Abu Dhabi Commercial Bank Study - Research Paper Example

Finance project; A case study of Abu Dhabi commercial Bank Table of Contents Finance project; A case study of Abu Dhabi commercial Bank 1 Table of Contents 2 Capital structure and cost of capital 4 Capital Structure Policy 5 Dividend Policy 5 Investment Policy 5 Past and future financial performance 6 Case study; Abu Dhabi Commercial Bank Analysis 8 Introduction 8 Cost of capital for Abu Dhabi Commercial Bank Analysis 8 Using the capital asset pricing model (CAPM) to calculate the required rate of return for Abu Dhabi Commercial bank 9 Valuation Analysis of Abu Dhabi commercial Bank based on WACC 10 Analysis of the financial performance; Ration Analysis 11 Profitability 11 Efficiency ratio 14 Analysis of past and future financial performance of the bank 15 Assumption of the forecast 15 Reasons for optimistic and pessimistic outcomes 16 Sensitivity Analysis of the bank 16 Possible opportunities for improvement for Abu Dhabi Commercial Bank 17 Improve the customer loyalty 18 Potential challenges for the Bank 19 Conclusion 21 Capital structure and cost of capital The cost of capital is the needed return appropriate to make the capital budgeting project like the building a new plant, valuable. The cost of capital entails the cost of debt and the cost of equity. A firm wills the debt source of finance, equity source of capital and the preferred equity to finance its new projects, classically in big amount. In the long run, the firm characteristically complies with the target weight for every of its source of capital. When the capital budgeting verdict is being made, it is vital to keep in mind the manner to which capital structure might be affected. Capital structure is a combination of company’s long term debt, specific short term debt, equity And preferred equity (Alastair, 2000). The capital structure depicts the manner to which the commonly funds its operations as well as the expansion with the use of diverse sources of capital. The debt comes in the form of bond or notes payables, whilst the equity is in the form of classified common stock, preferred stocks or the retained earning of the company. The short terms debt like the working capital needed is as well taken into consideration as part of the capital structure of a company. The company’s share of short and long term debt is taken into consideration in examining the capital structure. When individual refer to capital structure, they are referring to company’s debt to equity share that provide insight into the manner to which the riskiness of company is. Normally, a firm that uses huge capital funding from debt capital depict a greater risk as the company is comparatively highly levered (Aravossis, 2006). The optimal structure is a mix of debt and equity that would lead to low cost on capital and high value of the company, in other others, optimal capital is the ideal debt to equity of the company that increase the value and reducers the cost of capital. In theory, debt capital offers the least cost for capital as a result of tax offset. Nevertheless, it seldom the optimal structure because the company’s risk is growing as the debt grows. An ideal capital structure therefore is an induction of financial fitness which depicts a healthy equity capital unlike the debt capital. Factors affecting cost of capital that the company has control over (Cloonan, 2015). The following are some for he factors that affect the cost of capital of a firm Capital Structure Policy A company has control over its capital structure as well as its targets an ideal capital structure. Where the company uses more debt finance, the cost of debt will grow and when the company uses more of equity source of finance, the cost of equity will grow. Dividend Policy Provided that the company has the control over its payout ratio, the breakpoint of the marginal cost of capital schedule might be altered. For instance, when the payout ratio of firm gross, the breakout between the least cost internally created equity and the latest issued equity is lowered. Investment Policy It is presumed that in making a venture verdict, the company is making venture with same extent of risk. Where a firm alters the venture polices relative to its risk, the cost of debt and the cost of equity will as alter. The Level of Interest Rates the level of interest rates will have an effect on the cost of debt and significantly, the cost of equity. For instance, when the rate of interest grows, the cost of debt grows which lead to an increase in the cost of capital. The Tax Rates Tax rates depict effects in the after-tax cost of debt. Since, when there is an increase in the tax rates, the cost of debt reduces, leading to a decrease in the cost of capital. Past and future financial performance Every single number in the company’s financial statement provides huge insights into the past trend of the company financial performance and the financial health as well. They are the opened doors to the company’s past performance and whilst it is significant to understand that the past for history, it is even significant to understand the past and make use the past financial performance as the predictor of the future financial performance. The financial statement of the company sis strong tool that might be used to understand the company’s future financial performance. Setting the company goods and objectives as well as controlling and supervising the financial performance are importance for the company success (Cloonan, 2015). The