Strategic and Financial Decision-making - Assignment Example

Financial Analysis Table of Contents Financial Analysis Table of Contents 2 Answer to the question no 4 a. Beta Calculation 4 b. Characteristic Line 5 Answer to the Question no 2 7 Influential factors behind the differences between the beta values on different resources 7 Answer to the question no 3 9 Difference in beta values for different companies 9 Answer to the Question no 4 10 a. CAPM and Organic Growth 10 b. Organic growth and Acquisition 11 Reference 13 Bibliography 14 Appendix 15 Answer to the question no 1 a. Beta Calculation The stock returns fluctuate with the changes in the prevailing market return. Here market return can even be represented by the return on its benchmark index. This variation is responsible for creating inherent market risk. One of the widely used statistical variables to represent this risk is the beta estimation. Beta value reveals the magnitude and direction of this volatility in accordance with the market. The calculation of beta is as follows. Beta = Covariance (R stock, Rmarket ) / Variance (R market ) (McNully, 2010). To calculate the beta values for British Airways and Pearson, the stock closing prices have been gathered for 24 months (Yahoo Finance, 2010). The return on the benchmark index has been taken as the market return for the respective calculation. For this purpose, the Financial Times Stock Index 100 closing prices were gathered to represent the market price. The closing share prices for the corporate stocks and the benchmark index have been shown in the appendix. For each of the two stocks, beta has been calculated considering the covariance of the stock returns against the market returns and by dividing the same with the variance in the closing prices of the index. The calculated beta values have been represented in the tabular form. The stipulated period for this calculation had started from 17th May, 2008 to 17th May, 2010. A positive beta value means the stock returns are aligned in the same direction as that of the index return. A stock return with negative beta values means that the fluctuation of the stock return is in the opposite direction to that of the market return. Higher the absolute value of the beta figure, higher the intensity of the market risk inherent in the corporate stocks. British Airways has a beta value of 0.05732. This means that if the index return experiences 100 percent growth in any stipulated time period, the corporate stock price return for British Airways is expected to move only 5.73%. The market risk inherent in British Airway is much lower. Pearson would experience 10.88 % movement in its price return as compared to 100 % movement in the market return. The beta values can prove advantageous in the bear market; however it will fetch less return when the market is experiencing a very high growth, i.e. in bull market. b. Characteristic Line The characteristic line is a regression line representing the relationship of the corporate stock returns with the index returns for a stipulated time period. Coefficient of determination, i.e. the R-squared, measures the degree at which the characteristic line is able to reveal the variability in the stock returns against the market returns. To measure the R- squared, the regression has been done on the sock returns, keeping the market returns on the Y-axis. The characteristic line graphs have been shown below. For British Airways the R- squared value has come around 0.43. This means that the characteristic line can explain around 43 % of the volatile movement in the stock returns using the returns of the FTSE 100 index. In this case, the alpha has come around 0.003. This is the vertical intercept of the characteristic line. The beta value for this stock is 0.212. If the market has a movement of 100 %, the stock is supposed to have 21 % movements in the same direction as that of the market. Pearson stock returns have a coefficient of determination of around 0.353. This means that about 35 % of the variability in the stock returns can be explained by the characteristic line. The alpha value for the Pearson corporate stock is around 0.015. The beta value for this stock is 0.566. As per the regression analysis, if there is 100 % movement in the market return figures, the stock movement is supposed to have around 56 % movement in its stock return values. Answer to the Question no 2 Influential factors behind the differences between the beta values on different resources The standard beta values have been collected for both the stocks. Beta value for British Airways has come around 1.40 and that of Pearson is 0.67. It has been noticed that there are differences in the beta values collected and calculated in three different ways. There are different methods to calculate the beta value for the corporate stocks. At the same time there are some more factors which are influential in determining