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BAFI-1045 Investment Company Valuation Assignment Semester 1 2018 Company: To be advised by local lecturers Submission Date: Friday 23rd March 2018, 7:00 PM (Singapore Time) [Syndicate (Group) Assignment – minimum 3/maximum 6 students per syndicate] For this assignment you are required to use publicly available information to analyse a publicly listed company and prepare a report which provides an assessment of the company’s current position and future prospects, and which incorporates the use of a range of valuation models to arrive at an estimate of the company’s share price. To provide structure the assignment should include the points listed below: The final submission of the Group Assignment should include the following: Part 1: Financial Performance and Current Issues (15%) In this section, students are expected to provide: • • • Part 2: An evaluation of the company’s brief recent history and financial performance over time and also include peer group analysis. Conduct ROE for the company following the DuPont ROE approach and include peer group comparison. An analysis of the current issues facing the company, the industry it operates in, and explain the impact of the issues on the company’s future earnings. Valuation Models (20%) The second part/section of the assignment should contain the estimation of the value of the company’s share using:     Dividend valuation model (DDM) Free Cash Flow to Equity model (FCFE) Price/Earnings Ratio model (P/E) Price/Book Value Ratio model (P/B) You are expected to use the Capital Asset Pricing Model (CAPM)- discussed in topic 3 - to estimate the required rate of return or discount rate needed for each model. For CAPM estimation, you are required to calculate the following: 1. Beta: You cannot pick a beta value estimated elsewhere (e.g., Bloomberg) and use it in your report. Follow topic 3 lecture notes and relevant chapter (chapter 8) of the prescribed textbook to estimate the beta of the company and attach details of your work as an appendix. Also adjust the raw beta using appropriate methodology (refer to topic 3 lecture notes). 2. Risk-Free Rate: Use10 years Govt. Bond Yield as a proxy for the risk-free rate. Indicate any advantages or disadvantages if there are any. 3. Market Risk Premium: The estimation of the expected market risk premium is crucial. You must carefully explain what you do and any assumption you make while estimating market risk premium. • Risk Premium Estimation To estimate the risk premium, first, you have to estimate the expected market return. Assume that expected return on the market portfolio is related to a Macroeconomic variable, e.g., GDP. Then use the expected changes in the macroeconomic variable, with appropriate possible returns and appropriate probabilities (assume these returns and probabilities based on your analysis of current economic condition) to estimate expected return on the market portfolio. Then, subtract the RFR from the expected market return and arrive at your market risk premium. Once you estimate these three figures (1-3) you will be able to estimate the required rate of return or discount rate following CAPM that can be used in valuation models. Important points to be covered in Part 2: • • • Part 3: Explain any assumptions made in implementing the models. Where appropriate, explain how you arrived at the variables you are using. E.g., it is not enough to say you are assuming a 2 percent growth rate. You would be expected to provide justification/motivation of how you arrive at 2 percent growth rate. Provide an indication of the sensitivity of your valuations to changes in the assumptions. E.g. perform sensitivity analysis for each model. Evaluation/Discussion of the value/price of the company (5%) Comment on your valuations from part 2, including a discussion of possible explanations of why your valuations differ from the current/recent share price. If appropriate, discuss why some of the above models may be unsuitable for valuing the company. Maximum word limit for the Company Valuation Assignment is 10,000 words. Assignment will be marked by 100 then will be scaled down to 40. 