Money

Introduction

Sensing the time to be right, the long serving Managing Director of River Island Clothing Limited has approached Apax Partners, a leading equity valuation firm, with a request to determine the value of River Island.

While valuation of a company’s shares needs to be based on the financial figures, these alone do not provide the full picture. It is also necessary to understand the business conditions and the industry situation.

Moreover, the financial analyses are made under a set of assumptions, and it is the duty of the valuing consultant to explain the assumptions underlying the valuation, and also examine the impact of any change in any of the assumptions on the overall value of the business.

This paper examines the business and financial situation of River Island Clothing Limited, and makes a financial analysis of the company with a view to determining its value. The valuation is accompanied by a sensitivity analysis involving some of the key factors.

Analysis of business situation

The global economic recession has had its impact on the retail apparel industry as well. Although clothing, being an item of necessity, normally bucks the general trend during a downturn, this has not been true in the case of the current economic recession. The growth in the industry has been sluggish, with negative growths being recorded in individual segments during specific periods.

At the same time, bigger companies have been in a consolidation mode, while smaller companies have found it very difficult to even survive. This presents an opportunity to the bigger companies.

In the past, River Island had always managed to grow even when other companies were facing adverse conditions. However, the 2008 figures for the company show that there was no growth, and business remained static during the year.

Forecast of Future Economic Benefits Stream of River Island

The turnover of River Island grew from £456.58 million in 2004 to £877.36 million in 2008, representing a compound annual growth rate (CAGR) of 17.73%. The growth during 2008 was 2.95%. However this was over a negative growth of -2.1% during the previous year, so that the effective growth during the period 2006-2008 was practically nil.  Profits after tax grew from £60.06 million in 2004 to £110.06 in 2008, representing a CAGR of 16.35%.

The Compound Annual Growth Rate for the Apparel industry, as a whole, during the period 2004-08 was 2.7%. (Datamonitor 2009, p.8) The rate of growth for the year 2008 was 1.8%. (Datamonitor 2009, p.9)

Although the overall CAGR for the period 2004-08 has been much higher in the case of River Island than that of the industry, the growth during 2007-08 has been very close to the industry growth rate of 2.7%. Moreover, River Island had experienced a negative growth rate during the previous year (2006-07).

The industry is expected to slow down to a compounded annual growth rate of 1.6% during the next five years, with negative growth rates in the first one or two years.

Considering all the above facts and forecasts, it is unrealistic to assume a much higher growth rate for River Island during the period 2009-13 than the anticipated industry growth rate. Hence this growth rate (1.6%) has been assumed for the projections of cash flows during this period for River Island.

Although the industry is expected to experience negative growth in the initial years, the growth has been assumed at a uniform rate, throughout the five year period, in the case of River Island.

The above considerations are applicable to the expected growth in the sales turnover. The growth rate in sales turnover only helps in projecting the gross income of the company. In order to arrive at the cash flow projections, the figure of Profit after Tax needs to be computed.

For this purpose the average ratio of profits to turnover during the five year period 2004-08 could be used as the basis.

The ratio of Profit after tax for the five year period 2004-08 works out to 13.59%, with the average for the past three years being 12.45%. For the purpose of the projections of cash flows during the period 2009-13, a rate of 12.5% has been assumed.

With these assumptions, the turnover and profit after tax, projected for the period 2009-13 are shown in Table – 1.

Table – 1

Weighted Average Cost of Capital

Using the Capital Asset Pricing Model (CAPM), the cost of equity capital can be assessed as a function of the risk-free rate, the expected market yield on similar investments, and the beta for the investment representing the volatility associated with it. The expected yield and the beta of the stock together provide the risk premium that needs to be added to the risk free rate to arrive at the cost of capital.

The formula for calculating the expected rate of return from this class of investments (cost of equity capital) is

Expected rate of return = Risk Free Rate + Risk Premium.

The risk free rate in the U.K. is taken as the return on 15 year gilt yields, which was 4.64% as on February, 2010. The U.K. risk premium is 5.00% (Portsmouth Business School 2009, p.3)

Hence the cost of equity capital = 4.64 + 5 = 9.64%.

The debt component in the capital structure is assumed to be zero, since the summary figures for 2008 show only a minimal figure of long-term liabilities, which can be ignored. (Portsmouth Business School 2010) Hence the entire capital is assumed to be made up of only equity capital.

Consequently, the weighted average cost of capital is the same as the cost of equity capital, which is 9.64%.

Quantitative Assessment of the value

The valuation of company shares can be made by employing a number of different approaches such as asset based methods, earnings based methods, dividend valuation models, or discounted cash flow methods. More recently, methods such as market value addition and economic value addition approaches are also being used. (McMenamin 1999, 252-282)

The Discounted Cash Flow methods offer the advantage of taking into consideration the time value of money, and therefore represent a true picture, particularly in cases of variations of cash flows from year to year. The Net present value of projected future cash flows gives a reasonably good idea of the value of the business.

