• Internal Code :
  • Subject Code : BB831
  • University : Open University
  • Subject Name : Accounting and Finance

Part A:

1.

Weighted Average Cost of Capital as the name suggests is the weighted average of the cost of each of the sources of funds for the company, so effectively this is the cost that the company pays for its funds. There are various sources through which company raises funds, some of the common sources are equity share capital, preference share capital, debt instruments, etc.

WACC is an important tool of corporate finance, used for more than one purpose, including but not limited to valuation of the company, determination of the investment decision to be taken by the company.

As explained above, since WACC is the cost of capital for the company, any project that the company undertakes should generate a return higher than or equal to the weighted average cost of capital of the company.

Thus, in the investment appraisal for projects, weighted average cost of capital is used as the discount rate for computing the present value of the cash flows that would be generated by the company and, for an investment proposal to be accepted, its return must exceed the weighted average cost of capital of the company, thus it is also known as hurdle rate for the investment appraisals. (Robbert S. Harris, 2017)

2.

a.

 

Cost of debt

Interest

5,473.30

Interest net of tax

5,473(1-0.25) =4,104.75

Total debt

58,649+25,141 = 83,790

Cost of debt (Net of tax)

4.899%

Cost of debt (Gross)

6.53%

 b.

 

Cost of Equity

Cost of equity

Risk free rate + Beta (Market premium)

Risk free rate

6%

Beta

0.91

Market premium

4%

Cost of Equity

9.64%


c. Capital structure of the company:

Particulars

Amount

% of Capital

Equity

98,359

54%

Debt

83,790

46%

 

182,149

100%

d. Overall WACC of the company = Kd(1-tax rate)*Debt /Total Capital + Ke*Equity/Total Capital

= 4.899%*46% + 9.64%*54%

= 7.46%

e. Company currently has 46% of the total capital funded through debt and still the company is able to raise capital at a weighted average cost of 7.46%. Whereas the weighted average cost of capital for industry on average is 10%, this implies that the company has been able to raise funds at the cost of capital lower than the industry average, which indicates that the financial position of the company is strong and the lenders or providers of the capital assumes lower risk in the company as compared to the industry.

Part B:

Q2.

a.

Particulars

Values

Market price of share (A)

305.6

Net Assets (B)

98,359

Number of shares (C)

545.325

Book value per share (B/C) (D)

180.368

Price to book ratio (A/D)

1.694

b.

Particulars

Values

Market price of share (A)

305.6

Total profits (B)

-1,829

Number of shares (C)

545.325

Earnings per share (D)

-3.354

Price earnings ratio (A/D)

-91.12

 

Since the company has incurred a loss in the current year, the price earnings ratio is showing haphazard results and doesn’t give the inputs as to whether the stock price of the company is under-valued, over-valued or valued at par.

c.

Particulars

Values

Number of shares (A)

545.325

Market price per share (B)

305.6

Market capitalization (A*B) (C)

166,651.32

Outstanding debt (D)

58,649

Cash and cash equivalents (E)

219

Enterprise value (C+D-E)

225,081

EBITDA (Note-1)

15,357.20

EV/EBITDA

14.654

EV/EBITDA = Enterprise Value/EBITDA

Note-1

EBITDA = Profit before taxes + Interest + Depreciation and amortization

= Rs. (-5,203.7+5473.3+15087.6)

= Rs. 15,357.20

d.

Particulars

Values

Enterprise value (A)

250,222

Sales (B)

49,858.70

EV/Sales (A/B)

5.02

e. Markets are expected to reflect the true value of a company, the price at which the stock of a company trades in the market, is the fair value of the stock, irrespective of what is shown in the books of accounts. Thus, market multiples are used widely for the valuation of a Company.

The accounting ratios studies in the last chapter reflects the value of the stock based on the amounts recorded in the accounting books, which represents historical data related to the company. Whereas, on the other hand, market multiples of a company represents the forward looking data, that markets have discounted in the prices of the shares.

f. Price earnings ratio is the ratio of price of the share to the earnings per share of the company. It provides the multiple, which the share of the company trades at, as compared to the earnings of the company.

Since Bharti Airtel had incurred a loss in the current financial year and hence the ratio as computed above is not presenting the correct picture. Thus, the PE ratio of Bharti Airtel cannot be said to be the meaningful estimate of the market multiple, as based on the price earnings ratio computed for the company, the price of the company’s share cannot be estimated, as the PE ratio is a negative number and price cannot be computed using a negative number.

g. Enterprise value if the total worth of an enterprise from the perspective of providers of finance, it is sum of market capitalization of the company and debt component in the capital structure of the company, as reduced by the balance of cash and cash equivalents held by the company.

EBITDA on the other hand is the amount of earnings of the company before accounting for any expense relating to the providers of the capital.

Thus, EV/EBITDA multiple is an indication of number of years that it will take for the company to be able to generate wealth equal to the capital deployed. It can also be said to be a measure of how many times of the EBITDA is the company valued.