growth steadiness in the company’s past financial performance measures is important in forecasting the future stock returns. The company steadily ranking in the least 30% of the past financial expansion evaluates the greater rates of return in relation to their unsteady low growth companies. The return disparity involving the two groups increase the length of approximation interval of past performance data, company steadily that ranks 30% of growth rates realize a return unlike the unsteady growth companies. The finding concludes that investors react to unsteady financial metrics, but the overreaction is pronounced and unrelenting low growth company unlike that for the steady companies that are performing well. The link between the past and future financial performance of a company depict that steady company’s past financial performance forecasts subsequently presentenced. This links involving the past growth steadiness and the future return are strong for the steady low growth companies in relation to steady high growing companies (Damodaran, 2010). Case study; Abu Dhabi Commercial Bank Analysis Introduction Abu Dhabi commercial bank is United Arab Emirates bank. The company was formed in 1985 as public shareholding corporations with limited liability upon the company merge with the emirates commercial bank and the federal commercial bank with the Khaleej commercial bank that was formed in the year 1975. The government of Abu Dhabi has 65% shareholding in ADCB shares, the remaining 35% is held by other companies and persons. The bank is the leading commercial bank in Abu Dhabi in terms of shareholding, finance as well as market capitalization. Cost of capital for Abu Dhabi Commercial Bank Analysis WACC=E/V*Ke} +D/V*Rd (1-T) Where WACC= is the weighted average cost of capital Re = is the cost of equity Rd =is the cost of debt E = is the market value of the company’s equity D = is the market value of the company’s debt V = E + D = is the value of a firm (Equity plus debt) E/V = percentage of financing that is equity D/V = percentage of financing that is debt Tc = tax rate To get the cost of capital for Abu Dhabi, we will use the capital asset pricing model (CAPM) l. The Beta (β) evaluates the volatility of the stock u=in relation to the market like the S&p500. It is an important tool that evaluates the security risk. It hence appraises the market risk in entirety whilst standard deviation evaluates the risk of some security. It is an evaluation of the dispersion of data set for the mean where there is more dispersion from the mean depicts the high deviation. The standard deviation of is arrived at by taking the square root of the variance. From our assessment for Abu Dhabi commercial bank, we evaluate Beta by finding the slope of the linear trend crated by plotting the benchmark against the equity return. Beta will be similar to the sloe of the trend line. It might as result is observed that Bets for Abu Dhabi Commercial bank to be 0.7. This value is less than one which is a sign that the security for the company is not volatile unlike the stock in the market in banking sector in Abu Dhabi. Hence, it can be concluded that the Abu Dhabi commercial bank is an ideal investment alternative (Bourke, 1998). Using the capital asset pricing model (CAPM) to calculate the required rate of return for Abu Dhabi Commercial bank Risk free rate of return is 5% (extracted from the central of Abu Dhabi) The CAPM might be defined as the model that ascertains the risk premium of a security. The model discloses the return that is similar with the risk realized under the situation that the capital market maintains balances. Hence, CAPM is given as ra = rrf + Ba (rm-rrf) Where: rrf = the required rate of return rm = The market expected return Ba = Beta of the security Expected return = Risk free rate + Beta * (Market Risk Premium)  Abu Dhabi Commercial bank capital asset pricing model is worked as follows CAPM=5%+0.7(2.9-5%) =6.47% Required rate of return is the minimal rate earned by a venture that will persuade an investor to spend more in a stock of a company. From the above analysis, it can be observed that the required rate of return for Abu Dhabi commercial bank is 6.47% which would mean that the security for the Bank is viable for investment because, a positive return will be realized from investing in this financial institution. Calculation of weighted average cost of capital for Abu Dhabi commercial bank (WACC) Equity= 22,072 Debt= 161,654 Cost of capital is 6.47% Hence WACC= (22072/ 183,726)*6.4 %+( 161,654/183,726)*0.7 WACC= {0.00778+ 0.61591} =6.24% Valuation Analysis of Abu Dhabi commercial Bank based on WACC From the above valuation analysis based on weighted average cost of capital for Abu Dhabi Commercial Bank it can be observed that the bank will depict low cost on capital of 6.24% and value of bank will remain high. This sings that the liquidity situation of the bank is low and hence the bank depicts going concern assumptions. This is because, the bank is having an optimal capital structure which is mix of debt and equity finance that would lead to low cost on capital and high value of the bank. The weighted average cost of capital is recommended fro the Abu Dhabi commercial bank since the bank will incur less cost on finance its capital (Evans, 2002). According to Modigliani and Miler, an optimal capital structure is a mix of debt and equity that would lead to, low cost on capital and high value of the firm. Analysis of the financial performance; Ration Analysis From