Tesco Case Study Solutions PDF

Preview

Summary

Case study solutions...

Description

IB114 Financial Management

_________________________ Valuing Tesco shares - Solution Q1. Use the Capital Asset Pricing Model to estimate Tesco’s cost of equity RE. The Capital Asset Pricing Model (or CAPM, for short) relates a company’s cost of equity RE to the company’s equity beta,  and to two macro-economic variables viz. the risk-free rate and the market risk premium: R

E

 risk  free rate  (equity beta )  (market risk premium)

The risk-free rate can be approximated by the return on 3-month UK Treasury bills. This information can be found in the Financial Times. Assume a value of 6% per annum. [The T-bill rate published in the FT of 24 April 2008 was actually 5.85%]. The market risk premium measures how much the return on the stock market is expected to exceed the return on the risk-free asset over the long term. Assume a value of 4% per annum. Equity betas can be obtained e.g. from Datastream. Assume a value of 0.9. The CAPM then implies Tesco’s (after-tax) cost of equity RE equals: R

E

 6%  0.9  4%  9.6%

Q2a. Calculate the compound average rate of growth of Tesco’s dividend per share over the period 2002-2008. Tesco’s dividend (in pence) per share over the period 2002-2007 was: 2003 6.20

2004 6.84

2005 7.56

2006 8.63

2007 9.64

2008 10.90

Source: Tesco Annual Reports, 2003-2008 The compound average growth rate G in the dividend per share over the period 2003-2008 is given by the solution to the equation:

6.20  (1  G) 5  10.90 i.e. G  12%

IB1140 Financial Management Q2b. Assuming that this compound average growth rate continues for the next five years, calculate the projected dividend per share for each of the next five years. Assuming the growth rate remains at 12% per annum for each of the next five years, dividends (in pence) per share are projected to grow as follows: 2009 12.21

2010 13.67

2011 15.31

2012 17.15

2013 19.21

Q2c. Using the cost of equity RE obtained in part (a), calculate the present value of the stream of dividends per share that is forecast for the next five years. The forecast dividends per share over the next five years form a 5-year growing annuity, with present value:

12.21 0.096 - 0.12

  1+ 0.12  5   1 -    = 58.18   1+ 0.096  

where we have used the company’s cost of equity capital RE = 9.6% as the discount rate. Q3a. Calculate the projected dividend per share six years from now, assuming that the growth rate in Year 6 is one-half the growth rate of Years 1-5. The projected dividend (in pence) per share six years from now equals:

D6  D 5  (1 0.06)  19.21  1.06  20.36 Q3b. Use the Gordon growth model to calculate the present value of the stream of expected dividends per share that starts six years from now. The value five years from now of the stream of expected future dividends per share that starts at the end of Year 6 and grows indefinitely thereafter at a rate of 6% per annum is: D6 R G

20.36  565.56 0.096  0.06



E

We need to discount this value back to the present day, using Tesco’s cost of equity RE:

1 (1  R ) 5 E



D6 R G E



1 (1  0.096) 5

 565.56  357.62

Q4. Deduce the fair value of one Tesco share on the xd date, 23 April 2008. Our estimate of the fair value for Tesco’s shares is therefore P0 = 58.18 + 357.62 = 415.80 Compare this with Tesco’s actual share price of 410.50 pence on 23 April 2008. 2...