Capital Infusion Case Study

Abstract

For expansion the company needed $200,000 and they have many options, this paper will provide a narrative about private debt, private transfer of partial ownership, private transfer of entire ownership, public debt issuance, and public equity offering. Then it we will discuss of the impact of each alternative which would include issues of structure and cost of capital. And finally we will discuss the impact of an infusion of capital of $200,000 on the financial statements

Keywords: IPO, corporate bonds

 

 

 

 

 

 

 

 

 

Private Debt financing –

Private debt and corporate bonds are different in a way that the private debt is usually held by intuitional investors, funds, insurance companies (Reicherter, n.d.). And these private debts are not as liquid as corporate bonds. The company needs to find a fund or company to get the private debt. This debt is similar otherwise. There is no change in ownership due to private debt. The company will have to make the interest payment and at the end of the loan term, they will have return the full amount due to the lender. In any case, the business does not do well or has to file for bankruptcy, they will have to liquidate the assets to pay back the lender.

This company has a current Debt t Equity ratio of 0.6, so based on a rating on rating agency, it will have to pay the interest on the debt. And the payment of interest on debts will go out from earnings. Most probably the company will have to pay a higher interest rate, although there will be a tax advantage since the interest payment happens from before-tax income, so the cost of capital will be less.

So, if we ignore the cost of finding the private debt, there will be few changes in the balance sheet, the current asset will increase as the cash will stand at $ 4,136,400. And long-term debt will increase to $3,970,300.

There will not be any change in shareholder equity. But the current ratio will change to 1.5 (rounding up 1.47). And Debt ratio will change to .67 (rounding up .666).

From next year there will be a cash outflow towards paying the coupon or interest on the bonds to the bondholder.

 

Private investor(s) who would be willing to share ownership –

            The owners of the company can sell there 50% stake to private equity firm or venture capitals. Once the ownership is shared, the private investor will be the single largest stakeholder. So any management decision will have to have the investors consent. But, it will not impact liability or anything else. And there won’t be any obligation such as a coupon or interest payment. The dividend is not mandatory. The major impact will be in management, other than that everything else will be almost same balance sheet wise.

Here one point to note, initially the company had 50 investors or shareholders, so when the company’s 50% stake is being sold, some of the investors can sell their stakes completely or each investor can give up 50% stake to the private investor for $200,000. The existing shareholders will lose the ability to control or even influence the decision as minority shareholders (Simpson, 2017).

Now let us see, how selling 50% stake in the company will impact the balance sheet. The existing common stock was worth $300,000, 50% of it being sold for $200,000. So the existing shareholders are making a profit worth $50000 on their holding, increase the common stock value and that will actually change the Total stockholder equity, too.

Shareholder’s equity = Total Assets – Total liabilities

And in this case where 50% stake is being sold, there would not be any change in total liabilities but the total assets will go up, since the amount in common stock would increase, resulting in increasing the shareholder equity. This signifies this amount would be returned to shareholders if all assets are sold to pay off all liabilities.(Investopedia, n.d.).

Private buy-out –

            The company can sell 100% share without going public. Private equity funds or venture capital funds can buy out 100% stake in the company for $200,000 they need. Although it will be a bad deal for the current shareholders as the common equity costs $300,000 and selling those shares for $200,000 will be a bad deal.

Selling full stake would mean that the management team or the previous shareholder will not have any control or say in the company anymore. But they will not be liable for any liability or asset the company may or may not have in future.

Private equity funds can go out and buy all the publicly traded stock to gain control of the company too. Or Private equity fund can borrow the money to buy out companies. In this case, for the shareholder of this company, the source of fund is not a problem, and it is private, so the private equity or venture capital fund which is essentially funded by high net worth individuals can just purchase the shareholder equity.

            If the buyout happens for $200,000, then there would not be much change in assets or liabilities or income statement, the shareholder equity will get reduced, as the common stock worth $300,000 will be sold for $200,000, so the total shareholder value will be reduced for the next owner of the company.       

Public debt (corporate bonds) –

The company can issue corporate bonds. Issuing corporate bond does not impact or change ownership structure. The corporate bonds have to be rated by the rating agency and based on rating the company will have to pay a coupon rate to the bond hold until maturity of the bond. Upon maturity, the par value or face value will have to be repaid to the bondholder.

While the regular coupon payments will impact earnings, since the bond is a debt and the coupon payment or par value payment on maturity cannot be deferred, on the positive side the interest paid amount on bonds, goes out from before tax earning, hence it reduces overall tax liability. So the cost of capital comes down. In case the company goes out of business before the bonds mature and final par value is paid back, in that case, the company might have to liquidate assets to pay off the debts/bonds.

So, if we ignore the cost of issuing the corporate bonds, there will be few changes in the balance sheet, the current asset will increase as the cash will stand at $ 4,136,400. And long-term debt will increase to $3,970,300.

There will not be any change in shareholder equity. But the current ratio will change to 1.5 (rounding up 1.47). And Debt ratio will change to .67 (rounding up .666).

From next year there will be a cash outflow towards paying the coupon or interest on the bonds to the bondholder.

Common stock –

The company can go public to raise $200,000. Currently, the common stocks are valued at $300,000. They will have to hire an investment bank to underwrite and prepare for the IPO.

Before going public the company needs to make sure it has experienced management team since equity sale is essentially selling stakes in the company, the management will have to be accountable to investors/shareholders. And the company would need accounting and legal team to meet SEC requirement to stay listed.

To comply with regulations the company has to review and publish last 5 years financial statements (Investopedia, 2018). This process starts with 6-12 before going public.

The company has to engage investment bank for underwriting, who has prior experience with the same market sector. The underwriting, account and any legal work will be done by the investment bank to comply with SEC regulations.

