- 14 Marks
FM – L2 – Q121 – Cost of capital
Question
Kofi Textiles Ltd is a Kumasi-based textile company owned and managed by its two founders. The company has been selling to only domestic consumers in Nigeria since inception. The founders think it is time to extend the operations of the company to foreign markets, particularly those in neighbouring West African countries. Moving into foreign markets requires additional financing and capabilities, which the company does not have. The owners have agreed on ceding 40% stake in their company to a strategic investor who would provide the additional financing and capabilities needed to compete successfully in the international business environment. However, they are not sure of what range of prices to accept for the shares they would give up.
Below is a summary of financial data for Kofi Textiles Ltd for the recent financial year:
| Item | Amount |
|---|---|
| Issued shares | 2 million |
| After-tax profit | GH₦’000 9,600 |
| Total dividends | GH₦’000 1,920 |
| Property, plant and equipment | GH₦’000 50,500 |
| Current assets | GH₦’000 25,300 |
| Long-term borrowings | GH₦’000 9,100 |
| Current liabilities | GH₦’000 11,100 |
The following information is relevant to the position and value of Kofi Textiles Ltd:
(1) The assets of Kofi Textiles Ltd were valued just after the recent financial statements were published. Inventories and trade receivables, which are included in current assets, were written down by GH₦80,000 and GH₦95,000 respectively. Property, plant and equipment were valued at GH₦52,400,000.
(2) Kofi Textiles Ltd falls into the textile and apparel industry. The average P/E ratio for listed equity stocks in the industry is 10. The average required return on listed equity stocks in the industry is 16%.
(3) Marketability of shares in Kofi Textiles Ltd is limited as its equity stock is not listed on the stock exchange. Consequently, investors demand a marketability risk premium of 7% above the industry average required return on equity in order to invest in the equity stock of Kofi Textiles Ltd.
(4) Earnings and dividends of Kofi Textiles Ltd are expected to grow by 5% every year to perpetuity.
Required:
(a) Estimate an appropriate required rate of return on the equity stock of Kofi Textiles Ltd.
(b) Estimate a range of suitable considerations for 40% stake in Kofi Textiles Ltd using the net assets method, P/E ratio method, and dividend valuation method.
Answer:
Answer
(A) Appropriate required rate of return on the equity stock of Kofi Textiles Ltd:
The average required rate of return on industry listed stocks is 16%. With a marketability risk premium of 7 percentage points, the required rate of return on the equity stock of Kofi Textiles Ltd should be 23%:
“Appropriate required return on equity = Industry return on equity + Marketability risk premium”
Appropriate required return on equity = 16% + 7% = 23%
(B) Range of consideration for 40% stake in Kofi Textiles Ltd:
Net assets method:
| Item | GH₦’000 |
|---|---|
| Property, plant and equipment | 52,400 |
| Current assets (25,300 – 80 – 95) | 25,125 |
| Total assets | 77,525 |
| Long-term borrowings | (9,100) |
| Current liabilities | (11,100) |
| Net assets | 57,325 |
Value per share = GH₦57,325 / 2,000 = GH₦28.66
The P/E ratio method:
Using the P/E ratio method, the value per share is estimated as under:
Value per share = Justified P/E ratio × EPS
The earnings per share (EPS) of Kofi Textiles Ltd is GH₦4.8:
EPS = Profit attributable to ordinary shareholders / Number of shares = GH₦9,600 / 2,000 = GH₦4.8
The P/E ratio for the purpose of valuing an unlisted company could be one-half or two-thirds of the industry average P/E ratio. If we take a figure equal to 50% of the industry P/E ratio for the purpose of valuing Kofi Textiles:
Justified P/E ratio = 10 × 0.5 = 5
Value per share = GH₦4.8 × 5 = GH₦24
Constant growth dividend discount model:
When dividend will grow at a constant rate, the constant growth DDM can be used to estimate the value of equity as under:
Value per share = DPS₀(1 + g) / (kₑ – g)
Recent dividend per share, DPS₀ is GH₦0.96:
DPS₀ = GH₦1,920 / 2,000 = GH₦0.96
Required return on equity, kₑ = 23%
Growth in dividend, g = 5%
Value per share = GH₦0.96(1 + 0.05) / (0.23 – 0.05) = GH₦5.6
Range of suitable considerations:
| Method | Value per share | Total equity value | Consideration for 40% |
|---|---|---|---|
| (x) | (y) = (x) × 2 million | (z) = (y) × 40% | |
| Net assets method | GH₦28.66 | GH₦57,320,000 | GH₦22,928,000 |
| P/E ratio method | GH₦24 | GH₦48,000,000 | GH₦19,200,000 |
| Dividend valuation method | GH₦5.6 | GH₦11,200,000 | GH₦4,480,000 |
- Topic: Business valuations
- Uploader: Samuel Duah