Corporate Valuation and Risk Management - Woolworths - Assignment Example

Woolworths Name Course Date Abstract Investors usually make their investment decisions based on data that is available concerning value of a company. An investor must first determine the risk involved in any investment, and the returns that will be associated with the same investment. A worthy investment should be one that has high risk accompanied by high returns or with low risk, and lower returns. A cost benefit analysis should be taken to determine if an investment is feasible according to the goals of the investor. An investor may either have long or short term goals for investing. The returns to an investment may be determined by the calculation of the dividends that are associated with a company. A company that is more worth would be an advisable investment since returns would be assured at the end of the day. The analysis report below will give a justification of the values attached to investments made in Woolworths and a report determining if an investment in Woolworths is worthwhile or not. Introduction Woolworths is a company that is based in Australia. The company mainly deals with liquor and food products used for resale in New Zealand and Australia supermarkets. The sales of the company have been increasing over the years. The increase in sales may be as a result of diversification of the company’s operations. The company does not base its operations in only one country and that increases the sales volume of the company. The sales volume of the company can also be associated with dynamic advertising. The operating income of the company also increases over the years. The increase in operating income may be associated with minimization of the company’s expenses. The expenses of the company are minimized as a result of efficiency in a company. Efficiency may be achievement from operations of the company. The valuation of a company can be done by calculating the weighted average cost of capital. The value of the company is used to show the net worth of the company’s assets and shareholders wealth. The value of equity of a company is a part that is fundamental in financial matters as a result of its implications that are critical in the valuations of the company wealth. Measurement Of Company’s Value: The weighted average cost of capital signifies the total cost of the company’s portfolio. The portfolio to a company should be diverse in order to minimize the risks attributed to portfolios. The ability of a company to diversify in different sectors would ensures that it posts relevant returns that are all rounded since the failure of one portfolio would probably not affect another portfolios for which it has invested. In Woolworths, the company has diversified its operations in a manner that allows it to handle its operations in a number of countries. In the Australian stock yields and index, bonds and bills are usually reported on the basis of the actual value. The bills are affected by inflation. Inflation rates are usually determined in the course of valuating a company. In most instances, it is usually assumed that nominal and real returns on equity are similar because of the effects of inflation which have been accounted for in the course of valuating both the bonds and equity return rates. However, the assumption is not true because risk premium for equity is usually determined by the difference between bond discrete returns and equity. That makes it necessary for the reporting of risk premiums using both the nominal and real amounts. According to Boudoukh and Richardson (1993), measurement of inflation is done by measuring the return on a consumer price index (CPI). Series from the Australian Bureau of Statistics (ABS, 2005). The index numbers in the series of the consumer price index are a true reflection of the average of the four quarterly index numbers in the financial years of a Company at hand. Imputation tax considerations: A dividend imputation tax system has operated in Australia since July 1987. Under the previous classical tax system, return on equity is attributed to two components which are capital gains and dividends. Comparable returns post-imputation now consist of three components: capital gains, posted dividends as well as the values of the attached imputation (franking) credits. The existing stock accumulation indices in Australia take into account returns from (cash) Dividends and capital gains only and, therefore, post-July 1987, these indices attributed to no value of different imputation credits which were to be allocated to investors. Under the imputation system, corporate tax is akin to a prepayment of both the personal tax as well as the extent through which imputation credits are valued, returns draw from (unadjusted) the accumulation of different indices underestimate the after-corporate-before-personal tax return on equity (Officer, 1994). One view is that franking credits do not carry any form of value in which case the conventional measurement of the historical equity risk premium required no form of adjustment in any imputation background. This is the approach that is implicitly adopted by Dimson et al. (2003). An alternative approach to conducting this task involves adding back the value of imputation credits to the traditional measure of the equity risk premium. For instance, this approach has been adopted in practice recently by Woolworths and the Essential Services Commission of South Australia. The debate concerning the value of franking credits is discussed elsewhere and is outside the scope of the assignment. Therefore, I will present three sets of estimates for the historical equity risk premium without passing judgment on which is the most appropriate figure. The first estimate coincides with the traditional measure of capital gains plus cash dividends. Then, we present two additional estimates of the potential impact of imputation on the historical equity risk premium in Australia. The first assumes that franking credits are fully valued and the other assumption is that franking credits are valued at 50 cents par the dollar. Because of restrictions on data availability and the short sample period involved, these estimates are considered to be indicative only of the potential impact that imputation might have had on the equity risk premium. To estimate the additional series, we require an annual series of imputation Credit yields applicable to the underlying stock index. For the period 1998– 2005, we use the (weighted) average imputation credit yield on the ASX All Ordinaries index for the 12 months ending December of each year, as sourced from the Australian Taxation Office. Finally, we adjust our series of estimated imputation credit yields under different assumptions as to the value of those credits to determine alternate series of annual grossed-up equity risk premiums. Estimation periods: The objective of the paper is to determine the value of Woolworths and the historical equity risk premium in Australia corresponding to periods of increasing data quality and that of the decreasing sample size. All ordinary Shares price index are calculated on a daily, rather than a retrospective, basis and (approximately) the first year for which marketable short-term government securities – seasonal securities/treasury notes – were