The underwriters come up with S-1 which is required by SEC for IPO filing, S-1 is the main disclosure document and it contains the business model, organization structure, financial statements, competition information, employee information and the risks company foresees. And then the company has to submit the S-1 to SEC for review and approval until review and approval is done the company cannot come out in public with their IPO plan.

Once SEC approves S-1, the CEO or executives and investor relations can start road shows to increase awareness and generate buzz. This step starts 20 days before listing.

Based on the response received from potential investors during the roadshow, the underwriting team and company decide on offer price and amend the prospectus to update the offer price and date. 10 days before going public, underwriters start advertising the IPO. Once everything is finalized, the company decides to list on NYSE or NASDAQ and start trading.

The underwriting team will finalize the price of the stock, and based on that it will be decided how much stake needs to be sold to raise $200,000, as long as the current stakeholders manage to keep controlling shares, they will have the power to make decisions.

But, each common stockholder will have voting rights, and any major decision can be taken as long as majority shareholder is in agreement.

Once the share price is finalized, the common stock price will have to be revised and the shareholder equity will also have to revise based on common stock price.

 

 

 

 

 

 

References –

Simpson, S. ( December, 2017). How To Sell stock in your company. Retrieved from https://www.investopedia.com/articles/stocks/12/how-to-sell-company-stock.asp

Reichter, M.( n.d.). Private Debt. Retrieved from http://www.goldingcapital.com/en/investors/private-debt.html

Retrieved on 5/27/2018. Retrieved from https://www.investopedia.com/terms/s/shareholdersequity.asp

Discuss how your approached this calculation. Also describe the tax shield advantage debt capital provides.

The Secure and Safe Waste Management Company specializes in handling recyclable materials as well as traditional waste removal services. It is a small but publicly traded corporation. It currently has a capital structure of $50 million in bonds which pay a 5.5% coupon, $20 million in preferred stock with a par value of $50 per share and an annual dividend of $2.75 per share. The company has common stock with a book value of $25 million. The cost of capital associated with the common stock is 12%. The marginal tax rate for the firm is 30%.

The management of the company wishes to acquire additional capital for operations maintenance purposes. The chief financial officer (CFO) suggests that another public debt offering in the amount of $45 million. He believes that because of favorable interest rates, the company could issue the bonds at par with a 4.5% coupon.

Before the Board of Directors convenes to discuss the debt IPO, the CFO wants to provide some data for the board of directors’ meeting notebooks. One point of analysis is to evaluate the debt offering’s impact on the company’s cost of capital. To do this:

  • Calculate the current cost of capital of Secure and Safe on a weighted average basis
  • Calculate the cost of capital of the company assuming the $45 million dollar bond issue with a 4.5% coupon is approved.

Discuss how your approached this calculation. Also describe the tax shield advantage debt capital provides.

 

 

 

The current cost of Capital of Secure and Safe on a Weighted average basis

 

Cost of Debt –

The company currently has $50 in bonds which pay a 5.5% coupon

Applicable tax rate – 30%

So cost of the debt is = 0.055(1 – 0.3) = 0.0385 or 3.85%

The cost of this debt is less because of the tax shield. Interest expenses are tax-deductible for the company (Folger, 2018). In other words, the company pays $2,750,000 in coupon payment. The company can save 30% of interest paid in tax payment, or $825,000 is saved in tax, and that reduces the cost of capital for this bond.

Cost of Preferred Cost –

The company has $20 million in preferred stock of par value $50 which pays $2.75 per share

Cost of preferred stock = 2.75 / 50 = 0.055 = 5.5%

Preferred stocks are both equity and debt component. There is no upside for the investor but the dividend payout is consistent. For the company, there is no tax benefit on dividend payout though, on $20 million preferred stocks the company hands out $1,100,000 but there is no tax break for it.

Cost of Common stock –

The company has common cost worth $25 million and cost of capital is 12%

 

Total market value of working capital = 50 + 20 +25 = $95 million

We add up the bond, preferred stocks and common stocks, and then find out the percentage of each type of funding.

Percentage of bond = 50/95 = 52.63%

Percentage of preferred stocks = 20/95 = 21.05%

Percentage of common stocks = 25/95 = 26.32 %

So, WACC

(0.5263)*(0.0385) + (0.2105)(0.055) + (0.2632) (.12) =    0.02026255+ 0.0115775+ 0.031584 = 0.06342405 = 6.34%

We get the WACC by multiplying the cost of capital and percentage of each capital type and then add all of them.

 

Cost of capital of the company assuming the $45 million dollar bond issue with a 4.5% coupon is approved

 

We already have the cost of capitals for previous capital types, we need to find the capital cost for the $45 million, which it wants to issue.

Now if this bond is issued, cost of the bond will be –

0.045(1 – 0.3) = 0.0315 or 3.15% because the interest payment will be tax deductible for the company, that will reduce the effective cost of new capital.

The process to calculate remains same, but the total capital will go up as the $45 million will be added.

With the new $45 bond the total market value of working capital = 50 + 20 +25 +45 = $140 million

Percentage of bond paying 5.5% coupon= 50/140 = 35.71%

Percentage of preferred stocks = 20/140 = 14.29%

Percentage of common stocks = 25/140 = 17.86%

Percent of bond paying 4.5% coupon = 45/140 = 32.14%

With the new $45 bond the WACC will be

(0.3571)(0.0385) + (0.1429)(0.055) + (0.1786) (.12) + (0.3214) (0.0315)  = .01374835 + .0078595 + 0.021432 + .0101241 = 0.05316395 or 5.32%

Cost of capital is multiplied with the percentage weight of the capital and then adding all of them.

