Corporate Finance

Introduction to Mastering Cash Flow and Valuation Modelling

This report has been carried out for the purpose of examining the financial strength of a public listed company. In this context, it has primarily conducted shareholder analysis of the company that mainly involves examining its owners and the methods that are used by it for assessing the cost of return. This is followed by conducting a risk-return analysis that primarily involves analyzing the return received by the company ion context of the identified market risks. Also, it includes a section in regards to determining the cost of the capital of the company with the use of different methods and presenting an analysis of the findings developed. The last section is about carrying out the financial statement analysis of the company for determining its future performance. The company selected for the analysis purpose is Ramsay Health care, that is an ASX listed company operating within the healthcare sector of Australia.

Summary of the Business

Ramsay Health Care is known to be a leading provider of health care services having its major operations within the UK, Australia and other parts of the world. The company has been established within Australia in the year 1964 and is specialized in provide surgery, rehabilitation and psychiatric care services. It is known to be a recognized global health care company that has reputation of providing high quality patient care services. The company at present is known to provide wide range of acute and primary healthcare services in about 480 facilities across 11 countries. It has become one of the largest and most diverse healthcare companies in the world. It provides employs about 80,000 staff and gives treatment to approximately 9 million patients within hospitals and primary care clinics across the world (Ramsay Health Care, 2020). It complies adequately with the highest standards of quality and safety to protect the interests and welfare of the patients.

The company operates about 73 hospitals within Australia and in the UK it has a network of over 30 acute hospitals and day procedure centers. It provides a wide range of clinical specialists to private and self-insured patients. In addition to this, the company also operates diagnostic and neurological services (IBIS World, 2020). It has developed a unique culture and recognized the staff and doctors as the most important asset responsible for the success of the company. It possesses an excellent record in providing high quality patient care through continuing its focus on the improvements that helps in giving excellent health care services. Ramsay Health Care mainly intends to provide private hospital services such as psychiatric care, surgery and rehabilitation services. The health care services provided by the company are delivered to both public and private patients Ramsay Health Care: Annual Report, 2019).

Chairmen/Director Message

As per the chairman’s message stated within the annual report of the company, it has been depicted that the company is presently in a good position in terms of growth. Its recent acquisition of a European healthcare company of Capio has enabled it to become one of the largest private health care operators in the world. The company is recording an increase in the profitability position and has depicted a rise of about 2% in the net profit as compared with the previous financial year. It has also been analyzed that the company is making a strategic investment in expanding its network in Europe through its acquisition strategies. In addition to this, the company is also aiming towards expanding its business through fostering continued investment in the hospitals and as such has completed about 16 capacity expansion projects within Australia. It is also committed to invest a further amount of $244million to support the growth in the future projects and fostering its long-term development (Ramsay Health Care: Annual Report, 2019).

Part 2: Risk-Return Analysis

  1. Review of Listed Risk

Risk analysis of an entity is important for estimating the possibility of its survival in the market. An entity has several types of risks that should be appraised efficiently for assessing the survival risk of the entity. Ramsay Health Care Limited has several risk factors including credit risk, interest rate risk, exchange rate risk, and others. The analysis of all kinds of risks efficiently will help to understand the risk and return relationship for estimating the worth of the company.

Credit Risk: RHC has an issue of credit risk, which can be arisen from the potential failure of counterparties regarding fulfilling their obligations at the maturity of financial derivatives contracts. The failure of credit risk will restrict gains from derivatives cause a significant loss to the company. However, the management of RHC monitors the fair value of all contracts for protecting the interests of the company. The management of the company deals in the prime financial institutions with sound credit ratings to avoid credit risk. The credit risk level of the company is significant, but the management of the company is effective for controlling its credit risk by considering only high credit rating entities for the purposes (RHC, 2020).

