TOPIC 04 - CA Sri Lanka 202 - cf… · 05/08/2018 · Topic 4.01 / 4.02 8/5/2018 1 TOPIC 04 BUSINESS VALUATION. CAPITAL STRUCTURE & DIVIDEND POLICY EDABS 202 – Corporate Financial

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TOPIC 04BUSINESS VALUATION.CAPITAL STRUCTURE &DIVIDEND POLICY

EDABS 202 – Corporate FinancialManagement (CFM)

Conducted by Nadun KumaraMBA(USJP), ACMA(UK), CGMA(USA), BA(Hons)(UK), DipPsychOrg(UK)

TOPIC 04 - 01BUSINESS VALUATION



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www.newcastlebusinessschool.co.uk

Company Valuation• Valuation is critical in merges &

acquisitions:– Aids evaluation of acquisition

candidates– Helps to set goals and

benchmarks• Framework essential to discipline

valuation estimates:– Comparable (Companies,

Transactions)– Discounted Cash Flow

(Spreadsheet, Formula)– Use of multiple methods offers

differing perspectives• Valuation should be guided by a

business economics analysis of thefirm and its environment

Value and the Marketplace• If the market is reasonably efficient

the market price can be trusted as afair assessment of value of an asset.

• Usually a company’s value is made ofthings which are easy to value (realassets) but also intangibles which aremuch harder to quantify.

• The most problems arise in valuing:– unique assets, or assets such as

the shares of most privatecompanies

– unique brands or unique core(irreplaceable) competencieswhich have no easy comparator

EDABS 202 – Corporate Financial Management (CFM) – Topic 04 – 01 – Business Valuation


Share and Company ValuationOf use to:

• Investors

• Managers wishing tounderstand whatincreases shareholdervalue

• Companies eitherconsidering merger andacquisition activity, or thetarget of such activity (toorganise defences orsimply to know whichprice to sell at)

01.Stock

MarketValuation

02.Net Asset

Value BasedValuations

03.IncomeBased

Valuations

ValuationApproaches


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Stock Market Valuation = No. Shares x Current Market PriceThe market value is “ theoretically correct” if the Efficient Market Hypothesis Holds

01. Stock Market Valuation

Issues

• Managers may have extrainformation

• Quotes share price does notreflect the value of all shares

• Can’t do it for privatecompanies

• Usually requires asubstantial premium to getshareholders to give up theirshares



02. Net Asset Based ValuationNet 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.

FixedAssets

NetCurrentAssets

Long TermDebt

Net AssetValue

+ - =

• 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


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03. Income Based ValuationsIncome based valuations of shares and companies have the innate advantage inthat they are orientated towards the future assuming that the company will continueto 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 18.182 32 0.826 26.433 40 0.751 30.044 30 0.683 20.495 20+100 0.621 74.52

169.66

Terminal Value 100M

03. Income Based Valuations


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• Calculation of a growth rate? Canwe predict a growth rate with anyaccuracy given the instability ofmacroeconomic factors?

• What about companies that do notpay dividends?

• Model is are highly sensitive to theassumptions made

• The quality of input data is oftenpoor

• If expected Growth g exceeds Ke anonsensical result occurs

Discounted Cash FlowModels

• Assumes that Modigliani andMillar’s Dividend IrrelevanceTheory is correct

• Is usually based on publishedaccounts data which manyusers may be sceptical

• Deciding the rate of growth ofcash flows can be speculative

• Problems deciding the periodover which future cash flowsare discounted

Model Issues

Dividend Valuation Models



Task

• Write up a summary the three methods. ThisYouTube video may help:

https://www.youtube.com/watch?v=YG51nUZBsHU


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TOPIC 04 – 02 -01COST OF CAPITAL




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


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Features Debt Equity

for the user(the company)

Interest must be paid on time

Repayments must be made ontime

The lender has the right torepossess assets

A HIGH-RISK INSTRUMENT

No capital repayment obligation

Can choose whether to payDividends

A LOW-RISK INSTRUMENT

for the provider(the investor)

Interest is contractual and mustbe paid.

Capital is contractual and must bepaid

Can take over the assets if notpaid on time

A LOW-RISK INSTRUMENT

No guarantee of returns or capital tobe paid

A HIGH-RISK INSTRUMENT

Source : Corporate Finance Strategy by Keith WardEDABS 202 – Corporate Financial Management (CFM) – Topic 04 – 01 – Business Valuation


Risk Vs Cost of FundingType of Funding Risk To the

companyRisk to theProvider

Cost of funds

Venture CapitalFinance

Very Low ExtremelyHigh

ExtremelyHigh

Ordinary Shares Very Low Very High Very High

Preference Shares Low High High

UnsecuredDebentures

High Low Low

Bank Loans / SecuredDebentures

Very High Very Low Very Low

Internal Funding Neutral Neutral Medium


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Cost of Capital“The rates of return that a company has to offer finance providers toinduce investors to buy and hold a financial security”

How toCALCULATE?