Calculation of Net present Value involves the assumption and use of a particular discounting rate. The Weighted average cost of capital can be used as the discounting rate, as this is the return that is actually required.

Strictly speaking, the entire life of the project should be considered for valuing any project. In this .case we could consider a greater number of years or an infinite stream.

However, this might not provide accurate results because it is difficult to forecast even with a low level of accuracy, the cash flows for such a long period, as we have no idea of what future conditions are likely to prevail.

On the other hand, ignoring the cash flows beyond a certain period, which is 5 years in this case, makes the estimate conservative, and hence does not vitiate the conclusions. The cash flows for a period of five years 2009-2013, have accordingly been considered in these calculations.

With these assumptions, the Net Present Value of the future cash flows works out to £438.88 million. As against this, the total shareholders’ funds as of 2008 were £ 213.74 million. Since the exact number of shares issued is not available, the price per share has not been calculated.

The total value of the business is, consequently, estimated as £438.88 million.

Appraisal of Assumptions and Sensitivity Analysis

Assumptions

The above valuation of the business involves a number of assumptions, some of which are listed below.

• Compounded Annual Growth rate: The rate of growth is assumed from past trends. This may vary substantially in the future years. In particular, the growth rate for the later years may be very different from what is assumed based on present figures. (Harman 2010)
• Discount rate: The discount rate is computed using one of the methods for assessing the cost of capital such as the Capital Asset Pricing Model (CAPM). In this paper, the CAPM has been used. Under this approach, the calculation of the cost of capital makes assumptions regarding the risk free return and the risk premium. The risk free rate can be taken variously as 10-year, 20-year or 30-year bond yields. (Mramor, Joksimovic and Mcgoun 2003, 18)  In this particular case, the 15-year yield has been taken as the risk free rate. Another variable that can affect the discount rate is the risk perception. The calculation of cost of capital is made on certain assumptions regarding the risk premium. This can change with changes in the risk perceptions. (Dayananda, Irons, Harrison, Herbohn & Rowland 2002,  118)
• Cash Flow Projections: Cash flow projections are made on the basis of previous years’ figures. Even minor errors in the assumption of the cash flows in the initial years can magnify the errors over the years and give erroneous results. (Harman 2010)
• Costs: Variation in input costs can affect the cash flow projections by altering the profit to turnover ratio.
• Price variations: The growth rates used in the computation assumes that the prices of the products are constant. Variations in prices can affect the cash flow projections, even though the growth rate remains the same.

Sensitivity Analysis

In order to test the extent to which changes in these assumptions can affect the final conclusions, sensitivity analyses can be done on the data, by varying one or more of the values at a time and observing the results. In the present case, sensitivity analyses were done by changing the values of a few variables. The values that were changed, the extent of changes, and the resulting NPV after incorporating the changes are shown in Table – 2.

Table – 2

From Table – 2, it can be seen that variations in growth rates and discount rates do not affect the NPV significantly. However, the valuation is highly sensitive to changes in the costs. In this case, when costs increase by approximately 3%, the NPV is reduced by nearly 20%.

(Note: The Cost/Turnover ratio was changed from 12.5% to 10%.Thismeans that costs have increased from 87.5% to 90%, representing an increase of 3 %.)

Critical Evaluation of the methodologie

The discounted cash flow methods use the projected cash flows from the project as the basis of valuation. Projected cash flows are facts (subject to assumptions) and are not based on judgments like accounting profits.

Earnings based methods rely on judgments such as market assessments about this or similar class of investments. They can therefore vary depending on market perceptions.

Dividend based models consider only the dividends and not the retained earnings. Although this makes sense to the investor, in the long run, retained earnings also belong to the shareholder, and should be included in the valuation for greater accuracy.

The discounted cash flow method offers several advantages over other methods because it considers the time value of money. Some of the advantages of this method are:

• These methods consider the actual cash flows, reducing the subjectivity in the assumptions.
• Discounted Cash Flow methods consider the time value of money, and hence the valuation will be more accurate. (Shim & Siegel 2007, p. 210)

However, these methods also suffer from some deficiencies.

• Discounted cash flow methods are usually sensitive to the discount rates and other variables assumed. Hence changes in the cost of capital can vitiate the results.
• DCF calculations are made on the basis of a number of assumptions. Variations in any of these assumptions can render the calculations less reliable.
• Discounted cash flow methods make an implicit assumption that any surplus available with the business because of surplus cash flow generation can be employed in such a manner as to yield the same return as required by the cost of capital. This may not be true in all cases. (Polimeni, Handy & Cashim, 1993, p.158)
• Many of the valuation and appraisal methods, including DCF methods ignore the risk factor altogether. Although sensitivity analyses can throw some light on the extent to which these factors are likely to affect the results, more precise methods are now available to assess the impact of risks. Activity based methods, for example, can be used to vary the activity drivers and their levels to get a more realistic view of the risks and variability of results. (Cook, Grove & Coburn 2000, p. 305)

Conclusion

Based on the available facts and the above considerations, the business is valued at £438.88 million. In the absence of information about the number of shares issued, the price per share could not be calculated. The above valuation can be significantly changed if the input costs vary substantially.

