Applied Finance - Coates Hire Limited - Assignment Example

Applied Valuation (E102) Assignment Answer Template Marker feedback Comment on overall performance: Begin your assignment answers from this point. Question 7: A) Coates’ revenue growth is dependent on demand for equipment rental services, and its ability to supply this demand. In turn, demand is dependent on the level of activity in construction, mining, and oil drilling; and construction, in particular, is sensitive to the overall state of the Australian economy and perceptions of future trends. (While Coates does have some presence outside Australia, the vast majority of its business is domestic.) Coates’ ability to supply increasing demand for its services will depend on its ability to acquire additional equipment, either by purchasing new equipment or by acquiring other companies with appropriate stock of equipment. B) The high growth forecasts for 2007 and 2008 assume that overall economic activity in Australia will increase, or at least remain stable; and that Coates will be able to expand its equipment-rental fleet in order to improve its market share. If the economy suffers any unexpected reversals (which could reduce the level of construction activity), or if Coates is unable to increase its fleet size fast enough, these growth forecasts will not be met. C) [I’M NOT REALLY SURE ABOUT THIS ONE – I DIDN’T SEE A CUSTOMER-INDUSTRY BREAKDOWN IN THE ANNUAL REPORT!] Sustained declines in commodity prices would reduce activity in the mining and oil sectors – and thus reduce Coates’ revenues from these sectors. Given that Coates derives most of its revenue from construction rather than resource extraction, the effect of such a decline on Coates’ revenues should be only marginal. D) While oil prices have declined since mid-2006, they remain at relatively high levels, and are unlikely to decline further – at least not for long. As a result, drilling activity should remain at a stable or increasing level. Since the oil industry represents only a small proportion of Coates’ overall business [CHECK THIS!], Coates’ overall revenue shouldn’t be affected much one way or another – barring a major interruption in oil supply or a sustained and severe increase in oil prices. E) The main reason earnings per share grew at a lower rate than after-tax profit from 2005 to 2006 is that a larger number of shares were outstanding – 249 million compared to 208 million. Question 8: [NOTE: PLEASE TREAT THIS AS VERY MUCH A FIRST DRAFT. I’D LIKE TO GET SOME CONTENT INPUT FROM YOU (PARTICULARLY “SPECIFIC EVENTS IN THE INDUSTRY”), AND INCORPORATE IT INTO A REVISED VERSION.] 1) Threat of Entry: There is no absolute barrier preventing new firms from entering the equipment-hire industry, as there are no patents, proprietary methods, or other factors allowing existing firms to offer a unique product. On the other hand, large firms may have an advantage in arranging favorable terms for purchasing and financing new equipment, and customers are likely to remain loyal to suppliers from whom they’ve received good service in the past. A firm that already has a presence throughout the target market will have an advantage over a startup, in that large customers can rely on the established firm to provide a wide range of equipment over a wide geographical area. 2) Customer Bargaining Power: Customers have a low cost of switching between suppliers of equipment rental; but on the other hand, the number of customers for equipment rental is large. Thus, customer bargaining power is moderate: customers can easily switch to a different supplier, but they cannot easily combine forces to bargain as a collective. 3) Supplier Bargaining Power: There are a number of different firms providing the various types of equipment that make up a rental fleet, although the competition between suppliers may be relatively limited for more specialized items. Overall, supplier bargaining power should be relatively low. 4) Threat of Substitutes: While large construction firms can purchase their own equipment and use it efficiently, many smaller firms would not be able to do so. There is no practical substitute for proper equipment; labor costs I a developed economy like Australia’s are simply too high to use more workers as a substitute for inadequate tools and equipment. 5) Competitive Rivalry: The above items all factor into the overall assessment of competitive rivalry. Thus, we have moderate ease of entry into the equipment-hire business; moderate customer bargaining power; low supplier-bargaining power; and a low threat of substitutes. Since any given piece of equipment can be hired out at most 100% of the time, there is a limit to the amount of business any given firm can do; assuming that a firm is operating at or near capacity, the only way to expand the business is to purchase more equipment. Equipment-rental firms are thus likely to cut prices only when they are operating at significantly less than full capacity; and even then, they are not likely to cut prices to a level that would be inadequate to cover depreciation of their equipment fleet through use. At the same time, customer loyalty, reputation, and other good-will factors will not be sufficient to raise prices significantly above those of the competition. At least in stable times, rivalry in this industry should be significant but not extreme. Question 9: A. SWOT Analysis: Strengths: Coates is the leading provider of equipment-hire services in Australia, with a good reputation and a strong record of sales and profit growth. Its 200 branches cover all of