Bus5Iaf Introduction To Accounting And Assessment Answers
The purpose of these questions is to require you to demonstrate your ability to conduct research into real companies, their operations and events affecting those companies. You should demonstrate your ability to interpret data, summarise your findings and to communicate your views in a report. The emphasis is on explaining the financial management of the company, as revealed in the accounting reports, and also to place those reports within the wider economic context.
(I) Debt Valuation
- What are the short-term and long-term debts used by your firm?
- Is your company’s debt structure consistent with the industry?
- How does the industry your company operates in influence the proportion of short-term to long-term debts of your company?
- What is your company’s the cost of debt?
(II) Share Valuation
- What is your company’s cost of equity?
- Evaluate and discuss your company’s revenue, earnings, EPS, dividends and growth expectations. Use the most recent reported earnings results from the annual report you submitted in PART A for your analysis.
- Value your company’s stock using comparables approach (ie. P/E) and constant dividend growth rate model. What are the factors that influence your company’s stock price and how are they captured in these models?
- Which of the values in question 3 appear most reasonable compared to the market price of your company’s stock?
- What additional data and information would you prefer for valuing your company’s stocks? Explain your reason(s).
(III) Cost of Capital
- Calculate the weighted average cost of capital (WACC) of your company?
- Explain the company’s tax rate in the calculation of WACC?
- Why is there a difference in the cost of debt and the cost of equity?
- Should current liabilities be included in the cost of capital calculation? What are the pros and cons?
- What is the major value of the WACC calculation for your company and how is it applied in investment decision-making?
- Provide examples of how your company might have recently used WACC in its investment decision-making with reference to two projects recently undertaken by your company. You may need to synthesize information from your readings (ie. Annual reports, GPFS etc.) to identify the projects.
- Define and explain capital structure of your company. Discuss whether it is consistent with the industry and why or why not.
- What is the optimal capital structure and what economic circumstances will likely cause a change in it?
(IV) Market Analysis
- Comment on your chosen company’s financial performance relative to its industry. You will have to investigate your company’s industry using sources such as Bureau of Statistics, industry journals/publications, analysis in financial press, IBISWorld etc.
- Conduct a literature search on your company. Summarise and explain how your company is being viewed by financial analysts and others in the press (or has been viewed over recent years, as appropriate to your company). Do you agree with the comments? Why/why not? Explain.
- Comment on any other item that is important or different about your company (that is relevant to the topics in this course).
Answer:
This report is analysis of financial management and strength of Alliance Aviation Services which is listed on Australian Stock Exchange under the code of AQZ. Alliance Aviation Services operate in airline industry and hold major portion of charter market. This report is divided into four major sections which are Debt Valuation, Share Valuation, Cost of Capital and Market Analysis. Debt valuation section will include short and long term debt analysis and cost of capital. Share valuation will contain analysis of stock of Alliance Aviation through comparative technique and dividend discount model. Cost of capital section will include discussion of important and calculation of WACC. Market analysis section will include the opinion of financial analysts about performance of Alliance Aviation Services.
Debt Valuation.I.1:
Alliance Aviation Services use debt finances for expansion and growth purposes. Debt used by Alliance Aviation Services can be divided into short and long term debt. Short term debt of Alliance Aviation Services includes bank loans and long term debt is also acquired from banks. The primary reason of using bank loan is secure and low cost of financing as compared to the acquiring finance from public through bonds.
Debt Valuation.I.2:
Airline industry is pursuing very aggressive growth strategy that increase ratio of debt to total assets. Industry leaders in airline industry borrow as much as 80% of total assets while average debt to equity ratio in airline industry is less than 50%. Qantas and Virgin Airlines are largest airlines in Australia and their debt to equity ratio is significantly higher than industry benchmark. Debt structure of Alliance Aviation Services is very consistent with industry benchmark. Debt ration of Alliance Aviation Services was 53% in 2013, 54% in 2014, 71% in 2015 and 54% in 2016.
Debt Valuation.I.3:
Airline industry in Australia is very competitive and growing that gives birth to higher debt financing. Although debt finances increase risk of bankruptcy but airline industry is highly leveraged. Airline industry significantly influences Alliance Aviation Services to acquire more debt to financing expansion projects. Higher earnings in this industry forces banks to lend money to airline industry and banks perceive lending as safe lending. Technically speaking, short term debt is raised to support day to day operations and acquisition of short term assets while long term borrowing is associated with long life projects. Therefore, airline industry influence Alliance Aviation services to borrow long term basis.
