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Financial Management In Organization

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Introduction

Valuation methods are commonly used by the firms to make decisions. In the current report varied methods of valuation are described in detail. Some methods like cost of debt before and after tax and WACC are applied on the firm data and results are interpreted. At end of the report, methods like DCF, PE ratio and EV/EBITDA are applied on the firm data and results are interpreted.

(A) Methods of estimating cost of capital and limitation of computed figures

Cost of capital refers to the cost of equity and debt (Dhaliwal and et.al., 2011). Methods for computing cost of debt and equity are given below.

Costof debt

There are two approaches that are commonly used for computing cost of debt. One can either compute cost of debt before and after making tax adjustment. Formula for computing cost of debt before tax adjustment is as follows.

Kd= Interest/principal*100

Table 1 Calculation of cost of debt without considering tax for Easy jet

Interest

11

Principal

504

Cost of debt

2%

In this formula only principal amount up to which debt is taken and interest are used to compute cost of debt. Tax is not considered in calculation.

Interpretation and limitation of figures

Cost of debt for Easy jet is only 2% when tax is not taken in to consideration. Main limitation of this figure is that tax amount is not considered in calculation (Li,  2010). It can be observed that in income statement after deducting interest

Opposite to this there is another approach of calculating cost of debt under which after considering tax cost of debt is computed. Formula for same is explained below.

Kd= Principal amount*interest rate*(1-tax rate)

Table 2 Cost of debt without considering tax for Easy jet

Principal

504

Interest rate

2%

Tax rate

20%

Cost of debt

8.8

Interpretation and limitation of figures

After considering tax cost of debt for the business firm is only 8.8%. It can be said that after and before considering tax rate big difference comes in the cost of debt. There is no limitation of figure because in this tax factor is consider to calculate cost of debt.

Cost of equity

Like debt there are two methods that are used to compute cost of equity. These two approaches are dividend yield method and dividend yield plus growth method (Damodaran,  2012). Formula for computing cost of equity by using dividend yield method are given below

Ke= DPS/Net proceeds

Table 3 Cos of equity for Easy jet

DPS

55.2

Net proceeds

767

Ke

7%

In this formula only dividend per share and net proceeds that are received per share are taken in to account. Other method that is used to compute cost of equity is earning yield method. Formula of this method is given below.

Ke= EPS/Net proceeds

Table 4 Cost of capital by using earning yield method

EPS

139.1

Net proceeds

767

Ke

18%

Interpretation and limitation of figures

Cost of equity is 18% which is very high. The main limitation of value is that EPS is considered to compute cost of equity. Earnings per share refers to the earning that is received by shareholder on each unit he hold in the specific firm. Investor receive dividend amount out of earning on each unit of specific company share (Boubakri and et.al., 2012). Means that he does not receive entire EPS amount from the firm. Hence, figure 18% does not reveal actual cost of equity.

Weighted average cost of capital

This is another method that is used to estimate cost of capital (Chen and et.al., 2011). In this method weight is given to the debt and equity in the overall capital structure and on this basis cost of capital is computed.

Table 5 Cost of capital on the basis of CAPM model

CAPM Assumptions

 

K(e)

4.08%

RFR

1.0%

Beta

0.44

Rp

8%

Table 6 Calculation of enterprise value

Enterprise Value (EV)

 

 

 

 

 

Current Market Price

         1,000

Diluted Shares

           3.97

Market Capitalization

         3,970

Long Term Liabilities

            322

Less: Cash & Cash Equivalents

            650

Enterprise Value

         3,642

Table 7Computation of WACC

Debt Equity Weightage

 

 

E/(D+E) @ Enterprise Value

 

99.92%

D/(D+E) @ Enterprise Value

 

7.50%

 

 

 

Interest Rate (%)

 

8%

Tax Rate (@)

 

20%

 

 

 

WACC Calculation

 

 

WACC

 

2.63%

Interpretation and limitation of figures

Weighted average cost of capital is 2.63% which means that on average basis overall cost of capital for Easy jet is 2.63%.  Hence, it can be said that firm cost of capital is very low. Limitation of this method is that beta value is taken in to consideration (Chen and et.al.,  2011). With every day change in price and index value WACC value also change slightly. Hence, in order to compute cost of debt by using WACC method one needs to do calculation of beta every time.

It can be said that most methods that are used to compute cost of capital are different from each other. Each of these methods have some advantages and disadvantages. So, it depends on the managers that which method they used to compute cost of capital.

