Balfour Beatty Case Study on Corporate Finance And Valuation

Questions: (a) As an investor, provide valuation and analysis of your assigned company using the shareholder value analysis (SVA) methodFirst of all, this part of the report requires you to critically evaluate the appropriateness of SVA model to value a company. Further, you need to perform the valuation of the company in numerical terms using SVA model and present the findings in a professional manner. As an investor, you are required to explain and justify the variables used in the valuation model. You also need to provide a sensitivity analysis to identify the critical variables influencing the valuation of the company. You should also compare the actual value of the company with the value estimated by SVA model and explain of any difference or similarity.(b) Identify and evaluate one issue that your company is facing with reference to the appropriate finance theories.This part of the report requires you to identify one specific issue that the company is currently facing or has faced in the last 5 years. For example, an issue in raising new finance may have implications to agency theory, the expected yield curve of interest rates, future projects pipeline, sources of finance, management influence and corporate reputation, risk and its management, etc. As an investor, you need to determine the context for your analysis. Another issue could be the impact of mergers and acquisitions on companys strategic position. This may be done by reading around the relevant theory and linking these to the issue concerned. An analysis which does not have appropriate in-depth theoretical input will not achieve high marks. Answers: Introduction Executive Summary This assignment is about the shareholder value analysis of Balfour Beatty, which is an infrastructure development company, which has its operations in UK, US, Middle East and South East Asia. The assignment is bifurcated in two parts. The first part is about the appropriateness of the shareholders value analysis method to value Balfour Beatty. Moreover, the first part requires the valuation of the company in numerical terms and explanation of the variables used in valuing the company. The sensitivity analysis is also to be conducted for the purpose of identifying the most critical variables of the company. Lastly, the comparison is to be made between the actual value of the company and the value derived from shareholders value analysis method. The second part of the assignment requires us to identify and evaluate any one critical issue that the company is facing now or any issue faced by the company in last five years about the appropriate finance theories. The issue could be any among the example given or any other new issue. Balfour Beatty is an infrastructure company that finances, builds, develops and maintains the infrastructure that is a basic need of the society. Its in operations with more than 100 years of experience. The key market sectors of the company are as follows. Commercial buildings Social Buildings Power, energy and water Transport facilities Infrastructure Above given is the basic information about Balfour Beatty. a. Shareholders value analysis method to value the business of the company. The valuation is made based on the returns the company gives to its shareholders. The SVA method like other theories also assumes that the aim of the management is to maximize the wealth of the shareholders of the company. The concept was developed by Alfred Rappaport in the year 1980. The analysis involves calculating the value of the business by discounting the free cash flows of the business at cost of capital of the company. Further, to find out shareholders value, marketable securities and other investments are required to be added, and the value of debt of the business is to be deducted. Free cash flows of the firm reflect the cash flow generated from the operations of the business without adjusting for the cash flows of the shares and debts like interest and dividend payments and other related cash flows. Free cash flows of the firm can be derived as follows. Operating Profits After Tax (OPAT)= Revenue-Operating Profit+ Depreciation-Tax on profit Free cash flows from the operations=OPAT-Investments in fixed capital-investment in working capital The above formula would provide us the free cash flows from the business. To derive the value of free cash flows of the firm accurately, the calculation of the free cash flows should be divided into two parts. One should be the free cash flows during the planning horizon and other is free cash flows after planning horizon, that is future years. Free cash flows can be derived as follows. Value of the firm=PV of free cash flows during planning horizon+ PV of free cash flows after planning the horizon The value of the free cash flow for each year during the planning horizon can be derived by using seven value drivers as follows. The value for each component should be calculated differently by using seven value drivers detailed below. The annual sales growth rate Operating profit margin rate Income tax rate Incremental capital investment rate Incremental working capital rate Planning horizon Cos of capital With the help of above information, we can achieve the value of free cash flow of the business during the planning horizon. The second part of the valuation is free cash flow of the operations after the planning horizon. The value of the infinite period after planning horizon is called terminal value. Most of the companies, do not earn much after the planning horizon who are working in the competitive environment. It is assumed therefore that the business will not earn anything more than capital invested in the business. Hence, the assumption would be that the free cash flow earned at the end of the planning horizon would continue to earn for rest of the years for an infinite period. This way, the shareholder value of the business is measured in numerical terms. One use of shareholder value analysis is to value the business of the company. Moreover, another effective use of shareholder value analysis is to analyse and evaluate the strategic decisions made by companies. The evaluation of strategic