Company Background
ABC Corporation, owned by the Finance Ministry, operates the country’s weekly lottery with an indefinite license and tax-free status. Its annual net profit of $300 million has remained stable, with a required return of 10%. To boost counter sales, directors plan to raise gaming payouts in three years, expecting 5% annual profit growth starting in year four. However, if sales do not increase, profits may decline, leading analysts to apply a 2% risk premium.
Estimating the Current Value of ABC Corporation (Without Gaming Payout Changes)
The most appropriate method for valuating the ABC company given the data is the capitalized earnings method. The idea behind the system is to turn future earning of a company in to capital. The approach is based on evaluating the price of a company by estimating the expected future earnings. According to Scott (2020), the approach to valuation is most appropriate when a company has a history of stable earnings for a prolonged time period. Since the ABC corporation has had a regular estimated income of $300,000,000 per year, the capitalized earnings method is the most appropriate for valuing it.
In order to valuate a firm using the method, annual net earnings need to be divided by the discount rate. A discount rate, or a capitalization rate, is a rate of return required by an investor to accept an investment opportunity (Hayes, 2023). According to Scott (2020), risk free rate is often used as the discount rate for a company, which is usually a Treasury bond annual yield. However, every investor may have its own accepted rate of return based on the situation. In the scenario, the rate of return is given to be 10%. Thus, the price of the corporation can be estimated as follows:
Value = Annual Income / Discount Rate = 300,000,000 / 0.1 = $3,000,000,000
Thus, the estimated value of the corporation is $3 billion.
Estimating the Value of ABC Corporation (With Gaming Payout Changes)
If a company changes the strategy to increase the expected income by 5% with increased risk by 2%, perpetual growth Discounted Cash Flow (DCF) model can be used to valuate the terminal value of a company. The DCF method focuses on determining the net present value of a firm based on the company’s future free cash flow (Boyle, 2022). In order to estimate the value of the ABC company, the value at the end of Year 3 needs to be calculated and the discounted to the current money. Thus, the formula is the following:
Value at end of Year 3 = Year 4 Cash flow / (Discount rate – Growth rate)
There are three assumptions that need to be made. First, the cash flow is assumed to the ne income, which is currently $300 million. Second, at the start of Year 4, since the payouts are expected to grow, the cash flow will increase by 5%, which will make it $315 million. Finally, the new discount rate is 12%, as the risks increased by 2% from the original 10%. Thus, the value at end of Year 3 can be calculated the following way:
Value at end of Year 3 = Year 4 Cash flow / (Discount rate – Growth rate) = 300,000,000 / 0.12 – 0.05
Now, the DCF model will be used to value the firm. The following calculations can be used to estimate the value of the corporation:
Business value = 4,500,000,000 / (1 + 0.12)3 = $3,203,011,115.16
Thus, it can be stated that the current business value increases if the company chooses to utilize the new strategy.
Privatization and Share Sale Impact
If the government privatizes ABC Corporation through tender sale of 1 billion shares of the company, the highest bid price per share would be the total value of the company divided by the number of shares. The highest price per share can be calculated by dividing the value of the company by the number of shares. The value of the company was estimated to be $3,203,011,115.16 in Part 2, and the number of shares is 1 billion. Thus, the fair share price can be calculated as follows:
Price per share = Company Value / Number of shares = 3,203,011,115.16 / 1,000,000,000 = $3.2 per share
A forward price-earnings (P/E) ratio as a proxy to calculate the maximum bid per share can be used. In order to calculate that, it is necessary to know the price-to-earnings (P/E) ratio of a suitable company and the earnings per share (EPS) of the ABC corporation. The current company’s EPS is can be calculated be dividing the current net earnings ($300 million) by the number of shares (1 billion). Thus, the EPS is currently $0.3. At the same time, the P/E ratio of Genting Singapore Limited is 21.25 (Yahoo Finance, 2023). Thus, the maximum bid can be calculated as follows:
Highest Bid = Forward P/E Ratio * Estimated Future Earnings per Share = 21.25 * 0.3 = 6.375 ≈ $6.38 per share
References
Boyle, M. (2022). Calculating Terminal Value: Perpetuity Growth Model vs. Exit Approach. Investopedia. Web.
Hayes, A. (2023). Discount Rate Defined: How It’s Used by the Fed and in Cash-Flow Analysis. Investopedia. Web.
Scott, G. (2020). Capitalization of Earnings: Definition, Uses and Rate Calculation. Investopedia. Web.
Yahoo Finance. (2023). Genting Singapore Limited. Web.