Excerpt
Content
List of Figures and Tables
1 Cost of Equity Capital
2 Financial Issues
3 Revenue Forecast
4 Forecast of Earnings and Dividend per Share
5 Call Option Estimation
References
List of Figures and Tables
Figure 1: Rolls-Royce trend forecast
Figure 2: Rolls-Royce combined forecast
Figure 3: Historic EBITDA by revenue of Rolls-Royce
Table 1: Annual GDP growth forecasts, weighted by Rolls-Royce revenue per country
Table 2: Rolls-Royce DVM forecast
Table 3: Rools-Royce option price calculation
Task
Estimate the cost of equity capital for Rolls-Royce plc using the Capital Asset Pricing Model, the Market Derived Pricing Model and the Dividend Valuation Model. You should comment on the potential sources of error in your estimate and discuss the reasons why the three models give different results.
1 Cost of Equity Capital
The cost of equity capital of a company can be calculated in different ways. The most common are:
- Dividend Valuation Model (DVM)
- Capital Asset Pricing Model (CAPM)
- Market Derived Capital Pricing Model (MCPM).
The first, the Dividend Valuation Model, is a very simple yet efficient model based on the discounted cash flow (DCF) calculation using the company’s dividends paid. But, instead of calculating the DCF with a given rate of return we assume that the current share price already incorporates the present value of all future dividends – created by the invisible hand of the market – and rearrange the formula to the implied discount rate ri.
By applying a dividend growth g, derived from historic dividends[1], we can control for inflation and company growth. With a both current dividend d0 of £p 22 and a share price p0 of £p 1,085, the formulas for Rolls-Royce plc (RR) look like DVM[2]:
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The cost of equity capital based on the DVM calculates to 11.21%.
The Capital Asset Pricing Model basically derives the internal rate of return from the market. Therefore, firstly the correlation of the company to the market – the beta – has to be determined. This is done by conducting a regression of the ordinary least squares (OLS) with history market and company values (usually an index and the company’s share price). I used the monthly Rolls-Royce share prices from June 2004 to June 2014[3] and the FTSE ALL-SHARE index[4]. Using an improved version of Ryan’s Very Useful Spreadsheet[5], I calculated an adjusted[6] beta of 1.032.
Then an equity risk premium which controls for the market risk has to be calculated. This means we again use the DCF method, but this time to discount the dividends of the market (i.e. dividend yield of our index[7] ). Again, we assume that the dividends are growing, so we include UK’s real GDP growth GDP Growth real[8] and inflation rates[9] in the forecast. Using the goal seek function Excel calculates the implied market discount rate that discount future dividends to a present value that is equal to the current index price (£ 3,643): 7.94%.
This can now be used with the beta and a risk-free (1 month) interest rate of 0.35%[10] to calculate the CAPM cost of equity capital:
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In contrary to the two previous models the Market Derived Capital Pricing Model does not concentrate on historical data but focuses instead on estimates of future volatility derived from the options market. According to McNulty et. al.,[11] MCPM addresses three kinds of risk investors require compensation for:
- national confiscation risk
- corporate default risk
- equity returns risk
Using the above mentioned spreadsheet I controlled for the national confiscation risk by including the GBP LIBOR rate.[12] Then I calculated the average company’s term to maturity and the average yield on corporate debt by analyzing and weighting Rolls-Royce’s bonds and loans from the 2013 Financial Report’s foot notes.[13]
Finally, to compensate for the equity returns risk I created the company’s option model after Black and Scholes. The required volatility (31 per cent) has been calculating with the volatility estimator using the latest RR share prices – the only look into historic values. The cost of equity capital results in (American put):
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One may now ask where the observed differences come from. First, all these models produce estimates. Despite the decimal places of the results they are everything but exact. The different approaches furthermore use different inputs: from historic share and index prices over historic dividends to current interest rates and company figures. Even if it is the same market and the same company in all calculations – the market is neither reasonable nor transparent or even perfect.
For instance, the risk free rate of only 0.35% is currently extremely low leading to a very low CAPM return rate. On the other hand the assumed RR dividend growth of 9% is quite high resulting in a high DVM return rate respectively. In general DVM can only be used if the analyzed dividend history is typical and is expected to continue in the future. Further, the calculated maturity and debt cost may not be exact as we do not have all the details. The MCPM return rate is quite in the middle.
I would go for suggest a value of around 9 per cent as a reasonable compromise.
Task
On behalf of a potential shareholder you are required to analyse the financial accounts as at year end 31 December 2013 noting the five most important financial issues faced by the company and how they are being resolved by the company.
2 Financial Issues
The financial statements of Rolls-Royce hold some pain points. One is the value of unfunded pension obligations. In 2013 it increased by 65 per cent to £m 935. The total obligations sum up to £m 10,539.[14] The major part is for retired German and US employees (health care and life insurance for the latter[15] ).
