Course: Equity Analysis and Evaluation - II

29.11.2023
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Sachin Saroa

NMIMS Global Access School for Continuing Education (NGA-SCE)

Internal Assignment Applicable for December 2023 Examination

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Answer to Question No. 1

Cost of Debt (Rd)

The total of the credit spread and the risk-free rate determines the cost of debt. 150 basis

points, or 1.5%, of the 10-year Treasury yield is the credit spread.

Rd = Risk-Free Rate + Credit Spread

Rd = 5.2% + 1.5%

Rd = 6.7%

Market Value of Debt (D)

The current bond trading price multiplied by the total number of bonds issued is the

market value of debt.

D = Number of Bonds × Bond Price

D = 1,000,000 x $255

D = $255,000,000

Cost of Equity (Re)

One may compute the cost of equity by utilising the Capital Asset Pricing Model (CAPM):

Re = Risk-Free Rate + Beta × (Market Return - Risk-Free Rate)

Re = 5.2% + 1.3 × (12% - 5.2%)

Re = 5.2% + 1.3 × 6.8%

Re = 5.2% + 8.84%

Re = 14.04%
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Market Value of Equity (E)

The number of outstanding shares multiplied by the current market price per share

determines the market value of equity.

E = Number of Shares × Market Price per Share

E = 20,000,000 × $410

E = $8,200,000,000

Total Market Value (V)

The sum of the market values for debt and equity is the total market value.

V=D+E

V = $255,000,000 + $8,200,000,000

V = $8,455,000,000

Weight of Debt (WD) and the Weight of Equity (WE)

The market value of debt divided by the whole market value is known as the weight of

debt, while the market value of equity divided by the total market value is known as the

weight of equity.

WD = D / V

WD = $255,000,000 / $8,455,000,000

WD = 0.0302 or 3.02%

WE = E / V

WE = $8,200,000,000 / $8,455,000,000

WE = 96.98%

WACC

With the weights and costs of debt and equity now known, you can use the following

formula to get WACC:

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WACC = (WD × Rd) + (WE × Re)

WACC = (0.0302 × 0.067) + (0.9698 × 0.1404)

WACC = 0.0020214 + 0.13617592

WACC ≈ 0.1382 or 13.82%

Using market value weights of debt and equity, Hexaware Systems Limited, a corporation

with one million bonds trading at $255 each and a AAA credit rating, determines its

weighted average cost of capital (WACC). The WACC is calculated to be around 13.82%

utilising a debt cost (Rd) of 6.7% and an equity cost (Re) of 14.04% that were found using

the CAPM model. By accounting for the market prices of debt and equity, which are 3.02%

and 96.98%, respectively, this provides a thorough assessment of the cost of capital for the

company that may be utilised for valuation and investment choices.

Answer to Question No. 2

Value per share may be computed by the application of the Dividend Discount Model,

commonly referred to as the Gordon Growth Model. The first step is to calculate the

dividend amount, which is based on net income (NI).

EBITDA

EBITDA Margin = 30%

EBITDA = 0.3 * $5100 million

EBITDA = $1530 million

EBIT (Operating Income)

EBIT = EBITDA - D&A

EBIT = $1530 million - $7 million

EBIT = $1523 million

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Earnings Before Tax (EBT)

EBT = EBIT - Interest Expense + Interest & Dividend Income

EBT = $1523 million - $5 million + $12 million

EBT = $1530 million

Net Income (NI)

Tax Rate = 20%

Tax = EBT * Tax Rate

Tax = $1530 million * 0.2

Tax = $306 million

NI = EBT - Tax

NI = $1530 million - $306 million

NI = $1224 million

Dividend Amount

Dividend Payout = 30%

Dividend = NI * Dividend Payout

Dividend = $1224 million * 0.3

Dividend = $367.2 million

Dividend Per Share (DPS)

DPS = Dividend / Diluted Number of Shares

DPS = $367.2 million / 7.4 million

DPS = $49.62 million

Growth Rate for Dividend (g)

Growth for 5 years = 15%

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Stable Growth = 6%

Cost of Equity (k):

