lower margin business of underwriting and trading of investment grade debt and municipal bonds.

    However, DLJ also faced critics that worried that DLJ did not have sufficient operations overseas or larger, recurring-fee operations. They were unsure that DLJ could find new business lines to expand, in which would maintain its profits margins and growth rates. Anther problem addressed dealt with maintaining post-IPO profits. The stock market has increased from 1. 896 in ’86 to 4. 789 in ’95 thus creating an incentive for DLJ to offer an IPO. Strategy involved being the IPO allowed employees to exchange their compensation plans for shares and options in DLJ thus giving them an incentive to stay with the company.

    There were also many advantages and disadvantages related to DLJ going public. Advantages included DLJ increasing liquidity and allowing founders to harvest their wealth, permitting founders to diversify, facilitated raising new corporate cash, established value for the firm, and increasing the potential markets. Disadvantages included the cost of reporting, new disclosure requirements, self-dealings, a possibility of inactive markets reducing price, the firm losing some of its control, and a higher degree of investor relations had to be maintained.

    Equitable chose an equity carve-out method for DLJ. This would allow them to retain at least 50% of the equity of the subsidiary, so it could still consolidate its financial statements as well as file a consolidated tax return. An obvious advantage of this method is the parent company doesn’t lose control over its subsidiary. Another advantage of this method and the spin-off method is pro-rata selling it for more than it is worth; allowing them to make a profit, and it creates pure play stocks that are easier for investors to value.

    A disadvantage is the agency conflict between old stakeholders and new stakeholders. The underwriting process begins with DLJ planning to offer 9. 2 million shares of stock, with 5. 9 million shares consisting of secondary shares sold by Equitable and 3. 3 million of primary shares offered by the company. Since the shares sold by Equitable were already outstanding, they would not increase the number of shares outstanding. 7. 36 million shares were to be sold domestically and 1. 84 million abroad. Equitable granted the underwriters a “green shoe”, a 30 day option to purchase 1. 8 million additional shares to cover any over-allotments. After the offering, it was anticipated that they would have 51. 5 million shares outstanding, and Equitable would own 83% of DLJ’s stock (80% if the green shoe were exercised). DLJ obtained its own debt rating from Standard & Poor’s of A- and Baa1 from Moody’s. An increase in DLJ’s leverage would not affect Equitable’s debt rating A+ and A2. During the underwriting process, DLJ asked the underwriters to reserve 550,000 shares to sales to directors and current and former employees of DLJ and Equitable.

    These groups would have the opportunity to purchase the reserved shares at a price equal to the initial public offering price less underwriting discounts and commissions, and would be prohibited from selling them for five months. After selecting Goldman Sachs, Merrill Lynch, and Morgan Stanley as underwriters, DLJ was chosen to serve as lead manager of the offering. The role of the four investment banks was to buy Equitable and DLJ’s shares and reselling them to investors. The co-managers also invited 26 securities firms to participate in the underwriting syndicate, with each firm being allocated a certain number of shares to sell.

    The selling group consisted of 73 firms, with the option of returning unsold shares back to the underwriters. This option reduces the risk endured by the selling group. After completing the due diligence process, the Form S-1 registration statement was written by co-manager, DLJ executives, and their lawyers. This statement provided a preliminary filing range ($26-29), which implied an offering size of $239. 2 million to $266. 8 million. Next, the filing statement is registered with the SEC, creating the “registration date”, which in this case was on August 29th.

    The SEC then has 20 business days to review and comment on the S-1. During this time, managers and issuers marketed the security by embarking on a road show and established the underwriting syndicate. On the road show, information was gathered regarding the potential offers from all the underwriters and consolidated into a book to be used to estimate demand at different prices and to price the issue. When satisfied with the level of indications and the condition of the market, managers and underwriters then negotiated the price of the security.

    The final prospectus would become effective, with the sale of securities happening on the public offering date. The underwriters tried to minimize the time between when the price was set—the price at which they committed to buy the securities—and the time when they sold the securities to the public. The underwriters were faced with the risk of having to consider the interest of both of their clients. They would face problems if they security was too overpriced or underpriced, which would eventually lead to a decrease in demand of the security.

