a)
Expectation of company = monthly 24 receipts
1 monthly receipt = $ 3600
Present value is compounded semi annually
Data of 1st payment = 1 month from the current date interest rate = 12 % per year
r=12%,t=24 months
Therefore annual rate has been divided by 2
Because interest is compounded semi annually (Guillén et al. 2015).
r=12/2=6%, i= 6/100= 0.06
A=R [(1+i) n-1/i(1+i)]
=3600*[(1+0.06)24-1/0.1(1+0.06)24]
3600*12.550= $ 45180
(a) Given,
P= 10,000
R= 10%
T=12 years
S.I = p*r*t/100 =10000*12*10/100 = $12000
(b) If interest is compounded annually (Hubbard et al. 2016)
A= R [(1+i)-1/i(1+i)n]
=10,000*[(1+0.1)12-1/0.1(1+0.1)12
10,000*(1+0.1)20=10*(1.1)20
=31383.2837
c)
Common equity of ANB Ltd = $ 35.5 mn
Long term debt = $ 319 mn
Preferred equity = $ 10.3 mn
The above values are as per the books.
Require return on common equity = 12%
Require return on Long term debt = 8%
Require return on common equity = 10 %
Market value of common equity = $ 46.6 mn
Market value of Long term debt = $ 35 mn
Market value of preferred equity = $ 10.3 mn
Effective tax rate = 30 %
WACC = (E/V* R_{e}) + [D/V*R_{d}*(1-Tc)]
Where, E = firm’s equity market value (Ondraczek et al. 2015)
D = Firm’s debt market value.
V = E + D = 35.5 + 31.9 = 67.4 mn
E = 10.3
D = 46.6 mn and 35 mn
Tc = 30 %
R_{d} = 30 %
E/V * R_{e} = 46.6/67.4 * 10.3 = 7.121
[D/V *R_{d} * (1-Tc)] = 31.9/67.4 * 35 * (1-30)
[31.9 /67.4* 35 * 29] = 480. 39
Therefore, 480. 39 + 7.121 = 487.51
Calculation of net “present value”:
Initial cost $6000
Project life span 6 years
Cash inflow annually $2,200
Salvage value 0
“Rate of return” required 20%
Item |
Year (s) |
Cash flow amount |
20 % factor |
The present value of company cash flow |
Cash inflow annually |
1-6 |
$2,200 |
3.326 |
7,317 |
initial investment |
Now |
(6,000) |
1.000 |
(6000) |
Net present value |
$1,317 |
Purchase decision:
Yes, the company must purchase the equipment because the “net present value” that is ($1317) is positive. And a positive “net present value” shows that there is a higher rate of return from the project as compared to the “minimum rate of return” demanded by the company. (20% in the example above)
The above example illustrates, required “minimum return rate” is 20 %. it means that if money is invested somewhere else instead of purchasing the equipment, then that investment will fetch a 20% return to the company (in our illustration). This is used for discounting the “cash inflow’ to the present value and that’s why this known as a discount rate.
The main intention of investment is the generation of revenue or reduction of cost in the future. Increased revenue is contemplated equivalent to reduced cost, and therefore it must be taken as “cash inflow” for Capital budgeting computation.
b)
Following the “net present value” method, ABC Company must opt to purchase the equipment because the cost of purchasing and installing the equipment is lower than the “present value” of the equipment.
Given below are the calculations for better understanding:
Initial cost $15,000
Projects life 15 years
Cost savings annually $4,200
Salvage value 0
Required “rate of return” 25%
Item |
Year(s) |
“cash flow amount” |
25% Factor |
Present value “Cash flow |
Cost savings annually |
1-15 |
$4,200 |
3.859 |
$16,208 |
Initial investment |
Now |
(15,000) |
1.000 |
(15,000) |
Net present value |
$ 1,208 |
Fundamentals associated with stock valuation aim to calculate the “intrinsic value” of particular stocks which shows the business profitability and the forecasted market value. Stock valuation is done mainly for the investors as it assists them in making decisions regarding the purchase or sales stocks. In the process of determining the underlying value of stock sometimes it is undervalued or overvalued. There are different processes by which one can recognize the overvaluation and undervaluation of the company’s stock (pdfs.semanticscholar.org, 2019).
