Firms current return on equity is low and we

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firm’s current return on equity is low, and we anticipate that it will improve over the next 5 years. As it increases, earnings growth will be pushed up. n Why FCFE? Corporate governance in China tends to be weak and dividends are unlikely to reflect free cash flow to equity. In addition, the firm consistently funds a portion of its reinvestment needs with new debt issues.
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Aswath Damodaran 18 Background Information n In 2000, Tsingtao Breweries earned 72.36 million CY(Chinese Yuan) in net income on a book value of equity of 2,588 million CY, giving it a return on equity of 2.80%. n The firm had capital expenditures of 335 million CY and depreciation of 204 million CY during the year. n The working capital changes over the last 4 years have been volatile, and we normalize the change using non-cash working capital as a percent of revenues in 1999: Normalized change in non-cash working capital = (Non-cash working capital 1999 / Revenues 1999 ) (Revenuess 1999 – Revenues 1998 ) = (180/2253)*( 2253-1598) = 52.3 million CY Normalized Reinvestment = Capital expenditures – Depreciation + Normalized Change in non-cash working capital = 335 - 204 + 52.3= 183.3 million CY n As with working capital, debt issues have been volatile. We estimate the firm’s book debt to capital ratio of 40.94% at the end of 1999 and use it to estimate the normalized equity reinvestment in 1999.
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Aswath Damodaran 19 Inputs for the 3 Stages High Growth Transition Phase Stable Growth Length 5 years 5 years Forever after yr 10 Beta 0.75 Moves to 0.80 0.80 Risk Premium 4%+2.28% --> 4+0.95% ROE 2.8%->12% 12%->20% 20% Equity Reinv. 149.97% Moves to 50% 50% Expected Growth 44.91% Moves to 10% 10% n We wil asssume that Equity Reinvestment Ratio= Reinvestment (1- Debt Ratio) / Net Income = = 183.3 (1-4094) / 72.36 = 149.97% Expected growth rate- next 5 years = Equity reinvestment rate * ROE New +[(ROE 5 -ROE today )/ROE today ] 1/5 -1 = 1.4997 *.12 + [((.12-.028)/.028) 1/5 -1] = 44.91%
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Aswath Damodaran 20 Tsingtao: Projected Cash Flows Year Expected Growth Net Income Equity Reinvestment Rate FCFE Cost of Equity Present Value Current CY72.36 149.97% 1 44.91% CY104.85 149.97% (CY52.40) 14.71% (CY45.68) 2 44.91% CY151.93 149.97% (CY75.92) 14.71% (CY57.70) 3 44.91% CY220.16 149.97% (CY110.02) 14.71% (CY72.89) 4 44.91% CY319.03 149.97% (CY159.43) 14.71% (CY92.08) 5 44.91% CY462.29 149.97% (CY231.02) 14.71% (CY116.32) 6 37.93% CY637.61 129.98% (CY191.14) 14.56% (CY84.01) 7 30.94% CY834.92 109.98% (CY83.35) 14.41% (CY32.02) 8 23.96% CY1,034.98 89.99% CY103.61 14.26% CY34.83 9 16.98% CY1,210.74 69.99% CY363.29 14.11% CY107.04 10 10.00% CY1,331.81 50.00% CY665.91 13.96% CY172.16 Sum of the present values of FCFE during high growth = ($186.65)
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Aswath Damodaran 21 Tsingtao: Terminal Value n Expected stable growth rate =10% n Equity reinvestment rate in stable growth = 50% n Cost of equity in stable growth = 13.96% n Expected FCFE in year 11 = Net Income 11 *(1- Stable period equity reinvestment rate) = CY 1331.81 (1.10)(1-.5) = CY 732.50 million n Terminal Value of equity in Tsingtao Breweries = FCFE 11 /(Stable period cost of equity – Stable growth rate) = 732.5/(.1396-.10) = CY 18,497 million
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Aswath Damodaran 22 Tsingtao: Valuation n Value of Equity = PV of FCFE during the high growth period + PV of terminal value =-CY186.65+CY18,497/(1.1471 5 *1.1456*1.1441*1.1426*1.1411*1.1396) = CY 4,596 million n Value of Equity per share = Value of Equity/ Number of Shares = CY 4,596/653.15 = CY 7.04 per share n The stock was trading at 10.10 Yuan per share, which would make it overvalued, based upon this valuation.
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