Works Cited

1. Cook, T. J., Grove, H. D., & Coburn, S. 2000, ABC Process-Based Capital Budgeting,. Journal of Managerial Issues, 12(3), 305.
2. Datamonitor 2009, United kingdom – Apparel Retail, Datamonitor.
3. Dayananda, D., Irons, R., Harrison, S., Herbohn, J., & Rowland, P. 2002, Capital Budgeting:  Financial Appraisal of Investment Projects. Cambridge University Press, Cambridge, England.
4. Harman, Bryn 2010, Top 3 DCF Analysis Pitfalls,[Online] Available at <http://www.investopedia.com/articles/07/DCF_pitfalls.asp>
5. Mcmenamin, J. 1999, Financial Management: An Introduction, Routledge, London.
6. Mramor, D., Joksimovic, D., and Mcgoun, E. 2003, “2 How Uncertain is Firm Valuation?”. In Practical Financial Economics:  A New Science, ed. Murphy, Austin:13-30. Praeger, Westport, CT.
7. Polimeni, RS, Handy, SA, and Cashim, JA 1993, Schaum’s Outline of Theory and Problems of Cost Accounting, McGraw-Hill, New York.
8. Portsmouth Business School 2010, Business Valuation, Portsmouth Business School.
9. Shim, J. K., & Siegel, J. G. 2007, Schaum’s Outline of Financial Management (3rd ed.), McGraw-Hill, New York.

Merlin Entertainments Group is one of the world’s largest family entertainments visitor attraction operator. Over 30 million people visit their 52 attractions each year. In the UK, these include Madame Tussauds, the London Eye, Alton Towers, Legoland, Sea Life, Thorpe Park and much more. They are owners of internationally recognized brands in Legoland Discovery Centers, Madame Tussauds, Sea Life and Dungeons. They also have the development skills internally to identify land and build 4 or 5 new Midway Attractions each year.

Priority of Merlin Entertainment Group is delivery of memorable experiences to their millions of visitors constantly monitored visitor satisfaction, they have developed strategy, and the very high customer service and health and safety standards. This kind of location based entertainment, specifically tourist attractions, is dynamic, fast growing and fun.

Merlin Group Entertainment is different and unique, in terms of its range of quality, branded businesses and its commercial success (Merlin Entertainments Group, 2010). Merlin Entertainment Group uses marketing concept ,which is easily, applicable to a leisure services such as an event to succeed in their goals. According to Pine and Gilmour (1999) we moved beyond simply products and services it is not just trade anymore, these days it is more about engaging customers and giving them an experience which they cannot easily forget and which will make them return to the place.

While Berridge (2007) explained that big impact on consumer has a design, brand name; example is a well- known brand name in leisure services like Merlin Entertainment Group. Events as services also differ from products in number of ways, we have to experience them to consume them (Bowdin, 2011). According to these facts Merlin Entertainment Group has succeed in their intensions and become a leader in the entertainment business.

Financial Statements provided will present us financial health of the company. To fully analyze firm, it is important to assess the value of the information supplied by management (M. Fraiser and A. Ormiston, 2010). The financial statements are giving as information of the financial position, performance and changes in the company. Financial report includes the following components: balance sheet, income statement, cash flow statement, a statement of changes in equity and notes to financial statements.

The balance sheet is a financial report of the financial position assets, liabilities or what the firm owes to others and equity what the inside shareholders or owners own on the particular date such as the quarter or year. Income or earning statement presents the results of operations- revenues, expenses, non-profit and loss per share for the accounting period (R. H. Parker, 2007).

Merlin Entertainment Company has showed in their accounts for 2009 that their profit was  769 million, revenue, in this case represents the amounts received from customers for the sale of goods specifically, admissions tickets, room revenue retail and food and beverage sales of which they are directly invested or spent on the different kind of costs  104. 4 million, principal costs under this category represent the expense of food and beverage and retail consumables according to this their gross profit was 664. 6 million.

Their indirect costs were  428. 9 million which means they earned  235. 7 million before finance income and costs, taxation, depreciation, amortization and impairment. Their loss for the year 2009 was  30. 8 million, we count total loss when we subtract profit which is  769 million, cost of sales, which is  104. 4 million and total expenses.

When we compare profit 2009 with profit in 2008 we can see that their profit was 662. 3 million which means that their total profit was less for  106. 7 million in 2008. Since their cost of sales were also less than in 2009 and they were  87. 9 million their gross profit was  574. 4 million when we subtract this amount with all expenses which were  373. 7 million we came to total of  200. 7 million.

