• Internal Code :
  • Subject Code : BB831
  • University : Open University
  • Subject Name : Corporate Finance

Corporate Finance

Contents

PART A..

Question a) WACC..

Question b) i: Cost of Debt (Kd):- 

Question b) ii: Cost of Equity (Ke):- 

Question b) iii: Capital Structure. 

Question b) iv: WACC.. 

Question b) v: Comments on health of business. 

Part B: Q2. 

Question 1: Price to Book value. 

Question 2: Price to Equity value. 

Question 3: EV/ EBITDA.. 

Question 4: EV/ Sales. 

Question 5: Market Multiples. 

Question 6: Negative PE ratio. 

Question 7: Significance of EV/EBITDA.. 

Part B: Q3. 

Question 1: Operating Cash Flow.. 

Question 2: Terminal Cash Flow.. 

Question 3: Enterprise Value. 

Question 4: Interpretation of Enterprise Value. 

Part B: Q4. 

Question 1 to 3: Price of the bond @ YTM 6%, 7% and 6.5%.. 

Question 4: Price of the bond, one year left for maturity. 

Question 5: price of the bond right before the final coupon payment 

Question 6: price of the bond after the final coupon payment 

Question 7: price yield curve. 

Reference. 

PART A

Question a) WACC

Companies raise funds from various sources to do their respective businesses which, mainly comprises of two major components including equity and debt. Both equity holders and lenders expect a definite return against the funds (money) or capital they have provided. This return that is expected by the financers is the cost (of capital) to the company (or business) which is required to be returned to debt holders and to shareholders. WACC basically is the average return that both of these financers are expecting from the company. It represents represent the opportunity cost of the risk that the investors (including both equity and debt) takes by putting their money into a business (El Ghoul et al. 2018).

Hurdle rate is basically the minimum acceptable rate of return (MARR) on an investment or on a project as required by the investors. It helps businesses in making crucial decisions about whether to pursue a specific project or not. Now WACC is generally used as the hurdle rate while project appraisal because for the company, it is the minimum return that company must earn so as to return back to the investors.

Question b) i: Cost of Debt (Kd):-

= > Kd = 6.5 %

Question b) ii: Cost of Equity (Ke):-

Ke as per CAPM is given by

Where:

  • Rf = risk free rate of return

  • β = Beta

  • Rm – Rf = Risk premium

Given:

  • Rf = 6%

  • β = 0.91

  • Risk premium = 4%

Therefore,

=> Ke = 9.64 %

Question b) iii: Capital Structure

Capital Structure

 Amounts

Total Equity

98359

Total Debt

83790

Total Capital

182149

Capital elements

Weights

% of equity

54%

% of debt

46%

Question b) iv: WACC

Costs of capital:

Ke = 9.64%

Kd = 6.5%

Weights:

We = 54%

Wd = 46%

Tax rate = 25%

=>

=> WACC = 7.5 %

Question b) v: Comments on health of business

The cost of debt (or Kd) is the fixed cost that the business has to pay back to the lender in addition to the principal amount. Kd (as calculated) of Bharti Airtel Ltd. is 6.5% whereas the risk free rate is 6.0%, the difference is just of 50 basis points. In other words the company has a very lower cost of debt. That means lower fixed cost obligations and fewer burdens on liquid asset pools (Frank and Shen 2016).

The cost of equity (or Ke) is the required rate of return that the equity investors expect against purchasing shareholding in the company. The Ke of Bharti Airtel Ltd is 9.64 % with a beta (measure of systematic risk) of 0.91 (close to 1), that means the stock of Bharti Airtel is expect to be same as volatile as the market and will be able to generate similar returns as that of market. The Ke of 9.64% with a beta of 0.91 can be considered to be steadier rather than volatile 

Cost of capital (or WACC) represents a hurdle rate (or MARR) that a company must overcome before starting to start generating some value. The WACC of Bharti Airtel is 7.5% which is due to lower Kd with approx half of financing from debt. The company also has a lower WACC than the average industry WACC of 10%. This indicates that company will start generating value very early after overcoming the hurdle rate (El Ghoul et al. 2018).

Part B: Q2

Given:

Share price on 29 Mar‘19 (per share)

305.6

No. of shares outstanding

545.325

Question 1: Price to Book value

Total Non-current assets

202165

Total Current assets

20520

Total Assets

222685

Total Non-current liabilities

63863

Total Current liabilities

60463

Total Liabilities

124326

(Dergiades, Milas and Panagiotidis 2020)

Book value = Total assets – Total liabilities

=> Book value = 98359

Book Value per share = Book value/ No. of shares outstanding

=> Book Value per share (BVPS) = 180.37

PB ratio = Market price / BVPS

=> PB ratio = 1.7

Question 2: Price to Equity value

Profit/Loss for the Period (Net income) = -1829

EPS = Net income/ No. of shares outstanding

=> -1829/545.325

=> EPS = -3.35

PE ratio = Market price per share/ EPS

=> 305.6/ -3.35

=>PE ratio = -91.1

Question 3: EV/ EBITDA

EBITDA:

 

Total Revenue

49858.7

Less:

Purchase Of Stock-In Trade

0

Operating And Direct Expenses

29245.1

Employee Benefit Expenses

1471

EBITDA

19142.6

EV

 

Market Cap

166651

Add: Total Debt

83790

Less Cash and cash equivalents

219

EV

250222

(Dergiades, Milas and Panagiotidis 2020)

=> EV/EBITDA = 13.07

Question 4: EV/ Sales

=> EV/Sales = 5.02

Question 5: Market Multiples

Market multiples are financial measurement tools that helps in quantifying the values of a company. However, these types of valuation metrics are generally not used in isolation but while comparing a company with another. E.g. the PE ratio of SBI of 9.81 (Yahoo Finance) alone provides very less material information about the valuation of the company, but when it is compared with the PE ratio of HDFC Bank of 17.75, it can be said that to claim a single rupee of earnings stock of SBI is cheaper than HDFC.

Accounting ratios determines the financial health and periodical performance of the company while valuation ratios provide value to the company on the basis of such health and performance. Valuation ratios include and uses market related for various ratio calculations data (Dergiades, Milas and Panagiotidis 2020).

Question 6: Negative PE ratio

The PE ratio determines the value that investors are willing to pay per share on the basis of its past periodical (annual) earnings. However, a negative PE ratio for a stock is possible and indicates that EPS, or earnings of the company remain negative in other words the company reported a net loss.

The PE ratio in terms that investors are willing to receive money against purchasing Bharti Airtel’s shares will not be an accurate interpretation, but still PE ratio can determine various material information if comparative analysis is done. The PE ratio of current year can be compared with previous year’s ratio, if the company is continuously showing negative PE values, and then there are possibilities of bankruptcy. In telecom and tech companies, it is not uncommon that companies shows negative PEs, therefore, it is required to compare PE of Bharti Airtel with other telecom players (Dergiades, Milas and Panagiotidis 2020).

Question 7: Significance of EV/EBITDA

EV/EBITDA compares Enterprise Value (EV) of a company with its Earnings before Interest, Tax, and Depreciation & Amortization (EBITDA). The ratio is typically used as a valuation tool to “compare the relative values” of businesses. It determines the amount in EBBITDA times that investors needs to pay to acquire the overall business. A low EV/ EBITDA value is generally preferred.

This is a popular relative valuation tool and in order to value a business, the ratio of the company is compare with the industry average. E.g. the EV/ EBITDA measure of Bharti Airtel (as calculated) was 13, now if the industry average is less than 13, then the stock is over values and vice versa. The metric is also used in calculating the terminal value in a Discounted Cash Flow DCF model (Dergiades, Milas and Panagiotidis 2020).

Part B: Q3

Question 1: Operating Cash Flow

 

2019

2020

2021

2022

2023

2024

Revenue

50,000,000

55,000,000

60,500,000

66,550,000

73,205,000

80,525,500

Expenses

25,000,000

27,500,000

30,250,000

33,275,000

36,602,500

40,262,750

EBITDA

25,000,000

27,500,000

30,250,000

33,275,000

36,602,500

40,262,750

Depreciation

20,000,000

15,000,000

11,250,000

8,437,500

6,328,125

4,746,094

EBIT

5,000,000

12,500,000

19,000,000

24,837,500

30,274,375

35,516,656

Tax expenses

1,500,000

3,750,000

5,700,000

7,451,250

9,082,313

10,654,997

NOPAT

3,500,000

8,750,000

13,300,000

17,386,250

21,192,063

24,861,659

Add: Depreciation

20,000,000

15,000,000

11,250,000

8,437,500

6,328,125

4,746,094

Less: Increase in WC

10,000,000

10,000,000

10,000,000

10,000,000

10,000,000

10,000,000

Operating Cash Flow

13,500,000

13,750,000

14,550,000

15,823,750

17,520,188

19,607,753

(Miles and Van Clieaf 2017)

Question 2: Terminal Cash Flow

Terminal Value = Rs. 168,299,881

Question 3: Enterprise Value

 

2019

2020

2021

2022

2023

2024

PERPETUITY

WACC

15.00%

           

YEARS

 

1

2

3

4

5

 

Discount Factor

 

0.870

0.756

0.658

0.572

0.497

 

OCF (PV)

 

11,956,522

11,001,890

10,404,372

10,017,224

9,748,519

83,674,785

PV for 1-5 year

53,128,527

sum of PV

PV for terminal value

83,674,785

perpetuity growth

Total PV

136,803,313

(sum of PV) + (perpetuity growth

net debt level

-

 

Enterprise Value

136,803,313

total PV - net debt level

 

2019

2020

2021

2022

2023

2024

PERPETUITY

WACC

15.00%

           

YEARS

 

1

2

3

4

5

 

Discount Factor

 

0.870

0.756

0.658

0.572

0.497

 

OCF (PV)

 

11,956,522

11,001,890

10,404,372

10,017,224

9,748,519

83,674,785

 Question 4: Interpretation of Enterprise Value

Enterprise value (or EV) determines the total value of a company, which is often considered to be a more comprehensive or all-inclusive substitute of equity market capitalization (Market Cap). EV includes the market capitalization of a company in its calculation along with company’s long-term debt and short-term as well as the cash pools on the balance sheet (Behr, Mielcarz and Osiichuk 2018).

