ASSIGNMENT SAMPLE ON U30286 MANAGERIAL FINANCE AND PORTFOLIO THEORY
Section A
Question 1)
| Calculation of Estimated FCFE ($ million) | |||||
| 2022 | 2023 | 2024 | 2025 | ||
| Earnings before interest and taxes | 2500 | 4500 | 15800 | 1000 | |
| Less: Tax | -300 | -550 | -120 | -80 | |
| Less: Interest | -120 | -140 | -140 | -140 | |
| Plus: Depreciation and Amortization | 150 | 200 | 250 | 200 | |
| Less: Capital Expenditure | -500 | -200 | -100 | -50 | |
| Less: Working Capital Expenditure | -50 | -50 | -20 | 0 | |
| Plus: Borrowings | 200 | 0 | 0 | 100 | |
| Free Cash Flow to Equity | 1880 | 3760 | 15670 | 1030 | |
Table 1: Calculation of Estimated Free Cash Flow to Equity
(Source: MS Excel)
- b)
“Estimated Market Value of Antiviral Equity as of the end of 2021”
| Calculation of Estimated market value of Antiviral Equity | |||
| Antiviral Company “$” | |||
| Total Share Outstanding | 20,00,000 | ||
| Share Price | 40 | ||
| Equity Value | 80000000 |
Table 2: Calculation of Estimated market value of Antiviral Equity
(Source: MS Excel)
c)
Free Cash Flow to Equity
The “free cash flow to equity” helps to understand the availability of cash for the equity shareholders in an organization after paying all the expenses, debts and investments. FCFE is composed of “Capital expenditure, net income, debt and working capital”. The FCFE metrics help to understand the value of an organization. Various analysts analyze the FCFE to understand the financial condition of an organization. This particular method of valuation also plays as an alternative for the dividend discount model. The most important thing in this context is many analysts use FCFE to understand if the stock repurchase and dividend payments are paid for with the “free cash flow to equity or some other form of financing”.
Free Cash Flows to the Firm
“Free cash flow to the firm” helps to understand the amount of cash flow from various operations after deducting the taxes, depreciation and amortization, working capital and other investments.
It is one of the most important aspects for comparing and analyzing financial health of an organization. In the context of FCFF, it can be said that the FCFF represents the surplus cash flow of an organization. FCFF is one of the most important parts of the “Two Step DCF Model”. In the context of the DCF model it is very important to say that it is an intrinsic valuation process. FCFF is one of the most important financial indicators for understanding the stock value of an organization. Positive value of FCFF represents that the company has enough fund after spending all their expenses. While on the other hand the negative value in FCFF indicates that the organization failed to generate sufficient revenue to cope with its investment and cost activities.
One can value the common equity after calculating the present value of FCFE or they can indirectly use the FCFF model at first to estimate the value of an organization then needs to subtract the “value of non-common stock capital” to “arrive at an estimate of the value of equity”.
There are two types of free cash flow one is Free Cash flow to firms and the other one is free cash flow to Equity. The discount rate is the interest rate that helps to understand the present value of future cash flows. In this context it is very necessary to say that it is very important to have a different discount rate when doing a valuation of FCFE or FCFF.
Question 3)
a)
True.
When two assets move in the same direction together, they are considered highly correlated. When the asset class moves in the opposite direction they would negatively correlate. A positive correlation means when the return on one asset increases the other asset class return also increases. The correlation coefficient estimate of 0.40 between two assets into a portfolio funds and after considering the recent return data the correlation and the coefficient estimate to be updated to 0.65. In this context it is very important to say that according to the recent data no other characteristics of the two asset classes are going to change. The diversification benefits of combining two things in a portfolio helps to increase the return on assets.
b)
True
Acquisition comparable method is one of the most important methods for mergers and acquisition. It helps to understand the value of an organization. A comparable Company analysis is one type of process used to evaluate the value of an organization by using the metrics of other organizations of similar size and from similar industries. “Comparable company analysis” Operates after assuming that the similar companies have similar valuation multiples like EBITDA. An analyst compiles various lists of available statistics for an organization for calculating the valuation multiple for comparing them. It is very helpful for determining the valuation ratio of an organization. In this context it is very important to say that if the valuation ratio is high then the company is overvalued and if the ratio is low then the company is undervalued. It is also helpful for analyzing the “enterprise value to sales, price to earnings, price to book, and price to sales.”
c)
False
According to the “Gordon growth model” the growth of an organization depends on various things. The assumption of the “Gordon’s Growth model” is
- i) The business model of the organization is in a stable condition. There are hardly any chances of significant changes in the organization.
- ii) The organization has stable financial leverage.
iii) The free cash flow of the organization is paid as the dividend to the shareholder.
In this context it is very important to say that according to the question a firm can use the Gordon growth model for valuation “without having to figure out the free cash flow.” but according to the Gordon model the free cash flow of an organization is used for paying the dividend to shareholders.
d)
True
Beta is helpful for measuring the volatility of a stock in comparison to the overall market. The stock with beta more than 1.0 is considered as high beta stock and the stock with beta less than 1.0 is considered as low beta stock. In this context it is very important to say that the risk of the high beta stock is always high and the risk of the low beta stock is always low. Though there is a huge risk in the high beta stock but it also provides higher return and on the other hand the stock with low beta provides lower return. Now according to the question the fund manager is assuming a bad year for the equities therefore he is thinking of shifting her equities into a defensive stock with beta less than 1. In this context it is very important to say that if she invests her money in the defensive stock she will get less return but as it is going to be a bad year for the equity market therefore it will be beneficial for her to gain a little from the market.
