**Business 4465**
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Question #1: You will find the answer in Ch7 Solution file
If you were working as an analyst and you were asked to value Porter Inc, would you consider Porter’s accounting earnings or cash flow?
Discuss the positive and negatives aspects of using discounted cash flow to value Porter Inc. (4 marks)
There are two main advantages of the discounted cash flow method of valuation. Firstly, the discounted cash flow method only uses cash items that have been realized. Therefore, it cannot be manipulated by management since there are no subjective estimates. Secondly, the discounted cash flow method is also straight forward since there are no estimates that are required or accruals that are to be assessed. It uses cash items that have been realized which can easily be obtained.
There are two key disadvantages of discounted cash flows method. Detailed cash flow information may not be publicly available for external stakeholders compared to accounting earnings. Therefore, external analysts may have to make numerous adjustments to obtain the cash flows. Secondly, analysts use measures that are not conventional. Therefore, the average investor may not make of the analysis as easily as they would for accounting measures such as profit margin or return on equity.
B) Discuss the positive and negatives aspects of using accounting earnings. Discuss the following comment. “I don’t know why anyone would ever try to value earnings. Obviously, the market knows that earnings can be manipulated and only values cash flows.” (4 marks)
There are two main advantages of using accounting earnings. Firstly, accounting earnings allows the analyst to focus on the key measures of firm performance such as return on equity, return on assets or profit margins. Secondly, accounting earnings provide a simple valuation technique since it relies on readily available information. In cases where a detailed analysis is not necessary, the accounting earnings can form an appropriate valuation technique.
The most obvious disadvantage of accounting earnings is that accounting earnings contains non-cash flow items that are often subjective. It also employs an accrual system of accounting. Therefore, accounting earnings can be manipulated by management to suit their selfish interests. For instance, management may want to create the impression that the business is performing better than it actually is by encouraging consumers to stock up goods just before year end by offering favorable credit terms. That way, they can report sales that would have otherwise be made in the next financial period in the current period. Therefore, the sales revenues will higher than real sales revenues.
C) Explain why terminal values in accounting-based valuation are significantly lower than those for discounted cash flow valuation. (2 Marks)
Terminal values comprises of normal and abnormal expected cash flow beyond the forecast horizon. Normal earnings are those that are expected and can be forecasted while abnormal earnings are those that cannot be anticipated. Accounting-based valuation uses an accrual system. It incorporates all expected earnings that have been earned but will be received in future. Therefore, terminal values comprises of only the abnormal portion of the terminal value. However, the terminal value under the discounted cash flow valuation comprises of both the normal and abnormal earnings.
Question #2: You will find the answer in Ch7 Solution file
(10 marks) Define free cash flows (FCF) used in discounted cash flow valuations, from both a debt and equity perspective together and from only an equity perspective. Provide the full formula and explain it.
FCF to debt and equity = Earnings before interest and taxes × (1-tax rate) + Depreciation and deferred taxes - Capital expenditures -/+ Increase/decrease in working capital
Free cash flows provides for cash items while ordinary accounting profits (after tax earnings) is prepared using accrual system and includes non-cash estimates.
Earnings before interest and taxes × (1-tax rate) gives the after tax earnings.
Depreciation is added back because it is a non-cash estimate that is subtracted when computing the after tax earnings.
Deferred taxes are also added back because they are subtracted from the earnings yet cash or its equivalent have been paid out for the item.
Capital expenditure is not considered when computing earnings after tax. Capital expenditure is subtracted because it results in an outflow of resources.
An increase in working capital results in an outflow of cash while a decline in working capital results in an inflow in cash.
FCF to equity = Net income + Depreciation and deferred taxes - Capital expenditures -/+ Increase/decrease in working capital +/- Increase/decrease in debt.
The FCF to equity only considers the cash flows that are relevant to equity shareholders. Therefore, it encompasses all items included in the FCF to equity and debt. Besides, it makes adjustment for changes in debt.
