Company Valuation - Assignment Example

1. Synopsis and introduction (5 marks) Synopsis The report centre on appraising the detailed appraisal of the JB-HI company by appraising the forecasting and valuation technique such as the use of weighted average cost of capital WACC) in understanding the optimal capital structure for the business that would lead to low cost of capital with high value of the firm as well as using the dividend model and free cash flow model to understand the firms value. This process is important since, it will provide an over view of the company past and future performance as well as concluding on the business viability. Introduction JB HI-FI was created in Melbourne in the year 1975. The company specializes in equipment and CDs and is the Australia’s music retailers. The company has diversified its business from selling music CD to key retailers to many clients electronic inclusive of plasma as well as LCD TV, digital camera and many more electronic devices. At present, the company is a leading one retailer of Apple and Dell computer hardware across Australia. In understating the business performance and financial situation JB-HI Company, the applicable financial, analysis such as the free cash flow model analysis is conducted. The company’s prospective analysis has been evaluated and the conclusion reached based on the company’s financial report. Some of the valuation technique adopted in the report is the use of free cash flow method, the dividend approach, as well as ascertaining the capital structure of the firm in order to understand if its optimal or not (Adams 2014). These are a key fundamental tool in valuing and understanding the company business situation. The prospective analysis for JB-HI limited is made based on three years trend using the above valuation model in order to appraise on the relevance of the business operation as well as aid in making an investment decision to investors. 2. Company valuation a. WACC WACC WACC= {Ks(S/V) +KD (d/v) Where Ks is the cost of equity KD is the cost of dent D is the value of debt S is the value of equity V= (D+V) 1. Cost of equity Ks=CAPM CAPM (Rs) = risk free rate + (beta * market risk premium) Market risk (rm) Risk free rate (Rf) Risk free rate 3.5 % Beta 0.64 Market premium=(RM-RF) 5.50% CAPM (ks) CAPM Ks)={3.5%+0.64(5.5)= Ks={3.5+3,52}=7.02% Cost of equity = 7.02% i. Cost of debt Cost of debt (Kd)=(Interest(net of tax)/value of debt) 2013 2014 2015 Interest 10 9 6 Tax (30% -3 -2.7 -1.8 Net of tax 7 6.3 4.2 Vale of debt 124 180 139 Cost of debt 6% 4% 3% ii. Capital structure WACC= Ks(s/v)+Kd(d/v) Where Ks is the cost of equity S is the value of equity V is the value of a levered firm KD is the cost of debt D is the value of debt KS(S/V0 Kd(D/v) 2013 2014 2015 2013 2014 2015 Equity (S) 243 295 343 Debt (D) 600 565 552 Value (V) 843 860 895 Value (V) 500 860 895 S/V 0.288256 0.343023 0.38324 S/V 1.2 0.656977 0.61676 cost of equity (Ks) 7% 7% 7% cost of equity (Kd) 6% 4% 3% KS(S/v) 0.020 0.024 0.027 KS(S/v) 0.07 0.03 0.02 KS(S/v) 0.001 0.002 0.002 WACC 2% 3% 3% From the above data analysis, it can be concluded that an optimal capital structure is a mix of debt and equity since, it yield low cost of capital with higher returns unlike the value of unlevered firm as observed by individual cost of equity and cost of debt. b. Total value I. Free cash flow Free cash flow model employs the discounted cash flow to establish the value of the firm. The benefit of the model is that it may be used with a collection of firms that does not provide payment of dividend.   2013 2014 2015 CASH FROM OPERATIONS 156 41 180 Capital Expenditure -35 -36 -42 Free cash flow   121 5 138 From the above data analysis on the company’s free cash it can be concluded that the company is having huge capital investment since, there are a lot of cash unused for investment as depicted by the positive value of free cash flows. ii. Total value calculations TEV = { Market Capitalization + Interest Bearing Debt + Preferred Stock - Excess Cash}   2013 2014 2015 Debt (D) 600 565 552 Preferred stock 12 16 18 Free cash flow   612 581 570 Total value   612 581 570 iii. Alternative methods Dividend discounting model The model works out the company’s value based on the dividend paid to shareholders. The reasons for using dividends to value the company is that, dividend depicts the real cash flows to be paid to company’s shareholders consequently, valuing the present value of the cash flows ought to provide a worth for how much the shares should valued (Alan Sitkin 2013).   