Interest Rate Risk: RHC has an issue of interest rate risk, which has a potential impact on the company’s financial instruments because of a change in market interest rates. The financial instruments concerning the company have a potential impact of change in market interest rates that means a loss can be caused to the company due to adverse change in the market interest rates. The long-term debt has interest rates, which is affected by the change in the market interest rates. The company has a huge amount of long-term debt that incurs interest costs to the company and if there is an increase in the market interest rates, it will cause a huge burden of interest costs on the company. It will lower overall profitability and ultimately this impact can be seen in the downfall in the market price. The company has the main source of market interest rates risk in the form of floating interest rates in debt funding. RHC is effective for controlling the adverse impact of change in interest rates in the market for ensuring a high profitability performance by keeping financial costs at a low level over the period (RHC, 2020).

Foreign Currency Risk: Foreign currency risk is also one of the main risks for the company to cause failure if this risk is not monitored effectively. This risk is caused by a change in exchange rates unfavorably. The adverse change in exchange rates will cause low cash inflows from sales receipts while increased cost of payments for expenses. A significant portion of revenue is generated in foreign currencies and the change in foreign exchanges causes a huge risk to the survival of the company. This risk can affect the cash flow statement for providing adequate operating cash inflows for covering expenses. The company has a high risk of changes in foreign exchange rates but the management of the company is effective by taking foreign currency swaps and forwards to avoid a potential impact of exchange rate fluctuations. RHC is effective for managing its foreign exchange risk by considering possible fluctuation in the exchange rates and respective hedging instruments. The company is interested in covering its major portion of foreign exchange with the forward contracts for ensuring static cash inflows for maintaining high profitability status over the period (RHC, 2020).

  1. Evidence of Risk

The risk and return analysis of RHC needs analysis of market price performance as it is an important part of return analysis with the risk level. The market price of the company’s common shares reflects all valuable information for affecting its return and risk level over the period. For analysis of the return and risk level of the company and the market, the prices are taken for three years starting from July 2016 and ending with June 2019. The collected data over the period is sufficient for finding the return performance of the company (Yahoo Finance, 2020).

RHC has a fluctuated trend in return that reflects ups and downs in the market performance. The market price performance of RHC’s common shares is on upward movement in the recent periods that presents an improved performance in the present scenario. The market performance is higher than that of the company as the market has less fluctuation as compared to the company that indicates a better position of the market against the company. Over the recent three years, the company has an overall reduction in its market price level that reflects a slight downfall in the market price performance whereas the market has improving trend overall over the recent three years. Hence, the return performance of the company has fallen over the considered period (Yahoo Finance, 2020).

  1. Shareholder Returns

Particulars

RHC

All ORD

Average Monthly Return

-0.11%

0.52%

Standard Deviation Monthly

5.38%

2.52%

Average Return Annually

-1.28%

6.44%

Standard Deviation Annually

18.65%

8.71%

The monthly average return is -0.11% in the case of RHC whereas All ORD has a monthly average return of 0.52%, which indicates the poor performance of RHC whereas the high performance of the market. The monthly standard deviation of RHC is 5.38% showing high variability in the market price whereas the monthly standard deviation of All ORD is 2.52%, which indicates a reasonable risk of the market. However, the comparative analysis of the standard deviation of the market and the company provides a lower risk level of the market against the company. The company has a high risk whereas the market has a low risk. The annual average return is -1.28%with an annual standard deviation of 18.65%, which assets high variability with low return. All ORD has an annual return of 6.44% with a standard deviation of 8.71%, which indicates low variability to the return performance of the market. The market has a lower risk against high return while the company has a high risk against the low return (Yahoo Finance, 2020). Therefore, the market return states that the company has reduced its market price performance resulting in the downfall in the return performance over the period.

