Corporate Finance Essay: Cost Of Capital, Share Valuation, And Capital Structure.

Question 1: Cost of Capital

Question 1: Cost of Capital 
Reconsider Widget Ltd in Assignment 1. Assume your boss Diane Jones has asked you to re-estimate the company’s cost of capital for capital budgeting purposes based on up-to-date information. If the re-estimated cost of capital is different to that used previously, she would also like a brief qualitative assessment (no calculations necessary) of the impact of the difference on (a) the NPV of the project and (b) the value of the firm. Also discuss briefly the appropriateness of using the Widget cost of capital as a discount rate for the project.

Question 2: Share valuation

Your textbook provides share valuation examples related to an ASX listed company called JB Hi-Fi. In late 2016 JB Hi-Fi purchased a large private home appliance retailing company called The Good Guys with sales in the 2016 financial year of about $2 billion. Your task is to value JB Hi-Fi’s shares and discuss the results. Collect all required data from Morningstar DatAnalysis. Answer each of the following:

(a) Assuming the same equity cost of capital as given on page 210 of the text, but using the total dividends per share paid by JB Hi-Fi in the 12 months to 31st December 2016, value the shares assuming constant dividend growth of (i) 5.69% and (ii) 7%. 
(b) Pages 298-299 of the text show an example of valuing JB Hi-Fi shares using free cash flow. You are required to update this valuation. Use calendar years for your updated valuation to keep things simple. Start your new valuation with an assumption of 2016 calendar year sales of $6 billion ($6,000 million) for the combined company and estimate the future calendar year free cash flows from 2017. Assume calendar year sales growth of 4% in 2017, 4% in 2018 and 3% thereafter. These are similar growth assumptions
as the example in your text. Make the same assumptions as the text example about the EBIT margin, net working capital changes, equivalence of capital expenditures and depreciation expenses, tax rate and cost of capital. Update the cash, debt and shares outstanding their 31st December 2016 interim balance sheet values. 
(c) Compare your valuations in (a) and (b) to each other and to JB Hi-Fi’s actual closing share price on 31 December 2016. Explain the differences and discuss whether you would recommend buying the shares.

Question 3: Capital Structure

Reconsider the information you have on Widget Ltd from Assignment 1 and Question 1 in the current assignment. Assume your boss Diane Jones is concerned about the firm’s heavy reliance on debt and has asked you to develop an argument based on trade-off theory for the need to shift the firm’s capital structure more towards equity. Further information on Widget that may help you in this task is:? Widget has traditionally had variable earnings and operating cash flows, although it has made a taxable profit each year ? The firm’s earnings are almost entirely related to software development. This highly competitive industry is subject to rapid technological change. 90% of the firm’s book value assets are intangible. 

1. The re-estimated cost of capital of Widget Ltd. is as follows:-

(Singhal, 2013)

Thus, the old estimated cost of capital of 10% cannot be considered for present valuation of Cash flows and the business as a whole.

The change in cost of capital will have the following impacts:-

NPV - The NPV will decrease as a result of increase in the estimated overall cost of capital of the company. This decrease will be due to two reasons. Firstly, the involvement of debt in the capital structure of Widget Ltd. Earlier, Widget Ltd. was a wholly owned company with no debt in the capital structure. But it has raised borrowed capital in the form of Bonds carrying 10% interest and a Bank Loan carrying 9% interest of total $29 million. Therefore, the fixed interest expense on this borrowed amount will reduce the cash flows. Secondly, the increase in the rate of cost of capital leading to changed discount factors for discounting the cash flows.

Value of firm - The Widget Ltd. earlier had only owned capital worth $44.75 million. With the change in cost of capital due to change in capital structure of the company the value of the firm has increased to $$ 72.25 million. This increase in due to involve of debt capital and their current market values. 

