BUSINESS AND CORPORATE FINANCE (C3) BUSINESS VALUATION C COVENANT FINANCIAL CONSULTANTS & Ciat —T COVENANT INSTITUTE OF ACCOUNTANCY AND TECHNOLOGY Prepared By: Goodhape Mkaro [MBA (Finance), B. Com (Acc) (Hons), PGD in Tax Management, CPB, CISI(UK), CPA (T)] Dr. Emmanuel Christopher, PhD, MBA (Finance), B Com Acc (Hon), CPA (T) Godson Mkaro [MSc in Finance & Investment, BSc in Computer Science, ATEC II, CPBE, CISE, CCSP, CPA (T)] Ally Mshana MFA-OG, B, Com (Acc) (Hons), ATEC Il, CPA(T) For more information Call/ WhatsApp: 0° Website: www.covenantfinco.com | Email: info 99 621 | 0 (8.616 | OT14 965 564 | O713 762 45 ‘ovenantfinico.com | Instagram@covenantfinco |Page 1PONCE ee tne Sn BYE BUSINESS VALUATION Question 01 (NBAA NOV 2017) (a) Discuss how the Capital Asset Pricing Model (CAP\1) can be useful in making better investment decisions with respect to launching of a new product. (5 marks) (b) Explain the main features of value based management. (6 marks) (6) Kibo Group is a manufacturing company headquartered in Dodoma, Tanzania. Last year the company reported an operating income or Earnings Before Interest and Tax (EBIT) of TZS.500,000,000. The company had a net depreciation expense of TZS.100,000,000 and an interest expense of TZS.100,000,000; its corporate tax rate was 40 percent. The company has TZS.1,400,000,000 in non-interest-earning current assets and TZS.400,000,000 in non-interest bearing current liabilities; it has ZS. 1.500,000,000 in net plant and equipment. It estimates that it has an after- tax cost of capital of 10 percent. Assume that Kibo Group's only non -cash item was depreciation. REQUIRED: (i) Determine the company’sinet cash flow. (ii) If capital in the previous year was TZS.2,400,000,000, what was the company’s Free Cash Flow (FCF) for the year? (iii) What was the company’s Economic Value Added (EVA)? Suggested solution @ ‘A company can use its weighted average cost of capital (WACC) as the discount rate in appraising an investment project as long as the project's business risk and financial risk are similar to the business and financial risk of existing business operations. Where the business risk of the investment project differs significantly from the business risk of existing business operations, a project-specific discount rate is needed. The capital-asset_pricing-model-(CAPM)-can-provide-a_project-specific discount rate, The equity beta of a company whose business operations are similar to those of the investment project (a proxy company) will reflect the systematic business risk of the project. If the proxy company is geared, the proxy equity beta will additionally reflect the systematic financial risk of the proxy company. The proxy equity beta is ungeared to remove the effect of the proxy company’s systematic financial risk to give an asset beta which solely reflects the business risk of the investment project. This asset beta is regeared to give an equity beta which reflects the systematic financial risk of the investing company. For more information Call/WhatsApp: Website: www.covenantfinco.com | Email: info@covenantfinco.com | Instagram@covenantfinco | Pa 718 499 621 | O7 18 G16 | O714 965 564 | O71 762PONCE ee tne Sn (b) © BYE BUSINESS VALUATION The regeared equity beta can then be inserted into the CAMP formula to provide a project-specific cost of equity. If this cost of capital is used as the discount rate for the investment project, it will indicate the minimum return required to compensate shareholders for the systematic risk of the project. The project-specific cost of equity can also be included in a project-specific WACC. Using the project- specific WACC in appraising an investment project will lead to a better investment decision than using the current WACC as the discount rate, as the current WACC does not reflect the risk of the investment project. Value based management Value-based management can be defined as an integrated management control system that measures, encourages and supports the creation of net worth. It aims to provide consistency in an organization's mission, strategic plans, governance modes, culture, communication systems, processes of decision making and performance management, etc: Main features of VBM: (i) Value creation, that is, methods which would result in increasing future value. (ii) Value management which is concerned with organizational culture, governance, leadership, change management, etc. (iii) Value measurement. Kibo group (Net cash flow Net cash flow = Net Income + Depreciation