Valuation of BlueScope Steel Company - Case Study Example

Valuation of BlueScope Steel Ltd This paper deals with estimation of the value of BlueScope Steel Company. the company is publicly listed and majors in the production of flat steel. Capital structure The capital structure of a company refers to the relationship among the different types of long term capital that the company has used (Lewis and Pendrill, 2004). Whenever a company has an investment proposal the management has to do some serious financing decisions. The management should consider whether to use debt or equity or both with regard to the financial implication of the debt-equity mix in its capital structure. BlueScope Steel Company is financed by both debt and equity as shown in the table below Source of Capital Amount ($) Amount ($) Weight Short/Current Long Term Debt 40,500,000 Long Term Debt 687,700,000 Total debt 728,200,000 0.1352 Common Stock 4,659,400,000 0.8648 Total financing 5,387,600,000 1 These figures are for the most recent financial report as at 30th June 2014. From the table above it is clear that BlueScope Steel Company is mostly equity financed. Equity comprises about 79% of the total long term capital of the company whereas debt financing takes the remaining 21% of the long term capital to the company. Cost of capital Brigham and Herhardt (2009) define the cost of capital as the cost involved for the company to have the specified capital in its capital structure. All companies require capital at some point in their operations. The possible ways that have been used by BlueScope Steel Company to raise capital for the year ended 30th June 2014 was debt and selling equity. These methods involve different costs to the company. Therefore, the cost of one type of capital cannot be said to be the cost of capital for the company. This means that the appropriate way is to consider the weighted cost of each type of capital in the capital structure of the company. This is the weighted average cost of capital commonly referred to as WACC. In case of debt capital its cost is the interest paid on debt whereas the cost of equity capital is the dividends paid to the shareholders of the company. There are many ways that can be used to determine the cost of capital. The calculations done factor in the methods used by a company to raise capital and the assumed risk of investments. Nevertheless, each method serves a given purpose in understanding the existing company’s financial strength and helps in projecting the future cash flows expected to emanate from the operations of the company. The WACC computes the overall cost of capital for the company based on the proportions of equity and debt in raising capital. Estimation of company’s WACC The data used to estimate the beta of BlueScope Steel Company are for the price per share of the company for the last 5 years from 1st April 2008 to 31st May 2013. This period was chosen to coincide with the most currently available data for interest charged with respect to Australian 5 year government bond in order to determine the risk free rate. The price per share of the stock of the company will help to compute the monthly returns of the company’s stock. The market index used is S&P and since you are interested in the market return which when you deduct the risk free rate as measured by the interest charged for the five year Australian government bond you will get the excess returns which is the market premium associated with the stock of the company. The interest rate for the five year Australian government bond is given as an annual rate which is divided by 12 to get the corresponding monthly interest rate in order to have a good comparison with the monthly stock returns. Risk free rate In the determination of the risk free rate this paper used a 5 year Australian government bond since it has a lower risk. This is because Government bonds are very secure. We choose 3.38 because inflation needs time to be established; moreover, it is more representative. Longer bond, gives you a bigger picture. Short comparison range, for instance, 2 years is too short to tell. On the other hand, a 20-year bond is considered are too long. Therefore, the risk free rate is the average of the interest rate that has been charged for the last five years. This rate has been determined as 0.36% per month which is annualized to arrive at an annual rate of 4.35%. Beta The regression analysis between the monthly stock returns and the market premium produced a beta of 0.1801. Market risk premium The market risk premium is the average of the excess returns which is to be 0.05%. Having all the information necessary in calculating the cost of equity, the estimation is done using the CAPM model as shown below Cost of equity, Ke = risk free rate + beta*market risk premium = 4.35% + 0.1801* 0.05 = 4.36%. Determination of the cost of debt The cost of debt financing is the interest charge which has been paid on for the debt. In the case of debt finance, it is the effective cost which is taken to consideration when determining the WACC. Interest on debt is an expense allowed for purposes tax since it reduces the profit of the business that is taxable. Therefore, the effective cost of debt finance is the actual cost less benefit that comes with tax deductibility. The average cost of debt for the year 2014 was 5.6%. BlueScope Steel Ltd is a company operating in Australia hence it is subjected to the taxation law in Australia. All companies operating in Australia pay a corporate tax rate of 30%. When this is factored in the cost of debt then the effective cost of debt capital for BlueScope Steel Company is determined as per the formula below Effective interest rate = 5.6 %*( 1-Tax rate) = 5.6 %*( 1-30%) = 3.92% Therefore, since we have all the components for determining the WACC for the company we use the formula below WACC = Ew * Re + Dw * Rd where; Re = cost of equity = 4.36% Rd = effective cost of debt = 3.92% Ew = proportion of equity financing = 0.8648 Dw = proportion of debt financing = 0.1352 Therefore, WACC = 0.8648 * 4.36% + 0.1352 * 3.92% = 4.30% valuation by constant growth of free cash flow The growth rate in free cash flow to the company has been made using the historical growth rate. This method has used the company data for the last six financial year to 2014 as shown in the table below Year FCF Growth rate 2009 363,800,000 - 2010 249,300,000 -31.47% 2011 271,200,000 8.78% 2012 312,600,000 15.27% 2013 312,900,000 0.10% 2014 365,900,000 16.94% Average growth rate   1.92%       Since the growth rate per year is not constant, it is assumed that the average growth rate in cash flows is the constant growth rate that will continue to be experienced by the company for the years to come. This is 1.92%. This growth rate has then been applied according to the formula below to determine the value of the company. Value = current FCF * (1+growth rate)/(WACC- growth rate) = 365,900,000* (1+1.92%)/(4.30%- 1.92%) = 15,669 Million The estimated value using the free cash flow method is higher than the current market value debt and equity. Therefore, the company is undervalued since the estimated value is higher than the current market value debt and equity. However, the company cannot be valued using the price earnings ratio valuation since its most recent financial report in the year 2014 showed a loss. The company cannot be valued with a current share of loss for earnings per share. Therefore, the most applicable method for valuing BlueScope Steel Ltd is free cash flow to the company. References Lewis, R. & Pendrill, D. 2004. Advanced Financial Accounting (7th ed.). Harlow, England: FT Prentice Hall. Brigham, E. and Herhardt, M. 2009. Financial Management: Theory and Practice, 13th Edition. Ohio: Thompson South-Western. Read More