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ADVANCED CORPORATE FINANCE

CHINHOYI UNIVERSITY OF TECHNOLOGY


SCHOOL OF BUSINESS SCIENCES & MANAGEMENT
DEPARTMENT OF ACCOUNTING SCIENCE & FINANCE
ADVANCED CORPORATE FINANCE (CUAC401)
BCOM (HONS) ACCOUNTANCY
BPFA
COURSE OUTLINE 2009
COURSE LECTURER: T.J MABVURE (Mr.)
General Information

Office: Room 7-16/11-08


Phone: 0913 593 523
E-mail: jmabvure@cut.ac.zw, jmabvure@gmail.com,
tjaym2003@yahoo.com

1.0

Aim
This course is designed to develop an understanding of finance and
corporate financial analytical tools at a higher level. The course is a
continuation of Corporate Finance.

2.0

Objectives
By the end of the course, students should be able to:
2.1
Determine the value of Equity and Firms
Analyse Mergers and Acquisitions of Companies
2.2
2.3
Discuss Short term Financial strategies of firms

3.0

Method of instruction
3.1
Lectures
3.2
Demonstrations
3.3
Group discussions
3.4 Assignments

4.0

Assessment
4.1
Assignments
4.2
Intrasessional test
4.3
Final examination

T.J Mabvure (Mr.)

15%
15%
70%
1

Total
5.0

100%

Course Content
5.1
5.2

Corporate Strategy And Financial Strategy


Introduction To Valuation

5.3

Approaches To Valuation
5.3.1 Discounted cash flow valuation
5.3.2 Relative valuation

5.4

Discounted Cash Flow Valuation


5.4.1 Free cash flow to equity (FCFE)
Free cash flow to equity for Unlevered firms
Free cash flow to equity for Levered firms
5.4.2 Free cash flows to the firm (FCFF)

5.5

Valuation Of Companies
5.5.1 Valuation of Equity
Valuation in the stable growth model
Valuation in the two stage model
Valuation in the three stage model
5.5.2 Valuation of the Firm
5.5.3 Growth rate in FCFE and Growth rate in FCFF

5.6

Relative Valuation
5.6.1 Price Earnings Ratio
5.6.2 Price To Book Value Per Share
5.6.3 Price to sales

5.7

Short Term Financial Strategy


5.7.1 Spontaneous Sources of funds
5.7.2 Internal sources
5.7.3 External Sources
5.7.4 Relationships between sales and debtors, fixed assets and
current
Assets, stocks and creditors.
5.7.5 Constant ratio method
5.7.6 Formula methods

5.8 Mergers and Acquisitions


5.8.1 Horizontal, conglomerate, and vertical mergers
5.8.2 Reasons for mergers
5.8.3 Terms of mergers
Payment of Cash
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Share issues

Course Text(s) Recommended Reading


Bender R, Ward K.
Edition.2008.Elsevier.

Corporate

Financial

Strategy.3rd

Revised

Brigham, E.F, Brigham D.P, Gapenski L.C, Intermediate Financial


Management.6th edition. 1999. South Western.
Correia etal. Financial Management 3rd edition. Juta & Company,
Johannesburg
Damodaran Aswath.Investment Valuation Tools and Techniques for
determining the value of any asset.2nd Edition.1996.Wiley Frontiers in
Finance.
Hinderling C. Capital Budgeting
Kotler D. Marketing Strategy
Stickland A.J, Thompson A.A, Strategic Management: Concepts and
Cases. 13th Edition.2003. McGraw Hill Higher Education. University of
Alabama.

Text
1. Brigham and Gapenski; Financial Theory, Policy, and
Practice
a. Financial Planning
b. Restructuring,Mergers,acquisitions
c. Financial Reporting
2.
3.

Correia etal, Financial Management


a. Mergers and Acquisitions
Companies Act 24:03

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b. Legal Provisions on the


Restructuring,liquidations,arrangements
4.

Aswath Damodaran; Investment Valuation: Tools and


Techniques for determining the value of any Asset.
a. Main Textbook

5.

Strickland; Strategic Management


a. Reference book for strategic issues

6.

D. Kotler; Marketing issues


a. Reference for Strategic issues

7.

Keith Ward; Corporate Financial Strategy.

Functional Strategy
a)
b)
c)
d)

Marketing Strategy
Human Resources Strategy
Production Strategy
Financial Strategy

Financial Strategy
Issues to consider in crafting this strategy:
a) Sources of funds
b) Uses of funds
c) Capital structure(Debt/Equity structure)
d) Risk return(measured by ke,P0,g,)
e) Dividend policy
Main Corporate Strategy issues: How financial strategy fits into it.
a) Market share and growth rate of the market
b) Product range(Product life cycle)-At what stage of the PLC is each
product
c) Strategic Business Units (SBU)-every SBU is strongly related to each
product in each product range. For e.g. Pioneer has Passenger transport,
trucking, courier (removals) as its SBUs.Each SBU will follow the PLC of
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its product or product range. The PLC of the product is the PLC of the
SBU.
Product Life Cycle (PLC)

Stage 1: Introduction
Profits are negative
Promotion of the product(Heavy expenditure on promotional activities
resulting in low profits)
Heavy expenditure on R&D
Cash flow are negative
Stage 2: Growth
Profits are positive and are increasing
Advertising expenditure because of new competitors
Developing of Brands e.g. Buddie, Mango.Cashflows will be negative
because of brand building. If positive they are still low.
Stage 3: Maturity
Market growth rate has started to decline
Rebranding activities/brand transfer; Buddie to Libertie; Mazoe orange
crush to raspberry, Granadilla.
Large companies who have survived
Large market share
Growth rate of market stabilized
Cash flows now positive, now exploiting the characteristic of your brand
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Stage 4: Decline
Cash flows now negative
Growth opportunities now small
Divesting from Subs e.g. Harvesting SBUs like gold mining where gold has
run out.Kamativi tin mine was divested long ago because of the increase
in plastic.
Boston Consultant Group

SBU
Star

SBU
Question Mark
High relative market share in a
Low relative market share in a
high growth market
high growth market
2.Growth
1.Introduction
 Dividend payments low
 Dividends nil
 Listing or private placement
 Equity finance-venture capital
 Option based borrowing
 Gearing nil
 PE ratio high
 P/E ratio high
 Operating risk high
 Operating risk high, financial
 Gearing low
risk
low
SBU
SBU
Dog
Cash Cow
High relative market share in a
Low relative market share in a
low growth market
low growth market
3.Maturity
4.Decline
 Dividend high because of
positive
Cash flows
 Net cash flows high
 Rights issues
 Operating risk now low
 P/E ratio now low

Financial Strategic Issues


1.
2.
3.
4.

Net cash flows at each stage


P/E ratio at each stage
Dividend policy at each stage
Gearing ratio determined by the total risk

Introductory stage
 Net cash flows will be negative or very low because revenues are still
low and there are outflows in concept development
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Dividends are nil because profits still low and cash flows are negative.
Retention ratio is 100% in order to gain market share in the growing
market.
P/E ratio will be very high. Market perception that the company will do
well in the future are very high. Price per share relative to earnings per
share is high.
Total return(Dividend yield plus capital gain yield)
The investors are the promoters of the product concept and they are the
sponsors. The investors are venture capitalists using venture capital
(venture capitalists have different portfolios in different SBUs, i.e invest
in a controlling stake. They will be looking for capital gains and not
dividends. They sell their equity holdings as soon as the company grows
they pull out. Angel capitalists are an alternative to venture capitalists.
Financing structure will be all equity finance. Therefore the gearing
ratio will be Nill.The Company can not sustain loan obligations as they
come due.
Operating risk (business risk) will be very high so the required rate of
return by debt holders will be high and can not be sustained. Total
risk=Operating risk+Financail risk), so financial risk has to be maintained
at low levels.

Growth Stage








Still fighting competitors if the barriers to entry are very low. In the
telecoms industry POTRAZ and BAZ for broadcasting have artificially
raised the barriers.
Net cash flows are still low because of the heavy expenditures
incorporated in strengthening the brand, e.g netone, telecell, and
econet.
Dividends payments are very low
P/E ratio still very high
Capital gains being sought for, other than dividends
Gearing lo because at this stage the business risk is still relatively high,
thats why there is need for reducing financial risk by reducing
borrowings
Equity financing but changed from venture because the company will be
listed to facilitate a new share issue (IPO) for expansion of the company.
Equity is now shareholders equity and the venture capitalists will pull
out. At listing there will be a price which will determine the price at
which the venture will sell their share. Private placements (approaching
institutional investors such as the MIPF, PTC, NSSA, OLD MUTUAL, etc)
would also be considered when the company does not want to list.
Option based financing; financing with imbedded options such as
convertible debentures, convertible bonds will be considered. This are
issued at a lower cost than plain vanilla bonds. These will be converted
after a period of time agreeable. The option to convert is not obligatory,

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only exercised when its profitable to do so. Also there can be


debentures with warrants attached, i.e. the right to buy an agreed
number of the companys ordinary equity at an agreed time and at an
agreed price (strike price/exercise price) .A convertible is known as a
European option because it can only be exercised at an expiration date.
A bond with a warrant is an American option because it can be exercised
at any time before the expiration time. It gives an option within an
option. With a warrant you become a shareholder and also a bond
holder, the warrant can be detached from the bond, i.e it can have its
own market value. Its a highly valued instrument compared to the
convertible. At this stage the company has to take advantage of
financial leverage because earnings are increasing but can not borrow
outright because business risk is still high and financial risk has to be
minimized. To go around this problem, option based instruments have to
be used. Option based bonds (sweeteners) are cheaper than plain vanilla
bonds. They reduce the total cost of borrowing. Option based bonds can
be issued at low coupon rates because they will gain value, that is they
are participating in the growth of the company. Ordinary bondholders
have a fixed return and they dont benefit from the increase in the value
of the share. After the exercise the equity base will increase and the
debt will decrease, that is the capital structure will shift, for the
convertible bonds. For the bond with warrants, the debt levels will
remain the same and the equity will increase, also with these bonds
there will be a fresh injection of funds as the shares have to be bought.
With the options the company will be preparing for the restructuring of
the balance sheet, i.e restructuring at the initial public offer (IPO) and
then another restructuring at the exercise of the options.
Maturity
This is a stage at which the balance sheet will also be restructured.
 Rights issue/seasoned issue; New shares to existing shareholders. The
rationale is to reward the shareholders for being loyal because they have
made the company grow by accepting low or no dividends for capital
gains. The company does not want to dilute the earnings of the
shareholders.
 Exercise of options if convertibles and warrants had been issued.
 Net cash flows are now high, that is positive. High turnover with low cost
of R&D. Main expenditure is advertising rather than promotional because
brand is now established. Consolidating your position by tour brand. No
needs to reinvest as the market opportunities for expansion are now
low.
 Dividends now high because growth opportunities now reduced,i.e
retentions now reduced
 Cash cow because some of the cash flows can be used to finance new
SBUs.
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The returns now dividends yields rather than capital gains


Bond holders now interested in dividends rather than capital gains and
also this holds for all the former shareholders who the company started
with.
The P/E ratio now low
The operating risk now very low
Gearing ratio low, can now afford to have plain vanilla debt because the
cash flows are there.