the financial statement analysis of Abu Dhabi commercial bank, we will derive some likely opportunity for improving the bank performance in order to realize the net growth and recognition of likely challenges that may f-hinder future financial performance of the bank. The ratio analysis for the bank for the last three financial period starting December 2013-2015 As depicted below. Profitability Profitability 2013-12 2014-12 2015-12 TTM Tax Rate % 0.21 0.06 0.13 0.14 Net Margin % 56.23 51.31 61.80 60.35 Asset Turnover (Average) 0.03 0.04 0.04 0.03 Return on Assets % 1.85 2.00 2.22 2.08 Financial Leverage (Average) 7.58 7.73 7.95 8.49 Return on Equity % 13.89 15.27 17.39 17.30 From the above profitability ration, it can be observed that the bank is having an improved trend in its portability every year with return on equity depict the highest value followed by asset turnover and then the return on asset. This is because, the forecasted revenue for the bank will increase each financial period due to the bank’s improved debtors and credits management leading to short debtors payment period and long credits payment period making the bank to have an effective working capital to finance its daily activities. The bank’s strategic marketing plan is intended to enhance the customer awareness of the banks services and thus it is believed that the marketing will lead to improved revenue and growth in terms of profitability. The implication for the growth in profitability for the ban is that the Abu Dhabi commercial bank is an ideal investment opportunity since, an investor will realize positive return from investing in this bank since, the company’s having positive profitability trend. In this regards, it is evident that the business will be successful since, the company will have positive cash ending balance at the ending of every month. This is an implication that the company will be having more cash to finance its business operations effectively. Furthermore, it is apparent that the cash balance is growing each month which signify business expansion in terms of profitability and hence, it can be concluded that the business will be successful (Hacioglu, 2013). From the above graph of liquidity ration, it can be observed that the liquidity situation of the bank is improving since the debt to equity is declining while the finance leverage is improving. This depicts the best strategy of financing the company business operation since; the company will not incur loot of cost in funding the debt. In this regards, the bank is having an effective working capital management and thus the going concern of the bank is guaranteed. Efficiency ratio Efficiency 2013-12 2014-12 2015-12 TTM Fixed Assets Turnover 7.23 9.34 9.45 9.13 Asset Turnover 0.03 0.04 0.04 0.03 From the above effciency ratio, it is evident that the fixed asset turnover ratio is delcining which is an implciation that the company is havcing an imporved asset maangment which in turn would lead to reduced cost on asset management and imprived revenue (Hacioglu, 2013). Analysis of past and future financial performance of the bank The change that is experience is determining the weight of equity and debt so as to guarantee that the bank capital structure is optimal. To manage the change, Abu Dhabi commercial bank will require venturing more on debt since, the debt is considered the cheapest source of capital due to tax effect and thus it will not have an effect on the net profit and the verdict making of the bank. This is due to the fact that the debt holders will just pay the interest and the principal amount unlike the equity source of finance where the equity holders will be dividend which in turn will reduce the amount of retained earnings and lead to an increase in the number of shareholder in the company (Schuster, 2015). From the ration analysis undertaken for Abu Dhabi Commercial Bank, it can be observed that the there is change ratios. This is due to the fact that the revenue growth rate is forecasted at an assumed average growth that portrays the main change in the financial statement. The impact of the revenue forecast will have an effect on ration because the differed tax incurred in the reformatted balance sheet. Assumption of the forecast The revenue will grow constantly for every financial period and the growth rate will increase at a steady rate in perpetuity. Also, it is assumed that the effect of inflation will have an effect on the forecast and the effect of interbank competition in the market will depict no major effect on the sales. Reasons for optimistic and pessimistic outcomes The main reason for the optimist and pessimist result from the ratio analysis is on the basis of the sensitive analysis based on the result of the past and future financial performance as well as the effect of the external risk factors on the ratios and the company’s future performance. Because the forecast is on the basis of five years assessment, it is evident that the forecast will experience some external risk factors like the effect of inflation and the threat of competition that might depict negative impact on the future financial performance. In this regards, a pessimistic and optimistic result so as to provide a comprehension of the worst and best case scenario of the future financial performance of the bank. This is ideal because it reduces the venture and forecast from the adverse risk on the bank operations (Palepu, 2007). Sensitivity Analysis of the bank To clear understand the past and future financial performance of