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PGDBFS 301 Cases in Business Finance and Strategy (CBFS) Postgraduate Diploma in Business Finance & Strategy
SESSION 02
Conducted by – Nadun Kumara
01. Last Session Recap Do you remember the basics?
2
01.01 – Last Session Recap 3
Read Situational Analysis
Assumptions & Missing
information
Problem Definition
Strategic Analysis
Alternatives Recommen-
dations
R S A P S A R
02. Situational Analysis The theories…
4
02.01 – Situational Analysis
5
Read Situational Analysis
Assumptions & Missing
information
Problem Definition
Strategic Analysis
Alternatives Recommen-
dations
Situational Analysis
Internal
“SW”OT Ratio
Analysis
External
SW“OT” PESTEL P5Fs
02.01 – Situational Analysis – SWOT 6
02.01 – Situational Analysis – Ratio Analysis 7
▸Gross Profit Ratio
02.01 – Situational Analysis – Ratio Analysis 8
▸Net Profit Ratio
02.01 – Situational Analysis – Ratio Analysis 9
▸ROCE
02.01 – Situational Analysis – Ratio Analysis 10
▸Current Ratio
02.01 – Situational Analysis – Ratio Analysis 11
▸Gearing Ratio
02.01 – Situational Analysis – PESTEL 12
Political
Economical
Social
Technological
Environmental
Legal
02.01 – Situational Analysis – P5F’s 13
03. Strategic Analysis More theories…
14
03.01 – Strategic Analysis – Vision & Mission
▸ Vision
▸ Mission
15
03.01 – Strategic Analysis – Goals & Objectives
▸ Goals
▸ Objectives
16
03.01 – Strategic Analysis – Porter’s Generic Strategies
▸ Porter’s Generic Strategies
17
03.01 – Strategic Analysis – Ansoff’s Matrix
▸ Ansoff’s Matrix
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03.01 – Strategic Analysis – BCG Matrix
▸ BCG Matrix
19
03.02 – Strategic Analysis – Share and Company Valuation
▸ BCG Matrix
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Of use to: • Investors • 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)
01.
Stock Market
Valuation
02.
Net Asset Value Based
Valuations
03.
Income Based
Valuations
Valuation
Approaches
03.02 – Strategic Analysis – Share and Company Valuation
21
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
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”
Effectively for both ways though the equation is the same.
The only difference being how you value each of those different components.
Fixed Assets Current
Assets
Non
current
liabilites
Net Asset
Value + - =
• Uses historical costs which are both factual and available
• 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 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
Example - Discounted Cash Flow Method
End of Year Cash Flow ( $ M) D/F (10%) Pv ( $ M)
1 20 0.909 18.18
2 32 0.826 26.43
3 40 0.751 30.04
4 30 0.683 20.49
5 20+100 0.621 74.52
169.66
Terminal Value 100M
03. Income Based Valuations
03.02 – Strategic Analysis – COST OF CAPITAL 25
Options Available
2. Debt
•Debentures – 2.1
(Redeemable /
Irredeemable)
•Long Term Loans /
Overdrafts – 2.2
1. Equity
•Ordinary Shares – 1.1
•Preference Shares –
1.2
•Internal Funding – 1.3
EXAMPLES
EXAMPLES
Internal Funding (1.3)
Combination of –
RETAINED EARNINGS
&
RESERVES
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.
EXAMPLES
Loans / Overdrafts (2.2)
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
A HIGH-RISK INSTRUMENT
No capital repayment obligation
Can choose whether to pay
Dividends
A LOW-RISK INSTRUMENT
for the provider
(the investor)
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
No guarantee of returns or capital to be paid
A HIGH-RISK INSTRUMENT
Source : Corporate Finance Strategy by Keith Ward
Cost of Capital
How to CALCULATE?
Is it “EQUITY”?
COST OF EQUITY
DIVIDEND GROWTH MODEL
CAPM
Is it “DEBT”?
COST OF DEBT
BANK LOAN / OD
Debentures
Cost of Capital Type of Funding Cost of Capital
Equity -
Ordinary Shares
Expected Rate of Return by the future share holders
to compensate risk , using CAPM
Equity -
Preference Shares
Fixed dividends stated in the prospectus.
Debentures Interest Rates stated in the prospectus
Bank Loans Commercial interest rates set in the loan agreement
Internal Funding Current Return On Investment (ROI) of the company
Cost of Capital –
Equity – Ordinary Shares – Listed Companies
ke = (d1 / p0) + g
Gordon’s Dividend Growth Model
ke = Cost (k) of equity (e)
d1 = Dividends in Y1
p0 = Price of Share in Y0
g = Growth rate in dividends
Capital Asset Pricing Model (CAPM)
ke = Rf + (Rm – Rf) b Rf = Risk Free Return
Rm = Market Return
b = Beta factor (risk factor)
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?
37
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?
38
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?
39
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?
40
Cost of Capital –
Equity – Ordinary Shares – Unlisted Companies • Estimate the ke 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
Cost of Capital –
Equity – Preference Shares
kp = Cost (k) of Preference (p) share
DPS = Dividends per Share
MPS = Market Price of Share
Preference Shares - Irredeemable
kp = DPS / MPS
Preference Shares - Redeemable
kp = IRR of Preference Share 0
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%.
43
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%.
44
Cost of Capital – Debt
kd = I (1 - t)
Bank Loan / Overdraft kd = Cost (k) of debt (d)
I = Interest rate
t = tax rate
MP = Market Price of Debenture
IRR = Internal Rate of Return Debentures - Irredeemable
kd = [ I (1 - t) ] / MP
Debentures - Redeemable
kd = IRR of Debenture 0
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?
46
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?
47
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.
48
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.
49
Cost of Capital - Overall (WACC)
k = Cost
V = Value
keVe + kdVd + kpVp
Ve + Vd + Vp
WACC =
Example WACC
Suppose the Widget Company has a capital structure composed of the following, in billions:
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?
51
Debt €10
Common equity €40