The EV computed above basically represents the economic value of the company which comes out to be Rs. 136,803,313(or approx. 137 million). During a potential takeover, the enterprise value can be considered to be the minimum amount that acquirer company have to pay to the host company (the company for which EV is calculated). If this is a public listed company, the price per share of the stocks of the company can be calculated by dividing the EV by outstanding number of shares. Thus the financial manager can identify, whether the stock is overvalued or undervalued (or rightly valued).

Part B: Q4

Calculation of bond price using excel function of present Value (= PV)

Function = PV (YTM, N, PMT, FV)

Where:-

  • YTM = yield to maturity
  • N = no. of periods
  • PMT = Periodical Payments
  • FV = face value

Question 1 to 3: Price of the bond @ YTM 6%, 7% and 6.5%

Given

Government Bonds

   

10-year Government of India bond (G-Sec)

Face Value

1000

 

Semiannual Coupon Rate

6.50%

 

Period left till maturity

7

 
 

Q1

Q2

Q3

YTM

6%

7%

6.50%

N

14

14

14

PMT

32.5

32.5

32.5

FV

1000

1000

1000

PV

$1,028.24

$972.70

$1,000.00

(Thomas, Madhanagopal and Ghosh 2017)

Question 4: Price of the bond, one year left for maturity

Government Bonds

   

10-year Government of India bond (G-Sec)

Face Value

1000

 

Semiannual Coupon Rate

6.50%

 

Period left till maturity

1

 

YTM

6%

7%

6.50%

N

2

2

2

PMT

32.5

32.5

32.5

FV

1000

1000

1000

PV

$1,004.78

$995.25

$1,000.00

Question 5: price of the bond right before the final coupon payment

The Price right before the final coupon payment will be the price (clean price) before 6 months including the accrued interest for the 6 months. That means when one wants to sell the bond right before the coupon payment will get the bond price at that date and the 6 months accrued interest which is basically called the dirty price (Dong, Korobenko and Deniz Sezer 2020).

The clean price of the bonds before 6 months is:-

YTM

6%

7%

6.50%

N

1

1

1

PMT

32.5

32.5

32.5

FV

1000

1000

1000

PV

$1,002.43

$997.58

$1,000.00

The accrued interest for the 6 months period is 32.5 for each bond and the dirty price is given by:-

Dirty price = Clean price + accrued interest

Therefore, the required (dirty) price is as follows:-

Question 6: price of the bond after the final coupon payment

The price of the bond as the final coupon payment is being paid is the clean price when the period remaining for the maturity is 6 months. The clean price is given as follows:-

YTM

6%

7%

6.50%

N

1

1

1

PMT

32.5

32.5

32.5

FV

1000

1000

1000

PV

$1,002.43

$997.58

$1,000.00

(Dong, Korobenko and Deniz Sezer 2020)

Question 7: price yield curve

(Thomas, Madhanagopal and Ghosh 2017)

It can be clearly observed from the above graph that the price is inversely related to the yield of the bond (or YTM). As yield is increasing from 6% to 7%, the price of the bond is continuously decreasing. The price-yield curve relates the price of a coupon bond to its annual yield.

The price at 6% YTM was $1028, when the YTM increases to 6.5%, the price decreased to $1000. The price gets further decreased to $973 when the YTM increases to 7%.

Reference

Behr, A., Mielcarz, P. and Osiichuk, D., 2018. Terminal value calculation in dcf valuation models: An empirical verification. e-Finanse: Financial Internet Quarterly, 14(1), pp.27-38.

Dergiades, T., Milas, C. and Panagiotidis, T., 2020. A mixed frequency approach for stock returns and valuation ratios. Economics Letters, 187, p.108861.

Dergiades, T., Milas, C. and Panagiotidis, T., 2020. A mixed frequency approach for stock returns and valuation ratios. Economics Letters, 187, p.108861.

Dong, J., Korobenko, L. and Deniz Sezer, A., 2020. A variation of Merton's corporate bond valuation model for firms with illiquid but observable assets. Quantitative Finance, 20(3), pp.483-497.

El Ghoul, S., Guedhami, O., Kim, H. and Park, K., 2018. Corporate environmental responsibility and the cost of capital: International evidence. Journal of Business Ethics, 149(2), pp.335-361.

Frank, M.Z. and Shen, T., 2016. Investment and the weighted average cost of capital. Journal of Financial Economics, 119(2), pp.300-315.

Miles, S.J. and Van Clieaf, M., 2017. Strategic fit: Key to growing enterprise value through organizational capital. Business Horizons, 60(1), pp.55-65.

Thomas, S.J., Madhanagopal, S. and Ghosh, B., 2017. Analysing Indian G-Secs with a Predictive Approach. Ushus-Journal of Business Management, 16(3), pp.39-55.

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

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