a) How effectively have we delivered shareholder value compared to the FTSE100 over each of the last 3 years?
As per London Stock Exchange The FTSE 100 Index is a share index of the 100 most highly capitalized companies. The index was introduced from 1984 where the companies must meet a number of criteria’s to set out by the FTSE Group. This index has been considered as a barometer of British economy success of the and also the leading share index in Europe which holds about 80% 1.
BHP Billiton is a dual-listed company the world’s foremost miner. It was tailored in 2001 through the merger of the Broken Hill Proprietary Company (BHP), an Australian company, and Billiton the British company with extensive operations in South Africa and 25 other region of the globe for mining.
In March 2005 BHP Billiton announced a US$7.3 billion agreed bid for another mining company WMC Resources. The takeover achieved in 2005. The group publishes its accounts in US Dollars. Its revenue (or turnover) for the year ending 30 June 2006 was $32.153 billion. Profit before tax was $14.166 billion and profit for the year was $10.534 billion.
At the time of the merger, BHP Billiton articulated its vision to earn superior returns for shareholders as the world’s premier supplier of natural resources and related products and services. Despite the challenging environment, our earnings before interest, tax, depreciation and amortization were US$ 4.9 billion; our operating cash flow reached US$ 3.6 billion and we increased the dividend to 14.5 US cents a share, an increase of 11.5 per cent over last three year.
Shareholder Value Creation:
BHP Billiton Financial Data 2
The value of a firm is the market value of its assets, which is reflect in the capital markets through the market values of equity and debt. Thus, shareholder value is:
Shareholder value = Market value of the firm
= Market value of debt.
The Market value of the shareholder’s equity is directly observable from the capital markets. In theory, the market value should be equal the warranted economic value of the firm. The true economic value of a firm or business or division or project of any strategy depends on the cash flows and the appropriate discount rate. Here we shall discuss briefly three most commonly advocated methods of shareholder value.
The first method, called the free cash flow method, uses the weighted average cost of debt and equity (WACC) to discount free cash flows. You can recall that free cash flows are calculated as follows:
PBIT= profit before interest and tax,
T= corporate tax rate,
DEP= tax depreciation,
ONCKI= other non-cash items,
∆ NWC+ change in net working capital 3,
∆ CAPEX= incremental investment.
Terminal or residual value reflects the value of post-planning cash flows. Thus, the economic value or simply value of a firm or a business is:
The value of a firm or a business generating perpetual FCF will be as follows:
We may recall that FCF estimates do not make any adjustment for interest charges. Thus, FCF do not include financing (leverage) effect. The weighted average cost of capital (WACC) includes after tax cost of debt. Hence, the financing effect is incorporated in WACC rather than cash flows. WACC, you may, recall, is calculated as follows:
We may recall that WACC is based on assumptions that the firm has an optimum 4 capital structure and that debt is perpetual.
The second method calculate the economic value of a firm or a business into two parts:
Notice that ku is the cost of capital of an unlevered firm. For the levered firm, the second part includes the value of interest tax shields (VITS):
Thus, the value of levered firm of business is:
Value of a levered firm = Value of a unlevered firm+ Value of interest fax shield
We can obtain value of shareholders’ equity as the difference between the economic value of the firm and the claims of debt-holders. The value per share (VPS) can be obtained by dividing the value of shares (E) by the number of shares (N):
The share price of the company in 2006 is gained by D/K.
Here D is 36 and K is .05 so the share price is 720
In 2005, D is 28 and K is .046 so the share price is 608.69
In 2004 D is 26 and K is .046 so share price is 565.2
In 2003 D is 14.5 K is .046 so share price is 315.2
The percentage change in the years is
From 2003 to 2004 is 79.3% found by (565.2-315.2)/315.2*100
From 2004 to 2005 is 7.69% found by (608.69-565.2)/565.2*100
From 2005 to 2006 is 18.28% found by (720-608.69)/608.69*100
We can see from the annual report of BHP Billiton that the increase in index is 5.5%. So we can see that the percentage change in the share price is higher than the index.
We can summarize the steps involved in the second method of estimation of the firm’s total value and the shareholder value as follows:
1. Estimate the firm’s unlevered cash flows and terminal value.
2. Determine the unlevered cost of capital.
3. Discount the unlevered cash flows 5.
4. Calculate the present value of interest tax shield discounting at the cost of debt.
5. Add these two values to obtain the levered firm’s total value.
6. Subtract the value of debt from the total value to obtain the value of the firm’s shares.
7. Divide the value of shares by the number of shares to obtain the economic value 6.
b) Can you provide calculations showing “Cost of Capital” our and explain exactly what this means? Why is it important for us to know what this figure is?