Another issue is the huge increase in warranty and guaranties provisions from £m 247 to £m 419 (plus 70 per cent).[16] This could have “a direct impact on the company’s cost structure, thus influencing its profits and margins.”[17]
Furthermore, the development of gas turbines and similar high-tech products require large upfront investments.[18] To do so, Rolls-Royce needs cash and they have plenty of it (£m 3,990). However, the increase mainly derives from an increase in loan.[19]
Investments lead to another issue: the company's Weighted Average Cost of Capital (WACC) of 13 resp. 11 per cent seems to be quite high compared to the values of 8.2 to 11.2 per cent calculated in task 1.[20] This results in the effect that projects with an internal rate of return between just above 9 and 11 per cent would not be realized despite being quite profitable.
Finally, exchange rates generate another financial issue of Rolls-Royce. Due to international clients and the main businesses realized in US Dollar the company has to hedge against losses. However, in 2013, foreign currency contracts generated fair value gains of £m 287.[21]
Task
Forecast the revenues for the next five years for Rolls Royce using the most up to date information available relevant to the company.
3 Revenue Forecast
The five year revenue forecast (2014 to 2018) consists of three independent forecasts:
- a trend forecast,
- a firm forecast, and
- a market forecast.
The trend forecast for Rolls-Royce is based on the historic underlying revenues from 1995 to 2013.[22] The history shows a roughly exponential trend. This gets even more visible after taking out the revenues of Tognum, now Rolls-Royce Power Systems, that lead to a significant and extraordinary increase of revenue in 2013. The historic revenues of Tognum (2007 to 2013[23] ) however show no growth at all and thus have a rather linear trend.
Both trends have been extrapolated until 2018 independently. The sum of both forms the overall trend forecast.
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Figure 1: Rolls-Royce trend forecast
The firm forecast was conducted upon an individual forecast for each strategic business unit. Beside others I paid attention to the sale of the major part of the energy unit which will result in an extraordinary gain in 2014 (sales price) and 2015 (licenses) but to a much lower revenue in future.
The market forecast is derived from GDP forecasts of the countries Rolls-Royce is operating in. I used figures from the International Monetary Fund.[24] The obtained growth rates were further weighted by the 2013 distribution of revenue[25], leading to the following forecast of GDP growth:
Table 1: Annual GDP growth forecasts, weighted by Rolls-Royce revenue per country
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The firm forecast is now aggregated with the market forecast according to the systematic risk (R²0.39) calculated with the beta in task 1. The result is then combined with the trend forecast with a ratio of 1:1. This brings up the combined forecast.[26]
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Figure 2: Rolls-Royce combined forecast
Task
Forecast the earnings per share and dividend per share for Rolls Royce assuming dividends grow at 8% per annum and using the equity cost of capital from task 1. Estimate the equity share value of the company.
4 Forecast of Earnings and Dividend per Share
Based on the forecasted revenues of task 3 we can now derive the earnings before interests, tax, depreciation & amortization (EBITDA) by retrieving a trend from historic values (2003 to 2013). This gives us the following plot:
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Figure 3: Historic EBITDA by revenue of Rolls-Royce
From the so estimated future EBITDAs we can now deduct depreciation and amortization (D&A) and financing costs, and tax. For D&A and finance costs I assumed the ratios of 2013 remain constant. The tax rate was calculated using the tax expenses (£m 380) and the profit before tax (£m 2,019) of the 2013 income statement and the taxation foot note. This brings us to a rate of 18.8 per cent. Applying an annual dividend growth of 8 per cent and the cost of equity capital according to CAPM of 8.2 per cent results in the following earnings and dividends per share:
Table 2: Rolls-Royce DVM forecast
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[1] Stockopedia 2008-2014
[2] Ryan 2007, pp. 152ff
[3] Yahoo! UK & Ireland Finance 2014b
[4] Yahoo! UK & Ireland Finance 2014a
[5] Ryan and Mueller
[6] Adjusted for mean reversion by using Blume’s method.
[7] Financial Times 2014a
[8] UK Office for Budget Responsibility 2014, p. 57
[9] ibid., p. 59
[10] Financial Times 2014c
[11] McNulty et al. 2002, pp. 8f
[12] Financial Times 2014b
[13] Rolls-Royce plc 2014, p. 67
[14] ibid., p. 79
[15] ibid., p. 76
[16] ibid., p. 75
[17] MarketLine 2013, p. 7
[18] Rolls-Royce plc 2014, p. 35
[19] ibid., pp. 41f
[20] ibid., p. 63
[21] ibid., p. 58
[22] Rolls-Royce plc 2005, p. 7, Rolls-Royce plc 2009, p. 2, Rolls-Royce plc 2014, p. 28
[23] Tognum 2011, pp. 192f, Tognum 2013, pp. 196f
[24] International Monetary Fund 2014
[25] Rolls-Royce plc 2014, p. 57
[26] For details see appended spreadsheet