Edith Cowan University

FACULTY OF BUSINESS AND LAW

SCHOOL OF ACCOUNTING, FINANCE AND ECONOMICS

Assignment 1
Semester 2, 2011

ECF5220 PRINCIPLES OF FINANCE (BMA)

DUE: Week 8 You are required to attempt the case study Share Valuation which accounts for 15% of the assessment for this unit. The objective of this assignment is to allow you to apply the theories, principles and techniques that you have learned in class to analyse a business situation. The information presented in the case is generally sufficient for you to develop an understanding of the situation. It is important to demonstrate your knowledge of financial concepts and tools in analysing the case. The assignment may be completed individually or in pairs. If you work as a team make sure that both your names and student numbers are shown on the cover page of your finished work. Submission information Assignment 2 is to be submitted to your tutor or lecturer in Week 8. Late submission will attract a penalty as per University guidelines. Grading: Your assignment will be graded on the standard of presentation, good understanding and logical arguments in analysing the problems, and accuracy in deriving the solutions. Extensions: Requests for extensions must be made in writing before the due date. Requests for extensions on the grounds that you have other assignments due at the same time are very unlikely to be granted. Requests for extensions after the due date must be accompanied by a medical certificate. Length: There are no specific word limits. Answers are expected to be literate and coherent. Presentation: Work should be typed in 1.5 line spacing with reasonably wide margins for comments. Formula may be handwritten. Referencing: You must include in-text referencing where appropriate and all assignments should have a bibliography. All referencing should be in accordance with the University Referencing Guide, which is available from the ECU Bookshop or online from the ECU Library homepage.

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Academic Misconduct Edith Cowan University has firm rules governing academic misconduct and there are substantial penalties that can be applied to students who are found in breach of these rules. Academic misconduct includes, but is not limited to: plagiarism; unauthorised collaboration; cheating in examinations; theft of other students work. The university defines academic misconduct as follows: academic misconduct means conduct in relation to any academic work that is dishonest or unfair. cheating plagiarism means conduct in any assessment that is dishonest. means to knowingly or unknowingly present as ones own work the ideas or writings of another without appropriate acknowledgment or referencing This includes, but is not limited to: paraphrasing text without acknowledgment of the source; paraphrasing text inadequately with acknowledgment of the source; copying the text of another students assignment or other students assignments; and copying of visual representations (cartoons, line drawings, photos, paintings and computer programs).

Additionally, any material submitted for assessment purposes must be work that has not been submitted previously, by any person, for any other unit at ECU or elsewhere. A staff member, who has reasonable grounds to believe that a student has committed some form of academic misconduct, will discuss the matter with the student. If some form of academic misconduct has been committed then an appropriate penalty will be applied. The ECU rules and policies governing all academic activities, including misconduct, can be accessed through the ECU website. Learning outcome/s and Graduate Attributes Completing this assignment will help you achieve the following learning outcome/s and ECU Graduate Attributes:
Learning outcomes

Demonstrate an understanding of the principles of financial systems and the time value concept in valuing financial assets. Apply the valuation and corporate concepts to make decisions that maximise value in such areas as capital budgeting, choice of capital structure, dividend policy and current assets management.
Graduate Attributes

Ability to communicate clarity of written and spoken expression, including in public forum, and through appropriate use of technology. Critical appraisal skills planning, organising, problem solving and decision making.

