Maximizing Stock Market Valuation - Assignment Example

1. In your judgement what level of gearing and structure of debt would maximise the stock market valuation of BT and why Level of Gearing and Structure of Debt for Maximising Stock Valuation: The proportion of debt and equity employed by the company to finance its functioning have a large implication for the value the stockholders. The expected returns of the shareholders and the risk being faced by the creditors of the company are influenced by the leverage of the company which in turn depends on the capital structure of the firm. While the proportion of debt, preference shares and ordinary shares used by the company represents the capital structure, the amount of debt the company uses is denoted by the leverage. A firm with lot of debt is said to have a high capital gearing ratio that increases the cost of capital for the firm by way of interest provisions. With this background, as per the BT management's opinion as on 31st March 1983 with the NFL loan amount of 2944 million the debt ratio for the company was too high and a new capital structure was needed to increase the stock valuation for the proposed floatation move. In the management's view the ideal capital structure should have a low level of debt which not only increases the value of the stock but also reduces the interest burden. One possible way to achieve this was to consider writing off of some portion of the debts or converting them into equity. The management also estimated that the company would have to borrow additionally to meet the cash outflow in the form of dividends, tax payments, interest charges and other necessary capital expenditure. This may increase the debt content of the capital structure which will further have negative impact on the stock valuation. Taking the argument of the management it would be ideal for the company to arrive at a capital structure where the debt equity ratio is kept at the ideal level from the point of payment of interest as well as to maintain the value of the stock. In order to achieve these objectives, the proposal by the government in converting 750 million of debts into preference shares would have been the best suggestion to follow. This can be substantiated by the following arguments that go in favour of this suggestion: 1. The calculation of the financial leverage ratio and debt equity ratio based on the projected balance sheets after incorporating the proposed conversion of debt into preference shares look as shown below: 2. In view of the lowering leverage and debt equity ratio figures the proposed Scheme of structuring of debts as suggested by the government appear to be of the optimum solution available to BT in the matter of capital structuring. 3. The proposed leverage ratio and equity ratio make the shares attractive to the shareholders since it will result in increased earnings per share. 4. Since immediately after the floatation there would be no chances for BT to go in to the equity market for making a right issue to raise funds for the capital expenditures. Even if the company had to go in for acquisitions, the company should have more cash resources to meet the acquisition cost. Such a situation can be handled only with the above proposed restructuring where the company's cash flow position improves every year with lower cost of capital. 5. Another argument that goes in favour of the proposed restructuring is that without the government converting certain portions of the loan into equity BT would be showing a 126 percent debt to equity as at the end of the year 31st March 1983 and even with the flow of retentions without the write offs the debt-equity ratio would at best be at 96 percent as the end of 31st March 1984. These levels are very high as compared to the other quoted companies. 6. Moreover the level of gearing without debt restructuring along with the interest cover of 2.8 times as existed for 1983-84 would not have made the BT's share attractive for investment. 2. As an advisor to the Government, what level of gearing would you recommend for BT and why Even from the government's angle the proposed conversion of 750 million debts in to preference capital is the ideal structuring that would suit the circumstances as exited prior to the planned floatation. The reasons for advocating the conversion are: 1. Though the government also had the intention to get the highest possible price as a result of the proposed sale of 51 percent of the stakes in the company BT, from the angle of the government, low rating to the shares will be applied to the shares by the investors only at debt equity ratios much higher than those as proposed by the government. 2. Also from the government's point of view, BT represent the characteristics of an utility more than a business venture and hence the investors would attach a lower risk factor only for the investment in the shares of the company. Hence the proposed gearing percentage would do well to attract the investors. This view is supported by the fact that BT has a higher quality of earnings resulting from base telephone calls which is much superior to any other business firm and that this quality would go well with the investors in making their decisions concerning the shares of BT. 3. While the debt-equity levels of the US telecommunication companies have debt equity ratios ranging from 50 to 70 percent the stand taken by the government in capitalizing 750 million makes the ratio for BT in the same lines as those of the US companies. Even within UK coverage ratios of around 3 to 5 were considered safe and acceptable. Hence the proposed changes in the capital structures by the government stands justified. 