SU22_2~1.PPT BUSINESS VALUATIONS FINANCIAL MANAGEMENT NOTES 2019

SU22_2~1.PPT BUSINESS VALUATIONS FINANCIAL MANAGEMENT NOTES 2019

1. Valuation of capital
structure components
Study unit 2.2
Chapter 6

2. Use principles
of:
-Capital
budgets
-Portfolio
management
-Valuations
and
take-overs
-Cost of
capital
INVESTORSWant to
Maximise profit
CONSIDER
PRINCIPLES
OF:
-Analysis and
interpretation
-Risk and
return
-Hedging
-Time value of
money
INVESTMENT DECISION
Thus seek investment opportunities
And consider different aspects
FINANCING DECISION
If decided upon an investment,
must consider how to finance it
DIVIDEND DECISION
Hopefully the investment yielded
a profit, and then one must
Decide how the profit will be
applied
Invest in:
-EAT
-Operational-
assets
-Businesses
-Shares
Use principles
of:
-Sources of
financing
-Capital
structure
-Types of
financing
(leases/inter-
national)
Finance
with:
-Equity
-Debt
OBTAIN INFORMATION:
-Internal:
Accounting
records and
management
-External:
Economic and
Business
environment

3. Learning outcomes
Upon completion of the Study unit you
should be able to:
•Know and apply the valuationtechniques of
the following items:
DEBT EQUITY
Debentures/BondsOrdinaryshares
Long term loans
Preference shares

5. Debentures
3 Typesof debentures:
1.Redeemabledebentures
2.Non-redeemabledebentures
3.Convertibledebentures

6. 1. Redeemable debentures
Company A holds R1 million's debentures in
company B. The annual interest rate is 15%.
The debentures are redeemable over 5 years
at par. The current market return for similar
debentures with a life of 5 years is 20%.
Current tax rate is 28%.
Required:
Calculate the market value of the debentures.

7. 1. Redeemable debentures

8. 2. Non-redeemable debentures
Company A holds R1 million's non-redeemable
debentures in Company B. The annual interest
rate is 15%. The current market return for similar
debentures is 20%. The current tax rate is 28%.
Required:
Calculate the market value of the debentures
Formula:
(Interest/ Market related interest rate)

9. 2. Non-redeemable debentures

10. 3. Convertible debentures
Debentures in issue:1 000 000 Value: R1 000 000
These debentures expires in 2 years and the debenture holders have
the option to:
Convert their debentures into ordinary shares at an exchange rate of 1
debenture for 1 ordinary share.
OR
The debentures can be redeemed for cash at a 28% premium.
All issued debentures currently earn interest at 28% per year. Debentures are
currently trading at a market return of 30%.
Ordinary shareholders currently receive a dividend of 0.25c. Annual growth
was 4%, and shareholders expect a return of 26.22% on equity.

11. 3. Convertible debentures
Approach to convertible debentures/bonds:
1.Calculate the market value of both options
@time of conversion (over 2 years in this
example) –draw a timeline if needed
2.Choose highest value
3.Calculate the value as of TODAY for the
chosen option (discount back)

12. 3. Convertible debentures
Option 1: Convert to equity
Vo = D1/ (Ke-g)
(0.25*1.04(3)) / (26.22-4)
1.27 * 1 000 000
= 1 270 000 (value over 2 years)
Note that D1 is the dividend in the
year after the conversion date i.e.
Year 3.
Option 2: Cash
1 000 000 *1.28
= 1280 000 (value over 2
years)
Choose option2!!!

13. 3. Convertible debentures
Calculate present value:
N= 2
I= 30% (market rate)
FV= 1 280 000
Pmt= 280 000 (1 000 000 * 0.28) (debenture
interest or coupon rate)
Comp PV = 1 138 461

15. Preference shares
•3 Types of preference shares:
1. Redeemable –the same as debentures
(no tax)
2. Non-redeemable –the same as
debentures (no tax)
3.Convertible

16. 1. Redeemable preference shares
The example has a par value of R100 and bears
dividends at 15% per year. A market-related
dividend rate for similar investments is 16%. This is
redeemable over 5 years.
Required:
Calculate the market value of the preference shares

17. 1. Redeemable preference shares

18. 2. Non-redeemable preference
shares
A person wants to sell 100 preference shares. The
preference shares have a face value (the value
printed on the shares certificate) of R1 and bears
interest at 10%. A market-related interest rate for
similar preference shares is 8%.

19. 2. Cumulative non-redeemable
preference shares

20. 3. Convertible preference shares
Preference shares 5 000 000
Issued Value 5 000 000
Currently shareholders are earning R200 000 of dividends on
preferred shares and similar preference shares are currently trading
on the market at 11%
In 5years time preference shareholders will have a choice to convert
their preference shares into 10 000 ordinary shares OR
to keep it in perpetuity and earn dividends of 10%.
Ordinary shareholders are currently earning a dividend of R15per
share and shareholders require a return rate of 21%. The company
has a growth rate of 6%

21. 3. Convertible preference shares
Option 1: Convert to equity
Vo = D1/(Ke-g)
= (15 * 1.06(6) / (21-6)
= 141.85 pa * 10 000
= 1 418 500
Option 2: Keep in perpetuity
(5 000 000 * 0.10) / 11%
= 500 000 / 11%
= 4 545 455
Choose option2!!!