Where; Net income = EBIT 500,000,000 Less: Interest= 100,000,000 EBIT 400,000,000 Tax (40%) 160,000,000 Net income Tshs. 240.000,000 Net cash flow = 240,000,000 + 100,000,000 Net cash flow = Tshs.340, 000,000 (ii) Free cash flow Free cash flow = NOPAT - Net investment in operating capital Where; NOPAT = EBIT (1-7) 500,000,000 (1 - 0.4) ‘Tshs.300, 000,000 Net investment in operating capita Net investment in operating capital Therefore; 2,500,000,000 - 2,400,000,000 Tshs.100, 000,000 For more information Call/WhatsApp: Website: www.covenantfinco.com | Email: info 718 499 621 | O717 348 G16 | O714 965 564 | OT19 762 ‘ovenantfinico.com | Instagram@covenanttinco | PaUSINESS AND CORPORATE F BUSINESS VALUATION Free cash flow Free cash flow 100,000,000 - 100,000,000 'shs. 200,000,000 (ii) EVA EVA = EBIT (1-7) -[(total capital) (after tax cost of capital)] EVA = 500,000,000(0.6) - (2,500,000,000) (0.1) EVA = Tshs. 50,000,000 Question 02 NBAA Aadapted Mbimbi Company, a construction company is considering the purchase of Ngwinde Ltd, an unlisted cement company that has discovered, patented and marketed a rare limestone quarry. The development of the quarry is expected to increase Ngwinde’s sales by 20% per year for three years, and by 10% per year in perpetuity. Currently, 35% of Ngwinde is owned by its Senior Managers, 30% by a venture capital company, 25% by a single shareholder who is a member of the Board of Directors, and 10% by about 100 others private investors. Summarised accounts for Ngwinde for the last two years are as shown below:- Extract of Statement of Comprehensive Income for the Year ended 31st December (in TZS millions) 20X1 20X0 Revenue 892,017 800,948 Operating Profit before exceptional items 359,185 305,656 Increase paid (net) 9379 1,060 Profit before taxation 349,806 304,596 Taxation 76,685 71,813 Dividend 95,993 66,368 Retained earnings 177,128 166,415 Statement of Financial Position as at 31* December (in TZS million) 20X1 20x0 Non ~ Current assents (Net) 476,093 405,322 Current assets Inventories 126,448 127,859 Accounts receivable 86,357 55,130 Bank and cash 49,442 100,509 Total Asset 738,340 688,820 Equity & Liability Share capital 29,493 29,498 Retained earnings 415,275 336,410 Reserves 42,834 33,137 Total equity 487,602 399,040 For more information Call/ WhatsApp: 0° Website: www.covenantfinco.com | Email: info 99 621 | 0 (8.616 | OT14 965 564 | O713 762 45 ‘ovenantfinco.com | Instagram@covenantfinco |P:PONCE ee tne Sn BYE BUSINESS VALUATION Liabilities Non - current Liabilities 43,737 91,687 Trade and other payables 129,505 167,089 Other current liabilities 77,496 31,004 Total equity and liabilities 738,340 688,820 Other information relating to Ngwindeare as follows: 1. Corporate taxation is at the rate of 30% per year 2. Operating profit before tax and interest is expected to be approximately 8% of turnover in the next year, and is expected to remain at the same percentage in future years. Dividends are expected to grow at the same rate as turnover The realizable value of existing stocks is expected to be 80% of its book value. 10% of the accounts receivable is deemed uncollectable. 6. The estimated cost of equity is 15% Information regarding the industry sector of Ngwinde. 1. The average PE ration of listed companies of similar size to Ngwinde is 20:1 2. Average earnings growth in the industry is 6% per year. see REQUIRED: (i. Estimate the value of Ngwinde Company using: * Assets Based Valuation (Liquidation Basis) (6 marks) * P/E Ration Valuation (6 marks) * Dividend Based Valuation. (6 marks) i). Comment on the accuracy of each of the methods used in psrt (i) above and recommend, ith reasons, a value, or range of values that Mbimbi Company should bid for Ngwinde Company. (6 marks) Juestion 02 (b): Dividend valuation model within a given period ‘An investor is considering the purchase of some shares in CFC Ltd. At the end of one year a dividend of Tshs 22 will be paid and the shares are expected to be sold for Tshs 243. How much should be paid if the investor judges that the rate of return required on a financial security of [di/ (1+ ke)] + [P1/(1 + ke)] Po = [22/(1 +0.2)] + [243/(1 + 0.2)] = Tshs 220.8 = Tshs 221 ‘Question 03: Dividend valuation model to infinity If a firm is expected to pay dividends of Tshs 20 per year to infinity and the rate of return required on a share of this risk class is 12% then 20/(1 + 0.12)] + [20/(1 + 0.12))] + [20/(1 + 0.12) +... + [20/(1 + 0.12)>] 7.86 + 15.94 + 14.244 ++ For more information