Calculation, Optimal Debt Ratio, And Capital Structure Theories

NPV Calculation

• Initial Investment = $500,000
• Cash flow in year 4 = 50,000*(1.20) ^2*(1+3%) = $74,160
• Terminal value = Cash flow in year 4 / (rate-growth) = $74,160/(0.12-0.03) = $824,000
• NPV = PV of all the cash flows – Initial Investment =

50,000/ (1.12) + 50,000*(1.20)/ (1.12) ^2 + 50,000*(1.20) ^2/ (1.12) ^3 + 824,000/ (1.12) ^3 – 500,000 = $230,229.59.

• Since, the NPV of the project is positive using a discount rate of 12 percent per annum, FBA should undertake the project.

• Cost of equity = Risk free rate + beta *(Market return – Risk free Rate) = 3%+1.50*(8%-3%) =10.5%
• Terminal Value = cash flow in year 4 /(rate – Growth) = $74,160/(0.105-0.03) =$988,800
• NPV = PV of All cash Flows – Initial Investment =

50,000/ (1.105) + 50,000*(1.20)/ (1.105) ^2 + 50,000*(1.20) ^2/ (1.105) ^3 + 988,800/ (1.105) ^3 – 500,000 = $380,612.60.

• The NPV of the project is positive after discounting the cash flows using the required rate of return calculated using the Capital Asset Pricing Model approach.

In case the long-term growth rate is expected to be zero, the following is the calculation for the NPV of the project:

• Terminal value = Cash flow in year 4 / (rate-growth) = $74,160/(0.12-0.0) = $618,000
• NPV = PV of all the cash flows – Initial Investment =

50,000/ (1.12) + 50,000*(1.20)/ (1.12) ^2 + 50,000*(1.20) ^2/ (1.12) ^3 + 618,000/ (1.12) ^3 – 500,000 = $83,602.86.

After incorporating the above information, and a growth rate of 0 percent, the NPV of the project is still positive at a value of $83,602.86. Hence, the project should be accepted.

 P0 = [D0 x (1 + g)]/ (r – g] = [$2 x (1 – 0%)]/ (0.10 – 0.00)] = $2 / 0.10 = $20

g = ROE x b = 15% x (1 – 0.60) = 6%

D0 = $2 x 0.60 = $1.20

P0 = [$1.20 x 1.06] / [0.10 – 0.06] = $1.272 / 0.04 = $31.80

The stock price of the company is equal to $31.80 taking into considerations the growth factor.

The Optimal Debt Ratio trade-off theory may be described as the theory in which a company’s managers select to grow debt to a level where the value of the greater interest tax shield is exactly offset by the additional expenses of financial crisis. Financial difficulty is defined as a circumstance in which a corporation is unable to pay its creditors (Abel 2018). Investors are concerned about the cost of financial turmoil in this circumstance. Even if the firm is not now in default, investors consider the possibility of future difficulty when determining the current worth of the company. The firm’s entire worth would be represented by:

Overall value of the firm = Value if all equity financed + PV of interest tax shield – PV of cost of financial distress.

When debt financing is moderate, the risk of financial distress is low, thus the tax benefit of debt takes precedence (Agrei, Sun and Abrokwah 2020). However, when borrowing increases, the risk of financial distress rises, and the cost of financial distress rises. When the present value of the savings from tax exactly offsets the present value of the cost of distress, only then the theoretical optimum capital structure is achieved. The theoretical optimum capital structure is achieved when the present value of tax savings from borrowings exactly offsets the present value of the cost of distress; otherwise, the company’s value would be significantly reduced (Serrasqueiro and Caetano 2015).

The signaling hypothesis suggests that news about a firm seeking to add debt to its capital structure is perceived as a signal in the market. A firm may raise capital in two ways, as we all know: by issuing stocks or by raising debt. The equity type of financing dilutes a company’s ownership, whereas debt capital necessitates a continuous stream of payments to repay the loan, known as interest payments. Positive and negative signals are the two sorts of signals (Bhattarai, Eggertsson and Gafarove 2015).

Optimal Debt Ratio Theory

When a corporation announces its intention to use debt as a source of funding to fund a project, it sends a good signal to the markets. It persuades investors that the firm has greater investment possibilities and that it will be able to deliver earnings to shareholders in the future. When a corporation takes on debt, it becomes entitled to pay interest to the loan holders and has a high level of trust in the project’s ability to create sufficient cash flows (Jaralleh, Saleh and Salim 2019).

