Valuation of Teabucks by P/E Ratios

Finance Week 2 - Assignment 3
The valuation of Teabucks by P/E Ratio is the industry average (35) * Teabucks Net Income (40) => $1400M

The valuation of Teabucks by Price/Sales is industry average (2.0) * total sales (750) => $1500M

The valuation of Teabucks by Price/Cash Flow is industry average (20) * cash flow, which is in this case net income + depreciation and amortization (85) => $1700M

These numbers differ, and that helps explain why valuing a company is a subjective thing. There is no 'right' way to value a company, and in practice analysts typically use a number of different methods to approximate the correct answer. As you can see we are getting a sense of how much Teabucks is worth from the above calculations, but it is imprecise because there's no reason a company's sales, it's cash flow or its net income should be the determining factor in its value. We use the 'industry average' because that gives us a broad idea of where similar companies fall in the current market. Other aspects that affect company value include its intellectual property, its people, its strategy relative to its peers, its particular strengths and how they impact its future.

Week 3 - assignment 4
(IN MILLIONS)
The cash flows from year 6 onwards grow at a constant rate of 7%.
We use the constant growth model to find the terminal value at the end of year 5
Terminal value at the end of year 5 = FCF6/(Required return - growth rate)
FCF 6 = free cash flow in year 6 = 69X1.07 = 73.83
Required return = cost of capital = 10%
growth rate = 7%
Terminal Value = 73.83/(10%-7%) = $2,461

Week 4 - Assignment 3
The current value of the firm is the present value of all FCF. We discount the FCFs including terminal value at 10% to get the current value
Current value = 5/1.1 + 12/1.1^2 + 24/1.1^3 + 44/1.1^4 + (69+2,461)/1.1^5
Current value = $1,633.48

calculate the beta and the cost of equity capital.

Year Market Rate of Return Firm Rate of Return
20X0 25% 15%
20X1 10% 6%
20X2 15% 9%
20X3 20% 12%

Using the above data calculate the beta of the firm.
If the risk-free rate is 4%, and the market rate of return is 14%, calculate the required rate of return (cost of equity) for the stock using CAPM.

Step 1: Calculate the mean return , variance of return and covariance of return and correlation of return for market and the firm

Year Market Rate of Return Firm Rate of Return
20X0 25% 15%
20X1 10% 6%
20X2 15% 9%
20X3 20% 12%

Market (X) Firm (Y) X 2 = Y 2 = x= X-mean y= Y-mean xy

0.25 0.15 0.06250 0.02250 0.075 0.045 0.003375
0.10 0.06 0.01000 0.00360 -0.075 -0.045 0.003375
0.15 0.09 0.02250 0.00810 -0.025 -0.015 0.000375
0.20 0.12 0.04000 0.01440 0.025 0.015 0.000375
Total= 0.70 0.42 0.13500 0.04860 Total= 0.007500

n=no of observations= 4

Mean of X= 0.175 =0.7/4
Mean of Y= 0.105 =0.42/4

variance of X ={ΣX 2 - n(Mean) 2 }/(n-1)= 0.004167 =(0.135-4*0.175^2)/(4-1)
standard deviation σ x =√Variance= 0.0646 =√0.004167

variance of Y ={ΣY 2 - n(Mean) 2 }/(n-1)= 0.0015 =(0.0486-4*0.105^2)/(4-1)
standard deviation σ y =√Variance= 0.0387 =√0.0015

Covariance (XY)= Σxy / (n-1)= 0.002500 =0.0075/3

Correlation (XY)=Covariance(X,Y)/σx σy = 1.0000 =0.0025/(0.0646*0.0387)

Step 2: Calculate Beta

Beta = correlation x standard deviation of return of the firm/ standard deviation of return for market
or Beta= 0.60 =1x0.0387/0.0646

Step 3: Use CAPM to calculate required return

CAPM (Capital Asset Pricing Model equation is:
r A= r f + βA (r m - r f)

risk free rate= r f = 4% (Given)
beta of stock= βA= 0.60 (Calculated above)
return on market portfolio= r m = 14% (Given)
required return on stock r A = to be determined
Plugging in the values
r A = 10. % =4.%+0.6*(14.%-4.%)

Answer:
Beta= 0.60
Required return= 10. %

Week 5 - Assignment 3

1. Outline the procedure for issuing an IPO.

The first step for issuing an IPO is to ensure that the organization meets the minimum criteria for issuing the IPO, such as audited financial results for the last years, etc. The organization should conduct an extensive analysis of the viability of the IPO, the money that it expects to generate via the IPO, the deployment of the funds, etc. Once the organizational management is convinced about the prospects of IPO and ensures that it meets minimum criteria, the next step is to select an investment banker for underwriting the public issue. A good investment banker is critical for your IPO. They draft your prospectus, assist with the filing, solicit investors, determine the offering price and sell the stock.