Call/ WhatsApp: 0718 499 621 | 07 Website: www.covenantfinco.com | Email: info@covenantfinco.com | Instagram@covenantfinco | Pa 18 G16 | O714 965 564 | O71 762USINESS AND CORPORATE F BUSINESS VALUATION Given this is a perpetuity there is a simpler approach: Po= di = 20 1S 166.67 ke 0.12 Question 04: A constant dividend growth valuation If the last dividend paid was do and the next is due in one year, di, then this will amount to do (1 + g) where g is the growth rate of dividends. For example, if BCD Ltd has just paid a dividend of Tshs 10 and the growth rate is 7% then: ch will equal do(1 + g) = 10(1 + 0.07) = Tshs 10.70 and do will be do(1 + g)? = 10(1 + 0.07)? = Tshs 11.45 The value of a share in BCD Ltd share will be all the future dividends discounted at the risk-adjusted discount rate of 11%: Po=do(L+g) + do(L +g}? +edo(let gy +......+ do(l+g)" (l+ke) (1+ke? ¢ (+ keP (1+ ke) Py = 10(1 + 0.07) +10(1 + 0.07? + 101 + 0.07 +...... + do(1 +g)" (+01) — (1+0ane (1 +0115 (l+kp Using the above formula could require a lot of time. Fortunately it is mathematically equivalent to the following formula which is much easier to emplo Po = [di/ (ke - g)] = [do(1 + g)]/ (ke ~ g) ={(10.7)/ (0.11 - 0.07)] = Tshs 267.50 Note that, even though the shortened formula only includes next year's dividend all the future dividends are represented.A further illustration is provided by a real case example of CFC ple discussed below. CFC_ple,the-6.5-billion Pounds Sterling turnover defence, power-systemsand telecommunications giant has the following dividend history: Year Net dividend per share (p) 2018 103 2019 108 2020 4 2021 125 2022 13.2 The average annual growth rate, g, over this period was: g = [(13.2/10.3)"/4] - 1 = 0.064 or 6.4% If it is assumed that this historic growth rate will continue into the future and 14% is taken as the required rate of return the value of a share can be calculated. For more information Call/ WhatsApp: 0° Website: www.covenantfinco.comUSINESS AND CORPORATE F BUSINESS VALUATION Po = [di/ (ke - g)] = [13.2(1 + 0.064)] / (0.14 - 0.064) = 184.8p In fact, in the summer of 2017 GEC’s shares stood at over 350p. Perhaps analysts were anticipating a faster rate of growth in future under the new managing director, George Simpson, than in the past. Perhaps in the example an excessively high discount rate has been employed, or perhaps the market consensus view of GEC’s growth prospects was overoptimistic. Question 05: Worked non costant growth You are given the following information about CFC Ltd. The company has just paid an annual dividend of Tshs 15 per share and the next is due in one year. For the next three years dividends are expected to grow at 12% per year. This rapid rate is caused by a number of favorable factors: for example an economic upturn, the fast acceleration stage of newly developed products and a large contract with a government department. After the'third year the dividends will grow at only 7% per annum, because the main boosts to growth will, by then, be absent. Shares in other companies with a similar level of systematic risk to JML Ltd produce an expected return of 16% per annum. What is the value of one share in JML It? Answer Stage 1: discount dividends for the super-normal growth phase di = 15(1 + 0.12) = 168 dy = 15(1 + 0.12? = 16.8 dy = 15(1 + 0.12)3 = 16.8) Stage 2: calculate share price a time 3 when the dividend growth rate shifts to the new. permanent rate. P3 = [da(1 + g)] / (ke - g) = [21.11 + 0.07)] / (0.16 - 0.07) = Tshs 250.9 Stage 3: discount and sum the amounts calculated in stages 1 and 2 [di / (1 + ke)] = [16.8 / (1 + 0.16)] = 145 + [de / (1+ ke)?] = [18.8 / (1 + 0.16)2] = 14.0 + [ds / (1+ ke)?] = [21-1 / (1 + 0.16)5] + [di / (1+ ke)?] = [250.9 / (1 + 0.16)°] 13.5 For more information Call/ WhatsApp: 0° Website: www.covenantfinco.com | Email: info ‘ovenantfinico.com | Instagram@covenantfinco | Page 7Eee BUSINESS VALUATION QUESTION 06 : (ACCA Adapted) Recent financial information relating to Close Co. a stock market listed company, is as follows TZS m Profit after tax (earnings) 66.6 Dividends 40.0 Statement of financial position information TZSm TZSm Non- current assets 595 Current assets 125 Total assets 720 Equity Ordinary shares (TZS I nominal) 80 Reserves 410 190 Non-current liabilities 6% Bank loan 40 8% Loan notes (TZ5 100 nominal) 120 160 Current liabilities 70 Total equity and liabilities 720 Financial analysts have forecast that the dividends of Close Co will grow in the future at a rate of 4% per year. This