2 Note: Every single member of the syndicate is expected to do a part of implementing the valuation models. That is to say, there should not be the situation where a member only does the history and financial performance of the company without any input in the actual implementation of valuation model. The focus of this assignment is on the valuation, specifically generating the inputs into the valuation process and applying valuation models to these inputs to arrive at a range of share price estimates. The requirements outlined above have been designed to aid this process. For the discounted cash flow valuation models the primary requirement is to produce the appropriate expected return measures and discount rates to use in the models. For the relative valuation techniques the focus is on estimating the appropriate ratio multiples. It is important that forecasts of expected returns reflect the impact of the factors identified as current issues facing by the company. A common mistake is to identify a range of issues which will impact on the company’s future earnings or cash flows, but then produce a set of return forecasts which are simply extrapolations of historical returns, ignoring the impact of the factors identified as current issues. The development of return estimates requires judgement; it is not simply a statistical or mathematical forecasting exercise. References/Resources for group assignment Reilly, Frank K. and Keith C, Brown, Investment Analysis and Portfolio Management (10th Edition), Thomson South-Western (2012): Chapters 10, 11, 12, 13, and 14. [Much of the material in these chapters is covered in earlier courses and these chapters should be used for revision purposes]. Search Bloomberg, Yahoo! Finance, Google Finance site for business and financial market news. These deliver world economic news, stock futures, stock quotes, & personal finance advice. Damodaran, Aswith, Investment Valuation [2nd Edition], available online at: http://pages.stern.nyu.edu/~adamodar/ Assignment submission procedure All assignments must be submitted online through the course Canvas. They must be accompanied by an assignments cover sheet and submitted through Turnitin on Canvas, a plagiarism checking tool. For information on Turnitin see: Student FAQ, http://www.rmit.edu.au/academicintegrity/studentfaq Student procedures and account setup (pdf), http://www.rmit.edu.au/academicintegrity/studentprocedures 3 Turnitin student information page, Student Quick Guide - How to submit an assignment through Turnitin available from the ADG webpage; http://www.rmit.edu.au/bus/adq Turnitin will assess your work in approximately one minute, and return a colour coded response for the originality of the text. Penalties for late submission All assignments will be marked as if submitted on time then the mark awarded will be reduced by 10% each day (or part of a day) it is late. Assignments that are late by 7 days or more will not be marked and will be awarded zero marks. Presentation of Report The report is to be presented in the form of a business report. It should have an executive summary, outlining the main findings, at the beginning. The remainder can be structured in line with the above points. Calculations should be included in appendices. Reports are to be typed in Arial/Times new roman with a font size 11 in single or one and one-half space on A4 paper. Reports are to be stapled with two staples down the left-hand side, or secured with a fold-back clip. Do not attach information you have used in compiling the report, i.e. annual reports, newspaper articles etc., to the report. Syndicate Composition Syndicates are strictly limited to a minimum of three (3) and a maximum of six (6) students. Experience has shown that numbers either smaller or larger than these are dysfunctional. Syndicate composition is to be finalised by week 2. All groups are expected to include a GROUP CONTRIBUTION STATEMENT detailing, in exact terms, what each person in the group has done, when you submit the assignment. Fail to attach the contribution statement to the report submission will be 50% mark deduction. Please note that all students are expected to participate and contribute to the group assignment. Free riding would not be rewarded. As such students would be given a zero mark if it is shown that s/he did not contribute enough to the final output. 4
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Explanation & Answer

