CAPM Method: Valuing Equity with Market & Treasury Rates Assignment Sample

Financial Analysis Assignment Sample

Introduction

The valuation of Equity is done by various methods among which the most famous method CAPM (Capital Asset Pricing Model).  The required rate of the equity shareholders is calculated based on the market return, risk-free return, and a beta of the company. In the given case the risk-free rate is taken as the yield of the three months treasury bills and also the market rate and treasury rate are assumed to be post-tax rate (Karadag 2015). Generally, the Treasury bill for the same period or nearest to the period of projection is taken for calculation but as per given information calculation is done.

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Valuation of the Bond

Bond Valuation
Face Value	100
Price	105
Coupon Rate	10%
Maturity	5Years
Coupon Amount	10
Post Tax Coupon Amount	7
Cost of Bond	6.67%
Preference Valuation
Dividend	10
Post Tax Dividend	7
Market Price	98
Cost of Preference Issue	7.14%

Equity Valuation
Risk Free Rate  (Rf)	3%	year	EPS Earring per share	Increase/Decrease Percent
Market Return (Rm)	10%	2015	20
Beta	1.5	2016	25	25.00%
		2017	18	-28.00%
Tax	30%	2018	22	22.22%
		2019	26	18.18%
CAPM	+ (Rm-Rf)Beta
	+ (0.10-0.03)*1.5
	13.50%
P0	34.80
G	9.35%
D1	1.31
DDM	/ P0 + G
	>
	13.11%

 

The market rate of return is the return that the shareholders may earn if they have invested their money in the market or some other company instead of investing in the company (Carlon 2019). Each stock or share price have a different relationship with the market and thus the market beta is taken as 1 and stock beta represents the sensitivity of the stock in relation to the market, that is if market moves by 1 point upwards or downwards than how many times the stock price of the company would change. The main advantage of this method is that it is simple to calculate and disadvantage is that it ignores the trend of the returns of the company and shareholders' confidence.

The dividend discount model is also a very simple method that is calculated based on past dividends and the current market price of the shares. The company may increase its value in the given method by controlling its payout ratio as it is in the hands of the company to determine the dividends to be paid to the shareholders and this is as per the pre-defined policy of the company (Davydov 2016). The company may have the policy to give a constant dividend to maintain stability and avoid volatility in the market and share price. The increase in the dividends is more than 18% each year but due to the downfall in the year 2017, the average growth rate is coming as 9.35%. Thus because of a single year of downfall, the average rate or the growth rate has almost reduced by 50%.  This method ignores the market rate of return which the shareholders can get.

2. Determination of the optimum cost of capital

WACC
Sources of Funds	Weightage	Cost	Net Cost
Equity	40%	13.50%	5.40%
Bonds	50%	6.67%	3.34%
Preference	10%	7.14%	0.71%
			9.45%

 

Thus the optimal cost of capital is 9.45%

3. Evaluation of the total value addition

Particulars		2020	2021	2022	2023	2024
Units Sold		8000	8000	10000	11000	12000
Rate		30000.00	30000.00	30000.00	31000.00	31000.00
Production Cost		15000.00	15750.00	16537.50	17364.00	18233.00
Contribution Per Unit		15000.00	14250.00	13462.50	13636.00	12767.00
Contribution (£ m)		120.00	114.00	134.63	150.00	153.20
Depreciation (£ m)		30.00	30.00	30.00	30.00	30.00
Fixed Cost (£ m)		20.00	20.00	15.00	10.00	10.00
R&D Cost (£ m)		5.00	5.00	5.00	5.00	5.00
Profit		65.00	59.00	84.63	105.00	108.20
Tax		19.50	17.70	25.39	31.50	32.46
Profit after Tax		45.50	41.30	59.24	73.50	75.74
Depreciation (£ m)		30.00	30.00	30.00	30.00	30.00
Cash Flow per year		75.50	71.30	89.24	103.50	105.74
Initial Outflow	-150
Working Capital	-0.85					0.00
Net Cash Flow	-150.85	75.50	71.30	89.24	103.50	105.74
Discount Rate (9.45%)	1	0.914	0.835	0.763	0.697	0.637
Net Present Value	-150.85	68.98	59.52	68.06	72.12	67.32

 

NPV	185.16
IRR	46.67%

 4. Sensitivity of the projected NPV

If the Unit Sales fall by 10%
Particulars		2020	2021	2022	2023	2024
Units Sold		7200	7200	9000	9900	10800
Rate		30000.00	30000.00	30000.00	31000.00	31000.00
Production Cost		15000.00	15750.00	16537.50	17364.00	18233.00
Contribution Per Unit		15000.00	14250.00	13462.50	13636.00	12767.00
Contribution (£ m)		108.00	102.60	121.16	135.00	137.88
Depreciation (£ m)		30.00	30.00	30.00	30.00	30.00
Fixed Cost (£ m)		20.00	20.00	15.00	10.00	10.00
R&D Cost (£ m)		5.00	5.00	5.00	5.00	5.00
Profit		53.00	47.60	71.16	90.00	92.88
Tax		15.90	14.28	21.35	27.00	27.87
Profit after Tax		37.10	33.32	49.81	63.00	65.02
Depreciation (£ m)		30.00	30.00	30.00	30.00	30.00
Cash Flow per year		67.10	63.32	79.81	93.00	95.02
Initial Outflow	-150
Working Capital	-0.85					0.00
Net Cash Flow	-150.85	67.10	63.32	79.81	93.00	95.02
Discount Rate (9.45%)	1	0.914	0.835	0.763	0.697	0.637
Net Present Value	-150.85	61.31	52.86	60.87	64.80	60.50
NPV	149.49
Original NPV	185.16
Fall in NPV	19.26%