Section B
Question 4)
- The company owner loses its portion of the ownership through the public listing of the company in the stock market. There are two probable scenarios where the founders are seeking for an IPO or “initial listing offering”. One scenario is where the founders are no longer able to expand their own market. Expanding in the market or diversifying the portfolio of the business consists of the multiple components working simultaneously to provide a favorable result. During this process, the funding or the access to cash is one of the most important aspects for the business, and the IPO allows the business owners to get the access to the liquid cash in exchange of their ownership. This allows the owners to implement the new strategies for their business and help the business to expand in various markets which will help the company to improve their overall revenue generation. Another scenario is where the existing investor wants to exit the company. There are various private investors who are responsible for holding a significant portion of the company’s share. If those private investors or the stakeholders want to dissolve their stake in the company, then they list the company on the stock market and those existing shareholders sell their stakes in the stock market for a particular price. Founders lose their ownership however, this is a crucial aspect which allows the business to grow in the market.
b)
Relevant factors on key capital structure theories
There are various capital structure theories which are very helpful for understanding the proper relationship between equity financing, debt financing, market value etc.
Equity Raising
It is a process of raising the capital of an organization by selling the share of them. A company can choose this process for paying the short term needs of the organization or for paying the bills of an organization. In this context it is very important to say that it helps an organization in achieving their long term goals.
Credit Finance
The growth of an organization depends on the flow of capital. Credit finance is the agreement between the borrowers and lenders. In this agreement the borrower receives a sum of amount of value and pays the lender at a later date. In this context issuance of bonds can be described. Issuing the bond is one of the ways for raising the money of an organization. An organization can face various problems related to finance in their business operation. Money plays the most important role for the growth of any business. In this context it is very important to say that the bond assurance helps an organization a lot in coping with the financial issue. In this process the investor agrees to give a specific amount of money to an organization for a specific period of time. Therefore it can be said that the bond assurance plays an important role in helping an organization to cope with the financial situation.
Question 5)
a)
- i) (£750+ £180) = £930 – £ 60 = £870 – £ 8 = £ 862 million.
- ii) The cleanup waste management is going to acquire the home clean. It will give the cleanup waste management a huge advantage.
- The first advantage that clean up waste management will get is they will be able to expand their operation as the value of home clean is £180 million.
- It will also help to increase the investment of the company as the share of the subsidiary company will be added with the cleanup.
- It can be helpful for the company to enhance their effectiveness.
- It will also help the company in accessing the capital. After the acquisition the capital of the cleanup will be increased.
iii) Synergy is the concept that states the performance and value of two companies’ combined will be more than the sum of individual performance of the company. In the context of this question it can be said that the cleanup waste management is going to acquire home clean. It will help to increase the efficiency and effectiveness of the company. The subsidiary cleanup has a strong hold in their market therefore it will be helpful for the holding company to acquire more profit in the future. The performance of the company will be improved and they will be able to enhance their market operation.
- b)
- i)
Leverage Buyout
Leverage buyout is the process of acquiring an organization by using a sufficient number of borrowed money in the form of loans and bonds for meeting the cost of acquisition. In this context it is very important to say that the asset of an organization generally used as the collateral for the loans asset of the acquiring organization added to it. The leveraged buyout happens when the acquisition process occurs fully with the borrowed funds. The ratio of debt and equity in the Leveraged buyout is 9:1.
Difference between Leveraged Buyout and others
The leverage buyout process is only used for the private business while the others can be used for both. This process values an organization by discounting future cash flow. The LBO uses only debt.
- ii)
Problems that can arise in a leveraged buyout
In this context it is very important to mention that the leveraged buyout plays an important role in the acquisition process but it has some disadvantages also.
- i) The most common problem in this regard is in this process it is impossible to obtain additional financing.
- ii) The second disadvantage of this process is in this process the equity can disappear quickly.
iii) It is a very minimal financial cushion to manage problems. When an organization acquires another organization with an LBO, it often leaves the organization without a proper financial cushion.
iii)
A merger is described as the agreement between two existing organizations to unite into a single entity. It is a type of strategic effort which helps to boost the value of shareholders. An acquisition can be done in various methods. There are basically four types of methods that can be discussed for understanding the various methods of acquisition.
- i) Vertical Acquisition
This is such a process where an organization buys another organization from a different supply chain. The vertical acquisition will be entirely for the organization who have higher or lower manufacturing processes. Vertical acquisition helps an organization to stay more independent.
- ii) Horizontal acquisition
This is a process of buying an organization which deals in the same type of products. It helps an organization in enhancing their performance. It also helps to reduce the market competition and enhance the productivity of an organization.
iii) Conglomerate Acquisition: It occurs when an organization but another organization which is totally linked to a separate industry. In this context it is very important to say that an organization chooses the conglomerate acquisition when they want to expand their business in other sectors.
- iv) Market Extension Acquisition: This type of acquisition happens when two companies produce the same products but in different markets.
Theories of Business Acquisition
- i) Synergy Theory: This theory defines that an organization merges because the value of the combined firm will be greater and the scope of the combined organization will also be better.
- ii) Undervaluation Theory: This theory defines that an organization chooses the merge because of the undervaluation of another organization. It helps an organization in increasing their market operation and profitability.
Reference List
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