Business Financial Planning - Evans Plc - Assignment Example

Name : xxxxxx Tutor : xxxxxx Title : Business Financial Planning Course : xxxxxx Institution : @ 2010 Q1. Redeemable debt Market value debt = 6.1m*1.065= 6,496,500 Net interest = 9(1-0.3) = 9*0.7 = 6.3% Internal rate of return: Year CF 5% PV1 10% PV2 0 106.5 1 106.5 1 106.5 1-5 -6.3 4.330 -27.29 3.790 -23.877 5 -100 0.784 -78.4 0.621 -62.1 0.81 20.523 Internal rate of return = 5 + (.81/.81-20.523) * (10-5) = 5 + (-0.041)*5 = 4.795 = 4.795% Irredeemable debt Market value debt = 2.3m*.84 = 1,932,000 Cost of debt (Kd) = 6(1-0.3)/.84 = 4.2/.84 = 5% Equity PBIT = 6,320,000 Interest (9% on 6.1m) = 549,000 Interest (6% on 2.3m) = 138,000 PBT = 5,633,000 Tax 30% = 1,689,900 PAT = 3,943,000 Profit paid as dividends = 3,943,100*0.45 = 1,774,395 No of shares = 6,600,000/250 = 2,640,000 Dividend just paid = 1,744,395/2,640,000 = 0.6722 = 67.22p Cost of Equity = 67.22 (1+0.0565)/842 + 0.0565 = 14.08% Market value of equity = 2.64*8.42 = 22,228,800 Market value of equity and debt = 6,496,500+1,932,000+22,228,800 = 30,657,300 WACC WACC = 14.08*(22,228,800/30,657,300) + 5.04*(1,932,000/30,657,300) + 4.795*(6,496,500/30,657,300) WACC = 10.209 + 0.318 + 1.016 = 11.543 WACC = 11.5% The above calculations indicate that the Evans Plc is in a better position worthwhile to undertake its business adventure. This is so because the calculations show the firms cost capital being in a position to venture into risk and competitive markets. Since the WACC of Evans Plc is 11.5 percent, 0.5 percent below the standard value, the company should engage in investments which will bring a higher rate of return which is more than 11.5 percent. Q2. If Evans Plc needs to base its future developments through the use of dividend valuation model, the management of the company must understand what the model pertains in terms of its strengths and weaknesses (Kretlow, McGuigan and Moyer 2009). Dividend valuation model which is quite traditional though popular in company analysis is referred as dividend discount model (DDM). This valuation model is simply a mathematical approach used by businessmen or the stockbrokers which helps in pricing of the share of the company in respect to its dividend value (Eakins and Mishkin 2006). This is an approach which is chiefly used by companies, for instance Evans Plc which wants to venture in new lines of business in valuing their stocks which are regarded as common by the company (Kretlow, McGuigan and Moyer 2009). Evans Plc, which is considering to venture in the game console as its new line of business, whose target market is the children’s toy, using the dividend valuation model alone will not be sufficient since the model does not put into consideration the cost of estimation of the market survey, it only deals with future gains (Eakins and Mishkin 2006). This is so because the dividend valuation model, when used in the financial theory which the case for Evans Plc, will give the present value of all future cash flow that the company is deemed to receive (Kretlow, McGuigan and Moyer 2009). The result of using the dividend valuation model will be the intrinsic value of stock (value of all future dividends discounted at the appropriate discount rate), which does not cater for the market survey and the market plan development. Evans Plc has already a WACC that is equivalent to 11.5 percent which is not fully enough to keep the company going. This method which makes valuation on common stock (the right to receive future dividends) is fully appropriate to be the only source of development for the company that has good reputation in its area of operation. This model has certain assumptions which the management of Evans Plc needs to be aware of before thinking of implementing it in its new adventure of game console (Eakins and Mishkin 2006). One of the main assumption is that the dividend value is will only be known by the investors of Evans Plc and this will exclude other stakeholders. Distribution of the dividends of the company should be conducted on an annual basis and this should be conducted to infinity. If Evans Plc only uses this model in establishing or developing of the existing business, it will mean that dividends will be the only source of the company will get money and this may not be sufficient enough to sustain the development of the company hence the inappropriateness of the dividend valuation model (Kretlow, McGuigan and Moyer 2009). Therefore these assumptions of the model portray its limitation and its inappropriateness