Strategic and Financial Decision-making - Literature review Example

Strategic and Financial Decision-making Table of Contents Table of Contents 2 Introduction 3 The Sources of Data and Computation of Betas 4 The Difference between the Published and the Computed Beta 7 Beta Analysis 8 CAPM Model and Decision Making 9 Critical Analysis of Organic Growth and Acquisition 10 Conclusion 11 Reference 11 Introduction Financial analysts play an important role in the capital market. Random movement of the stocks makes capital market the most uncertain of its kind. The financial analysts attempt to predict the movement of the capital market by employing statistics and other models. The stock exchange is the medium through which the stocks of different companies are traded. The stocks are issued by different public sector companies and the investors buy and sell the stock keeping in mind the market situation and the forecast made. Most of the investors are influenced by the forecast delivered by the analysts. The brokers of the stock exchanges or any qualified individual can play the role of the analysts. They try to identify the trends by analyzing the past behaviour of the stock and other market important information. The statistical tools such as beta, alpha, regression, time series etc are popular among the analysts. London Stock exchange (LSE) is the prominent exchange in UK and FTSE 100 is a popular index of LSE followed by most of the investors and analysts. Beta of a stock measures the volatility of that particular stock with the market movement. In this report the betas of two FTSE 100 companies will be calculated using covariance and variance, and using the linear regression model. The two chosen companies are Experian (EXPN) and Sainsbury(J) (SBRY). EXPN is one of the leading companies in global information services. It provides data analytical tools and other systems that help an organisation to take proper decisions (Experian, Plc. n.d.). Organisations like banks, government departments or retailers etc are the clients of EXPN. SBRY is UK’s third largest chain of supermarket and convenience store engaged in retail marketing of daily household products like grocery, garments etc. “Sainsburys Supermarkets is UKs longest standing major food retailing chain, having opened its first store in 1869, presently consisting a chain of 525 supermarkets and 303 convenience stores – and Sainsburys Bank” (J Sainsbury Plc. 2010). SBRY and EXPN, both the companies were listed in the LSE on July 11, 1975 and on October 26, 2006 respectively and the stocks of these companies are currently traded at the rate £323.78 and £600 respectively (London Stock Exchange. 2010). The Sources of Data and Computation of Betas In order to calculate the betas of both the companies, the historical stock prices are required. The beta will be calculated using the covariance of stock return and market return relative to the variance of market return. The second method uses linear regression analysis of the stock return and the market return. The historical monthly average price of shares and FSTE 100 are taken from the Yahoo Finance, a reliable online source (Yahoo Finance, 2010). In order to analyse the computed Beta and the published beta, the published beta of both the companies are taken from the msn-money U.K. which also an authentic online source. According to this website, EXPN’s and SBRY’s beta are 0.67 and 0.66 respectively (msn-money U.K. 2010). The first methodology for beta computation uses the covariance of stock return of a company and the variance of the marker return. FTSE 100 is being used as the market indicator and the return on FTSE 100 is taken as the market return (Rm). All these calculations have been done using MS Excel. The covariance of the Re and the Rm is 0.002426 and the variance of Rm in 0.003665. By dividing these two the beta for EXPN has been calculated i.e. 0.662003 (Table 1) Table 1: Beta of EXPN The same methodology has been applied to calculate the beta of SBRY. The covariance of Re and Rm is 0.001748 and the variance of Rm is 0.002633 and the beta of the company is 0.6638 (Table 2) Table 2: Beta of SBRY The second methodology uses linear regression analysis. This method has also been done using the MS Excel. This regression analysis is a ‘Bivariate Regression’ where two factors: independent and dependent are present and it explains the manner in which dependent variable responds to changes in the independent variable. In this context, the market return is an independent variable and the stock return is a dependent one. The linear regressed relation between the two variables is represented by an equation i.e. [Y=a+βX+Ei]. Here the ‘Y’ is a dependent and ‘X’ is an