The first step in the formal IPO process is for the company to register with the Securities and Exchange Commission (SEC). Plan on it taking at least six to eight weeks to prepare all the documentation. To start the process an "all-hands" meeting is scheduled to determine an appropriate timetable and responsibilities for each member of the team. Included are all of the members of the internal IPO team the accountant, law firm and lead investment bank. One of the most critical documents that needs to be developed by this group is the prospectus. The prospectus is a brochure that is used to describe all aspects of the company - its financial data for the past five years, the management team, the target market, competitors and growth strategy. Since the SEC imposes a quiet period of 25 days between the time you file with them until the stock starts trading, this brochure is all that you can tell prospective investors about yourself so its accuracy and informativeness is a vital part of the IPO. Prospectuses for all U.S. companies are available free from the SEC web site or from the company itself.

Knowing that the quiet period will be occurring, the six to eight week period also includes a multi-city tour, known as the "road show". For a number of weeks the company management goes to a new city every day to meet with prospective investors to present their business plan. Common stops are Boston, Chicago, Los Angeles, New York, San Francisco, and Washington, D.C. with others added that seen appropriate to the business. For internationally placed firms, London and Hong Kong are additional "must" stops. The goal of this tour is to get institutional investors excited enough about the offering to interest them in purchasing a stake. Staging the road show is one of the places your investment banker earns his money. Their sponsorship brings the institutional investors and big money investors in to view the presentations.

Following the road show and the preparation of the prospectus, the management team and the investment banker choose the offering price and size of the offering, based on the expected demand for the stock and market conditions. The price needs to be chosen to provide sufficient funding for the business, yet give investors a sense that there will be reasonable appreciation on their investment. Investors expect to receive at least a 15 percent immediate appreciation on their initial investment.

An IPO is declared effective at least two days after potential investors receive the final prospectus and the offering price is set. This happens after the market closes for the day with trading commencing the following morning. The lead underwriter is responsible for ensuring smooth trading of the stock during the initial few days. They can legally support the price of the stock by buying shares of the stock themselves or by selling them short. They can also impose penalty bids on investors selling shares right after buying them. A company's IPO is considered completed seven days after it officially goes public.

Reference: http://www.smallbusinessnotes.com/financing/ipo.html

2. How would you go about choosing an investment banker for the issue?

The choice of the investment banker will depend on host of factors. First of all, it is important to ascertain the reputation of the investment banker on the basis of his past transactions/experience in handling the IPO, market reports/market information about the investment banker and overall reputation/goodwill in the financial market. Secondly, the fees of the investment banker is also an important criteria in the final choice. Many a times, an investment banker is also chosen on the basis of the banker's experience in handling IPO's of a particular industry or coverage of a particular sector. Often, prior banking relationships also influence the choice of the investment banker.

3. How many shares would you issue and at what price would you offer Teabuck's?

The number of shares to be issued to the public via the IPO will depend on host of factors, such as regulation pertaining to minimum issuance of shares, the percentage of equity that owners are willing to or feel comfortable to dilute, recommendations of the investment banker on the basis of expected funds that owner wish to raise and the pricing of the IPO, etc.

The pricing will depend on the valuation conducted by investment banker using variety of methodologies such as discounted cash flow approach, premium or discount relative to current valuations of listed entities in the same space or peer valuation, market conditions, etc. The investment banker will arrive at a price that will attract maximum number of investors towards the IPO and will also yield maximum value to the company's owners

4. Discuss if you would use traditional method of issuing the IPO or the Internet to issue the IPO as Google did. Discuss the pros and cons in each case.

As the market conditions are weak, the traditional method of using the investment bankers to issue the IPO will be suitable for Teabuck's because investment bankers will play a great role in full subscription of the IPO among institutional and retail investors as the company is small and not well known like a large company such as Google. Google's dutch auction IPO would have been suitable if the company had been well known such as Google and the market conditions would have been strong.

The dutch auction process is full of advantages and disadvantages from the perspective of the issuing company. On the one hand, it increases the ability of small investors to participate in the IPO process, and minimizes the traditional dominance of larger institutional investors who were lucrative clients of the underwriting investment bank. On the other hand, small investors may lack the ability to efficiently price an IPO due to lack of information. This information gap could arise because small investors lack access to the sources that institutional investors have, or because companies are not required to provide detailed information in the online process.

Furthermore, investors could discount an IPO issued through the auction process by perceiving it to be a company that may not have a clear sense of the uses for the funds that it is raising, or that may have done poorly using the traditional IPO issuance processes. Although the online auction process certainly provided publicity for Google's IPO, which may have stimulated the interest of small investors and others who are normally less involved in the process, it is unlikely that it would have generated this benefit for a less well-known IPO.

One of the principal advantages of the online auction process is supposed to be that the increase between the offer price and the open price of an IPO is minimized, providing the issuer with greater value. Although this did not occur in the case of Google, the management and venture capital firms did benefit from the ultimate high valuation that the markets placed on Google stock. It is unclear if a less well-known company, once it experienced underpricing relative to its true value, would enjoy the price spiral that Google achieved.

Reference: http://hbswk.hbs.edu/archive/4747.html

The main advantage of traditional IPO's is that investment bankers will be able to market the shares of the company effectively and help in fully subscribing the shares of the company. The major disadvantage is the steep costs of hiring the investment bankers.