 

Reference –

Folger, J ( April 2018). What Is The Formula For Calculating Weighted Average Cost Of Capital (WACC)?. Retrieved from https://www.investopedia.com/ask/answers/063014/what-formula-calculating-weighted-average-cost-capital-wacc.asp

Raising Capital Constantine’s Grocery

Abstract

 

For expansion the company needed $135 million, and they have two options, although the company sounds small with operation is only in one city, but IPO or selling shares of the company to public is one option, but that is giving up control on company and comply with regulations and another option is corporate bonds. This is debt, not necessarily giving up stake but in this case, the company has to make consistent coupon payments to bondholders. We will explore the processes and explore the risks.

 

Keywords: IPO, corporate bonds

 

 

 

 

 

 

 

For the company, there are 2 options available. Going public with an initial public offering or selling equity to investors or bonds worth $135 million. These 2 options are very different than each other. Let us first explore what will happen if they want to sell equity in the company.

 

Through an Initial Public Offering or IPO, a company raises capital by issuing shares of stock, or equity in a public market (Fuhrmann, 2013). But this is a family business and privately held company so they never had to make their financial results public or any information such as a change in the board of directors’ public, but going public means this company will have to make all these information public. To be precise they will have to file this information with SEC. But before they can file IPO they will have to hire an Investment Bank. Hiring investment bank starts 12 months before going public, and the fees and experience play crucial roles in selection.

Before going public the company needs to make sure it has experienced management team since equity sale is essentially selling stakes in the company, the management will have to be accountable to investors/shareholders. And the company would need accounting and legal team to meet SEC requirement to stay listed.

To comply with regulations the company has to review and publish last 5 years financial statements (Investopedia, 2018). This process starts with 6-12 before going public.

 

The company has to engage investment bank for underwriting, who has prior experience with the same market sector. The underwriting, account and any legal work will be done by the investment bank to comply with SEC regulations.

The underwriters come up with S-1 which is required by SEC for IPO filing, S-1 is the main disclosure document and it contains the business model, organization structure, financial statements, competition information, employee information and the risks company foresees. And then the company has to submit the S-1 to SEC for review and approval until review and approval is done the company cannot come out in public with their IPO plan.

Once SEC approves S-1, the CEO or executives and investor relations can start road shows to increase awareness and generate buzz. This step starts 20 days before listing.

Based on the response received from potential investors during the roadshow, the underwriting team and company decide on offer price and amend the prospectus to update the offer price and date(Investopedia, 2018). 10 days before going public, underwriters start advertising the IPO. Once everything I finalized, the company decides to list on NYSE or NASDAQ and start trading.

Any public company has to spend $1.5 million to comply with financial, legal and regulatory burdens ( Fuhrmann, 2013).

Selling share is selling the stake in the company, so the company has to publish quarterly financials and annual financials to SEC for the regulators and investors, the forms are known as 10-Q and 10 – K respectively.

And common stockholder has voting right in management decisions, so selling too much share might mean losing control from the company. Even another competitor can buy the controlling stake from an open market, so it is important to consider how much stake to sell.

 

The process of Issuing Corporate Bonds –

The other option is to issue corporate bonds. And selling corporate bonds do not give away ownership to the company (SEC, n.d.). In order to issue corporate bonds, first, the company needs to hire underwriters from Investment Bank.

First step Underwriting – The underwriters / Investment Bank tend to initially buy the bonds. The company will not issue one single bond worth $135 million, but many bonds worth par value or face value $1000. The investment bank will bring in legal counsel too, which will require throughout the journey.

Regulatory Compliance – The Company has to file the preliminary prospectus with SEC informing them the intention to issue and sell the bond, and this has to be done at least 20 days prior to bond issuance. (Hoyes, n.d.).

Structuring the Bond – is another major step and the underwriters mostly drive this. The underwriters work with potential major institutional investors and fix coupon rate, maturity etc. The underwriter has to inform the final outcome to trade report and compliance engine too (Hoyes, n.d.).

Bond Market – The underwriters have to file certain paper works with Depositary Trust and Clearing Corporation before then can commence public selling of the bonds. And underwriter can collect their fees. (Hoyes, n,d,)

A bond comes with a coupon rate, and this is a promise to the bondholder that the company would pay the interest/coupon rate to the bondholder and will return the par/face value to the bondholder upon maturity of the bond.

And even if the company makes losses it has to make these payments, both coupon payment and payment of maturity amount. In case the company goes out of business and goes for bankruptcy and liquidation, bondholder will still be able to claim the money owed to them. But, on the bondholder do not have any claim on ownership of the company, so they do not have any claim or say in management decision or companies upside when the company goes public.

Credit rating agencies will periodically look into company’s financials and may or may not revise credit rating based on outlook. (Investor.gov, 2013).

Although the bondholder does not take part in management, the company needs to make coupon payments and that will take away part of earning, and that means less money to reinvest back in business, and a higher coupon rate can damage earning and slow down company growth.

 

 

 

References

FuhrMann, R. (August 2013).The Road To create An IPO. Retrieved from https://www.forbes.com/sites/investopedia/2013/08/29/the-road-to-creating-an-ipo/#3edbc024631e

Investopedia. (2018, April 08). Going Public. Retrieved from https://www.investopedia.com/terms/g/goingpublic.asp

Investopedia. (2018, January 24). Underwriting Agreement. Retrieved from https://www.investopedia.com/terms/u/underwriting-agreement.asp

Retrieved on 5/22/2018. Retrieved from https://www.sec.gov/fast-answers/answers-bondcrphtm.html

Hoyes, S(n.d.). How To Issue a Corporate Bond. Retrieved from http://smallbusiness.chron.com/issue-corporate-bond-73963.html

Retrieved on 5/23/2018. Retrieved from https://www.investor.gov/additional-resources/news-alerts/alerts-bulletins/what-are-corporate-bonds

please discuss the IPO process in the USA. Then, identify and discuss the critical events, points-in-time, for an IPO.

please discuss the IPO process in the USA. Then, identify and discuss the critical events, points-in-time, for an IPO.