 

NPV	149.49
Original NPV	185.16
Fall in NPV	19.26%

 

Thus the project is sensitive to the Units sold as 10% fall in Units lead to almost twice the fall in NPV.

If the Cost of Capital increases to 12%
Particulars		2020	2021	2022	2023	2024
Units Sold		8000	8000	10000	11000	12000
Rate		30000.00	30000.00	30000.00	31000.00	31000.00
Production Cost		15000.00	15750.00	16537.50	17364.00	18233.00
Contribution Per Unit		15000.00	14250.00	13462.50	13636.00	12767.00
Contribution (£ m)		120.00	114.00	134.63	150.00	153.20
Depreciation (£ m)		30.00	30.00	30.00	30.00	30.00
Fixed Cost (£ m)		20.00	20.00	15.00	10.00	10.00
R&D Cost (£ m)		5.00	5.00	5.00	5.00	5.00
Profit		65.00	59.00	84.63	105.00	108.20
Tax		19.50	17.70	25.39	31.50	32.46
Profit after Tax		45.50	41.30	59.24	73.50	75.74
Depreciation (£ m)		30.00	30.00	30.00	30.00	30.00
Cash Flow per year		75.50	71.30	89.24	103.50	105.74
Initial Outflow	-150
Working Capital	-0.85					0.00
Net Cash Flow	-150.85	75.50	71.30	89.24	103.50	105.74
Discount Rate (12%)	1	0.893	0.797	0.712	0.636	0.567
Net Present Value	-150.85	67.41	56.84	63.52	65.77	60.00

 

NPV	162.69
Original NPV	185.16
Fall in NPV	12.13%

The project is also very sensitive to cost of capital as increase in cost from 9.35% to 12% has reduced the NPV by 12.13%. Since the NPV is very high so even after such variances the NPV is remaining positive and thus the thus the project is viable.

5. Impact of Brexit on the UK automobile manufacturing sector

After the implementation of this strategy, the market will have fewer brands and the famous brand will also be available at cheaper rates with improved quality. Thus this will change the consumption pattern of the customers as the branded product is easily available at affordable prices than the consumption of non branded products would reduce. Thus the maintenance of the brand image and goodwill will be highly required and also the dependency of the company on the particular brand will also increase.

Thus the proper research and development of the brand are required to keep up with the changing technology and reduction of the production cost to increase the profitability of the company and also reaching more customers and new markets.

Part B: Financial Analysis for internal Management:

Answer 1

The price strategy selected by the company depends on various factors such as market share, the life cycle of the products, targeted customers, etc. The four mainly used pricing strategies used in the market are Skimming Pricing, Penetration Pricing, Premium Pricing, and Economy Pricing. In the Skimming pricing in case of a new product, the price is kept high as the substitute and alternate products are not available and thus high margin is charged (Dosch & Wilson 2010). This is done generally in the case when the new product is launched in the market and it fulfills the demand which was earlier unsatisfied. When the substitutes are developed than the price is corrected and normal profits are attained. In the case of penetration pricing strategy the motive is opposite the skimming pricing strategy. In the given case the target is to reach the maximum customers in the market and gain the market share so the prices are kept very initially and later when the demand is developed than the prices are normalised (Drury 2011). Thus in the initial stage the profit is low and is regularised with passage of time. Premium pricing is done to build the brand and show superior quality of the product of the company. This can be done only when the strong brand image exists in the market. Economy pricing are done for generally used items and products and thus the quality products at cheap prices attract more customers.

The car market is different as compared to markets as earlier it was a luxuries product but recently it has become necessity and large numbers of customers are entering the market. Thus pricing strategy depends upon the target customers if the high class are the targets than premium pricing is required to be done and if the customers are middle and lower class than economical pricing would be more beneficial. Since the brand is also in the market thus the skimming or penetration pricing could not be undertaken. Thus proper strategy should be used to increase the popularity of the brand and attain the organisational objective (Spires, Wallin & Youg 2012).

Answer 2

Sales Unit	46000	£80
Produced Units	50000
Total Variable Cost	55
	Units	Rate	Total
Opening Stock	5000	55	275000
Closing Stock	9000

 

Marginal Costing
Sales		3680000
Cost of Sales
Add: Opening Stock	275000
Less: Closing Stock	-495000
Add: Variable Cost	2750000	-2530000
Contribution		1150000
Less: Fixed Cost
-Production Overhead	350000
-Selling Overhead	140000
-Administrative Overhead	80000	570000
Profit / Loss		580000

Closing Stock is valued at 55 and Overheads are taken on incurred basis.