The cost of capital is defined as the rate of return that a company would receive if it invested the money anywhere with comparable risk. The company can raise money through a borrowing, stock issue or a mix of the both 7.
General Formula For Cost of Capital:
The required rates of return are market-determined. They are established in the capital markets by the actions of competing investors. The influence of market is direct in the case of new issue of ordinary and preference shares and debt. The market price of securities is a function of the return expected by investors. Thus, the opportunity cost of capital is given by the following formula:
Where, I0 is the capital supplied by investors in period 0 8,
Ct is returns expected by investors 9 and k is the required rate of return or cost of capital.
Weighted average Cost of Capital vs. Specific costs of CapitalA firm obtains capital from various sources. As explained earlier, because of the risk differences and the contractual agreements between the firm and investors. The cost of capital of each source of capital is known as component, or specific cost of capital. The combined cost of all sources of capital is called overall, or average cost of capital. The component costs are combined according to the weight of each component capital to obtain the average cost of capital. Thus, the overall cost is also called the weighted average cost of capital 10.
Cost of Debt:
A company raises debt in various ways. It may borrow funds from financial institutions or public either in a form of public deposits or debentures for a specified period of time at a certain rate of interest. A debenture or bond may be issued at par or at a discount or premium as compared to its face value. The construal rate of interest or the coupon rate forms the basis for calculating the cost of debt.
Debt issued at Par:
The before tax cost of debt is the rate of return required by lenders. It is easy to compute before-tax cost of debt issued and to be redeemed at par; it is simply equal to the contractual 11 of interest.
Where k is the before-tax cost of debt, i is the coupon rate of interest, b is the issue price of the bond (debt) and in Equation (2) it is assumed to be equal to the face value (F), and INT is the amount of interest. The amount of interest payable to the lender is always equal to:
Interest= face value of debt x Interest rate
We could arrive at same results as above by using Equation (1): BHP Billiton cash outflow are US$ 15 interest per year for 7 years and US$ 100 at the end of seventh year in exchange for US$ 100 now. Thus;
By trial and error, we find that the discount rate (k) which solves the equation, is 15 percent:
Clearly, the before-tax cost of bond is the rate, which the investment should yield to meet the outflows to bondholders.
Debt Issued at Discount or Premium:
Equation (1) and (2) will give identical results only when debt is issued at per and redeemed and can be written as follows top the before-tax cost of debt 12:
Where B is the repayment of debt on maturity and other variables as defined earlier. Equation (3) can be used to find out the cost of debt whether debt is issued at par or discount or premium, i.e.,
B0=F or B0>F or B0<F. Let us consider an example.
Cost of bond Sold at discount:
Assuming that in BHP Billiton the preceding example of 7 year 15 percent bonds, each bond is sold below par for US$ 94. Equation (3), Kd is calculated as
If the discount or premium is adjusted for computing taxes, the following method 13 can also be used to calculate the before-tax cost of debt:
Note that the short-cut method gives approximately the same result as Equation (3).
Cost of equity using BETA= Risk-Free Rate + (Beta times Market Risk Premium)
The after-tax cost of debt-capital = The Yield-to-Maturity on long-term debt x (1 minus the marginal tax rate in %)
=5 %*(1 – .15)
The cost of capital number means” the opening cost of all assets invested in an endeavor”
Significance Of The Cost Of CapitalWe should recognize that the cost of capital is one of the most difficult and disputed topics in the finance theory. Financial experts express conflicting opinions as to the correct way in which the cost of capital can be measured. Irrespective of the measurement problems, it is a concept of vital importance in the financial decision-making. It is useful as a standard for:
· Evaluating investment decisions
· Designing a firm’s debt policy, and
· Appraising the financial performance of top management.
Investment EvaluationThe primary purpose of measuring the cost of capital is its user as a financial standard for evaluating investment projects. In the NPV method, an investment project is accepted if it has a positive NPV. The project’s NPV is calculated by discounting its cash flows by the cost of capital. In this sense, the cost of capital is discount rate used for evaluating the desirability of investment project. In the IRR method, the investment project is accepted if it has an internal rate of return greater than the cost of capital. In this context, the cost of capital is the minimum required rate of return of an investment project 14.
Designing Debt PolicyThe interest tax shields the overall cost of capital, though it also increases the financial risk of the firm. In designing the financing policy, that is, the proportional of debt and equity in the capital structure, the firm aims at maximizing the firm value by minimizing the overall cost of capital.
Performance AppraisalThe cost of capital framework can be used to evaluate the financial performance of top management. Such as evaluation will involve a comparison of actual profitability of the investment projects undertaken by the firm with the projected overall cost of capital, and the appraisal of the actual costs incurred by management 15. The cost of capital also plays an important role in dividend decision and investment 16.
c) How does our market capitalization compare to a valuation based on discounted cash flows?
