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PGDBFS 301Cases in Business Finance and Strategy (CBFS)Postgraduate Diploma in Business Finance & Strategy

SESSION 02

Conducted by – Nadun Kumara

01. Last Session RecapDo you remember the basics?

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01.01 – Last Session Recap3

Read Situational Analysis

Assumptions & Missing

informationProblem

DefinitionStrategic Analysis Alternatives Recommen-

dations

R S A P S A R

02. Situational AnalysisThe theories…

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02.01 – Situational Analysis5

Read Situational Analysis

Assumptions & Missing

informationProblem

DefinitionStrategic Analysis Alternatives Recommen-

dations

Situational Analysis

Internal

“SW”OT Ratio Analysis

External

SW“OT” PESTEL P5Fs

02.01 – Situational Analysis – SWOT6

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02.01 – Situational Analysis – Ratio Analysis7

▸Gross Profit Ratio

02.01 – Situational Analysis – Ratio Analysis8

▸Net Profit Ratio

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02.01 – Situational Analysis – Ratio Analysis9

▸ROCE

02.01 – Situational Analysis – Ratio Analysis10

▸Current Ratio

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02.01 – Situational Analysis – Ratio Analysis11

▸Gearing Ratio

02.01 – Situational Analysis – PESTEL12

Political

Economical

Social

Technological

Environmental

Legal

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02.01 – Situational Analysis – P5F’s13

03. Strategic AnalysisMore theories…

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03.01 – Strategic Analysis – Vision & Mission

▸ Vision

▸ Mission

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03.01 – Strategic Analysis – Goals & Objectives

▸ Goals

▸ Objectives

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03.01 – Strategic Analysis – Porter’s Generic Strategies

▸ Porter’s Generic Strategies

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03.01 – Strategic Analysis – Ansoff’s Matrix

▸ Ansoff’s Matrix

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03.01 – Strategic Analysis – BCG Matrix

▸ BCG Matrix

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03.02 – Strategic Analysis – Share and Company Valuation

▸ BCG Matrix

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Of use to:• Investors

• Managers wishing to understand what increases shareholder value

• Companies either considering merger and acquisition activity, or the target of such activity (to organise defences or simply to know which price to sell at)

01.Stock Market

Valuation

02.Net Asset

Value Based

Valuations

03.Income Based

Valuations

Valuation Approaches

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03.02 – Strategic Analysis – Share and Company Valuation

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Stock Market Valuation = No. Shares x Current Market PriceThe market value is “ theoretically correct” if the Efficient Market Hypothesis Holds

Issues• Managers may have extra

information• Quotes share price does not

reflect the value of all shares• Can’t do it for private

companies• Usually requires a

substantial premium to get shareholders to give up their shares

02. Net Asset Based ValuationNet Asset Valuation is has three main ways to value a companies assets. Net Book

Value & Net Realisable Value/“Fairness Opinions”Effectively for both ways though the equation is the same.

The only difference being how you value each of those different components.

Fixed Assets Current Assets

Non current liabilites

Net Asset Value+ - =

• Uses historical costs which are both factual and available

• Ignores intangible assets such as goodwill, human capital & brand names • Issues with depreciation method company has chosen (i.e. straight line vs

reducing balance)• Doesn’t value the entity as a going concern, and has little link to future

wealth generation ability

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03. Income Based ValuationsIncome based valuations of shares and companies have the innate advantage in that they are orientated towards the future assuming that the company will continue to remain a going concern for the foreseeable future.

Two main methods examined in this module are:

• Discounted Cash Flow Models

• Dividend Valuation Models Gordon’s Dividend Growth Model

Example - Discounted Cash Flow Method

End of Year Cash Flow ( $ M) D/F (10%) Pv ( $ M)1 20 0.909 18.182 32 0.826 26.433 40 0.751 30.044 30 0.683 20.495 20+100 0.621 74.52

169.66

Terminal Value 100M

03. Income Based Valuations

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03.02 – Strategic Analysis – COST OF CAPITAL25

Options Available

2. Debt

•Debentures – 2.1 (Redeemable / Irredeemable)•Long Term Loans / Overdrafts – 2.2

1. Equity

•Ordinary Shares – 1.1•Preference Shares –1.2•Internal Funding – 1.3

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Cost of Capital

How to CALCULATE?

Is it “EQUITY”?

COST OF EQUITY

DIVIDEND GROWTH MODEL

CAPM

Is it “DEBT”?

COST OF DEBT

BANK LOAN / OD Debentures

Cost of CapitalType of Funding Cost of Capital Equity -Ordinary Shares

Expected Rate of Return by the future share holders to compensate risk , using CAPM

Equity -Preference Shares

Fixed dividends stated in the prospectus.

Debentures Interest Rates stated in the prospectus

Bank Loans Commercial interest rates set in the loan agreement

Internal Funding Current Return On Investment (ROI) of the company

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Cost of Capital –Equity – Ordinary Shares – Listed Companies

ke = (d1 / p0) + g

Gordon’s Dividend Growth Modelke = Cost (k) of equity (e)

d1 = Dividends in Y1

p0 = Price of Share in Y0

g = Growth rate in dividends

Capital Asset Pricing Model (CAPM)ke = Rf + (Rm – Rf) b Rf = Risk Free Return

Rm = Market Return

b = Beta factor (risk factor)

ExampleCost of Ordinary Shares - DGM

ProblemSuppose the Gadget Company has a currentdividend of £2 per share. The current price of ashare of Gadget Company stock is £40. TheGadget Company has a dividend payout of20% and at a dividend growth rate of 9.6%.What is the cost of Gadget equity?

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ExampleCost of Ordinary Shares - CAPM

Problem:If the risk-free rate is 3%, the expected market risk premium is 5%, and the company’s stock beta is 1.2, what is the company’s cost of equity?

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Cost of Capital –Equity – Ordinary Shares – Unlisted Companies

• Estimate the ke of similar listed companies and then add a further risk premium for business and financial risk

• To the Risk free rate (Rf) rate add estimated risk premiums for both the Business risk and the Financial risk of the entity

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Cost of Capital –Equity – Preference Shares

kp = Cost (k) of Preference (p) share

DPS = Dividends per Share

MPS = Market Price of Share

Preference Shares - Irredeemable

kp = DPS / MPS

Preference Shares - Redeemable

kp = IRR of Preference Share0

ExampleCost of Preference Shares

Problem:A company issues 10,000 shares 10% PreferenceShares of £100 each. Cost of issue is £2 per share.Calculate cost of preference capital if these sharesare issued (a) at a premium of 10%, and, (b) at adiscount of 5%.

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Cost of Capital – Debt

kd = I (1 - t)

Bank Loan / Overdraftkd = Cost (k) of debt (d)

I = Interest rate

t = tax rate

MP = Market Price of Debenture

IRR = Internal Rate of ReturnDebentures - Irredeemable

kd = [ I (1 - t) ] / MP

Debentures - Redeemable

kd = IRR of Debenture0

ExampleCost of Debt – Bank Loan

Problem:A company is considering raising of funds of aboutGBP 100 million via a 14% institutional term loan.Assume a tax rate of 20%. What is the cost of debt?

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Cost of Capital - Overall (WACC)

k = Cost

V = Value

keVe + kdVd + kpVp

Ve + Vd + Vp

WACC =

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THANKS!Any HELP?nadun.shk@gmail.com0773 796 063