Absorption Costing
Sales		3680000
Cost of Sales
Add: Opening Stock	275000
Less: Closing Stock	-567000
Add: Variable Cost	2750000	-2458000
Contribution		1222000
Less: Fixed Cost
-Production Overhead	400000
-Selling Overhead	140000
-Administrative Overhead	80000	620000
Profit / Loss		602000
Estimated production cost per>
8

 

Thus value of Closing Stock is variable cost plus overhead rate that is 55+ per unit

Reconciliation Statement
Profit as per Marginal Costing		580000
Less: Over Absorption of Production Overhead		-50000
Add: Difference in Closing Stock Valuation		72000
Profit as per Absorption Method		602000

Answer3

The Zero Based Budgeting is the advanced form of budgeting which covers the grey areas left in the traditional budgeting system. The Zero based budgeting start the budget process from the scratch and ask for justification and rational of every items of the statement (Brown et al 2017). In the traditional only the incremental or detrimental trends where analysed. Thus this project consumes lot of time and cost is associated with it (Needles 2011). Thus it is not feasible for the small organisation and would also be good for large scale work as cost benefit would match. The justification of each line items of the statement is required whether being a small or large expense. Thus through study is required for every activity and cost of the alternative source is also required for better advice on the changes required.

In the given company this budgeting method is feasible as it is ongoing process and should be continued for several years so that all the areas are covered and alternatives analysed. The various processes are involved in this company to reach the final product. Many items which are outsourced can be planned to be produced in-house if the cost of production is less than the cost of purchase and on the other hand if some inventory item which is produced at a cost higher than at what is available in the market than the production should be terminated and acquisition should be done from outside. Thus will reduce the cost of production and give competitive advantage to the company apart from saving its valuable resources and time. Thus the management would be able to focus other important matters. Since huge amount of investment is involved and planning is to be done for 5 years the use of zero based budgeting should be recommended.

Answer 4

Number of Employees	200
Material Cost per Unit	20
Labour Hours per Unit	2
Labour Hour Rate	5
Labour Cost per Unit	10
Variable Overhead per hour	5
Variable Overhead per Unit	10
Total Variable Cost	40
Number of Units	25000
Depreciation Per Annum	100000
Corporate Overhead Rate per Unit	7.5
Total Variable Cost of 25000 Units	1187500.00
Depreciation Cost	100000.00
Total Cost	1287500.00
Profit	321875.00
Sales	1609375.00
Selling Price per unit	64.38

 

Answer5

The Company used to sell the cheap video screen production for 80 whereas the cost of production was coming as variable cost being 55 plus fixed cost. In the given case the variable cost is coming as 40 and fixed overhead cost per unit as 7.5, apart from this the depreciation is to be charged. Thus the total variable cost will be 47.50 per unit and fixed cost in the form of depreciation being 100 000 per annum. Thus if the company wants to maintain the profit margin of 20% on the selling price than the selling price is coming approx 64 per unit. Thus the smart screen production is available at reduced cost and higher margin. Thus the market would easily absorb the product. The company may also increase its margin as the gap between the selling price of the old system and the new system is high and skimming pricing policy may be used here as the customer would higher for the new system as compared to the old system being latest and more advanced product.

The company is maintaining 200 employees whereas the just 2 labours hours are required per unit and as the demand is not high now only 25000 units are budgeted thus the company should reduce the number of labours in the new plant as this is excess of labours.

Thus overall the product is feasible and the company should proceed with its production. This would improve the market share of the company and give competitive advantage to the company.

References

Brown, J. L., Fisher, J. G., Peffer, S. A. & Sprinkle, G. B 2017,  ‘The effect of budget framing and budget-setting process on managerial reporting’, Journal of Management Accounting Research, vol. 29, no. 1, pp. 3-44

Carlon, S., 2019, Financial accounting: reporting, analysis and decision making. 6^th ed. Milton, QLD John Wiley and Sons Australia, Ltd

Davydov, D 2016,  Debt structure and corporate performance in emerging markets. Research in International Business and Finance Assignmnet, vol. 38,pp.  299-311.

Dosch, J. & Wilson, J 2010,  ‘Process costing and management accounting in today’s Business Environment’, Strategic Finance, vol. 92, no. 2, pp. 37–43.

Drury, C 2011, Cost and management accounting, Andover, Hampshire, UK: South

Karadag, H. 2015, ‘Financial Management Challenges In Small And Medium-Sized Enterprises: A Strategic Management Approach’, Emerging Markets Journal, vol. 5, no. 1, pp. 26-40.

Martine, C., Kristof, S., & Alexandra, V.A 2017,  ‘Management control for simulating different types of creativity; The role of budgets’, Journal of management accounting research, vol. 29, no. 3, pp. 23-26

Needles, S. C 2011, Managerial Accounting, Nason, USA: South-Western Cengage Learning.

Spires, E.E, Wallin, D.E,& Young, R.A 2012, Aggregation in Budgeting: An Experiment, Journal of Management Accounting Research, vol. 24, pp. 177-199.