Treasury

Management
Week-12, Capital Structure and Company
Valuation

Company Valuation Cash Flow

Based Techniques
Dividend Stream Approach
This method takes the present value of future dividend
streams discounted at the companys cost of equity capital
If the dividends were expected to remain constant overtime,
then the perpetuity valuation method would apply
Po = d1
Re

d1 = the next dividend, Po is the current share price or market

value, Re is the cost of equity capital
However, dividend would be expected to grow, so using the
Gordon Growth Model, the growth, g, can be incorporated
Po =

d1
Re -g

Example Constant Growth Rate

Expected
If the next dividend on Z Ltd shares is expected to
be 100p, if future dividends are expected to grow
4%, and if the companys cost of equity capital is
16.5%, what is the likely current share price?

Po = 100 = 100
= 800p
0.165 0.040 0.125

Example Super Growth For a Period

Followed by normal growth
Many firms go through a cycle where their growth is
much faster than that of the economy as a whole,
before it falls back in line with the economy. This can
be due to having a temporary competitive advantage
which will eventually be acquired by other firms
Suppose X Ltd expects its dividend to grow by 20% for
10 years, and then to grow by 4% thereafter, and
suppose its cost of equity capital is 9%. The latest
dividend was 2p per share. What might the present
market price of the shares be?

Example Super Growth For a Period

Followed by normal growth
Stage 1 Calculation of NPV of the dividends over the
next 10 years

Hence the present value of the next 10 years

dividend stream is 35.24p

Example Super Growth For a Period

Followed by normal growth
Stage 2 Calculate the value of the share in year
10 (P10), based on the GG Model with dividends
growing at 4%

Where d II = year 10 dividend x year 10s growth rate, so:

dII = 12.38 x 1.04 = 12.88

Stage 3 Calculate the present value of P10 today

Example Super Growth For a Period

Followed by normal growth
Stage 4 Sum up the present value of the next 10
years dividends and the present value of the
share price in 10 years time
= 35.24 + 108.77 = 144.01 or Rs 1.44
Thus under the GG Model the shares would
presently be priced at Rs 1.44

Dividend Stream Approach Closing

thoughts
Dividend valuation methods are appropriate for a

potential minority shareholder who will not be able

to influence policy but who will simply be able to
invest to receive dividends
For quoted companies, brokers can give estimates
of future dividends, but is much harder to find
meaningful estimates for unquoted companies
It is not easy to work out a meaningful cost of
equity for unquoted companies. One method is to
find a similar quoted company, but this is not easy.

Question
Suppose Engro expects its dividend to grow by
15% for 5 years, and then to grow by 5%
thereafter, and suppose its cost of equity capital is
17.75%. The latest dividend was 500p per share.
What might the present market price of the shares
be?

Answer
Stage 1 Calculation of NPV of the dividends over the
next 10 years

Hence the present value of the next 5 years

dividend stream is Rs 23.30

Answer
Stage 2 Calculate the value of the share in year
5 (P5), based on the GG Model with dividends
growing at 5%

Where d II = year 5 dividend x year 5s growth rate, so:

dII = 1005 x 1.05 = 1055.25

Stage 3 Calculate the present value of P5 today

Answer
Stage 4 Sum up the present value of the next 5
years dividends and the present value of the
share price in 5 years time
= 23.30 + 36.59 = Rs 59.89
Thus under the GG Model the Engro would
presently be priced at Rs 59.89

Free Cash Flow Model (Based on NPV)

The method attempts to forecast cash flows and

then to discount them at the appropriate rate

The question is which cash flow and which
discount rate to use ?
There are various methods, but the two most
commonly used are:
Value entire firm, i.e. debt plus equity
Value equity portion only

Free Cash Flow Model (Based on NPV)

Value entire firm, i.e. debt plus equity
Cash flow = Profit before interest and tax +
depreciation capital expenditure - change in working
capital tax payable
Discount Rate = WACC (after tax) based on target
gearing
Note
1. Deduct market value of debt to obtain equity
2. The cash flows are those available to all providers of
finance i.e. to both debt and equity holders

Free Cash Flow Model (Based on NPV)

Value Equity portion only
Cash flow = Profit after tax + depreciation capital
expenditure - change in working capital
Discount Rate = After tax cost of equity
Note
1. When valuing a potential take-over target, the bidder
will need to include in his estimate of free cash flows
any re-organization costs and any sale proceeds from
surplus assets
2. Cash flow forecasts cannot be meaningful unless there
is access to the books of the company being valued

MCQs
Modigliani and Millers series of propositions
ultimately predicted which of the following in
practice?

a) Capital structure doesnt matter

b) Maximum debt gives the lowest cost of capital
c) There is an optimal mix of debt and equity
d) Debt should be repaid as fast as possible
e) Dont know.