Cost of Equity = 13%

Value Per Share

Calculate dividends for the next 5 years with 15% growth rate:

D1 = D0 * (1 + Growth Rate) = $49.62 million * (1 + 0.15) = $57.06 million

D2 = D1 * (1 + Growth Rate) = $57.06 million * (1 + 0.15) = $65.62 million

D3 = D2 * (1 + Growth Rate) = $65.62 million * (1 + 0.15) = $75.46 million

D4 = D3 * (1 + Growth Rate) = $75.46 million * (1 + 0.15) = $86.78 million

D5 = D4 * (1 + Growth Rate) = $86.78 million * (1 + 0.15) = $99.79 million

Calculate the Terminal Value (TV):

To calculate the terminal value, we'll use the stable growth rate of 6% and the last

calculated dividend (D5)

TV = D5 * (1 + Growth Rate) / (Cost of Equity - Growth Rate)

TV = $99.79 * (1+0.06) / (0.13-0.06)

TV = $1511.10

Present value of Terminal value

= TV / (1 + Cost of Equity)^5

= $1511.10 million / (1 + 0.13)^5

= $820.16 million

Calculate the Present Value of Dividends:

Calculate the present value of dividends for years D1 to D5

PV_Dividends = D1 / (1 + Cost of Equity) + D2 / (1 + Cost of Equity)^2 + D3 / (1 + Cost of

Equity)^3 + D4 / (1 + Cost of Equity)^4 + D5 / (1 + Cost of Equity)^5

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PV_Dividends = $57.06 million / (1 + 0.13) + $65.62 million / (1 + 0.13)^2 + $75.46 million / (1

+ 0.13)^3 + $86.78 million / (1 + 0.13)^4 + $99.79 million / (1 + 0.13)^5

PV_Dividends = $50.49 million + $51.39 million + $52.29 million + $53.22 million + $54.16

million

PV_Dividends = $261.55 million

Calculate the Value per Share:

Value per Share = PV_Dividends + Terminal Value

Value per Share = $820.16 million + $261.55 million

Value per Share ≈ $1081.71 million

Sigma Enterprises is projected to be worth $1081.71 million per share. The Dividend

Discount Model (DDM) was used to determine this valuation. It used expected dividends for

the following five years, a terminal value based on a steady growth rate, and a 13% cost of

equity.

Together with growth and dividend payment assumptions, the DDM considers the

company's financial information for 2022, including sales, EBITDA margin, interest

expenditures, depreciation and amortisation (D&A), interest and dividend income, and a

20% tax rate.

Answer to Question No. 3 (a)

A technique for valuing private firms that uses price multiples from similar public company

data is called the Guideline Public Company Method (GPCM). Next, the multiples are

modified to take into consideration the distinctions between the similar corporations and

the private company we want to value. We must do the following actions in order to value

Meta Soft using the GPCM:

1. Determine which publicly listed firms, taking into account industry, size, growth,

profitability, risk, and other pertinent characteristics, are comparable to Meta Soft.

These are the reference firms that will be used to determine valuation values.
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2. Gather financial information about the reference firms, including market

capitalization, profits, sales, cash flow, book value, and other pertinent indicators for

the software sector. Using these variables, determine the price multiples for each

guideline firm. For instance, dividing the market capitalization by the earnings yields

the price-to-earnings (P/E) multiple.

3. Determine the group of guideline firms' average or median price multiples. These

are the market valuations of comparable publicly traded corporations represented

by these sample multiples.

4. To take into consideration any discrepancies between Meta Soft and the guideline

firms, adjust the representative multiples. For instance, Meta Soft's multiples ought

to exceed the indicative multiples if it possesses greater growth potential, lower risk,

or superior profitability than the typical guideline firm. On the other hand, Meta

Soft's multiples need to be lower than the representative multiples if it has a lesser

potential for growth, more risk, or worse profitability than the typical guideline firm.

Using a premium or discount factor derived from qualitative or quantitative study,

the representative multiples can be adjusted.