22. 3. Convertible preference shares
Calculate present value of option 2:
N = 5
I = 11%(market rate)
FV = 4 545 455
Pmt = 200 000 (earning currently)
Comp PV = 3 436 685

24. Equity
Valuationof ordinaryshares:
1.Gordon'sgrowthmodel
OR
2. Sharepricex numberof shares
Market price (V
0) = D1
Ke -g

25. Equity –Constant growth
Company A's dividend for the next year is
estimated at 50c. It is evident from the last 5
years' results that the company has an annual
growth rate of 15%. The investor expects a
return of 20% on his investment.
Required:
Calculate the market value

26. Equity –Constant growth
V
0=

27. Equity: Non-Constant growth
•In the case of non-constant growth, the share must
be valued on the date on which the growth changes.
•This value then has to be discounted back to the
current date, togetherwith the other dividends (Cfi
function).
•2 dimensions:
–Calculate the value of the dividends
–Calculate the value of the share
•Example in CorreiaC6.10 pp 6-15

28. Equity: Non-Constant growth
X just paid a dividend of 60c per share.
Shareholders demands a return of 12% p.a.
Growth for the next 3 years are expected to be
30% and after that growth will stabilize at 6% p.a
*Draw a timeline

29. Equity: Non-Constant growth
•0= 60 c
•1= 0.78c (0.60*1.30)
•2= R 1.01 (0.78*1.30)
•3= R 1.32 (1.01*1.30)
•4= R 1.39 (1.32*1.06)
1.39/(12%-6%)
=R23.17 is the value over 3 years
now calculate the present value (y0)

30. Equity: Non-Constant growth
•0= 0 Ent
•1= 0.78c Ent
•2= R 1.01 Ent
•3= R 1.32 + R23.17 = R 24.487
•2
nd
F Cfi
•12% Ent
•Down button NPV Comp= R18.93

31. Self study
•Please look at the example in Correia pp 6-17.
Here dividends weren't pay for a number of
years. (Delayed dividend)

32. Weighted average
cost of capital
Study unit 2.3
Chapter 7

33. Learning outcomes SU 2.3
•Calculate the cost of debt;
•Calculate the cost of preference shares;
•Calculate the cost of equity;
•Calculate the weighted average cost of capital at
market value; and
•Determine the cost of capital of specific projects
and advice on it.

34. WACC -introduction
•Weighted average cost of capital
(WACC) is the weighted average of the
required rates of return of equity, debt and
preference shares employed by the entity.
•Capital refers to all permanent sources of
economic resources used by the business to
conduct its business activities.

35. WACC -introduction
If investment has a higher return than cost of
capital, what happens to the value of the company?

36. WACC -introduction
•Investments create value for a business
when the return of the investment exceeds
the cost of the funds that were used to
finance it.
•The cost of capital is the best estimate of the
cost of finance and therefore only projects
with returns in excess of the cost of capital
are typically taken on by management.

37. WACC –introduction

38. WACC –introduction
•Why is WACC important?
–A company makes investments decisions by
comparing return generated from a project to
WACC (cost of financing the project)
–WACC reflects both risk and capital structure
–If WACC is calculated inaccurately this could
lead to the company accepting projects that
will destroy wealth

39. WACC-introduction
Apple 8.04%
Burger King 12%
Coca-cola 11.38%
Guess 15.22%

40. WACC -introduction
•Each company has a target equity / debt
relation, e.g. 60% / 40% (SEE SU7).
•Each project is not financed with the same
capital in the same relation as capital structure.
•Equity and debt will reflect the capital structure
in the long term.
•Which cost of capital to use:
•Marginal cost of capital
•Pooling of funds

41. Marginal cost of capital
•Cost of newincrements of capital that is issued
•Use marginal cost of capital for decisions
regarding new projects that can possible change
the company's WACC profile (Large projects)!!!
•Historical capital is not suitable to base one’s
decision on for new projects

42. Pooling of funds
•An entity’s target capital structure may not
necessarily be the same as the capital
structure that the entity achieves on a day-
to-day basis.
•Each project is not financed with capital in
the same ratio as the capital structure
•Equity and debt will in the long term
represent the capital structure

43. Pooling of funds
A company can invest in a project that will
yield a 15% return. This project will be
financed by a 13% loan. WACC is 17%
Which rate should be used to evaluate the
project against?

44. Pooling of funds

45. Current WACC assumptions
•The project is marginal
•The entity’s capital structure will remain
unchanged after accepting the project. This does
not refer to minor deviations in the short term, but
rather major divergences from the target capital
structure as a result of the new investment.
•The project’s systematic risk is the same as the
systematic risk of the entity’s existing operations.

