Small Iinvestment Company Capital Fashion Ltd

Discuss about the Small Iinvestment Company Capital Fashion Ltd.

Based on the required rates of return given for each investment of bind, preference share capital and ordinary share capital, the value of each investment has been calculated using the appropriate valuation models.

Value of a bond = C*(1-(1/ (1+i) ^n))/i + M/ (1+i) ^n

Where:

C = Interest paid on bonds

I = required rate of return

N = number of years to maturity

M = face value

C = 87.5, I = 6%, N = 12 years, M = $1000

Hence,

Value of bond = 87.5* (1-(1/(1.06)^12))/0.06 + 1000/ (1.06) ^12

 Value of the bond of Capital Fashions Ltd. = $1230.56

Value of preference shares = Annual preference share dividend / required rate of return

Annual dividend = $2.5, required rate of return = 7%                                              

Hence,

Value of Agri Credit Ltd. preference shares = 2.5/0.07

= $35.71

Value of Equity = D1 / (RE – g)

Where,

D1  = dividend at the end of year 1

RE  = required rate of return on shares

G = constant growth rate of dividend

Growth rate = (present dividend/past dividend) ^1/n – 1   (where n= no. Of years)

= (3.06/1.49)^1/5 – 1

= 15.4%

D1 = recently paid dividend * growth rate

     = 1.32 *1.15 = $1.52

RE  =  15%

Value of ordinary shares of Southern Cross Electrical Ltd. = 1.52 / (0.15 – 0.154)

                                                                                                = $-380.8

Investment

Value

Price

Difference

Bond

$1230.56

$1314

$-83.44

Preference share

$35.71

$25.5

$10.21

Ordinary share

$-380.82

$36.75

$-417.57

From the above table, we see that the bond is selling at a premium. The returns from a bond are in the form of two cash flows, first one being periodic cash flows in the form of interest till maturity and the second being principal payment at the end of the bond maturity. Both the cash flows are discounted to present to arrive at the value of bond. If the value of bond is less than the market price of bond, it means that the investor will receive an amount less than what he has paid as price for the bond and thus his returns will be low.

The intrinsic value of the preference shares of Agri Credit Ltd. is higher than its current market price. The value of the preference shares has been calculated using the zero growth rate dividend discount model assuming that the dividends paid by the company remain same throughout. According to the model, the value of the stock is equal to the present value of all cash flows discounted by the required rate of return, and here cash flows are in the form of dividends, which has been discounted by the required rate of return of the investor because this is the risk the investor is ready to take for the preference shares. Here, the preference shares are undervalued as they are trading at less than their intrinsic value and hence the price of the shares is expected to rise in the future.

The value of the ordinary shares has been calculated using the dividend discount model. Under the model, the dividend which is the only cash flow is discounted by the required rate of return minus the constant growth rate. This model can be used only when the company operates under steady conditions and it is assumed that the growth rate is going to remain the same forever. Also it is assumed that the growth rate of dividends of the company is the same as its earnings growth rate. For the ordinary shares of Southern Cross Electrical Ltd. the value of the shares is negative and they are currently selling for $36.75 and hence the shares are overvalued.

Depending on the difference in the value of the investment and its current market price, it is recommended that the investor should go ahead with investing in preference shares of Agri Credit Ltd. as they are undervalued and will provide returns equal to more than their expectations since the prices are expected to increase in the future. Bonds and equity are selling higher than their intrinsic values which means the investor will not be able to obtain his required rate of return at the current market prices of shares and bonds. Moreover, the required rate of return for equity is less than its dividend growth rate, hence it is not advisable to invest in equity.

Current Trends and Future Prospects of the Industries

Apparel Retail Industry

Currently the apparel retail industry was driven by high competition, cautious consumer spending due to economic uncertainty in the past few years which affected the revenue and profits of the industry.  However, with the advent of ecommerce, online selling has increased at a great speed and is offering high levels of revenue and profits to the companies. The industry is expected to grow at a rate of 3.3% (IBISworld, 2016) over the next five years as a result of increase online selling and improved economic conditions. Moreover, many international companies are entering the retail market and as such competition has forced the domestic players to increase their offerings and also their establishments. (Euromonitor, 2016)

Financial Services Provider

Australia has one of the most sophisticated and developed financial markets and is well regulated. The main expertise lies in superannuation and funds management. (FSC, 2014). This industry is the largest contributor of income in Australia (more than mining and manufacturing) with well educated professionals working in the industry.