Market capitalization is a calculation of corporate volume, which refers to the current stock price times the integer of outstanding shares. It is frequently abbreviated to market cap. Market capitalization is totally unlike from equity value in context of some company has outstanding stock options even other securities convertible to common shares. Market Capitalization’s growth and size is one of the critical indicators of a public company’s failure or success. Acquisitions, divestitures, stock repurchases, and such other performance are the reason of increase or decrease of market capitalization.
Market capitalization is derived from the current price of the shares multiplied by the number of common shares. The term market capitalization also denotes the total amount of funds used to finance a firm’s balance sheet and is calculated as market capitalization plus debt 17plus preferred stock.
The Valuation Market capitalization is a function of the price of a firm’s stock. It may not accurately reflect intrinsic value because of varying future expectations held by investors. This is common for all-firm’s market capitalization to surpass “book value” 18. It caused for market prices tend to increase at a quicker pace than earnings accumulate due to value placed on expected future growth.
The quantity of available shares on the open market is sometimes less than the total number of shares. Because of a portion of the “free float” shares are held by insiders and also by the company 19. In addition, to float being perhaps much smaller than the total number of shares, large institutional investors who rarely trade may own a significant portion of the float. As a result, on any given trading day, generally only a small percentage of shares are traded.
Discounted Cash Flow (DCF):
Discounted cash flow is one of several methods for security valuation to forecasts of many different variables. Here I use simulation to examine the sensitivity of the stock price forecast to these different variables. The main purposes of discounted cash flow modeling are to provide meaningful benchmarks used to justify the operating performance of a company over time. The ultimate market benchmark is usually earnings or earnings growth. Finally, I examine different assumptions about the primary forecast time horizon and how the choice of time horizon 20.
Security analysts use different methods to determine stock recommendations. Many consider discounted free cash flow (DCF) analysis to be the ‘gold standard’ of the all valuation methods. However, DCF analysis imposes a burden on the analyst in terms of the number of variables that she needs to forecast. Because of the complexity of the model many opt for simpler P/E models and forecasts of earnings growth. In this paper, I present an example that shows how to use simulation to determine which the most important variables 21.
The expected enterprise value of company is the discounted value of its future free cash flows. Since a firm does not have a finite life we represent the expected total enterprise value (TEV*) of a firm as—
Where FCFt = free cash flow in time t; and
r = the firm’s weighted average cost of capital.
To determine the expected stock price, P*, add excess cash, subtract the firm’s debt from TEV* and divide by the number of shares outstanding.
The security analyst makes a buy or sell recommendation by comparing either P* or TEV* with the current share price or the current Total Enterprise Value (TEV) of a firm. If P* is greater than current share price, then in the analyst’s view the firm is under-valued and would recommend purchasing the stock.
Market Capitalization is the equity value of the firm, and is equal to shares outstanding times 22 the current stock price.
The discounted free cash flow model is perpetuity since there is no finite life for a firm. Typically, an analyst forecasts a detailed model of free cash flow for a predetermined number of years, and then assumes that the free cash flow will grow at a constant rate, g, in perpetuity. When the growth rate is less than the cost of capital, the enterprise value will be given by: is called the terminal value. An important modeling decision is when to begin the constant growth rate. Many times the terminal value is large portion of TEV*. A firm’s free cash flow is found using the following financial statement variables:
The weighted average cost of capital, r is found as follows:
Where Wd = the proportion of debt financing;
We = the proportion of equity financing;
rd = the cost of debt capital;
re = the cost of equity capital; and
τ = the marginal tax rate 23.
Market capitalization is multiplying the number of securities a corporation has by the market price of those securities.
So it is
Calculation of market capitalization,
Discounted cash flow using average cash flow of past 10 yrs (no Interest)
Source: Shareholder information of BHP Billiton.
Here net sales and other information can be estimated by using these values.
The cost of capital is determining the weights of debt and equity as a percentage of the Total Enterprise Value of the firm. The cost of debt is the yield to maturity on outstanding bonds and the cost of equity capital is found using the Capital Asset Pricing Model or using the cost of debt and adding an equity risk premium.
Investors often focus on forecasts of earnings per share (EPS) and earnings growth. The forecast EPS and a P/E ratio are used to determine the expected price. The expected price, P*, is given by P* = EPS estimate * benchmark P/E ratio. Another equivalent use of P/E ratios is to determine a firm’s P/E ratio using the forecasted EPS and comparing P/E ratios across firms. Low P/E ratios may mean a distressed or an under-valued firm. While high P/E ratios may mean a growth or an over-valued firm. However, there are several problems using earnings as a valuation metric 24.
