PGDBFS 301 Cases in Business Finance and Strategy (CBFS)

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1 SESSION 02 PGDBFS 301 Cases in Business Finance and Strategy (CBFS) Conducted by Nadun Kumara Postgraduate Diploma in Business Finance & Strategy

2 2 01. Last Session Recap Do you remember the basics?

3 Last Session Recap Read Situational Analysis Assumptions & Missing information Problem Definition Strategic Analysis Alternatives Recommendations R S A P S A R

4 4 02. Situational Analysis The theories

5 02.01 Situational Analysis Read Situational Analysis Assumptions & Missing information Problem Definition

5 Situational Analysis Read Situational Analysis Assumptions & Missing information Problem Definition Strategic Analysis Alternatives Recommendations Situational Analysis Internal External SW OT Ratio Analysis SW OT PESTEL P5Fs

6 Situational Analysis SWOT

7 Situational Analysis Ratio Analysis Gross Profit Ratio

8 Situational Analysis Ratio Analysis Net Profit Ratio

9 Situational Analysis Ratio Analysis ROCE

10 Situational Analysis Ratio Analysis Current Ratio

11 Situational Analysis Ratio Analysis Gearing Ratio

12 Situational Analysis PESTEL Political Economical Social Technological Environmental Legal

13 Situational Analysis P5F s

14 Strategic Analysis More theories

15 Strategic Analysis Vision & Mission Vision Mission

16 Strategic Analysis Goals & Objectives Goals Objectives

17 Strategic Analysis Porter s Generic Strategies Porter s Generic Strategies

18 Strategic Analysis Ansoff s Matrix Ansoff s Matrix

19 Strategic Analysis BCG Matrix BCG Matrix

20 Of use to: BCG Matrix Investors 03.02 Strategic Analysis Share and Company Valuation 01.

20 20 Of use to: BCG Matrix Investors Strategic Analysis Share and Company Valuation 01. Stock Market Valuation Managers wishing to understand what increases shareholder value Companies either considering merger and acquisition activity, or the target of such activity (to organise defences or simply to know which price to sell at) Valuation Approaches 02. Net Asset Value Based Valuations 03. Income Based Valuations

21 03.02 Strategic Analysis Share and Company Valuation Stock Market Valuation = No.

21 Strategic Analysis Share and Company Valuation Stock Market Valuation = No. Shares x Current Market Price The market value is theoretically correct if the Efficient Market Hypothesis Holds Issues Managers may have extra information Quotes share price does not reflect the value of all shares Can t do it for private companies Usually requires a substantial premium to get shareholders to give up their shares

22 02. Net Asset Based Valuation Net Asset Valuation is has three main ways to value a companies assets. Net Book Value & Net Realisable Value/ Fairness Opinions Fixed Assets Effectively for both ways though the equation is the same. Non Current + - Assets current = liabilites Net Asset Value Uses historical costs which are both factual and available The only difference being how you value each of those different components. Ignores intangible assets such as goodwill, human capital & brand names Issues with depreciation method company has chosen (i.e. straight line vs reducing balance) Doesn t value the entity as a going concern, and has little link to future wealth generation ability

03. Income Based Valuations Income based

innate advantage in that they are orientated

will continue to remain a going concern for

Two main methods examined in this module are:

23 03. Income Based Valuations Income based valuations of shares and companies have the innate advantage in that they are orientated towards the future assuming that the company will continue to remain a going concern for the foreseeable future. Two main methods examined in this module are: Discounted Cash Flow Models Dividend Valuation Models Gordon s Dividend Growth Model

24 03. Income Based Valuations Example - Discounted Cash Flow Method End of Year Cash Flow ( $ M) D/F (10%) Pv ( $ M) Terminal Value 100M

25 Strategic Analysis COST OF CAPITAL

26 Options Available 1. Equity Ordinary Shares 1.1 Preference Shares 1.2 Internal Funding Debt Debentures 2.1 (Redeemable / Irredeemable) Long Term Loans / Overdrafts 2.2

27 EXAMPLES

28 EXAMPLES

29 Internal Funding (1.3) Combination of RETAINED EARNINGS & RESERVES

30 Debentures (2.1) Debentures are loan instruments used to raise funds from a collection of investors. Debentures could be issued to investors, through securities exchange (for a listed company) or could be privately placed. A secured debenture is one that is specifically tied to an asset as security. The debenture holder has a legal interest in that asset and the company cannot dispose of the asset unless the debenture holder agrees. Unsecured debenture has no assets tied to the outstanding hence carries a higher risk than secured debentures from the lender s perspective Debentures have the right to receive a fixed interest payments. The interest must be settled in full before any dividend is paid to shareholders Even if a company makes a loss, it still has to pay its interest charges as it is contractual.

