Investment And Valuation Analysis: Case Studies

Capital Expenditure Decision and Investment Criteria

1. Capital Expenditure Decision and Investment Criteria

Newton plc

The board of directors of Newton plc has to decide whether or not to invest in a manufacturing plant to produce a new product that has been developed on the basis of research undertaken within the company. The development of the product has been expensive and at a cost of £2.00 million has significantly exceeded the initial budget allocation for the product. One member of the board has argued that the company should not proceed with the investment as it is most unlikely that it will be able to recover what has already been spent on the product.

The marketing department has suggested that the product should be sold at £14.00 per unit and it is anticipated that sales in the first year will be about 400,000 units, rising to 600,000 in year two. Sales are expected to remain at this level for the following three years and fall to 300,000 units in year six. It is thought that the product is unlikely to be competitive after six years given the rate of product innovation in the sector, and it will be withdrawn from the market at this stage.

To manufacture the product an investment of £9.00 million will be necessary in new production facilities. This expenditure can be written off for tax purposes using a 25 per cent writing down allowance. The re-sale value of the equipment has been estimated to be about £2.50 million at the end of the six year anticipated product life. Use will also be made of some equipment the company already owns. This equipment is now fully depreciated for tax purposes, but would be sold today for £1.20 million. If used in the manufacture of the product its value expected to fall to £0.30 million by the end of year six.

The production facility will be located in one of the company’s factories that is not being fully utilised. The company has no alternative uses available for this space that is currently being rented out to another manufacturer for £80,000 per annum. The product will be charged £40,000 per annum for the space it utilises through the company’s internal budgetary system. The fixed costs associated with the production are expected to be £250,000 per annum. Each product sold by the company is also allocated by the company’s accountant an overhead charge of 5 per cent of the revenues it generates to cover head office expenses. The direct manufacturing costs are expected to be £7.00 per unit.

The company will need to hold stocks of the final product at the start of each year equivalent to 20 per cent of the sales expected in the next year and also stocks of materials and components equivalent to 20 per cent of the production expected in the next year. The materials and components account for £4.00 per unit out of the £7.00 overall direct cost per unit. The increase in debtors as a result of introducing the product will be offset by the increase in creditors. The company requires a rate of return of 12 per cent on investments of this nature, and the tax rate is 25 per cent.

Valuation of a Company’s Shares

a) Determine the investment’s net present value, the internal rate of return, payback period and discounted payback period. All key assumptions should be specified and explained very carefully.

b) Interpret the NPV, IRR, payback period and discounted payback period, using the results of your evaluation of Newton’s proposed investment to illustrate your answer.

2.  Valuation of a Company’s Shares

Take the price earnings ratios for three companies traded on the London Stock Exchange from the data set given in the attached file. These companies are drawn from the FT 100, the hundred largest companies traded on the exchange, and the P/E ratios specified are for the end of each year from 2007 to 2013. The data also gives the P/E ratios for the index.

Discuss the factors that might explain the differences in the price earnings ratios of the three companies you have chosen and the changes that have occurred in their price earnings ratios over the six year period. (Choose companies with a range of P/E ratios to give you one with a relatively low value, one with a relatively high value, and another with a middling value.)

You should use the insights provided by valuation models on the determinants of the price-earnings ratios in your discussion, but you should also discuss the role of any other factors that might influence the reported values of price-earnings ratios of the companies you have chosen.

Whilst you need to gather some information on the companies you choose it is not anticipated that you undertake an in-depth analysis of the companies. It is acceptable to make use of some possible reasons to account for the differences in the price earnings ratios as well as employing the information that you gather on the companies.

3. Rights Issue

Barclays announced on July30 2013 that the company would make a rights issue in September of the same year. The rights issue was planned to raise approximately £5.8 billion, with the shareholders being offered one new share at a subscription price of £1.85 for every four shares they were holding. The total number of shares to be issued was 3,216,893,546, equivalent to twenty five per cent of the shares outstanding at the time of the announcement. The share price immediately prior to the announcement was £3.095 and this fell to £2.93 when the issue was announced, a fall of 5.3 per cent. The announcement of a rights issue did not surprise the market, but the size of the issue was larger than anticipated. The issue was the 4^th largest issue ever made by a bank. The issue was designed to help the bank meet a requirement that Barclays increased the ratio of its risk capital to its assets to 3 per cent and at the time Barclays had a shortfall of £12.8 billion in its risk capital given the value of its assets. Other measures were also announced at the same time to explain how Barclays intended to cover the deficit.