the bank, we will undertake the sensitivity analysis which on the basis of the past financial data of the company combined with some external and internal factors that might affect the forecast. The sensitive analysis of Abu Dhabi commercial bank is undertaken so as to provide a comprehension on the bank’s viability and opportunity for business growth. This is undertaken to appraise what is the very sensitivity analysis among the revenue growth. From the sensitivity analysis it can be observed that the revenue growth for the bank is very sensitive meaning that the change in external and internal factors will depict a big effect on the revenue growth in terms opportunities as well as the challenges that may be experienced by Abu Dhabi commercial bank in making sure that the revenue growth and business growth is attai9ned within the shortest time and at low cost on capital. Table of sensitivity Analysis Base price$6.14 Trading price$2.6 AssumptionOptimisticOptimistic pricePessimisticPessimistic priceRevenue growth9.1%$14.20 8%$3.97 PM12.11%$5.69 5.381%$5.518 ATO6$4.43 4.27$5.910 Div87%$4.23 72%$6.113 Eiat7%$4.12 5%$6.113 Rf11%$16.62 14.1%$3.814, it can be observed from the above table of sensitivity analysis that it the revenue growth is very sensitive. This act as a basis of appraising the performance of the bank in terms of business viability in the future. The sensitivity analysis is explained graphically below. The graph of sensitivity analysis for Abu Dhabi Commercial Bank Possible opportunities for improvement for Abu Dhabi Commercial Bank It is likely opportunity for enhancement for the bank is business growth by increasing the revenue. This is achieved by making sure that there is enhanced effectiveness in terms of business operations and marking of the bank. The variable cost depicts an effect on the attainability of the business growth in terms of revenue expansion which is the cost that increases with the increase in the sales level. To reduce the unplanned cost, the bank must incur just the relevant variable cost to ensure that there is improved net profit to the bank in the future (Tessa Hebb, 2015), Improve the customer loyalty The appraisal of the Abu Dhabi Commercial Bank core business entails the evaluation of the company net profits on the basis of the customer loyalty which entails the development of the superior impact on the customer’s sub-division. This is significant because to is an initial step to recognition of the comprehended customer and likelihood for business growth. The constitute entails the sub-division of customers into groups on the basis of the current study, the trend in the purchasing power and the effect on the business growth. Potential challenges for the Bank The revenue growth might imply that the growth in the production capability as well as the need to promote the bank. In this regards, there is need for addition cost incurred on the bank’s product expansion. The cost of capital is the biggest challenge to the bank for expanding hence; there is need for additional cost to fund the capital investment. Capital rationing is the main challenge that effect the growth of the bank and thus to avoid this challenge, there e is need to guarantee that the source of capital is cheap and thus the bank need to go for an optimal capital structure that will make the company to have a value with less cost on capital. The debt source of finance will grow the pressure on the banks business situation as a result of debt repayment. This is beneficial since, the net profit will not be affected unlike the equity source of capital, where the equity holder will be entitled to dividend from the rationed earning of the bank. The equity source of finance will increase the number of stakeholders in the company any time the company goes for equity capital to finance its daily operations. But with the debt capital, the retained profit is preserved since, there is no control on company as the debt capital and interest on debt is repaid back (Fabozzi, 2014). Another challenge for the bank is the growth in the competition commercial bank in Abu Dhabi. Abu Dhabi commercial bank grows in terms of business operations, the level of customer awareness as well as the need for the product expansion as well as the level of competitions in the banking sector in Abu Dhabi. This will be likely when the company enhance the banking effectiveness and quality of service provided to the customer. The product awareness is needed in order to be enhanced in the market by venturing in promotion. The bank need to venture in services standard is in compliance with the customer’s expectation since it will lead to enhanced revenue growth in the future. Since the market farce competition is variable, there is need to constantly updating the company marketing and demand strategy to ensure that the company remains a price leader in the market. There is need to invest on technology in order to guarantee effective production operations and quality product that meets the customers expectation in the market (Aravossis, 2006). To reduce the effect of increased competitive firm commercial bank in Abu Dhabi, the bank must depict the future financial performance in the current by ascertaining the past financial performance of the bank. This entails the ascertainment of the future financial performance and devising the contingent planning that will aid the bank in remaining the price leader in the competitive banking sector in Abu Dhabi. To tachi9eve this, there is need for changes that