2013 2014 2015 Earnings Per Share $1.17 $1.27 $1.36 Dividends Per Share $0.94 $1.10 $1.26 From the above table , it can be observed that dividend per share is increasing and the earning per share is growing. It therefore implies that the business worth is growing because the firm depicts a higher retained earning for venture as observed by the growth in value of the divided per share as well as the earning per share (Collier 2015). This method of valuing the company is significant since the company has already a steady growth rate, which portrays a steady growth in DPS and EPS due to increase in steady of cash flow generated. The benefit of the model is that is simple as well as directs thus it saves lots of time in working out the component cost of capital and cost of debt c. Value of equity and debt Value of equity= (cost of equity*cash flow) 2013 2014 2015 Equity (S) 243 295 343 Value (V) 843 860 895 S/V 0.288256 0.343023 0.38324 cost of equity (Ks) 7% 7% 7% Cash flow 612 518 570 Value of equity 42.840 36.260 39.900 It can be observed that the value of equity of the firm is decreasing each financial year, which is an indication that the business performance is decline in terms of reported net profit. As a result, it can be concluded that the value of the firm is decline. Value of debt=(cost of debt*value of cash flow) 2013 2014 2015 Debt (D) 600 565 552 Value (V) 500 860 895 S/V 1.2 0.656977 0.61676 cost of equity (Kd) 6% 4% 3% Cash flow 612 518 570 Value of debt 36.72 20.72 17.1 The value of debt is as well as decline, which is an implication that the company debt finance is declining as well. This is risky for business operation is ideal capital finance is debt due to interest tax shield. Value of the firm (Wacc*value of cash flow) Value of equity 42.840 36.260 39.900 Value of debt 26218.08 18782.68 22743 Value of the firm 26260.9 18818.9 22782.9 The value of the firm is optimal since, a mix of debt and equity would lead to a growth in value of the firm. It can therefore be concluded that an optima capital structure is a mix of debt and equity that would to high value with low cost of capital as observed above. ii. Critical evaluation of values calculated It can be observed from the above valuation that that a levered firm commands higher value with low cost of capital unlike unlevered firm as observed above. The company should therefore ensure that it is having an optimal capital structure in order to ensure that the risk is diversified and minimized as ensure that there are high returns on investment. Because the market risk is recurring risk to the business, it is hard for a firm to frequently control similar recurring of such risk (Cristiano Busco 2013). To get rid of it, firm must take into consideration asset diversification by holding an efficient portfolio. Asset diversification is the process of buying security of different company with different maturity and expiry periods. This will be relevant the financial risk lf a certain security will not be the same with the financial threat of another security and thus a company will be able to manage business risk. The workings as per the Modigliani and miller proposition provides that a levered firm commands a higher value with low cost of capital implying that asset diversification is relevant if a business would be in position of minimizing such market risk. As a result, investors continue to depict significant scope relating to the extent to which they control as well as manage their asset risk. The derivative as well as portfolio, structuring is turning to be more intricate and thus it requires extra-improved risk control. As a result, it creates a much better understanding to investors to control the risk exposure of their portfolio (David Alexander 2007). Market risk is inevitable for every public company registered in a security market and thus every business registered in public trace must always ensure that it mitigate for such market risk in order to ensure that the investment earns a return inform of profit. Some of the mitigation include as diversification, employing value at risk as well as taking into consideration commitment approach. this are some of the security tool employed in order to forecast on the variability of a security as well s making an informed decision of whether to buy or dispose a security (David Alexander 2007). d. Financial management policy (10 marks) Investment policy The company investment policy is 35% since, the company anticipates paying 65% dividend payout ratio. This is slight a decline in investment plan from 30.4 to 30.02 million dollar as compared to 2014 investment policy. In this regards, the decline investment policy for the business is due to a decline in debt and equity finance (David Alexander 2007). Dividend policy It can be observed that the company is having an increasing trend in earning per share . this is an indication that the firm performance is improving each financial year and thus the value of company’s stock will as grow in the security market. Free cash flow affect the company’s dividend policy since, the company will dividend where there is