(Google “Barclays rights issue 2013” to gain access to the press coverage of the announcement.)

Rights Issue

a) Explain and discuss the rationale provided for the rights issue. In answering the question take into account the financial performance and position of Barclays Bank at the time of the issue.

b) Specify the terms of the issue, the anticipated ex-rights price and calculate the value of a right. Utilise the price just prior to the announcement to undertake your calculations.

c) Demonstrate that an investor will in principle be equally well off from investing in the issue or selling the rights they have been allocated.

d) Identify and comment on the market’s reaction to the announcement of the issue. Can the price pressure hypothesis account for the market’s reaction or does the information hypothesis provide a better basis for interpreting the reaction?

4. The attached file (Stock returns 2007- 13) gives 84 monthly returns for securities drawn from the FT ALL Share Index for the period January 2007 and December 2013.

a) i. The data set provided identifies four equally weighted portfolios of one, five, ten, and fifteen securities. Determine, using the appropriate Excel function (see fx)) the standard deviation and variances of the monthly returns for each of the companies included in the portfolios. (Use the 84 months returns data in the calculations and use the Excel functions identified as Variance.P and Standard Deviation P.)

Next determine the monthly returns on the four portfolios along with the standard deviation of these returns. The monthly portfolio returns are simply the average of the monthly returns for each security included in the portfolio.

Compare the average value of the standard deviations of the returns on the securities included in each portfolio with the standard deviation of portfolio’s returns. Comment on the difference between the outcomes.

Discuss the consequences of increasing the number of securities in the portfolios. Compare your results to those of the studies of naïve diversification.

ii. Determine the variance of each security and the co-variances for each pair of securities in the portfolio of five securities using the relevant Excel function. Employ this information to calculate the standard deviation of the returns on the portfolio using the equally weighted portfolio risk equation. Compare your results to those obtained for the portfolio in part i above.

b) Determine  the  betas  for  SSE  (Scottish  and  Southern  Energy),  a  utility  company,  and  Barratt
Developments, a construction company, by regressing the returns for each of the two companies on the returns for the FT ALL Share Index (the first column in the spread-sheet).

i) Explain what the values of the betas (the slope coefficients in the regression) indicate and discuss the factors that might explain the differences in the values of the betas of the two companies.

ii) Comment on the implications of the estimated value of beta for investors and the cost of capital for the two companies

1. According to all the board members of Newton PLC and the board of directors of Newton PLC, the development cost of the company cannot be recuperated. The amount of money spent by the management of the Newton PLC will be failed to recover. This is because the theory of agency, which causes the separation among the management of the organization, and the owner of the organization control the management of the organization (Balla, 2012). This makes a problem among the objectives of the directors of the organization and the main objectives of the company set by the management of the company. This will also hamper the performance of the organization in the market. This may also hamper the market share price of the company which may effect on the stake holders of the company and also to their share holders of the company present in the market (Davies and Crawford, 2012).

Portfolio Returns

While developing a new product for the company, the management of the company has considered a cost for the new product of the company, which is financially known as the sunk cost. If the management of the company has problem with the sunk cost then the management of the Newton PLC Company cannot develop their new product in the market which will hamper the goodwill of the company in the market (Edmonds, et al, 2013). This will also effect on the wealth of the share holders of the company in the market.

Calculation is given on the appendix part:

The assumptions are discussed in the following points

• For the development of the new product in the company, the management of the organization has considered 2 million as the sunk cost.
• During inflation, the price of the raw materials and the other components used for developing the new products are high. So, it has been observed that the selling price of the product is less than the cost price of the newly developed product of the company.
• Assuming all the prices and the estimated prices of the newly developed product are accurate (Harrison, et al, 2013).
• All the tax rates and the rate of return are considered as the constant rate.
• The rate of inflation during the completion of the project is constant.
• All the cash flows are considered as the nominal rate.
• The business risk are treated as the financial risk involved in the organization.
• It will bring a positive impact on the net working capital of the company.
• The opportunity cost of the newly developed by the management of the company is 80K and the management of the company has decided to allocate around 40K as the financial cost of the product to develop the product in the market.
• The incremental cost of the company is around 250 thousand, which is treated as the overhead cost of the newly developed product.
• The depreciation amount has been deducted from the calculation part of NPV and the amount of capital allowances has been included in the NPV calculation. This is because the amount of depreciation has been excluded as depreciation is a part of non-cash items.