An increase in debt means taking additional funds from debt providers thus an inflow of cash to equity while a decrease in debt means repaying existing debts thus resulting in an outflow of cash to equity
Which of the following items affect free cash flows to debt and equity holders? Which affect free cash flows to equity alone? Explain why and how.
All answers assume a tax rate > 0.
A) An increase in accounts receivable – It will cause both of them to decrease because an increase in account receivable increases the cash that is required as working capital.
b) A decrease in gross margins – It will cause both of them to decrease because a decrease in gross margins will result in a decline in the earnings before interest and taxes.
C) An increase in property, plant, and equipment – It will cause both of them to decrease because of the increase in capital expenditure
D) An increase in inventory-It will cause both of them to decrease because an increase in inventory increases the cash that is required as working capital.
E) Interest expense- It will only affect free cash flows to debt alone. It will decrease the free cash flow to equity.
F) An increase in prepaid expenses-It will cause both of them to decrease because an increase in prepaid expenses will increase working capital.
G) An increase in notes payable to the bank- It will only affect free cash flows to debt alone. It will decrease the free cash flow to equity because notes payable to bank are part of the debts.
Question #3:
What will Porter’s cost of equity be if the equity market risk premium is 5 percent, common equity beta is 0.8 and risk free rate is 3.4%? (3 marks)
(7 marks) Assume that Porter changes its capital structure so that its market value weight of debt to capital increases to 30%, and its after-tax interest rate on debt at this new leverage level is 3.5%. Assume that the equity market risk premium is 6.7%. What will be the cost of equity at the new debt level? What will be the new weighted average cost of capital?
Note that the beta of Porter’s assets will not change, since its assets are unchanged. Will the equity beta increase to reflect the increased financial risk faced by shareholders. Explain your answer. Under the prior capital structure, where the pre-tax cost of debt was 4.4%, the risk premium was 6.7% and the risk free rate was 3.41%, Porter’s debt beta was (4.4%-3.41%)/6.7% or 0.15. Given its equity beta of 0.8 and its debt weighting of 20%, what is the asset beta for the company?
Asset beta = Equity beta * (1 - Debt weight) + Debt beta * (Debt weight)
= 0.8*.7 + 0.15*.3 = 0.605
The changes in the capital structure are very small. Therefore, the changes in the financial risk will be very small as well.
Under the new capital structure, the debt beta will increase. If the after-tax cost of debt is 3.5%, and the tax rate is 38%, the pre-tax cost of debt is 5.65%, the debt beta will be (5.65%-3.41%)/6.7% or 0.33. What is the adjusted equity beta?
Equity beta = [Asset beta – Debt beta * (Debt weight)]/(1-Debt weight)
= [0.67 - .33*0.3]/0.7 = 0.82
Explain the affect of making changes in capital structure on the firm’s cost of equity or WACC.
There is a negative relationship between equity beta and the level of debt in the cost structure. Therefore, increasing debt in the cost structure reduces the cost of equity.
Question #4:
Consider capital market efficiency.
Do you think that capital markets are efficient? Explain the different levels of efficiency. (5 marks)
Capital markets are not efficient. This is because there are numerous cases of invested who have managed to generate returns that are higher than that of the market. There are three forms of market efficiency: strong, semi-strong and weak.
Strong efficiency is when all information is public available. Semi-strong efficiency incorporate past and present information only. Weak efficiency is where only past information is publicly available.
B) If the capital markets are efficient. Some would argue that that they don’t know why anyone would bother devoting their time to following individual stocks and doing fundamental analysis. The best approach is to buy and hold a well-diversified portfolio of stocks.” Do you agree? Why or why not? (5 marks)
I agree. If the market is efficient, a well-diversified portfolio allows an investor to generate risk-return combination that is better than that of investing in a few stocks. This is because the there are no investors who have an information advantage over others. All relevant information is publicly available. Therefore, investors cannot outperform the market. The best they can do is to invest in diversified portfolio whose performance mimics that of the market.