Ques 3

a. Computation of operating cash flows during the forecast period:

Particulars

2019

2020

2021

2022

2023

Revenues

50.0

55.0

60.5

66.6

73.2

Less: Expenses

(25.0)

(27.5)

(30.3)

(33.3)

(36.6)

 

25.0

27.5

30.3

33.3

36.6

Depreciation

(20)

(20)

(20)

(20)

(20)

Profit before tax

5.0

7.5

10.3

13.3

16.6

Less: Tax

(1.50)

(2.25)

(3.08)

(3.98)

(4.98)

Profit after tax

3.5

5.3

7.2

9.3

11.6

Add: Depreciation

20

20

20

20

20

Less: Working capital

(10)

(10)

(10)

(10)

(10)

Operating Cash flows

13.5

15.3

17.2

19.3

21.6

b. Terminal cash flows for forecasted period=(Free cash flow for last forecaster period*(1+g))/(d-g)

= Rs. (21.6*(1+0.03))/ (0.15-0.03)

= Rs. 22.248/0.12

= Rs. 185.4

c. Enterprise value using cash flows generated by the entity:

Particulars

2019

2020

2021

2022

2023

Operating Cash flows

13.5

15.3

17.2

19.3

21.6

Present Value Factor @ 15%

0.87

0.76

0.66

0.57

0.50

Present value

11.74

11.53

11.29

11.03

10.75

Enterprise value = Present value of cash flows for 5 years + present value of terminal value

= (11.74+11.53+11.29+11.03+10.75) + 0.497*185.4

= 56.34+ 92.14

= 148.48 Mn

d. Enterprise value computed above is not based on the market forces or prices. It is the present value of cash flows that company will be generating over its remaining life, based on the assumptions of the management. This is value of cash flows that the firm would generate over its useful life.

If a business wants to takeover this business, enterprise value would serve as a good basis to decide the consideration that he would be willing to pay for the entity. The amount of consideration would also depend on the rate of return that the investing entity aims to earn from the entity, if it is more than 15%, the consideration would be lower and vice versa.

Answer 5:

i.

Market prices generally reflect all the historical as well future information about a stock, the markets are classified into three forms, depending on the time that the market takes to reflect the information available about a stock in the price of the stock.

Markets are categorised into three forms, based on degree to which the prices respond to the information, those are:

1. Strong Form Efficient Market Hypothesis (EMH):

Strong form of market is the one where, the market price of the stock factors in all the information about it, whether the same has been made public yet or not. For an information to be factored in, in the market price of the share, in such form of market, the information need not be available in public domain. Even if an information has been generated inside the company and is still among a closed group of people, the stock price factors in the information.

This can be better explained with the help of an example, a Company ABC Ltd., which trades in two segments, Sanitary and footwear, the company in the meeting of its board of directors decides to shut down the footwear business, as the company is not able to meet its revenue as well as profit targets in the business and a lot of capital is stuck in this business, the company would rather prefer to free up this capital and use it in the sanitary business. This decision was taken in the meeting of the board of directors of the company but the same has not been made public yet. But share price in the strong form market already reflected this information and the price of the share dropped by 25%.

As in strong form market, the information is factored in, in the price of the stock

In a strong form EMH market, it is not possible for an investor to earn abnormal gains as market price of the share would reflect the information, even before the shareholder gets to know about it.

2. Semi-Strong From EMH:

As per this school of thought, the prices of stocks in the market reflect all the publicly available information and hence it is not possible for an investor to earn abnormal gain based on publicly available information, in case an investor wants to earn abnormal gain, he can do so, only if he has access to unpublished price sensitive information about a company or if he is able to draw conclusion as to the affect that the information might have on the stock price of a particular company, before the market does.

The example to explain this form of market is, A company B Ltd., which is engaged in Information technology business, declared its quarterly results on 05th May, 2020, wherein it mentioned that though the sales volume for the past quarter has been healthy, owing to situation due to COVID-19, the company expects significant fall in sales for the next quarter.

The market price of the share would reflect this information and the share of the company would show sharp correction, as soon as the information is absorbed by the market. If an investor, concludes it even before it is understood by the market experts, he might end up earning abnormal gains.

3. Weak form EMH:

This is the form of market, wherein the prices of the shares of various companies, reflect only the historical information about a company. The best example of such market, is fundamental analysis, fundamental analysis of the information pertaining to stock, will provide an investor an overview of the operations of the company and based on that, it could be predicted that the company might outperform its peers and give higher returns in the short term.

But based on fundamental analysis, future price of the company’s share cannot be predicted. Hence, in this form of market hypothesis, it is difficult to predict future price.

If a trader wants to earn abnormal profits his strategies in all the forms of market cannot be the same, for weak form of market, the trader can use published information to conclude the direction of movement of the stock and take the trade accordingly, since published information will be reflected in the stock price at a later time, the trader will earn abnormal profit, if his time of entry was correct.

Whereas, for a trader to earn abnormal profits in the semi-strong form of market, the trader needs to get hold of the insider information, which is not yet made public and take trade accordingly, as when an information is made public, the same is reflected in the price of the stock and a trader cannot then make abnormal profit based on that information.