the differences between the different beta values. The standard beta values have been collected from the Reuters website. Difference in index used: The above mentioned two methods have taken FTSE 100 as the market index. Reuters take S&P 500 as the benchmark index. This is one of the reasons behind the discrepancies among the three values. Time frame: The time frame to calculate the CAPM beta and the regression beta have been calculated using a time frame of 24 months. Reuters may use a different time frame period which is an influential factor to calculate the beta values. Most of the websites take data for 52 weeks period to measure the corporate beta values. Calculation Method: Most of the websites use regression analysis to calculate the stock beta values. That is why there are more differences between the beta values taken from the websites and the ones calculated using the CAPM procedure. It has been noticed that the beta value for the Pearson stock has been quite similar for the beta, calculated using the regression analysis, and the beta value, taken from the website. Fundamental Beta and Historical Beta: The beta values are calculated using historical data, while Reuters keep the most recent beta values. This may be one of the significant factors that explain the variation in the calculated and collected beta values. Different companies can use different procedures to measure the inherent market risk. Apart from these procedures, the managers must consider the different events that can affect the estimated beta values by increasing or reducing the beta values for the companies. Answer to the question no 3 Difference in beta values for different companies The beta values of the companies depend on various reasons. That is why the beta values are different for various companies operating in different industries. The paper has taken into account two different companies from various industries. British Airways operate in the airlines and aviation industry, while Pearson operates in the global media organisation dealing with business information, consumer publishing and education. During the recent downturn, the aviation industry has been badly affected by the reduced consumer demands, fuel scarcity leading to increased fuel prices and the deregulation of the industry. A number of airlines companies have seen bankruptcy in the last few years. Even now people prefer low cost airlines. Although British Airways has been able to mark its sign and is liked by the sophisticated business people, it along with many European airlines has asked for government aid. On the other side, the organisation Pearson has been dealing with media and publications. The media, education and publication industry are much less affected by the aviation industry. So it seems Pearson would face less risk than British Airways. The volatility in the stock returns of British Airways would be much more compared to the Pearson stocks. Hence it means that the risk would be quite high for the British Airways compared to that of the Pearson. In Reuters, the beta value for Pearson is 0.67 (Reuters, 2010). This means that with 100 % volatility in the market returns, there would be 67 % volatility in the stock return movements. The stock is less volatile than the index return. On the other side, the beta value of British Airways is 1.4 (Reuters, 2010). The stock is supposed to move 140 % when the market will move 100 %. This means the British Airways stock is much more volatile than the benchmark index, itself. Apart from this also, the beta estimation depends on the operations of the company, specifically how the management of the organisation manages the inherent risks of the business and the industry. Some influential factors like UK’s economic conditions are common to all the organisations operating in UK. UK economy has been in a troublesome state during the recent recession period. The beta value depends on the factors like the efficiency with which the management of the companies manage the operational and financial activities of the organisations to survive in the trembled economic conditions. The management in Pearson seems to be more efficient in their activities than that of the British Airways. Answer to the Question no 4 a. CAPM and Organic Growth Capital Asset Pricing Model is one of the most useful and simple models to calculate the required rate of return. This is known as the cost of equity. This is the minimum return, the shareholders expect from their investments. The cost of equity is calculated as follows. Expected Return = Risk Free Rate + (Market Return – Risk Free Rate) * Beta. The market premium is calculated as the difference between the market return and the risk free rate. The beta value is one of the significant factors that influence the cost of equity and hence the cost of capital of the organisation. Beta is known as the systematic risk. A number of companies can