### Learning outcomes (LO) mapping

**1.**Explain the concept of valuation and the purpose of valuing assets.

**2**.Construct a valuation based on the discounted cash flow valuation technique.

**3.**Explain capital market theory.

**4.**Analyse the determinants of the pricing of debt securities.

**5.**Evaluate how hybrids provide flexibility for management.

**6.**Explain the basic principles in pricing futures and options.

### Section A — Undertaking the Net Present Value analysis

**Introduction**

Section A of the assignment requires you to undertake a Net Present Value analysis of a project. Assume you are the CFO of a food manufacturing company. Your CEO has requested you to undertake a discounted cash flow (DCF) analysis of a proposed upgrade to the manufacturing plant as part of a presentation to the Board. You have been asked to prepare forecasts and a DCF model. You must also provide qualitative and quantitative analysis to support your model.

The details of the proposed upgrade are as follows:

• the Company is profitable and cash flow positive

• the business is projected to turn over $100m for the forthcoming financial year, and gross margin is typically 40%

• sales have been historically growing slightly higher than inflation, at 3% p.a.

• the cost of the upgrade is $15m

• the expected economic life of the upgrade is seven (7) years, which is also the life for taxation purposes. Assume a nil salvage value

• the CEO believes the new plant will further enhance the quality and taste of the finished product, and has requested you include a ‘modest’ increase in sales of 2% as a result

• the benefits of the upgrade include lower wastage in the manufacturing process which will lower cost of goods sold (or increase gross margins) by 3% p.a. It will also result in a one-time reduction in inventory of $300,000 (but no further savings thereafter)

• an additional staff member will be required to be employed to operate the additional plant.

The cost of this employee is $100,000 per annum (indexed to inflation).

**Question 1 Cash flows**

LO2: Construct a valuation based on the discounted cash flow valuation technique.

Build the Cash Flow Model. The Cash Flow Model should take into account all the incremental cash flows identified in the assumptions above, including the following elements:

• Revenue

• Cost of Goods Sold

• Gross Profit

• Total Operating Expenses

• EBITDA

• EBIT

• Working Capital

• Taxation

• Capital Expenditure.

**Question 2 Discount rate**

LO2: Construct a valuation based on the discounted cash flow valuation technique.

LO3: Explain capital market theory and other pricing theories.

This question requires you to perform a DCF valuation on the project using a high and low weighted

average cost of capital (WACC).

Calculate the WACC in the ‘Discount_Rate’ worksheet and assume the following:

• Equity beta for the low rate is 0.80.

• Equity beta for the high rate is 1.00.

• The company will borrow the entire $15m to fund the upgrade. As a result the company’s gearing will increase to 25.0% which is typical in the industry

• The Company has a pre-tax cost of debt at a margin of 3.20% above the risk-free rate.

**Question 3 Net present value **

LO2: Construct a valuation based on the discounted cash flow valuation technique.

(a) Based on the cash flows in your model and the average of your low-rate and high-rate WACC, determine the NPV of the project.

(b) How would your answer in part (a) above change if you had included the interest repayments in the DCF model? Explain why adding interest costs is not appropriate.

(c) Calculate the number of years, to one (1) decimal point, it takes in order for the project to break even on a discounted basis. (Hint: Calculate the NPV on a cumulative basis and interpolate.)

**Question 4 Analyse valuation results **

LO1: Explain the concept of valuation and the purpose of valuing assets.

In answering this question refer to the valuation you completed in Questions 1 to 3 of the assignment.

(a) Analyse two (2) strengths and two (2) weaknesses of the financial model used.

(b) Provide a recommendation to the CEO as to whether the Company should pursue this project and why.

(c) An important part of valuation analysis is undertaking scenario analysis, to see how sensitive the model is to changes in assumptions. Identify two (2) inputs and undertake sensitivity analysis by increasing or decreasing them by 10% (e.g. alter the capital cost to $13.5m and $16.5m). Comment on how sensitivity analysis improves the robustness of the analysis.

(d) Another important aspect of project evaluation is applying different metrics, such as ‘payback’ period, which you calculated on a discounted basis in Question 3(c) above. Assume there is an alternative project which the Company could undertake instead (but not as well) as this upgrade. If the alternative project has an NPV which is 20% lower, but a discounted payback which is 30% shorter, which project would you recommend? How would your answer change if the company was listed compared to being owned by private equity? (Note: There is no ‘right’ answer here — please discuss the issues involved and what factors the directors should consider based on their appetite for risk.)

### Section B — Equity pricing

**Introduction**

Section B of the assignment requires you to calculate Price / Earnings and Earnings before Interest and Tax (EBIT) multiples.