independent variable, ‘a’ is a constant factor and ‘Ei’ is the standard error. Table 3 is a summary output of linear regression analysis of EXPN and market return. Table 3: Regression analysis of Re and Rm From the summary output given in Excel, the linear regression equation will be [Re=0.021666+0.690785Rm+0.009535]. Here the beta for the company is 0.690785. This explains that the stock of EXPN is less volatile to market movements. In the same way, with the help of the MS excel the regression analysis of SBRY’s stock and the market has been calculated. The table 4 shows the summary output of the regression analysis. Table 4: Regression Analysis of Rs and Rm The equation for the linear regression analysis is [Rs=0.0023212+0.49775Rm+0.0113014]. The beta for the company is 0.49775 which means the stock price of SBRY is less volatile to market movements. The Difference between the Published and the Computed Beta Apart from computing the beta by applying the two methodologies, the monthly data and the published data have also been taken from msn-money. The published beta for EXPN is 0.67 and for SBRY is 0.66. The computed betas for EXPN and SBRY under first methodology are 0.662003 and 0.6638 (Table 1 & 2). Under the linear regression analysis, the betas for both the companies are 0.6907 and 0.4977. Observing all these betas, it is realized that there exist differences in the values of beta. According to James R. Hitchner, the published betas of different sources differ in their value as the data they collect are different. This is because the time span taken is different, the methodologies used and the adjustments made are different. (Hitchner, 2003. p.154). However, the results of the first methodology show minor differences but the results obtained through regression analysis have deviated from the published source. The share prices of the stock have been taken as the average of the last 24 months. The published source may have used the daily average price or the time period taken might differ. In this report the betas have been calculated by using two different methodologies, therefore the published source may have used any other methodologies. One major factor that is responsible for the differences is the use of different index. In this analysis the FTSE 100 has been taken as market index but in London Stock Exchange, there are other indexes available like FTSE AIM 100, FTSE 250, FTSE 350 etc. Hence the results are bound to be different from the calculated results. Beta Analysis The beta of company indicates valuable information to the investors as well as to the company itself. The interpretation of data helps investors to take decisions regarding their portfolio. The management of the company also gets important information which helps in the decision making process. If the beta of any company’s stock is more than one, it means that stock is more volatile to market movements and if it is less than one, it implies that the stock prices are stable in the market. “It must be stressed that the future beta of a share is the relevant measure of its market risk” (Correia. et.al. p.4.21). The calculated betas of EXPN derived by using both the methodologies are 0.662 and 0.690 and betas of SBRY are 0.663 and 0.497. The betas of both the company are lower than one which indicates that the stock prices are less volatile to market movements. Therefore the chances of association of risk are lower in respect to the market. However, it also indicates a lower return but the return is quite reliable. In both the results, there are minor differences but the beta of SBRY is lesser therefore it seems to be more consistent against the market fluctuation. CAPM Model and Decision Making Capital Asset Pricing Model (CAPM) model is a popular model to calculate the cost of equity. This model includes three important components like risk free rate of return (Rf), the market return (Rm), and the beta of that equity (β). This model explains the relationship between risk and return. The equation is given below. “Re=Rf+β(Rm-Rf)” The ‘Re’ is the cost of equity or return on market. The investors and analysts use this model to estimate the required rate of return on equity. In a rational equilibrium market, the CAPM helps to find the return against the given risk. As per the financial theory, the risk is directly related with the return; with the rise in risk the return also rises. This theory is numerically explained by the CAPM model. From the management’s point of view the CAPM helps to decide the price of the equity against the given systematic risk. As Hemilton said, a small change in discount rate can lead to a great difference. Therefore, deciding that discount rate which minimises the associated