Question 1: Cost of Capital
1. The re-estimated cost of capital of Widget Ltd. is as follows:-
|
Particulars |
Capital |
CMP |
Current Value |
Weights |
Cost of Capital |
|
10% Bonds |
15000000 |
900 |
13500000 |
0.132 |
4.21% |
|
9% Bank Loan |
14000000 |
– |
14000000 |
0.123 |
6.30% |
|
12% Preference Shares |
5000000 |
95 |
4750000 |
0.044 |
12.63% |
|
Equity Shares |
80000000 |
5 |
40000000 |
0.702 |
15.10% |
|
Total |
114000000 |
72250000 |
WACC |
12.48 |
(Singhal, 2013)
Thus, the old estimated cost of capital of 10% cannot be considered for present valuation of Cash flows and the business as a whole.
The change in cost of capital will have the following impacts:-
NPV – The NPV will decrease as a result of increase in the estimated overall cost of capital of the company. This decrease will be due to two reasons. Firstly, the involvement of debt in the capital structure of Widget Ltd. Earlier, Widget Ltd. was a wholly owned company with no debt in the capital structure. But it has raised borrowed capital in the form of Bonds carrying 10% interest and a Bank Loan carrying 9% interest of total $29 million. Therefore, the fixed interest expense on this borrowed amount will reduce the cash flows. Secondly, the increase in the rate of cost of capital leading to changed discount factors for discounting the cash flows.
Value of firm – The Widget Ltd. earlier had only owned capital worth $44.75 million. With the change in cost of capital due to change in capital structure of the company the value of the firm has increased to $$ 72.25 million. This increase in due to involve of debt capital and their current market values.
|
Year |
Cash Inflow |
Adding net working Capital |
Total Cash flow |
Discounting Factor |
Discounted Cash flow |
|
0 |
(17,200,000) |
– |
(17,200,000) |
1 |
(17,200,000) |
|
1 |
(3,760,000) |
– |
(3,760,000) |
0.89 |
(3,342,817) |
|
2 |
10,568,000 |
– |
10,568,000 |
0.79 |
8,352,994 |
|
3 |
13,508,000 |
– |
13,508,000 |
0.70 |
9,492,162 |
|
4 |
10,568,000 |
– |
10,568,000 |
0.62 |
6,602,244 |
|
5 |
(2,560,000) |
1,320,000 |
(1,240,000) |
0.56 |
(688,724) |
|
Present Value |
20,415,860 |
||||
|
Net Present Value |
3,215,860 |
|
Particulars |
0 |
1 |
2 |
3 |
4 |
5 |
|
Profit before Interest and Taxes |
(3,000,000) |
15,000,000 |
19,200,000 |
15,000,000 |
(1,800,000) |
|
|
Interest: |
||||||
|
10% Bonds |
1,500,000 |
1,500,000 |
1,500,000 |
1,500,000 |
1,500,000 |
|
|
9% Bank Loan |
1,260,000 |
1,260,000 |
1,260,000 |
1,260,000 |
1,260,000 |
|
|
Profit before tax |
(5,760,000) |
12,240,000 |
16,440,000 |
12,240,000 |
(4,560,000) |
|
|
3,672,000 |
4,932,000 |
3,672,000 |
||||
|
Profit after tax |
(5,760,000) |
8,568,000 |
11,508,000 |
8,568,000 |
(4,560,000) |
|
|
Depreciation |
2,000,000 |
2,000,000 |
2,000,000 |
2,000,000 |
2,000,000 |
|
|
Total Cash Flow |
(3,760,000) |
10,568,000 |
13,508,000 |
10,568,000 |
(2,560,000) |
2. Share valuation of JB Hi-Fi using constant dividend growth model(Singhal, 2013):-
- When the dividend is growing @ 5.69%
- The spreadsheet showing the valuation of JB Hi-Fi using Free cash flows(Singhal, 2013) is as follows:-
|
Year |
2016 |
2017 |
2018 |
2019 |
|
FCF forecast ( in $ million) |
||||
|
Sales |
6,000.00 |
6,240.00 |
6,489.60 |
6,684.29 |
|
Growth versus prior year |
4% |
4% |
3% |
|
|
EBIT(5% of sales) |
300.00 |
312.00 |
324.48 |
334.21 |
|
Income [email protected]% |
90.00 |
93.60 |
97.34 |
100.26 |
|
Depreciation |
0 |
0 |
0 |
0 |
|
capital Expenditure |
0 |
– |
– |
– |
|
Increase in NWC (20% of sales) |
0 |
48.00 |
49.92 |
38.94 |
|
FCF |
210.00 |
170.40 |
177.22 |
195.01 |
For Discrete Period (2016-2018):-
|
Year |
2016 |
2017 |
2018 |
|
FCF |
210.00 |
170.40 |
177.22 |
|
0.893 |
0.797 |
0.712 |
|
|
Present Value of FCF |
187.50 |
135.84 |
126.14 |
|
Total Present Value |
449.48 |
For Continuity Period:-
P3 = P4
= 195.01
12%-3%
= 195.01
9%
= 2166.78
Present Value of Continuity period = 2166.78 X 0.712
= 1542.75
Total Present Value = 449.48 + 1542.75
= 1992.23
Value per share = 1992.23+40-150
= 19.01/-
According to the above calculations, it is evident that the share price of the company is increasing with the increase in constant dividend growth. As calculated in part (a) of the question, when dividend growth was 5.69% the price becomes $9.40 per share and when the dividend growth is increased to 7% the price becomes $ 11.60 per share. This shows that dividend growth has a direct relation with the share price. This can also be concluded by the fact that when the shareholders will get more return in the form of dividend for their investments they will tend to buy more shares of the company for increased earning thereby increasing the share price.