Decline





Divesting/harvesting
Zero opportunities
Total dividend, that is 100% payout
Not able to increase borrowings because the required rate of return will
be high. If the company increase borrowings and the company is wound
up the share of the debt holders will increase in the company. Therefore
the debt/equity ratio has to be decreased.
The company will grow(g) at the same rate as the growth of the
economy

APPROACHES TO VALUATION
The purpose is to arrive at the value of the company using its fundamentals,
which is the value of its assets. There are three approaches to valuation.
1. Discounted cash flow Valuation
1. Value of equity-specifically the price per share(P0)
2. Value of the firm
 The value of an asset is the present value of the expected future
cashflows, discounted at the required rate or return that reflects
the risk ness of these expected cash flows.
n

Value=
t =1




CFt

(1 + ke)t

n=Life of the asset


CFt= Cash flow in year t
Ke=required rate of return given the risk
The value of equity is found by discounting the expected cash
flows to equity at the rate of return required by equity investors.
If we assume that the firm is in a stable growth period:

Value of equity=
t =1

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CFEt

(i + ke)t
9

Where t is starting from year 1 to infinity


CFE=Cash flow to equity
Ke= risk adjusted required rate of return [ke=RF+ (rmrf)]
Rf=
Risk free rate, ie the average money market rate, TB
rate is used as proxy .Not that it is the only risk free
rate, as all the securities in the money market are
risk free.
=
Beta coefficient, measure the volatility of the
returns on the security relative to the returns on the
market. Its a measure of the systematic risk
rm-rf= risk premium on the market
[illustrate with a diagram the risk premium]

Value of firm=
t =1

CFFt

(1 + WACC )t

CFF=Cash flow to the firm


WACC=Weighted average cost of capital
Value of firm is the cash flows to the firm discounted to the
weighted present value of the weighted average cost of
capital(WACC)
Cash flows to the firm are the equity to the shareholders
and debt to debt holders.
WACC=Wd[kd(1-T)]+WeKe+WpKp
kd=
Ke=
Wd=
Wk=
Wp=

cost of debt adjusted for tax(T) because interest is


Allowable for tax to make the debt cheaper.
cost of equity
weight of debt
weight of equity
weight of preference shares

Applicability






Discounted cash flow valuation is based on expected future cash flows


and discounts rates.
The expected cash flows have to be estimated
Given these informational requirements the approach is easier for firms
whose cash flows can be reliably estimated for future periods.
The approach also requires the use of a proxy for risk to be applied to
the discounted rates and the proxy is the coefficient
With other models other than CAPM the is not a sufficient proxy
however.

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The discounted cash flow approach may be difficult to use because of


the following:
1. Firms in trouble: A distressed firm generally has negative earnings
and cash flows. To estimate the future cash flows for such a firm
may be difficult because of the high probability of bankruptcy.
2. Cyclical firms: This is affirm whose earnings and cash flows tend
to follow the economic cycle, that is increasing during economic
booms and falling during recessions.
3. Firms with unutilized assets: Discounted cash flow valuation
reflects the value of all assets that produce cashflows.If a firm
has assets that are not utilized and therefore didnt produce cash
flows the value of these assets would not be reflected in the total
value. For example a firm with a piece of land, mining claim not
exploited.
4. Firms with Patents and Product options: Firms that have
unutilized patents or product options that are not currently
producing Cash flows but can be exploited are not also easy to
value using this approach.
5. Firms in the process of restructuring: For example the firm maybe
in the process of selling some of its assets and acquiring others,
e.g Delta disbanded some of its subsidiaries like the hospitality,
furniture and remained with the beverages.
6. Firms involved in acquisitions: This causes the problem of synergy
(expected benefits of the merger and they are not easy to
quantify.).

2. Relative valuation approach


1. This approach says that the value of an asset is derived from the
pricing of comparable assets standardized using a common variable
such as earnings, cashflows, book values or revenues.
2. We can use the industry average P/E ratio assuming that the other
firms in industry are comparable to the firm being valued.
3. We can also use the price to book value (market price/book value). A
firm selling at a discount to its book value relative to other firms in
the industry is considered undervalued.
4. Also price to sales multiple is used in this valuation process.
5. To use these multiples we relate the multiple to the firms
fundamentals such as; the growth rate in earnings, and dividend
payout ratio. This allows us to explore how the multiple will change
as the firms characteristics change for e.g. we would want to know
the effect of changing profit margins on the P/Sales ratio or the
effect of changes in the growth rates on the P/E ratio.
6. This approach is useful when there is large number of comparable
firms being traded on the financial markets and the market is on
average pricing these firms correctly.
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3. The contingent valuation method


This approach uses option pricing models to measure the value of assets
with option characteristics (warrants and convertible bonds).

Discounting cash flow approach


Estimating cash flows

I.Free cash flows to equity(FCFE)




Equity investors receive a residual claim on the cash flows to the


firm, is they are entitled to any cash flow that is left over after
meeting all the financial obligations of the firm including debt
repayments and the re-investment needs of the firm.
The free cash flow to equity (FCFE) are the cash flows that remain
after operating expenses and principal repayments and any
capital expenditures that are required to maintain the growth
rate in projected cash flows.

a) Free cash flows for and unleveled firm: An unleveled firm has no
debt in its capital structure, therefore there are no interest and
principal Repayments, it finances all capital expenditures and
working capital needs with equity therefore the free cash flow to
equity will be as follows:
Gross Profit
Operating Expenses
EBITDA
Depreciation and Amortization
EBIT
Taxes
Net Income
Depreciation and Amortisation
Cash flow from operations
Capital Expenditure (CAPEX)
Changes in Working capital
Free cash flow to Equity (FCFE)

xxx
(xx)
xxx
(xx)
xxx
(xx)
xxx
xxx
xxx
(xx)
(xx)
xxx

Amortization is the w/o of intangible assets e.g. goodwill, preoperations costs.

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Assuming an increase in working capital if there was a decrease we


will add.






The FCFE is the residual cash flow after meeting all the firms
financial needs; it can be negative in which case the firm must
raise new equity. If its positive it could but is not always paid out
as dividends to equity investors.
When we reach net income the amount w eventually deduct for
dividends has to take into consideration the CAPEX, and the
change in working capital.
Depreciation and amortization are treated as tax deductible
expenses in the income statement but they are non-cash expenses
and therefore they should be added back.
Equity investors can not withdraw the entire cash flow from
operations from the firms since some or all of it will have to be
re-invested to maintain existing assets and to create new assets
to generate future growth.
Funds tied up in working capital cant be used elsewhere in the
firm therefore increases in working capital are cash outflows and
decreases are cash inflows(specifically non-cash working capital)

Net Income
Depreciation
Funds from operations
CAPEX
WC
FCFE

2009($m)
100
40
140
(80)
(40)
20

2010($m)
20
45
65
(20)
(10)
35

The drop in the CAPEX and WC in 2005 resulted in increased FCFE through the
net income was much lower.
b) FCFE For a levered firm
In addition to making all of the outlays that an unleveled firm must
make the levered firm must also generate cash flows to cover
interest expenses plus principal repayments. It can also finance some
of its capital expenditures and working capital needs with debt
thereby reducing the equity investments needed.
Gross Profit
Operating Expenses
EBITDA
Depreciation and Amortisation
EBIT
Interest
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xxx
(xx)
xxx
(xx)
xxx
(xx)

EBT
Taxes
Net Income
Depreciation and Amortisation
Cash flow from operating Activities
CAPEX
WC
Principal Repayments (debt repayments)
Proceeds from new debt issues
FCFE

xxx
(xx)
xxx
xxx
xxx
(xx)
(xx)
(xx)
xxx
xxx

The interest is tax deductible but the principal repayments are


not tax deductible.
i) A levered firm at its desired level of leverage
 The desired leverage is the debt ratio that is viewed as
acceptable for future financing so there is no plan to change
it:
Debt
Debt Ratio=
debt + equity
 If the debt ratio is regarded to be optimal the free cash flows
to equity (FCFE) will be: Net income-(1-d) (CAPEXDepreciation)-(1-d) (WC). d=Debt ratio regarded as optimal.
 For such a firm the proceeds from new debt issues will be
given by the following: Principal repayments+d (CAPEXDepreciation+ WC).
 Since the firm is at its desired capital structure principal
repayments are made with proceeds from new debt issues.
CAPEX and WC needs are financed using the desired mix of
debt and equity.
E.g. In 2009 a firm had $10million of debt outstanding and $30million in
market value of equity giving a debt ratio of 25%. This debt ratio is assumed to
be stable (there is no attempt to change it). The following information is
available:

Net income
Depreciation
CAPEX
WC (2008=10)
Sales

2009(Reported)
$
250
50
150
25
1000

Question: calculate the FCFE


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2010(Projected)
$
400
75
300
1500

Working capital in 2010 is projected to be at the same percentage of sales as in


2004
WC (2009) =

25
* 100 = 2.5%
1000

WC (2010) =2.5%*1500=$37.5million

Net income
- (CAPEX-Dep)
FCFE




2009
250
(75)
(11.25)
163.75

2010(Projected)
400
(168.75)
(9.38)
221.87

The FCFE will increase as the amount of debt used by the firm increases,
that is the FCFE is an increasing function ofd.
Suppose we increase the debt ratio to 40%, the FCFE will be high.

d=40%
Net income
- (Capex-Depn) (1-d)
- (WC) (1-d)
FCFE



2009
250
(60)
(9)
181.00

2010
400
(135)
(7.5)
257.50

This is tying up with the financial leverage effect


This increase in FCFE however comes at the price of increased risk to
the equity holders (financial risk), that is as we increase debt there is
a probability that our earnings would not be able to pay our interest
and principal obligations.
This risk will result in a higher coefficient for the firm. The higher
the , the higher the ke, that is investors, will penalize the firms
equity by increasing the required rate of return.

ii) A levered firm with a debt ratio below the optimal level
 A levered firm that is operating at a debt ratio below its desired level
can afford to use more debt in financing its capital expenditures and
working capital needs until it reaches the target debt ratio(optimal
level) and the FCFE for such a firm will be as follows.
Net Income
Depreciation and Amortisation
Cash flow from operations
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xxx
xxx
xxx

CAPEX
WC
Principal Repayments
Proceeds from new debt issues
FCFE



(xx)
(xx)
(xx)
xxx
xxx

If the firm decides to increase its leverage towards its targeted levels
then the proceeds from new debt issues would be greater than the
principal repayments plus the CAPEX and WC needs.
Can not use the short cut method because debt levels not optimal
Proceeds from new debt>Principal repayments+d (CAPEX+ WC)




During the period when the firm is financing its investment needs
disproportionately with debt, the FCFE for such a firm would exceed
that of a firm which does not have such financing slack. A firm with
financial slack will have more FCFE than a firm with no financial
slack.
The principal repayments are still financed with new debt issues
therefore dont affect the FCFE.
Suppose the company has reported the following:

2009(Reported)
$
Net Income
900
CAPEX
400
Depreciation
80
WC
50
Debt(mkt value)
250
Principal repayments70
Equity(mkt value) 800

2010(Projected)
$
1500
600
100
55
70
-

d=

250
* 100 =24%
800 + 250

The company wants to increase this debt ratio to 40% which it


considers optimal, to achieve this target the company plans to
finance 60% of its CAPEX and WC needs with debt between 2009 and
2010.

Calculate The FCFE in 2010:


We cant use the short cut method since the debt ratio is not
optimal.
Net Income
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1500
16

Depreciation
Cash flow from operations
WC
Principal Repayments
Proceeds from new debt issues
Capex
FCFE

100
1600
(55)
(70)
463
(600)
1338

Proceeds from new debt issues=70+0.60(600+55) =463


60% should be debt and 40% equity if the company wants 100% capital
injection. Equity will not remain at $800; it will increase by 40%.
iii) A levered firm with leverage above the optimal.


The d is the desired level of debt

A firm will have to use disproportionately more equity in financing its


investments needs in order to reduce its debt ratio and may also have
to generate funds from equity in order to meet some or all of its
principal repayments.

The FCFE will be as follows


Net income
Depreciation and Amortisation
Cash flows from operations
CAPEX
Principal Repayments
WC needs
Proceeds from new debt
FCFE




xxx
xxx
xxx
(xx)
(xx)
(xx)
xxx
xxx

There is some short-term debt which needs to be refinanced as


they mature, we cant live without them.
If the company decides to reduce its leverage towards the optimal
level then proceeds from new debt issues will be less than principal
repayments + WC and CAPEX.
In the period that the company is raising disproportionately more
equity to finance its investments needs and principal repayments the
FCFE would be lower than the FCFE for an otherwise similar firm
which is operating at its desired leverage.
In Zimbabwe companies above leverage were (2007 and before)
financing through retained earnings to reduce debt levels but in the
process they were reducing FCFE.

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17

Question-levered firm below the optimal


Net income
CAPEX
Principal Repayments
WC
Depreciation
Mkt value of debt
Market value equity
Proceeds From new debt
FCFE
d=


2009(Reported)
400
120
20
50
55
450
1200
90
355

2010(Projected)
850
240
20
60
70

740

450
* 100 = 27.27%
450 + 1200

The company plans to increase the debt ratio to 35% by 2012. to


reach this target it plans to finance 40% of its capital expenditures
and WC requirements between 2010 and 2012 with debt.

Calculate the current FCFE and the projected FCFE for 2010.
Proceeds from new debt issues=Principal repayments+d(CAPEX+ WC)
=20+0.4(240+60)
=140

Net income
Depreciation
Cash flow from operations
CAPEX
WC
Principal repayments
Proceeds from new debt issues
FCFE

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18

2009

2010

400
55
455
(120)
(50)
(20)
90
355

850
70
920
(240)
(60)
(20)
140
740

Question-levered firm above the optimal


2009

2010

Net income
CAPEX
Depreciation
WC
Mkt value of debt
Mkt value of equity
Principal repayments
New Debt issues

18500
3600
2950
1850
7500
-

d=

14000
1750
1900
1400
40000
45000
5000
10000

40000
* 100 = 47.1%
45000 + 40000

The company plans to reduce its debt ratio from 47% to 25% by 2012,
to achieve this only the short term debt which is currently standing
at $10000 will be refinanced. All CAPEX and any increases in WC
needs would be financed primarily with equity that is 90% and 10%
debt. Long term debt outstanding would be repaid with cash flows
from equity.

Calculate the FCFE for 2009 and the projections for 2010.
Proceeds from new debt issues=New debt issues+0.10(3600+1800)=10540
For 2010 the 10000 which the company had in 2009 will be refinanced
and raise 10% in the proportion of CAPEX and WC.

Net income
Depreciation
Cash flow from operations
CAPEX
WC
Principal repayments
New debt issues
FCFE

T.J Mabvure (Mr.)

2009

2010

14000
1900
15900
(1750)
(1400)
(5000)
10000
17750

18500
2950
21400
(3600)
(1800)
(7500)
10540
19090

19

II. Free cash flows to the firm


FCFF1
WACC g
This is the value of the firm for a company in a stable growth model.
The firm can be valued more realistically when we use the above
model than the dividend growth model as some firms dont offer
dividends.
A firm is composed of all its claim holders(claim to the cash flows
Including equity investors, debt holders, and preferred stock
holders).
The cash flows are the total cash flows to all these claimholders. The
cash flows to the firm are those left over after meeting operating
expenses and taxes but before making any payments to any
claimholders.

Value of the firm=







Free cash flows to the Firm (FCFF)=FCFE+Interest expenses(1T)+Principal repayments+New debt issues+Preferred Dividends


Another approach will give the same result is where we start with
Operating earnings.

EBIT(1-T)[Pre-tax EBIT]
+Depreciation
-CAPEX
- WC
=FCFF
Suppose we have the following information.

EBIT
Depreciation
CAPEX
Tax rate

2009

2010

5000
200
3250
40%

10500
350
4500
40%

2009

2010

3000
200
(3250)
(1300)

6300
350
(4500)
(2500)

What is the FCF to the firm?


EBIT(1-0.4)
Depreciation
CAPEX
Increase in WC
T.J Mabvure (Mr.)

20

FCFF




1350

(350)

1-T is the tax shield


Principal repayments are added back because they are payments to
debt holders.
Since cash flows to the firm are before debt payments they are not
affected by the amount of debt that the firm is using but this does
not mean that the value of the firm is not affected by the amount of
leverage because as the amount of debt increases the WACC will also
increase because the cost of capital (ke) will increase.
WACC=Wdkd(1-T)+Weke,as Wd increase the will increase and the
ke(cost of equity) will increase.

The difference between FCFE and Net Income


FCFE different from net income for the following reasons:
 Non-cash charges are added back to net income to arrive at the cash
flows from operations therefore the earnings reported by firms that
take significant non-cash charges against current might be lower
then cash flows.
 FCFE are residual cash flows after meeting CAPEX and WC
needs,whre as these are not included in the calculation of net
income, therefore high growth firms that have significant CAPEX and
WC needs might report positive growing earnings but negative FCFE.
Investors are however more interested in FCFE.
Estimating Growth
FCFE1
;we discussed about the FCFE,Ke. Now we
Ke g
desire to discuss about the g.

In the formula,P0=

g is the expected growth rate in earnings and dividends assuming that


earnings and dividends grow at the same rate.
There are two approaches to estimating the growth rate in earnings.
1) Estimating using an average of past growth rates and assuming that
this growth rate reflects the expected growth rate.
 The most common ones are the arithmetic average and the
geometric Mean.
 The arithmetic average is the mean of past growth and the
geometric average takes into account the compounding effect.
 The geometric mean is a more accurate measure of the growth of
the earnings especially when the year to year growth in the past
has been erratic.
 The geometric mean will always be lower than the arithmetic
T.J Mabvure (Mr.)