decisions by the SVA method is conducted by comparing the pre and post strategy value of the company. The sensitivity analysis can also be conducted with the seven key value drivers of the business. The only difficult part of the SVA method is to predict the variables used in the analysis. Justification of Variables used For the purpose of calculating shareholder value of Balfour Beatty, the first calculation made costs of capital of the company. WACC is calculated to use it as the cost of capital of the company. As the capital structure of the company consists of debt and equity, WACC is used as the cost of capital of the company. SVA first emphasize on calculating the value of the business by discounting the cash flows of the business during the planning horizon and then adding marketable securities into them and deducting the value of the debt. The basic concept of finance suggests that to calculate the value of equity for equity shareholders, the cost of equity only is taken as the cost of capital. However, the SVA method first calculates the value of the business by discounting the free cash flows of the firm during the planning horizon and then it makes other relevant adjustments to find out the shareholders value. For the purpose of calculating WACC, following are the factors considered. Tax rate, equity beta, risk-free rate, risk-free premium, cost of debt, market value of equity, market value of debt, total market value of equity and debt, the proportion of equity and debt and cost of equity as well as the cost of debt. VARIABLES Amount Tax Rate (T) 20% Equity Beta (Be) 0.481 Risk free rate (Rf) 2.10% Risk premium (Rm-Rf) 5.20% Cost of debt (Kd) 2.30% Market value of equity (MVe) 1,820.22 Market value of debt (MVd) 957.00 MV (MVe + MVd) 2,777.22 As percentages: Equity (E) 66% As percentages: Debt (D) 34% Cost of equity (Ke) 4.60% WACC (Ko) 3.65% The first factor considered here is the tax rate applicable to the company. The tax rate used to calculate WACC is 20%. The operations of the company are scattered across different countries like UK, US, Middle East and South East Asia. The operations carried out by the company are construction services, support services and infrastructure investments. Major activity carried on by the company is construction services, and it is located in UK, US, Middle East and South East Asia. Major revenue is earned from the construction activities. Major revenue is earned from the activities carried on in UK. (AR 2014, Page No. 106). The corporation tax rate in UK for the year ended 2014 was 21.5% and the tax rate for the year ended 2013 was 23.25%. Other countries tax rates were different. Hence, to coordinate with all the countries tax rates, the tax rate of 20% is assumed as the tax rate of UK is reduced to 20%. Beta is the value of the sensitivity or volatility of the portfolio. Here, beta is used to derive the value of the cost of equity. Equity beta is the riskiness attached to the ordinary shares of the company. There are different alternatives available to calculate the beta of the company. However, the beta of Balfour Beatty is taken 0.481 from The Financial Times. Risk-free rate of return for calculating WACC is taken as 2.10%. The risk-free rate of return is the minimum return that we receive from the government securities that are free from any kind of risks. The risk-free rate of return is always same for every company. The market return is the return that we earn from the securities we have invested in. It is a return that is earned from the market. It is based on the prices of the securities that are earned from market. The price of Securities keeps on changing, and the market rate also keeps on changing based on the reaction of the prices in the market. As the risk attached with the securities that are non-government is higher, the return earned on them is also higher compared to risk-free securities. The difference between the risk free rate of return and market return is called risk premium. It is a premium earned for higher risk and the risk attached with the securities invested in. The risk premium of the company is 5.20%. This risk premium is the premium earned on the securities the company has invested in. The cost of debt is the rate at which company is given debt by financial institutions. The cost of debt is the rate of interest charged by the financial institutions on the amount they have lent to the company. The cost of debt is taken in use after deducting the tax amount on it. The cost of date taken here is 2.30% after deducting the portion of a tax on the rate. (AR, Page No. 14) The market value of equity is 1820.22 million. The ordinary shares of the company are 690 million. The market value of shares on the last day of the financial year is used to calculate the market value of equity of the firm. The market value of a share is taken from The Financial Times. The market value of debt of the company is 957 million. (AR, Page NO. 92). The total value market value of the equity and debt is 2777.22 million. From the financial statements of the entity, we can derive the proportion of the debt and equity of the company that is 34% and 66%. The proportion of the debt and equity is used to calculate the WACC of the company. The method used to calculate the cost of equity is CAPM. The cost of equity of the firm is 4.6% by using the below-given model. Ke =Risk Free Rate+ Beta of equity*(Market Return-Risk Free Rate) WACC of the company is calculated by taking the weighted average of the cost of equity and cost of debt of the company in proportion to their weight in the capital structure of the company. WACC=Ke*(MVe/MVe+MVd)+Kd(MVd/MVe+MVd) The WACC of the capital of the company came to 3.65%. The WACC would be used as the cost of capital to discount the free cash flows of the company. The WACC rate would be used as the required rate of return of the company. The following data is used as a base to derive the free cash flows of the company during the planning horizon and for rest of the life of the company to find out the terminal value of the company. Particulars Amount Info. About variables Last sales 7,264 Million Sales growth 1.0% per year Op. Profit Margin 1.0% of sales Associate Cos profit 