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Case Study
Share Valuation1
Dwayne Stevenson, aged 58, had joined the Pharmacopia Company approximately thirty years ago, as a post-doctoral researcher in the field of immunology. Through his strong work ethic and knowledge of science, he was given share options as part of his remuneration package five years ago. At that time, shares of Pharmacopia (PCU) were trading at $35 per share. The company had annual sales in excess of $5 billion and the sales of earnings growth forecast for the next few years were good. However, PCU suffered a few setbacks about 3 years later. Sales began to suffer and profits began to shrink sending its stock price into a downward spiral. About a year later, when the company was downsizing and cost cutting, Dwayne was offered the option to take early retirement. Part of the retirement package included a significant amount of PCU shares which was trading at $15 at the time. As a result of having exercised share options and his early retirement package, Dwayne had accumulated over 100,000 PCU shares. This caused his investment portfolio to not be well diversified and Dwayne knew that he needed to restructure it. In recent month, the share price of PCU has declined to $12 per share. Dwayne wondered whether he should sell the share or hold it until it reached a better price. Having had very little financial and investment training, Dwayne contacted his broker, Jonathan Price, for some advice. His main question to Jonathan was, How low can it go? Jonathan told him to hold on to the share because his calculations showed that it was significantly undervalued at $12 per share and should rise to about $35 per share in three years. He felt that the company was having temporary regulatory problems and should be able to weather the storm quite well. He said the current intrinsic value of the share, in his opinion, was in the range of $16 $26. Not convinced, Dwayne asked him to explain how he arrived at that range. Jonathan replied that he used alternate forms of the dividend discount model, to which Dwayne responded, Dividend what? Jonathan realised that he would have to give Dwayne an educational presentation on share valuation and set up an appointment for the following week. In preparation for the appointment, Jonathan prepared Table 1 showing the sales, net income, earnings per share (EPS), and dividend per share (DPS) data for the prior 10-year period. In addition, he estimated the firms beta and noted down the risk-free rate, market risk premium, and the expected growth rate of the pharmaceutical industry (shown in Table 2). Jonathan knew that he would have to keep his explanation simple, yet convincing, and expected to be faced with many difficult questions.

This case study was adapted from Case 11: How Low Can It Go? by DeMello, J. (2006), Cases in Finance (2nd ed.), Sydney: Mc-Graw Hill.

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TABLE 1 Pharmacopia Company Key Financial Data for Prior 10-year Period (in $ millions, except EPS, DPS) Year 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Sales 3,400 3,800 4,500 4,700 5,200 5,400 5,800 5,600 5,300 5,500 Net Income 170 190 225 235 260 270 290 280 265 275 EPS 1.70 1.90 2.25 2.35 2.60 2.70 2.90 2.80 2.65 2.75 DPS 0.68 0.76 0.90 0.94 1.04 1.08 1.16 1.12 1.06 1.10

TABLE 2 Systematic Risk, Industry Growth, Interest Rates Beta 30-year Treasury Bond Yield Expected Market Risk Premium Industry Average Growth Rate 0.8 5% 10% 9%

You are required to answer the following questions 1 to 8. Your assignment will be graded based on presentation, good understanding and logical explanation, and accuracy of calculations in solving the problems. The mark allocations for individual questions (including 5 marks for presentation) will total to 100 marks and will be scaled by a factor of 0.15 to produce a mark consistent with 15% weighting in the unit assessment. For numerical questions, students need to show sample workings in deriving the answers to be awarded full marks.

QUESTIONS: 1. How should Jonathan describe the rationale of the dividend discount model (DDM) and demonstrate its use in calculating the justifiable price of PCU share? [12 marks]

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2.

Being a researcher, Dwayne asked Jonathan a key question, How did you estimate the growth rates used in applying the model? Using the data given in Tables 1 and 2 explain how Jonathan should respond. [8 marks] What is the rationale of the required rate of return that Jonathan used and how did he estimate it? [8 marks] What other variation of the DDM can be used and why? asked Dwayne. What should Jonathan response be? [10 marks] Why are you using dividends and not earnings per share, Jonathan? ask Dwayne. What do you think Jonathan would have said? [8 marks] Dwayne wondered whether PCUs preference share would be a better investment than its ordinary share, given that it was paying a dividend of $2.50 and trading at a price of $25. He asked Jonathan to explain to him the various features of preference share, how it differed from ordinary share and the method that could be used for estimating its value. [15 marks] If PCU has an outstanding issue of $1,000-par-value bonds with a 11% coupon interest rate, would it be a better investment than its ordinary share, given that it was paying interest semi-annually, maturing in five years and trading at a price of $1,050. He asked Jonathan to explain to him the various features of corporate bond, how it differed from ordinary and preference shares, and the method that could be used for estimating its value. [20 marks] How did Jonathan derive the intrinsic value of PCU share to be in the range of $16 $26? [Hint: Assume the dividend would grow at current rate for the next five years and thereafter the industry growth rate.] Why did Jonathan think that the PCU share would rise to $35 per share in three years time? Justify your analysis. [14 marks]

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