Strategic Corporate Finance - Essay Example

STRATEGIC CORPORATE FINANCE By of the of the School Task Valuation of BPplc. a) Net asset value per share The tangible assets £89,589m-£2,500m= £87,089m The property, plant and equipment £87,089m+150m= £87,239 Trade receivables £21,608-100m= £21508 Total assets= £87,239+£21508+11804+19122+3530+15950+21057= £180210 Net asset value per share= (total assets – intangible assets – liabilities) no of shares outstanding 2014: 180210-21057-110291)/18260= £2.676 b) Cost of capital i. Calculate the cost of equity capital for BP using the Capital Asset Pricing Model. Cost of Equity Capital = Risk-Free Rate + (Beta *Market Risk Premium). =0.01 + 1.74(0.06-0.01) =9.7% ii. Calculate the cost of debt capital (assume a taxation rate of 20%). After-Tax Cost of Debt Capital = coupon on long-term debt x (1 minus the marginal tax rate) = 4 %*( 1-0.20) =3.2% iii. Calculate the weighted average cost of capital (WACC). WACC = wdrd(1-T) + wsrs wd = Book Value of Debt / [Market Value of Equity + Book Value of Debt] Book Value of Debt= £69419m Market Value of Equity= no of shares*share price =18.26Bn*£478p= £87282.8m wd =£69419m/ (£69419m+£87282.8m) = 0.4430 ws= 1-0.4430= 0.5570 WACC = 0.443*3.2% + 0.557*9.7% =6.8205% c) Dividend growth model Value of stock = D1/ (k - g) D1 = expected annual dividend per share for next year k = required rate of return as per CAPM g = dividend growth rate (i) g = 0% Value of stock = D1/ (k - g) Value of stock= (23.85(1+0.00)/ (0.097-0.00) =£245.876 (ii) g = 2% Value of stock = D1/ (k - g) Value of stock= (23.85(1+0.02)/(0.097-0.02) =£315.935 d) Value per share using the price earnings (p/e) ratio P/E ratio= Market Value per Share / EPS 31 December 2013: 488p/75.12= 6.50 31 December 2014: 409/75.12= 5.44 This ratio shows a share’s expected price based on its earnings. From the calculation, it is clear that the P/E ratio for BP decreased from 6.50 in 2013 to 5.44 in 2014. The decrease is an indication of the company’s poor current as well as future performance with regards to what investors perceive. It is therefore a bad investment. In comparison to the industry value, the industry has a higher P/E ratio. This indicates that investors are anticipating higher performance as well as growth for other companies in the industry. Investors are willing to pay more for the shares of such companies. Task 2 Limitations of Price-to earnings ratios Price-to earnings ratios as a method of share valuation aids in the determination of whether a company is undervalued or overvalued, however, P/E ratio has a number of limitations or pitfalls and is only valid in specific circumstances. Its usefulness is undermined by the following factors. The first factor is accounting. Earnings from which is it derived is an accounting figure that is determined under the guidance of accounting rules known as Generally Accepted accounting Principles, GAAP) that are subject to change and they usually vary from one country to another (Barnhart & Giannetti 2009: 79). Therefore, EPS can be squeezed, twisted and prodded into numerous numbers depending on how one decides to do the books. It is therefore subjective and the figures being compared may not be the same. The second factor that limits the usefulness of P/E ratio is inflation. During times of high inflation, P/E ratio tends to e much lower because the market normally views the earnings as being artificially distorted upwards (Ball 2012: 327). During such times, depreciation as well as inventory costs tends to be understated since the replacement costs of equipment as well as goods increase with the rise in general level of prices. Information therefore, makes it hard to value the shares because past information is often less useful today. P/E ratio cannot therefore give a clear picture regarding the valuation of the shares of the company in times of high inflation Another limitation is about market interpretations. The values of P/E can be interpreted in a number of ways, for instance, a low P/E ratio may mean that the company is undervalued. On the other hand, it may indicate that the market thinks that the firm in question is headed for trouble or problems in the near future. This implies that the earnings of the company will reduce lower than expected (Ball 2012: 330). It is clear that companies are able to manipulate their earnings. This is able to distort earnings per share (EPS) as well as the P/E ratio. Trailing price-to earnings ratio usually takes into account the past earnings of a firm; therefore, it fails to provide a clear picture or idea of the prospective company’s future earnings (Ball 2012: 341). Just looking at the P/E of a stock is not sufficient in determining whether it should be bought, other factors such as business risks, market share as well as company leadership is often considered. Limitations of dividend growth model as an approach to share