MCQs
Answer

The right answer is (c).

The tax shield on debt initially reduces cost of capital as
debt is increased. However the cost of distress becomes
significant above acceptable levels of debt and
therefore the debt cost starts to rise and increases the
cost of capital.
Answer (a) was the initial finding, given no taxes.
Answer (b) was the intermediate finding, before
including the effect of financial distress.

MCQs
The propositions of Modigliani and Miller, which
have shaped much of the current thinking on
capital structure, are based upon which one of
the following?
(a) equity being riskier than debt
(b) debt being cheaper than equity
(c)capital structure is irrelevant
(d) risk transference between equity and debt
(e) dont know

MCQs
Answer

The right answer is (d) risk transference between

equity and debt

Equity is riskier than debt from the investors

point of view; debt is riskier than equity from the
companys perspective. Neither is core to the
propositions. The core is that risk is transferred
between the two as proportions of debt and
equity change.

Special Consideration for valuation of

Overseas Investments
The usual investment appraisal considerations apply to any

form of capital budgeting, but where overseas projects are

considered, then the following additional points apply:
The discount rate must take account of the special risks of the

project (e.g. appropriation of assets, special tax rates on

overseas investors)
The discount rate will differ depending on whether the
projected cash flows are denominated in domestic or overseas
currency. The domestic currency value of overseas currency
remittances will change with time
Project cash flows may exceed the remittable cash flows (i.e.
the cash flows which can be remitted to the investing company
and which can be converted into home currency)

Methods of Appraising an Overseas

Investment
Let us consider an investment by a UK based

company in a Pakistani subsidiary. There are two

possible methods, each of which should give the
same NPV in sterling terms
Method 1

Method 2

Cash flow

converted from
PKR at appropriate
forward rate

PKR

Discount Rate

Sterling

PKR

NPV

Sterling

Sterling converted
from PKR NPV at
spot rate

Accountancy Based Techniques

Price Earning Method
This takes the required price earnings ratio and multiplies it by
the earnings per share (EPS). This formula is simply:
PE = Share Price
EPS
Therefore: Share Price = PE x EPS (use the EPS forecast for
the next period)
Problems with this methods are:
1. The price earning ratio is based on minority share price valuation
for a quoted company. The number of shares changing hands on
a particular day, from which the price is determined, is only for a
small percentage of the total equity. Thus if the valuation is for a
potential bidder, it may be worth adding, say 10% to the targets
earnings, because new management will be in full control

Accountancy Based Techniques

Price Earning Method
If the company is unquoted, it may be necessary to
ascertain the required PE ratio by looking for that ratio
in a similar quoted company. Deduct say, 25% from
the PE ratio to take account of the lower marketability
of shares in an unquoted company. Once again, it is
difficult to find a similar quoted company as the
market is thin in some stocks. In addition, the owners
of the unquoted company may have been awarding
themselves large, unjustified directors fees, so the
earnings will need to be adjusted upwards.
There is inherent problem of forecasting EPS

Accountancy Based Techniques

Net Asset Value (NAV)
Realizable Value
If the bidder intends to sell subsequently, value at
realizable value Include non balance sheet assets
such as brands.
Replacement Value
If the bidder intends to keep the asset and use
them in his business, then this is the best way of
valuing the assets

Accountancy Based Techniques

Net Asset Value (NAV)
Normally, assets based values represent the minimum
which the vendor could accept. It is a matter of
negotiation in a full take-over as to the final amount
paid
Take care to ensure there are no tax suits pending for
the target, and take into account any hidden assets
such as potential claims for insurers
Usually earnings or dividend based methods will
indicate a higher value than asset based values
because earnings and dividends will have benefited
from intangible factors such as contacts and goodwill