21

average.
Year

EPS
$
0.66
0.90
0.91
1.27
1.13
1.27

2000
2001
2002
2003
2004
2005

%
36.36
1.11
39.56
-11.02
12.39

36.36 + 1.11 + 39.56 + (11.02) + 12.39


= 15.68
5
1.27
Geometric mean=1 + g = 5
0.66

Arithmetic mean=

g= 5

1.27
1 = 13.99%
0.66
1

1.27 5
or geometric mean=
1 = 13.99%
0.66
Estimating Issues
 The first problem is that the EPS must grow at the same rate as the
DPS.
 The growth rate is sensitive to the starting and ending period for the
estimation, for e.g. the growth rate in earnings over the past five
years will be different from the growth rate over the past 6 years but
the length of the estimation period is subject to the judgment of the
analyst for e.g. if 1999 had EPS of $0.65 then the arithmetic average
will be 13.32% and the geometric mean will be 11.81%.
2) Using the fundamentals reported in the current year: what are the
determinants of earnings growth?
 The growth rate in earnings is determined by the decisions that
the firm makes with regards to product lines, profit
margins,leverage,and dividend policy.
The retention ratio and the Return on Equity(ROE)
NetIncome
 The ROE=
BookValueofEquity
NI NI t 1
 gt = t
NI t 1
NIt =Net income for this year
NIt-1 =Net income for last year
gt =Growth rate in the net income
T.J Mabvure (Mr.)

22

ROE=

NetIncome
BookValueofEquity

Therefore


NI =ROE*Book value of equity


NIt-1 =ROEt-1*Book value of equityt-1
Assuming that the ROE is unchanged, that is to say
ROEt =ROEt-1,

ROEt BVEt ROEt 1 BVEt 1 ROE (Re tained t 1 )


=
NI t 1
NI t 1
REt 1
gt =
* ROEt
NI t 1
gt =Retention ratio*Return on Equity
gt =b*ROEt
gt =

g is the growth rate in Earnings per share




This relationship assumes that the ROE doesnt change over


time. If it changes, that is ROEtROEt-1 the growth rate in
period t(now) will be given by the following relationship.
gt=

BVEt 1 (ROEt ROEt 1 )


+ b * ROEt
NI t 1

BVEt 1 (ROEt ROEt 1 )


measures the effect of
NI t 1
changing the ROE on the existing equity base. Increases in the
ROE make it more profitable to create a higher growth rate.
the first term,

The following information was reported in 2008


BVE
NI
b

= $15600
= $4200
= 60%

ROE

=
=
Suppose
increase
T.J Mabvure (Mr.)

4200
* 100 = 27%
15600

60*0.27
16.15%
that in 2009 we had projected that the ROE will
to 30% from the current 27%. The retention ratio will
23

however remain at 60%. Therefore we now use the other


method.
g =

15600(0.30 0.27 )
+ 0.6 * 0.30 = 29%
4200

An increase in the ROE of 30% translates to an increase of:


29 16.15
* 100 = 79.57% In the growth rate of earnings,
16.5
i.e. the higher the ROE, the higher the growth in the earnings.

The relationship between the growth rate and leverage


 In this case leverage is being measured using the D/E(gearing).
 The ROE and by implication the growth rate in earnings is affected by the
leverage decisions of the firm. Increasing leverage will lead to a higher
return on equity if the pre-interest after tax return on assets exceeds the
after tax interest rates paid on debt. This is captured in the following
formulation of the ROE, i.e. expansion of ROE.
Pre-interest after tax earnings = EBIT (1-T)
The expanded version of the ROE:
ROE = ROA+ D/E(ROA-i)(1-T)
= ROA+ D/E(ROA-I)(1-T)
Where ROA=

D/E=

EBIT (1 T )
BVA

BVD
BVE

BVD=Book value of Debt


BVE=Book value of equity

InterestExpenses
i=
BVD

T=Tax rate
BVA=BVD+BVE
Interest expenses are those found in the income statement.
 Using this expanded version of the ROE the growth rate in earnings:
g=b*[ROA+D/E (ROA-i)(1-T)]

T.J Mabvure (Mr.)

24

The effect of the product line analysis with respect to growth


rate


A firm with an ageing product line mix may look healthy in terms of
historical growth and current profitability, but it is not likely to sustain
this growth into the future. The analysis of growth for a firm can be
made more complete by looking at its individual products line and
examining where they stand in terms of the PLC.
The growth rate across product lines can then be estimated using the
following relationship:
gjt=b*[Mjt*Tjt-D/E(Mjt-i(1-T)]
Where

gjt =growth rate in year t for product line j


Mjt =Pre-interest after tax profit margin in year t for product
line j
EBIT (1 T )
=
Sales
Tjt =Asset turnover in year t for product line j
Sales
=
TotalAssets
D/E=gearing ratio of the firm as a whole
i =interest expenses
InterestExpenses
=
BVD
T =Tax rate

Now to ke


Ke=Rf+(Rm-Rf)
CAPM
Rf=Risk free rate which can be the Treasury bill rate as a proxy for the
risk free rate, normally its the money market rate.
Rm =Average return on the market index, ie Holdings Period Return
(HPR) on the index.
Rm=HPR=

M 2 M1
M1

M2=Index at the end of the year


M1=Index at the beginning of the year
Beta coefficient()

T.J Mabvure (Mr.)

25

 The beta coefficient measures the risk of the asset in relation to the
market. The volatility of the return on the assets in relation to return on
the security.
 if an asset has a =1.2,it means that if the return on the market increases
by 10% then the expected return on the security will increase by 10*1.2=12.
if the market is bullish you hold an offensive security. If the market
sentiments are bearish you hold a defensive security.
 To estimate the we regress the excess returns on the security against the
excess returns on the market.
Diagram

The beta coefficient for a private company


 Get the average gearing ratios for similar companies that are listed as well
the average
.
 Suppose our market consist of 3 listed banks and we have gathered the
following information about the banks.

Firm
Barclays
CBZ
NMB
Average

Beta
1.20
0.90
1.40
1.17

D/E
0.40
0.25
0.42
0.36

What is the beta for stanbic whose debt ratio is 30% and is not listed
 The beta of a levered firm L:
L =U[1+(1-t)(D/E)]
U= for an unlevered firm
L
U =
I + (1 T )(D / E )
Then calculate the unlevered betas of the firms; we want to remove the
leverage effect from the companys. Assuming that tax rate is 40%.
T.J Mabvure (Mr.)

26

U =

1.17
I + (1 0.40 )(0.36 )

L =0.96[1+(0.6)(0.30)]
=1.13
 Therefore the for stanbic is 1.13
 The formula has now taken into effect the 30% leverage of stanbic.

Valuation of companies
Valuation of Equity
i.Valuation using the stable growth model
ii.Two stage model
iii.Three stage model
We are canceling out the decline stage

 In the stable phase the company is growing but the growth is stable
 Opportunities for expansion are no longer there
 The growth rate is now equivalent to that of the economy is identical to
normal growth rate
T.J Mabvure (Mr.)

27

Stable growth Model

FCFE1
Ke g n
Where gn=stable growth rate which is expected to be maintained in
perpetuity
 This assumption is suitable for a firm that is large for a firm that is large
In size (because it has gained relative market share in that industry) but is
not likely to grow much faster than the economy in the long term because
there are no more growth opportunities in that industry.
 It generates large cash flows, which means that it will pay out much less
dividends than its generating in FCFE, because of this the financial
leverage will be higher but stable.
 Free cash flows large thats why its called a cash cow.
 Free cash flows also used to pay dividends as well as support other SBUs.
P0=

E.g. The following information was reported by ABC Limited


$
3.15
3.15
2.78
0.50
25%

EPS
CAPEX per share
Depreciation per share
WC
Debt ratio

1. Earnings, Capex, Depreciation and other WC are all expected to grow


at 6% p.a, the coefficient is 0.9. the TB is 7.5%, and the average
return on the market(Rm) is 13%
Question
Estimate the value per share.
Once a company enters into a stage (introduction, Growth, Maturity) the
debt ratio in that category is considered optimal and can only change
when it comes out of the stage.
Can use EPS instead of Net income but have to reduce everything to per
share.
Ke= Rf+(Rm-Rf)
= 7.5+0.90(13-7.5)
= 12.45
very low because the company is now in the growth stage

T.J Mabvure (Mr.)

28

EPS-(CAPEX-Depreciation)(1-d)-( WC)(1-d)
FCFE =3.15-(3.15-2.78)(1-0.25)-0.50(1-0.25)
=2.4975
FCFE1
Ke g
FCFE (1 + g )
=
Ke g
2.4975(1.06 )
=
0.1245 0.06
=$41

P0=

Two stage model


Earlier we assumed that the firm was in stage 1 and now the firm is in stage
2. We will Have FCFE1, FCFE2, FCFE3, and then discount them to year 0 to
get P0.

FCFE n +1
Ken g n
FCFE 4
P3=
Ken g n

Pn =

PV of P3=

P3

(1 + Ke)3

The Two stage model


 This is designed to value a firm that is expected to grow much than a
stable firm in the initial period and at a stable rate after that. The value
of the FCFE per year(p.a) for the extra ordinary growth period(growth
above the normal growth)plus the present value of the terminal price at
the end of the period.
P0

=PV of FCFE+PV of Terminal price


t =n
FCFEt
Pn
=
+
t
(1 + Ke )n
t =1 (1 + Ke )
n = end of the high growth period
Pn =Price at the end of high growth period
FCFE n +1
=
Ken g n
Ken=Ke for the stable growth period

T.J Mabvure (Mr.)

29

gn =g for the stable growth period


Ke =Ke for the high growth period
g =growth rate for the high growth period
ABC Ltd has a history of extra ordinary growth but its growth rate is now
stabilizing because its becoming a much larger company and its products
are maturing and facing competition.
The company pays very low dividends but has some FCFE. This FCFE is
likely to increase as the company gets larger and the growth rate
stabilizes.
The financial leverage is currently considered stable. The financial report
for this year has the following data.
EPS
Revenue per share
Capex per share
Depreciation per share

15
40
5
1.50

The following estimates have been made for the high growth period:
Length of period
Return on Equity
Retention ratio

4 years
22%
95%

The company pays very low dividends because its shareholders are more
interested in capital gains.
g=b*ROE=0.95*22=20.9%
the following market parameters will apply during this period:
TB rate
Average return on the market
coefficient




15%
27%
1.8

Ke = Rf+(Rm-Rf)
= 15+(27-15)
= 36.6%
CAPEX, Depreciation and revenues are expected to grow at the same
rate as earnings
The WC is expected to be 20% of revenues. The debt ratio which is
considered to be optimum at this stage will be 5%.