Is it “EQUITY”?

COST OF EQUITY

DIVIDENDGROWTHMODEL

CAPM

Is it “DEBT”?

COST OF DEBT

BANK LOAN / OD Debentures



Cost of CapitalType of Funding Cost of CapitalEquity -Ordinary Shares

Expected Rate of Return by the future shareholders 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 loanagreement

Internal Funding Current Return On Investment (ROI) of thecompany


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Cost of Capital –Equity – Ordinary Shares – Listed Companies

ke = (d1 / p0) + g

Gordon’s Dividend Growth Modelke = 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)



ExampleCost of Ordinary Shares - DGM

ProblemSuppose the Gadget Company has a current dividend of£2 per share. The current price of a share of GadgetCompany stock is £40. The Gadget Company has adividend payout of 20% and at a dividend growth rateof 9.6%. What is the cost of Gadget equity?

18EDABS 202 – Corporate Financial Management (CFM) – Topic 04 – 01 – Business Valuation

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ExampleCost of Ordinary Shares - DGM

ProblemSuppose ABC Co. has a dividend growth rate of 8.05%and has a current dividend of £3.50 per share. Thecurrent share price is £42 per share. What is the cost ofequity?



ExampleCost of Ordinary Shares - CAPM

Problem:If the risk-free rate is 3%, the expected market riskpremium is 5%, and the company’s stock beta is 1.2,what is the company’s cost of equity?


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ExampleCost of Ordinary Shares - CAPM

Problem:If the risk-free rate is 6%, the expected market riskpremium is 4%, and the company’s stock beta is 1.5,what is the company’s cost of equity?



Cost of Capital –Equity – Ordinary Shares – Unlisted Companies

• Estimate the ke of similar listed companies and then adda further risk premium for business and financial risk

• To the Risk free rate (Rf) rate add estimated riskpremiums for both the Business risk and the Financialrisk of the entity


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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 Share0



ExampleCost of Preference Shares

Problem:A company issues 10,000 shares 10% PreferenceShares of £100 each. Cost of issue is £2 per share.Calculate cost of preference capital if these shares areissued (a) at a premium of 10%, and, (b) at a discountof 5%.


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ExampleCost of Preference Shares

Problem:A company issues 15,000 shares 12% PreferenceShares of £100 each. Cost of issue is £5 per share.Calculate cost of preference capital if these shares areissued (a) at a premium of 5%, and, (b) at a discountof 4%.



Cost of Capital – Debt

kd = I (1 - t)

Bank Loan / Overdraftkd = Cost (k) of debt (d)

I = Interest rate

t = tax rate

MP = Market Price of Debenture

IRR = Internal Rate of ReturnDebentures - Irredeemable

kd = [ I (1 - t) ] / MP

Debentures - Redeemable

kd = IRR of Debenture0


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ExampleCost of Debt – Bank Loan

Problem:A company is considering raising of funds of aboutGBP 100 million via a 14% institutional term loan.Assume a tax rate of 20%. What is the cost of debt?



ExampleCost of Debt – Bank Loan

Problem:A company is considering raising of funds of aboutGBP 400,000 for 6 months via a 12% institutional termloan. Assume a tax rate of 20%. What is the cost ofdebt?


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ExampleCost of Debt – Debentures

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



ExampleCost of Debt – Debentures

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


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Cost of Capital - Overall (WACC)

k = Cost

V = Value

keVe + kdVd + kpVp

Ve + Vd + Vp

WACC =



ExampleWACC

Suppose the Widget Company has a capitalstructure composed of the following, in billions:

If the post-tax cost of debt is 9%, the required rateof return on equity is 15%, and the marginal taxrate is 30%, what is Widget’s weighted average costof capital?

32

Debt €10Common equity €40


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ExampleWACC

Interpretation:When the Widget Company raises €1 more ofcapital, it will raise this capital in the proportionsof 20% debt and 80% equity, and its cost will bexx%.

Copyright © 2013 CFA Institute 33EDABS 202 – Corporate Financial Management (CFM) – Topic 04 – 01 – Business Valuation


ExampleWACC

A company has the following capital structure:• Equity share capital (2,00,000 shares) $40,00,000• 6% preference shares $10,00,000• 8% Debentures $30,00,000

The market price of the company’s equity share is $20. It isexpected that company will pay a dividend of $2 per share atthe end of current year, which will grow at 7 per cent for ever.The tax rate may be presumed at 50 per cent.

You are required to compute the weighted average cost ofcapital based on existing capital structure.


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TOPIC 04 – 02 -02CAPITAL STRUCTURE




Capital Structure Theory – 04 Main Models

Trade-offModel

PeckingOrder

Models

SignallingModels

Agency CostModels

What is “Capital Structure”?

