Strategic Corporate Finance - Security Analysis and Portfolio Management - Assignment Example

Company Analysis Here of a) Net asset value Calculate the Net asset value per share for BP. Net asset value= Net asset value/ Number of ordinary shares Net asset value=2013= 79,083,000,000/ 18510000000= 4.27245 2014= 72,371,000,000/18260000000=3.96336 b) Cost of capital i. Calculate the cost of equity capital for BP using the Capital Asset Pricing Model. Re = rf + (rm – rf) * β Cost of equity= 1+ (6-1)* (1.34+1.74/2) = 1 + 5*1.54 = 1+7.7 =8.7% ii. Calculate the cost of debt capital (assume a taxation rate of 20%). Cost of Debt Capital = Coupon Rate on Bonds (1 - tax rate) = 4 (1-0.2) = 4 * 0.8 =3.2% iii. Calculate the weighted average cost of capital (WACC). (use the share price as at 31 January 2014 for the value of equity) WACC = * Re + * Rd * (1 – Tc) = 72371.01/(72371.01 +69,419)*8.7 + 69,419/(72371.01 +69,419)*3.2 =72371.01/141790.01*8.7 + 69419/141790.01*3.2 =4.44 + 1.5667 = 6.0067 % c) Dividend growth model Use the dividend growth model to calculate the theoretical price of a share under the following assumptions: Stock Price = Dividends (Div) / (Expected Return (R) - Dividend Growth Rate (G) (i) g = 0% P= D/R-G =23.85* 409.3/8.7 = 1122.05 g = 2%= P= D/R-G =23.85* 409.3/8.7-2 = 9761.805/6.7 =1456.99 d) Value per share using the price earnings (p/e) ratio Calculate the price earnings ratio using the share prices as at 31 December 2013 (488p) and 31 December 2014 (409p) and the EPS figure for 2013. Price earnings ratio= Market Value per Share / Earnings per Share (EPS) =488/75.12 =6.5 Price earnings ratio= Market Value per Share / Earnings per Share (EPS) =409/75.12 =5.44 TASK 2 Calculate the value of a BP share and advise your client a) Use the information from your calculations above and any information other you deem appropriate to arrive at the valuation of a BP share. In doing so critically evaluate the Price-Earnings and Dividend Growth models used in your calculations and relate your calculations to the current and historic share price information as appropriate. Considerably financial analysis of BP share using calculated financial ratios act as a measure of the financial performance in terms of profitability, market value, leverage and liquidity levels in operations. In most cases, price-earnings (P/E) ratio is used by investors to measure the market value of company’s viability in terms of investment relative to its earnings in the market (Davies & Pain, 2011). Profitability ratios used to measure the level of returns arises from investment price-earnings (P/E) ratio (Warren, Reeve, & Duchac, 2012). This is because keen investors use the ratio to determine how well they can invest their shares based on how the management creates value for its shareholders. BP’s, price-earnings (P/E) ratio based on the earning per share of 2013 shows a decline in profitability as it indicates that the rate of return on the shareholders equity has drastically fallen down by 1.06. Indeed, market value measure of price-earnings (P/E) ratio expresses the relationship between the market price of common stock share and the prevailing earnings per share. As a result, investors use the calculated value of price-earnings ratio and other market value ratios including dividend cover, dividend yield and earnings per share as a gauge of future earning power of company’s shares (Atrill & McLaney, 2011). Notably, shortcomings in price-earnings (P/E) ratio is because it gives an obsolete market value ratios as compared to dividend cover, dividend yield and earnings per share that can alternatively be used to make fundamental investment decisions. This is because calculation of price-earnings (P/E) ratio is based on expected earnings of the future and ignores shifts in the cost structure and demand change in an industry as it quickly renders existing assets of a company obsolete (Black, 2009). Therefore, the calculation gives a likelihood of overestimation or underestimation that either indicates high growth opportunities or low growth trends. In most cases, price earnings ratio seeks to give market confidence based on recent earnings per share in relation to prevailing market share price which leads to shortcomings in its calculations as it involves developing economic assumptions for expected revenues. More significantly, calculation of price-earnings (P/E) ratio does not consider the increased effects of capacity expansion expected to increase market value of capital in the future (Graham & Smart, 2011). More so, calculation of price-earnings (P/E) ratio is based on less information including prevailing market prices, where financial analyst can only apply the method in publicly traded companies as opposed to private companies. As a result, price-earnings (P/E) ratio remains relatively easy to establish in actively traded bigger stocks, as compared to smaller, less liquid stocks that have low volumes of transactions in the market. Even as, price-earnings (P/E) ratio remain as an obsolete market value ratios dividend cover, dividend yield and earnings per share can alternatively be used to make fundamental investment decisions. This is because, dividend yield gives a measure of cash returns on shares in terms of cash dividends and capital growth this is suitable because the method can only be used on listed companies as it requires the prevailing share prices (Gowthorpe, 2011). On the other hand, dividend cover as a measure of market value gives the certainty of safety in dividends payments as it indicates how the company can pay the current level of dividends using the prevailing profits to be earned. In addition, the earnings per share measure assist in estimating the amount of potential dividend that is available per share as it remains published in the annuals accounts of companies as stipulated by the international accounting and auditing standards. As an equity valuation measure use of growth dividend model gives increased depth and complexity in company performance forecasting based on selection of an appropriate valuation model suitable for investors when making recommendation on whether or not to purchase company shares (Davies & Pain, 2011). In most cases, companies choose valuation models that are considered best suited in giving the intrinsic value based on a firms cost of capital. With the variance level dividend growth model is applicable to companies paying dividends at a reasonably constant rate based on estimated 1% growth rate with no explicit consideration of risk. Given the calculations of dividend growth the company still has an opportunity to increase its profits and undertake expansive growth within its ready market, and make sustainable profit levels from dividends growth levels of shareholders. More than often, use of constant growth dividend discount model assumes constant growth rate for a company thus remains suitable for large and stable companies that have consistent earnings and dividends. In addition, use of Gordon dividend model indicate unknown company earning and growth rate that is not equivalent to the required rate of return (Tracy, 2012). However, it is essential to consider that even as earnings and dividend per shares used remain accurate, required rate of return and growth rate of dividends is based on assumptions as it fluctuates over time. More so, the constant growth model remains simple in calculation of stock price especially based on the investors purchase stocks future payments based on price of a share of stock, using expected dividend growth. More significantly, the model has drawbacks because it is based on assumption that dividends grow at a constant rate (Brigham & Ehrhardt, 2013). This is because, Gordon constant dividend growth model growth ratio ignores the various factors, such as earnings, that affect a company’s dividend payout. For this reason, the model is less suitable for growing companies with fluctuating dividends as compared to well established companies with clear steady flow of dividend payments. On the other hand, the model calculation using constant growth calculation on the expected dividend ignores periodic variance as it is based on dividends paid in one year. Discuss whether you would advise your client to purchase shares in BP on the 5th May 2015. BP’s balance sheet position indicates the flow of companies operations that enhances the firm’s generation of profits through its investments because the firm has sustainable reserves. Based on the income growth levels and increased market price of the company shares in 2015 there is an expected accrual of interest income over to the company upon the attainment of the maturity period because of increased market price and dividend growth. In carrying out the financial analysis of BP Company, there is a need to come up with the trend analysis of the firm’s performance over the years. An analysis of profitability ratios of the company for two consecutive years 2013 and 2014 in carry out an evaluation of the company performance indicate a decline in the company’s profit levels (Fields 2011). With sustainable reserves and profits from increased assets over liabilities financial analysis evaluation should be carried out to identify several actions the company management might undertake to improve its results and enhance its profitability levels. As an investor the company liquidity remains favourable in terms of business short-term solvency and ability to pay back its debts as it runs its business operations. In addition, BP’S leverage based on debts