Market Based Techniques

Synergy
For a quoted company about to be taken over, one method is the
bid premium, or how much above the current share price must
be paid to acquire control
If the Efficient Market Hypothesis (covered later) holds true, the
current share price of the target must reflect all known
information so the only way that the target could be worth more
than its current share price is to the bidder is if there are
synergies, or some other justifications
When synergy applies the value of the target to the bidder is:
Current Share Price + Present Value per share of Synergy
The lowest price bid will be the current share price and the
highest bid will be the current share price plus the full present
value of the synergy. However, it is difficult to quantify synergy
without full access to the targets books

Notes on Company Valuation Methods

All these methods are simply for guidance. In

practice the value of a company is what a willing

buyer will pay a willing seller
In practice bidders and targets in a take-over
situation may calculate valuations using each of
the above methods and will and then set a price
somewhere in the middle
There follows a brief overview of the Random
Walk Hypothesis and the Efficient Market
Hypothesis to provide further background to the
bid premium/synergy valuation method

Quick Quiz
Firm A has a market value of Rs 30m and Firm
B has a market value of Rs 5m. Merging the
firms allows cost savings with an NPV of Rs
3m. Firm A buys firm B for Rs 6m
What is the gain to be had from the
acquisition?
What is the control premium? (Also known as
bid premium)
What is the gain to As shareholders?

Quick Quiz
1. The total Gain is the NPV of the future cash

savings i.e. Rs 3m
2. 6 5 = 1
3. 5+3-6 = 2

Quick Quiz
Firm C has a market value of Rs 20m divided
between 1 million shares and Firm D has a
market value of Rs 2 million divided between
0.25 million shares. Two weeks ago, before
rumors of a takeover, Ds share price was
only Rs 6. A merger would produce gains
with a PV of Rs 1m. If C buys D for Rs. 2.1
million
1. What is the control premium
2. How much of the merger gains will be
enjoyed by C?

Quick Quiz
1. The value of D should be taken at Rs 1.5m, the

price before rumors began to incorporate the

potential bid premium in the share price (0.25x6)
Bid Premium = 2.1 -1.5 = 0.6m
2. The total merger gain is Rs 1m. C pays a bid
premium of Rs 0.6m, so the amount of merger
gains enjoyed by C shareholders is Rs 0.40m
The alternative calculation is 1.5+1-2.1 = 0.4

The Random Walk Hypothesis

The random walk hypothesis states that stock markets are highly

efficient and therefore at any one time, share prices reflect all the
available information about companies and economies, including
the best guess of millions of investors about what the future holds
In those conditions prices will change for one reason only: that
new information has become available, including any facts or
ideas that alter perceptions of the future
Since new information is unpredictable, future share price
movements are unpredictable. Yesterdays share price
represented the collective view of yesterdays information
Every day starts out fifty-fifty, so that prices could move up or
down depending on the market reaction to new information
The current share price is the best estimate of tomorrows price,
since it reflects all known information and all the estimates which
investors have made as regards the future

Efficient Market Hypothesis

The Efficient Market Hypothesis developed from the Random

Walk Hypothesis. It takes Three forms:

Weak forms of EMH
The Semi-Strong Forms of EMH
Strong form of EMH

Weak forms of EMH seeks to expose the vulnerability of

technical analysis by stating that whatever information

may be conveyed by charts has already been recognized
in the current price. Thus current share price already take
account of past price trends therefore the chart of a share
cannot help in predicting the future share price
One derogatory quotation concerning charts says Market
have no memory referring to the previous comment that
every day starts out as fifty-fifty

Efficient Market Hypothesis

The Semi-Strong Form of EMH
This theory goes on to say that not only is the chart of the
share price reflected in the current price of a share, but also
all other publicly available information has been taken into
account in the current share price
The justification for this semi-strong EMH is that all leading
companies are under constant examination by large number
of fundamental and technical analysts
Therefore the prices of the shares in these companies reflect
the consensus of this expert advice to investors
As new information becomes available, the market will react
to it. Thus new information will change the markets view of
the fundamentals and the share price will therefore
immediately adjust to its new intrinsic value