Capital structure is the specific mix ofdebt and equity that a firm uses tofinance its operations


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Capital Structure Theory – 04 Main Models01. The Trade-off Theory (Kraus & Litzenberger, 1973)

This refers to the idea that a company chooses how much debt finance and how muchequity finance to use by balancing the costs and benefits.




• An important purpose of the theory is to explain the fact that corporationsusually are financed partly with debt and partly with equity.

• It states that there is an advantage to financing with debt, the tax benefits ofdebt and there is a cost of financing with debt, the costs of financial distressincluding bankruptcy costs of debt and non-bankruptcy costs (e.g. staff leaving,suppliers demanding disadvantageous payment terms, bondholder/stockholderinfighting, etc.).

• The marginal benefit of further increases in debt declines as debt increases,while the marginal cost increases, so that a firm that is optimizing its overallvalue will focus on this trade-off when choosing how much debt and equity touse for financing.


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Capital Structure Theory – 04 Main Models02. Pecking Order Models• Pecking order theory was first suggested by Donaldson in 1961 and it was modified by

Stewart C. Myers and Nicolas Majluf in 1984.

• Financing comes from three sources, internal funds, debt and new equity.

• Companies prioritize their sources of financing, first preferring internal financing, andthen debt, lastly raising equity as a “last resort”.

• Hence: internal financing is used first; when that is depleted, then debt is issued; andwhen it is no longer sensible to issue any more debt, equity is issued.

• This theory maintains that businesses adhere to a hierarchy of financing sources andprefer internal financing when available, and debt is preferred over equity if externalfinancing is required (equity would mean issuing shares which meant 'bringing externalownership' into the company).

• Thus, the form of debt a firm chooses can act as a signal of its need for external finance.


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Capital Structure Theory – 04 Main Models03. Signalling Models

• The signalling models are based on the conception that managers have more superiorinformation than outside investors when it comes to the financial performance and nonfinancial performance of the firm, and would thus send some form of message throughthis potential information to investors by increasing leverage. The signalling modelsassume that financing decisions are designed basically to convey future prospects tooutside investors. This is usually done to raise the value of shares when managers thinkthey are undervalued.

• Gatsi (2012), argued that debt obligates firms to make a fixed cash payment to debt-holders over the term of the debt security. They also mentioned that firms could beforced into bankruptcy and liquidity, if they default in honouring their debt obligations,and would ultimately affect the managers as they could lose their jobs. Managers maybe aware of this and do everything possible to maintain their positions, all things beingequal.

• Barclay and Smith (2005) contend that, dividend payments are not obligatory andmanagers have more judgment over their payments and can omit them in times offinancial difficulty. EDABS 202 – Corporate Financial Management (CFM) – Topic 04 – 01 – Business Valuation


Capital Structure Theory – 04 Main Models03. Signalling Models

• Ross et al (2011) indicated that adding more debt to the company’s capital structure can show as acredible signal of higher expected future cash flows as it shows that the firm has a crediblereputation been able to redeem their credit responsibilities on time. In view of this, increasinggearing has been suggested one of the potentially effective signalling tools.

• Two other signalling models are described by Heinkel in 1982 and Blazenko in 1987. The Heinkelmodel is focused on debt signalling information to the investors about the average and variability ofthe returns. In that model he assumed that positive relationship between the average and thedegree of variability facilitates signalling equilibrium in which higher value firms signals their qualitywith higher debt levels while the Blazenko model observes that managers that are prone to themean variance criterion would shift risky positive net present value investments opportunities thusreducing the value of the firm.

• From the fore-going discussion, it evident that higher – value firms would use more debt in theircapital structure to signal this value relative to their low – value counterpart and this is based onthe premise that inefficient firms cannot manage debt and any attempt to use more debt wouldjeopardize the financial health of the firm due to bankruptcy and its associated costs.


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Capital Structure Theory – 04 Main Models04. Agency Cost Model

• Agency costs are the costs associated with the separation of owners andmanagement.

• Types of agency costs:• Monitoring costs• Bonding costs• Residual loss

• The better the corporate governance, the lower the agency costs.

• Agency costs increase the cost of equity and reduce the value of the firm.

• The higher the use of debt relative to equity, the greater the monitoring of thefirm and, therefore, the lower the cost of equity.



Capital Structure Theory – 04 Main ModelsTHEN, what is the “OPTIMAL” CAPITAL STRUCTURE?

• We cannot determine the optimal capital structure for a given company, but weknow that it depends on the following:

• The business risk of the company.• The tax situation of the company.• The degree to which the company’s assets are tangible.• The company’s corporate governance.• The transparency of the financial information.


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TOPIC 04 - CA Sri Lanka 202 - cf… · 05/08/2018 · Topic 4.01 / 4.02 8/5/2018 1 TOPIC 04 BUSINESS VALUATION. CAPITAL STRUCTURE & DIVIDEND POLICY EDABS 202 – Corporate Financial