Question

Suppose Company ABC Ltd. is the manufacturer of Refrigerators and this company is counted in top ten companies of Pakistan with high market capitalization and quality production. The company is consistent in generating profits each year, hence its share is considered as an attractive investment for investors. The company has captured major market shares and is very keen about its Going Concern Value, because its management believes that if they will not grow they will liquidate. Why the going concern value is so important for company and they are escaping from liquidation value.

The company is currently focusing to expand its business units therefore it needs extra funds to purchase new assets. The company has already issued both preferred and common stock in the market. You are supposed to calculate value per share of preferred stock, if company is able to sell 18% preferred stock issue at Rs.100 par value and the required rate of return on this investment is 15%.

However the demand of company’s Common stock is increasing day by day in the market. The Company’s financial highlights show that it has announced Rs. 6 dividend on common stock this year. According to investor expectations it would grow at the rate of 5% for next 3 years, then at the rate of 6% for next 3 years and then at the rate of 7% thereafter. If required rate of return of investor is 14%.Calculate the intrinsic value of share.           

The company’s financial analysist has proposed the directors to issue Perpetual Bonds and Coupon Bonds to raise funds instead of taking loan from banks. For this purpose company is also analyzing that if Rs.1000 par value bond with coupon rate of 11% is issued in marker for maturity period of 14 years then what would be the current market price of bond keeping in view that investor’s required rate of return on this bond is 10%. You are supposed to calculate value of this bond and also highlight difference between perpetual bond and coupon bond.

Furthermore another idea is to raise funds by taking long term debt from financing company. The Financing Company requires to pay back loan in equal installments at the beginning of each year. Hence if company avail this option and pays Rs. 10000 at the beginning of each year for the next 8 years to financing firm then what amount will accumulate after 8 years as company’s total debt worth? Assume an interest rate of 15% compounded annually.                              

Answer 1

Going Concern concept assumes that every business or enterprise has a long and indefinite life or existence. According to this company would continue its business activities indefinitely, i.e. for a fairly long period of time and would not be liquidated in the foreseeable future. The company will not liquidate until the law required. If a business or company is not a going concern, it shows that it's going to be liquidate or windup.

Going Concern Value means a company will operate and carried their business activity for the indefinite period and earn profits continuously. It is also termed as " Total Value "

Liquidation Value means sale or liquidate assets to earn or realized Cash.

Going Concern Value is differ from Liquidation Value as in Going concern Continuing operations or business activities can earn profits, which is useful for total value of a company.Generally Going Concern Value is higher than Liquidation Value. The difference of Going Concern Value and Liquidation Value is called Goodwill. If the company's goodwill has value then investors are ready to invest their money in that company.

Liquidation of a going concern can results bad reputation of the company in the market between the invetors.

That's the reason going concern value is so important for company and they are escaping from liquidation value.

value per share of preferred stock = ( Preferred stock price * Dividend rate ) / Rate of return on investment

= ( Rs.100 * 18% ) / 15%

= 18 / 15% = Rs.120

Intrinsic Value of Share is total of Present Value of all future dividends forecasted. Till the time growth rate is different we should calculate dividend each year seperately, and once growth rate is constant we can apply perpetuity formula.

In the question after 6 year growth rate is constant, so we calculate 6 years dividend seperately in below table

year		Dividend* (1+growth rate )	Dividend (in Rs.)
1	D1	6*1.05	6.30
2	D2	6.30*1.05	6.62
3	D3	6.62*1.05	6.95
4	D4	6.95*1.06	7.37
5	D5	7.36*1.06	7.80
6	D6	7.80*1.06	8.27

till 6 year growth rate varies so first we calculate price of share at the end of year 6 from perpetuity formula because after this growth rate is constant.

P₆ = [ D₆ * (1 + g) ] / ( R - g )

D₆ =  Dividend at the end of year 6

P₆ = Value of Share at end of year 6

g = growth rate after 6 year ownwards

R =  Rate of return of investor

= [ 8.27 * (1+0.07) ] / (0.14 - 0.07)

= (8.27 * 1.07) / 0.07

= 8.85 / 0.07 = Rs.126.43

Now we calculate present value of all dividends along with present value of share in 6th year.

year		Dividend	PVIF @ 14%	Present Value
1	D1	6.30	0.8772	5.53
2	D2	6.62	0.7695	5.09
3	D3	6.95	0.6750	4.69
4	D4	7.37	0.5921	4.36
5	D5	7.80	0.5194	4.05
6	D6	8.27	0.4556	3.77
6	P6	126.43	0.4556	57.60
			Total	85.09

Intrinsic value of Share = Rs.85.09

Value of Coupon Bond = present Value of all Coupon till the maturity + Present Value of Maturity Amount

= Coupon Amount * PVIFA ( 10%,14years ) + Maturity Amount * PVIF ( 10%,14year)

= 1000 * 11% * 7.3667 + 1000 * 0.2633

= 110 * 7.3667 + 1000 * 0.2633

= 810.34 + 263.30

= Rs.1,073.64

[ value of PVIFA and PVIF extract from respective tables you can also calculate from following formula]

PVIFA = [ 1 - {1 / ( 1+r )n} ] / r PVIF = 1 + (1+r)ⁿ

PVIFA = present value interest factor of annuity

PVIF = present value interest factor

r = interest rate per period

n = number of periods

Perpetual bond have no maturity period. Interest will be paid forever on agreed rate of interest and time. Investor will receive interest till the holds bond.

In comparison, Coupon Bond has maturity period. Till maturity interest or can say coupon amount paid on agreed period and interest or coupon rate.