Strategic Corporate Finance - Case Study Example

STRATEGIC CORPORATE FINANCE Table of Contents Task Valuation of Morrison Plc 4 a) Net Asset Value 4 b) Cost of Capital 5 i) Cost of Equity 5 ii) Cost of Debt 6 iii) Weighted Average Cost of Capital (WACC) 6 iv) Comment on Results 7 c) Dividend Growth Model 8 d) Value per Share using the Price-Earnings (P/E) Ratio 9 Task 2 9 a) Value of Morrison’s Share 9 b) Recommendation to Client 12 Task 3 Share Price Tracking 13 References 15 Bibliography 16 Task 1 Valuation of Morrison Plc a) Net Asset Value The net asset value (also known as NAV) is determined by deducting the total value of liabilities from the total value of assets of that entity. This tool is widely used by the investors to compare the present market capitalisation of company with its NAV. The NAV is derived from the balance sheet of the company which depicts the financial position of an entity on a given date, in terms of assets, liabilities and equity (Kellerhals, 2004, p.54). Theoretically, whenever the investors believe that any company has considerable growth prospects in future, they would be willing to premium on NAV. The formula to compute NAV of Morrison Plc from its balance sheet is, NAV = (FA + CA) – (FL + CL) Where, FA = Non-current Assets = £9,299 m CA = Current Assets = £1,430 m FL = Long-term Liabilities = £3,164 m CL = Current Liabilities = £2,873 m Additional information on Morrison Plc shows that its intangible assets are overstated by £40 m. This means net intangible assets will have to be adjusted as, (£458 m- £40 m) or £418 m. Similarly, it is also given that the property, plant & equipments are understated by £30 m whose net adjusted value would be, (£8,625 m+ £30 m) or £8,655 m. It is also given that £7 m of receivables cannot be collected from debtors implying that net ‘Trade and other Receivables’ would be, (£ 316m- £7m) or £309 m. After making the above adjustments in the balance sheet of Morrison Plc, the NAV of the company can be calculated as follows: NAV Morrison = (£9,289m + £1,423m) – (£3,164m + £2,873m) = £4,675m The share capital (nominal value 10p) of Morrison is £234 m, implying that number of outstanding shares can be calculated as follows: Outstanding shares of Morrison = Share Capitalisation/Share Price = £234 m/240p*1,000,000 = 975,000; Therefore, NAV Morrison per Share = (£4,675/975,000)*1000,000 = £4,974.87m b) Cost of Capital i) Cost of Equity The CAPM helps to determine the expected rate of return for an asset relative to market risk. Such comparison will help the investor to analyse whether it is worthwhile investing into the security. The market risk-reward ratio is also known as the market risk premium (Armitage, 2005, p.278). The systematic risk can be estimated using the Beta factor (β). Beta measures the sensitivity of excess expected return of security to the excess market return. Mathematically, β = Covariance (Ri, Rm) / Variance (Rm); CAPM = Rf + β x [E (Rm) – Rf] Where, Rf = Risk-free return = 3% Rm = Market Return = 5% Excess market return or Risk Premium = Rm – Rf = (5 – 3) = 2% According to the given case the risk-free rate of return is assumed to be 3 percent and average market return is 5 percent. The Beta for Morrison is assumed to be 0.5. Based on the above assumptions, the expected cost of equity capital of Morrison’s Plc using CAPM is, 4.00% [that is, 3%+(2%*.5)]. ii) Cost of Debt It is given in the case that the company pays a fixed coupon of 5% on its borrowings that is currently being traded at £100 per £100. Therefore, the before-tax cost of bonds can be computed as follows: Pd = i/Kd; Where, Pd = £100 i = 5% Kd = 5/100 = 0.05 or 5% Since, taxes are said to be ignored for Morrison’s, the after-tax cost of debt is equal to 5% (that is, [5*(1-tax rate)= 5*(1-0)=5%]) (Brigham and Ehrhardt, 2013, p.365; Brigham and Houston, 2009, p.310). iii) Weighted Average Cost of Capital (WACC) The cost of capital of a firm that is financed only by equity can be determined using the CAPM as discussed earlier. However, the cost of capital for firm’s that have hybrid capital structure including debt and equity is calculated on the basis of weighted proportion of respective source of finance. According to this case, the capital structure of Morrison includes only equity and debt capital (Sheeba, 2011, pp.283-288). Hence, the WACC of Morrison’s can be computed using the following equation: Where, KD = Cost of Debt = 5% KE = Cost of Debt = 4% VD = Value of Debt = £3,164m VE = Value of Equity = £4,692m WACC = (4*0.4)+(5*0.6) = 4.403% iv) Comment on Results The results computed above reveals that the cost of equity of Morrison’s is only 4% whereas the cost of debt is 5%. This implies that company can reduce its overall cost of capital using a combination debt and equity capital. The weight of equity is greater than debt because it constitutes greater proportion in capital structure