Franking Credit = ((Dividend Amount / (1 − Company Tax Rate)) − Dividend Amount) × Franking Proportion

Franking Credit = ((1.465 / (1 −30%)) – 1.465) × 100%

Franking Credit = 0.628

Gross up dividend = Franked dividend + Franking credit

Gross up dividend = 1.465 + 0.628 = $2.093

Total return for year 2018/2019 will be as per below calculations:

Selling price = $72.24

Buying price = $56.24

Capital gain/loss = $72.24 - $56.24 = 16

Total income = 16+2.093 = 18.093

Return = 18.093/56.24×100 = 32.17%

Therefore, the total returns for the shareholder in one year are 32.17%.

  1. Review of Capital Projects

Brownfield Capacity Expansion capital project has cash outflows of $244 million with the expectation of cash inflows of around $2 billion over 10 years’ life of the project. However, there can be a possibility of some fluctuation in estimated cash inflows over the life of the project, which can change the outcomes of the project slightly. The project has low risk as highly expected for success to support the growth of the company’s business. The project has low risk so the expected return to shareholders is also low for investment decision purposes (RHC, 2020).

Part 3: Cost of Capital

  1. CAPM: Cost of Equity

The company's cost of capital includes both costs of debt and the cost of equity. The cost of debt is easy to determine because of the fixed interest rate and tax rate while the cost of equity is quite difficult. A dividend can be taken as the base of cost of equity but it cannot be taken as an adequate base for estimation of the dividend because all earnings cannot be distributed to common shareholders that means the cost of equity cannot be based reliability on dividend for the purpose (RHC, 2020).

The cost of equity can be estimated based on the Capital Asset Pricing Method, which is an essential method for estimating the cost of equity adequately. The CAPM considers beta as the instrument for assessing return level. The beta is capable of evaluating the risk of the company and the return is justified based on the risk level of the company. The comparative analysis of risk level between the market and the company can be possible with the assistance of beta (Sander & Haley, 2011).

Beta reflects the comparative risk level of the company against the market. The beta of the company is 0.62 that indicates the risk level of the company is lower than that of the market. The beta value less than one indicates a lower risk level of an entity against the market because the market has assumed a beta value of one. If the beta is equal to one, the company and the market have an equal level of risk. if the beta is more than one, the company has a higher risk than the market. The lower beta value than one of the companies needs a lower cost of equity as per the CAPM (Yahoo Finance, 2020).

The risk-free rate of return is taken based on 10 Years Australian Government Bonds, which is 0.82%. The 10-years government bond has risk free return because of no risk to return as the Australian government has never failed to repay bonds that assurance risk free return on investment in the government bonds (Bloomberg, 2020).

The market return is determined based on All ORD, which is 6.44% taken for determining the cost of equity of the company. The market return is high as compared to risk-free return because of the risk and returns relationship. The high risk always provides high returns and the low risk provides low return (Yahoo Finance, 2020).

The CAPM is essential instrument for evaluating cost of equity as equity has several factors that can affect its costs and dividend is not efficient instrument for finding the cost of equity. The CAPM formula for calculation of cost of equity is given below (Day, 2012):

Ke = Rf + (Rm-Rf)×Beta

Variable

Rate (%)

Sourced at (date)

Period of (date to date)

Rf

0.82%

22/9/2020

2020

Rm

6.44%

22/09/2020

2018/19

Beta

0.62

22/9/2020

2020

Where

Rf = Risk free return = 0.82%

Rm = Market return = 6.44%

Beta = 0.62

Ke = 0.82% + (6.44%-0.82%)×0.62

Ke = 0.82% + (6.44%-0.82%)×0.62

Ke = 4.30%

Therefore, the cost of equity of RHC is 4.30% for the estimation of the weighted average cost of capital as the overall cost of capital of the company.