5. To get the enterprise value of Meta Soft, apply the adjusted multiples to its financial

data. For instance, Meta Soft's enterprise value is $200 million if its adjusted P/E

multiple is 20 and its earnings are $10 million.

6. To find the equity value of Meta Soft, deduct its net debt (total debt less cash and

cash equivalents) from its enterprise value. For instance, Meta Soft's equity value is

$150 million if its net debt is $50 million.

7. To find the value per share, divide Meta Soft's equity value by the total number of

outstanding shares. For instance, Meta Soft would have been worth $150 per share

if company had one million outstanding shares prior to the IPO.

8. Determine the range of prices for Meta Soft's IPO by using its value per share as a

point of reference. Other aspects including investor demand, market circumstances,

underwriter costs, and the dilution effects from newly issued public shares should

all be taken into account when determining the IPO price range. For instance, Meta
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Soft will have 1.2 million shares outstanding after the IPO if it intends to issue

200,000 more shares to the public during the IPO. Its value per share will decrease

by 16.67% as a result. Meta Soft must set its IPO price at $125 per share ($150 / 1.2)

in order to retain its pre-IPO equity worth of $150 million. To draw in more investors

or raise more money, Meta Soft may choose to set an IPO price range that is higher

or lower based on the state of the market and investor demand.

It is significant to remember that there are some restrictions and presumptions with this

procedure that might impair its precision and dependability. A few of these restrictions and

presumptions

1. Data about similar public corporations may not be readily available or may be out of

current.

2. Price multiples may be chosen and adjusted in an arbitrary or subjective manner.

3. The distinctive qualities and competitive advantages of Meta Soft that might not be

represented in its financial statistics or in the price multiples of similar public firms

are not taken into consideration by the GPCM.

4. The future growth potential and cash flows of Meta Soft, which can vary from those

of similar public firms, are not taken into consideration by the GPCM.

This is a brief explanation:

1. A private software business called Meta Soft is hoping to go public.

2. Through comparison with comparable publicly traded firms, the GPCM provides an

estimate of its worth per share.

3. The eight-step GPCM contains some restrictions and presumptions.

4. Prior to the IPO, Meta Soft's value per share was $150, and following the IPO, it was

$125. (It could change)

Answer to Question No. 3 (b)

A valuation technique called the residual income method concentrates on a company's

capacity to make extra profits above its cost of capital. It is a method of estimating a
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company's or its stockholders' worth based on the net income or profit that is left over

after operating profit is subtracted from capital costs.

Here is a step-by-step process for applying the residual income approach to value per

share calculation.

1. Compute the Cost of Capital: The initial stage involves determining the return that

potential investors want from their investment in the firm. Both the cost of debt and

the cost of equity are usually included. One can use techniques such as the Capital

Asset Pricing Model (CAPM) to calculate the cost of equity.

2. Estimate the projected Operating Profit: The next step is to project the

company's projected operating profit for a future time frame. This might span one

year or more, based on the particular valuation you're doing. After all operational

expenditures are subtracted, but before interest and taxes are taken into

consideration, the operating profit should be determined.

3. Calculate Residual Income:

The net income that is left over after deducting the cost of capital from the

anticipated operational profit is known as residual income. The following is the

formula for residual income:

Residual Income

= Expected Operating Profit - (Cost of Capital x Shareholder's Equity)

The whole equity capital of the business, comprising common stock, retained

earnings, and any additional equity components, is known as shareholder's equity.

4. Determine the Value of Equity:

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Using the residual income approach, you take the current book value of equity and

add the present value of the predicted residual income to get the value of the equity

(or shares). The formula below may be used to compute this:

Value of Equity = Book Value of Equity + Present Value of Residual Income

By applying the cost of capital as the discount rate to the projected residual income,

the present value of residual income is computed.

5. Calculate Value Per Share:

Divide the entire equity value by the total number of outstanding shares to

determine the value per share. The following is the formula:

Value Per Share = Value of Equity / Number of Shares Outstanding

The fundamental idea behind the residual income approach is that the ability of a business

to produce revenue over its cost of capital determines how valuable the business is. A

positive residual income shows that the business is adding value for its investors. In the

event that it is negative, it implies that the business is not making enough money to pay for

its capital expenses.