This means that the difference between profit in 2009 and 2008 is 35 million, they made bigger profit in 2009 for this amount of money. Merlin Entertainment Group also succeed to reduce their loss compared to the year 2008 for 49. 1 million. As provided in the Merlin Entertainment accounts on page 6 we can find more details of exceptional and non-trading items in note 3 (Appendix 1).

By definition, ‘the account balances on the balance sheet must balance; that means that total of all assets must equal the sum of liabilities and stockholders’ equity’ (M. Fraiser and A. Ormiston, 2010). In the statement of financial position of Merlin Entertainment Company non-current assets represent long term investments and intangible assets, such as goodwill recognized in business combinations, patents, trademarks, copyrights, brand names, and franchise.

Value of non-current assets as stated is  1. 891, 4 million. Details about assets are shown in notes 11, 12 and 13, goodwill represents amounts arising on acquisition of subsidiaries and joint ventures (Appendix 2). Current assets include cash, inventory, and marketable securities, prepaid expenses and other liquid assets that can be readily converted into cash. Value of current assets in 2009 is  139. 1 million. Value of total assets is  2,030. 5 million (Appendix 2). Current liabilities are what a company currently owes to its suppliers and creditors, and it shows that for 2009 current liabilities are 224. 7 million.

These are short-term debts, all due in less than a year, bank overdrafts, interest bearing loans and borrowings finance, leases, tax payable, and provisions (D. Adams, 1997). Liabilities are: “Total of funds owed for assets supplied to our business or expenses incurred but not yet paid” (Wood and Sangster, 2006, pg. 667). Non- current liabilities are opposite than current liabilities, it is the obligation that is not required to be satisfied in 12 months of the balance sheet date. With company’s ability to pay its bills we measure a liquidity ratio. The denominator of a liquidity ratio is the

company’s current liabilities, obligations that the company must meet soon, usually within one year. We count liquidity ratio by dividing value of current assets and current liabilities, and it would look like this  139. 1 million / 224. 7 million =  619. 047. (J. Robertson and W. Mills, 2000), (Appendix 2). Anything the firm owns or has title to are assets. Net assets are: Net Assets = Total Assets – Total Liabilities. We use the net assets to measure value of the business, the value of everything the business owns after all the debts have been taken account of.

Net assets of Merlin Entertainment Company are  481. 6 million =2,030. 5 million –  1,548. 9 million. in 2009 while in 2008 net assets were 476. 6 million excluding non-current shareholders loans. After the shareholders loan which is 481. 6 million and non-current shareholder loans net liabilities and total equity are  114. 3 million. Equity capital represents invested money which is not repaid to the investors in the normal course of business, it is the risk capital stalked by the owners through a purchase of the firm’s common stock (J. Robertson and W. Mills, 2000),(Appendix 2).

Strengths

• UK’s largest full service scheduled airline – this makes it a popular company with customers which brings in more business which will then bring in more money for the company.
• Caribbean routes are new and selling well – as they are selling well, the sales will be up on the flights which will bring in more money and more popularity with the customers which will then mean more and more people will use the company rather than their rivals which will then bring in more money and make rival companies miss out on money
• Head office is situated near Gatwick which is convenient – it is convenient because customers and/or staff will easily be able to get there if they need to as it is situated near the company’s main working airport and not in the middle of nowhere or in a different country.
• This means that any problems can be sorted out quicker as people don’t need to travel to the head office if it was situated anywhere else
• Pilots are well paid and tend to stay – the company are then able to keep flights on schedule which will keep the customers happy and wanting to fly with them
• Half of the Airbus and Embraer fleet has been bought new in 2002 which is good for passenger confidence – passengers will have confidence in the technology of the planes and trust them not to fail which will keep them happy and wanting to fly with them
• Passenger growth was up 16% from 2003 to 2004 with over 8 million passengers per year carried – more passengers means that the company is making more money and also means more passengers are using this company rather than rival companies

Awards won

• Business Airline 2002: What Airline?
• Best European Carrier: Passenger News
• Top Airline Cuisine 2003: The Flying Chef (Sunday Times column) – with these awards won, the company will have popularity as the best for these features and will keep customers wanting to travel with the company and make new customers from rival companies

Kestrel Air uses travel agents to sell its products – this makes it easier as travel agents are good at selling products

Has its own reservations department at head office and a website where customers can book online – customers will find it easier to book flights so the company can sell more flights easier and quicker. Also less staff will be needed so money can be saved in their wages

New features

• Participates in the Pet Travel scheme
• Telemedicine service on all flights
• Laptop plug in and telephone service in business class
• Self check in at Heathrow and Gatwick – all these features give passengers more reason to use this company rather than others if the others don’t already have the features