From the calculation, it can be concluded that the net present value of the project is 6.899 million. This shows that the net present value is positive which means that the cash out flow for the project is lower than the cash inflow from the project (Horngren, et al, 2012).

• On the basis of cash flow, the NPV of a project has been calculated.
• NPV helps to understand the value of money as compared with time.
• NPV helps the management of the company to take decision whether to invest on a particular project or not.

The meaning of internal rate of return is the return rate, which helps us to find out the zero return rates to calculate the NPV value of project. From the above calculation, it has been concluded that the discounted rate of NPV is around 15 % and the 15 % discounted rate is a positive rate, which gives a positive NPV for the project. Therefore, from the above calculation it can be stated that the discounted rate of IRR should be greater than 15 % (Kemp and Waybright, 2013). This method of IRR helps us to calculate the proposal of the investment whether to accept the project or not. This method of IRR helps us to compare among the other projects and to decide which project is appropriate to invest by the company.

The payback period of the project is calculated and the results of the payback period are between the 2^nd year and the 3^rd year. This payback period of the project helps us to calculate that in how much time we can recover the amount of money invested initially in the project and found that the in between the 2^nd year and the 3^rd year, the initial investment can be recovered.

From the above calculation, it has been observed that in between 3^rd year and 4^th year of the project life lies the discounted payback period. This discounted payback period will help to fid out the value of money with respect to time.

Appendix to answer of Q 1:
Sale price per
unit		14
direct cost		-7
Contribution		7
								000
	T0		T1	T2	T3	T4	T5	T6
Unit sale	–		400,000	600,000	600,000	600,000	600,000	300,000
Revenue	–		5,600	8,400	8,400	8,400	8,400	4,200
Cost of goods
sold	–		(2,800)	(4,200)	(4,200)	(4,200)	(4,200)	(2,100)
Contribution	–		2,800	4,200	4,200	4,200	4,200	2,100
Initial
Investment	(9,000)
Scrap								2,500
opportunity
cost “rent”	–		(80)	(80)	(80)	(80)	(80)	(80)
Fixed cost
associated	–		(250)	(250)	(250)	(250)	(250)	(250)
Used
equipment	(1,200)							300
Net WC	(880)		(440)	–	–	–	660	660
Taxation	300		(141)	(558)	(634)	(691)	(734)	(704)
Add
Depreciation	–		1,625	1,219	914	686	514	1,542
CF	(10,780)		3,514	4,531	4,150	3,864	4,310	6,068
I = 12%
(factor)		1.000	0.893	0.797	0.712	0.636	0.567	0.507
PV		(10,780)	3,137	3,612	2,954	2,456	2,446	3,074
NPV		6,899
accept the project  because it has positive NPV that means the  shareholder wealth
maximization
I = 15%
(factor)		1.000	0.870	0.756	0.658	0.572	0.497	0.432
PV		(10,780)	3,055	3,426	2,729	2,210	2,143	2,623
NPV		5,406
accept the project  because it has positive NPV that means the  shareholder wealth
maximization
·	IRR is more  than 15% where the project  NPV will be zero
·	Pay back between year 2 and  3
·	Discounted pay back between year 3 and  4
Tax working		T0		T1	T2	T3	T4	T5	T6
Scrap value									2500
Contribution		–		2,800	4,200	4,200	4,200	4,200	2,100
Tax = account
dep.		–		(1,625)	(1,219)	(914)	(686)	(514)	(1,542)
Fixed cost
associated		–		(250)	(250)	(250)	(250)	(250)	(250)
opportunity
cost “rent”		–		(80)	(80)	(80)	(80)	(80)	(80)
Used
equipment		(1,200)		–	–	–	–	–	300
Overhead			0	(280.00)	(420.00)	(420.00)	(420.00)	(420.00)	(210.00)
Taxable
income		(1,200)		565	2,231	2,536	2,764	2,936	2,818
Taxation @
25%		300.00		(141.25)	(557.81)	(633.98)	(691.11)	(733.96)	(704.38)
Depreciation working on the 25% reducing balance
T0	6,500
T1	4,875	(1,625)
T2	3,656	(1,219)
T3	2,742	(914)
T4	2,057	(686)
T5	1,542	(514)
T6		(1,542)
Working Capital
	T0	T1	T2	T3	T4		T5	T6
								300,00
Unit sale	–	400,000	600,000	600,000	600,000		600,000	0
20% Final
product	80,000	120,000	120,000	120,000	120,000		60,000
Direct cost
price		7	7	7	7	7	7
Product Cost
(A)	560	840	840	840	840		420	–
20% Material	80,000	120,000	120,000	120,000	120,000		60,000
Material price		4	4	4	4	4	4
Material Cost
(B)	320	480	480	480	480		240	–
Working
capital	880	1,320	1,320	1,320	1,320		660	–
Net WC	(880)	(440)	–	–	–		660	660