Efficient Market Hypothesis

Strong Form of EMH
This strong form states that not only is all publicly available
information reflected in the share price of leading shares, but also
all privately known insider information
Most insider information in leading companies is quickly available
to the analysts, because it can be anticipated from other sources
Thus the shares in leading companies are considered to be fairly
valued as all information (both public and private) is reflected in
the present share price
The strong form of EMH explains and backs up the Random Walk
Hypothesis. Leading shares are priced at their current intrinsic
values, and their prices will fluctuate in line with changes in
information
Changes in fundamentals cannot be predicted, hence share prices
will move in a random manner

The Paradox Regarding Expert Market

analysts and Advisors
If the current market price represents the intrinsic

value of a share, there is little point in individual

investors trying to use experts to beat the
market
On the other hand, the continuing efficiency of the
market may well depend on the efforts of those
analysts which will ensure that price movements
continually reflect new information

The Balance of Evidence for and

Against the EMH
There is no single correct answer which can prove or

disprove the validity of the EMH

The strongest argument against the EMH is the crash of
October 1987. Was this caused by new information or
was it the result of mass hysteria and program trading?
On the other hand, the failure of professionally managed
funds to significantly out-perform the market over a long
period of time, would tend to support the EMH
If all information is available then why insider trading is
illegal, Galleon Group, Hedge Fund, Raj Rajaratnam,
made billions of dollars from insider trading and finally
got arrested

The relevance of the EMH to take-over

situations
If the EMH can be believed, then every share is priced at its intrinsic

value, since the share price represents the views of the expert
investors in the light of all available information
It therefore seems illogical that there is normally a bid premium in
a take-over
However from the bidders point of view, a bid premium could still
be justified if a successful take-over would:
Result in synergy
Allow the bidder to change shape quickly and easily, in that it can

enter a new industry or a new geographical area by acquiring the target

Give the bidder a competitive advantage or prevent a rival from
acquiring a competitive advantage by acquiring the target
Secure supplies or outlets if the target is a supplier or buyer (some
books call this vertical integration)
Gain control of a competitor (sometimes called horizontal integration)

Dividend Policy
It is widely agreed that the dividend decision is an extremely

important decision for any company to make; for not only does it
have a direct impact on the capital structure of the company, but
also it may have implications for the companys cost of capital
The importance of the dividend decision, and the factors which a
companys management are likely to take into account when
formulating that decisions, will be discussed in this part of lecture
In order to understand the debate on the dividend decision, it is
necessary to appreciate the nature of the returns earned by a
shareholder. These returns may be divided into the dividend
received and the capital gains (or loss) on holding the shares,
thus
R = D + P1 P2
P1

Dividend Policy
As shares may be sold on the stock market, it is

possible for shareholders to realize their capital gains

at any time, (although in practice there will be
associated transactions costs to take into account)
This fact is most significant, as the dividend decision
not only affects the shareholders return directly
(through dividend paid), but also it affects it indirectly
via its influence on the market price of the share
The relationship between the level of distribution and
the share price is extremely complex, but a crucial
factor is undoubtedly the efficiency with which the
management of the company is able to use retained
profits

Dividend Policy
If it was believed that retained profits were being used

inefficiently, with returns being below what could be

obtained by investors outside of the company, then it is
likely that the price of the companys shares would be
depressed if retentions were set at a high level
Indeed, the risk that this might occur, provides a good
reason for arguing that all after-tax profits should be paid
out as dividends
The management would then have to justify explicitly each
amount of additional capital that it wished to raise
However, the transaction costs associated with this form of
operation (rather than simply ploughing back profits within
the business) weigh against a 100% payout of after-tax
profits

Dividend Policy
The tax regime may also encourage retention
For example, there may be generous capital

allowance to off-set against taxable profits, and

dividends received by shareholders may be taxed
at a different rate to realized capital gains, (which
reflect earlier retention by the company)
In addition transactions costs faced by the
shareholders complicate the calculations of the
true relative tax rates

Alternative Dividend Policies

One view to be found in the literature is that a company should

plough back its internally-generated funds so long as the

projects undertaken are expected to increase the shareholders
wealth (i.e. expected to give positive NPV)
Any excess of after-tax profits not used in this way should then
be distributed
This view of course makes dividends a residual item, and hence
is likely to conflict with the general belief that there should be
stability in dividends, with a steady growth over time if possible
If latter position is accepted, then it would be the level of
retentions which would become the residual variable, with the
amount of new external financing in any given year being
dependant upon that years after-tax profits and the desired
amount of new capital investment for the company