Weaknesses

• Operation slots are very expensive and difficult to acquire – as they are difficult to acquire, it will be hard for the company to get enough of them as they need, but even if some do become available, they will be expensive to purchase so the profits will be used to buy them
• Failed to gain permission to operate on the lucrative Heathrow/US routes – because these routes are unavailable to the company, they are losing out on money from the tickets that would be purchased by customers therefore customers would use rival companies to get to these destinations
• No eastern European routes are operated as yet – because these routes are not operated yet, the company is losing out on money from the tickets that would be purchased by customers, therefore customers would use rival companies to get to the destinations
• Being situated near Gatwick is expensive in rents and rates – the rent and rates will bring down the profit that the company will make
• Cabin Crew have created some bad press locally – if this carries on, the customers will stop using the company and use one of its rival companies
• Pilots are only qualified to fly particular aircraft – other pilots will need to be brought in that are trained to fly other aircraft, so more wages and training will need to be paid out that will reduce the profits
• There are no pilots who can fly all the different aircraft in the company fleet – other pilots will need to be brought in that are trained to fly other aircraft, so more wages and training will need to be paid out that will reduce the profits
• The airline employs its own ground crew and baggage handlers and finds it difficult to recruit enough people – this means that jobs will take longer to do so there will be a longer wait for departures and arrivals at the airports which will upset customers and may tempt them to use rival companies
• The capacity of each aircraft is different so it is ot possible to switch aircraft from route to route – if a problem occurs with one particular aircraft and makes it dangerous to fly, it will have to stop and passengers will have a big delay as they all won’t fit on any of the other aircraft available at that particular time. Customers will become unhappy with the company and may use rivals from then on
• Because half of the Airbus and Embraer fleet has been bought new in 2002, it has been a major expense – as it has been a big expense, there is a massive drop in the profits that the company are making so there is less money to spend on other things, although the money has been spent well

Opportunities

• The airline would like to expand operations from Heathrow – with more operations the company would bring in more money which will add to the profits.
• Considering becoming a member of Star Alliance Considering new measures including sponsorship and developing a relationship with educational establishments – these opportunities will increase the company’s reputation with the establishments and also bring in more money towards the profit that they are making
• Kestrel Air may decide to contract out ground crew and baggage handlers – this means the company will bring in more people that are capable of doing the job quicker to make sure arrival and departure times are kept
• Kestrel Air hope to consolidate the type of aircraft in the future to cut back operating costs and cut pilot training costs – this will save the company money which will add to the profits

Threats

• Germanic Air has substantial debts and likely to sell its shares (22%) – as 22% is owned by the Germanic’s there will be a massive whole in the shareholders which will cause disruption to the way the company is run. This may result in loss of money and disruptions in the way staff are paid. Staff could go on strike leaving the customers to use rival companies
• The turnover of Cabin Crew is high
• Training for the Cabin Crew is constant – if the training is constant, then oney is always being paid out to fund it which will keep profits down and will waste money as they keep bringing in new staff that need training
• Many airlines consolidate the type of aircraft in order to save on operating and engineering costs – as other companies are doing this, they will save money unlike Kestrel Airways, and they may become under threat with their finances and rival companies will take control of the percentage of people using airlines
• Profits are going down so costs are getting higher as they are making about the same amount each year – if this carries on then the company will start to lose money each year and the company will start to become unsuccessful Political Failed to gain permission to operate on the lucrative Heathrow/US routes because of a restriction arising from the Bermuda 2 treaty – the US are wanting the routes so therefore Britain are having to agree and not make the money from them
• Taxes on fuel etc – as taxes are going up, more money is being spent than what is coming in so therefore the company will end up losing money

Economical

• The World is currently in a recession – more people are not travelling abroad because they can’t afford it so instead they are taking holidays in Britain or not at all
• Germanic Air is an ailing airline with substantial debts and is likely to sell its shares (22%) – as the German company own a large percentage, there will be a massive hole in the shares, which will disrupt the way the company is run and may become bankrupt
• Taxes on fuel etc – as taxes are going up, more money is being spent than what is coming in so therefore the company will end up losing money Social The Euro is too high – as of this, people are avoiding flying to European destinations as it would be cheaper to go to long haul destinations such as the Caribbean because of the currency over there is cheaper
• People are choosing different destinations each year – as of this, Kestrel Air need to keep up on what are the most popular holiday destinations, whether they are long haul or short haul and get flights to the destinations so that customers don’t use other companies
• Cabin crew have recently created some bad press and exacerbated the problem of recruitment – as many people are not recruiting, the company aren’t getting in enough people as they need to do jobs so jobs will be running slower than normal which can cause disruption with the way the company is run which will affect departure times, therefore customers will become unhappy and start using rival airlines