(b) Valuation of Easy jet by using varied methods

In corporate finance valuation of the firms is usually done in order to evaluate value of the company. The valuation that is reflects by the relevant model is used to make firm purchase and investment in security related decisions. There are varied methods of the valuation that are available to the relevant intellectual people (Bhattacharya and et.al., 2011). All these methods have some strong and weak points and it depends on the analyst that which approach it consider most appropriate to do company valuation. Some methods of valuation are explained below in detail.

  • Discounted cash flow model: Discounted cash flow model is the method that is widely used by the research analysts to do company valuation. Under this method past year values are taken in to consideration in order to prepare projections about income and expenditure. In this regard growth rate of revenue is estimate and percentage that expenses cover of revenue is determined (Damodaran, 2016). On this basis cash flows under DCF model are computed. Thereafter, by using discount rate present value of cash flows is computed.  Thereafter, enterprise value is calculated and divided by issues shares. In this way intrinsic value is computed.

Table 8 Four year cash flows of Easy jet

 

2012

2013

2014

2015

Seat revenue

3794

4194

4462

4616

Non seat revenue

60

64

65

70

Total revenue

3854

4258

4527

4686

 

 

 

 

 

Fuel

1149

1182

1251

1199

Airport and ground handling

955

1078

1107

1122

Crew

432

454

479

505

Navigation

280

294

307

313

Maintenance

203

212

212

229

Selling and marketing

104

101

103

102

Other costs

200

10

245

276

EBITDAR

3323

3331

3704

3746

 

531

927

823

940

Aircraft dry leasing

95

102

124

114

Depreciation

97

102

106

125

Amortization of intangible assets

8

10

12

13

Operating profit

331

713

581

688

Interest receivable and other financing income

11

5

11

9

Interest payable and other financing charges

25

24

11

11

Net financing charges

-14

-19

0

-2

PBT

317

694

581

686

Tax charge

62

80

131

138

Net profit or FCF

255

614

450

548

Table 9 Growth rate on year on year basis of Easy jet

Growth rate

 

10.54%

6.39%

3.45%

Table 10 Cost sheet of Easy jet for last four financial years

Cost sheet

 

 

 

 

Cost of material

30.28%

31.15%

28.04%

25.97%

Purchase of stock in trade

25.17%

28.41%

24.81%

24.31%

Inventory

11.39%

11.97%

10.74%

10.94%

Employee benefit expenses

7.38%

7.75%

6.88%

6.78%

Finance cost

5.35%

5.59%

4.75%

4.96%

Depreciation

2.74%

2.66%

2.31%

2.21%

Other expenses

5.27%

0.26%

5.49%

5.98%

Table 11 Present value of cash flows at 4.08% discount rate

PV at 4.08% WACC

 

 

 

 

Present year

1

2

3

4

Discounting factor

0.960799

0.92313546

0.886948

0.85217907

PV of cash flows

245.0038

566.805171

399.1266

466.994133

Table 12 Calculation of terminal value as percentage of total value

Terminal Value

 

Sum of PV of FCF for explicit forecast

                1,678

WACC

4.08%

Long term growth in Revenues

3%

Present Value of terminal value

              36,784

Terminal Value as % of Total Value

95.637%

Table 13 Calculation of equity value

Equity Value

 

Enterprise Value

       38,462

-   Debt

            322

+  Cash

            650

Net Debt

       38,790

Equity Value

       77,253

Table 14 Intrinsic value of shares of Easy jet

Intrinsic Value

 

Equity Value

      77,253

Diluted Shares

           108

Intrinsic Value

715

Interpretation

It can be seen from the table given above that intrinsic value of the firm shares is 715. This means that by considering firm revenue real value of the Easy jet shares is 715. Current market price is 1000 which reflects that valuations of the firm shares are not correct and they are overvalued. Means that investors are buying shares of Easy jet at a very high price. There are some issues with DCF approach. In this approach growth rate of cash flows and stock market is estimated. If wrong estimation will be made then shares wrong value will be computed by using DCF method. Hence, this is one of the major limitation of DCF method.

  • PE ratio multiple: PE ratio is the one of the most important valuation method because by using same it is identified whether firm shares are overvalued or undervalued. In this method simple comparison of firm is made with the industry in terms of earning. Output of PE ratio reflects whether or not firm shares are fairly valued (McInnis, 2010). If PE ratio of the Easy jet will be greater than same of industry then it will be assumed that firm shares are not fairly valued and price of same is very high in the stock market. Contrary to this, if PE ratio of the firm is lower than industry than in that case it is assumed that shares are undervalued. On comparison of DCF and PE ratio method it can be identified that both methods do valuation of the firm in different way. Means that in DCF method cash flows are considered and real value of the shares is computed. Contrary to this, in case of PE ratio value of shares is not computed and only on the basis of comparison it is identified whether firm shares are overpriced.