The different ways which can be undertaken for valuation are:
Earnings yield (E/P) and price-earnings ratio (P/E Ratio): This ratio is used to determine the value of a company by measuring the “current share price” to the relative EPS. This is also referred to as price multiple because it reflects the amount in which investors are ready to pay for the earnings per rupee. An example can be taken for understanding the PE for the company. If the P/E of stock trading currently is 30, it means that investor is ready to pay $ 30 for current earnings of $ 1. This method is mostly used by investors and companies for valuing the stocks. P/E is always considered to the margin, brand wealth and growth because a lower P/E is never compared with the higher p/E. the index value states the stock overvaluation or undervaluation. The undervaluation of the company’s stock is stated when the index is low and overvaluation is stated when a high index is observed.
“Price to Book value ratio (P/B Ratio)”: This method is common and useful in determining the valuation of the stock. This approach is also used in the evaluation process of a company for valuation. P/B ratio states the market value of share over equity’s book value. This method is a selective type and implemented in a specific industry. The implementation of this ratio is mostly done in the business dealing in capital intensive namely energy, financial and transportation firms (jstor.org, 2019).
EV/EBITDA: This method is used in the stock undervaluation when a company goes for acquisition or merger. This method is best implemented in the mergers of companies or acquisition of the same. The ratio is enterprise multiple and the determination of company value is done by EBITDA. This method is applied to telecom, power and internet companies. According to this approach, high multiple values of company states overvaluation and low values state the exact opposite which undervalued stocks.
Dividend yield: This particular method is used to measure the valuation but to a certain extent. This is because of the reason that dividend yield is the amount which is obtained by dividing each share dividend with the per-share price. According to this approach when a high dividend yield has obtained the valuation of the stock is stated as undervalued. The overvaluation is observed when the dividend yield is lower. This approach can be understood more commonly, stocks with high dividends make investors suspicious and restrain them from investing bins such as stocks and companies.
The margin of safety: This method is comparatively new to all the above-mentioned methods. The stocks are valued under this method so that undervaluation or overvaluation can be stated. The gap between the value of stock and market price is stated as the difference. The undervaluation of the company's stock is stated when the margin of safety is lower.
The fundamental analysis is the process where the valuation of stock intrinsic value is done by observing the basic factors related to economic which are fundamental. It further affects the value of a stock. The fundamental factors which can be considered in the valuation process are income, revenue, and expenses. It also includes the growth of enterprise and the challenges it faces in the competitive environment. The expected return is also stated as a relevant factor. it is used in terms of investment which are long term and it establishes values for companies stock.
FIG 1: Method for stock valuation
(Source: Self-Created)
The technical analysis evaluates investment which is based on market activities. The relevant factors are the prices of shares and over time trading value. It also includes the trend prevailing in the industry (Edwards et al. 2018).
Fundamental analysis is considered for investment which is long term whereas; technical is selected for the short term.
Fundamental analysis relies on the value underlying and technical analysis aims to gather return from the occurring trend.
Books
Edwards, R.D., Magee, J. and Bassetti, W.C., 2018. Technical analysis of stock trends. US: CRC press.
Journals
Guillén, O.T., Hecq, A., Issler, J.V. and Saraiva, D., 2015. Forecasting multivariate time series under present-value model short-and long-run co-movement restrictions. International Journal of Forecasting, 31(3), pp.862-875.
Hubbard, E., Matthews, P. and Samek, A., 2016. Using online compound interest tools to improve financial literacy. The Journal of Economic Education, 47(2), pp.106-120.
Ondraczek, J., Komendantova, N. and Patt, A., 2015. WACC the dog: The effect of financing costs on the levelized cost of solar PV power. Renewable Energy, 75, pp.888-898.
Crosby, N., Devaney, S. and Wyatt, P., 2018. The implied internal rate of return in conventional residual valuations of development sites. Journal of Property Research, 35(3), pp.234-251.
Porter, J.C. and South-Winter, C.A., 2017. Accounting Basics Part 3: Time Value and Internal Rate of Return. Radiology management, 39(1), pp.9-12.
Online Article
pdfs.semanticscholar.org, (2019), Undervaluation of stocks, Available at: https://pdfs.semanticscholar.org/b514/6d36b1de3a12ee77d74846ba15ab850746c8.pdf, [Accessed on 20.07.10]
Website
jstor.org, (2019) Overvaluation of stock, Available at: https://www.jstor.org/stable/27647255, [Accessed on 20.07.10]
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