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hey guys i have a few questions to askkk
firstly,can anyone plz explain the concept of return on fixed capital employed with respect to the solution the examiner has given?
secondly,while computing NOPAT for EVA calculation,can we take the profit after tax figure for example for 20×9 figure,860m and then add back the interest net of tax?if we do tht,the NOPAT figure calculated this way isnt the same as the one given in solution-whyy?
thirdly,in part d,regarding the undervaluation assumption,can we compute the value by taking the FCFE figure of 420(150 plus the dividend paid of 270)-i mean wud this be correct?-since the answer is different obviosly..and tht wud result in different conclusions than the one given in the solution
wud be grateful fo any help:-)
1 answer:
Return on fixed capital employed helps to identify how economically firm has used its working capital policy..investment in working capital does not contribute to overall firm’s return..like cash,stock,debtors does not generate return in itself…but if these investment are financed by current liabilities..then our investment from equity and debt will go to non-current asset only due to which return on capital employed and return on Fixed capital employed would be the same..In other words if current ratio is equal to one then our capital employed(debt+equity) will equal to Fixed asset capital(investment in Non-current Assets)..but if our current ratio is more than 1(this means firm has invested in current assets) then ROCE would be lower than ROFCE and vice-versa..in the exam question ROCE is higher than ROFCE…because current ratio is less than 1(which means company has generated extra return due to finance from current liabilities which has ho cost attached with it)..
2. answer:
you can do what u r proposing..but the problem is in question..taking profit after tax as $860 million would be wrong because the tax calculation is wrong in question (30% of 1170=351) in question it is 310..if we correct profit after tax it would be $819 million and adding interest cost net of tax would give $875 million..
3.answer
even in semi-efficient market..we should assume that market does price business correctly which is question comes to 4.16 billion..using FCFE its comes $6.3 billion approx..this would suggest that existing investors doest not expect current FCFE to continue in perpetuity or it could be that even FCFE would be generated in perpetuity it would be lower than existing level…or it may be that investor is valuing expected future dividend rather than FCFE..assuming dividend remains constant value would be 4.049 which slight lower than current market capitalization..so they expect little growth..as per our evaluation of suitable target for acquisition..we should base our decision (to acquire this company) on our growth prediction of target’s future expected dividend and probability of prediction being correct using simulation analysis..
this is how we could comment when using FCFE as valuation…To question 3:
The company in question has net cashflow of 150, if you assume that the same conditions will hold infinetily long, the cash balance will be increasing to perpetuty, however, in real life companies do not accumulate cash, they reinvest excess cash into either working capital or non-current assets, or repay debt or repurchase shares.Ideally, FCFE model should give the same answer as the dividend model (because they have the same underlying assumptions).
In FCFE model,,FCFE is made of dividend and retained earning….whereas in dividend model..we value future expected dividend..common is cost of equity…
using zero growth assumption in both model…we would find different answer FCFE model gives $6.3 billion and dividend model gives 4.049…(this is because of FCFE being more than dividend)…
Now what u said would become basis of our comment..you said
“Ideally, FCFE model should give the same answer as the dividend model”Note: To prove this statement growth rate used in dividend model should be higher than FCFE model to arrive equal value..(unless FCFE is equal to dividend)
Firstly as we don’t have information regarding expected growth rate in FCFE and Dividend..we assumed zero in both of them..In reality growth rates would be different for FCFE and for dividend..this is because growth of 2% in FCFE would grow dividend for than 2% (unless FCFE is equal to dividend)..
so difference between two value in this example is due to assumption of same growth rate (i.e is zero) in both model..if we had assumed constant growth of 2.5% in dividend then (270*1.025/(.06668-.025)=6.63 billion approx..it will be same result given by FCFE model..
But in question..what we should focus is that FCFE model gives higher value than market capitalization..so either we comment that current level of FCFE is not expected to be sustainable in future by investors..or to comment more closely we should use dividend model..which would give value slight lower than market capitalization..our comment would now be more precise than by using FCFE model..we would now be able to comment investor is expecting little growth in dividend..
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