and interest rate shows firm’s ability to finance its obligation and its ability to generate income to service the debts and interest rates accrued thus, cannot become bankrupt (Thukaram, 2007). Given that, the financial analysis of BP shows enhanced company’s performance as an investor decision-making based on investing in the company share remains viable based on increased dividends growth over the year. There is no doubt that increase business levels leads to high profitability and as a result, there will be continued proceeds that arises from the investment leading to increase in dividends issued to the shareholders based on increased profitability in the company’s financial year. Task 3 Share price tracking and the EMH (20 marks) Critically analyse the movement of your allocated share during the period it was being tracked (Jan 2015 – April 2015). You may choose any length of time within that 4 month period from 1 day and up. Refer to relevant theories and academic literature to explain why and to what extent the share moved in response to new information. More than often, trend analysis of company market share remains as an essential part of good financial management practice that involves a process of identifying the market price trend. More considerably, a financial analysis of Games Workshop company share price has continuously exhibited unpredictable performance as its shares price has moved from upward to downwards trend irregularly between January to May 2015. During the month of January the share price remained constantly low with an indicated growth level rise in price in early February, however there was an increased decline in between March and April. In most cases, the changing customer’s preference and competition is highly likely to affect the company revenue that declines thus, create the need for organization to formulate new strategies on meeting customer needs. Currently, Games Workshop company earnings per share remains low thus there is less trading because investors expect a decline in their dividends. This clearly indicates that the management needs to continuously foresee the utilization of assets in order to ensure that the company derives more revenues thus, increase its return on assets and generate more returns. More significantly, the investors focus on profitability estimates based on return on assets, profit margin, return on equity, and earnings per share ratios which influence value of shareholders (Gibson, 2008). Games Workshop company, dividend cover as a measure of market value certainty of dividends payments indicates low prevailing value in the year 2014 which affects the share price leading to decline in market price. In addition, dividend yield gives a measure of cash returns on shares in terms of cash dividends and capital growth showing the prevailing low share prices. Given that, the trend analysis is an essential analytical tool of company’s market performance. There is no doubt that carrying out a financial analysis of a company will ensure that the management and investors get more information that will guide them in decision-making. References Atrill, P. & McLaney, E. (2011) Accounting & Finance for Non-Specialists – 7th Edition. Harlow, England New York: Prentice Hall Financial Times. Black, G. (2009). Introduction to accounting and finance. Harlow, England New York: FT Prentice Hall. Brigham, E. and Ehrhardt, M. (2013). Financial Management: Theory & Practice, Ohio: South-Western Cengage Learning Brigham, E. and Houston, J. (2009). Fundamentals of Financial Management, Ohio: South-Western Cengage Learning Dash Ambika. Security Analysis and Portfolio Management, Second Edition, K. International Pvt Ltd: New York. 2009. Davies, T. & Pain, B. (2011) Business Accounting and Finance – 3rd Edition. Harlow, England New York: Pearson/Financial Times Prentice Hall. Fields Edward. (2011) The Essentials of Finance and Accounting for Nonfinancial Managers. Washington D.C.: AMACOM Div American Mgmt Assn. Gibson, C. (2008), Financial Reporting and Analysis: Using Financial Accounting Information, Ohio: South-Western Cengage Learning Gowthorpe, C. (2011) Business, Accounting & Finance – 3rd Edition. London: Thomson Learning Graham, J. and Smart, S. (2011). Introduction to Corporate Finance: What Companies Do. Ohio: South-Western Cengage Learning. Ryan, B. (2007), Corporate Finance and Valuation, Ohio: South-Western Cengage Learning. Thukaram, R. (2007). Management Accounting. New York: New Age International Tracy, A. (2012) Ratio Analysis Fundamentals: How 17 Financial Ratios Can Allow You to Analyse Any Business on the Planet, Australia: RatioAnalysis.net Warren, C., Reeve, J. & Duchac, J, 2012, Financial and managerial accounting. Mason, Ohio: South-Western Cengage Learning. Read More