Attached.

Part 1: Financial Performance and Current Issues
(D) Estimation of ROE for the Five Years Using Du-Pont ROE Approach
Du-Pont analysis involves with de-composition of the earnings’ components to assess the quality
and sustainability of earnings. In the Du-Pont analysis, return on equity (ROE) of a company is
decomposed into three components including net profit margin, assets turnover, and financial
leverage to observe the impact of these on the earnings of the company. The higher the value of
these components, the higher the impact of these on the earnings of the company.
The ROE of Frencken for 2012, 2013, 2014, 2015, and 2016 based on the Du-Pont ROE Approach
are -6.32%, 8.64%, 5.49%, 4.53%, and 7.48% respectively. Even though, ROE of the company
has been declined in 2015, in 2016 ROE has been increased. This increase of the ROE is an
indication of the recovery of the profitability of the company. The earnings of the company can be
said as of good quality and sustainable as it is mainly driven by leverage and efficiency in cost
management (as implied from the increase of financial leverage and net profit margin after 2014).
The company is getting more efficient in managing of its cost of sales and other operational
expenses to increase net earnings of the company. Also, the efficiency of the company is managing
external funds to gear-up the return for the shareholders has been improved.

Year

2012
2013
2014
2015
2016

Du-Pont Analysis for Frencken Group Limited
Components
ROE
Net Profit
Total Assets
Margin
Turnover
Financial Leverage
=
(Net Income/
(Net Income/
(Revenue/ Total
(Total Assets/Total
Shareholders'
Revenue)
Assets)
Shareholder's Equity)
Equity
-6.32%
=
-3.27%
1.01
1.90
8.64%
=
3.99%
1.33
1.63
5.49%
=
2.40%
1.34
1.70
4.53%
=
2.10%
1.29
1.67
7.48%
=
3.41%
1.28
1.71
Table 1: Du-Pont Analysis of Frencken Group Limited

2016

7.48%

2015

4.53%

=

2014

5.49%

=

-6.32% 8.64%

2012

=

2013

Du-Pont Analysis of Frencken Group Limited

=

=

Net Profit Margin

Total Assets Turnover

Financial Leverage

Figure 2: Du-Pont Analysis of Frencken Group Limited
The ROE of Frencken in 2016 is higher than that that of MSM International and IEV Holdings. In
2016, the ROE of MSM International was very low, and ROE of IEV Holdings was negative. The
ROE of IEV Holdings even though has been increased in 2014 and 2015 but has been significantly
decreased in 2016. Based on the review of ROE of three companies it can be said that currently
among the three companies, Frencken is most efficient in managing of its shareholders funds to
generate return.
ROE of Frencken, MSM International, and IEV Holdings
20.00%
15.00%
10.00%

ROE

5.00%
0.00%

-5.00%

-10.00%
-15.00%
-20.00%
-25.00%
-30.00%
-35.00%
Frencken Group

2012

2013

2014

2015

2016

-6.32%

8.64%

5.49%

4.53%

7.48%

MSM International

6.15%

3.24%

13.58%

-2.90%

0.35%

IEV Holdings

-4.35%

-5.04%

5.76%

12.02%

-30.83%

Figure 3: ROE of Frencken, MSM International, and IEV Holdings

PART: B Valuation
(1) Beta Estimation
Beta is a measure of the systematic risk as well as security return’s volatility in comparison to overall market’s volatility. Beta of a
stock is calculated by the dividing the covariance of market and stock return by the variance of market return (Beta = Covariance of
Stock and Market Return/ Variance of Market Return). The unadjusted (raw) beta of the Frencken stock is calculated as 0.624
[Detailed in Appendix 04]. Here, the monthly stock price data of Frencken and Straits Times Singapore (STI) for 2013-2017 (five
years) has been considered for the beta estimation [Detailed in Appendix 04].
The beta tends to depict mean reversion tendency (Reilly & Brown, 2011), and thus the raw beta estimated with the historical data is
required to adjust [Adjusted beta = (2/3)*(Unadjusted Beta) + (1/3)*(1.0)]. The adjusted beta of the Frencken stock is calculated as
0.748 [(0.67*0.624) + (0.33*1.0)].
Beta Estimation
Covariance of Index and Stock Return
Variance of Index Return
Variance of Stock Return
Unadjusted Beta of Frencken Group
Adjusted Beta of Frencken Group

0.00065
0.00104
0.00929
0.624
0.748

Risk Free Rate of Return: The risk free rate of return is the theoretical rate of return of an investment with zero risk (Petty, Titman,
Keown, & Martin, 2015). Risk free rate actually represents the opportunity cost of holding money over a specified period of time. The
risk free rate considered here is 2.390%. In this case, the current yield of the Singapore 10-Year Bond has been considered as the proxy
of the risk free rate (Investing.com, 2018).
Risk Premium: The risk premium refers to the additional return offered for undertaking additional risk (Petty, Titman, Keown, & Martin,
2015). Market risk premium refers to the additional market return over the risk free rate. The expected market return is estimated here
as 10.8230%. It should be noted that Straits Times Singapore (STI) has been considered as a proxy of the market. The annual return of
1983-2016 (28 years) have been utilized to develop forecasting technique for predicting the market return [Detailed in Appendix 05].
The expected market risk premium is 8.43% and expected equity risk premium is 6.31% given risk free rate of 2.390% and beta of the
stock of 0.748.
Estimation of Cost of Equity: Cost of equity refers to the return demanded by the equity investors or shareholders as compensation for
the risk undertaken in investing their capital (Petty, Titman, Keown, & Martin, 2015). Cost of equity represents the opportunity cost of
the equity investors or shareholders. The cost of equity can be determined with many techniques including dividend discount model
(DDM) approach, Bond yield plus risk premium approach, capital assets pricing model (CAPM) approach etc. (Vishwanath, 2007).
Among these, CAPM is most widely used approach to determine the cost of equity. Under the CAPM approach, additional risk premium
(that compensate against the sytematic risk of the stock) is added to the risk free rate to determien the cost of equity (Reilly & Brown,

2011). Given risk free rate of 2.390%, expected market risk premium of 8.43%, and beta of 0.748, the estimated cost of equity of
Frencken is 8.30%.