BHP Billiton has a market capitalization of approximately US$ 42 billion, compared to a market capitalization of US$ 28 billion at the time of the merger and US$ 35 billion at year-end 25.
Q: d) Why have so many companies decided to buy back so many of their shares? What do you think are some of the arguments that could be raised against this policy?
The buyback of shares is the repurchase of its own shares by a company. By back has both positive and negative impact in the economy. Some companies take the advantage of this immediately and offered to buy back the equity of shares for financial reasons. It is believed that the buyback will be financially beneficial to the company, the buying shareholders, and the remaining shareholders.
The bought up shares will be extinguished and will not be reissued. If the company distributed surplus cash and it maintains its operating efficiency, it will increase the share price as P/E ratio is expected to remain the same after the buyback. Yet, another consequence will be the increase in the company’s debt-equity ratio due to reduced equity capital. Companies with exiting low debt-equity ratio will be able to move to their target capital structure 26.
The most possible reason for the buyback seems to be that a company may like to return surplus cash, which it cannot put to any profitable investment, to shareholders. Companies may also like to surplus cash to buyback shares rather than pay large dividends, which they cannot maintain in the future years. In those countries, where dividends are taxed at a higher rate than the capital gains, companies may like to resort to shares buyback from time to time to reduce shareholders tax burden. However, it is inconceivable that a profitable, growing company will like to distribute cash to shareholders through the buyback route.
There might be other reasons for the buyback programs of the companies. A company, which has very low debt-equity ratio, may like to reduce equity capital through the buyback mechanism to achieve a higher target debt-equity mix. The only reason for doing so may to reduce the chances of takeover. Yet, another reason may be need to buyback shares from the employees who hold shares after exercising stock options, and they are unable to sell or are restricted to sell shares to the outsiders 27.
We can Point out the advantages of the buyback as follows:
· Return of surplus cash to shareholders The buying shareholders will benefit since the company generally offers a price of the share.
· Increase in the share value When the company distributes the surplus cash, its operating efficiency and P/E ratio remains intact. With reduced number of shares, EPS increase, and share price also increase.
· Increase in the temporarily undervalued share price the share price of a number of companies may be undervalued. This may be especially true for the developing capital markets. Companies may buyback shares at the higher prices to move up the current share prices 28.
· Achieving the target capital structure If the company has the high proportion of equity in its capital structure, it can reduce equity capital by buying back its shares.
· Consolidating control, the promoters of the company benefit by consolidating their ownership and control over companies through the buyback attractive for others. Their proportionate ownership increase.
· Tax savings by companies Divided payments are taxable in the hands of companies at 12.5 percent. They will avoid paying dividend taxes if they compensate shareholders through the share buyback. This game will be played only if the tax authorities disregard it.
· Protection against hostile takeovers In a hostile takeover, a company may buyback its shares to reduce the availability of shares and make takeover difficult.
Argument Against Buy-Back:
I do not think that the share buyback is a virtuous tool in the hands of the company. The following are the drawbacks of the buyback:
· Not an effective defence against takeover The buyback of shares may be useful as a defence against hostile takeover only in case of the cash rich companies. Therefore, the buyback is not effective in protecting those companies that do not have cashed.
· Shareholders do not like the buyback Most companies will not offer the buyback schemes frequently; they will buyback shares once in a while. Shareholders may not, therefore, like the buyback of shares; they might prefer increasing dividends more dividends to the years. They consider dividends more dependable 29.
· Loss to the remaining shareholders The remaining shareholders may loss f the company pays excessive price for the share under the buyback scheme.
· Signal of low growth opportunities the buyback of shares utilizes the firm’s cash. It may signal to investors that the company does not have long-tem growth opportunities to utilize the cash. It may also weak competitive position 30.
1) Pandey. I. M. (2006), “ Financial Management”. New Delhi: Vikas Publishing House. Page 168- 172, 733-740.
2) BHP Billiton Annual Report –2006 31
1 Of the UK share market2 Annual Report 2006, BHP Billiton3 i.e. stocks plus trade debtors minus trade creditors
4 Target5 Also the terminal value by the unlevered cost of capital
6 Per shares7 Determined by the Board8 It represents a net cash inflow to the firm
9 They represents cash outflows to the firm
10 WACC11 Or coupon rate
12 Equation (1)
13 Short-cut method
14 It is also known as the cutoff rate, or hurdle rate15 By raising the required funds16 In current assets
17 Book or market value18 Shareholders’ equity19 Treasury stock20 Terminal values21 Shown in Formula22 Multiply23 For the Company24 Earnings growth Correction25 Annual Report –2005, P -1226 Buy-Back Policy27 Company Strategy28 Present Market29 Than Buyback The Share30 Strength of the Company31 P- 37