Technological

• Half of the Airbus and Embraer fleet has been bought new in 2002 – all the new planes will have new, trusted technology in them that was better than the previous planes which will gain customer confidence and make them want to travel with the company
• Kestrel Air has its own website where customers are able to book online – this will be easier for customers that are wanting tickets as they don’t need to leave their homes in order to book a flight, it can be done quickly, easily and securely over the internet
• Full body scanners – these are all located at the airports to check people for weapons, bombs etc to stop terrorism. The scanners add safety and comfort to the passengers because they know that anybody will be caught that has suspicious items
• Self check in at airports – this means that as soon as customers arrive at the airports, they can check themselves in which will be quicker and easier for them, which will reduce queue’s and late departures

Efficiency Ratios

The efficiency ratio is an indicator of how well Johnson and Johnson (J&J) is run on an organizational-wide basis. Efficiency ratios are also defined as asset turnover ratios (Finkler, Kovner & Jones, 2007). The asset turnover ratio measures how productive J&J is in managing all of its assets to generate sales. This efficiency ratio is calculated by dividing sales by total assets by total revenue. For year. 2010, J&J had an asset turnover of 0. 6. Comparing J&J’s asset ratio to the industry, it is the same (Key Financial Ratios: Financial Results – Johnson & Johnson, 2011). Thus J&J is as efficient in the use of its assets as its healthcare competitors in the industry.

Revenue to assets = Total revenue. Total assets.

Total revenue of $61,587. 0= 0. 598 or 0. 6

Asset turnover Total assets $102,908. 0.

The days’ receivables ratio is calculated by dividing the accounts receivable by the revenue per day. The days’ receivables will indicate how long, on average, it takes for J&J to collect on its sales to customers on credit. This ratio is also known as the average collection period (ACP). The shorter the collection period, the sooner the organization can pay bills or invest to earn interest (Finkler, Kovner & Jones, 2007). A short ACP is more efficient for the organization. J&J had an ACP of 58 days in 2010. This is a slight increase from the previous year’s ACP of 57 days.

Revenue per day = Total revenue 365$61,857. 0 = $168. 731 365 days.

Day’s receivable = Accounts receivable

Revenue per day AR $9774. 0 = 57. 92 days DR $168. 731/day|.

Reference

1. Key financial ratios: financial results – johnson & johnson. (2011).
2. Retrieved from http://moneycentral. msn. com/investor/invsub/results/compare. asp?Page=ManagementEfficiency&symbol=JNJ

FIN 4414 – Financial Management – Spring 2009 “Arundel” Case Assignment Due: March 23, 2009 Case: “Arundel Partners: The Sequel Project,” HBS, Case # 9-292-140, Revised 12/92. Main Question: Is $2million per movie a fair price? Why or why not? Additional Questions 1. Provide a brief overview of the proposed venture. Clearly describe the relevant time line. 2. Why do the proponents of this venture believe that Arundel Partners can make money buying movie sequel rights? Why do they propose buying a portfolio of rights rather than negotiating the purchase price on a film-by-film basis?

Why do they propose to purchase the sequel rights at t=0 (before the first film is released) rather than at t=1? 3. Assuming a discount rate of 12% (risk free rate of 6% and a risk premium of 6%) calculate the NPV for all the sequels. Use the expected negative costs and the expected revenues given in Table 7. 4. Using the “decision-tree” approach, calculate the per-movie value of the sequel rights to the entire portfolio of 99 movies released in 1989 by the six major studios. . Assume that a maximum of ten sequels can be made in any given year. Using the same decision-tree approach, what would you estimate to be the per-movie value of the sequel rights to the entire portfolio of 99 movies released in 1989 by the six major studios? 6. Using the Black-Scholes approach, calculate the per-movie value of the sequel rights to the entire portfolio of 99 movies released in 1989 by the six major studios. Assume once again that there is no maximum to the number of sequels that can be made in a given year). You must provide details of how you estimated the inputs to the B-S formula. a. Asset value b. Exercise price c. Volatility of asset returns d. Time to maturity e. Risk-free rate HINT: Note that the time to maturity of the options is when uncertainty is resolved not necessarily when the sequel is made. The asset value is what you will get if you exercised the option to make the sequel.

Again use average values for all the sequels. Similarly use the average value of the cost to make the sequels for the exercise price. Estimating standard deviation is a little trickier. Note that you do not have past information on returns to each sequel to estimate volatility for a sequel. However, you have information on a portfolio of sequels and you know the returns to these sequels and you could use these to estimate a standard deviation based on a cross-section of returns (DO NOT USE PRICE LEVELS).

Also the standard deviation should be based on all 99 sequels – that is it should be based on the entire distribution. 7. Carry out a sensitivity analysis of the value of the option to the values of the underlying asset, exercise price, and volatility. 8. What problems or disagreements would you expect Arundel and a major studio to encounter in the course of a relationship like the one described in the case? What contractual terms and provisions should Arundel insist on?