T.J Mabvure (Mr.)

30

Inputs for the stable growth stage period:









The ROE will increase to 30%


The retention ratio will decrease to 50% as the company pays higher
dividends
The during the stable growth stage period will decrease to 1.1
because of reduced operating risk.
The debt ratio will increase to 20% which will be considered optimal
at this stage
Risk free rate will be 15%
Rm will be 27%

Question
Estimate the value per share. The assumption is that the debt ratio is at its
optimal level
Three stage model
The company is still at the introduction stage and wants to move through other
stages,ie to grow and then mature.

T.J Mabvure (Mr.)

31

P0=

n2

FCFEt

FCFEt

(1+ Ken) + (1+ Ke ) (1+ Ke )


t =1

t n1

n1n2

n1

n1

n2

Pn2

(1+ Ke ) (1+ Ke )
n2 n1

n2

n1

n2

CAPEX VS Depreciation
 Its reasonable to assume that as a firm goes from high growth to stable
growth the relationship between CAPEX and depreciation will change. In the
high growth stage CAPEX is likely to be much higher than depreciation.
 In the high growth stage CAPEX is likely to be much higher than depreciation,
because we are buying new assets and depreciation, that is wearing and tear
is minimal.
 In the transition stage the difference is likely to narrow down and in the
stable phase they are likely to be equal

E.g. A company is expecting a growing rate in earnings in excess of 30% per


year due to the high growth rate of its markets and its market share. The firm
currently pays no dividends but has a negative free cash flow to equity due to
its large CAPEX and working capital requirements. The firm is using very little
debt in relation to equity and does not plan to change this in the near future.

T.J Mabvure (Mr.)

32

Current financial information is as follows:


$
EPS
CAPEX
Depreciation per share
Revenues per share
WC as a % of revenues

30
40
10
100
20%

Inputs (Projections) for the high growth period


 The high growth period will last for four years and during this period the ROE
is expected to be 60%.
 The retention ratio will be 100%, therefore g will be 60
%(g=b*ROE=60%*100%).
 CAPEX, depreciation and revenues will grow at the same rate as earnings
which is 60%,ie CAPEX,Depreciation will increase at 60%.
 WC will be maintained at 20% of revenues.
 The debt ratio(D/E) will be 5% and the following market parameters will
apply:
coefficient
1.9
Rf
15%
Rm
22%
Ke=28.3%
Inputs for the transition period
 Length of period
3 years
 The growth rate in earnings will decline from 60% in yr 4 to 15% in yr 7
linearly.
 Capex will grow at 40% p.a and depreciation will continue to grow at 60%(so
that they will converge).
 Working capital will remain at 20% of revenues which will now be growing at
40%.
 The debt ratio will increase to 10%(because at this stage we are not
borrowing much).
 The other market parameters will remain the same but the will decline to
1.5, therefore Ke=25.5%.
Inputs for the stable period
 Earnings will grow at 10% in perpetuity
 Capex will be exactly offset by depreciation (we are now replacing what we
bought and not buying.
 Revenue will grow at10%
 WC will remain at 20% of revenues
T.J Mabvure (Mr.)

33

 The debt ratio will increase to 20%


 The will decrease to 0.9
 The other parameters will remain the same, Ke=21.3%
Question
Calculate the value per share
VALUE OF A FIRM
Free cash flow to the firm (FCFF) are the sum of the cash flows to all the
claimholders in the firm including debt holders, preference shareholders and
equity holders. To value the firm we discount the FCFF at the required rate
which is the weighted average cost of capital (WACC).
FCFF=EBIT (1-T)-(Capex-Depreciation) - WC. The debt ratio does apply in the
determination of the FCFF. For a firm in the stable growth period the value of
the firm is determined as follows.
Value of Firm=

FCFF1
WACC g n

gn=Expected growth rate in perpetuity


 This model requires that the growth rate of the firm should be reasonable,
relative to the normal growth rate of the economy.
 The relationship between Cape and depreciation must also be consistent
with the assumptions of stable growth,ie a stable firm generally should
not have Cape that are significantly greater than depreciation, since
there are no growth opportunities there would be no need for additional
capital investment.
E.g. Two stage model
The valuation of a firm which is highly leveraged.
The base year information
$
3800
500
300
10000
25%
40%
40%
15%
22%

EBIT
Capex
Depreciation
Revenues
WC as a % of Revenues was
Tax rate
Tax rate
TB rate
Rm

T.J Mabvure (Mr.)

34

 The firm is approaching a high growth phase which will last for 4 years
after which earnings will stabilize.
 Expected growth rate for operating earnings (EBIT) during the high growth
phase will be 20% p.a
 will be 1.5
 The other market parameters will remain the same.
 The WC as a % of revenue
25%
 The pre-tax cost of debt
20%
 The debt ratio(D/E)
50%
 This high level of leverage is targeting the resulting of a leveraged buyout
in the last 2 years.
 Its anticipated that this high debt ratio will be reduced gradually over the
next 4 years to acceptable levels.
 Capex,revenues and depreciation will grow at 20%
Inputs for the stable growth phase
Expected growth rate in earnings
throughout the period
Pre-tax cost of debt
Debt ratio(D/E)
CAPEX will be offset by depreciation
WC as a % of revenue
Revenues will grow at

10%
0.9
8%
25%
30%
10%

Q. Calculate the Value of the Firm


Three stage Firm valuation model
Current inputs (2009)
$m
EBIT
Capex
Depreciation
WC
Tax rate

400
550
300
10% of Revenues
40% for all periods

High Growth Period


Length of period
Growth rate in revenues and EBIT
=1.8, Rm=22%, Rf=15%
Debt ratio
Pre-tax cost of debt
Capex and Depreciation will grow at 40%
T.J Mabvure (Mr.)

35

4 years
40%
30%
12%

WC

10% of Revenues

Transition Period
Length of Period
3 years
Growth rate of EBIT and Revenue will decline linearly from 40% in year 4 to 10%
in year 7
Capex will grow at
20%
Depreciation will grow at
15%
will drop from 1.8 in Y4 to 1.20 in Yr7 linearly
WC=10% of revenue
Debt ratio
10%
Pre-tax cost of debt
10%
Stable Period
Growth rate in EBIT and Revenues
Pre-tax cost of debt
Capex and Depreciation will cancel each other
=1.00, Debt ratio
WC=10% of Revenues

5%
15%

Qn. Calculate the value of the firm


Growth rate in FCFE vs. Growth rate in FCFF
SEE ASWATH DAMODARAN
RELATIVE VALUATION
Another method for evaluation is the relative valuation method. In this
valuation model we use the following:
P0
i) P/E multiple=
P0 = Price per share
EPS
P
ii) PBV
= 0
BVE
P
iii) Price to Sales= 0
Sales

Estimate the P/E ratio of the fundamentals


 The P/E ratio can be related to the same fundamentals that determine
the value using discounted CF models. The fundamentals are:
a.
The expected growth rate in earnings and dividends per share.
b.
Dividends payout ratios
c.
Risk as reflected in the cost of equity
T.J Mabvure (Mr.)

36

The P/E ratio for a stable firm


 A stable firm is a firm that is growing at a rate that is comparable to the
normal growth rate in the economy in which its operating.
 For a stable firm the value of equity is given by the following:
D1
If we use the dividend growth model
P0 =
Ke gn
Since DPS1=EPS0 (Payout ratio) (1+g) =Dividends next year, i.e. dividends at
the end of this year.
This means that the value of equity (P0)
P0 =

EPS 0 (PayoutRatio )(1 + g )


Ke gn

We know that P E =

Therefore P E =

P0
EPS 0

P0
(PayoutRatio )(1 + g )
=
EPS 0 (1 + g )
Ke gn

If the P E ratio is stated in terms of expected earnings in the next period,


ie we are saying:
P0
P
= 0
EPS1=EPS next year
EPS 0 (1 + g ) EPS1
EPS0=EPS this year
P0
PayoutRatio
=
EPS1
Ke gn
 This means that the P/E ratios an increasing function of the payout ratio
and the growth rate in earnings and a decreasing function of the risk ness of
the firm as reflected in the coefficient of the firm in Ke(Required rate of
return).
 Therefore in calculating P/E we are calculating.
P0
(PayoutRatio )(1 + g ) OR
=
EPS 0
Ke gn
P0
(PayoutRatio )
=
EPS1
Ke gn
This is the P/E ratio taking into account the fundamental characteristics of
the firm. These fundamentals are:
a) The expected growth rate in earnings and dividends
P E=

T.J Mabvure (Mr.)

37

b) Risk ness of the firms cash flows as reflected by the beta of the
company in the cost of equity(Ke)
c) Dividend payout ratio.
E.g. A firm had EPS of $250 in 2009 and paid out a dividend of $120. The
growth rate in earnings and dividends in the long term (stable state) is
expected to be 10%. The market parameters are as follows: RF=20%, Rm=25%,
=1.2
Calculate the P/E today based on these fundamentals.
Ke=26%
120
= 0.48
250
P0
(PayoutRatio )(1 + g ) = 0.48(1.10) = 3.30Times
P/E =
=
EPS 0
Ke gn
0.26 0.10

Payout ratio=

 If the actual P/E at the time of the analysis was say 10.5. the low P/E of 3.3
is an indication that the firm was not paying out what it could afford as
dividends.
 If the firm is paying out significantly less dividends than it can afford we can
use FCFE in stead of DPS to calculate P/E.
E.g. A company has EPS of $400 and paid no dividends. The following market
parameters apply, RF=20%, Rm=20%, =0.9. The expected growth rate in
earnings was 10% and the FCFE per share was 350.
The P/E ratio based on these fundamentals will be:
Ke=24.5%
Payout =

FCFE 350
=
= 0.875
EPS
400

FCFE
is the free cash flow payout ratio, as an equivalent of the dividend
EPS
payout ratio.
P E=

0.88(1.10)
= 6068
0.245 0.10

 The firm didnt payout dividends,ie we are saying what will be the P/E if we
use FCFlows rather than the dividends that are giving a 3.0 value.
T.J Mabvure (Mr.)