The industry is expected to grow at a faster rate in the future with technological innovations taking place where most of the transactions can be done online and new services can be provided faster and in an easy manner through FinTech firms. (treasury.gov.au, 2016) Exports of investment services will also play a major role in enhancing the growth rate of this sector. (austrade.gov.au, 2016)

Electrical Appliance Industry

Australians have a busy lifestyle and hence require appliances which reduce their efforts in everyday tasks. Hence, demand for appliances is high in Australia with the consumers being acceptable to premium pricing for highly designed products. This has led to a value growth in the appliances industry. The industry is highly competitive with many fragmented players and emerging presence of foreign players especially China has made the industry even more competitive.

The appliance industry is expected to grow at a positive rate due to increasing rates of water and energy which will compel the manufacturers to increase the efficiency level of appliances and with sophisticated lifestyle and easy availability of products through online selling, the industry is expected to grow. (euromonitor, 2016)

New growth rate = 15.4% – 3%

                                    = 12.4%

Value of Equity = 1.48 / (0.15 – 0.124)

                        = $57. 06

Investment

Value

Price

Difference

Bond

$1230.56

$1314

$-83.44

Preference share

$35.71

$25.5

$10.21

Ordinary share

$57.06

$36.75

$20.31

With a decrease in the growth rate by 3%, the intrinsic value of the ordinary shares will increase and will be above the current selling price of the shares, which renders the shares undervalued.

 From the above table, we see that preference shares and ordinary shares have intrinsic value more than their market value; however, the ordinary shares have a higher intrinsic value as compared to preference shares and thus are is more profitable. It is recommended that the investor should invest his money in ordinary shares as they are the least expensive and the value is expected to rise in the future. Moreover, the ordinary shares will give higher return than preference shares.

Required rates of return which will make the recommendation indifferent to all three options:

Required rate of return for bond = (C + (F – P)/n) / (F+P)/2

                                                    = 87.5 + (1000-1314)/12) / (1000+1314)/2

                                                    = 5.3%

Required rate of return on preference shares = D/ P

                                                                         = 2.5 / 25.5

                                                                        = 9.8%

Required rate of return on ordinary shares = D1 / p + g

                                                                        = 1.52 / 36.75 + 0.154

                                                                        = 19.6%

At the above expected rates of return calculated for each investment, the recommendation will be indifferent because at this rate the value of the investment is same as the price at which the instrument is currently trading. Hence we can say that the instruments are neither undervalued nor over valued and are correctly priced and the market is efficient. In an efficient market, there are no gainers as everybody has the same amount of information and the stock prices reflect the true value of the instrument, thus an investor may choose to invest in any instrument since market prices reflect their true intrinsic value.

References

IBISWorld, (2016), ‘Clothing Retailing in Australia: Market Research Report, retrieved from http://www.ibisworld.com.au/industry/default.aspx?indid=407

Euromonitor, (2016), Apparel and Footwear in Australia, retrieved from, http://www.euromonitor.com/apparel-and-footwear-in-australia/report

Euromonitor, (2016), ‘Consumer Appliances in Australia’, retrieved from, http://www.euromonitor.com/consumer-appliances-in-australia/report

FSC, (2014), ‘Financial Services is Now Australia’s Largest Industry’, Media Release, Sydney, Financial Services Council

Treasury.gov.au, (2016), ‘The Strength of Australia’s Financial Sector’, retrieved from, http://fintech.treasury.gov.au/the-strength-of-australias-financial-sector/

Austrade.gov.in, (2016), Financial Services: A Sophisticated Hub for the Asia- Pacific, retrieved from  https://www.austrade.gov.au/International/Buy/Australian-industry-capabilities/financial-services

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