On the contrary, it is nearly impossible for a trader to earn abnormal profit in a strong form of market efficiency, as in that form, the information is factored in the prices, even before it is made public. Thus, in such case, a trader can trade only based on the technical charts and chances of earning news based abnormal gains are low in such form or market.

Corporate governance refers to the processes defined by the management of the company, using which the company is operated. Corporate governance refers to the good practices that a company adopts in managing the operations of a company. The company is owned by the shareholders, whereas the day to day operations and management of the company is led by the board of directors of the company.

Directors are appointed by the shareholders, to perform day to day activities of the company and also to take various crucial decisions, as are required to be taken for the operations of the company. Directors get paid in the form of salaries and share in profits generated by the company.

Aim of the company is to maximise the shareholders’ wealth, as shareholders assume highest risk in the company. Shareholders wealth will be maximised when the company is able to generate consistent profits in the longer run.

Whereas, directors’ salaries as well as the profit share is based on the profit earned by the company in the current year, thus directors are incentivised to manage the affairs of the company in such a way, that it generates lucrative profits in the shorter run, so that they can get paid more, although, the decisions taken by them might impact the long run profitability of the company, in turn affecting the share price of the company negatively.

Thus there needs to be culture, wherein the directors of the company, who are entrusted with the responsibility to manage the operations of the company should be motivated to manage it in a way so that, the ultimate objective of the company, i.e. to maximise shareholder’s wealth, is achieved. Such culture or manner of operation is called corporate governance.

ii.

Corporate governance, from the other angle, also separates the owners from the day to day decision making, as the directors or other top or middle level management is empowered to take decisions in relation to the operations of the company. This separation implies that the owners of the company can not for their own selfish motives take the decisions in a company, thus, impacting the other stakeholders, such as minority shareholders, etc.

Corporate governance ensures that the decisions of the company are focussed on the shareholders and other stakeholders of the company. There are various advantages of having corporate governance, some of them are as under:

  1. Corporate success and growth are the outcomes of good corporate governance

  2. Good corporate governance creates a good image for the company in the market, thus lowering down the cost of capital for the entity

  3. If the investors are convinced as to the fact that the company has good corporate governance, it increases their confidence in the company, making it easier for the company to raise capital.

  4. Good corporate governance also creates a brand for the company

  5. Share price of the company reacts positively to the good corporate governance decision.

  6. Good corporate governance also ensures that the company is managed in a manner that it ensures the best interest of everyone.

In companies, which lacked corporate governance, management override of control has been found to be severe issue, wherein the top level management of the company is involved in the day to day operations of the company, they are also empowered to take all the decisions for the company, in doing so, they at times take decision which are driven by selfish motive and is not beneficial for the company.

There are various examples in the Indian market, wherein the companies have failed due to lack of good corporate governance. Wherein the owners or majority stakeholders of the entity took advantage of their position and power and used the resources of the company for personal benefit, ultimately causing damage to the company.

One of the recent examples was Fortis Healthcare, wherein, the promoters of the entity, Shivinder Mohan Singh and Malvinder Mohan Singh were the owners of the group and they were also involved in the day to day operations of the company. Though, there was a board of directors and also certain independent directors on the board, but when the fraud in relation to advancing money to their related parties, arose, it was made public that such loans were approved on the influence of the promoters, implying a management override of control by the promoter.

The share price of the company as well as the operational performance of the company was impacted, as a result of such management override.

References:

ASX Corporate governance council, Corporate Governance Principles and recommendations with 2010 amendments, 2010, viewed on 21 May, 2020, available at http://ict-industry-reports.com.au/wp-content/uploads/sites/4/2013/09/2010-Corp-Governance-Principles-2010-Amendments-ASX-2010.pdf.

C Justin Robbinson, Prosper Bangawayo-Skeete, 2017, Semi-strong form of market efficiency in Stock markets with low levels of trading activity: Evidence from Stock price reaction to major national and international events, viewed on 21 May, 2020, available at https://journals.sagepub.com/doi/abs/10.1177/0972150917721768.

Dr. Kinjal Jethwani, Kumar Ramchandani, 2018, Semi Strong Form of Efficiency of Stock Market: A review of literature, viewed on 21 May, 2020, available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3193854.

Mallikarjunappa Thathaiah, Janet Dsouza, 2013, A Study of Semi-Strong Form of Market Efficiency of Indian Stock Market, viewed on 21 May, 2020, available at https://www.researchgate.net/publication/317017352_A_Study_of_Semi-Strong_Form_of_Market_Efficiency_of_Indian_Stock_Market.

Robert S.Harris, 2017, The Weighted-Average Cost of Capital, viewed on 20 May, 2020, available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2974368.

Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer, Robert Vishny, 2000, viewed on 22 May, 2020, available at https://www.sciencedirect.com/science/article/pii/S0304405X00000659.

Sanjai Bhagat, Brian Bolton, 2008, Corporate governance and firm performance, viewed on 22 May, 2020, retrieved from https://www.sciencedirect.com/science/article/pii/S0929119908000242.

Remember, at the center of any academic work, lies clarity and evidence. Should you need further assistance, do look up to our Accounting and Finance Assignment Help

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