38

 If the company was selling at a P/E of $10.5, then dividends alone cant be
blamed for the low valuation.
 The low value of the firm is not sorely to do with dividends. The firm is over
valued by the market yet the fundamentals are lowly valuing the firm.
E.g. a company has EPS of $40 and paid out a dividend of $12.50/share. The
growth rate in earnings and dividends is expected to be 10%. The =0.9,
TB=15%, Rm=22%. Calculate the P/E ratio based on these fundamentals.
Ke=21.3%
Dividend payout ratio=

12.50
= 0.3125
40

g=10%
P E=

0.315(1.10)
= 3.05Times
0.213 0.10

E.g. A Company is currently selling at a P/E ratio of 6.00. The company had EPS
of $60 and paid out dividends of $22/share. The FCFE was $30 per share.
Expected growth rate in earnings is 10%. RF=15%, Rm=22%, =0.9. Comment on
the value of the company.
Ke=21.3%
Dividend payout=

22
= 0367
60

g=10%
P E=

0.367(1.10 )
= 3.57Times
0.213 0.10

FCF payout=

30
= 0 .5
60

g=10%
P E=

0.5(1.10 )
0.213 0.10

 The Firm is overvalued by the market.


 Dividends alone, ie low dividend payout are not the only one to blame for the
low value of the firm.
 The free cash flows also low according to the market expectation
 The market is paying more than what the company is worth given the
fundamentals of the company.
T.J Mabvure (Mr.)

39

 The company is paying out less dividends than what the market is expecting.
Comment
 The market is overvaluing the company because the company is paying less
dividends than what the market is expecting and the market is anticipating
higher cash flows than what is being generated and at the same time the
market is understating the risk of the cash flows or the risk ness of the firm.
Comparing the P/E ratio with other P/Es
 P/Es across countries(markets)
 P/Es across time
 P/Es across firms
SEE ASWATH DAMODARAN
P/E Ratio for a High Growth Firm
Valuation for high growth; two stage model

P0 =
t =1

Pn =

FCFE
+ PVofTer min alValue
(1 + Ke)

FCFE n +1
= Ter min alValue
Ken gn

 The P/E ratio for a high growth firm can also be related to the fundamentals
in the case of the two stage model.
n

(
1+ g)
PayoutRatio(1 + g )1

(1 + Ke )n PayoutRation (1 + g )n (1 + gn )
P0

P E=
=
+
EPS 0
Ke g
(Ke gn )(1 + Ke)n

EPS0
g
Ke
gn
period)
Payout ratio
Payout ration
Ken
n

=EPS in the current year


=Growth rate in the current phase
=Cost of equity in the current year(phase)
=Growth rate after the first phase(growth rate in the stable
=Payout in the current phase(first)
=Payout in the second phase
=Cost of equity in the second phase
=Length of the current phase

The P/E ratio is determined by:

T.J Mabvure (Mr.)

40

1) The payout ratio during the high growth phase and the stable period, the
P/E ratio increases as the payout ratio increases.
2) The riskiness of the firm through the discount rate Ke. The higher the risk
the lower the P/E.
3) The expected growth rate in earnings in both the high growth and stable
periods. The higher the growth rate, the higher the P/E. If the firm is not
paying dividends we use the ratio of the free cash flow to equity to EPS
instead of the dividend payout ratio.
E.g. A firm is expecting a five year period of high growth after which the
growth rate will normalize in line with the growth rate of the economy.
 The following data pertains to the high growth period:
Expected ROE
20%
Expected payout ratio
25%
Therefore growth rate in the high growth period will be:
g=b*ROE=0.20(1-0.25) =0.15=15%

Rm
Rf

1.5
20%
15%

Ke=22.5%
Stable growth period
Expected growth rate
Expected ROE

Rf
Rm

5%
15%
1.1
15%
20%

Expected Payout ratio=Payoutn(1+g)n(1+gn)


g=b*ROE
b=1-payout
g=ROE(1-Payout)
Therefore Payoutn=1

g
0.05
= 1
= 0.667
ROE
0.15

Ke=20.5%

T.J Mabvure (Mr.)

41


(1 + g )n
Payout (1 + g )1

(1 + Ke)n Payout n (1 + g )n (1 + g n )

P E=
+
Ke gn
(Ke gn )(1 + Ke )n
5

1.15)
(
(0.25)(1.15)1

(1.225)5 0.667 1.15 5 (1.05)(1.05)


0.08
1.41

=
+
=
+
= 4.35
5
0.225 .15
(0.205 0.05)(1.225) 0.225 0.15 0.44

E.g. A firm is expected to have five years of high growth after which it will be
in a steady state. Inputs for the high growth period
Expected ROE
Expected payout ratio

Rm
Rf

22%
25%
1.8
22%
15%

Stable period
Expected growth rate

Rf
Rm
Expected ROE

6%
0.75
15%
22%
15%

Calculate the fundamental P/E


2. Price to Book Value
 The book value of equity is the difference between the book value of
assets and the book value of liabilities.
 The measurement of the BVA is largely determined by accounting
conventions.
Book value VS market value
 The Market value of an asset reflects its earning power and expected cash
flows since the book value of an asset reflects its original cost. It might
deviate significantly from the market value if the earning power of the
asset has increased or decreased significantly since its acquisition.
Reasons for using book values ratios
 The following are the reasons why investors use price to book value ratios.
1. Book value provides a relatively stable intuitive (easily understood)
measure of value.\
T.J Mabvure (Mr.)

42

2. Price to book value ratios can be compared across similar firms for
signs of under or overvaluation, even firms with negative earnings
which cant be overvalued using the PBV ratios.
Disadvantages of using PBV ratios
 Book values like earnings are affected by accounting decisions on
depreciation and other variables (accounting can manipulate the book
by either increasing or decreasing depreciation).
 When accounting standards vary widely across firms(some companies
may not be consolidating the earnings of their subsidiaries; stock
valuation methods such as FIFO, LIFO, AVCO, straight line, and reduced
balance method may be in use in different companies).
 Book values may not carry much meaning for service firms that dont
have significant fixed assets (e.g. insurance companies; most of the
assets are in investments a.w.a real estate).
PBV for a stable firm
DPS1
P0 =
Ken g n
Substituting EPS0 (Payout) (1+g) for DPS1
EPS 0 (Payout )(1 + g )
Ken gn
EPS 0
ROE =
BVE
EPS 0 = ROE * BVE
P0 =

This means that


ROE * BVE * Payout (1 + g )
P0 =
Ken g n
P
PBV = 0
BVE
Dividing both sides by BVE
P0
ROE * Payout (1 + g )
=
BVE
Ken g n
If we express the book value of equity in terms of expected BVE for next
year.
P0
ROE * Payout
=
BVE (1 + g )
Ken g n

T.J Mabvure (Mr.)

43

P0
ROE * Payout
=
BVE1
Ken g n

 This indicates that the PBV ratio is on increasing function of the ROE, the
payout ratio and the growth rate of earnings. It is an increasing function of
the risk ness of the firm as indicated by in Ke.
P0
ROE * Payout
= PBV1 =
BVE1
Ken g n

g=b*ROE
=ROE (1-Payout)
Relating g to the ROE.
g = ROE*b
=ROE (1-Payout)
=ROE-ROE (Payout)
g+ROEPay=ROE
ROE*Payout=ROE-g
ROE*Pay is identical to ROE-g
P0
ROE g
=
BVE Ken gn





This relationship is telling us that the PBV of a stable firm is determined by


the differential between the ROE and the required Rate of return on its
profits.
If the ROE exceeds the RRR (Ke) the price will exceed the BVE (because g is
constant).
This formulation can therefore be used to estimate the PBV ratios for firms
that dont pay dividend.

A firm had EPS of $600 in 2009 and paid 40% of its earnings as dividends that
year, the growing rate of earnings and dividends in the long term is expected
to be 10%. The ROE for the firm is 20%. The following parameters apply:
=0.9,
Rm =20%,
Rf =15%
Therefore Ke =19.5%
Qn. what is the PBV a) Today
not paying dividends

T.J Mabvure (Mr.)

b) next year and (c) when the company is

44

PBV 1 =

P0
ROE g
=
BVE1
Ke g

P0
ROE * Payout (1 + g )
= PBV0 =
= PBVToday
BVE0
Ke g
P0
ROE * Payout
= PBV1 =
PBV based on expected earning next year
BVE1
Ke g
P0
ROE g
=
BVE1
Ke g

PBV based on return differential (used when we are dealing


with a firm that does no payout dividends).

Therefore PBV today


P 0 ROE * Payout (1 + g ) 0.20(0.4 )(1.10 )
=
= 0.93
BVE 0
Ke g
0.195 0.10
PBV1 =

ROE * Payout
(0.20 )(0.4) = 0.84
=
Ke g
0.195 0.10

P0
ROE g
0.20 0.10
=
=
= 1.05
BVE1
Ke g
0.195 0.10

 The purpose of these values is to compare them with fundamental based


PBV and the market PBV.
 Lets suppose the market PBV is 2.00 then the price per share is twice the
Book Value of the share.
 The market is saying the market price of the share is twice the book
value.
NB. What is the relationship between the PBV and the ROE?
 If the ROE decreases the PBV will also decrease because g will also
decrease, therefore a firm with a high ROE will sell above its book value.
A firm with a mismatch between the PBV and the ROE will attract the
attention of investors.
 A mismatch is a low priced book value associated with a high ROE or a
high PBV associated with a low ROE.
 High Price to book value is always associated with high ROE.
 The ratio between PBV and indicates whether a firm is overvalued or
undervalued. A ratio of less than one indicates an undervalued firm.