Debt Valuation.I.4:
Cost of debt is cost of borrowing and mainly it is interest rate that is payable each year. Interest rate on borrowing mainly depends on maturity of borrowing and macroeconomic factors in the economy. Alliance Aviation Services borrowings in 2016 are given in table below with interest paid in that is considered as cost of borrowing (Morningstar, 2016). The cost of debt of Alliance Aviation Services is 6.231%.
|
Short Term Borrowing |
11,500,000 |
|
Long Term Borrowing |
68,750,000 |
|
Interest Expense |
5000000 |
|
Cost of Debt |
6.231% |
Share Valuation.II.1:
Cost of equity is cost for raising finance through equity and Capital Asset Pricing Model is used to calculate cost of equity. CAPM approach of calculating cost of equity (Ce or rs) is nearly accurate as compared to other models. In order to calculate Cost of Equity through CAPM, beta (β), Market return (rm) and Risk Free Rate (rf) are required. Beta Coefficient of airline industry is risk of investing in airline industry (Morrell, 2013). Beta (β) of Alliance Aviation Services is risk of investing in its stock which is 0.27 (Reuters, 2017). Yield on 10 year government bonds is usually treated as risk free rate which is 2.78% (Bloomberg, 2017). Market return is same as annualized return on S&P 300 index which is 8.34% (S&P Dow Jones, 2017). Cost of equity of Alliance Aviation Services is calculated below.
Re = rf + β (rm - rf)
= 2.78% + 0.27 (8.34% - 2.78%)
= 2.78% + 0.27 (5.56%)
= 2.78% + 1.50%
Re = 4.28%
Share Valuation.II.2:
Alliance Aviation Services maintained a good history of revenue in past. In 2015 total revenue was 194M in 2016 revenue decreased to AUD 179M. Decrease in revenue in last year caused by increase in fuel prices and competitive price. Although revenue decreased in 2016 but net income was significantly higher than year 2015. Net loss in 2015 was AUD 37M while net income in 2016 was AUD 13M. Loss in 2015 is mainly associated with higher operating expenses of AUD 151M compared to AUD 94M in 2016. In 2016, Alliance Aviation Services achieved operating efficiency through reducing operating expenses. Earnings per share (EPS) in 2015 were AUD -0.34 per share while reached to AUD 0.12 per share in 2016. Alliance Aviation Services maintained a good history of dividend payment and to maintain investor’s confidence in year 2015, management announced dividend of AUD 0.03 per share even though company realized net loss. In 2016, Alliance Aviation Services did not paid dividend due to finance growth and increased retained earnings. As company retained income in 2016 therefore is expected that Alliance Aviation Services will achieve more revenue and income in next year.
Share Valuation.II.3:
Price to Earnings ratio is used by investors to determine the actual value of the stock. P/E ratio is calculated below according to price and earnings in 2016.
Price on 30 June 2016 = AUD 0.5
Earnings Per Share 2016 = AUD 0.12
P/E = 4.17
Valuation of stock through constant dividend growth rate model requires estimation of growth rate in dividend. Although Alliance Aviation Services has a history of dividend payment but we expect that next year dividend will be AUD 0.03 and will grow at a rate of 6% for next year.
D2017 = AUD 0.03
g = 2%
Required rate of return = 4.28%
Intrinsic value of stock = D2017/ (K-g)
Intrinsic value in 2017 = 0.03 / (4.28% - 2%)
Intrinsic value in 2017 = AUD 1.32
Dividends significantly affect the price of stock because it is considered as income from investment. Earnings per share also affect the price of stock which is directly related to stock price because higher earnings per share will increase price of stock.
Share Valuation.II.4:
Constant dividend growth rate model is very accurate in estimating the future intrinsic value of the stock. This model is most reasonable model to compare with the stock price of Alliance Aviation Services.
Share Valuation.II.5:
Share valuation is based on the forecast but accurate data will help to estimate an accurate stock price. For good forecast, information such as management intention, future projects and macroeconomic factors is necessary. This information will help to estimate a true next year dividend and growth rate of dividends.