 

Through an Initial Public Offering, or IPO, a company raises capital by issuing shares of stock, or equity in a public market (Fuhrmann, 2013).There are few reasons for a private company to go public –

  1. Raise cash for expansion or debt reduction
  2. Some initial investors ( angel investor or venture funds) might want to exit
  3. Becoming public can generate buzz and might mean awareness of the brand or the company
  4. The shareholders like CEO or the founder members can see value unlocking of their holdings

Before a private company can go public it has to hire investment banks with experience in same business sector, so that they (Underwriter of the bank) can value the business. Here important point to note that businesses are usually valued based on valuation multiples of the sector, potential future earning etc,. And Investment banks usually find initial investors too.

Before a company goes public, it has to come up with a prospectus with all the company related information for Security and Exchange Commission or SEC and investors. And the company has to file S-1 with SEC. S-1 provides detailed information about the business, financial statements, potential risks and plan for the cash raised from public offering (Hall, 2015).

S-1 files can be found in SEC website https://www.sec.gov/cgi-bin/browse-edgar?company=&CIK=&type=s-1&owner=include&count=40&action=getcurrent

According to PWC, a company intending to go public (file IPO) can expect to pay 5 – 7% to underwriters. And there will be costs related to legal, accounting distribution, mailing etc. But, underwriters work on coming up with the price to make maximum profit, share allotment and finding a stock exchange to list. In US every company will try to be listed on NYSE or NASDAQ, since these markets are so liquid (Fuhrmann, 2013).

Next the CEO , CFO, investor relations individuals start roadshows essentially to convey the vision, mission and future prospect of the company to the potential investors.

After going public, each public company files 10 Q every quarter with all those information and every year these public companies file 10-K. All these information filed with SEC are for public to access, who can be investment firms or individual investors.

Any public company has to spend $1.5 million to comply with financial, legal and regulatory burdens ( Fuhrmann, 2013).

So, we can see going public is not an easy task for a company, but per The Economist IPO process is the locomotive of capitalism (Fuhrmann, 2013).

 

 

 

 

https://www.fool.com/investing/general/2015/06/22/sec-form-s-1-what-is-it-why-is-it-important.aspx

 

Major Methods of Company Valuation

Abstract

This paper will discuss valuing a company or business based on market capitalization method, book value method, expected future earning method and valuing company based on multiples, such as price/earnings method. After that, we will compare all these methods.

Keywords: market cap, book value, price to earning

 

 

 

 

 

 

 

 

 

 

 

 

Market Capitalization method is one of the easiest ways to value businesses/companies listed in the stock market. In this method, we need to multiply the number of outstanding stocks with the market price of each share to find out the market capitalization of the business/company (Investopedia, n.d.).

For example – a fictitious company ABC Inc. is listed in NYSE, it has 1 billion outstanding shares, and on NYSE each share is priced at $10, in this case, the market capitalization of AB Inc. is $10 billion.

 

Book value is very different than market capitalization. Book value is calculated based on the assets and liabilities a company has. So, it is more of an accountant’s job than the market price (Investopedia, n.d.).

Book Value = Total assets – Total liabilities

Book value per share = book value/number of shares outstanding

Note – here a company can have more current and long-term liabilities than its current and long-term assets, so book value can be negative.

 

On the other hand, an old company can have a lot of assets in land, real estate, equipment, unsold inventories and that would make the book value higher for the company, but the assets might not be income producing. But in certain businesses book value might help determine the size of the business, and real estate would be a good example of that, in such cases book value of a stock can impact the share price in the stock market.

Expected Future Earning is another method and most widely used method to value a company based on future earning potential by that company. Here we use NPV method, PV of all future earning and using a discount rate that will factor is the cost of capital, inflation etc.(Investopedia, N.d.).

But this is highly speculative too, analysts often take their best guess to estimate future earnings growth. But we need to remember the cost of capital can increase due to interest rate increase or due to inflation. And input cost can increase for the same reasons bringing down the cash flow.

For example, for a company XYZ Inc. the analysts forecast cash flow of $100000 in year 1, $150000 in year 2, $200000 in year 3, $250000 in year 4 and they do not have much information to calculate much further in time with much accuracy, so 5th year cash flow they will consider as Terminal value, $500000

If we use the discount rate of 10% then the estimated value of the company would be $846,353. But, in case the discount rate goes up to 12% then the company value would change to $793,813.

 

Valuing Company based on multiples is another quick way to value any business. And we can use price to earning to quickly value a business. P/E ratio is price one share / earning per share or

Market capitalization / Earning of one year.

The same way a company can be valued based on price/sales or price/asset too. These are all quick way to determine or get an idea of the price of a business.

Compare different valuation methodologies –

 

Market capitalization method Book value method Expected future earnings method Valuation based on multiples
This is a simple method to value public companies, price or 1 share multiplied with a number of outstanding shares would give market capitalization This can be applied to both privately held and public businesses. This valuation is also can be used for both public and private companies This can be used for public companies or for those companies those have outstanding shares.
In an open market when the shares are being traded, market capitalization can change in moments and news or speculation can affect the price Book value usually won’t change if there is no change in asset or liability, so this method is comparatively stable This is done based on estimation and based on discounted cash flow valuation can be way off too, things in economy might change very fast , very soon Valuation based on multiples are stable, although it might go up or down based on share price as they are traded in open equity market,
Valuation based on market cap often shows how market looks at a company’s future based on it’s earning potential Book value by itself can tell us if a company has enough asset to cover its liabilities, but that does not always tell us earning potentials Estimating future earning growth might go wrong, so this is not exact science, but usually people impose expectation based on the outlook of economy and for the company This is more of a comparative method, in the same sector the ratios can be compared to understand if a company is undervalued or overvalued, but after that future investigation is required
A Company can be overvalued due to over-optimism in traders A high book value might represent lot of unsold inventory and unproductive assets, which might justify ow price in stock During estimation in future earnings, the earnings growth can be overestimated, or economic slowdown can cause lower cash flow, that can throw off valuation The multiple can also vary based on high share price or low earning etc.