Further, when the valuation principle has changed from growth in dividend to the total growth in earnings model which is reduced to the present value on the basis of weighted average cost of capital for the company, the price calculated is greater than what is calculated in part (a) above. There can be many factors for the same for example, the WACC is taken as 13% in part (a) whereas it is 12% in part (b), the dividend growth model considered growth in dividends as the basis for valuation of shares. However, in part (b) overall change in the earnings as well as working capital has been taken into consideration. The comparison of above calculated price with actual share price of the company shows that whether the shares of the company is overpriced or underpriced in the market and an investor may decide about the investment accordingly.
Question 2: Share Valuation
3. The cost benefit analysis of different theories by a decision maker in a business to find the net profit or loss from a project or portfolio is called trade off. These projects or portfolios are based on different kinds of leverage plans. Normally, some interior solution is tried to find out so that the marginal cost and benefit could be neutralized. Initially, the trade off theory was based on the model developed by Modigliani-Miller theorem according to which tax had the major impact on the profitability of the concern. This theory constantly preferred 100% debt for every concern so that maximum tax shield could be taken which is considered as the saving of the profitability of the concern. But this situation was an extreme one. This is because if there is such an increase in the debt financing of the concern it will lead to heavy costs burdens in the form of fixed interest thereby leading to a debt trap for the concern. Such situation normally ends up in bankruptcy of the concern. This extreme situation needs to be avoided and therefore a theory of trade- off was developed according to which any business concern interested in trading- off will first calculate the optimum level of debt for its concern based on the past and present profitability as well as the market conditions. The concern will then go for debt financing to earn marginal benefits of tax savings. It will further lead to increase in price earnings ratio by trading on equity which will be beneficial for the stakeholders. Hence, according to the trade-off theory, the firms are divided into two categories. First, the firms calculating their trade-off in single period only by the cost benefit analysis from the tax benefits and cost of bankruptcy. Second are the firms which first calculate their optimum level of debt financing and set a target debt ratio. Then the dent financing is done. Any variation in the target ratio and actual ratio is analyzed and tried to remove over time. (Frank & Goyal, 2005)
In the given case, Widget Ltd. profit is majorly dependent on the software development wing. The software development business is considered to be highly competitive and there is a greater probability that the company may lose present level of market demand. Further, the company has a past record of variable earnings and operating cash flows which affirms the condition mentioned above. Hence, the more involvement of debt fund may prove harmful for the business in long run. This is because the company does not have any source which has the capability of earning fixed income. The huge investment in intangible assets is a major indication of this situation. When the fixed cost in the form of income would be large the company will have to earn at least equal profits so that the costs can be tolerated. But with the prevailing situations this cannot be expected of the business. Therefore, the company should gradually shift towards more funding through equity capital as the borrowed capital’s cost may be unbearable for the business and may lead to bankruptcy.
Frank, M.Z. & Goyal, V.K., 2005. Tradeoff and Pecking Order Theories of Debt. [Online] Tuck School of Business at Dartmouth Available at: https://www.tc.umn.edu/~murra280/WorkingPapers/Survey.pdf [Accessed 15 May 2017].
Singhal, D.K., 2013. Capital Budgeting. In Strategic Financial Management. 3rd ed. Jaipur: Parv Management Services (P) Ltd. p.644.
Singhal, D.K., 2013. Cost of Capital. In Strategic Financial Management. 3rd ed. Jaipur: Parv Management Services (P) Ltd. p.644.
Singhal, D.K., 2013. Dividend Decisions. In Strategic Financial Decision. 3rd ed. Jaipur: Parv Management Services (P) Ltd. p.644.
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