Remember that this approach requires making assumptions on the cost of capital and

projected operating profit, which may affect the valuation outcomes. Furthermore, while

applying the residual income approach for valuation, it is crucial to take the accuracy of the

estimations and the selection of suitable discount rates into account.

The residual income technique is a method of valuation that is used to calculate the

common stock value of a company. It centres on earnings that are produced over the cost

of capital, or "residual income." To figure out the price per share:

1. Commence with the balance sheet's common equity book value.

2. Calculate how much equity capital (Ke) investors will need.

3. Estimated equity income based on projections.

4. Subtract projected revenue from cost of capital to find residual income.

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5. Add the present value of residual income and book value to get the value of

common equity.

6. Divide the common equity value by the total number of outstanding shares to find

the value per share.

Negative residual income denotes a possible decline in value, whilst positive residual

income shows value development for shareholders. The quality of the prediction

determines accuracy, therefore it is important to select appropriate revenue and expense

estimates.

Let's go over a condensed example of applying the residual income method to get the

value per share.

We'll use fictitious numbers in this case to provide illustration:

● Cost of Capital (Discount Rate): 10%

● Expected Operating Profit for the next year: $1,000,000

● Shareholder's Equity: $5,000,000

● Number of Shares Outstanding: 100,000

Now, let's follow the steps:

1. Calculate the Cost of Capital:

The cost of capital for the company is 10%

2. Estimate the Expected Operating Profit:

Suppose the company is expected to generate an operating profit of $1,000,000 for

the next year.

3. Calculate Residual Income:

Shareholder's Equity is $5,000,000.

Residual Income

= Expected Operating Profit - (Cost of Capital x Shareholder's Equity)

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= $1,000,000 - (0.10x$5,000,000) = $1,000,000-$5,00,000 = $5,00,000

4. Determine the Value of Equity:

The book value of equity is $5,000,000 (as given).

Value of Equity = Book Value of Equity + Present Value of Residual Income

Value of Equity = $5,000,000 + (Present Value of $500,000)

5. Calculate Present Value:

You must discount the residual income at the cost of capital rate in order to

determine its current value. There is just one year to discount since, assuming we

are looking one year into the future.

Present Value of Residual Income

= $5,00,000 / (1+0.10) = $5,00,000 / 1.1 = $454,545.45

6. Calculate Value Per Share:

If the company has 1,000,000 shares outstanding, you can determine the value per

share as follows:

Value Per Share

= Value of Equity / Number of Shares Outstanding Value Per Share

= ($5,000,000 + $454,545.45 ) / 1,00,000 = $5.45 per share

Accordingly, the value per share in this condensed example calculated with the residual

income technique is around $5.45. This figure shows how much each share of the business

is worth depending on how well it can make money after paying for its capital.

Using the residual income approach, one may calculate the value of a company's stock by

looking at how much profit it can make over its cost of capital. In this simplified example,

the residual income is $500,000. This is the result of a corporation having a 10% cost of

capital and an estimated profit of $1,000,000. The value of equity is obtained by adding this

to the book value of equity. You may calculate the value per share, which in this case is
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around $5.45, by dividing this amount by the total number of shares. By comparing the

company's income to the cost of financing and investment, this strategy evaluates the

potential of the business to generate value for shareholders.

The residual income approach looks at earnings above the cost of capital to determine how

much a company's common stock is worth. We can take the following actions to ascertain

the value per share:

1. Determine the common equity's book value.

2. Calculate the equity capital cost (Ke).

3. Projected equity income is determined by using financial estimates.

4. Subtract projected revenue from cost of capital to find residual income.

5. Add the book value to the present value of residual income to determine the value

of common equity.

6. Divide the common equity value by the number of outstanding shares to find the

value per share.

This approach aids in determining if the business adds value for its owners. While negative

residual income signifies possible value erosion, positive residual income suggests value

creation. Remember that the quality of the forecasts determines how accurate the

valuation is, so choosing the appropriate cost of equity and income estimates is essential.