 

 

 

 

 

 

 

 

References:

 

Retrieved on 5/12/2018. Retrieved from https://www.investopedia.com/terms/m/marketcapitalization.asp

Retrieved on 5/12/2018. Retrieved from https://www.investopedia.com/articles/investing/110613/market-value-versus-book-value.asp

Retrieved on 5/14/2018. Retrieved from https://www.investopedia.com/terms/d/discounted-future-earnings.asp

 

Please describe market capitalization as a valuation method, what are strengths and weaknesses? Then, please discuss book value as a valuation method. Compare it to market capitalization.

Please describe market capitalization as a valuation method, what are strengths and weaknesses? Then, please discuss book value as a valuation method. Compare it to market capitalization.

A Company’s market capitalization is calculated by multiplying the number of outstanding stocks and the current market price of one share. This one way to calculate the value of the business by investors (Investopedia, n.d.).

For example “Xyz Company” has 10 million outstanding shares and in a major stock exchange, one share is being sold at $50. In that case, the market capitalization of this company is only $500 million and investors might call it a small cap company at current context. Apple, Google, Exxon they are big cap companies, but the formula to calculate market cap is same all across for all companies.

It is a fairly easy way to calculate the value of a company and an investor might decide to invest solely based on the market cap, although that won’t be a good investing strategy. One simple fact is, an investor with $50 million to invest can buy every single share ( but the current shareowners should be willing to sell) and own 100% of the business.

Market capitalization definitely tells us how the market values the company, risk, the future of the business and capabilities of generating cask. But then it is all from market’s perspective, might not necessarily be accurate.

So the weaknesses are, for example during great depression or more recently during financial crisis many great companies share price fell and market capitalization also fell dramatically, but the underlying business model was not impacted due to the fall of the share price. So, greatest weakness is, the market cap is not the greatest tool to measure the strength of the underlying business.

 

Book Value – is the value of the business based on the balance sheet.

Book value = total assets – total liabilities

In other words, it is the difference between the total assets and total liabilities (Investopedia, n.d.).  If we go back to “Xyz company”, say its total asset is (i.e.: current assets+ long-term assets) worth 1 billion and total liabilities (i.e.: current liabilities + long-term liabilities) worth 1 billion to. In that case, the book value of the business will be worth 0 dollars.

Now you can ask, then why the market capitalization is 500 million. The market values the customer base the company has the employee, the knowledge and other intangible assets the company might have, more importantly, the market values the earning potential of the company in future. Hence book value and market capitalization are very different valuation methods.

 

Now for certain companies such as real estate or banks, book value might be important. Especially for a real estate company that sells properties. We can figure how much property or inventory they have to sell, same goes for banks, we can understand if the bank has more assets to back all the liabilities. But market capitalization would vary based on the earning potential or expectation, and it might not work based on book value all the time. Another instance might be, sometimes the older the company gets the better the book value of the company gets. One example would be unsold inventory, equipment, even the old equipment those are not being used anymore help to boost the book value. But all those assets do not help the company earn more, so the market capitalization might not get much help from a big book value.

Book value can be calculated per share too. book Value per share = Total book value/number of outstanding shares.

 

References:

 

Retrieved on 5/12/2018. Retrieved from https://www.investopedia.com/terms/m/marketcapitalization.asp

Retrieved on 5/12/2018. Retrieved from https://www.investopedia.com/articles/investing/110613/market-value-versus-book-value.asp

 

Quantitative Analysis of Portfolio

Abstract

In this paper we are going to review the portfolio position, calculate the estimated yields for each stock and overall dividend income. After that we are going to determine the weighted average factor and weighted average.

We will explain how all these are being calculated, explain the difference between yield that is based on cost and yield on current market price and finally I will make some observations and recommendations.

 

Keywords: weighted average, yield

 

 

 

 

 

 

 

 

 

First let us quickly find out total portfolio value we know the number of stocks and price of each stock, we can multiple number of stocks with price of each stock and then sum up –

Type of Investment Company Name Stock Symbol Portfolio Position (# of shares) Current Market Price Current Market Value
Common stock Altria MO 119 50.20 5,973.80
Common stock AT&T T 173 32.65 5,648.45
Common stock Chevron CVX 26 104.98 2,729.48
Common stock Coca Cola KO 59 40.55 2,392.45
Common stock Duke Energy DUK 65 76.78 4,990.70
Common stock Johnson & Johnson JNJ 31 100.60 3,118.60
Common stock McDonalds MCD 52 97.44 5,066.88
Common stock Pepsi Cola PEP 17 95.62 1,625.54
Common stock Philip Morris Intl PM 70 75.33 5,273.10
Common stock Proctor & Gamble PG 52 81.94 4,260.88
           
        Total Portfolio Market Value 41,079.88

 

First we need to multiply number of stocks with portfolio position or number of stocks. Then I added current market value of each company name to get total portfolio value.

 

Calculate individual yields

 

Now we know Current market value of each company in the portfolio and we know estimated dividend income from each company. So for example dividend yield for Altria would be –

Estimated Dividend / Current Market Value = 247/5973.80*100 = 4.13%

And I applied the same method to calculate estimated current yield for each company we have in the portfolio.