3. What dividend policies should be adopted and why The first made in respect of the dividend payment was that unless a significant reduction has been achieved the company would have to borrow again to fund dividend payments. The budget provisions of the year 1984 made the effective rate of Corporation Tax payable on the distributed profits i.e. dividends to the advantage of the company than the tax advantage of debt over equity. While the interest payments would continue to shield the company from the incidence of corporation tax, payment of dividends would not entail a higher rate of tax on the company and hence a careful restructuring of the company should be attempted to make the cash flow of the company fit to declare and pay dividend. For the proposed payment of an annual dividend of 550 million, the company expected a low debt equity ratio of as much as 15 to 20 percent. Assuming the company's worth at 8 billion this would result in a dividend yield of 7 percent. However without any reduction in the current debt levels, the company would not be able to distribute dividends of 550 million and pay the interest of 550 million. These payments then account for more than two thirds of the estimated profits for 1984. As per the consultants' advise, this situation would not meet with favour by the investors as they would be expecting a dividend cover of at least two times out of the post tax profits. Though maximizing the sale price of shares was not the intention of BT and also a high initial pricing would make it difficult for the company to perform, still it was argued from the company side that lowering the dividend yield may reduce the investment value of BT. The merchant bankers for the issue advised the government that the shares would be valued by the investors on the basis of the yield and hence it would be better to maintain the yield at 7 percent would be an appropriate dividend policy that could be followed. The bankers further stressed the point that while the yield of 7 percent are double the average yield of other industrial shares but much below the dividend yield of the US telephone companies. However the government was not convinced about this proposal of maintaining the dividend yield at 7 percent as it expected to have a much lower percent. Even if the government wanted to go by the 7 percent yield norm, still because of the mistrust crated on the company, by wrong estimates presented by the company in respect of the capital expenditure figures, the government didn't want to consider the arguments of BT. Moreover the government believed that even without write offs of debts the company because of its enhanced cash flows would be able to easily meet the proposed dividend payment of 550 million. The government also believed that the company would even after meeting the dividend payment of 550 million, be able to finance the capital expenditure and also service its debts with ease. The government also was concerned about the fact while it could be confident of receiving the interest on the debts, it was not certain on receiving the dividends on its 49 percent balance holding. This point also played a role in determining the quantum of debts to be converted in to equity and the resultant dividend policy. In view of the foregoing discussion on the payment of dividend and maintaining the yield at 7 percent, the advise from the merchant bankers seem to have a valid ground. Any investment on the shares would be valued on the basis of the returns from the investments and again on the market share of the shares. The market value of the shares would be decided again by the amount of return the investment gives. Hence in determining the value of any investments the yield from the shares plays a dominant role. Hence as advised by the investment bankers in order that the shares were made more valuable it was important the yield on the shares are comparable with the yield available from the shares of the companies in the same industry. Since the yield of 7 percent, though higher than that of other companies, since it is more or less equivalent to the yield from US telephone companies, the dividend policy to maintain the yield at 7 percent could be followed. 4. What valuation methods are available Which approach do you favour and why There are different methods available to value the shares. They are: Market Price (MP) Method: This method used the average of the historical prices of the shares as quoted in major stock exchanges. The method adopts the weighted average by volume so that the anomalies caused by the stray and small transactions do not mislead the average. The existence of a continuous and volume trading in the respective shares is an essential condition to adopt this method. Comparable Companies Multiples (CCM) Method: The share price as a percent of the past, current or future profit, sales volume or value figures is arrived at on the basis of the available market prices of shares of comparable companies in the same industry and compared to arrive at the correct price. However it must be noted that the price needs to be adjusted for factors like size, growth trend, country risk etc to have a realistic price. Discounted Cash Flow (DCF) Method: This method based on the future information, takes into account the present values of future residual cash flows available to the investors. This method uses "projections of cash flows referenced to market parameters" (Ernst&Young) The discounting factor is based on the market beta of the company concerned or that of the comparable company that is listed. Net Asset Value Method: Net Asset Value method is based on historical data and arrives at the valuation in terms of the stated net worth of the company. Of all the above methods the discounted cash flow method which is more scientific can be considered as the most suitable as it is not affected by the accounting practices and it takes into account all the tangible and intangible assets of the company. The method also incorporates the current and future position of the company. It also provides for all the financial and business risks. 5. What is BT worth The net worth of BT after the proposed change in the capital structure can be calculated as below: Amount million Word Count: 2075 Reference: Ernst&Young Business/Share Valuation Techniques http://www.ey.com/global/content.nsf/India/Val_-Business_Share_Valuation_Techniques Read More