surplus after investing in the project with positive net present value (Lawrence J. Gitman 2008). The approach rarely explains the observed dividend policy global firms. Many firms pay relatively constant dividend from year to subsequent year while the directors would rather pay a steadily growing dividend instead of paying a changing dividend financing policy The firm financing policy adopted is a mix of debt and equity that is deem optimal in terms of least cost of capital with high value. It is apparent that the company has adopted an optimal mix of debt and equity to finance the business operation. The optimal capital structure leads to low cost of capital as observed by the values of WACC as declining with an increasing value of capital structure. As a result, the firms will be diversifying risk in order to ensure that impact of risk on firm’s peprf0omance is minimal (Mintz 2013). The impact of diversification portfolios that there is a reduction in volatility of the returns and at the same time the reruns of the portfolio returns. IN this regards, it can be observed that the holding a portfolio investment returns is ideal since, there is less security risk as depicted by the value of variance and with maximum retains of investment (Stimes, 2011,p 86).There are two justification why we choose the portfolio as an ultimate investment strategy. Firstly, as the expected return of market is high with low cost of capital as depicted in the table for portfolio return and risk. The expected return of market after using CAPM formula (Regression Approach). The is small fluctuation of in holding portfolio of the expected return of different portfolio. Recommendation to an investor The financial performance of the company is improving and thus the increasing trend in dividend per share and earnings per share implies that the value of stock in the security market is growing. As a result, an investor should consider investing in this company since, the prospective assessment of company as observed by the earnings ratio depict a positive trend. There is strong cash flow and liquid position for the company and consequently, the business is depicting a free cash flow available for investment as well as meeting daily working capital. The current dividend payout ratio is 65% which implies that retention ratio is 35$.this quite impressive since, it provide an indication that the business is performing well as well as investment in this company would yield high returns to investors within the shortest time possible Also the company as adopted an optimal capital structure (A mix of debt and equity) which would lead to high value of firm with low cost of capital as observed from the above analysis. In this regard, it provide an assurance to investors that investing in this company is ideal due to the fact that the company has diversified its risk by holding an efficient portfolio of investment with an optimal mix of debt and equity that is growing each financial year. The future business operation is certain for JB HI-FI limited s well as the positive and growing free cash flow implies that the future business performance will be affected by the sufficiency of the capital to finance its business operation. The value of the stock currently is undervalued which means that flock of stock buy will create the value of stock to be overvalued leading to priceless of the stock. It is an indication that a loss to an investor. In this regards, the business situation for JB-HI FI limited is steady as well as depict venture opportunity for the future business performance. An investor who intends to invest in the company therefore should undertake a comprehensive risk assessment for the future business situation since it is significant. . Reference list Adams, C 2014, Understanding Integrated Reporting: The Concise Guide to, Ingage Laerning, London. Alan Sitkin, ‎B 2013, International Business: Challenges and Choices - Page 47, Sydeny. Collier, PM 2015, Accounting For Managers: Interpreting Accounting. - Page 160, John Wiley, London. Cristiano Busco, ‎LF‎R 2013, Integrated Reporting: Concepts and Cases that Redefine , John Wiley, New york. David Alexander, ‎B‎J 2007, International Financial Reporting and Analysis, John Wiley, London. David Alexander, ABA 2012, International Financial Reporting and Analysis, Cingage learning, New Yorl. Fredrik Nilsson, ‎-KS 2015, Financial Accounting and Management Control: The Tensions , John Wiley, New York. Lawrence J. Gitman, ‎DJ 2008, Fundamentals of Investing, Cingage learning, New York. Mintz, SM 2013, Accounting for the Public Interest: Perspectives on. - Page 1, Sdney. Peter Walton, ‎A 2006, Global Financial Accounting and Reporting: Principles and. Robert G. Eccles, ‎PK 2010, One Report: Integrated Reporting for a Sustainable Strategy, Cingage learning, London. Read More