Company Name Stock Symbol Portfolio Position (# of shares) Current Market Price Current Market Value Estimated Dividend/Interest Estimated Current Yield
Altria MO 119 50.20 5,973.80 $247.00 4.13%
AT&T T 173 32.65 5,648.45 $325.00 5.75%
Chevron CVX 26 104.98 2,729.48 $111.00 4.07%
Coca Cola KO 59 40.55 2,392.45 $77.00 3.22%
Duke Energy DUK 65 76.78 4,990.70 $206.00 4.13%
Johnson & Johnson JNJ 31 100.60 3,118.60 $86.00 2.76%
McDonalds MCD 52 97.44 5,066.88 $176.00 3.47%
Pepsi Cola PEP 17 95.62 1,625.54 $44.00 2.71%
Philip Morris Intl PM 70 75.33 5,273.10 $280.00 5.31%
Proctor & Gamble PG 52 81.94 4,260.88 $133.00 3.12%

Weighted average factor and the weighted average yields

 

We determine weighted average factor for each stock by dividing the current market value with total market portfolio value. For example, for Altria or stock symbol MO Current Market Value / Total Market Portfolio Value = 5973.80/41079.88 = .15 and did the same exact thing for each stock to find out the weight then have in portfolio(Weighted Average, n.d.).

Stock Symbol Portfolio Position (# of shares) Current Market Price Current Market Value Estimated Dividend/Interest Estimated Current Yield Weighted Average Factor Weighted Average Yield
MO 119 50.20 5,973.80 $247.00 4.13% 0.15 0.60%
T 173 32.65 5,648.45 $325.00 5.75% 0.14 0.79%
CVX 26 104.98 2,729.48 $111.00 4.07% 0.07 0.27%
KO 59 40.55 2,392.45 $77.00 3.22% 0.06 0.19%
DUK 65 76.78 4,990.70 $206.00 4.13% 0.12 0.50%
JNJ 31 100.60 3,118.60 $86.00 2.76% 0.08 0.21%
MCD  

52

97.44 5,066.88 $176.00 3.47% 0.12 0.43%
PEP 17 95.62 1,625.54 $44.00 2.71% 0.04 0.11%
PM 70 75.33 5,273.10 $280.00 5.31% 0.13 0.68%
PG 52 81.94 4,260.88 $133.00 3.12% 0.10 0.32%
            1.00  
    Total Portfolio Market Value 41,079.88        
            Weighte Averatge Yield: 4.10%

 

To calculate weighted average yield, we just have to calculate weighted average yield for each stock. We already have calculated weighted average factor for each stock, and we have current yield for each stock. I have multiplied estimated current yield with weighted average factor to get weighted average yield for that stock.

The market value of each stock is different in the portfolio and that is why we have to determine the average weight of each stock in the portfolio. And we have estimated yield for each stock, so we just multiply the estimated yield with the average weight factor to get weighted average yield.

Price of stock goes up and down. And yield can vary every day. For example say you purchase just 1 stock of ABC Company for $100. This company pays yearly dividend worth $2, so the dividend yield of the stock would be 2%. This yield is based at cost.

After purchasing the stock, say after 1 month the stock price increased to $120, but that dividend is still $2, so based on current market price the dividend yield would be 1.67%.

Next month the stock price drops to $80, at current market price the yield would be 2.5%. Yield at cost remains same until the stock is sold, because right now the purchase cost is still $100 and the yield is still $2, although the market value is changing and based on changing market value the yield is also changing.

 

 

My observation is my friend has common stocks in portfolio, these are not bonds or preferred stocks, so the dividend payments are not promised, on positive side those can go up but those might go down too, and even stop based on the financial results of company. So my friend should not consider the dividend income from the portfolio as fixed income for life. This income can go up or down in future, while common stocks bear greater risk than bonds or preferred stocks (Common Stock, n.d.). Based on all these observations, my recommendation would be based on my friends age and investment horizon, if he is young, has a regular full time job with minimum to no dependency on this dividend income , then he can stay invested, but if he wants to cash out sooner or have a regular source of income, maybe he should sell some shares, book profit and switch to bonds with regular coupon payouts.

References:

Retrieved on 5/9/2018. Retrieve from http://www.financeformulas.net/Weighted_Average.html

Retrieved on 5/9/2018. Retrieved from https://www.investopedia.com/terms/c/commonstock.asp

 

Corporate bond interest in terms of cost of capital

Please discuss corporate bond interest in terms of cost of capital versus investor yields. Also, discuss municipal bond interest in terms of investor yields.

 

Corporate bond interest in terms of cost of capital

A company can raise capital for a project or to cover other expenses, issuing bond in the market. Depending on the credit rating and other risk factors the company will have to offer coupon rate on the bond.

A corporate can issue bond at a fixed bond rate, say 5%, par value of $1000, the corporate will have to pay the bondholder $50 as coupon payment. Bonds come with a maturity date too. It is usually few years. The coupon rate in most of the cases are fixed, but could be floating too. In case of a floating coupon rate the bond rate usually changes with US treasury or some other benchmark rate. The coupon rate the corporate offers is usually the cost of capital (Investopedia, n.d.).

Corporate bonds usually yield higher than inflation and make good return on investment for investors. But the income from bonds are usually taxable. But from the corporate’s perspective the cost of capital will depend on the coupon rate it offers. The coupon rate is determined based on the credit risk, market risk and other associated risk factors. These risk factors are measured by credit rating companies like Moody’s, Fitch or S&P.

Now, interest on these bonds or investor yield depends on the price an investor pays for the bond and on the remaining future cash flow. Bonds price changes based on interest rate ( that is risk free rate), when interest rate goes up, bond prices fall, and when interest rate drops , bond prices goes up.

For example, say a Company ABC Inc., issued bonds of par value $1000 with coupon rate 5% on 1/1/2018, and bonds are due to mature in 3 years. Now you can quickly project a future cash flow –

The bondholder will receive $150 in coupon payment over 3 years, so $50 each year. In this case yield to investor is 5% pretax, if the investor has to pay 30% tax, then his or her income from the bond would be $35 every year, yielding 3.5%.