valuation Dividend growth model has been hailed by many people as being not subjective. It has also been hailed for being indisputable; however, the model has some criticisms leveled against its usefulness. The model that has been seen as a perfect valuation method has some glaring flaws that limit its applicability. First, the model has limited use, for example, it is only applicable to mature and stable firms that have proven track of giving out dividends consistently (Abhyankar & Garcia-Ares 2013). This makes investors to miss out high growth companies that have lots of opportunities in the future. Such companies do not have the luxury of keeping cash to pay dividends because they are in need of more cash than they have on hand to explore new markets or develop new products. This model therefore fails to value such companies like Facebook or Google because they do not have a proven track of paying dividends. The model is not practical for valuing companies that do not pay dividends. Another major limitation of the model is that it may not relate to earnings. It implicitly makes an assumption that the dividends that are paid out are correlated to earnings implying that the higher the earnings, the higher the dividends and vice versa. However, in practice, it is almost not the case because firms normally tend to maintain stable dividend payouts although their earnings may be experiencing extreme variations (Del Vecchio 2000: 2). The assumption that dividends are correlated to value creation is not true thus limiting the applicability of the model because some instances have been seen where a company maintains a stable dividend payout though they are simultaneously borrowing cash. In addition, the model is based on many assumptions that limit its usefulness in valuing stocks. Such assumptions regard tax rates, growth rate and interest rates. This factor reduces the model’s validity because most of such factors are beyond the control of the investors. For instance it assumes that dividend growth usually remain constant forever, in reality dividends grow at different rates (Akdeniz et al. 2007: 439). This renders the model impractical. On the other hand, for tax efficiency purposes, the model may not be applicable in some countries where paying dividends may not be efficient. Tax structures of some countries are created in such a manner that dividends are taxed more than capital gains. In addition, some tax structures may discourage paying out of dividend and encourage stock repurchase instead. Since it results into dilution of value, many companies in such countries may not pay dividends. Dividend growth model, therefore, fails to guide investors in such countries because they end up ignoring all the shares that pertain to those specific countries (Olweny 2011: 140). The best method for valuing stock Even though dividend growth model has a number of limitations, they are few and that makes it the best method for valuing shares of a company. The model can be made as applicable to the reality as possible by utilizing the most precise and reliable assumptions available. In addition, the model is usually simple and clear. Also, it is very useful for approximating the company’s expected rate of return. It helps in understanding the relationship that exists between required return, growth, payout ratio and value. In case an investor evaluates different assumptions regarding the growth as well as future prospects, he arrives at a more reliable valuation. By using more precise and reliable assumptions available, the new valuation is as follows Solution Required Rate of Return (k) Assumptions Systematic risk or (β) of the common stock of BP PLC is 1.97 Expected rate of return on the market portfolio of BP (Rm) is 13.79% Rate of return on the LT treasury composite (RF) is 2.72% Calculations RBP = RF + βBP [E(RM) – RF] = 2.72% + 1.97 [13.79% – 2.72%] = 24.59%  Dividend growth rate (g) g = 100 × (P0 × r – D0) ÷ (P0 + D0) Where: P0 = BPs common stock current price D0 = BPs common stock last year DPS r = BPs common stock required rate of return g  = 100 × ($42.81 × 24.59% – $2.34) ÷ ($42.81 + $2.34) = 18.13% Value of stock = D1/ (k - g) Value of stock= (23.85/ (0.2459-0.1813) =369.195p In my view, I will encourage the client to buy the share on the 5th May 2015 because of the following reasons. First, Even though the share is highly overvalued, the company has been very successful in the industry and therefore promises high returns to the investors. The current price of the share is 473.95p compared to the calculated value of 369.195p. The stock is trading above its intrinsic value; however, the dividend payout ratio of the company has been increasing considerably. Thirdly, the prices of the company’s stock has an increasing trend hence can be used for speculative purposes. One may buy the shares today and sell in future when the prices shall have