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Table 15 PE ratio of Easy jet and industry

CMP

1000

EPS

139.1

PE ratio

7.189073

Industry PE ratio

9.496667

Interpretation

PE ratio reflects the ratio that is between share price of the company and earning per share. It can be seen form the table that price earnings ratio of Easy jet is 7.18 and same of industry is 9.49. On comparison of both it can be said that firm shares are undervalued in comparison to the industry. There is some issue with this approach. In this method along with earning market price is also taken in to account. Market price apart from earning is affected by number of factors that are out of control of the business firm. Hence, firm shares are overvalued or undervalued cannot be fairly judged by using this method.

  • EV/EBITDA multiple: In this method company current capital structure is taken in to account and its comparison is made with the firm EVITDA. If the value of ratio is low then it is assumed that relevant financial instrument is trading below its fair value. Contrary to this, if value of ratio is high then it is assumed that shares are trading above their fair value. Capital structure greatly influence the firm profitability and financial position as well as business condition (The Single-Best Metric: EV/EBITDA, 2016). This ratio reflects the proportion of the earning that is covered by the capital structure. Low ratio reflects that small proportion of total earning is encompassed by capital structure means that firm is in good condition and finance cost does not cover big portion of the earning of the business firm.

Table 16EV/EBITDA ratio

EV

    38,462

EBITDA

3746

EV/EBITDA

     10.27

Interpretation

EV/EBITDA ratio value is high 10.27 and this means that Easy jet shares are overvalued and are available at higher price. Hence, one must abstain from making investment in the Easy jet shares at current price level. The main issue with this method is that there is no standard that is determined by using which one can identify whether firm shares are overvalued or undervalued. Thus, while using this method one use his own judgments to obtain specific result on valuation of the firm shares.

© Method of purchasing Target Company

There are some specific methods that are used to purchase a target company. Relevant methods are explained below.

  • Private equity and Leverage buyout: In this method purchase acquirer which is IAG will purchase entire debt of the Easy jet by paying a specific amount to the Directors of the latter firm. Further, IAG will be responsible to pay all debt related obligations of the IAG. While acquiring Easy jet it is very important for the firm to ensure that assets of the mentioned firm will generate sufficient amount of return and IAG without facing any problem will be able to pay principal amount with interest to the creditors. Funds for purchase can be raised through private equity firm. Mentioned type of firms have their own department for the LBO funds which after considering number of factors allow firm to finance LBO deal. This method of purchase is widely used in current time period by the business firms. It can be said that this method of firm purchase is appropriate for the IAG.
  • Retained earnings and debt (Equity purchase): This is another method of firm purchase and under this IAG needs to purchase equity stock in the Easy jet. It will need to purchase 60% shares of the Easy jet in order to obtain to substantial control on same. Like leverage buyout this method of purchase is quite popular among the business firms (Dhaliwal and et.al., 2011). It can be said that equity purchase is the traditional method that is followed by one firm to acquire other one. In order to finance equity purchase firm can take loan from the banks. If one bank is not ready to finance entire deal than consortium finance can be used to arrange entire amount of finance. Retained earnings can also be used by the firm to purchase Easy jet. There is no cost of the mentioned source of finance and due to this reason it is commonly used by the business firms for acquiring other firm.

On comparison of both source of finance it can be said it will be better to purchase Easy jet by using retained earnings and debt. This is because in case of private equity PE firm will obtain stake in IAG and will affects its decision making process. Moreover, cost of finance through PE is also high in comparison to debt. Hence, it can be said that it will be better to acquire Easy jet by raising fund from debt than private equity.

Conclusion

On the basis of above discussion it is concluded that there are varied techniques of valuation and all of them have some positive and negative points. Hence, with due care specific valuation method must be used by the managers to make decisions. Debt must be used to finance purchase of firm relative to equity because cost of finance is low in case of former one.

References

  • Bhattacharya, N. and et.al., 2011. Direct and mediated associations among earnings quality, information asymmetry, and the cost of equity. The Accounting Review. 87(2). pp.449-482.
  • Chen, H. and et.al., 2011. Effects of audit quality on earnings management and cost of equity capital: Evidence from China. Contemporary Accounting Research. 28(3). pp.892-925.
  • Damodaran, A., 2012. Investment valuation: Tools and techniques for determining the value of any asset . John Wiley & Sons.

 

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