is slightly less than the forecast growth rate of the profit after tax (earnings) of the company, which is 5% per year. The finance director of Close Co thinks that, considering, the risk associated with expected earnings growth, an earnings yield of 11% per year can be used for valuation purposes. Close Co has a cost of equity of 10% per year and a before-tax cost of debt of 7% per year. The 8% bonds will be redeemed at nominal value in six years’ time. Close Co pays tax at an annual rate of 30% per year and the ex-dividend share price of the company is TZS 8 50 per share. Required: (a) Calculate the value of Close Co using the following methods: (i) Netasset value method; Dividend growth model; Earnings yield method (6 marks) (b) Discuss the weakness of the dividend growth model as a way of valuing a company and its shares (5 marks) () Compute WACC (5 marks) QUESTION 7: (ACCA Adapted) MAT Co operates a chain of stores selling furniture. It has a successful business model and is seeking to raise additional finance in order to grow further. MAT Co is currently listed on AIM (a secondary market) but the shares in the company are only traded infrequently. The following information refers to MAT Co: For more information Call/WhatsApp: 0718 499 621 | 0717 348 616 | O714 965 564 | O71 762 Website: www.covenantfinco.com | Email: info@eovenantfinco.com | Instagram@ecovenantfinco | Page 8Eee AND ree tee eet aT BYE BUSINESS VALUATION Most recent statement of financial position Sm $m Assets Non-current assets 71 Current assets Inventory 8 Trade receivables i Cash’ 15 34 Total assets 105 Equity and liabilities Ordinary share capital 40 Retained earnings 7 Total equity 7 Non-current liabilities Long-term borrowings 18 Current liabilities Trade payables 20 Total liabilities 38 Total equity and liabilities 105 MAT Co has paid the following dividends in recent years: 2018-4.1 cents, 2019-4.3 cents 2020-4.7 cents Since the most recent statement of financial position the company has declared a dividend of 5.0 cents and this will be paid shortly: The ordinary shares of the company have a nominal value of 25 cents and a market value 66 cents per share. The equity beta of the company is estimated to be 1.15. Prior to considering potential source of finance the directors of MAT Co are keen to gain a better understanding of the value of the company. The directors are aware that the company has property with a current market value of $65mbuta book value of only $52m. Additionally following review of inventories the directors consider that a $2m write down is required. The return on government bonds is currently 5% and the equity risk premium is 8% Required: (a) Calculate the total equity value of MAT Co using dividend growth model as a business valuation method (marks) (b) Comment on the relevance of the total equity value calculated when compared to the total market value of the equity of the company (marks) For more information Call/WhatsApp: 0718 499 621 | 0717 348 616 | O714 965 564 | O71 762 Website: www.covenantfinco.com | Email: info@covenantfinco.com | Instagram@covenantfinco | P rage 9BUSINESS AND CORPORATE FINANCE (C3) [USINSSORZNUEGLONS QUESTION 8: (ACCA Adapted Phobis Co is considering a bid for Danoca Co. Both companies are stock-market listed and are in the same business sector. Financial information on Danoca Co, which is shortly to pay its annual dividend, is as follows: ‘Number of ordinary shares 5 million Ordinary share price(ex div basis) $3.30 Earnings per share 40.0 Proposed payout ratio 60% Dividend per share on one year ago 23.3c Dividend per share on two years ago 22.0c Equity beta 14 Other relevant financial information ‘Average sector price/earnings ratio 10 Risk-free rate of return 46% Return on the market 10.6% Required: Calculate the value of Danoca Co using the following methods: (i) Price/earnings ratio method; (i) Dividend growth model ‘And discuss the significance, to Phobis Co, of the values you have calculated, in comparison to the current market value of Danoca Co. QUESTION 9: (ACCA Adapted) The following financial information refers to NN Cor ‘Current statement of — financial position Sm] $m $m ‘Assets No-current assets ee ‘Current assets Inventory i Trade receivables 21 Cash 10 x Total assets 143 Equity and liabilities (Ordinary share capital 50 Preference share capital 5 Retained earnings 19 Total equity 34 For more information Call/WhatsApp: 0713 499 621 | 0717 548 616 | O714 965 56% | OT19 76 Website: www.covenantfinco.com | Email: info@covenantfinco.com | Instagram@ecovenantfinco | Page 10Eee BUSINESS VALUATION Non-current liabilities Long-term borrowings 20 ‘Current liabilities Trade payables 2 Others payables Is Total current liabilities 29 ‘Total liabilities 9 Total equity and liabilities 143 NN Co has just paid a dividend of $0.66 per share and has a cost of equity of 12%. The dividends of the company have grown in recent years by an average rate of 3%per year. The ordinary shares of the company have a par value of $0.50 per share and an ex div. market value of $8.30 per share. The long-term borrowings of NN Co consist of 7% bonds that are redeemable in six years’ time at their par value of $100 per bond. The current ex interest market price of the bonds is $103.50 The preference shares of NN Co have a nominal value of 50 cents per share and pay an annual dividend of 8%. The ex div market value of the preference shares is $0.67 per share. NN Co pays corporation tax an annual rate of 25% per year. Required: (a) Calculate the equity value of NN\Co using the following business valuation methods: (i) The dividend growth model; (ii) Netasset value (6 marks) (b) Explain the concept of market efficiency and distinguish between strong form efficiency and semi-strong form efficiency (marks) (Total 10 marks) QUESTION 10: (ACCA Adapted) Corhig Co is a company that is listed on major stock exchange. The company had struggled to maintain profitability in the last two years due to poor economic conditions in its home country and as a consequence it has decided not to pay a dividend in the current year. However, there are how clear signs of economic recovery and Corhig Co is optimistic that payment of dividends can be resumed in the future. Forecast financial information relating to the company is as follows: Year 1 2 3 Earnings (S000) 3,000 3,600 4300 Dividends($000) Nil 500 1,000 The company is optimistic that earnings and dividends will increase after year 3 at a constant annual rate of 3% per year. Corhig Co currently has an equity beta of 1.6 the risk rate of return is 4% per year and the equity risk premium is 5% per year. The current average price/earnings ratio of listed companies similar to Corhig Co is 5 times. For more information Call/WhatsApp: 499 621 | 0717 $48 616 | O714 965 564 | OT13 70 Website: www.covenantfinco.com | Email: info@covenantfinco.com | Instagram@ecovenantfinco | Page 11BUSINESS AND CORPORATE FINANCE (C3) [USINSSORZNUEGLONS Required: (2) Estimate the value of Corhig Co using the price/earnings ratio method and discuss the usefulness of the variables that you have used. (amarks) (b) Calculate the current cost of equity of Corhig Co and, using this value, calculate the value of the company using the dividends valuation model (6marks) QUESTION 11: (ACCA JUNE. Adapted) HTP Co is planning to buy CRX Co, a company in the same business sector, and is considering paying cash for the shares of the company. The cash would be raised by THP Co through a 1 for 3 rights issue at a 20% discount to its current share price. The purchase price of the 1 million issued shared of CRX Co would be equal to the rights issue funds raised, less issues costs $320,000. Earnings per share of CRX Co at the time of acquisition would be 44.8¢ per share. As-a result of acquiring CRX Co, THP Co expects to gain-annual after-tax saving of $96,000 THP Co maintains a payout ratio of 50% and earnings per share are currently 64¢ per share. Dividend growth of 5% per year is expected for the foreseeable future and the company has a cost of equity of 12% per year. Information from THP Co's statement of financial positon: Equity and liabilities $000 Share ($1 nominal value) 3,000 Reserves 4,300 7,300 ‘Non-current liabilities 8% loan notes 5,000 Current liabilities 2,200 Total equity and liabilities 14,500 Further information THP Co ‘THP Co dividend per share = 32c per share Share price of THP Co = $4.80 Market capitalization of THP Co Price earnings ratio of THP Co = 75 CRX Co Earnings per share of CRX Co = 44.8c per share Share price of CRX Co = $3.36 Market capitalism of CRX Co = $3.36 Required: (a) Assuming the right issue takes place and ignoring the proposed use of the fund raised, calculate; For more information Call/WhatsApp: 0713 499 621 | 0717 548 616 | 0714 965 564 | 0713 76 Website: www.covenantfinco.com | Email: info@covenantfinco.com | Instagram@ecovenantfinco | Page 12BUSINESS AND CORPORATE FINANCE (C3) [USINSSORZNUEGLONS (i) The rights issue price per share (ii) The cash raised (ii) The theoretical