of the company. The debt-to-equity ratio is 2:3 which implies 40 percent weight to debt and 60 percent weight to equity. The overall cost of capital or WACC of Morrison based on these assumptions turns out to be 4.403% only (Graham, Smart, and Megginson, 2009, p.422). c) Dividend Growth Model The dividend growth model can be used to calculate the theoretical price per share of Morrison Plc. The formula relies on dividends and determines the value of share based on present value of future dividends (Fernandez, 2007, p.19). Theoretical price can be determined using, Where, P0 = Price of Share today D1 = Dividends paid next year g = Expected growth rate of dividends i) Assuming g=0 and on the basis of given information, Ke is calculated as follows: Ke = (12/240)+0 = 0.05 or 5% Therefore, P0 = 12/(0.05-0) = 240p ii) Assuming g=2%, the Ke of Morrison would change as follows, D1 = 12*(1+2%) = 12.24 Ke = (12.24/240)+0.02 = 0.0710 or 7.10% Therefore, P0 = 12.24/(0.071-0.02) = 240p iii) From the calculations of theoretical price per share of Morrison’s using the Gordon Dividend Growth Model it is found that the intrinsic value of one unit share of the company is 240p. The results have not been found to vary with growth rate since both at 0% and 2% growth rate, the theoretical price of Morrison’s remain the same (Frankfurter, Wood, and Wansley, 2003, pp.71-77). d) Value per Share using the Price-Earnings (P/E) Ratio The value per share using the Price-Earnings (P/E) ratio is calculated using the following formula: (P/E) Ratio = Market price per share/Earnings per share The market price per share as at 2 Feb 2014 of Morrison is 240p and as at 20 March 2014 is 208p. The EPS of the company in 2014 is 10 and therefore the P/E ratio of Morrison for Feb 2014 and March 2014 are 24 (240/10) and 20.8 (208/10) respectively. It is given that the retail industry sector that contains Morrison’s has an average P/E ratio of 15.0 implying that the investors prefer the stocks of Morrison’s and they expect Morrison’s earnings to grow in future (Damodaran, 2004, pp.57-59). Task 2 a) Value of Morrison’s Share while determining the valuation of Morrison the investors should not be confused between value and price. Most of the valuation techniques compare the obtained value of company with the current share price of the company in market. The decision to buy, hold, or sell shares depend upon the relative theoretical price of share and current market price per share. When the theoretical price is less than the current market price then the company is certainly overvalued. This is because the investors are willing to pay more than actual worth of the shares. From the given information regarding Morrison’s it would most appropriate to implement NAV valuation model, Gordon’s Dividend Growth Model, and P/E multiple Model. A critical analysis of these models is discussed below: NAV Valuation Model This model is derived from the balance sheet of the organisation. NAV is the difference between market value of Assets and market value of liabilities. The NAV of Morrison is calculated below, Valuation Model all amount in £m except per share data 1 Total Fixed Assets 9,299 less: Adjust overestimation of intangible assets -40 Add: Underestimated vale of Property, Plant, etc. 30 Net Fixed Assets 9,289 2 Total Current Assets 1430 less: Bad debt -7 Net Current Assets 1423     3 Total Current Liabilities 2,873 less: Adjustments 0 Net Current Liabilities 2,873 4 Total Long-term Liabilities 3,164 less: Adjustments 0 Net Long-term Liabilities 3,164     Net Asset Value (NAV) in million £ 4,675 Outstanding shares 975000 NAV per Share of Morrison Plc (in £) 4794.87 This method might be transparent as it is based on the financial statements of the company however the techniques has certain limitations. Firstly, this method considers the value of assets based on accounting approach and not cash flows. This means items such as depreciation, working capital, etc. are not adjusted to arrive at fair value. Secondly, differences in accounting standards could lead to different valuation which could confuse the investors. Gordon Growth Model This model is one of the most simplest method for stock valuation that considers cash flows (since, dividends are actual cash receivable at the hand of investors). On the basis of this model, the theoretical share price of Morrison’s can be calculated as follows: Assumptions:- growth rate (g) = 0 2% Cost of Equity (Ke) = 4.00% 4.00% Share Price 240 240 Dividend next year (d1) = 12 12.24 Ke = Cost of Equity 5.00% 7.10% Theoretical Share Price (p) 240.00 240.00 The model has certain limitations as it is highly sensitive to the assumed growth rate of dividends. For instance, when the growth rate equals cost of equity of the firm, share price tends to infinite which is practically impossible. Then again, when the growth rate is more than cost of equity