diversify the risk by diversifying the business in different industrial arenas as a part of the growth strategy. Although the market risk cannot be totally diversified, still it can be somewhat reduced by globalisation and entry into different markets. When a company enters a different industry segment in a different country, the market risk would be consolidated in all the global markets, it is operating in. As a matter of fact different markets react to the various events like war, recession in different ways. For instance, UK has been badly affected by recession, while developing countries China and India has resisted the recession to a certain extent. On the other side, industries like medicine, tobacco and super markets have been less affected than the financial, aviation and automobile institutions. So exploring new market areas would help the companies to reduce the market risk to a certain extent. The cost of capital considers both the cost of equity and the cost of debt. The managers must decide on an optimal capital structure which would fetch the minimum possible cost for the business. The cost of capital is the discount factors which are used to get the present value of the cash flows. The formula to calculate the net present values of cash flows is as follows. Net Present Value = ∑ Cash Flowi / (1 + Cost of Capital) i i = 0,1,2..... As years will move on the denominator will increase, hence the cash flows will be heavily discounted with the increasing number of years. That is why even a change of 1 % in the cost of capital figure can increase or reduce the cash flow. b. Organic growth and Acquisition Organic growth means that growth which leads to the expansion of business on its own. On the other side acquisition refers to the process by which an organisation expands its business by acquiring some other company of its interests. By expanding the business on its own, the organisations have a better control over its operations. Acquisition can sometimes cost more than the one incurred while setting up a new business venture. However setting up a new business is also an expensive venture. Acquisition can be a good choice while expanding a new business in a new foreign country or may be in a new industry. The existent client base of the target company can help the acquirer to expand its business on a much stronger base. Moreover the acquirer company can expect more economies of scale, enhanced resources, qualified and experienced human resources when it expand its business through acquisition. In a foreign market, it is very much necessary to get accustomed to the political, legal, social and technological environment of the country. Acquiring a company would let the acquirer get hold of its local management as well as the local employee base. This would, in turn, help the organisation to get accustomed to the customers’ demands in that industry. Adding to it, access to the technical as well as human resources is expected to boost the operational performance of the company. Acquisition can be a significant expansion tool to expand business, mainly in a foreign competitive environment. Survival in such an environment while getting accustomed to the political and legal business environment, building up new customer base, meeting up the customer demands can be a tough task, otherwise. Reference McNully, N. 2010. Calculating Beta: Portfolio Math For The Average Investor. [Online]. Available at: http://www.investopedia.com/articles/financial-theory/09/calculating-beta.asp [Accessed on May 18, 2010]. Reuters. 2010. British Airways Plc. Available at: http://www.reuters.com/finance/stocks/overview?symbol=BAY.L [Accessed on May 18, 2010]. Reuters. 2010. Pearson Plc. Available at: http://www.reuters.com/finance/stocks/overview?symbol=PSON.L [Accessed on May 18, 2010]. Yahoo Finance. 2010. BR. Airways. Available at: http://finance.yahoo.com/q/hp?s=BAY.L+Historical+Prices [Accessed on May 18, 2010]. Yahoo Finance. 2010. Pearson Plc. Available at: http://finance.yahoo.com/q/hp?s=PSO+Historical+Prices [Accessed on May 18, 2010]. Yahoo Finance. 2010. FTSE 100. Available at: http://uk.finance.yahoo.com/q/hp?s=^FTSE [Accessed on May 18, 2010]. Bibliography Brealey, A. R., Myers, C., S. & Allen, F. Principles of Corporate Finance. McGraw Hill Companies, 2007. Bartholdy, J. & Peare, P. May, 2004. Estimation of expected return: CAPM vs Fama and French. [Pdf]. Available at: http://www.cls.dk/caf/wp/wp-176.pdf [Accessed on May 18, 2010]. Davis, L., J. & Desai, S., A. June, 1998. Stock Returns, Beta and Firm Size: The Case of Bull, Bear, and Flat Markets. [Pdf]. Available at: http://info.cba.ksu.edu/desai/beta.pdf [Accessed on May 18, 2010]. Reitz, A., T. 1999. Diversification and the CAPM. [Online]. Available at: www.biz.uiowa.edu/iem/assignments/capm1.ppt [Accessed on May 18, 2010]. Appendix (Source: Yahoo Finance) Regression: British Airways Regression Analysis: Pearson Read More