Question #5:
Explain the difference between fundamental and technical analysis? Can you think of any trading strategies that use technical analysis? What are the underlying assumptions made by these strategies? (5 marks)
Fundamental analysis relies on information obtained from the financial statements and other public information relating to a firm to predict the future financial performance of a firm and it potential value. Investors are recommended to buy shares for firms whose value is estimated to be higher than the prevailing market value and sell those that have a market value higher than the estimated value. Fundamental analysis assumes future earnings can be predicted accurately. On the contrary, technical analysis uses historical share metrics such as past share prices or trading volumes to predict future movements of share prices and make recommendations of when to sell or buy a given stock. Technical analysis assumes historical patterns can be used to predict the future.
B) Explain the value and usefulness of how ratio analysis and valuation help you do fundamental analysis. Also explain the value of doing strategy analysis. (5 marks)
Ratio analysis only uses financial information that can be expressed quantitatively. Therefore, it ignores important performance measurements that cannot be included in the financial statements. Strategy analysis enables fundamental analysis to assess the strategy risks that are likely to affect the predicted future performance. Understanding how strategy affects future earnings is important because it influences the accuracy of the estimates that are made.
Strategy analysis also allows the analyst to assess the potential risks that are likely to impede success as a result of a change in strategy. For instance, if a company changes its strategy from differentiation to a low cost structure, it can only be successful it reduces its cost structure otherwise it will risk selling highly priced undifferentiated goods which will place it at a disadvantage relative to its competition.
Strategy analysis also allows analysts to estimate the chances of success based on the external and internal environmental risks faced by a firm.
Question #6:
Porter Inc.’s stock has a market price of $20 per share and a book value of $12 per share. Its cost of equity capital is 15% and its book value is expected to grow at 5% per year indefinitely,
What is the market’s assessment of its steady state return on equity? Hint: Use the abnormal earnings formula. (4 marks)
Determine the market’s assessment of its steady state return on equity using the discounted abnormal earnings model.
Where V = 20 B = 12 g = .05 re = .15
ROE = .217. Hence, the market estimate of Porter Inc.’s stock steady state return on equity is 21.7 % per year.
B) If the stock price increases to $35 and the market does not expect the firm’s growth rate to change, what is the revised steady state ROE? (4 marks)
Where V = 20 B = 12 g = .05 re = .15
ROE = .24. Hence, the market estimate of Porter Inc.’s stock steady state return on equity is 24 % per year.
Question #7:
Many debt agreements require borrowers to obtain the permission of the lender before undertaking a major acquisition or asset sale. Explain why the lender would want to include this type of restriction? (4 marks)
They establish restrictions to prevent a firm from increasing business risks when the firm is facing financial difficulties. The restrictions prevent the conflict of interest and protects the funds of the debt providers.
B) The CFO of Porter feels that he would never agree to a debt covenant that restricts his ability to pay dividends to his shareholders because it reduces shareholder wealth.” Do you agree with this argument? Explain why or why not. (3 marks)
It is not true. In fact, lack of restrictions will reduce shareholders wealth because interest rates will be higher than when restrictions are present.
Question #8:
Porter Inc. is currently valued at $50 in the market. A potential acquirer believes that it can add value in two ways: $15 of value can be added through better working capital management, and an additional $10 of value can be generated by making available a unique technology to expand the target’s new product offerings. In a competitive bidding contest, how much of this additional value will the acquirer have to pay out to the target’s shareholders to emerge as the winner? (5 marks)
There are two key sources of value in the acquirer bid for Porter Inc. The first one is the 15 dollars in value added through the better management of working capital. The acquirer will generate 15 dollars due to better working capital management resulting in an aggregate value of 65 dollars. The second source is the unique technology which will add an extra 10 dollars by expanding product offering. Therefore, the Porter Inc. is worthy 75 dollars for every share but only 65 dollars to external parties. Therefore, it should slightly higher than 65 dollars.
Question #9:
A leading gold mining company decides to acquire a technology company at a 50 percent premium. The acquirer argues that this move creates value for its own stockholders because it can use its excess cash flows from the gold mining business to help finance growth in the new technology segment. Evaluate the economic merits of this claim. (10 marks)
The argument is based on capital market imperfections. Capital market constraints may prevent the technology firm from taking advantage of profitable projects. However, the purchase by the oil company will able the technology firm overcome the constraint and invest in growth opportunities that exist.
