BAO3403 Investment and Portfolio Management

Case study 1 Part a. You are an investment adviser. One of your clients approaches you for your advice on investing in equity shares of Theta Company. You have collected the following data: Earnings per share at the end of the previous year $10.00 Retention ratio 0.50 Return on equity 0.15 Cost of equity capital 0.20

The company plans to decrease the retention ratio to 40% from year 4. Required: i) Estimate the price of an equity share of this company using two-period dividend discount model and advise your client whether they should buy a share of the company.

ii) Your client is keen to know whether there are any growth opportunities from their investment. Explain to your client the meaning of this concept using appropriate calculations.

iii) If there are positive or negative growth opportunities, explain the reason for such opportunities.

Part B)

You are a senior financial analyst of a firm based in Sydney. You have been assigned with the task of training interns who recently joined your firm on how to use the free cash flow model to estimate the value of a company. You have collected data on the following data:

Year	2021	2022	2023	2024	2025
Interest rate on long-term debt (%	6.0	5.5	5.5	6.5	6.5
EBIT ($M	45,000	55,000	57,000	55,000	60,000
Cost of equity		0.10	0.12	0.10	0.13
WACC		0.13	0.14	0.15	0.16
Number of equity shares (Million)	4,000
Terminal growth rate	0.06
Tax rate	0.30

The company plans to invest 50% of the EBIT in capital projects each year. Depreciation in each year is expected to be 60% of EBIT. The long-term debt in 2021 was $50,000M. The company plans an annual compound growth rate of 5% for the long-term debt. The working capital of the company in 2021 was $15,000M. The company plans an annual compound growth rate of 6% for the working capital.

Using the information, you have collected above, perform calculations to explain to interns as to how the following are calculated:

i. Free cash flow to firm ii. Free cash to equity iii. Value of the firm according to the free cash flow to firm method iv. Value of the firm according to the free cash flow to equity method v. Estimated price of an equity share according to the free cash flow to firm method and the free cash flow to equity method

Note: For parts i and ii prepare a table showing how free cash flow to firm and free cash flow to equity are calculated.