Tullow oil has the highest P/E ratio among all the hundred companies in 2010. However, in 2009 Vodafone group has the lowest P/E ratio. Adequate value we have selected for the Ashtead group.

P/E ratio and earnings per share (EPS) considered using the following:

P/E ratio: Current market price/Earnings per share

Earnings per share (EPS): Net income- dividends preferred stock/average outstanding shares

The differences between the three companies can explain the factors those are following:

A. Due to the dramatic decreasing on EPS from 16.3 in 2009 to 5.51 in 2010, Tullow oil has the highest PE ratio in 2010. The declining results in EPS that affected in the financial statements in 2010. It is not so important for the financial statements, that market share price was higher in 2010 rather than in 2009. The Fluctuation in P/E ratio in 2010 has indicated that the EPS was the important factor by considering the market price in 2009. According to the annual report of the company, we can see that the profit of the company has drastically changed and decreased vigorously in 2009 compared to 2010 (Needles and Powers, 2012). In the financial statements, the issue of the shares is included as per the given standard of the financial statements. Therefore, the price and the issue of shares dramatically changed in the year 2010. For this, the P/E ratio has been increase and the EPS has fallen down drastically.

B. the Vodafone group has the lowest P/E ratio in 2009 as mentioned above in the case study. In the previous year that is in 2009, the P/E ratio has decreased. In 2008, when market price was lower, the P/E ratio was higher than in 2009 while the market share price was higher in 2009 when the P/E ratio was lower. The market share price and the EPS are the factors that are influenced the P/E ratio. The increase on the market share price has a significant influence on the increasing earnings per share. Due to increase in the company profits compared to the other profits of 2008, EPS are increasing. To reduce the capital the company is repurchasing their shares from the market. From the Vodafone’s annual profit, we can see that they made profits in 2009 that of half already made in 2008. Due to the redemption of shares, the profit was half the EPS increased. With the increasing market share, the company can improve their performance in the international market so that they can improve their financial statements by showing the company’s profit in it.

C. In the year 2010, the three companies that selected Ashtead group has almost middle P/E ratio, which is 91. In 2009, the P/E ratio is 81 due to the market share price. The share prices are double in 2010, which are 172.9. It is happening due to the decline in the company’s profit. Comparing to the previous year, the capital of the company is use to expand their business activities in the international market (Scott, 2012). Due to the increasing ratio of the market share, the company can increase their price earnings ratio that clearly states that if the company wants to make profit then they should increase their market share in the business activities.

At an average price of 23p per share under share, option plans the ordinary shares re-issued out of treasury. The ESOT purchased 491,513 shares at a total cost of £0.4m and 8247,172 shares held in treasury were canceling during the year of the companies purchased shares, which held in treasury.

Due to the different accounting period, the P/E ratio can be deceptive as per the case of our selected companies. The company should clearly states their financial position so that due to different accounting period it cannot hamper the company’s financial position in the market.   

Interpretation of financial results can be misleading in the case of the P/E ratio. When the company is already, declare their dividends for the stock market the company can improve their performance.

Sometimes it is very difficult to compare the company’s different business modules, products and different growth capabilities with the other companies in the market (Shim, et al, 2012). However, the calculation of the P/E ratios can be accurate but it can create problem when calculating the different business modules of the different companies.