increased further. Task 3 Share price tracking and the EMH Even though the prices of the share greatly fluctuated, in general it had an upward trend. From January to April the share prices increased. The share prices moved in response to new information (Ball & Shivakumar 2008: 978). According to Efficient market hypothesis, stock market efficiency always causes the prices of shares to incorporate as well as reflect all relevant information in the market. This is the main reason why the shares prices tend to move. New information is very vital because it provides the main reason why stocks or shares are valued a t a specific price level (Lo 2005). A share is priced based on all the information that the market has, so if positive information is available share prices tend to move up. However, when a market anticipates negative information, the share prices reduce greatly. As the information technology advances, more new information is released into the market which makes the market to adjust share prices either down or up depending on the market’s perception of the effect of such information on the company’s future earning capacity. Stock prices changes in response to new information because it is the basis for valuation (Giammario et al. 2004: 90). The movement of share prices in response to new information is also explained by Dow Theory. The theory maintains that the prices of stock quickly incorporate new information immediately when they become available. When news is released, the prices of stock changes to reflect this new information. For instance, between March 9 and March 16, the share prices dropped by 4.92 while between April 6 and April 13, it rose by 3.93. Therefore, the other reason why stock prices changes in response to new information is to incorporate it (Lo 2007: 28). Stock prices changes in response to new information due to market forces. New positive information makes investors to buy more of a given stock thus driving its price up (Mobeen & Waqas 2013: 64). On the contrary, negative information makes investors to sell more of a stock which in turn makes the price to fall. A greater supply than demand of the company’s stock is the main reason for the reduction in its prices. Therefore the third reason why there is movement in stock prices is fluctuations in demand and supply (Malkiel 2005: 7). Although share prices is also affected by other factors such as uncertainty and psychological factors like greed and fear, new information causes a great change than the other factors. Markets are gaining greater efficiency in this age of IT because it fastens the dissemination of information in an effective manner all over the world (Zettelmeyer et al. 2006: 170). It is making most markets to move towards the semi-strong form efficiency of the EMH. References Abhyankar, A. & Garcia-Ares, P.A., 2013. Dividend Growth Predictability: Isn’t It There? SSRN Working Paper Series. Available at: http://search.proquest.com/docview/1322056618?accountid=12528\nhttp://ssrn.com/abstract=2239227. Akdeniz, L., Salih, A.A. & Ok, S.T., 2007. Are stock prices too volatile to be justified by the dividend discount model? 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Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=991509. Malkiel, B.G., 2005. Reflections on the Efficient Market Hypothesis: 30 Years Later. The Financial Review, 40, pp.1–9. Available at: http://doi.wiley.com/10.1111/j.0732-8516.2005.00090.x\nhttp://onlinelibrary.wiley.com/doi/10.1111/j.0732-8516.2005.00090.x/abstract. Mobeen, U.R. & Waqas, B.K., 2013. TECHNICAL ANALYSIS OF EFFICIENT MARKET HYPOTHESIS IN A FRONTIER MARKET. Studies in Business and Economics, 8, pp.60–68. Olweny, T., 2011. The Reliability of Dividend Discount Model in Valuation of Common Stock at the Nairobi Stock Exchange. International Journal of Business and Social Science, 2, pp.127–142. Available at: http://www.ijbssnet.com/journals/Vol._2_No._6%3B_April_2011/14.pdf. Del Vecchio, J., 2000. Dividend Discount Model. The Motley Fool, pp.1–3. Available at: http://zing.ncsl.nist.gov/cifter/TheCD/TMFsite_instrumented/FoolSite/FoolMain/research/2000/features000406.htm. Zettelmeyer, F., Morton, F.S. & Silva-Risso, J., 2006. How the Internet Lowers Prices: Evidence from Matched Survey and Automobile Transaction Data. Journal of Marketing Research, 43, pp.168–181.  BP PLC Dividend Discount Model )DDM), accessed 19/05/2015. Retrieved from: https://www.stock-analysis-on.net/NYSE/Company/BP-PLC/DCF/DDM BP PLC historical prices, accessed 19/05/2015. Retrieved from: https://uk.finance.yahoo.com/q/hp?s=BP.L BP Stock Dividend Data (accessed 19/05/2015) retrieved from: http://www.dividend.com/dividend-stocks/basic-materials/major-integrated-oil-and-gas/bp-bp-plc/ Centaur Media PLC historical prices, accessed 19/05/2015. Retrieved from: https://uk.finance.yahoo.com/q/hp?s=CAU.L&b=1&a=00&c=2015&e=30&d=03&f=2015&g=w Read More