ABC Co is a company that is listed on a major stock exchange. The company has struggled to maintain profitability in the last two years due to poor economic conditions in its home country and as a consequence it has decided not to pay a dividend in the current year. However, there are now clear signs of economic recovery and ABC Co is optimistic that payment of dividends can be resumed in the future. Forecast financial information relating to the company is as follows:
The company is optimistic that earnings and dividends will increase after Year 3 at a constant annual rate of 3% per year.
ABC Co currently has a before-tax cost of debt of 5% per year and an equity beta of 1·6. On a market value basis, the company is currently financed 75% by equity and 25% by debt.
During the course of the last two years the company acted to reduce its gearing and was able to redeem a large amount of debt. Since there are now clear signs of economic recovery, ABC Co plans to raise further debt in order to modernise some of its non-current assets and to support the expected growth in earnings. This additional debt would mean that the capital structure of the company would change and it would be financed 60% by equity and 40% by debt on a market value basis. The before-tax cost of debt of ABC Co would increase to 6% per year and the equity beta of ABC Co would increase to 2.
The risk-free rate of return is 4% per year and the equity risk premium is 5% per year. In order to stimulate economic activity the government has reduced profit tax rate for all large companies to 20% per year.
The current average price/earnings ratio of listed companies similar to ABC Co is 5 times.
(a) Estimate the value of ABC Co using the price/earnings ratio method and discuss the usefulness of the variables that you have used.
(b) Calculate the current cost of equity of ABC Co and, using this value, calculate the value of the company using the dividend valuation model.
(c) Calculate the current weighted average after-tax cost of capital of ABC Co and the weighted average after-tax cost of capital following the new debt issue, and comment on the difference between the two values.
(d) Discuss how the shareholders of ABC Co can assess the extent to which they face the following risks, explaining in each case the nature of the risk being assessed:
(i) Business risk;
(ii) Financial risk;
(iii) Systematic risk.
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