Weighted average cost of capital measures the current opportunity cost of capital- what is required return for each dollar lent to the company? To estimate Disney’s weighted average cost of capital (WACC) we need a cost of debt and a cost of equity. Cost of Debt Although the cost of debt can be found on the 10-K, since Disney relies on several different types of debt, we can make an estimate of the cost of debt by looking at its long-term debt rating (in 2007 they were rated A2 which is an upper medium grade rating). Disney’s debt rating corresponds to a debt cost of about 5%. The after-tax cost of debt equals 4.33% multiplied by 65%, or 2.8%.

Cost of Equity

Cost of equity is implicit, so there are several methods for calculating it, including the CAPM. The capital asset pricing model is a traditional method in which the expected return is a function the presumed risk of the stock as implied by the equity’s beta. A higher beta implies greater risk which, in turn, increases the expected return – and the expected return is the same as the cost of equity. (Expected return is simply the view from the investor’s perspective while cost of capital is the same number from the company’s perspective.) Cost of Equity = Risk-Free Rate + (Beta x Equity Premium)

If Disney’s beta is 1.17, and if we take the equity premium to be the same as the T-bonds risk free rate, then by using the CAPM formula, we add 5.8% (a 4.94% equity premium x 1.17 beta) to a risk-free rate of 2.0% for a total estimate for Disney’s cost of equity capital of 7.8%. The Weighted Average Cost of Capital To calculate the WACC we now need to multiply the cost of debt and equity by their respective proportions of invested capital, and add these results. On Disney’s 2009 balance sheet, long-term debt plus short-term debt plus other liabilities equals $29.383 billion. The market value of the equity (market capitalization) is $70.25 billion. Debt is therefore 29.5% of invested capital and equity is 70.5%. Now we multiply each type of cost of capital by its respective proportion of total capital and then we add the two weighted costs together to arrive at WACC.

Cost Share of Capital Weighted Cost 2.8% 29.5% = 0.83% 7.8% 70.5% = 5.48% WACC = 6.31% The WACC is an Investment Tool used by Securities analysts when valuing and selecting investments. WACC is sometimes used as the discount rate applied to future cash flows for deriving a business’s net present value. It represents the minimum rate of return at which a company produces value for its investors.

In Disney’s case, in 2009 it has a ROE of 9.8% and a WACC of 6.31%. This means that for every dollar the company invests into capital, the company is creating 3 cents of value. Under the equity valuation assumptions, the forecasted ROE is 12.65%, which would mean 6 cents per dollar invested. If on the contrary, the company’s return was less than WACC, this would indicate that investors should put their money elsewhere.

The average investor generally does not go through the trouble of calculating WACC yet it serves as a useful reality check for investors when they see it in brokerage analysts’ reports. DCF Free Cash Flow To Equity is a measure of how much cash can be paid to the equity shareholders of the company after all expenses, reinvestment and debt repayment. FCFE is often used by analysts in an attempt to determine the value of a company. This method of valuation gained popularity as the dividend discount model’s usefulness became increasingly questionable. It uses a Discounted Cash Flow based on forecasted Return on Equity. The WACC is also sometimes used as the discount rate to calculate the FCFE.

If the expected rate of return is higher than your required rate of return then stock is undervalued for you. Otherwise, if expected rate of return is lower than your required rate of return then stock is overvalued for you. In this Disney’s case the forecasted rate of return on equity for 2011 is 12.65%, and the expected rate of return implied by market price of common stock is 9.20%, this means that if we use market price as a basis, then the stock would be undervalued and is a good option to buy.

Discounted Abnormal Earnings & Discounted Abnormal Return on Equity The Discounted Return is a term used to describe the returns generated by a given security or portfolio over a period of time that is different from the expected rate of return. The expected rate of return is the estimated return based on an asset pricing model, using a long run historical average or multiple valuations.

Disney’s Book-To-Market Ratio, which is used to find the value of a company by comparing the book value of a firm to its market value, is 1.9 indicating that the stock is undervalued. An undervalued stock tends to trade at a lower price. Analysts will usually recommend an undervalued stock with a strong buy rating. Abnormal Returns are merely a summary of how the actual returns differ from the predicted return. In 2010, Disney has a 3.3% present value of abnormal return on common equity indicating that is higher than the expected rate of return. In Disney’s case, return forecast throughout the following years is positive.

Sustainable Earnings Sustainable Earnings Sustainable earnings are those that arise from normal business operations in a “normal” economic environment. A firm’s sustainable growth rate is defined as: Sustainable growth rate = ROE x (1 – Dividend payout ratio) This is a rate at which a firm can grow while keeping its profitability and financial policies unchanged. A firm’s return on equity and its dividend payout policy determine the pool of funds available for growth. Results for the Company’s SGR are as follows: 2006 2007 2008 2009 Sustainable Growth Rate 9.0% 13.2% 11.6% 7.9% By comparing to the Historic Values of Key financial Ratios Table (Source: Financial statement data for al publicly traded U.S. companies between 1987 and 2005), we can tell Disney’s trend is above average since the highest ratio was 8.6% in 2003.