(2) Stock Valuation
Valuation models can be broadly categorized into two types including intrinsic value approach and ratio value approach (Petty,
Titman, Keown, & Martin, 2015). Intrinsic value approach involves with determining the stock value based on the review and forecast
of fundamental elements, and drivers that generate value for the company. On the other hand, ratio value approach involves with
determining the stock value based on linking of a comparable ratio (financial metric) to a specific financial statement item (earnings,
book value, cash flow etc.) (Petty, Titman, Keown, & Martin, 2015). Dividend Discount Model (DDM) and Free Cash Flow to Equity
(FCFE) Model are examples of intrinsic value approach, and price/earnings ratio (P/E) model and price to book (P/B) ratio model are
examples of ratio value approach.
(i) Dividend Discount Model (DDM)
The dividend discount model (DDM) involves with valuing a company’s stock based on the expected dividend payments (Nobles,
Mattison, & Matsumura, 2014). Under this model, the return to the stockholders are assumed to derive through dividend payments.
The summation of the discounted future expected dividends (net present value of future dividends) from a stock is considered as the
present value of the stock (Petty, Titman, Keown, & Martin, 2015).
The sustainable growth rate of the company has been estimated as 4.22%. This growth rate indicates that Frencken can sustain
maximum growth rate of 4.22% without having dependency on the outside (external) financing. This sustainable growth rate is
determined by multiplying the average ROE and Average retention ratio of the company for the last four years.

Average Retention Ratio Calculation
Particulars
2013
2014
2015
2016
DPS (SGD)
0.01
0.01
0.01
0.01
EPS (SGD)
0.04
0.03
0.02
0.03
Retention (Plaw-back) Ratio
75.00% 66.67% 50.00% 66.67%
Average Retention (Plaw-back) Ratio

ROE

Average

64.58%

Average Return on Equity (ROE) Calculation
Particulars
2013
2014
2015
8.64% 5.49% 4.53%

2016
7.48%

Average ROE

Average

6.54%

Particulars
DPS (SGD)
Growth Rate
Average Dividend Growth Rate

Average Dividend Growth Rate
2013
2014
0.01
0.01
0.00%

Average Retention (Plaw-back) Ratio
Average ROE
Sustainable Growth Rate

2015
0.01
0.00%

2016
0.01
0.00%

Average

0.00%
64.58%
6.54%
4.22%

The future expected dividends of the company for the next five years is expected to be SGD 0.01. After five years, the terminal growth
rate is considered as 4.22% (Sustainable growth rate). The terminal value of the dividends at the end of fifth year is estimated as SGD
0.23264. Given cost of equity of 8.70%, the intrinsic value of the stock of company under DDM is SGD 0.1925.

Particulars
DPS (SGD)

Current
Year 0
0.0100

Particulars

Dividend Forecast For Next Six Years
Forecast
Year 1
Year 2
Year 3
Year 4
0.0100
0.0100
0.0100
0.0100

Year 5
0.0100

Share Price Estimation with DDM Approach
Year 0
Year 1
Year 2
Year 3
0.01000
0.01000
0.01000

DPS (SGD)
Terminal Value
Total Cash Flow
PVIFA (8.70%)
Discounted Cash Flows
Theoretical Value of Stock (SGD)

0.0100
0.9200
0.0092

0.0100
0.8463
0.0085

0.0100
0.7786
0.0078

Perpetual
0.0104

Year 4
0.01000
0.0100
0.7163
0.0072

Year 5
0.01000
0.23264
0.2426
0.6589
0.1599

0.1925

Cost of
Equity

The stock price of the company calculated under DDM approach is very sensitive to cost of equity and terminal growth rate of
dividends after five years. Small change in the cost of equity or terminal growth rate of dividends after five years lead to high change
in the stock price of the company. The stock price of the company becomes higher when cost of equity is lower and terminal growth
rate of dividends after five years is higher, and stock price of the company becomes lower when cost of equity is higher and terminal
growth rate of dividends after five years is lower. In the Table 3, for different combination of cost of equity and terminal growth rate
of dividend, the stock prices are depicted. The combination for whose stock price is found higher than the initially estimated price of
SGD 0.1925 are marketed with green co...


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