3. The following are the three decisions taken by the manager of finance in an organization to improve the financial condition of the company:

• The capital of the organization should be raised to increase the capital funds of the company. This will help the organization to improve the level of optimization of the organization.
• If the value of NPV is positive, the finance manager of the organization should invest in that particular project.
• The finance manager of an organization should give dividend to their share holders in the market to attract more share holders for the organization (Weygandt, et al, 2012).

The reasons why the organizations needs to increase their funds:

• To expand the business of the organization, the finance manager of the organization should invest money in projects.
• The finance manager of the company should increase the optimal level.
• If the share price of the company is high, the finance manager of the organization should split their shares in the market.

The finance manager of every organization should take some responsibilities to raise their funds in the organization to minimize the risk involved in the project and to have a better capital structure of the organization.

In the case of Barclay Bank, the reducing level of the organization should maintain in the market to help the management of the bank to increase the optimal structure.

In the scenario of Barclay Bank, it has been observed that the management of the Barclay bank wants to minimize the gearing ratio of the organization to reduce all types risks associated in the organization which will help the management of the Barclay Bank to perform better performance in the market.

The management of the Barclay Bank has decided to issue new shares in the market which will help them to increase the funds of the organization. This will also attract more investors towards the organization. Usually, most of the organization can raise their funds by issuing shares in the market through IPO (Williams, 2012).

b) The management of the Barclay Bank has announced that they are offering a discount on their right issues. The price of the right issue of the Barclay Bank is 3.095 and they are giving a 40 % discount on the right issues of the Barclay Banks.

Value of the right issue = price of theoretical value – price of subscription

In this case, 0.99 is the per right option.

c) The investors can sell all the right shares of the Barclay Bank that can be illustrate as 400 shares.

d) After the calculation, it can be concluded that the Barclay Bank are giving an extra discount to the original price of their shares. The discounted rate of the Barclay Bank is 8 %. But in the market, the management of the Bank are giving only 5 % discount on the original price of the shares. The price of the Bank will fall, if the market is efficient.

Barclays
The right issue in 2013
Step 1:
P0=
	3.095
Ps=	1.85
number of existing number of share	12,867,934,184
number of new share to be issue	3,216,983,546
number of new share after right issue	16,084,917,730
the share price fall to	2.93
by %	-5%
value of the company before issue	39,826,256,299
amount to be raised	5,800,000,000
Step 2:
to raise 5.8b we need to issue at least	3,135,135,135
Step 3:	12,867,934,184
	3,216,983,546
	4
which is 25% of the existing share	1
Step 4:
Theoretical price after right issue	2.84
by %	-8%
Step 5:
the value of the right option	0.99
theoretically no change in the wealth	1,238.00
assuming 400 shares
If
subscribe the issue	1,418.29
	-185
	1,233.29
	-4.71
sell the issue
400 share	1,134.63
proceed of selling right	98.66
	1,233.29
	4.707

Reference List:

Balla, D. (2012). CLEP financial accounting. Piscataway, NJ.: Research & Education Association.

Davies, T. and Crawford, I. (2012). Financial accounting. Harlow, England: Pearson.

Edmonds, T., McNair, F. and Olds, P. (2013). Fundamental financial accounting concepts. New York, NY: McGraw-Hill/Irwin.

Harrison, W., Horngren, C. and Thomas, C. (2013). Financial accounting. Boston: Pearson.

Horngren, C., Harrison, W. and Oliver, M. (2012). Accounting. Upper Saddle River, N.J.: Pearson Prentice Hall.

Horngren, C., Harrison, W. and Oliver, M. (2012). Financial & managerial accounting. Upper Saddle River, N.J.: Pearson Prentice Hall.

Kemp, R. and Waybright, J. (2013). Financial accounting. Boston: Pearson.

Needles, B. and Powers, M. (2012). Financial accounting. Mason, OH: South-Western Cengage Learning.

Scott, W. (2012). Financial accounting theory. Toronto: Pearson Prentice Hall.

Shim, J., Siegel, J. and Shim, J. (2012). Financial accounting. New York: McGraw-Hill.

Weygandt, J., Kieso, D. and Kimmel, P. (2012). Financial accounting. Hoboken, N.J.: Wiley.

Williams, J. (2012). Financial accounting. New York: McGraw-Hill/Irwin.