When a firm announces plans to decrease debt, it signals to the market that it will be unable to fund its interest payments via operations. Equity financing is viewed by the market as a negative signal since it signifies that the firm will be unable to make interest payments and that the company’s confidence in its financial health is poor (Wu, Wang and Li 2015).

Overinvestment problems – A business can be called as overleveraged or overinvested if it has too much of debt capital into its capital structure. An overinvested company can find itself in a position where it struggles to pay off the interest payments and the principal payments of the debt (Benlemlih 2017). The debt burden of the company makes it prone to failure in meeting the operating expenses which takes the company down in a spiral. The company then falls into a trap of taking additional debt to finance the existing debt burden and related costs. The ultimate end of the trap is that the company has to restructure its debt or file for protection from the creditors under the bankruptcy laws (Thompson and Zhao 2017).

Underinvestment problems – This problem can be defined as the fall in value of a firm due to the presence of risky debt capital in the capital structure. It has been established that the managers of the company have the responsibility of identifying projects which are profitable for the company and increase the value of the firm (Khaw and Lee 2016). It is observed that high debt relationships in a company can has an impact on the managers which compel them to reject projects which might add value to the overall company. Underinvestment problems can cause the company to not identify potential growth opportunities and missed opportunity to enhance the growth of the business (Sarka and Zhang 2015).

The traditional theory of capital structure advocates that a company should strike a balance between debt and equity capital which is focused towards lowering the Weighted Average Cost of Capital of the company and maximizes the total value of the company (Baker and Wurglar 2015). This theory can prevent the issues of over and under investment as it prevents the management from taking up additional debt or taking up less debt which can affect the overall valuation of the company and cause the company to not optimize the potential growth and worth of it.

When a corporation repurchases its stock from its owners, it does so at market price or at an offer price. The shareholders’ equity and the number of outstanding shares is lowered when a corporation buys back its own shares. The asset balance, on the other hand, decreases when cash is paid to owners in exchange for repurchased shares. When a firm believes its stock is cheap, it will often repurchase its own stock. As a result, by lowering the number of outstanding shares, the profits per share (EPS) rises, even if the company’s profitability remains same. It also sends a signal to the market that the firm has a bright future and that the stock price will rise. As a result of the increased demand for shares, the market price of the company’s stock rises. Alternatively, the goal of public firms is to maximize the return to investors and as a result, when a firm has surplus cash but no attractive investment possibilities, it decides to repurchase its own discounted stock. Like in the case of KSA, where it has accumulated a huge amount of cash. Stock repurchases are used for a variety of purposes:

• Undervalued stock – If a company feels that the company’s stock price is undervalued or the actual market price is less than the intrinsic value of the stock, it may decide to purchase the stock which would in turn result in rise of price.
• Stable dividends – A company may be able to maintain a stable amount of dividend to be paid as repurchase of stock reduces the distribution of dividends and allows the firm to strike a balance between amount of dividend paid and the amount of profits re-invested.
• Make over of financial statements – After the stock repurchased have been accomplished, the financial statements of the company present a favorable picture in front of everyone as the assets, stockholder’s equity are improved with a reduction in the shares outstanding without even having an improved operational performance. A reduction in ratios take place which is more important than the ratios of return to equity or return on assets.

Signaling Hypothesis

As mentioned KSA is fully financed with equity and has a substantial amount of cash available with them, the announcement of the repurchase may push up the price of the stock as the demand for the share would rise significantly. This would happen because the investors would be expecting that the company may be gauging its stock price to be low and undervalued or they might have some profitable investment opportunity to invest into.

Hostile takeover can be referred to the acquisition of a company by a company in a way which is not acceptable by the board of the target company (Cain, McKeon and Solomon 2017). The acquirer company tries to lure the shareholders of the firm and try to acquire the company for benefits of the acquirer. A hostile takeover is generally unfriendly in nature and there are several methods that the target firm can adopt that could protect them from getting taken over. A hostile takeover refers to the acquirer’s hostile takeover of the target firm. The acquirer corporation seeks to purchase the target company in an unorthodox method in a hostile takeover (Kay 2018). When an acquirer business seeks to take over a target company without the agreement of its stakeholders or board of directors, this is known as a hostile takeover. It is one of the techniques of taking control of a company during its purchase. To prevent the acquirer firm from taking over the target company, the target company issues a tender and engages in a proxy struggle. The company’s management takes proactive and reactive measures to deter a hostile takeover (Issacharoff 2016). Some of the famous hostile takeover defenses are poison pill, crown jewel and pac-man. Tender offer is another way which the management of the acquirer can take to acquire the target company where it offers a premium price for the stock of the company. The three defenses against the takeover are discussed below:

Poison pill – The company under this defense mechanism offers new shares to the existing shareholders at a discounted price which makes the value of the company fall below the acquisition price offered by the acquirer. The target company does this to make themselves less attractive in the eyes of the target. The motive is to compel the acquirer to lose interest in the target company and reject the plans to acquire the company (Elder and Wittry 2021).