ex rights price per share; and (iv) The market capitalization of THP Co. (marks) (b) Assuming a semi-strong form efficient/capital market, calculate and comment on the post-acquisition market capitalization of THP Co in the following circumstances: () — THP Co does not announce the expected annual after-tax savings; and (ii) The expected after-tax saving are made public (Gmarks) QUESTION 12: (ACCA DEC. Adapted) Dartig Co is a stock- market listed company that manufactures consumer's products and it is planning to expand its existing business. The investment cots of $5 million will met by a1 for 4 rights issue. The current share price of Dartig Co is $2.50 per share and the rights issue price will be at 20% discount to this. The finance director of Dartig Co expects that the expansion of existing business will allow the average growth rate of earnings per share over the last four years to be maintained in the foreseeable future. The earnings per share and dividends paid by Dartig Co over the last four years are as follows 20X1 | 20X2] — 20X3 20Xa | 20X5 Earnings per share (cents) 277) 29.0] 29.0 30.2 324 Dividend per share (cents) msl sh 135 145 15.0 Dartig Co has cost of equity of 10%. The=price/earnings ratio of Dartig Co has been approximately constant in recent years. Ignore issue costs. Required: (@) Calculate the theoretical ex rights price’ prior to’ investing. in thé proposed! business expansion (3 marks) (b) Calculate the expected share price following the proposed business expansion using the price/earnings ratio method. (@ marks) (0) Discuss whether the proposed business expansion is an acceptable use of the finance raised by the rights issue, and evaluate the expected effect on the weather of the shareholders of Dartig Co, (4 marks) QUESTION 13: (ACCA DEC. Adapted) Kamala Co, a listed company, manufactures parts and machinery for the construction industry About five years ago, Kamala Co started to manufacture parts and machinery for hospitals and companies engaged in biomedical research using largely the same manufacturing and processing systems it already had in place. In 20X1, a young and ambitious chief executive officer (CEO) took over the running of the company. 199 621 | 07 For more information Call/WhatsApp: 348 616 | OTTE9G5 564 | O719 76 Website: www.covenantfinco.com | Email: info@covenantfinco.com | Instagram@ecovenantfinco | Page 13PON CCE Tee tne EAE Nee With the publication of the latest fin: BUSINESS VALUATION ancial statements for the year to 30 November 20X4, the CEO made a brief statement and it includes the following two points: ~ The CEO was very pleased with growth in the financial ratios provided and tales revenue from 20X2 to 20X4. More pleasing was growth in the share price, which increased even ~ The CEO expressed a desire to faster than the growth in the market index, suggesting that Kamala Co has been a successful company. make Kamala Co the leading manufacturer of parts and machinery for the construction industry by acquiring a major rival manufacturer in 20X5, and financing the acquisition through an issue of a new bond and a small rights issue, Ananalyst, after examining the recent financial statements and the two points above, was less positive about Kamala Co's future prospects. Given below are extracts from the recent financial statements, some ratios, and other financial information for Kamala Co. Kamala Co Year ending 30 November (all amounts in $m) 20X2 20X3 20x4 3,760 4,054 1,230 Sales revenue Operating profit Finance costs Profit before tax 819 168 Taxation Profit for the year 622 Dividends 152 Year ending 30 November (all amounts in $m) 20X2 20X3 20X4 ‘Total non-current assets 3,962, 5,507 7,669 Total current assets 980 1410 1880 Total non-current and current assets Equity Ordinary shares ($0.25) 750 750 750 Reserves 1,476 1,827 2,297 Total equity 2,226 2577 3,047 For more information Call/ WhatsApp: 0718 499 021 | 0717 948 G16 | O7 14.965 56% | 0713 762 Website: www.covenantfinco.com | Email: |: info@eovenantfinco.com | Instagram@covenantfinco |Page 14PONCE ee tne Sn BYE BUSINESS VALUATION Non-current liabilities Bank loans 476 1,176 Bonds 1,008 1,008 Total non-current liabilities 1,484 2,184 Current liabilities Trade and other payables 1,232 Bank overdraft - Total current liabilities 1,232 Total non-current and current liabilities 2716 6,502 Kamala Co: By activity Year ending 30 November (all amounts in $m) 20X2 20X3 20x4 Sales revenue Construction 2,420 2,644 3,660 Hospitals and biomedical 1,340 L410 