  1. DGM: Cost of Equity

The cost of capital can be determined with the assistance of dividend and growth rate but it is not much reliable as the dividend is not fully paid for earned profit over the period. The formula for the calculation of the cost of equity-based on the dividend is presented below:

Where,

D1 = Expected dividend

P0 = Current market price

G = Growth rate

Net Profit ($ millions)

572

Equity ($ millions)

3,023

ROE (572/3,023)

18.93%

DPS($)

1.465

EPS ($)

2.649

Dividend Payout Ratio = DPS/EPS

55.30%

Growth rate (1-55.30%)×(18.93%)

8.46%

Current price of Stock

72.24

Expected Dividend (1.465×1+8.46%)

1.589

Ke = (1.589/72.24)+8.46%

10.66%

The cost of equity is 10.66%, which is much high as per the normal cost of capital, which means this cost cannot be used for estimating the cost of capital. If a simple dividend against the current market is used, the cost of equity will be 2.03% (1.465/72.24) that reflects the dividend based cost of equity is not reliable for assessing the cost of the capital of the company.

  1. Cost of Debt

The cost of debt is also an important source of cost for the company as a lot of funding comes from debt sources for the development of the capital structure of the company. The debt funding is essential for taking financial leverage for the company so it is important for estimating the weighted average cost of capital by considering the cost of debt and debt weight for the purposes. The interest rate on debt is 1.22% over the period in the case of RHC, which is taken the cost of debt before tax, and the tax rate for the company is 17%. Bonds are secured by the pledge of the property of the company. The company has both debt funding with fixed interest and floating interest-bearing debts. The cost after tax of the debt is calculated as per the below calculations (Ainsworth & Deines, 2019):

Cost of Debt = 1.22%×(1-17%) = 1.01%

Therefore, the cost of debt for the calculation of the weighted average cost of capital is 1.01%.

  1. Comment on Re vs Rd

Now, there is a need to estimate the weight of debt and equity, which is essential for estimating the weighted average cost of capital as the WACC has the contribution of cost of each source with their respective weight in the capital structure.

 Particulars

$ million

Weight

Total Debt

9,510

0.76

Total Equity

3,023

0.24

Total Capital

12,533

1.00

The weight of debt is much high than the weight of equity, which means financial leverage advantage due to tax benefit, and a lower interest rate will be reflected in the WACC. The debt has a higher weight and lower cost than the equity has a lower weight and higher cost.

The company has high debt funding in the capital structure so there is no possibility of an increase in the debt funding. If the company increases its debt funding, the shareholders of the company will expect an increased return on their investment because of improved solvency risk.

  1. WACC Calculations

The formula for calculation of WACC is presented below (Day, 2012):

WACC = Equity Cost × Equity Weight + Debt Cost × Debt Weight

WACC = 4.30%× 0.24 + 1.01% × 0.76

WACC = 1.27%

Therefore, the cost of capital of RHC is 1.27%, which indicates a reasonable level of overall cost of capital.

References for Mastering Cash Flow and Valuation Modelling

Ainsworth, P., & Deines, D. (2019). Introduction to Accounting: An Integrated Approach (8 ed.). NY: John Wiley & Sons.

Bloomberg. (2020). Government Bond Yields. Retrieved 09 22, 2020, from https://www.bloomberg.com/markets/rates-bonds/government-bonds/australia

Day, A. (2012). Mastering Cash Flow and Valuation Modelling. New York: Pearson UK.

RHC. (2020). Annual and Financial Reports. Retrieved 09 22, 2020, from https://www.ramsayhealth.com/Investors/Annual-and-Financial-Reports

Sander, P., & Haley, J. (2011). Value Investing For Dummies (2 ed.). NJ: John Wiley & Sons.

Yahoo Finance. (2020). ALL ORDINARIES (^AORD). Retrieved 09 22, 2020, from https://au.finance.yahoo.com/quote/%5EAORD/history?period1=1467331200&period2=1561852800&interval=1mo&filter=history&frequency=1mo

Yahoo Finance. (2020). Ramsay Health Care Limited . Retrieved 09 22, 2020, from https://au.finance.yahoo.com/quote/RHC.AX/history?period1=1467331200&period2=1561852800&interval=1mo&filter=history&frequency=1mo

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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