Introduction
Following to the article of “Application of Pascal’s
Triangular in Corporate Financial Strategy” on link: http://emfps.blogspot.com/2012/04/application-of-pascals-triangular-in.html
and the article of “Case Analysis of GAINESBORO MACHINE TOOLS
CORPORATION: The Dividend Policy” on link: http://emfps.blogspot.com/2012/03/case-analysis-of-gainesboro-machine.html
In this article, I am willing to introduce you a new
financial simulation model which is based on EXHIBIT 8 (Projected Sources – and
Uses Statement Assuming a 40% Payout Ratio) of the case: GAINESBORO MACHINE TOOLS CORPORATION. In fact, the
template of this new simulation model is EXHIBIT 8 whereas I have developed this template by adding new
assumptions and new components. I can say that this simulation model is the combination
of Exhibit 8 and Discounted Cash Flow Analysis plus some new components. The
purpose of this simulation model is to analyze simultaneous impact two
independent variables which are the Cost of Capital (WACC) and Dividend payout
ratio on one dependent variable which is the Stock Price. My final result will
be to find the appropriate the Cost of Capital (WACC) and Terminal Value Growth
Rate for two given data in this case which are dividend payout ratio and the
Stock Price. Of course, maybe you think that I should depict dividend policy
which is the issue of the case. Yes, but I will analyze it in my next article.
Here, I will show you that I have still the problem with the calculation WACC
of Gainesboro Machine Tools Corporation. Anyway, I think that I have obtained
the best estimation for WACC.
Methodology
As I told you, I used from EXHIBIT 8 as my template
and I entered all data on my spreadsheet then I did following actions step by
step:
Step1: I added below assumptions to Exhibit 8:
Ø Depreciation
growth rate
Ø CAPEX
growth rate
Ø Change
in NWC growth rate
Ø Cost
of Capital
Ø Terminal
value growth rate
In the result, we will
have 8 independent variables.
Step 2: To complete my spreadsheet (template), I
should get the growth rate of CAPEX and Change in NWC and Depreciation growth
rate.
Firstly, I checked the amounts obtained from Exhibit
2 (Balance sheet) for CAPEX and Change in NWC replaced on Exhibit 8 for 2005
year.
Note (1): I can tell you that Change in
NWC (19.5) on Exhibit 8 is not true because we cannot consider Bank loan as
current liability. In the meanwhile, the growth rate of CAPEX for 2009 year had
been considered 3.5%!!!!
Please see my true and false calculation as
follows:
On the other hand, I calculated CAPEX as follows:
You can see on Exhibit 8 the amount of
CAPEX is equal to 43.8 (2005 year) while the true CAPEX is equal 39.63
I could not find any rational reason behind
a 10.5 % increase on CAPEX.
Anyway, if you have any time, you can contact
to writers (Robert F. Bruner and Sean Carr) or publisher (University of
Virginia Darden School Foundation, Charlottesville, VA) about these problems.
Step 3: Following to step 2, I worked on the
calculation of the cost of capital and terminal value growth rate as follows:
Ø Cost
of Debt
I considered the cost
of debt equal to 4.3% in the reference with Exhibit 3 and Ten – year Treasury
note yield of 2004 year.
Ø Cost
of Equity
The analysis of the cost
of equity in this case is very hard. I use from three methods as follows:
1) Cost
of Equity by using the Constant - Growth Valuation (Gordon) Model. Since the cost of equity by using of this method is calculated
approximately equal to 1.34% which is less than the cost of debt, I assumed the
cost of equity more than 4.3%.
2) Using of Stock valuation formula. This method is wrong way
3) The compare shareholders' expected
return and cost of debt. In this method,
I
assumed that the cost of equity is always less than the shareholders' expected
return
and
more than the cost of debt consequently we have 23% < Ke < 4.3%. I
considered
the average of it as the cost of equity equal to 13%.
Here is my details calculation:
As you can see, finally I considered a range between
4% and 11% for WACC.
One of the most crucial problems to use the
discounted cash flow analysis is to find the appropriate the Terminal Value
Growth Rate because this methodology is very sensitive to TVGR. There are many
ways to estimate TVGR as follows:
-Historic growth rates
-Forecast 3- year
growth rates
-Terminal capital
expenditure
-Competitive advantages
among the firms
-Current and future market
cap (refer to BGC matrix in Strategic Management)
-Porter’s five forces
such as competitions on barriers to entry
-Macroeconomic
indicators such as inflation, interest rate, GDP and so on
The based on Exhibit 3 and the growth rate of CAPEX
for final cash flow, I assumed the range between 0 and 3 for Terminal Value
Growth Rate.
Step 4: I have added some components to my
simulation model as follows:
-After dividend Excess cash
|
|
-Terminal value
|
|
-Total excess cash(borrowing
)
|
|
-Plug: excess cash(borrowing)
|
|
-Present value of flows
|
|
-Enterprise value
|
|
-Borrowing needs
|
|
-FV of borrowing needs
|
|
-Plug: FV of borrowing needs
|
|
-New borrowing needs
|
|
- Current outstanding debt
|
|
-Total outstanding debt
|
|
-Equity value
|
|
-Current shares outstanding
|
|
-Equity value per share
|
|
-Current share price
|
|
I used from formula = IF (PLUG < 0, - PLUG, 0)
and =IF (PLUG > 0, +PLUG, 0) for below parameters:
-Plug:
excess cash (borrowing)
-Borrowing
needs
-Plug: FV
of borrowing needs
Here is this part of my
simulation model:
Note (2): I think this part of my
simulation model is very important for Macroeconomic analysis because we can examine the risk of deficit financing where the final cash flow will
lead us to a NPV > 0 or a huge economic collapse throughout the world.
Step 5: In this step, I used two ways table of sensitivity
analysis in which I analyzed the impact of the cost of capital and dividend
payout ratio as independent variables on the stock price as dependent variable.
The findings are below cited.
Finding and Discussion
The final result of my sensitivity analysis is as
follows:
In the reference with Exhibit 5, the average current
stock price of Gainesboro Machine Tools Corporation is equal $29.15
As you can see on above sensitivity analysis, there
are four points which show us the current situation of Gainesboro as follows:
-WACC = 5%
and Dividend payout ratio = 35%
-WACC = 7% and Dividend payout ratio = 20%
- WACC = 9% and Dividend payout ratio = 5%
- WACC = 9% and Dividend payout ratio = 3%
In this analysis, I chose Terminal Value Growth rate
equal to 3%.
Now, please look at Exhibit 1 (Income statement).
You can see the dividend payout ratio for 2003 year is equal 35.7%
Dividend payout ratio = Total dividend payout / Net
income
Total dividend payout = 0.25 * 18,600,000 = $4,650,000
Net income = 12,993 * 1000 = $12,993,000
Dividend payout ratio = (4,650,000 / 12,993,000)
*100 = 35.7%
In the result, I can reserve my assumptions for
Terminal Value Growth Rate = 3% and Cost of Capital = 5 % as my primary data because
of current situation of Gainesboro. As the matter of fact, in my next article,
I will explain you how we can make decision for dividend payout ratio (Dividend
Policy) where the basic of our assumptions for WACC will be equal 5 % and
Terminal value growth rate will be equal 3%.
To be continued……