issued; (iv) 1980, the first year for which the ASX All Ordinaries accumulation index were calculated on a daily, rather than a demonstration basis; and (v) 1988, the first (full) year of operation of the dividend imputation tax system in Australia. The first four of the above dates correspond to the periods of increasing data quality but of decreasing sample size. We stress that these estimation periods are not arbitrary fixed but are determined by clearly particular and material changes within the data at hand. We also estimate the equity risk premium over three additional periods in that matter. Periods: 1883–1987 and 1900–2000, for the purposes of comparison with Officer (1989) and Dimson et al. (2002), and finally 1883–1957, were being a period of relatively poor data quality given the cumulative nature of the improvements in data quality over time. Although we get an improvement in data quality, we are also presented with a reduction in the statistical significance of the equity premium estimate, as a result largely of the high volatility of historical stock returns (see Jorion and Goetzmann, 1999). Furthermore, looking far into the past and calculating an arithmetic mean implicitly assumes we have a random sample of (1 year) observations on which to base our estimate. But as Welch (2000, p. 505) notes: ‘There is also the more mundane non-stationary problem that 50-year old equity premiums may have little relevance to the world today.’ Results: Our focus is on the historical equity risk premium in Australia, but first we present results on the underlying components: stocks, dividends, bills and bonds, in both nominal and real terms. The real return each year for Woolworths is equal to the geometric difference between the nominal return and the inflation rate. We also report the average annual dividend return implied from the stock accumulation index and corresponding stock price index. The implied dividend returns each year (and based on opening prices) is equal to the difference between the annual return on the stock accumulation index and the annual return on the stock price index. The following factors should be borne in mind: 1. Stocks have substantially outperformed both bills and bonds over 120 years. From 1883 to 2005, the nominal return on stocks, bills and bonds averaged 11.8, 5.3 and 5.7 per cent, respectively. Based on the corresponding geometric mean returns, an investment of $A1 in stocks at the end of 1882 and rolled over at the end of each year stocks would have grown to $A273 466 at the end of 2005. A similar investment in bills would have grown to $A539 and a similar investment in bonds would have grown to $A834. 2. Stocks have also substantially outperformed both bills and bonds in more recent years. Over almost 50 years from 1958 to 2005, the nominal return on stocks, bills and bonds averaged 14.5, 7.6 and 8.2 per cent p.a., respectively. In Real terms, the corresponding returns are 8.9, 2.3 and 2.8 per cent. 3. The (null) hypothesis of no change in the mean return on stocks between 1883–1957 and 1958–2005 cannot be rejected, irrespective of whether returns are expressed in nominal or in real terms. However, the nominal mean return on both bills and bonds are statistically significantly higher over 1958–2005 compared to 1883–1957 (t-test not reported), but when returns are expressed in real terms, the (null) hypothesis of equal means cannot be rejected. Therefore, it is reasonable to argue that if there has been any long-term change in the equity risk premium then it has been driven by changes in nominal yields rather than changes in equity returns. 4. The standard deviations of the nominal return on stocks, bills and bonds over 1883–2005 are 16.0, 3.2 and 3.0 per cent p.a., respectively. Over 1958–2005, the corresponding figures are 22.0, 4.0 and 3.4 per cent p.a. and in each case, this represents a statistically significant increase over the earlier 1883–1957 period (F-test not reported). However, when returns are expressed in real terms the annual standard deviations are 21.0, 3.7 and 3.2 per cent p.a. over 1958–2005 compared to 13.0, 6.3 and 6.0 per cent p.a. over 1883–1957. In comparison to Officer (1989) who reports that the nominal return on stocks and bonds averaged 13.1 and 5.2 per cent p.a., respectively, over 1883–1987, we find that the respective averages are 11.7 and 5.3 per cent p.a. In another comparison, over 1900–2000, we find that the nominal return on stocks, bills and bonds averaged 12.2, 5.4 and 6.0 per cent p.a., respectively, compared to 13.3, 4.6 and 5.8 per cent reported by Dimson et al. (2002). Conclusion: In conclusion, Woolworths is a worthy investment in which investors should feel comfortable investing in. The worth of a company is usually determined by the rate of return of the company and the risk that the company bears. The risk factor in Woolworths is minimal because the company has diversified its operations in a number of countries even though the company is based in Australia. The company also deals with diverse items and that also minimizes the risk borne by investors of the company. The beta for Woolworths is 0.35. Beta is the measure used to determine the risk involved in investing in a company. If a company has a beta that is greater than 1, that would imply that the company is risky. That is because the beta would act as an indicator that the stocks of the company are more volatile to the company waves. That means that a change in the market factors may lead to high returns or great loss. A beta that is less than one means that the company has low risk because the stocks of the company is less volatile to changes that occur in the market. A company that has a low risk is usually associated with low returns whereas one with high risk is associated with high returns. The earnings per share growth rate in the company are 6.48 while the sales growth rate is 4.74. The dividend yields for the company is 4.41. The growth for the company’s earnings per share is assured because the company has a record of increased growth every year. As compared to the industry competitors, the company is doing well and enjoys dominance in the market although it is faced by competition from the other market players. Therefore, the company’s managers should ensure that the company increases on its returns so that the company’s investors can get value for their money. References Barclay, M. J., 1987, Dividends, taxes and common stock prices: the ex-dividend day behavior of common stock prices before the income tax, Journal of Financial Economics19, 31– 44. Boudoukh, J., and M. Richardson, 1993, Stock returns and inflation: a long-horizon perspective, American Economic Review 83, 1346–1355. Brailsford, T. J., and S. A. Easton, 1991, Seasonality in Australian share price indices between 1936 and 1957, Accounting and Finance 31, 69–84. Brealey, R. A., S. C. Myers, and F. Allen, 2006, Principles of Corporate Finance, 8th edn (Irwin McGraw-Hill, New York). Dimson, E., P. R. Marsh, and M. Staunton, 2003, Global evidence on the equity risk premium, Journal of Applied Corporate Finance 15, 27–38. Fama, E. F., and K. R. French, 2002, The equity premium, Journal of Finance 57, 637–659. Gray, S. F., and J. Hall, 2006, Relationship between franking credits and the market risk premium, Accounting and Finance 46, 405–428. Read More