For the 12 months ended | 30 June 2010 | 30 June 2011 | 30 June 2012 | 30 June 2013 | 30 June 2014 | 31 December 2014 |

Revenue | 37.1 | 43.5 | 57.7 | 74.6 | 97.2 | 103.3 |

EBITDA | 13.1 | 14.0 | 18.5 | 10.7 | 20.1 | 23.2 |

Diluted EPS | 0.14 | 0.14 | 0.19 | 0.09 | 0.24 | 0.24 |

Dividends per share | 0.105 | 0.11 | 0.13 | 0.13 | 0.135 | 0.135 |

Payout ratio % | 57.7% | 73.0% | 63.8% | 147.8% | 54.7% | 55.8% |

(a) Comment on the trend in earnings and dividend per share from 2010 to the present

(b) The dividend payout ratio in 2013 exceeded 100%. How is this possible? Comment on what you think management’s perspective on the outlook for Webjet at the time was.

(c) Assuming a share price of $3.75:

(i) Calculate the historical dividend yield for Webjet.

(ii) Comment on how this compares to the risk-free rate and Webjet’s likely cost of equity.

(iii) Assume a cost of equity capital of 11% and a forecast dividend yield of 3.5%.In one year’s time, what is the forecast share price Webjet needs to reach in order to provide an appropriate risk-adjusted return to its shareholders?

(iv) Assume you had undertaken a DCF analysis of Webjet and it determined the likely share price in one year’s time was $4.25. Would this be a ‘buy’, ‘sell’ or ‘hold’ recommendation? Explain why.

**Question 2 Market-based valuation methods**

LO3: Explain capital market theory and other pricing theories.

Assume the following valuation metrics for Webjet:

• market capitalisation of $280m

• net debt of $28.3m

• FY14 net profit after tax of $19.2m

• FY14 EBIT of $19.1m.

(a) Calculate Webjet & historical PE and EBIT multiple.

(b) Comment on why the historical and forecast multiples, when calculated on the same date (and therefore use the same share price, market capitalisation and net debt), are different.

(c) In the recent takeover of Wotif, a competitor to Webjet, the Independent Expert (Grant Samuel) estimated the full underlying value of Wotif Group to be in the range from $651 million to $726 million. The implied forecast PE and EBIT multiples based on this range were 15.3×–17.0× forecast NPAT, and 10.5×–11.7× forecast EBIT. Assuming market and economic conditions are similar, provide two other reasons why these multiples for Wotif were higher than observed for Webjet.

### Section C

**Question 1 Understanding debt securities**

LO3: Analyse the determinants of the pricing of debt securities.

(a) Coupon and market yield are two interest rate-related components required to calculate the price or market value of fixed interest securities. Describe each of these components.

(b) The relationship between a security’s coupon and yield directly affects the corresponding relationship between its capital and face values. Identify and name the three (3) possible relationships that can exist between coupon and yield and describe the corresponding relationship between capital and face values.

**Question 2 Analysing debt securities**

LO3: Analyse the determinants of the pricing of debt securities.

(a) As treasurer of a large Australian corporation you are always trying to park surplus cash in the money market (either overnight or for up to a 12-month term). You currently have $12 million in surplus funds to be invested for a 12 month period. As a treasurer you have a relationship with a number of Australian commercial banks that quote you the following rates:

• Bank A 3.25% quarterly

• Bank B 3.15% monthly

• Bank C 3.25% semi-annually.

Based on these rates alone, which bank would you recommend investing with?

Show all workings for each option.

(b) The next day, your company receives an additional $500,000 surplus funds. The funds need to be invested for 90 days. Bank A states and offers the following:

‘We don’t offer wholesale interest rates on funds invested less than $1 million’.

Bank A does, however, offer 3.30% on a 90-day bank accepted bill and 3.30%

simple discount over the same period.

Compare the return on the two alternatives offered and calculate which is the more attractive investment option. Note: Assume that $500,000 is the FV.

**Question 3 Pricing debt securities**

LO3: Analyse the determinants of the pricing of debt securities.

(a) Calculate the value of a 8%, 15 April 2016 maturity Commonwealth Treasury bond with a yield to maturity of 7%. Assume a settlement date of 15 December 2014.In your answer show the values of each of the variables v, f, d, g, x, i and n. Show all workings.

(b) Calculate the value of a 5.75%, 10-year 2022 bond contract with a yield to maturity of 3.02%. The bond will mature on 15 July 2022. Assume a settlement date of 17 December 2014. In your answer show the values of each of the variables v, f, d, g, x, i and n. Show all workings.

**Question 4 Valuing hybrid securities**

LO5: Evaluate how hybrids provide flexibility for management.

(a) Research and analyse the following features of the hybrid issued by Australian Foundation Investment Company (AFIG:ASX).

(b) Discuss the issues confronted when valuing convertible notes and the most common valuation methodologies used.

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