46. Cost of capital
•Costof different sourcesof financingthatentityuses:
•Costof equity
•Costof preferenceshares
•Costof debt
•Principles
•Usemarketvalues
•Remembertheeffectof tax
•Usenominalrates

47. Cost of components of capital
WeightCost Weigthed cost
Equity 50% 20% 10.0%
Long-term debt 30% 9% 2.7%
Preference shares 20% 12% 2.4%
15.1%

49. Cost of debt
•Return expected by creditors
•Interest is tax-deductible –therefore use after
tax cost of debt:
•Sources:
–Long-term loans
–Debentures
–Permanent short term financing
K
d= I (1 –t)

50. Cost of Debt
•Cost of non-redeemable debt
•Taking tax into consideration

51. Cost of Debt
Cost of non-redeemable debt:
ABC has got 2.2 million non-redeemable 11%, R100
debentures. Similar debentures currently trade in
the market at R90 per debenture. Tax is 28%.
Kd= 11 / 90
= 12.22 *0.72
= 8.8%

52. Cost of debt
Cost of redeemable debt
•PV calculation
•Take tax into account

53. Cost of debt
Cost of redeemable debt:
ABC has got 2.2 million redeemable 11%, R100 debentures. Debentures are redeemable
at par value in 4 years. Similar debentures currently trade in the market at R90 per
debenture. Tax is 28%.
FV = 100 INTEREST is tax deductible, therefore
N = 4 AFTER TAX cost of debt!!!!!!
Pmt= (100 * 11%) = 11
PV = -90
Comp I = 14.46%
Can be redeemed at a discount
or a premium!!
AFTER tax = 14.46 * 0.72 = 10.41%

55. Cost of preference shares
•Rate required by investors in preference shares
•Dividends paid at the coupon rate of par value
of preference shares
•Calculation similar to debentures except for
dividends not deductible for tax, therefore use
pre-tax rate.

57. Cost of equity
•The required return expected by ordinary
shareholders
•Twomethodstocalculate:
Gordon’s growth model Capitalasset pricing model (CAPM)
Dividend growthmodel
(Gordon’sdividend growth
model) (manipulateformulato
isolate cost)
Ke = Rf+ (Market rate –Rfrate)

58. •Dividend growth model:
2 scenarios:
-Dividend stays constant
-Dividends grows at constant rate
Ke = D1 + growth rate
Vo
Cost of equity

59. Growthrate (g)
•Calculategrowthrate by usinghistorical
information.
•Itcanbegivenoritcanbecalculated.
Cost of equity

60. Growthrate (g)
•Example:
•A Companyhasthefollowingafter-taxearnings
fortheprevious5 years:
Year After-tax earnings
2006 1200 300
2007 1323 931
2008 1455 265
2009 1601 373
2010 1765 033
Cost of equity

61. Growthrate (g)
•Iftheannualgrowthis calculated, itwillbeas
follows:
Year Growth
2006 to2007 10.30%
2007 to2008 9.92%
2008 to2009 10.03%
2009 to2010 10.22%
Formula: (New –Old)/Old* 100
Cost of equity

62. Growthrate (g)
G can be determined in two ways:
Average:
(10.30 + 9.92 + 10.03 + 10.22) / 4 = 10.12%
OR
Compounded growth:
PV 1200 300
FV 1765 033
N 4
COMPi
Also 10.12%.
Notalwaysthesame.
Cost of equity

63. Capitalassetpricingmodel:
•Remembermarketpremium= (marketrate –
risk-freerate)
Cost = Risk-free rate + (Market rate –Risk-free rate)
Or in short:
Ke = Rf + (Rm –Rf)
Cost of equity

64. Risk free rate
•https://www.resbank.co.za/Research/Rates/Page
s/CurrentMarketRates.aspx

65. Beta
•Beta = 1 –Risk similar to market
•Beta < 1 –Less risk than market
•Beta > 1 –Higher risk than market
http://www.investing.com/equities/woolworths-
limited

66. Effect of flotation costs
•Companies often make use of outside parties
when issuing new finance.
•These services are not free and the costs paid to
the outside party reduce the amount that the
company receives from issuing new debt.
•This increases the effective cost of financing.

67. Effect of flotation costs
A wants toissue11% debenturesatR100 each. Current
marketvalueof R90. Flotationcostof 1%.
NormalMW = 90 but* 99% willbereceived
89.10
Kd= Pmt/ market
= (11% * 100) / 89.10
= 12.35 * 0.72
= 8.89%

68. WACC calculation
•StepstocalculateWACC:
a)Calculatethecostof thevariouscomponents
b)Determinetheweightof eachcomponent:
1. Optimalcapitalstructure
2. Market values
c)CalculateWACC ax b

69. Question
•Company Z

70. Homework and Preparation
•Class test 2: 2017 (2.1) adjusted
•Class test 1: 2012
Tutorial question:
•Flinstone crushers (flotation cost)
•Company A
•Prepare for SU 3
•Efundi test (WACC): 11 Feb 22:00
•Efundi test (SU3): 11 Feb 22:00