    To estimate DLJ’s fair value per share, we used four different approaches. The first approach we used was the discounted free cash flow valuation method. This method involved finding the correct WACC, which forced us to find the firm’s levered beta, the cost of debt, the tax rate applicable, the cost of equity, the expected growth rate, and the forecasted cash flows. We averaged the industry’s betas to find the unlevered beta. We then used the unlevered beta, with the DLJ’s debt/equity ratio and tax rate to find DLJ’s levered beta. The levered beta was calculated to be . 31. Next, we used the firm’s levered beta to determine the cost of equity. The typical Market Risk Premium is 3. 5%-6. 5%, so we assumed 5. 5% as the Market Risk Premium. We calculated the tax rate to be 40% by dividing the tax expense by pretax income, which we then could apply to cost of debt of 9%. We used the Treasury Bond yield of 6. 5% to calculate the cost of equity, which we found to be 11. 62%. Using 60% equity and 40% debt, we calculated the WACC to be 9. 13%. We used regression analysis of revenues to find a constant growth rate of 5. 86%.

    We then used the growth rate to find future cash flows, which we discounted using the WACC. The total firm value was $2,430. 01 million. We subtracted the value of debt ($723. 1), and then divided by the 51. 5 million shares outstanding. This gave us a value per share of $33. 14. Generally, bankers priced IPOs 10-15% below their estimated value in order to entice investors to purchase shares and to compensate them for buying stocks that lacked prior market prices. We adjusted the $33. 14 by 15%, which gave us a value per share of $28. 82. The second method was the price earnings multiple valuation model.

    Given the $27-29 estimated share price, we extended the range to $26-30 when computing the value for this method. We took the price per share of each dollar interval and divided it by the earnings per share of $1. 35. This gave us a price per share range of $35. 51-43. 13, with an average share price of $39. 32. We then adjusted it by the 15% IPO discount, which gave us a value per share of $34. 19. The third method we used was the book value method. This involved us looking at industry data related to the stock price, shares outstanding, EPS in the last 12 months, and the BVPS in the last 12 months.

    We took the stock price divided the BVPS for each company and found an average of 1. 4. We found DLJ’s BVPS to be $16. 96, which we multiplied by the average 1. 4, to determine the value per share of $23. 68. We then adjusted this by the 15% IPO discount, which gave us a value per share of $20. 60. The fourth method we used was the EBIT multiple method. Given the EBIT in 1995 of $132. 50, and the enterprise value $1,596. 7, we calculated an EBIT multiple of 12. 05. We divided the EBIT by the 51. 5 million shares outstanding, multiplied by the EBIT multiple, to find a share price of $31. 0. Adjusted for the 15% IPO discount, we were able to find a value per share of $26. 96. DLJ’s share price should be carefully planned out, so that it is not overpriced or underpriced. If the share price is overpriced this could lead to a problem with the underwriter’s ability to sell the amount needed for financing. Even if they sell the full amount of shares, the price could drop the same day and damper marketability. However, if the stock is underpriced DLJ could be missing out on the opportunity to receive maximum funds.

    The book offers three examples on why a firm would rather have a lower IPO price than a high IPO price. First, the company wants to create excitement and the potential price run up on the first day would do just that. Second, only a small percentage is offered to the public, so current stockholders give away less due to underpricing than it might appear. Lastly, firms that want another IPO would certainly want a successful previous one. We then compiled the four methods used before to compare each IPO price per share for DLJ. We came up with an IPO range from $20. 60-$34. 19/share.

    We then averaged those out and came up with a final IPO value of $27. 64. Given the above statement about successful IPO’s are underpriced, we recommend that DLJ price their IPO at a lower price of $25. 00. This will create excitement for DLJ’s stock and create a successful IPO for DLJ. Given that they have 60. 7 million shares outstanding and a value of $25/share, the total value placed on DLJ would be $1,517,500,000 or $1. 517 billion. This is on the low side for a valuation and a high side valuation would be $1,929,653,000 or $1. 929 billion, given the average market price of $31. 79.

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