1,570 Operating profit Construction 460 489 693 Hospitals and biomedical 254 330 405 Ratios: Kamala Co 20x2 20X3 20x4 Operating profit margin 19.0% 20.2% 21.0% Dividend cover 33 36 44 Earnings per share 1540 163¢ 207¢ Gearing [(debt/debt + equity)] 40% 46% 5% Other financial information 30November 30November —_ 30 November 20X2 20X3 20X4 Kamala Co share price ($) 169 201 269 Market index 4,539 3447 6,550 Industry index 840 1092 1422 Industry average PE ratio 924 241 15:1 20X3 20X4 (Sm) ($m) Depreciation deducted to arrive at the operating profit (equivalent to tax allowable depreciation) 826 1,150 Economic depreciation 990 1380 Non-cash expenses (excluding depreciation) 150 170 For more information Call/ WhatsApp: 0718 499 621 | 07 Website: www.covenantfinco.com | Email: info 18 G16 | O714 965 564 | O71 762 ‘ovenantfinico.com | Instagram@covenanttinco | PBUSINESS AND CORPORATE FINANCE (C3) [USINSSORZNUEGLONS Kamala Co's cost of capital is estimated to be 10%. The company’s corporation tax rate is 25%. Required: (a) Discuss the advantages and drawbacks of using the economic value added (EVA) technique to assess a company’s performance. (6 marks) (b) Estimate Kamala Co’s EVA for the years ending 30 November 20X3 and 30 November 20X4. (5 marks) (©) Evaluate Kamala Co's performance and conclude whether the analyst’s opinion or the chief executive officer's opinion has the greater validity. Include any additional ratio and activity trends, and share price analysis, which are deemed to be relevant to the evaluation. ANSWER TO QN 13 (a) Advantages of EVA™ The cost of capital indicates the minimum value which is required by the investors of a company and therefore any positive economic profit greater than the cost of capital times the capital employed should result in an increase in value for the investors. If the debt holders are paid a fixed return, then all the additional value created will go to the shareholders. EVA™ focuses on creating shareholder value. Capital is needed for investment purposes t@ create value and EVA™ recognises this when it takes into account the capital employed. EVA captures performance into a single figure, which if positive should increase shareholder value. Ratios on the other hand may require various different targets to be set. EVA™ is based on the residual income value principle and therefore it is relatively easy to understand, An EVA™ trend would give an indication of how the company is creating value over a number of years. Drawbacks of EVA™ EVA is an annual measure and) therefore it is relatively easy to manipulate. Short-term projects with early redemption but low yields-may be chosen to the detriment of longer term, high yield projects which may not show immediate high returns. Focusing on annual EVA™ figures may make the company’s managers adopt a short-term attitude and this may be to the detriment of the company’s long-term success. Paying attention to EVA™ trends instead may reduce or eliminate this drawback. Furthermore, EVA™ is an absolute measure, making comparison between companies in different industrial sectors more difficult. (b) EVA®* calculation: Kamala Co 30 November 30 November 2013 2014 $m $m Operating profit 819) 1,098 Add: Depreciation 826 1,150 Less: Economic depreciation (990) (1,380) Add: Non-cash expenses 150 170 Taxation excluding finance costs: 2013: 25% x $819m and 2014 25% x $1,098m (275) Economic profit 763 For more information Call/WhatsApp: 499 621 | 0717 $48 616 | O714 965 564 | OT13 70 Website: www.covenantfinco.com | Email: info@covenantfinco.com | Instagram@ecovenantfinco | Page 16Pi AND CORPORATE FI Capital employed: 2013: $2,226m; 51 484m + ACO BUSINESS VALUATION 2014: $2,184m + $2,577m + $616m 3,710 5377 10% x capital employed 371 538 EVA™ 29 225 (0) |Additional ratio trends: Kamala Co ‘Years Ratios 2o12| 2013 2014 ‘Operating profit/cap Return on capital employed 192% 172% {16.7% _ employed Sales revenue/cap Asset turnover 10] 085 079 employed Current assets/current Current ratio 6 065. 