of being solely dependent in establishing the game console, which is a new line of business for Evans Plc; this is so because the dividend valuation (discount) model has a limited practical value (Eakins and Mishkin 2006). However, Evans Plc may consider using this model alongside another one since it comes along with various strengths. The model provides room for flexibility when the company needs to estimate future dividend streams as well as giving approximations when there is oversimplification of inputs (Eakins and Mishkin 2006). The model which is deemed as traditional can be used by Evans Plc to impute market assumptions for the company’s growth and the expected return through reversing the current stock price (Kretlow, McGuigan and Moyer 2009). Q3. Book value debt: book value equity Debt/equity = 1600/(1000+500) = 1600/1500 = 1.07 = 107% Market value debt: market value equity Debt/equity = (1600*1.15)/(1000*2) =1840/2000 = 0.92 = 92% Interest Cover PBIT/Interest = 400/160 = 2.5 = 2.5 times Price/earnings ratio (using after-tax EPS) PAT/No. of Shares = 168/1000 = 0.168 = 16.8p 200/16.8 = 11.9 = 11.9 times Celtic Pharmaceutical Plc Industry Average Debt: equity (Book value) 107% 50% Debt: equity (Market value) 92% 35% Interest Cover 2.5 times 4 times Price/earnings ratio 11.9 times 15 times Book value (Debt: equity) The book value of Celtic Pharmaceutical Plc is double the industry book value average. This indicates that the company has a good net asset value that gives it a better momentum of thriving in the industry and commands a great share or become dominant (Eakins and Mishkin 2006). This indicates that if the Celtic Pharmaceutical Plc was to be liquidated today, the shareholders would receive more than their counterparts in the companies in the same industry. This gives Celtic Pharmaceutical Plc a better chance of investing more in the industry since it is in a position to woo shareholders. Market value (Debt: equity) This measures the company’s financial structure in the market in terms of its debt. The Celtic Pharmaceutical Plc has a market value that is far much higher than that of the industry and this show is long term debt over market in the competitive industry. The market value differs with book value in that it puts into consideration the future potential growth of a company (Kretlow, McGuigan and Moyer 2009). The market value of Celtic Pharmaceutical Plc compared to the rest in the industry is not undervalued and therefore the company has a greater opportunity of succeeding in future if the management wisely implements the growth prospects of the company. Interest cover The interest cover of Celtic Pharmaceutical Plc is that of the industry in the untied kingdom and this indicates that the company is not safe in advancing in the industry. Though companies with the interest cover of more than two are considered safe this is not the case with Celtic Pharmaceutical Plc since its interest cover is being compared with the larger industry in the region (Eakins and Mishkin 2006). The low interest cover of Celtic Pharmaceutical Plc which is 2.5 times indicates a greater risk of the company’s profit before interest to insufficient to cover interest payments. This can lead to bankruptcy or default of the company. Price/earnings ratio The price/earning ratio of Celtic Pharmaceutical Plc is less than that one which is prevailing in the industry. This means that the investors of Celtic Pharmaceutical Plc will expect lower earnings growth which is less than that of their counter parts in the industry. For effective use of the price/earnings ratio, Celtic Pharmaceutical Plc need to compare its ratio generally in the market, to that of its competitors as well as the companies history on price/earnings ratio (Kretlow, McGuigan and Moyer 2009). However, the price/earnings ratio should not be fully depended on since it is based on accounting practices that are subject to manipulation hence undermining its quality. Q4. Option1. = Issue 250m shares at £2 per share Option2. = Issue 50m shares at £2 per share + Issue 8% debenture stock at par with value of £400m Option 1 A B C PBIT 400+30= 430 400+120= 520 400+200= 600 Interest 0 0 0 Tax (30%) 430*0.3= 129 520*0.3= 156 600*0.3= 180 PAT 430–129= 301 520–156= 364 600–180= 420 No. of shares 250 250 250 EPS 301/250= £1.20 364/250= £1.46 420/250= £1.68 Probability 0.3 0.4 0.3 Expected EPS 1.20*0.3= 36p 1.46*0.4= 58.4p 1.68*.3= 50.4p Expected after tax earnings per share = 0.36+0.584+0.504= 144.8 = £1.45. Option 2 A B C PBIT 400+30= 