Pac-man – The pac-man is a defense mechanism which a target company follows when it feels that there is a threat of a potential hostile takeover by an acquirer company. In this mechanism, the target company themselves acquire the majority of the shares of the company which are outstanding and become the major shareholder of the company. In this way they can influence the decisions that are taken in view of the acquisition and exercise their control over the management of the company (Tachmatzidi 2018).

Crown Jewel – Crown jewel is a defense mechanism which is similar to the poison pill strategy as it allows the company to sell of its most priced assets to make itself look less valuable to the acquirer. The most revenue generating asset or the asset or technology that the acquirer wishes to own by means of acquisition is sold off in the market so that the acquirer backs off from the decision of taking over (Tachmatzidi 2019).

Investment Problems

The company is involved in manufacturing and distributing equipment related to the dentistry profession and the products include scanners, aligners and various other products which are patented by the company. The company generally operates in two basic segments which include Clear Aligner segment and the other is devices like Scanners and services. The home grown brand of the company which is the clear aligner system was the primary treatment methods for patients more than 12.2 million only in the United States (Annual report 2021). The company owns and markets its most important brand named Invisalign which is a kind of clear aligner and was approved by the FDA to be used in the year 1998. After a period of skepticism, the product grew popular among customers in the United States and around the world. In the year 2000, the corporation was involved in the execution of a $31 million marketing effort, which was at the time the most aggressive marketing campaign. The company has been actively involved in acquiring companies by means of mergers and acquisition. The company acquired Israeli Company named Cadent for a value of around $190 million which used to operate in the segment of manufacturing and distributing intraoral scanners and 3D imaging. It also acquired Exocad Global Holdings for which it had to cough out around $418.7 million The company was able to cross the $1 billion mark in terms of revenue in the year 2016 and the most recent revenue of the company in the year 2021 was around $3.9 billion which has been growing significantly over the years. The primary risks that are involved in the business are discussed below:

• The revenues of the company are highly concentrated in a few of its products primarily the I-tero scanners and the Invisalign system of the company. The company would suffer excessively if the price of the products it sells falls down in the future.
• The company has its operations in many international markets which makes the company exposed to factors like foreign currency risk, political risk and several other risks.
• The company is trying to adapt to ever evolving technology and any hindrances to the development of the technological framework can hamper the prospects of the company.

This section presents the assumptions and the processes used in the DCF method of equity valuation and the Residual Earning model of valuation:

The Discounted Cash Flow Model is a stock valuation technique which is based on the assumption that the value of a company’s stock depends upon the sum of all the present values of the company’s free cash flows. The model is used by multiple investors around the world and is one of the primary methods used in valuing companies for the purpose of mergers and acquisition or investment decision making assistance. The forecasted cash flows of the company are discounted using an appropriate cost of capital generally represented by the Weighted Average Cost of Capital if the firm has debt in its capital structure and the intrinsic value of the stock is calculated. There are multiple assumptions and elements that supports the valuation methods which are discussed in detail below:

Free Cash Flows – The Free Cash Flow of the firm represents the capital that the firm has with itself after meeting the liabilities both externally and internally. The FCF in other words can be described as the capital that the firm has which can be used to pay the dividends and the interest of the company’s stakeholders. The calculations for cash flows can take various forms. To arrive at the cash flows of the company here the following formula was used:

Traditional Capital Structure Theory

FCF = Cash flow from continuing operations – Capital Expenditures. The following table represents the FCF of the company for the latest as well as past years:

• Terminal value – The terminal value of the company can be defined as the value of the company after the completion of the valuation period. The company is expected to last till perpetuity and hence the terminal value represents the value of the firm till perpetuity using a terminal growth assumption which is equal to the growth rate of the GDP of the country. The terminal value is of greater importance in determining the intrinsic value of a stock as it takes up a major portion of the total enterprise value calculated using the DCF model. The growth assumption is the most important assumption in calculating an appropriate level of terminal value for the company. The terminal value of stock was calculated and it was based on the assumption that the firm would grow at the rate of 5.60 percent after the year 2025. This growth assumption was based on the annual growth rate of US’ GDP after the year 2025 as expected by the (Prmnews 2022).
• Growth rate – The growth rate of the company is the most important assumption in a DCF analysis as it decides the future growth of the company’s financials and the free cash flows. Since, the company does not pay dividend, the sustainable growth rate method cannot be deployed to estimate the growth rate of the company by assessing the amount of profits distributed and the amount re-invested into the company. The Compounded Annual Growth Rate (CAGR) of the company’s EPS has been estimated to be equal to the expected growth rate of the future cash flows of the company. The CAGR of the EPS was calculated as 19.15 percent as the EPS of the company grew from $3.86 per share to $9.27 per share. The company was expected to experience growth in three phases; the initial growth phase which is equal to the CAGR of EPS, the transition phase where the growth slowly transitions towards the long-term growth rate and the terminal growth phase which is equal to the expected growth in GDP.
• Cost of capital – Absence of debt in the capital structure compels us to use the cost of equity of the company instead of the WACC of the company which incorporated both the equity and debt capitals. To estimate the cost of equity, the Capital Asset Pricing Model was used which is based upon the assumption that the returns of a stock is only exposed to market related factors and is measured using beta of the stock (Barberis et al 2015). There are three primary components of CAPM model; the risk-free rate of return which is represented by the US 10-year treasury bond yield, the market return which is represented by the past 15-year average return on the NASDAQ composite and the beta of the stock which was taken from free available financial website called yahoo finance. After plugging all the three components of the CAPM formula the resulting cost of equity was 14.69 percent.

Taking into considerations the detail and assumptions mentioned in the above section, the discounted free cash flow method of valuation suggested an intrinsic value of $187 which is way below the current market price of $289.

The RI method is a stock valuation technique which estimates the amount of earnings that the company has after adjusting for the equity charge of the company. This method is not widely used across the investment universe to value the stock of a company but it can be useful in determining the appropriate value of a company’s equity. The primary assumption of the model is that the net profit of a company does not represent the correct earnings that is available to the company’s shareholders as it does not account for the amount of dividend that the company needs to pay to the shareholders. Once the dividend payment is adjusted to the net earnings of the company it is said to be the appropriate level of earnings available to the shareholders. The method is similar to the DCF method and the only exception to it is the free cash flows of the company is replaced with the level of residual earnings calculated. The method can be used in valuing companies which do not have free cash flows due to huge amount of capital investments and may provide deeper insight in the potential value of the stock. The book value per share of the company is ultimately added to the intrinsic value calculated of the stock to get the intrinsic value of the share in a comprehensive manner. The residual earnings of the firm is calculated below:

Equity Charge – To calculate the equity charge of the company the CAPM model was used and the process used was the same as it was in the case of DCF.

• Growth rate – The growth rate assumption was similar to that of the DCF method i.e. the company is expected to experience triple stage growth. The first phase is the initial growth phase, the second phase is the transition phase and the third phase is the terminal growth phase.
• Book value per share – The book value per share can be defined as the net worth of the company that is attributed to each shareholder. The book value per share is calculated by dividing the net worth of the company with the shares outstanding of the company. The BVPS of the company was found to be equal to $46 per share.

The residual income valuation method suggested an intrinsic value of $100.73 after discounting the residual earnings of the company using the cost of equity of the firm. The suggested intrinsic value was significantly less than the observed market value of the firm.

Conclusion and Recommendations

The report was focused towards estimating the intrinsic value of the stock using two famous equity valuation techniques; Discounted Cash Flow technique and the Residual Earnings model. The models have used market available data including the information published in the annual statements of the firm. The price that was estimated by employing the Discounted Cash Flow Model by discounting the cash flows of the company using the cost of equity was equal to $186.57. The intrinsic value of the stock that was estimated by the residual earnings model was equal to $100.73. Both the values suggested by the methods are significantly less than the observed market price of the stock which was equal to $289.91. To arrive at the final intrinsic value of the stock, we assigned an equal weight to each method and the resulting intrinsic value of the stock was equal to $143.65 as shown in the table below:

Based on the current price of the stock and a suggested intrinsic value of $143.65 it can b concluded that the stock was overvalued. Hence, we recommend to sell the stock from the existing portfolios of investors and no fresh position in the stock must be created 

References

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