0-63,_liabilities “urrent ratio without bank overdraft (Current assets - bank (o/d) 0-80 092 93 | _0/d)/current liabilities (NCL + bank 0/d)/(equity {Gearing with bank o/d 40% 52% 60% | + NCL+banko/d) Share price/earnings per Kamala Co PE ratio lao] 1284 3.01| share Dividend per share/share Kamala Co dividend yield 27%| 23% 19% | price [Hospitals and |Activity trends Construction ___ biomedical % % [Profit margin bo12 190% 19.0% pois 185% 238% pow. 18.9% 25.8% [Average annual growth: Sales evenue 23.0% 82% [Average annual growth: [Operating profit 22.7% 263% Share price and indices inalysis % Kamala Co: Average annual hare price growth’ 262 Market index: Average nual growth 204 lindustry index: Average annual growth 304 For more information Call/WhatsApp: 0713 499 621 | 0717 348 616 | O71# 965 564 | O719 762 452 Website: www.covenantfinco.com| Email info@eovenantfinco.com | Instagram@covenantfinco |Page 17BUSINESS AND CORPORATE FINANCE (C3) [USINSSORZNUEGLONS Evaluation A number of ratios and the EVA™ figures support the CEO’s assertions. The EVA™ shows that positive value is created in both years and these lend support to the increase in the share price, and this increase in the share price (26 2% annually over the last two years) has grown more rapidly than the market index (20:1% annually over the same period). There is a steady growth in the sales revenue, profit margin, earnings per share and dividend cover, together with significant investment in non-current assets, which seems to indicate a successful company. If the bank overdraft is not included, the current ratio has been improving as well. On the other hand, there are a number of indicators which suggest that perhaps Kamala Co's investment strategy may be flawed. Even though the economic profit between 2013 and 2014 has increased, the EVA™ in 2014 is less than the EVA™ in 2013. This is because there has been a substantial investment in non-current assets. This is also evidenced by a decline in the asset turnover ratio, Less sales revenue is being generated for every $ invested, leading to a decline in the return on capital employed, even though there has been a small increase in the profit margin in the three-year period, It may be that Kamala Co is making substantial investment now for deferred benefits in the future, but the markets do not seem to be convinced. In 2012, Kamala Co's price to earnings (PE) ratio was greater than the industry sector's average PE ratio (11.0 against 9 2), but by 2014 it was lower (13 0 against 153). The share price growth has also been lower at 26.2% on average annually, compared to the industry's index growth of 301% on average annually. Furthermore, the fall in dividend yield between 2012 and 2014 from 2.7% to 19% may not be viewed positively by equity holders, possibly leading to a less robust share price growth. It seems that Kamala Co is making substantial investments in its construction activity (23% annual sales revenue growth) but significantly less in the hospitals and biomedical activity (8-2% annual sales revenue growth). However, the profit margin of the hospitals and biomedical research activity has grown faster, from 19%, to 25 8%,compared to the construction activity, which has remained static at between 18'5% and 19%, The markets seemed to have viewed this in a less positive light, especially since the CEO stated that the company wanted to make further investment in an acquisition in the construction activity in 2015, The financing strategy of Kamala Co is also problematic. There seems to be a higher reliance on debt as a finance source, with no fresh issues of equity between 2012 and 2014. Book value gearing has increased from 40% to 54% from 2012 to 2014. If the overdraft is added to gearing, based on the assumption that it is being used as a long-term source of finance, then the increase is even more pronounced, increasing from 40% to 60% in the same period. It seems that Kamala Co is continuing to carry on with this policy in the future as well, because it wants to acquire a new company using mostly debt finance, by issuing a new bond, with only a small rights issue. This may lead to an increase in financial risk, putting further pressure on the share price. In conclusion, Kamala Co has been pursuing growth through debt finance. This may increase its financial risk but it is difficult to say for sure. If the industry’s norm is to have higher debt levels, then the financial strategy may be acceptable. However, the investment strategy looks to be flawed. The company seems to be pursuing growth in the lower profit margin activity area. This may have led to the share price not increasing at the same rate as the industry sector as a whole. The investment strategy warrants a re-assessment. (Note: credit will be given for alternative relevant comments for parts (a) and (c)) For more information Call/WhatsApp: 499 621 | 0717 $48 616 | O714 965 564 | OT13 70 Website: www.covenantfinco.com | Email: info@covenantfinco.com | Instagram@ecovenantfinco | Page 18