Corporate Finance: Fair Value of the Firms Stock - Research Paper Example

Q In order to calculate the fair value of the firm's stock, there are some requirements which need to be completed or defined. The first step wouldbe the outlining of some key assumptions based on which all the calculations will be done. Key Assumptions 1) Revenue growth will be in-line with the historical growth rates or GDP/GNP of the country. 2) No Taxation 3) All working capital items i.e. current assets as well as current liabilities of the firm will grow in direct correlation to the sales. 4) There will be no change in the fixed assets of the company. 5) Discount rate will be taken from the peer group securities i.e. the rate of return offered by securities of same risk profile. 6) All the data for future projections will be up to three years only. Free Cash Flow $000 Year I Year II Year III Net Income 441 560 670 Add: Depreciation/ Amortization 0 0 0 Minus: Change in Working Capital (56) (144) (158) Minus: Capital Expenditure (16) (18) (42) Free Cash Flow 369 398 470 In the absence of any proper market rate, we are assuming to take the interest rates on long term BBB Corporate bonds which are 12.8% as on March 1983. Using CAPM Ra = rf+beta(rm-rf) Where Ra = required rate of return Rf= Risk Free Rate of Return Rm= Market Rate Ra = 8.7% + 0.5 (12.8%- 8.7%) = 8.7% + 2.05% = 10.75% Required Rate of Return = 10.75% While calculating Beta we have taken the differential of P/E of NCH Corporation as given in Exhibit 11-3. i.e. = (14-9)/ 9 = 0.55 Value of Stock using Dividend Growth Model P = Dividend per Share / (rate of return- Growth rate) = D1 / (ra-g) = 7* / (10.75%-5%) = 7 / 5.75% = $86.95 per share $7 of dividend is taken from the first year of forecasted earning. Total numbers of shares are taken as follows: = Year end $ value / $10 of face value Working: = Total Earnings/ No. of shares = 441,000 / 31,800 = 13.86 approximately $14 Earnings per share = $ 14 Considering a 50% payout ratio, the dividend would be $7 The reasonable estimate of the 50% of the shares therefore would be: = 31800 x 50% = 15900 Estimate = 15900 x 86.95 Total Best Estimate = $ 1,382,505 Q#2 Market Structure and trading conditions The total market of the Polishing and other allied products are over $4.5Billion. The market is largely fragmented with many small to medium players serving different niches of their target market. Essentially, the market is distributed into three distinct categories based on product classification. Carlton falls under the category of Chemical suppliers supplying chemicals to independent distributors who then sell to the end users. The fragmentation of the market is also due to low barriers to entry due to low cost of production involved. Since, the market is typically divided into two broader classes of chemical supplies and cleaning machinery therefore the overall cost of producing is low. This is also reflected from the fact that the gross margin of Carlton is 44% suggesting that the cost of producing the finished goods is relatively low. However, net margin within this industry is relatively low mainly due to high marketing costs involved. It has been the industry practice that distributors once acquired are hard to replaced therefore it require higher resources and persuasion to list a distributor serving the competitors. Most of the costs, therefore, are incurred in marketing overheads therefore the overall net margins are low in industry as most of the key players have negative growth rates in terms of their net income. Overall the market is competitive with no clear market leadership however; different players serve their target markets with moderate success due to long established business and consumer relationships strengthened due to delivering high end services. Q#3 Financing the Buy-out From the perspective of financing this buy out, it is very important that some indicators must be taken into account before taking such decision. Historically, Co has profitable with consistent growth rates achieved in both revenue as well as profitability. Industry ratios indicate that despite enjoying higher gross margins, firms in the industry experience low net margins because of high marketing costs. However, despite this, Carlton has been able to achieve positive and consistent growth in profitability as well as revenue. Further, it is also critical to understand that historically, Co has incurred higher debt due to recapitalization of the shares owned by others therefore such recapitalization has the impact on the net profitability of the firm due to increased financial cost. The forecasts made by the firm also suggest an overall increase of 10% in revenue with consistent increase in operating profit of the firm i.e. as per pro-forma financial statements, the operating profit increased by 60% from the year 1983 to 1987. From a long term financing perspective, if profitability of the firm is consistent and growing than financing the buy out may not be such a bigger problem for the bank however considering the stability and maturity of the business, there is a very real possibility of above average growth in revenue therefore increased leverage may further reduce the profitability of the firm. On the whole, the buy out can be financed through bank Q#4 Considering the given facts in case study, it is clear that though Bank is offering prime rate + 2% with the condition that the agreement is also going to signed by Mr. Carlton himself however, the fact that firm is at the maturity Considering the given facts in case study, it is clear that though Bank is offering prime rate + 2% with the condition that the agreement is also going to signed by Mr. Carlton himself however, the fact that firm is at the maturity Considering the given facts in case study, it is clear that though Bank is offering prime rate + 2% with the condition that the agreement is also going to signed by Mr. Carlton himself however, the fact that firm is at the maturity stage of its life cycle therefore there are very little chances of achieving higher growth rates. Considering this situation, as a banker, I would be recommending following terms of the loan: 1. Charging a rate higher than 2% spread. This is because of the fact that borrowing firm has very low growth prospects due to stagnant growth in revenues and profits. 2. Attach fixed assets of the firm in order to further collateralize the debt. 3. Putting in more financial covenants such as maintaining of certain level of current ratio, debt to equity as well as dividend payout. 4. Future change in management shall not take place without the permission of the bank. Since, Mr. Carlton will sign the agreement therefore any further plans to change the ownership of the firm may create legal Q#5 Based on the available calculations, on best assumption bases, Carlton shall not buy the shares at this existing value as they are sold at premium i.e. Carlton would be purchasing them at the price higher than they worth. Secondly, since this transaction also include debt element therefore with the overall cost of debt, the required rate of return may increase thus bringing down the fair value of the shares. Read More