T.J Mabvure (Mr.)

45

Overvalued

Correctly valued

undervalued
Correctly valued

Lets suppose we have the following information about several companies

Price/Sales per Share


This is again related to the dividend model
 Unlike the price to earnings or the PBV which can become negative and
therefore meaningless. The price to sales multiple is always positive even for
firms in trouble (can be applied in all situations). Earnings and book values
are heavily influenced by accounting decisions such as decisions on:
a) Depreciation and inventory valuation, revenues are however not easy to
Manipulate.
 The price to sales ratio can also be related to fundamentals such as:
a) Growth rates in earnings and dividends
b) Payout ratios
c) Risk through Ke
Value of equity for a stable firm
D1
Ken g n
But D1=EPS0 (Payout) (1+g)
P0 =

Therefore P0 =

EPS 0 ( Payout )(1 + g )


Ken g n

In this case we are interested in the profit margin (PM)


PM =

NetIncome
Sales

PM =

EPS 0
SalesPerShare

T.J Mabvure (Mr.)

46

Therefore EPS0=PM (Sales per share)


PM (SalesPerShare )(Payout )(1 + g )
Ken g n
P
But Price to Sales (PS) = 0
Sales
P0
PM (Payout )(1 + g )
Therefore
=
Sales
Ke g
This is the fundamental relationship we want

Substituting:

P0 =

 If the profit margin is based on expected earnings next year we can re-write
P0
PM (Payout )
this as follows:
=
Sales (1 + g )
Ke g
P0
PM (Payout )
=
Sales1
Ken g n
 The price to sales ratio is an increasing function of the profit margin, the
payout ratio and the growth rate in earnings and dividends. It is a decreasing
function of the risk ness of the firm as reflected in the Ke(Required rate of
return).
 After calculation you have to relate your answer to these fundamentals as
said above.
QN. A Company has revenues/share of $100 in 2009 and EPS of $5. It paid out
60% of its earnings as dividends. The growth rate in earnings and dividends in
the long-term is expected to be 5%, =0.9, Rf=15%, Rm=20%. Calculate the
current price to sales ratio based on these fundamentals and also the Price to
sales ratio based on expected earnings next year.
 These must be compared to the market price to sales multiples.
 Suppose the company was trading on a price to sales of 0.3 then we would
conclude that its overvalued according to the fundamentals.

Relationship between the price to sales (PS) and the PM


 The key determinant of the PS ratio is the PM.

T.J Mabvure (Mr.)

47

 Firms involved in businesses that have high margins can expect to sale for
much higher PS multiples (they will be trading on higher PS than the market).
A decline in PM has two effects.
1. reduction in PS Margin
2. reduction in the growth rate of earnings
We can use the ratio between the sales per share to book value of equity to
link the profit margin to the expected growth rate.
g=b*ROE
Since ROE=

NI
Sales
*
Sales BVE

ROE= Operating Pr ofitM arg in * EquityTurnover


This is the pyramid that builds up the ROE. A DuPont type of ROE.
Therefore g = b *

NI
Sales
*
Sales BVE

g = b * PM *

Sales
BVE

g=retention ratio*profit margin*equity turnover


 The higher the PM the higher the expected growth rate provided that sales
will not decrease proportionately to the increase in profit margin.
 This whole discussion related to a firm which is in a stable growth period.
PS for a high growth model (Two stage model)
In the two stage model:
P0=PV of expected dividends in the high growth period+PV of the terminal Price
n

=
t =1

Dt
Pn
+
t
(1 + Ke ) (1 + Ke )n

Where Pn =

Dn +1
Ken g n

this is the same concept with the free cash flows

The H-model is a short cut for the above


D0=EPS0 (Payout)
T.J Mabvure (Mr.)

48

 When the growth at the end of a high growth period is assumed to be


constant for ever, then the value of the firm(P0):
n

(
1+ g)
EPS 0 * Payout (1 + g )1

(1 + Ke )n EPS 0 * Payout n (1 + g )n (1 + g n )

P0 =
+
Ke g
(Ken g n )(1 + Ke )n

But EPS0=Sales*PM
Therefore PM =

EPS 0
Sales

(1 + g )n
(
)
Payout
1
g
1
+

n
(1 + Ke) Payout n (1 + g )n (1 + g n )
P0

PS=
= PM
+
Sales
Ke g
(Ken gn )(1 + Ke )n

This is telling us that the PS multiple is determined by the following factors


a) The net profit margin, ie the PS multiple is an increasing function of the Net
profit margin.
b) The payout ratio i.e. to say the higher the payout ratio, the higher the PS
multiple.
c) Risk as reflected in Ke, ie to say the higher the risk the lower the PS
multiple.
d) The growth rate in earnings, the higher the expected growth rate the higher
the PS multiple.
E.g. a firm is expected to go through two growth periods,ie the high growth
period and a stable period.
Inputs for the high growth period
Expected length of period
Expected growth rate
The Average profit margin
Payout ratio

Rm
Rf

T.J Mabvure (Mr.)

5 years
25%
10%
5%
1.2
30%
25%

49

Stable period
During the stable period the profit margins will be maintained at
Expected growth rate in earnings
Payout ratio

Rm
Rf

10%
5%
60%
1.0
30%
25%

Qn estimate the PS multiple


Growth stage
n
=5
g
=25%
PM
=10%
Payout
=5%
Ke
gn
Payoutn
Ken

= 31%
=5%
=60%
=30%

(1 + g )n
Payout (1 + g )1

n
n
(1 + Ke ) Payout n (1 + g ) (1 + g n )

PS = PM
+
Ke g
(Ken g n )(1 + Ke)n

(1.25)5
0.05(1.25)1

(1.31)5 0.6(1.25)5 (1.05)

= 0.10
+
= 0.10[0.21768 + 1.99339] = 0.2211
5
0.31 0.25
(
0.3 0.05)(1.31)

Growth rate
We can use the following relationship to compare difference competitive
strategies which are:
High margin (product differentiation), low margin high volume (cost
leadership).

T.J Mabvure (Mr.)

50

Sales
BVE
A firm is considering these two strategies:

g=b*PM*

PM
Sales/BE




High Margin- low Volume


20%
2

Low Margin-High Volume


8%
4

The firm is expected to payout 20% of its earnings as dividends after that.
The growth rate in earnings after two years is expected to be 10% p.a in
perpetuity.
The book value of equity per share is currently $10,=1.5, Rm=30%,Rf=25%.
Ke=32.5%.

In the stable period the will decrease to 1.0, and other parameters will remain
the same. Ke=30%.
To compare these strategies we have to look at PS multiple in each case.
Typical Examination
A company has sales per share of $6.50 with earnings of $125 per share. The
book value of equity was $420 per share. The company paid 20% of its earnings as
dividends. Based on these results calculate the profit margin. The sales to book
value, the retention ratio and the growth rate in earnings. Its envisaged that the
current period is a high growth period which will last for 2 years. During this
period =1.2, Rf=25%, Rm=30%.


After the high growth period the growth rate will stabilize to 10% p.a and the
dividend payout ratio will be increased to 60%. The will drop to 1.0 and the
other parameters will remain in the same.

Qn.Calculate the current price to sales multiple.


EPS 0
125
PM =
=
= 0.192
Sales Share 650
Payout=20%
Sales 650
=
= 1.55
BVE 420
g=b*ROE
b=1-Payout
Sales
650
g=b*PM*
= 0.8 * 0.192 *
= 23.8%
BVE
420
Ke=31%
T.J Mabvure (Mr.)

51

Ken=30%
n=2
g=23.80
gn=10%
Ke=31%
Ken=30
Payout=20%
Payoutn=60%

(1.2380 )2
0.20 * (1.2380 )1

(1.31)2 0.60(1.2380)2 1.10


0.42692

PS = 0.192
+
= 0.192
= 0.647
2
0.31 0.2380
2.947
(
0.30 0.1)(1.31)

Second scenario
Suppose that the company cuts the profit margin to 10% all other things being
equal. Calculate the PS multiple. Will this be a wise move?
SHORT TERM FINANCIAL STRATEGY
This is all about planning. Planning looks at forecast (prediction of whats
going to happen).
 Forecast about sales levels in the future, WC requirements, profit, financing
mix (debt to equity); short term to long term.
Forecasting
 Income statement-projected income statement and balance sheet. We would
be basing on the income statement this year and then predict for the next 5
years.
 The starting point for an income statement is the sales projections e.g. by
10%.
 The projected increase in sales has to be financed. The firm needs extra WC
and Fixed assets.
 The increase in WC and fixed assets must be financed
 Projected assets to support the increase in sales.
 The Fixed assets and WC also depends on whether we are operating at full
capacity of below capacity. The former means there is need for increase in
financing and the latter means there is no need.


T.J Mabvure (Mr.)

52

Sources of funds to cover the required increase


a) Spontaneous sources, certain current assets will be spontaneously financed by
increase in current liabilities. Increase in sales means more debtors and
stocks and it also means increase in creditors, so there is self financing.
b) Internal sources. Retained earnings; as sales increase the operating earnings
also increase. Retained earnings available are influenced by the dividend
policy. Retained earnings are internal equity, i.e. this is equity financing.
c) External sources:
Financing gap=Financing needs-(spontaneous sources+ internal sources).
The external sources are debt (long term, short term) and equity (new share
issues)
Financing feedbacks
 Extra dividends payments resulting from new share issues.
 Extra interest payments resulting from new debt.
 So you will have some what if scenarios
Approaches to identifying the financing
a) Constant ratio method
b) Formula method
Constant ratio method
 Lets suppose we have got our income statement for year. We have
projected that sales will increase by 10%.
The DPS this year was $1.15 and this dividend is expected to be increased by
about 8% to$1.25. There are 50 million outstanding shares which means that
the projected dividend will be 1.25(50 million)=62.5,ie $63.