risk is very essential. In such a situation, the CAPM helps to decide the cost of equity. “Using the CAPM to provide a reasonable measure of a company’s cost of equity requires accurately estimating all three components” (Baker.et.al. 2008. p.351). It is basically an asset pricing model that helps a management to decide the price of equity. Critical Analysis of Organic Growth and Acquisition During acquisition, the acquiring company buys the maximum stake of the acquired company which enables the former to control the latter. Acquisitions, mergers or takeovers constitute the inorganic growth of a company. The inorganic growth helps a company to expand in new regions or to enter any new sector or industry. “Common benefits from M&As include the elimination of redundant resources and the achievement of operational efficiencies and synergies” (Wisconsin School of Business. 2006). Acquisition helps a company to grow within a short span of time. Apart from that, the operation of acquiring company gets enriched by integration of supported functions, technology, systems and process alignment. However, it also brings some challenges and difficulties. The sudden expansion makes the day-to-day operations tougher. The most common challenge is the one posed by the different management’s styles of two companies. According to Barrie Pearson, it (inorganic growth) is short way of growth that requires a lot of hard work without any guarantee of success. “When a company has the people available to develop and launch new product and services, or can recruit staff, or possibility headhunt nucleus of a team the funds required be much less than those needed for an acquisition” (Pearson. 1999. p.17). Therefore, in a situation when a company is not able to gather sufficient money for acquisition, the organic growth is an alternative for expansion. It requires a tremendous effort, commitment and hard work. The organic growth is considered as the true growth of company within the industry where the management shows had shown its efficiency by using the limited resources in order to expand the company. The major disadvantage of organic growth is that the expansion rate is very slow and it comes after a long time of hard work. Conclusion The growth of a company also brings with it various types risks. The managements, the policy makers, the investors and the analysts evaluate the growth rate and the risk factors attached with growth. They use different methods of calculations and try to predict the future of the company, so that the company remains profitable for a long time. Capital market is the platform where all the above mentioned activities take place. All the players of the capital market are concerned with the growth of the interested company. The nature of the growth may be organic or non-organic depending on the decision of the management. Reference Baker, H.K. & Powell, G.E. 2005. Understanding financial management: a practical guide. Wiley-Blackwell. Correia, C. Flynn, D. Uliana, E. & Wormald, M. 2007. Financial Management. 6th ed. Juta and Company Ltd. Experian Plc. No Date. About Experian. [Online] Available at: http://www.experianplc.com/en/about-experian.aspx. [Accessed on May 19, 2010]. Hitchner, J.R. 2003. Financial valuation: applications and models, Volume 2002. John Wiley and Sons. J Sainsbury Plc. 2010. About us: Company overview. [Online] Available at: http://www.j-sainsbury.co.uk/index.asp?pageid=12. [Accessed on May 19, 2010]. London Stock Exchange. 2010. EXPN EXPERIAN PLC ORD USD0.10. [Online] Available at: http://www.londonstockexchange.com/exchange/prices-and-news/stocks/summary/company-summary.html?fourWayKey=GB00B19NLV48JEGBXSET1. [Accessed on May 19, 2010]. London Stock Exchange. 2010. SBRY SAINSBURY(J) PLC ORD 28 4/7P. [Online] Available at: http://www.londonstockexchange.com/exchange/prices-and-news/stocks/summary/company-summary.html?fourWayKey=GB00B019KW72GBGBXSET1. [Accessed on May 19, 2010]. msn money, 2010. Experian PLC. [Online] Available at: http://uk.moneycentral.msn.com/investor/quotes/quotes.aspx?symbol=GB%3AEXPN. [Accessed on May 20, 2010]. msn money, 2010. J Sainsbury PLC. [Online] Available at: http://uk.moneycentral.msn.com/investor/quotes/quotes.aspx?symbol=SBRY. [Accessed on May 20, 2010]. Pearson, B. 1999. Successful acquisition of unquoted companies: a practical guide. 4th ed. Gower Publishing, Ltd. Wisconsin School of Business. 2006. Mergers and Acquisitions -Where Do Operations Fit In? [Online] Available at: http://www.bus.wisc.edu/erdman/PDF%20Files/Newsletter/Erdman_Center_Newsletter_SuFall06.pdf. [Accessed on May 19, 2010]. Yahoo Finance. May 19, 2010. EXPERIAN ORD USD0.10 (EXPN.L). 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