No that calculation was done based on par value $1000, is the investor purchases the bond from secondary market for $1050, in that case $50 in coupon payment would result in only 4.76% pre-tax , and 3.37% post tax yield.

Now one might wonder why the bond prices go up or down based on risk free rate. Say, you can buy risk free government bond at 3% interest rate, and the corporate bond offers 5%, many investors pay premium to on the par value of the corporate bond to earn the extra interest, that increases the bond value. Likewise, when risk free rate goes up and the difference between risk free rate and corporate coupon rate comes down, investors switch from risky corporate bonds to safer government bonds, hence bringing down the bond price.

 

Municipal bond interest in terms of investor yields

Municipal bonds or muni bonds work on same concept of corporate bonds with some basic differences. Municipal bonds are issues by municipalities or local governments to fund their local infrastructure projects or fund other expenses. There are 3 types of muni bonds

  1. GO or General Obligation bonds, where municipality has to repay the full obligation after bond matures, these type of bond yield lowest because these are most secure muni bond instrument.
  2. Revenue bonds which come with a promise of repayment from a specified stream of income.
  3. Assessment bonds – these are linked to property tax assessment in the municipal area.

Of course muni bonds are also rated by same credit rating agencies. But, major difference from corporate bond is that income from muni bonds are tax exempt (Pat s, n.d.), so you do not pay any federal or state tax on muni bond. But, muni bonds are vulnerable to interest rate hikes as corporate bonds are.

For an example, if any corporate issues bonds of par value $1000 with coupon rate 5%, and a municipality bond is available at par value $1000 with coupon rate 3.75%, an investor might find muni bond attractive, because the corporate bond would yield him 3.5% post tax, but since there is no tax on muni bond, it would yield him extra 25 basis point or 3.75%.

 

 

References:

Retrieved on 5/6/2018. Retrieved from https://www.investopedia.com/ask/answers/020415/what-difference-between-cost-capital-and-required-return.asp

Pat s(n.d.). What Are Municipal Bonds – Pros & Cons of Investing. Retrieved from https://www.moneycrashers.com/municipal-bonds-investing/

 

 

Capital Budgeting for WePROMOTE

Abstract

In this paper, I am going to perform NPV calculations for both plans and explain, how I did them. Then I will try to justify if we should pursue this idea and then will present my logic and arguments behind the conclusion.

NPV is used to determine if a proposed project would be profitable. NPV is calculated by finding out the difference between cash outflow and aggregated future cash inflows (Investopedia, n.d.).

IRR or Internal rate of return is used to estimate the profitability of proposed project/investment. It is a discount rate that makes the NPV of future cash flows to zero (Investopedia, n.d.).

Keywords: NPV, IRR

 

 

 

 

 

 

 

Before we start the NPV calculation, here are the facts we are going to use –

  • The cost to install the required equipment will be $105,000, this is the outflow on year 0, this is a tangible long term asset, and we are going to depreciate it over 5 years in straight line, so it will depreciate at the rate of $21000 every year until the book value becomes 0
  • The gross revenues from the project will be $25,000 for year 1, then $27,000 for years 2 and 3. Year 4 will be $28,000 and year 5 (the last year of the project) will be $23,000·
  • The estimated cash outflows are $13000 on year 1, $12000 on year 2 to 4 and on 5th year $10000
  • In 5 years, the equipment will stop working and can be sold for its parts for about $5,000.
  • The capital borrowing cost is 3%
  • Discount rate we will use to calculate NPV 7%

With these data we can calculate the net income from the project considering all cash inflows and cash outflows –

Year 0 1 2 3 4 5 5
Project Discount Rate 0.07            
Equipment purchase price ($105,000)            
Cash inflow from new equipment   $25,000 $27,000 $27,000 $28,000 $23,000  
Salvage value             $5,000
Depreciation   ($21,000) ($21,000) ($21,000) ($21,000) ($21,000) $0
Interest Payment on Loan   ($3,150) ($3,150) ($3,150) ($3,150) ($3,150)  
Outflow   ($13,000) ($12,000) ($12,000) ($12,000) ($10,000)  
Earning Before Tax   ($12,150) ($9,150) ($9,150) ($8,150) ($11,150) $5,000
30% Income Tax             $1,500
Net Income ($105,000) ($12,150) ($9,150) ($9,150) ($8,150) ($11,150) $3,500

 

In the table above we have considered the gross revenue (estimated) to the estimated cash inflows and the salvage value of the equipment to be cash inflow too.

Depreciation is considered as a deduction from revenue before tax (Investopedia, n.d.)

The $105000 was borrowed and we will have to make an interest payment at interest rate 3%, that is considered as cash outflow.

And we have to factor in the project cash outflows over 5 years period.

So, we can see in the above table the Income before tax is in negative, so the income tax won’t be applicable on those, apart from the cash the business generates for the salvage value of the equipment.

We can calculate the Operating Cash flow, just by adding the depreciated value back to net income

Year 0 1 2 3 4 5 5
Project Discount Rate 0.07            
Equipment purchase price ($105,000)            
Cash inflow from new equipment   $25,000 $27,000 $27,000 $28,000 $23,000  
Salvage value             $5,000
Depreciation   ($21,000) ($21,000) ($21,000) ($21,000) ($21,000) $0
Interest Payment on Loan   ($3,150) ($3,150) ($3,150) ($3,150) ($3,150)  
Outflow   ($13,000) ($12,000) ($12,000) ($12,000) ($10,000)  
Earning Before Tax   ($12,150) ($9,150) ($9,150) ($8,150) ($11,150) $5,000
30% Income Tax             $1,500
Net Income   ($12,150) ($9,150) ($9,150) ($8,150) ($11,150) $3,500
OCF   $8,850 $11,850 $11,850 $12,850 $9,850 $3,500

 

Taxes are included while calculating operating cash flow, but depreciation is added first to the revenue and then tax is subtracted (Investopedia, 2018). But in this case the company is not making any profit before taxes. Since the company is making loss there won’t be any tax on losses.