Sales
Operating expenses
Operating earnings (EBIT)
Interest
EBT (NI)
Tax (40%)
Net income
Preferred dividends
Net income to ordinary
Dividend to ordinary
Retained earnings


Actual
$
3000
(2716)
284
(88)
196
(78)
118
(4)
114
(58)
56

Forecast
$
3300
(2988)
312
(88)
224
(90)
134
(4)
130
(63)
67

The constant ratio method assumes that all expenses will increase at the
same rate as sales.

T.J Mabvure (Mr.)

53





The primary purpose of this part of the forecast is determined by how


much income the company will generate internally through retained
earnings.
The forecast now shifts to the balance sheet.
If the company was operating at full capacity this means that any increase
in sales will also lead to an increase in assets. For e.g. more cash will be
required, receivables and inventory will also increase. New plant and
equipment will also be required. These additional assets will lead to
additional liabilities.

Balance Sheet

Cash
Accounts receivables
Inventory
Current assets
Plant and equipment
Accounts payables
Notes payable
Accruals
Long term loan
Preferred equity
Ordinary share capital
Retained earnings
Equity and liabilities

Actual
$
10
375
615
1000
1000
2000
60
110
140
754
1064
40
130
766
2000

Projected
$
11
412
677
1100
1100
2200
66
110
154
754
1084
40
130
833(766+67)
2088

 Debt obligations that have nothing to do with sales will not increase when
sales increase.
 After calculating the projected balance sheet we would have spontaneous
increase in terms of accounts payable and accruals.
Additional funds needed (AFN) =2200-2088=112.
This is the financing gap which needs to be covered by external sources.
 The company requires 200m of new assets to support the projected sales
level which is 3300. if the existing capital structure is regarded to be optimal
then the additional funds of $112 must be raised by borrowing from the bank
as notes payable, issuing long term loans(bonds) and selling new ordinary
shares.
Raising additional funds needed.
 The financing mix will be determined by the target capital structure,
conditions in the debt and equity markets as well as restrictions imposed by
T.J Mabvure (Mr.)

54

existing debt agreements (the company may have borrowed too much
already).
 Assuming that the following financial mix is adopted.
Type of financing
Notes payable
Long term loans
Ordinary share





%
25
25
50

Amount
28
28
56

Cost(%)
8 interest
10 interest

On the notes payable we are paying 8% and on the long term 10% interest.
What this means is that there is going to be financing feedbacks which
require that we draw a new forecast, i.e. draft a new one.
The external funds raised to pay for the new assets create additional
expenses which must be reflected in the income statements.
This reduces the initially forecasted additions to retained earnings.

Financing feedbacks
a) Additional interest.
i) Short term debts(notes),i.e. 0.08*$28=$2.24
ii) Long-term debt
0.10*$28=2.80
$5.07m
b) Additional dividend.
Assuming that current share price is $23 and new share can be issued at
$56m
this price, therefore:
= 2.4millionShares
$23m

The dividend payout is projected to be $1.25 per share, therefore the
additional dividend payments will be: 2.4*1.25=$3m.

This means that the dividends to ordinary shareholders will now increase
to $66m(63+3).

The net effect of these financing feedbacks income by $7 million from
$68m to $61 million.

This reduces the projected retained income to $827m (766+61). This
results in a reduced financed gap of $7m that should be financed using the
mix of 25%,short term debt,25% long term debt,50% equity. It becomes a
vicious cycle.
After doing the feedbacks we have to now consider the restated income
statement and balance sheet.
Re-stated income statement
Sales
Costs
EBIT
Less interest (88+5)
EBT
T.J Mabvure (Mr.)

3300
2988(opp cost 2878 +dep 110)
312
(93)
219
55

Tax (40%)
Earnings to shareholders
Preferred dividends
Net income
Dividends
Retained income

(88)
131
(4)
127
(66)
61

Restated balance sheet


Cash
11
Accounts receivables
412
Inventories
677
Total current assets
1100
Plant and equipment
1100
Total assets
2200
Accounts payable
66
Notes payable (110+28)
138
Accruals
154
Long term loans (754+28)
782
Total debt
1140
Preferred equity
40
Common stock (130+56)
186
Retained earnings (766+61)
827
Total equity and liabilities
2193
Additional funds needed are now (2200-2193) =7



We continue doing this until the needed funds becomes insignificant.


After this we analyze the forecast.

Analysis of the forecast


 We must analyze the projected financial statements and compare them
with our target ratios as laid down in our long-term plans.
Formula method
 The following formula can be used to obtain an estimate of the financial
requirements needed to support any increase in sales:
(Additional funds needed)=required increase in assets-spontaneous increases in
liabilities-increases in retained income.
AFN=

( A * S ) (L * S ) MS1(1 div)

S
S
S=Actual changes in sales
A * S = These are assets that must increase is sales are to increase expressed
as a % of sales, i.e. the required dollar increase in assets per dollar
increase in sales.
= 2000 3000 = 0.667
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This means that for every $1 increase in sales, assets must increase by 67
cents.
Where A=Total assets
A*=assets that must increase
=A if the company is operating at full capacity.
L * S = Liabilities that increase spontaneously with sales as a % of sales,
i.e. the
Spontaneously generated financing per $1 in sales.
= (60+140)/3000=0.0667
 This means that every $1 increase in sales generated $7 cents in
spontaneously financing.
L*=the liabilities that increase spontaneously
L=Total liabilities
L will always be greater than L* because other liabilities like long term
liabilities does not increase spontaneously.
S1= Sales (Total) projected for next year
=3300
Where S0=current sales=Current sales=3000
M=Profit margin (net profit margin)
NI
114
=
=
= 0.038
Sales 3000
58
d= dividendPayoutRatio =
= 0.5088
114
AFN = ( A * S )S (L * S )S MS1 (1 d )


= (0.667 )300 (0.0667 )300 (0.038)(3300 )(1 0.5088)

= 200 20 62
= 118Million

Additional funds needed (AFN)

=
=

112
7
119

 If we increase sales by $300 we must increase assets by $200m to support


this increase in sales level.
 The $200m of assets (new) will be financed by 20million from spontaneous
increases in liabilities, 62million from retained earnings. The remaining
118m must come from external earnings sources.
 Assuming that the firm is operating at full capacity.
This formula is only a rough estimate because of the assumptions that we
made, which are:
i) Each asset item must grow at the same rate as the sales.
ii) Certain liability accounts e.g. Trade creditors (a/c payable and accruals)
also increase at the same rate as our sales.
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57

iii) Profit margins and dividends payout ratios are constant; we may not be
necessarily true.
What is the relationship between growth and financial requirements?
 The faster the growths rate in sales the greater the need for additional
financing.
 If we apply the formula to differential growth rates.
Growth
sales
(10%)
O
3.21
10
20




rate

in in Sales
(300)
0
96
300
600

Forecasted Sales

AFN

2700
3000
3096
3300
3600

(230)
(56)
0
118
293

Spontaneous plus retained earnings will be sufficient to meet the financial


needs. Its like a break even point.
The table can be converted into a financial feasibility chart.

Financial feasibility chart

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58

Break even growth rate in sales


The break even point is the growth rate that will be covered by funds generated
by spontaneous increase in liabilities and retained earnings (internally generated
equity).
Therefore we have to solve for g in the equation in the Additional funds needed
equation.

Mergers and acquisitions


Two ways in which a company can expand operations
1.
2.

Internal expansion: The acquisition of long term assets over the years
gradually.
External expansion: Can be achieved through a takeover, which is acquiring
control of the shares and assets in another company. This is more complex
because it involves legal, tax, accounting and management issues.

Types of mergers
Horizontal, conglomerate, vertical:
When two firms in the same industry merge, its called a horizontal merger,
like two banks, WMMI, and Nissan and Clover Leaf motors.
 A vertical merger is where either a firm expands towards a customer or
backwards towards the supplier. The former is the supply chain and the
latter is the distribution chain.
 Conglomerate is where you expand along unrelated lines of business. The
purpose of this is to diversify away operating risk, like ZSR who now
concentrates away from sugar to Trador, Advance, Redstar.
Reasons sighted for merger

a.


The most sighted reasons are the possibilities of synergistic benefits arising
from the merger. Always expressed as
1+1=3 effect. That is Vxy>Vx+Vy,ie
the value of xy is greater than the value of x and y stand alone.
Reasons or other benefits are:
 Economies of scale; as we increase the production the cost per unit
decreases.
 Operating economies; as we increase the size of operations the benefits are
bound ti increase.
 Managerial skills which are endowed with a certain company especially in
the highly technological engineering firms.
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Tax considerations; where a company has some tax assessed losses carried
over the years. The idea is to reduce the tax burden. In most of the cases
the company has to convince ZIMRA that the transaction was not for that
purpose.
Excess liquidity; the targeted company may have a strong liquidity position
e.g. retail organizations.
Diversification; new products and new markets
Reduced financial costs. The merger may result in reduced cost if the
company which is being targeted has a financial slack (excess borrowing
capacity).
Technology, acquisition that takes place in order to take/acquire the
technological expertise of the targeted company.

Terms of the merger


An acquirer can either pay cash for the acquisition or issue its own shares in
exchange for the shares of the target firm.
For an acquisition financed by cash the target company and the acquirer must
agree on the price to be paid per share.
Nominal value
Book value
Market value
Intrinsic value (Real value given the fundamentals of the business).
See Damodaran for more on these things

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