Cost of capital-share valuation-capital structure

Reference no: EM13742150

Question 1: Cost of Capital

You are to estimate the cost of capital for Boral Ltd, an Australian listed company, at its half year ended (31 December 2014). Boral manufactures and supplies building and construction materials mainly in Australia but also in the USA and Asia. Boral uses both debt and equity financing.

Before you can undertake this task, you will need to collect some actual finance data. The 'External Links' section of this unit's MySCU web site contains links to Internet sources of information that you might find useful for this assignment. Amongst other sources, you should consider Statistical Tables F2 (daily) and F3 (monthly) available through the RBA website.

In estimating the cost of capital, you can make the following assumptions:

Loans and borrowings on the Boral half-year (interim) balance sheet reflect market value.
All loans and borrowings can be classified as debt.
Gross debt, not net debt, is used to calculate the cost of capital.
Boral aims to maintain its current Baa long-term company credit rating.¹ An average yield on 10- year corporate bonds with a rating equivalent to Moody's Baa can therefore be used in this analysis.²
The CAPM is used to estimate the cost of ordinary equity.
The 10-year Australian Treasury bond rate is an appropriate proxy for the risk-free rate.
The beta for Boral is not expected to change in the near future.
The market risk premium is 6.4%.
Boral operates in a classical tax system. (Not true but we will assume so for simplicity.)
Boral's tax rate is 30%.

Set out full workings in a clear and logical manner. Label all input figures and reference their source.

Question 2: Share valuation

Boral Ltd had sales for the year ending 31 December 2014³ of $4,388.4 million. At that time, the company had cash and investments of $1,310.7 million. Suppose you forecast sales to increase at 7% per calendar year for the next 5 years. After this, you forecast free cash flows to grow at a constant rate of 4% per calendar year. Based on Boral's last 5 years and with some adjustment for trends over that time as well as predicted future trends, you have the following expectations:

EBIT will be 5% of sales
On average, capital expenditures will equal depreciation
Changes in net working capital will be 7% of changes in sales
Boral's tax rate will remain at 30%
Boral's WACC will remain the same as calculated in Question 1.

Answer each of the following:

a) Based on the data above, along with relevant data you collected or calculated in Question 1, what is your estimate of the value of a share in Boral at 31 December 2014?

b) Compare your valuation in (a) to the share price at 31 December 2014. Assuming you are confident in your valuation in (a), would you recommend buying shares in Boral Ltd?

c) If the industry average P/E is 16.52 and Boral's current EPS is $0.19, what is the value of a share in Boral using the P/E as a valuation multiple?

d) Explain why your valuations at (a) and (c) differ. In answering, ensure you address the assumptions implicit in the methods.

Question 3: Capital Structure

Answer each question below. You do not need to collect further financial data to answer these questions.

(a) Suppose that Boral Ltd operates in a world in which the only market imperfection is corporate taxes at a marginal rate of 30%. By how much would the value of Boral change if it permanently increased its borrowing by $100 million?

(b) Now suppose that Boral Ltd operates in a world in which the only capital market imperfections are corporate taxes and financial distress costs. Like most other companies in its industry, Boral's cash flows are quite sensitive to economic swings (construction tends to slow during economic downturns) and a large proportion of its assets are tangible. Referring to appropriate theory, discuss whether each of these characteristics of Boral suggests a low or high optimal level of debt in its capital structure.

(c) In reality, Boral has a debt to equity ratio that is twice that of its industry's average. Using appropriate theory, choose and discuss two factors that may explain this difference. (In choosing the factors, you may relax any necessary perfect capital market assumptions.)

Reference no: EM13742150

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