53 Tax rate 20% of op. Profit margin Inc. Cap. Inv. 50.0% of change in sales Inc. W. Cap. 50.0% of change in sales Planning Horizon 5 Years Required Rate of Return 3.65% Mkt Securities and cash 40 With the help of previous two years annual report of Balfour Beatty, the free cash flows of the company is calculated to find out shareholders value of the firm. Revenue for the year ended 2013 of the company was 7264 million. The value of revenue is taken from the annual report of the company for the year ended 2014. Sales growth of the company is estimated to be 1%. The growth rate of the company is derived from the following formula. Growth Rate= (Revenues2011-Revenues2010)/Revenues2013 Operating profit margin of the year is 1%. The profit margin % of the year is calculated using below-given formula. Operating profit margin= Operating profits2011/Revenues2011 Operating profit of the associate companies is 53 million. The value is derived from the annual report for the year ended 2014. Its the share of associates profit after tax in the profit of the whole group. The normal corporate tax rate of the company is assumed at 20% as explained above. The increase in the amount of capital investment is 50% of the change in sales. The % of the increase in capital investment of the company is calculated using below-given formula. The increase in capital investment= Change in FA/ change in revenue; FA = Intangible assets + property, plant and equipment The increase in working capital of the company is 50% of the change in sales. The increase in working capital is calculated using blow given formula. The increase in working capital= Change in WC/change in revenue; WC = Inventories + Trade and other receivables - Trade and other payables The planning horizon of the company is five years, and the required rate of return of the company is 3.65%. The marketable securities and cash of the company are 40 million. The marketable securities and cash of the company are calculated as below. = other fin assets(NCA)+other fin assets(CA)+cash and cash equivalent (CA) less other financial liabilities (CL) and (NCL) Employment of SVA model Year 1 2 3 4 5 6+ Actual Difference Sales 7,300 7,337 7,374 7,410 7,447 7,447 Profit 37 37 37 37 37 37 Associate profit 53 54 54 54 54 54 LessTax 7 7 7 7 7 7 Less ICI 18 18 18 18 19 0 Less IWC 18 18 18 18 19 0 Operating Cash Flow 46 46 47 47 47 84 117 32.65 PV of cash flows 45 43 42 41 39 1,927 2,675 747.91 NPV 2,136 2856.4 719.86 Add mkt secs 2,176 2896.4 719.86 Less debt 957 957 - Equity Value 1,219 1939.4 719.86 Actual Value 1,798 1798.4 - 68% 108% 40.00% In given example for year 1 operating profit is 40 which is calculated by deducting Tax @ 20% , Inc. in Capital Investments @ 50% of Sales, Inc. in working capital @ 50% of sales from profit so derived (i.e. sum of operating profit which is 0.5% of sales and Associate profit which is 0.5% of associate operating margin). Such an operating cash flow is then converted into present value by multiplying cash flow with required rate of return of 3.65% called as NPV i.e. Net Present Value. When debt id deducted from NPV Equity Portion is derived. Comparative Analysis The comparative study of the actual value and the value calculated as per SVA model shows that the actual shareholders value is 1798.4 million while as per SVA method the shareholders value is 1798.4 million. The value as per SVA model is 8% higher than the actual shareholders value. There could be many factors due to which there is a difference between the actual value and the value calculated as per SVA method. There could be the change in the beta value or the market rate of return of the company due to which there is a difference between the actual value and the value derived as per SVA. Moreover, there could be changes in the value of both the actual and the SVA value due to assumptions of the data used in the model. Sensitivity Analysis Sensitivity analysis is the technique to analyse the sensitivity of the project. It is also known as the what if analysis. In case, the revenue of the business decreases by some amount of %, what would happen to the shareholders value or in another way, if the required rate of return of the company rises by some amount of %, what would happen to the shareholders value. This way, the sensitivity analysis of the project of the company is conducted. Here when sales growth rate and operating profit margin are changed (i.e. in decreasing order) then operating cash flow reduces as compare to actual cash flow. And when operating cash flow changes comparatively NPV too reduces as compare to actual cash flow. When operating margin and Profit margin reduces by 0.5%, then actual value reduces by 40% b. The chief executive of the group gave a report about the financial performance of the company. The financial performance of the company is declining since the year 2010. Revenue of the company is declining, and the company is making losses since many years. The most obvious and noticeable decline in the performance of the company was over the past 12 months. Many issues have caused the decline in the performance of the company as there are many operational issues with the business in UK. Moreover, another reason behind the decline in the performance of the company is the cost base of the group s also too high. There is a constant outflow in the working capital of the company since the year 2009. The chairman of the group gave an overview about the understanding of the problems of the company. After the major downturn in the construction industry, the UK business of the group due to industry downturn and many other factors resulted in an operating loss for the whole group. The overhead of the company was 1% higher this year than the industry averages. The company is making losses since last many years due to which there can be many issues with the company like raising of capital for the purpose of running the business of the company. Moreover, according to the report of the group executive of the company, there is constant outflow in the working capital of the company. Moreover, the company sold off the rail business of the Austria and Germany. Apart from the above-listed issues, in between a year, Carillion