business finace

A2 ACC00152 S1 2015

Page 1 of 3

ACC00152 Business Finance Assignment 2

The assignment has a 20% weighting in your overall mark for this unit. It will be marked out of 20 and

consists of three main questions. Marks will be allocated as indicated for each question below. Your total

assignment submission (excluding your reference list) should not exceed five (5) A4 pages.

Question 1: Cost of Capital (8 marks)

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.

Marks for Question 1 will be awarded for: appropriate choice of input figures (up to 3.5 marks); correct

choice and application of method (up to 4 marks); and referencing of data sources (up to 0.5 marks).

1 Moody’s Investors Service 2015, Boral Limited, Ratings, https://www.moodys.com/credit-ratings/Boral-Limited- credit-rating-600052768, accessed 14 February 2015.

2 Specific types of debt securities issued by Boral may have different terms, currencies, credit ratings and yields. However, we will assume that the average rate Boral would have to pay on new debt would be the same as Baa rated debt and, to stay within the scope of this unit, that the debt is in Australian dollars. We also assume that, although Boral might borrow for shorter terms than 10 years, the purpose of calculating the cost of capital is to assess long-term cash flows (e.g. projects, company value) and hence we want to match the duration of capital and cash flows.

A2 ACC00152 S1 2015

Page 2 of 3

Question 2: Share valuation (7 marks total)

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?(4 marks)

(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? (0.5 marks)

(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? (0.5 marks)

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

assumptions implicit in the methods. (2 marks)

Question 3: Capital Structure (5 marks total)

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? (1 mark)

(Question 3 continues on the next page)

3 Sales is based on trailing twelve months (ttm) (author calculated from Boral Ltd annual and interim reports). Balance sheet items are 31 December 2014 interim report figures. Growth expectations are hypothetical. Expectations for EBIT, capex, depreciation and NWC are based on data sourced from Morningstar DatAnalysis, author calculations and simplifications for assignment purposes only. Industry P/E was sourced from Reuters (www.reuters.com) and is ttm for listed construction materials companies worldwide. Boral’s EPS (ttm) was sourced from Reuters (www.reuters.com).

A2 ACC00152 S1 2015

Page 3 of 3

(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. (2 marks)

(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.) (2 marks)