PGDBFS 301 Cases in Business Finance and Strategy (CBFS) Conducted - PowerPoint PPT Presentation

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

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

3 01.01 – Last Session Recap Assumptions Situational Problem Strategic Recommen- Read & Missing Alternatives Analysis Definition Analysis dations information R S A P S A R

4 02. Situational Analysis The theories…

5 02.01 – Situational Analysis Assumptions Situational Problem Strategic Recommen- Read & Missing Alternatives Analysis Definition Analysis dations information Situational Analysis Internal External Ratio “SW”OT SW“OT” PESTEL P5Fs Analysis

6 02.01 – Situational Analysis – SWOT

7 02.01 – Situational Analysis – Ratio Analysis ▸ Gross Profit Ratio

8 02.01 – Situational Analysis – Ratio Analysis ▸ Net Profit Ratio

9 02.01 – Situational Analysis – Ratio Analysis ▸ ROCE

10 02.01 – Situational Analysis – Ratio Analysis ▸ Current Ratio

11 02.01 – Situational Analysis – Ratio Analysis ▸ Gearing Ratio

12 02.01 – Situational Analysis – PESTEL P olitical E conomical S ocial T echnological E nvironmental L egal

13 02.01 – Situational Analysis – P5F’s

14 03. Strategic Analysis More theories…

15 03.01 – Strategic Analysis – Vision & Mission ▸ Vision ▸ Mission

16 03.01 – Strategic Analysis – Goals & Objectives ▸ Goals ▸ Objectives

17 03.01 – Strategic Analysis – Porter’s Generic Strategies ▸ Porter’s Generic Strategies

18 03.01 – Strategic Analysis – Ansoff’s Matrix ▸ Ansoff’s Matrix

19 03.01 – Strategic Analysis – BCG Matrix ▸ BCG Matrix

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

03.02 – Strategic Analysis – Share and Company 21 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

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. Non Net Asset Current + - = current Fixed Assets Assets Value liabilites • 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 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

03. Income Based Valuations 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

25 03.02 – Strategic Analysis – COST OF CAPITAL

Options Available 1. Equity 2. Debt • Ordinary Shares – 1.1 • Debentures – 2.1 • Preference Shares – (Redeemable / Irredeemable) 1.2 • Long Term Loans / • Internal Funding – 1.3 Overdrafts – 2.2

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

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

Cost of Capital Type of Funding Cost of Capital Equity - Expected Rate of Return by the future share holders Ordinary Shares to compensate risk , using CAPM Equity - Fixed dividends stated in the prospectus. Preference Shares 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 Gordon’s Dividend Growth Model k e = Cost (k) of equity (e) k e = (d 1 / p 0 ) + g d 1 = Dividends in Y 1 p 0 = Price of Share in Y 0 g = Growth rate in dividends Capital Asset Pricing Model (CAPM) k e = R f + (R m – R f ) b R f = Risk Free Return R m = Market Return b = Beta factor (risk factor)

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 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 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 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?

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

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 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 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%.

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