430 400+120= 520 400+200= 600 Interest 400*.08= 32 400*.08= 32 400*.08= 32 PBT 430- 32= 398 520-32= 488 600-32= 568 Tax (30%) 398*0.3 = 119.4 488*0.3= 146.4 568*0.3= 170.4 PAT 398-119.4= 278.6 488-146.4= 341.6 568-170.4= 397.6 No. of shares 50 50 50 EPS 278.6/50= £5.57 341.6/50= £6.83 397.6/50= £7.95 Probability 0.3 0.4 0.3 Expected EPS 5.57*0.3= £1.67 6.83*0.4= £2.73 7.95*0.3= £2.39 Expected after tax earnings per share = 1.67+2.73+2.39 = £6.79 Q5. Option 1: Book value debt: book value equity Debt/Equity= 1600/ (1000+500+250)*1= 1750 = 1600/1750= 0.914= 91.4% Market value debt: market value equity Debt/Equity= (1600*1.15= 1840)/ (1000+250)*2= 2500 = 1840/2500= 0.736= 73.6% Interest Cover No interest cover If Celtic Pharmaceutical Plc chooses this option 1 as its financing method, the option will guarantee improvement since the option does not risk dropping the interest cover since at first is not there. Option 2: Book value debt: book value equity Debt/equity= (1600+400= 2000)/ (1500+50)*1= 1550 = 2000/1550= 1.29= 129% Market value debt: market value equity Debt/equity= (1600+400= 2000)*1.15= 2300 / (1000+50)*2= 2100 = 2300/2100= 1.095= 110% Interest Cover A = PBIT/Interest= [430/(160+32)=192] = 430/192 = 2.24 times B= PBIT/ Interest= 520/192 = 2.71 times C= PBIT/Interest = 600/192= 3.13 times Expected Value: 2.24*0.3+2.71*0.4+3.13*0.3 = Current Option 1 Option 2 Book value debt/equity 107% 91.4% 129% Market value debt/equity 92% 73.6% 110% Interest Cover 2.5 (30m Profit) 2.69 times (120m Profit) 3.25 times (200m Profit) 3.75 times (30m Profit) 2.24 times (120m Profit) 2.71 times (200m Profit) 3.13 times Earnings Per Share £0.34 £1.45 £6.79 Option 2 risks dropping interest cover whereas option 1 guarantees improvement Q6. Discount Rate [using WACC from Q1] = (1+0.115)*(1+0.07) = 1.19 = 19% Year 0 1 2 3 4 5 Machinery (3,000) Revenue 1,200 2,080 3,944 5,499 Production costs: Direct materials 58*1.1¹= (64) 120*1.1²= (145) 184*1.1³= (245) 330*1.1 4 =(483) Direct labour 150*1.07¹= (161) 270*1.07²= (309) 486*1.07³= (595) 875*1.07 4 =(1,147) Variable p. overheads 30*1.1= (33) 64*1.1²= (77) 87*1.1³= (116) 195*1.1 4 =(286) N.C.F B.T 942 1,549 2,988 3,583 Tax (30%) 942*0.3= 283 1,549*0.3= 465 2988*0.3= 896 3583*0.3= 1075 Cash Flows (3,000) 942 1,266 2,523 2,687 (1,075) D.F. 19% 1 0.840 0.706 0.593 0.498 0.418 P.V. (3,000) 791 894 1,496 1,338 (449) N.P.V. 1,070 Risk factors The company faces several risks which if not put into a careful consideration can derail the performance of the company or even its advancement in the new line of business, game console. Such risks will include; economic risk which is due to the fact that the assets of Evans Plc will react to some economic changes which occur periodically (Joehnk and Gitman 2007). This is so because during the inflationary period, and the net present value being at 1,070 and the discount rate at 19 percent, the cost increase and this causes a decline in purchasing power. A similar thing which is opposite of this will occur during times of recessions since prices decline. The other risk factor is the interest rate risk. In this case an increase or decrease in the interest rate causes significant changes in market value for the assets of the company (Crowe 1990). Evans Plc will experience the business risk since the market is not monopolistic. This risk which involves stiff competition in the market place calls for measures which are aimed at combating the competition to favour the company (Joehnk and Gitman 2007). The liquidity risk is evident in Evans Plc since the company seems not to have enough capabilities of selling its assets easily in the market. The management of Evans Plc is not very sure that all its assets will generate no tax liability and this makes the company be prone to taxation risk (Crowe 1990). Finally the market risk is usually common with all investors investing in a new line of business and Evans Plc is not exceptional. This involves the manner in which Evans Plc will strategise to ensure that the investment does not result in unpredictable ways. References 1. accessed on 2010-05-23 2. Frederic S. Mishkin, Stanley G. Eakins, 2006. 5thedition. Financial markets and institutions, Addison Wesley 3. Lawrence J. Gitman, Michael D. Joehnk. 2007. 11th edition. Personal Financial Planning, Cengage Learning 4. R. Charles Moyer, James R. McGuigan, William J. Kretlow. 2009. 11th edition. Contemporary Financial Management, Cengage Learning 5. Robert M. Crowe. 1990. Fundamentals of Financial Planning, American College Read More