Range of Assumptions Stock Option Compensation Expense

The Company awards stock options and restricted stock units to a broad-based group of management and creative personnel each year during the second quarter (the Annual Grant). The Company uses a binomial valuation model which takes into account variables such as volatility, dividend yield, and the risk-free interest rate. The binomial valuation model also considers the expected exercise multiple (the multiple of exercise price to grant price at which exercises are expected to occur on average) and the termination rate (the probability of a vested option being cancelled due to the termination of the option holder) in computing the value of the option. Accordingly, the Company believes that the binomial valuation model should produce a fair value that is representative of the value of an employee option.

Although the initial fair value of stock options is not adjusted after the grant date, changes in the Company’s assumptions may change the value of, and therefore the expense related to, future stock option grants. The assumptions that cause the greatest variation in fair value in the binomial valuation model are the expected volatility and expected exercise multiple. Increases or decreases in either the expected volatility or expected exercise multiple will cause the binomial option value to increase or decrease, respectively.

The volatility assumption considers both historical and implied volatility and may be impacted by the Company’s performance as well as changes in economic and market conditions. See Note 13 to the Consolidated Financial Statements for more detailed information. If the expected volatility of 47% used by the Company during 2009 was increased or decreased by five percentage points (i.e. to 52% or to 42%), the weighted average grant date fair value of our 2009 stock option grants would have increased by 9% or decreased by 7%, respectively.

The expected exercise multiple may be influenced by the Company’s future stock performance, stock price volatility, and employee turnover rates. If the exercise multiple assumption of 1.39 used by the Company during 2009 were increased to 1.6 or decreased to 1.2, the weighted average binomial value of our 2009 stock option grants would have increased by 7% or decreased by 8%, respectively.

Employee Compensation – Retirement Benefits Key assumptions used for the measurement of pension and postretirement medical plans at the beginning of fiscal 2009 were 7.80% for the discount rate, 7.50% for the rate of return on plan assets, and 5.00% for salary increases. Based on this measurement of plan assets and benefit obligations, pension and postretirement medical costs decreased to approximately $214 million for fiscal 2009 compared to $255 million for fiscal 2008. The decrease in pension and postretirement medical expense was primarily due to an increase in the discount rate used to measure the present value of plan obligations.

The Company remeasured plan assets and benefit obligations at October 3, 2009 in accordance with new guidance on accounting for retirement plans. Key assumptions for the measurement at October 3, 2009 were 5.75% for the discount rate, 7.75% for the rate of return on plan assets, and 4.50% for salary increases. Based on the measurement at October 3, 2009, the Company recorded an increase in unrecognized pension and postretirement medical expense, which totals $2.8 billion ($1.8 billion after-tax) as of October 3, 2009.

Pension and Other Benefit Programs Net periodic benefit cost is based on assumptions determined at the prior-year end measurement date. Actuarial assumptions, such as the discount rate, long-term rate of return on plan assets and the healthcare cost trend rate, have a significant effect on the amounts reported for net periodic benefit cost as well as the related benefit obligations.

Discount Rate The assumed discount rate for pension and postretirement medical plans reflects the market rates for high-quality corporate bonds currently available. The Company’s discount rate was determined by considering the average of pension yield curves constructed of a large population of high quality corporate bonds. The resulting discount rate reflects the matching of plan liability cash flows to the yield curves.

The implication of this illegal act committed by Ultras management is committing fraud, so they are ultimately responsible for what happened. They sold automobiles that were fully depreciated on Ultras books to employees to generate an additional $50,000 in foreign currency which is illegal all with in itself.

They also knew the Caribbean country in which they were operating out of has strict laws governing the ranchers of funds to other countries, but an employee still went out of his/her way to smuggle $50,000 of foreign currency out of the Caribbean country so it could be deposited in one of Enormous bank accounts. Management did nothing to stop this employee from smuggling the money out of the country and most likely sanction the action. Enormous and Ultras management does not seem to care about these illegal actions and does not want to take any measures to resolve these Issues In the future, even though they are fully responsible.

B. ) If the CPA firm suspects that Enormous management is Involved In noncompliance (which they are), they should communicate the matter to the next level of authority in the organization. If Enormous next level authority is not cooperating, the firm should obtain their own legal advice from outside of Enormous legal team. Since they have already committed fraud once with this illegal action, the CPA firm should take a deeper look Into Enormous financial records to see If these types of Illegal transactions eave happened In years past.

C. ) I personally would report the Illegal act because It would be unethical not to even though It Is a small amount of money. Not only Is my reputation at stake, but so Is the reputation of my entire CPA firm. If I were to Ill about one companies financial records, I would be Jeopardizing any future business with other clients If I were to get caught. It Is always better to report everything you find In an audit so nothing comes back to negatively Impact you and your firm.