the result would be meaningless. The above discussion reveals that the model is very sensitive to assumptions of growth rate and that the share price would vary accordingly. The forecast of growth rate depends on the overall attractiveness of industry as well as competitive position of the firm in market (Dong & Hirshleifer, 2005, pp.2-6). P/E Ratio This model considers the current share price of the company in market relative to the earnings of the firm. The investor generally buy shares of those companies whose earnings are expected to grow in future. This valuation model exactly analyses the attractiveness of a particular stock based on expected earnings. On the basis of given information regarding Morrison’s, the P/E ratio of the company can be determined as follows: Feb 02 2014 March 20 2014 Share Price (p) 240 208 EPS 10 10 P/E ratio 24 20.8 Now, this model actually reveals how attractive a particular stock is at present in the market. The model also shows whether the stock is presently over or under-valued. In order to determine this we need to compare the P/E ratio of the firm with P/E of industry or similar firm. Although a higher ratio is considered to be good but it could also mean that the investors are over-optimistic regarding the growth of firm’s earnings (Albrecht and Stice, 2010, p.669). In this case, it is clear that the investors are hopeful about growth in firm’s future earnings because while the industry P/E ratio is 15 the same of Morrison’s is 20 based on share price of company as at Feb 02, 2014. b) Recommendation to Client The intrinsic value per share of the company 240p and the present market price per share of the company is 208p as on 20 March 2014. This implies that the stock is presently undervalued and there is every possibility that share price would increase in future to level of 240p. Hence, the investors are recommend to buy the shares of Morrison’s at cheaper market price at current levels. When the share prices increase to intrinsic value they may exit and make profit equal to 32p per share (that is, 240p – 208p). This strategy will maximise shareholders wealth in future. The expectation in the market as revealed by the P/E ratio is also showing positive signal to buy shares of Morrison’s. Task 3 Share Price Tracking The share price movement of Morrison’s was critically analysed during six month period starting from November 2013 to May 2014 and it was found that after reaching its 52-week high value of 312.30p in November 2013, its share prices experienced declining trend. The basic technical chart of the company is depicted below: (Source: Yahoo Finance, 2014) After announcing the monthly bond purchase programme by the monetary authorities (quantitative easing) during last quarter of 2013, the market sentiment turned positive in expectations of probable recovery in economic growth and higher inflation. However, in February 2014, US Fed hinted gradual rollback of quantitative easing after announcement of better than expected growth in job creation in the US economy. US is major international trade partner and probably due to this many investors booked profits expecting that money flow in market could reduce in future. Morrison’s which have a beta value of 0.5 (assumed in case), fell by 50 percent more relative to market when the later declined. This explains the movement of share price of Morrison Plc. References Albrecht, W., Stice, E. and Stice, J., 2010. Financial Accounting. United States: Cengage Learning. Armitage, S., 2005. The Cost of Capital: Intermediate Theory. United Kingdom: Cambridge University Press. Brigham, E. and Ehrhardt, M., 2013. Financial Management: Theory & Practice. 14. United States: Cengage Learning. Brigham, E. and Houston, J. F., 2009. Fundamentals of Financial Management. 12. United States: Cengage Learning. Damodaran, A., 2004. Investment Fables: Exposing the Myths of "cant Miss" Investment Strategies. New Jersey: FT Press. Fernandez, P., 2007. Company valuation Methods: The Most Common Errors in Valuation. [Pdf]. Available at: http://www.iese.edu/research/pdfs/di-0449-e.pdf. [Accessed on May 02, 2014]. Frankfurter, G., Wood, B., and Wansley, J., 2003. Dividend Policy: Theory and Practice. United States: Academic Press. Graham, J., Smart, S., and Megginson, W., 2009. Corporate Finance: Linking Theory to What Companies Do. United States: Cengage Learning. Kellerhals, B. P., 2004. Asset Pricing: Modelling and Estimation. 2. Germany: Springer. Sheeba, K., 2011. Financial Management. Noida: Pearson Education India. Bibliography Baker, H., 2009. Dividends and Dividend Policy. New Jersey: John Wiley & Sons. Dong, M. and Hirshleifer, D. (2005). A GENERALIZED EARNINGS-BASED STOCK VALUATION MODEL. [Pdf]. Available at: http://sites.uci.edu/dhirshle/files/2011/02/A-Generalized-Earnings-Based-Stock-Valuation-Model.pdf. 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