Now that we have Cash Flow, we can estimate the Present Value and Net Present Value –

Year 0 1 2 3 4 5 5 NPV
Project Discount Rate 0.07              
Equipment purchase price -105000.00              
Cash inflow from new equipment   25000.00 27000.00 27000.00 28000.00 23000.00    
Salvage value             5000.00  
Depreciation   -21000.00 -21000.00 -21000.00 -21000.00 -21000.00 0.00  
Interest Payment on Loan   -3150.00 -3150.00 -3150.00 -3150.00 -3150.00    
Outflow   -13000.00 -12000.00 -12000.00 -12000.00 -10000.00    
Earning Before Tax   -12150.00 -9150.00 -9150.00 -8150.00 -11150.00 5000.00  
30% Income Tax             1500.00  
Net Income   -12150.00 -9150.00 -9150.00 -8150.00 -11150.00 3500.00  
OCF   8850.00 11850.00 11850.00 12850.00 9850.00 3500.00  
Present Value of Future Cash Flow -105000.00 8271.03 10350.25 9673.13 9803.20 7022.91 2495.45  
NPV               -61854.88

 

Hence the NPV the negative, so this project is not financially profitable.

Conclusion – based on the NPV which is negative this project should not be pursued.

 

 

References:

Retrieved on 4/29/2018. Retrieve from https://www.investopedia.com/terms/n/npv.asp

Retrieved on 4/29/2018. Retrieved from https://www.investopedia.com/terms/i/irr.asp

Retrieved on 4/29/2018. Retrieved from https://www.investopedia.com/ask/answers/012615/are-taxes-calculated-operating-cash-flow.asp

 

Capital Budget Problem:

Please set-up solution model for the following capital budget problem. Explain the approach you plan to take and why. Then, please perform the calculations of your model and draw conclusions.

Capital Budget Problem:

This case continues following the new project of the WePPROMOTE Company, that you and your partner own. WePROMOTE is in the promotional materials business. The project being considered is to manufacture a very unique case for smart phones. The case is very durable, attractive and fits virtually all models of smart phone. It will also have the logo of your client, a prominent, local company and is planned to be given away at public relations events by your client.

More details have emerged and your estimates are becoming more precise.

The following are the new values to the data that you have been estimating up to this point:

  • You can borrow funds from your bank at 3%.
  • The cost to install the needed equipment will be $105,000 and this cost is incurred prior to any cash is received by the project.
  • The gross revenues from the project will be $25,000 for year 1, then $27,000 for years 2 – 4. Year 5 will be $23,000.
  • The expected annual cash outflows (current project costs) are estimated at being $13,000 for the first year, then $12,000 for years 2, 3, and 4. The final year costs will be $10,000.
  • After 5 years the equipment will stop working and will be worthless.
  • The discount rate you are assuming continues to be 6%.

 

 

 

 

 

 

 

 

 

 

 

We are going calculate the NPV with the data we have. Before we start –

  1. On year 0 of the project we are going to spend $105000 for the equipment and it is capital out flow that would cause increase in long term liability and increase in long term assets, we can use a liner depreciation too which will be $21000 starting year 1, in the project

Depreciation is an accounting trick which allows a business to write off the value of an long term asset over a period of time, but this is considered as a non-cash transaction (Investopedia, n.d.).

  1. Revenue on year 1 = $25000, years 2 – 4 = $27000 and on 5th year $23000
  2. Cash outflow for the project on year 1 =$13000 , years 2 – 4 = $12000 and on 5th year $10000
  3. There is no salvage value for the equipment after 5 years
  4. And the discount rate we will use is 6%, considering that the 3% bank borrowing rate is included with any inflation or other factors.

Considering all the points we can now quickly calculate the projected Operating cash for each year:

Project Timeline
  Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
 
Equipment Cost -105000          
 
Gross Revenue   25000 27000 27000 27000 23000
 
Current project Costs   -13000 -12000 -12000 -12000 -10000
 
Depreciation   -21000 -21000 -21000 -21000 -21000
 
Net Income   -9000 -6000 -6000 -6000 -8000
 
Operative Cash Flow -105000 12000 15000 15000 15000 13000

 

The negative numbers show cash outflow and the positive numbers are cash in flow

We have the projected future cash flow from this project, but these are future money (and of course not accurate amount, just projected amount) and we can determine what that means in present amount. But we need to calculate NPV. We can find out if we are going to profit (considering the projected cash flow) or make a loss in this project in terms of present dollars.

Now, to obtain the present value of the future cash flow we need to discount the future cash flow with 6% discount rate.

Net Present Value is the difference between the present value of all cash inflows and cash outflows over a period of time, in our case the time period for this project and NPV is used to do capital budgeting (Investopedia, n.d.).

So let us find out the NPV = (105000) + 12000 / (1+0.06) ^1 + 15000 / (1+0.06) ^2 + 15000 / (1+0.06) ^3 + 15000 / (1+0.06) ^4 + 13000 / (1+0.06) ^5 = ($43,527.59) or – $43,527.59

 

We can see it is a negative return, so we should not continue this project and it will not be financially beneficial.

 

Reference:

Retrieved on 4/28/2018. Retrieved from https://www.investopedia.com/terms/d/depreciation.asp

Retrieved on 4/28/2018. Retrieved from https://www.investopedia.com/terms/n/npv.asp