Plc with whom company dealt for the sale of one of the segments of the group called PB, withdrew their support despite of the public announcement made by the company. The directors of the Carillion gave an explanation about withdrawing the consent that the sale deal was not in the interest of the shareholders of the company. Another major issue was fall in the profitability of the company. The profitability of the UK construction business was materially impacted due to the issues happened with the UK construction business and the major downturn caused in the construction industry. Although, the year ended with the lower profitability, the receipt from the sale of PB benefited the company. The losses from the continuing business were higher than the losses made last year. The company made loss of 281 million in the year 2014 while company made a loss of 33 million in the year 2013. The loss per share of the company was eight paise compared to the earning of 21.5 paise in the year 2013. Total loss per share of the company was 8.6 paise. Even though, there were many cash outflows in the construction business of the company, the total cash flow of the c ompany was 219 million. Construction business in UK and US was the major source of revenue of the group. The company made the highest revenue from the construction business but in spite of making highest revenue from the business, the company ended up with the loss. The company is facing the major problem of the downturn of the construction industry in UK. The issue the company is facing since last five years is the downturn of the construction industry which is the major source of revenue of the company. The underlying loss from the operations for construction services was 209 million. However, in the year 2013, there was a profit of 18 million. The underlying loss from the UK construction business was 229 million which is included in this and in the year 2013, it was 20 million. The underlying revenue from the operations that are continuing is 6579 million which was 6594 million in the year 2013. Above cited problems can cause major problems with the financial position of the company. The company could face a problem with raising finance for the operations of the company as well as the share prices of the business could fluctuate with the information of the company. This could impact the image of the company on the shareholders of the company. The financial position of the company is weak since last many years, and that could affect a lot while issuing share capital or raising finance using other sources for operating the business of the company. If we look at the financial position of the company from the year 2010 to 2014, we can observe following things in the companys financial position. In the year 2010, the market conditions to conduct the business were stringent and very competitive compared to previous years. In spite of the above competitive market, the company performed very well in the year 2010. The company performed stronger than in the year 2009. The company started with a record order book in the year 2011. The record order book is a model to focus on the cost of the operations and the operational delivery of the business. The company is facing the UK and US market crisis since last many years. The annual report of the group concluded in the performance of the company that they did not expect a short-term recovery in the infrastructure markets of UK and US, but they truly expected a growth and progress in the operations and profitability of the company. In the annual report of the year 2010, it is stated that the company expected global market to be the growth market of the company. The financial performance of the company was better in the year 2010 compa red to 2009. The record order book was up to 8% at 15.2 billion which was only 14.1 billion in the year 2009. The pre-tax profit of the company was higher up to 3.2% while it was only 2.7% in the year 2009. The annual report of the company for the year ended 2011 showed good performance of the company. The order book revenue of the company was 7% higher than previous years revenue from order book. The revenue including joint ventures and associates were higher by 2% compared to previous year. The profit of the company before non-underlying items were higher by 2% compared to previous year. The above discussed operating review was of professional services. The company started making a loss from the construction services due to the downturn of the construction market in UK where the company had highest operations. The companys revenues declined by 8% compared to last year in order book. The annual report showed an increase in the revenue including JVs and associates by 5%. The company started making losses from the year 2011 as the profits before non-underlying items decreased by 16% compared to the year 2009. The operational performance of support services showed positive data compared to previous year. Even the infrastructure investment segment of the company performed well compared to previous year. The year 2012 was not so productive compared to previous year. The pre-tax profit of the company fell by 7% compared to previous year. In spite of low productivity, the dividends paid by the company were higher than the previous year. The underlying earnings per share of the company were 1% lower than the previous year. The performance of the company declined tremendously in the year 2013. The pre-tax profit of the year was 32% lower compared to the pre-tax profit of the year 2012. Moreover, the revenue of the group was just 1% higher compared to previous year. The underlying earnings per share were 37% lower compared to the year 2012. The dividend paid per share was same as it was paid in the year 2012. The chairman of the company said that 2013 was a challenging year of the company with 37% decline in the earnings per share of the company. The main issue the company is facing since last many years is the operating issues with the construction industry of the company in UK. As UK been the major operating area of the company, the company is facing challenges operating the business in UK. 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