will lead to growth in the revenue in future but the net margin of the bank will remain low. As a result, there is need of holding the diversified portfolio of venture so as to enhance the returns as well as minimize the risk on venture because the current client’s loyalty is not a guarantee that bank will experience a growth in revenue in the future. The best mitigation strategy to be adopted by the Abu Dhabi commercial bank is to hold a diversified investment portfolio and venture more on other nation in Banking section and insurance policy. This will, ensure that there is efficient productivity and enhanced quality standard that will upheld customer. There is challenge of complying with the operation effectiveness, the market demand as well as the manner to which the need of the making sure that only skillful workers are employed when the bank expands. In making future financial forecast of bank performance, there is need to incorporate the effect of the human resource since, this is key factor to business success. Where the bank growth is faster unlike the rate employment of skills workers, there is likelihood of loss or reduction in the business operations. In this regards, the human resource need to ensure that there is enough labor force with the right skills and expertise to handle the ban k operation efficiency. The cheapest approach to making sure that the bank incurs less cost to get right workers is to outsource the human resource. The challenge with human resource depict a strong correlation with the change in the capital rationing and hence the capital scarcity ad well as need for skillful workers need to be considered in order to guarantee that the reported net profit margin improving in the future financial performance of Abu Dhabi commercial bank (Swain, 2015). Conclusion Subsequent to detailed assessment of the bank’s past and future financial performance, it might be concluded that the bank is a capital investment business at present and hence an investors is guaranteed of positive returns on investment in the bank since the return on equity is growing each financial period furthermore, the bank is having a decline in price to book ratio which is a sign that the current shareholders of the bank are subjected to les risk which ensure that the bank’s liquidity situation is kept at control. Al this factors are some of the risk aspect that is nit experienced by Abu Dhabi commercial bank and must at all time be taken into consideration in appraising the business viability before making an investment decision of whether to invest in the company or not From our ration analysis and assessment of future financial operation of the bank based on the sensitivity analysis and weighted average cost of capital for Abu Dhabi commercial bank, it is evident that the bank will portray a growth in the sales level for the next five financial period ending 2021. This sis sing that investment in shares for Abu Dhabi commercial bank will be recommended since the returns will be guaranteed on venture. Nevertheless, the sensitivity analysis for the bank provided that the revenue will be very sensitivity to both the extern and internal factors in the future. The bank should hence take advantage of the growth opportunities and devise ways of curbing the future challenges that might hinder the growth of future financial performance of the bank. In this regards, it is advised that Abu Dhabi commercial bank must hold a diversified portfolio in order to minimize risk on investment given the fact the bank is making a venture options of growing in the future and thus, the cost of capital will be a factor to be taken into consideration in terms of the cheapest source of capital and the optimal capital mix that will lead to low cost and high value of the Abu Dhabi commercial bank. Bibliography Alastair, G. (2000) Cash Flow Forecasting and Liquidity - Page 21, New York: Cingage Learning. Aravossis, K. (2006) Environmental Economics and Investment Assessment, Londion: Cingage Learning. Bourke, P. (1998) ' Concentration and other determinants of bank profitability ', Journal of Banking and Finance, vol. 13, pp. 65-79. Cloonan, J. (2015) 'Measures of Portfolio Risk and How You Can Apply Them', Journal of American Association of individual investors. Damodaran, A. (2010) Applied Corporate Finance - Page 552, New York: Cingage Learning. Ehrhardt, M. (2008) Corporate Finance: A Focused Approach - Page 554, london: Cingage Learning. Evans, M. (2002) Practical Business Forecasting - Page 291, London. Fabozzi, P.P.&.‎. (2014) Capital Budgeting: Theory and Practice, London: Springer. Hacioglu, Ü. (2013) Managerial Issues in Finance and Banking: A Strategic Approach, London: Cingage Learning. King, A.M. (2012) Executive's Guide to Fair Value: Profiting from the New Valuation Rules, New York. Palepu, K. (2007) Business Analysis and Valuation: Ifrs Edition - Text Only - Page 11, New York. Parameswaran, S. (2007) Bond Valuation, Yield Measures and the Term Structure, New York: John Wiley & Son's. Schuster, U.G.‎.N.&.‎. (2015) Investment Appraisal: Methods and Mode, New York: Cingage Learning. Shim, J. (2009) Strategic Business Forecasting: Including Business Forecasting Tools, London. Stewart, B. (2007) Sport Funding and Finance, New york: John Wiley & Son's. Swain, M. (2015) Budgeting for Public Managers, New York: Cingage Learning. Tessa Hebb, ‎.P.H.‎.G.F.H. (2015) The Routledge Handbook of Responsible Investment. Ulrici, V. (2007) Bond Valuation in Emerging Markets - Page 145, New York. Read More