Australia, and it has a wide range of equipment offerings. Weaknesses: While Coates has created an overseas presence (in Indonesia, Great Britain, and New Zealand), the vast majority of its business is still in Australia. Accordingly, the firm is highly exposed to fluctuations in the Australian business climate. Opportunities: Even though Coates is the largest equipment-hire firm in Australia, it still accounts for only twenty percent of the Australian market for equipment-hire services. Thus there is considerable room for growth in Coates’ Australian market share, as well as in Coates’ international presence. Threats: Coates serves industries that are strongly future-based – that is, the level of activity in construction and mining reflects expectations of future demand for structures and resources. This means that these sectors can fluctuate more strongly than the actual state of the economy would predict; and thus Coates can be subject to “boom and bust” fluctuations. International diversification can reduce this threat, but operating in multiple countries brings on its own set of difficulties and uncertainties. B. i) Increased public concern about the environmental impact of resource extraction and large-scale construction could put a damper on the mining and building industries, respectively. Increased regulatory burden – for example, the need for lengthier environmental-impact approval procedures for projects – could reduce the overall level of activity in both sectors, and thus reduce demand for Coates’ services. ii) Changes in Australia’s birth rate (which, in turn, can be affected in part by government policy) and the net immigration rate (of which the main limiting factor is government regulation) would alter the rate of population growth, and thus, over time, would alter the demand for housing as well as for commercial and industrial construction. C. i) The fact that Coates’ asset beta is greater than 1 indicates that Coates’ business is more subject to economic fluctuations than the overall market. Given the firm’s gearing, the effective sensitivity of Coates’ stock to economic fluctuations is approximately 50% greater than that of the overall market. ii) In general, Coates’ results are likely to fluctuate more strongly than the economy as a whole – although given the forward-looking nature of many of the businesses that demand Coates’ services, an economic contraction that is expected to be only mild and short-lived might not have a significant impact. On the other hand, a general expectation of a significant and protracted contraction could strongly hurt Coates’ profitability even if the contraction turns out to be less severe than expected. Question 10: A) According to the assumptions given, the acquisition has a positive NPV of $65.150 million at high discount rate, and $101.802 million at low discount rate. Accordingly, Coates should proceed with the acquisition – assuming, of course, that no better acquisition opportunities exist. B) i. If Coates had to spend an additional $150 million over the first three years to upgrade the hire equipment of the acquired company, the NPV of the acquisition-related cash flows would be negative rather than positive – and thus the acquisition would no longer be a good idea for Coates. The revised NPV would be ($19.7 million) at low discount rate, and ($55.3 million) at high discount rate. (See worksheet Bolt_On_FO (2).) ii. If the competitor to be acquired had $80 million of tax-loss benefits at the date of acquisition, the NPV of the acquisition-related cash flows would increase – since the acquired company would pay no income tax for the first four years after the acquisition, and significantly reduced income tax in the fifth year. The revised NPV’s are $160 million at low discount rate, and $122.6 million at high discount rate – increased by 57% and 88%, respectively. (See worksheet Bolt_On_FO (3).) C) i. Companies undertake share buybacks for several reasons, some better than others. If a company has excess cash, it can invest it in expanding its business – either by investing in new plant, equipment, and staff, or else by acquiring another company. On the other hand, if the company’s management feels that its own stock is significantly undervalued, they may decide that buying back some of the outstanding stock – and thus increasing the value per share of the remaining outstanding shares – will benefit the remaining shareholders more than any other available investment opportunity. On the other hand, management may decide to repurchase shares not because they represent an undervalued investment, but simply in order to prop up the company’s share price. If, for example, Coates’ value per share is less than $6.00, buying back shares at $6.00 decreases the value of the remaining shares even though it will likely increase their market value in the short run. ii. 1. Assuming Coates has 250 million shares of stock outstanding, and after-tax net profit of $175 million for 2008, a buyback of 20 million shares would reduce the stock float to 230 million shares, and increase after-tax earnings per share by 8.7%, from $.70 to $.76. (Note that this calculation does not account for the impact on earnings of the additional borrowing to fund the buyback.) ii. 2. Since Coates’ cost of ordinary equity is higher than its cost of debt (13.2% to 13.8%, compared with after-tax borrowing cost of 5.3%), and since the buyback will increase the firm’s gearing, this share buyback will reduce Coates’ weighted average cost of capital and thus increase the NPV of future cash flows. Read More