31 EXAMPLES

32 Loans / Overdrafts (2.2)

33 Features Debt Equity for the user (the company) Interest must be paid on time Repayments must be made on time The lender has the right to repossess assets No capital repayment obligation Can choose whether to pay Dividends for the provider (the investor) A HIGH-RISK INSTRUMENT Interest is contractual and must be paid. Capital is contractual and must be paid Can take over the assets if not paid on time A LOW-RISK INSTRUMENT A LOW-RISK INSTRUMENT No guarantee of returns or capital to be paid A HIGH-RISK INSTRUMENT Source : Corporate Finance Strategy by Keith Ward

34 Cost of Capital How to CALCULATE? Is it EQUITY? Is it DEBT? COST OF EQUITY COST OF DEBT DIVIDEND GROWTH MODEL CAPM BANK LOAN / OD Debentures

35 Cost of Capital Type of Funding Equity - Ordinary Shares Equity - Preference Shares Cost of Capital Expected Rate of Return by the future share holders to compensate risk, using CAPM Fixed dividends stated in the prospectus. Debentures Bank Loans Internal Funding Interest Rates stated in the prospectus Commercial interest rates set in the loan agreement Current Return On Investment (ROI) of the company

36 Cost of Capital Equity Ordinary Shares Listed Companies Gordon s Dividend Growth Model k e = (d 1 / p 0 ) + g k e = Cost (k) of equity (e) d 1 = Dividends in Y 1 Capital Asset Pricing Model (CAPM) k e = R f + (R m R f ) b p 0 = Price of Share in Y 0 g = Growth rate in dividends R f = Risk Free Return R m = Market Return b = Beta factor (risk factor)

37 37 Example Cost of Ordinary Shares - DGM Problem Suppose the Gadget Company has a current dividend of 2 per share. The current price of a share of Gadget Company stock is 40. The Gadget Company has a dividend payout of 20% and at a dividend growth rate of 9.6%. What is the cost of Gadget equity?

38 38 Example Cost of Ordinary Shares - DGM Problem Suppose ABC Co. has a dividend growth rate of 8.05% and has a current dividend of 3.50 per share. The current share price is 42 per share. What is the cost of equity?

39 39 Example Cost of Ordinary Shares - CAPM Problem: If the risk-free rate is 3%, the expected market risk premium is 5%, and the company s stock beta is 1.2, what is the company s cost of equity?

40 40 Example Cost of Ordinary Shares - CAPM Problem: If the risk-free rate is 6%, the expected market risk premium is 4%, and the company s stock beta is 1.5, what is the company s cost of equity?

41 Cost of Capital Equity Ordinary Shares Unlisted Companies Estimate the k e of similar listed companies and then add a further risk premium for business and financial risk To the Risk free rate (Rf) rate add estimated risk premiums for both the Business risk and the Financial risk of the entity

42 Cost of Capital Equity Preference Shares Preference Shares - Irredeemable k p = DPS / MPS k p = Cost (k) of Preference (p) share DPS = Dividends per Share MPS = Market Price of Share Preference Shares - Redeemable k p = IRR of Preference Share 0

43 43 Example Cost of Preference Shares Problem: A company issues 10,000 shares 10% Preference Shares of 100 each. Cost of issue is 2 per share. Calculate cost of preference capital if these shares are issued (a) at a premium of 10%, and, (b) at a discount of 5%.

44 44 Example Cost of Preference Shares Problem: A company issues 15,000 shares 12% Preference Shares of 100 each. Cost of issue is 5 per share. Calculate cost of preference capital if these shares are issued (a) at a premium of 5%, and, (b) at a discount of 4%.

45 Cost of Capital Debt Bank Loan / Overdraft k d = I (1 - t) Debentures - Irredeemable k d = Cost (k) of debt (d) I = Interest rate t = tax rate MP = Market Price of Debenture IRR = Internal Rate of Return k d = [ I (1 - t) ] / MP Debentures - Redeemable k d = IRR of Debenture 0

46 46 Example Cost of Debt Bank Loan Problem: A company is considering raising of funds of about GBP 100 million via a 14% institutional term loan. Assume a tax rate of 20%. What is the cost of debt?

47 47 Example Cost of Debt Bank Loan Problem: A company is considering raising of funds of about GBP 400,000 for 6 months via a 12% institutional term loan. Assume a tax rate of 20%. What is the cost of debt?

48 48 Example Cost of Debt Debentures Problem: AG has $30 mn. par value of eight per cent debentures, which are redeemable at par in six years time. The debentures are trading at $101 per cent. The return on the market is 11 per cent, and the corporate tax rate is 30 per cent. You are required to calculate the Cost of Debt of the AG Company.

49 49 Example Cost of Debt Debentures Problem: A company has $50 mn. par value of 10% debentures, which are redeemable at par in six years time. The debentures are trading at $105. The corporate tax rate is 20%. You are required to calculate the Cost of Debt.

50 Cost of Capital - Overall (WACC) WACC = k e V e + k d V d + k p V p V e + V d + V p k = Cost V = Value

51 51 Example WACC Suppose the Widget Company has a capital structure composed of the following, in billions: Debt 10 Common equity 40 If the post-tax cost of debt is 9%, the required rate of return on equity is 15%, and the marginal tax rate is 30%, what is Widget s weighted average cost of capital?

52 52 THANKS! Any HELP?

CIMA F3 Workbook Questions

CIMA F3 Workbook Questions Lecture 1 Financial Strategy Shareholder Wealth - Illustration 1 Year Share Price Dividend Paid 2007 3.30 40c 2008 3.56 42c 2009 3.47 44c 2010 3.75 46c 2011 3.99 48c There are