Shareholders Attitudes
Naturally, these will have a critical influence on the decision

as to the proportion of earning to be distributed as

dividends
These attitudes in turn will be influenced by the relative tax
advantage in receiving dividends; the ability of
management to invest funds profitably within the business,
(and here the rate of return expected must be at least as
great as the shareholders desired return on equity); and the
implications for dilution of control if the company is forced
to issue additional shares, rather than retain earnings
There may also be disproportionate pressure from
institutional investors, who may favor distributions of
dividends in order to satisfy their own requirements to be
able to make disbursements of funds to their own investors

The Long-Term Trend in Dividends

Normally, management will wish to show a steadily

rising dividend, unless a reduced dividend is absolutely

unavoidable
Thus the level of last years dividend, current earnings
and expected future earnings will affect the current
years dividend decision
Consequently, management may declare only a small
increase in dividend this year, despite a good growth in
earnings, in anticipation of a down turn in activity in
the future
Stability of dividends, as an objective of management,
may lead to retentions being a residual in the financial
decision-making process

Availability of Cash and Legality of

Dividend Payments
High profits do not necessarily mean strong

positive cash flows, and a company can only pay

dividends when cash is available to do so
Care must be taken not to drain liquidity from the
business in an effort to meet the short-term
preference of share holders
There may be legal requirements relating to the
maximum amounts which may be distributed as
dividends during any particular financial year
Such requirements set limits to the degrees of
freedom available to the management

Restrictive Covenants and Structure of

Corporate Taxation
In the past, the company may have entered into

restrictive covenants with suppliers of funds

interested in securing the claim to their funds
These restrictions may set limits to the level of
distribution during any particular period, either in
absolute terms or as a percentage of total earnings
Capital structure may favor or discourage the
retention of profits or the raising of new debt or the
issuing of new shares
Taxation considerations are clearly important so
long as they do not distort the capital investment
decision to the long-term detriment of the company

Availability of Suitable investment

opportunities
Unless there are projects available within the

company which are expected to generate a rate of

return which is at least equal to the companys
cost of capital, there is little point, from the purely
financial perspective, in retaining earnings
The shareholders would be better off (not
withstanding the complications of taxation)
receiving dividends and then reinvesting the funds
themselves

Market Signals
Dividend announcements are often reported widely in the

financial press, and the reaction of the markets to these

statements may have an important influence on the
distribution decision
An unexpected cut in dividends, even for sound financial
reasons, may shock the markets into marking down the
price of the companys shares disproportionately
And although such action may not reflect the underlying
business fundamentals, it may still cause distress to
shareholders lead to criticism of management and make it
more expensive for the company to raise finance in the
future
Thus great care should be taken not only in deciding the level
of the dividend but also how the news will be made public

Access to New External Funds and their

Cost
For a given set of capital investment plans,

management will pay particular attention to the

availability of new external finance and its cost to the
company when deciding upon the level of distributions
It must be recognized in this respect that these issues
are not independent, as the level of distributions and its
reception in the markets are likely to influence the
attitudes of prospective lenders and shareholders, and
hence the availability and cost of new funds
Relevant to this decision is also the existing and likely
future gearing ratio of the company, as this will affect
the perceived financial risk associate with the business

Share Buy Backs

Share buybacks occur when companies use their own cash to

purchase their own shares

The effect of a share buyback is that the companys cash is reduced
and this reduction is matched by a corresponding reduction in the
share capital in the balance sheet
The reduction in share capital occurs because the shares which are
repurchased are cancelled
In the past, there were restrictions on this activity, since share
buybacks could have been used to create artificial demand for the
shares and hence to exert upward pressure on the share price
Later, under the treasury stock method, Companies have been able
to cancel the repurchased shares temporarily, with a view to reissuing them on a later date of the companys choosing
A typical example of this is where a company buys back its share
from the market, cancels the shares temporarily and subsequently
re-issue them to employees or directors under share option schemes

Share Buy Backs

Apart from buybacks of shares to meet future

employee share option obligations, the main

application of share buybacks occurs in cash rich
companies in mature industries with poor growth
prospects
These companies may feel that the shareholders
could obtain a better return on the cash by
investing outside the business