Question #10:
A) (5 marks) What are likely to be the long-term critical success factors for the following types of firms?
• A high-technology company, such as Microsoft
For a large, low-cost retailer such as Walmart
Long term Critical success factors for a high-tech firm:
• Investment in research & development (R&D) of new technologies as well as applications;
• Continuous improvement of its product portfolio in accordance with changing consumer needs to compete favorably.
• Having a large consumer base to provide ready market for it products as well as upgrades.
Critical success factors for a large, low-cost retailer, such as Wal-Mart:
• Maintain a low cost structure to ensure consumers have lowly priced goods. Maintenance of its low cost structure;
• Growth in store sales revenues; and
• Ability to expand geographical footprint by opening new stores.
B) (5 marks) How useful is financial accounting data for evaluating how well these two companies are managing their critical success factors? What other types of information would be useful in your evaluation? What are the costs and benefits to these companies from disclosing this type of information to investors?
For high-tech firm financial accounting data will include;
Sales revenues can show the market share
The expenditure in research and development can show commitment to developing new products and improving existing ones.
Profits of individual products
For low cost retailers financial accounting data will include;
The growth in expenses and profit margin to assess the cost structure
The sales revenue per store to assess growth in sales
The number of new stores opened will assess expansion.
For a high-tech firm, non-financial accounting information will include:
• Firm strategy and goals
• New products developed and updated versions of existing ones.
• Performance forecasts
• Third-party reviews of the firm products and consumer ratings
For a large, low-cost retailer, useful non-financial accounting information will include:
• Firm strategy and goals
• Foot traffic per store
• Number and locations of newly opened stores
• Number and locations of stores that have been closed
• Management initiatives to reduce costs;
• Volume and other discounts negotiated with key suppliers;
The firms will benefit from greater disclosure because they will be more trusted by the various stakeholders. It will also make management to work hard.
The firm will have to bear the cost of collecting the information and releasing the information. The information can also be accessed by competitors.
Question #11:
Two years after a successful public offering, the CEO of a biotechnology company is concerned about stock market uncertainty surrounding the potential of new drugs in the development pipeline. In his discussion with you, the CEO notes that even though they have recently made significant progress in their internal R&D efforts, the stock has performed poorly.
( 5 marks) What options does he have to help convince investors of the value of the new products? Which of these options are likely to be feasible?
The CEO can organize a meeting with analysts, make voluntary disclose of the R&D efforts, may increase dividends or repurchase some stock.
Meeting with analyst and voluntary disclosure are likely to feasible because they are efficient ways of releasing information to investors at the lowest costs
B) (5 marks) Why might the CEO of the biotechnology firm be concerned about the firm being undervalued? Would the CEO be equally concerned if the stock were overvalued? Do you believe that the CEO would attempt to correct the market’s perception in this overvaluation case? How would you react to company concern about market under- or overvaluation if you were the firm’s auditor? Or if you were a member of the audit committee?
An undervalued stock is easy prey for a takeover and the CEO maybe fired in the process. Secondly, undervaluation makes raising equity capital expensive. Lastly, the CEO maybe compensated based on the stock price. Therefore, undervaluation means that he or she is underpaid.
The CEO would not be concerned. There are benefits for overvalued stock. Raising equity capital will be cheaper and the CEO will earn high bonuses. Therefore, the CEO has incentive to correct because it may result in legal liability and the management may lose credibility because if it becomes public knowledge investors may assume it was a deliberate manipulation.
If I were the firm auditor or member of the audit committee, I would assess whether the over or under valuation is a as a result of deliberate manipulation. If it is, then I will advise on measures to stop share price manipulation. However, if it is not, I will not do anything. This is because intervening will be manipulating the market. Besides, there are various non-rational factors that influence market share price such as herd behaviour which cannot be controlled.