2. Share valuation of JB Hi-Fi using constant dividend growth model(Singhal, 2013):-

• When the dividend is growing @ 5.69%  

1. The spreadsheet showing the valuation of JB Hi-Fi using Free cash flows(Singhal, 2013) is as follows:-

For Discrete Period (2016-2018):-

For Continuity Period:-

P3 = P4   

= 195.01

12%-3%

= 195.01

     9%

= 2166.78

Present Value of Continuity period = 2166.78 X 0.712

= 1542.75

Total Present Value = 449.48 + 1542.75

= 1992.23

Value per share = 1992.23+40-150 

= 19.01/-

According to the above calculations, it is evident that the share price of the company is increasing with the increase in constant dividend growth. As calculated in part (a) of the question, when dividend growth was 5.69% the price becomes $9.40 per share and when the dividend growth is increased to 7% the price becomes $ 11.60 per share. This shows that dividend growth has a direct relation with the share price. This can also be concluded by the fact that when the shareholders will get more return in the form of dividend for their investments they will tend to buy more shares of the company for increased earning thereby increasing the share price.

Further, when the valuation principle has changed from growth in dividend to the total growth in earnings model which is reduced to the present value on the basis of weighted average cost of capital for the company, the price calculated is greater than what is calculated in part (a) above. There can be many factors for the same for example, the WACC is taken as 13% in part (a) whereas it is 12% in part (b), the dividend growth model considered growth in dividends as the basis for valuation of shares. However, in part (b) overall change in the earnings as well as working capital has been taken into consideration. The comparison of above calculated price with actual share price of the company shows that whether the shares of the company is overpriced or underpriced in the market and an investor may decide about the investment accordingly.

Question 2: Share Valuation

3. The cost benefit analysis of different theories by a decision maker in a business to find the net profit or loss from a project or portfolio is called trade off. These projects or portfolios are based on different kinds of leverage plans.  Normally, some interior solution is tried to find out so that the marginal cost and benefit could be neutralized. Initially, the trade off theory was based on the model developed by Modigliani-Miller theorem according to which tax had the major impact on the profitability of the concern. This theory constantly preferred 100% debt for every concern so that maximum tax shield could be taken which is considered as the saving of the profitability of the concern. But this situation was an extreme one. This is because if there is such an increase in the debt financing of the concern it will lead to heavy costs burdens in the form of fixed interest thereby leading to a debt trap for the concern. Such situation normally ends up in bankruptcy of the concern. This extreme situation needs to be avoided and therefore a theory of trade- off was developed according to which any business concern interested in trading- off will first calculate the optimum level of debt for its concern based on the past and present profitability as well as the market conditions. The concern will then go for debt financing to earn marginal benefits of tax savings. It will further lead to increase in price earnings ratio by trading on equity which will be beneficial for the stakeholders. Hence, according to the trade-off theory, the firms are divided into two categories. First, the firms calculating their trade-off in single period only by the cost benefit analysis from the tax benefits and cost of bankruptcy. Second are the firms which first calculate their optimum level of debt financing and set a target debt ratio. Then the dent financing is done. Any variation in the target ratio and actual ratio is analyzed and tried to remove over time. (Frank & Goyal, 2005)

In the given case, Widget Ltd. profit is majorly dependent on the software development wing. The software development business is considered to be highly competitive and there is a greater probability that the company may lose present level of market demand. Further, the company has a past record of variable earnings and operating cash flows which affirms the condition mentioned above. Hence, the more involvement of debt fund may prove harmful for the business in long run. This is because the company does not have any source which has the capability of earning fixed income. The huge investment in intangible assets is a major indication of this situation. When the fixed cost in the form of income would be large the company will have to earn at least equal profits so that the costs can be tolerated. But with the prevailing situations this cannot be expected of the business. Therefore, the company should gradually shift towards more funding through equity capital as the borrowed capital’s cost may be unbearable for the business and may lead to bankruptcy. 

Frank, M.Z. & Goyal, V.K., 2005. Tradeoff and Pecking Order Theories of Debt. [Online] Tuck School of Business at Dartmouth Available at: https://www.tc.umn.edu/~murra280/WorkingPapers/Survey.pdf [Accessed 15 May 2017].

Singhal, D.K., 2013. Capital Budgeting. In Strategic Financial Management. 3rd ed. Jaipur: Parv Management Services (P) Ltd. p.644.

Singhal, D.K., 2013. Cost of Capital. In Strategic Financial Management. 3rd ed. Jaipur: Parv Management Services (P) Ltd. p.644.

Singhal, D.K., 2013. Dividend Decisions. In Strategic Financial Decision. 3rd ed. Jaipur: Parv Management Services (P) Ltd. p.644.