Cost of Capital.III.1
Weighted average cost of Alliance Aviation Services is calculated below.
Total Debt Vd AUD 80,250,000
Weight of Debt Wd 39%
Cost of debt Kd 6.23%
Tax Rate t 30%
Total Common Stock Vcs AUD 127,000,000
Cost of Common Stock Kcs 4.28%
Weight of Common Stock Wcs 61%
Value of Firm Vf AUD 207,250,000
Solution:
WACC = (Wcs* Kcs) + (Wd * Kd(1-T))
WACC = (61%* 4.28%) + (39% * 6.23% (1-30))
WACC = 4.311%
Formula and Calculation:
WACC = (Wcs* Kcs) + (Wd * Kd(1-T))
WACC = (0.755920814* 9%) + (0.244079186 * 5% (1-62))
=7.658%
Cost of Capital.III.2
Corporate tax rate in Australia is 30% for year 2016-17 (Australian Taxation Office, 2016). While calculating WACC, it is necessary to multiply cost of debt with (1-t) because interest is tax deductible. Debt finance provide tax shield because higher the interest rate lower will be the tax.
Cost of Capital.III.3
Cost of debt is different from cost of equity because they differ in risk. Common stock is risky investment because at the time of bankruptcy, common shareholders have residual claim. Generally cost of equity is higher than cost of debt but for Alliance Aviation Services, cost of equity is lower than debt.
Cost of Capital.III.4
Yes, those currently liabilities that require interest payment must be included in cost of capital because these are used in projects. Current liabilities are also utilized in certain projects and are necessary to paid in short period of time. Considering current liability in cost of capital will give a tough hurdle rate that is will help in evaluating large projects.
Cost of Capital.III.5
Major value of WACC is cost of equity because it is not tax deductible and portion of common equity is higher than debt. As common equity has major value in WACC therefore, management prefers to finance projects with debt financing to achieve a lower cost of capital. Lower cost of capital will increase return on investment.
Cost of Capital.III.6
Alliance Aviation Services use Weighted Average Cost of Capital for evaluation of projects. Alliance Aviation Services use WACC because it helps management to achieve a target return on projects. WACC is calculated according to the average cost of all sources of finances and hence provide accurate results.
Cost of Capital.III.7
Alliance Aviation Services is a profitable organization and its success depends on the effective decisions. Capital structure decisions are very important because they affect the overall profitability of the firm and manage risk. Capital structure of Alliance Aviation Services is very consistent with industry because its capital structure changes according to industry. Alliance Aviation Services is less leveraged as compared to its competitors in the industry. The evidence is that airline industry is highly leveraged so is the Alliance Aviation Services. Given below is the capital structure of Alliance Aviation Services.
|
Debt to equity ration |
83% |
65% |
53% |
53% |
71% |
Cost of Capital.III.8
Optimal capital structure can be defined as capital structure which is less risky and result in lower cost of capital (Miao, 2005). Optimal capital structure differ for each industry and optimal capital structure in airline industry is 50% or below. It is difficult to generalize optimal capital structure for whole industry but researchers are in consensus that optimal capital structure of airline industry is 50%. Demand and cost of different source drive capital structure because higher demand increase operations and management will raise more finances.
Market Analysis.IV.1:
Alliance Aviation Airline is very healthy and growing business. Key performance indicators such as revenue, net income and Return on Invested Capital shows a growth trend. The overall performance of Alliance Aviation Airline is better than its competitors because it has achieved operating efficiency. Alliance Aviation Services Limited is performing better than its competitors in all perspectives. Alliance Aviation Services Limited dominates the charter market in airline industry which is strength of this firm. Higher market share in charter market in airline industry grabs the attention of competitors. According to Freed, Virgin Airline proposed Alliance Aviation Services for partnership in charter market to fight resource shortage (Freed, 2016).
Market Analysis.IV.2:
Alliance Aviation Services is a competitive organization in Australia because it is expecting higher growth in next decade. Although Alliance Aviation is expecting higher growth in next decade while financial analyst showed a great concern regarding high leverage. Alliance Aviation is less leveraged compared to industry leaders but it can lead to tough financial situation in next decade. According to Haas, Alliance Aviation Services can borrow more money because it has a good interest coverage ratio which is as much as 5 times (Haas, 2017).
Market Analysis.IV.3:
Alliance Aviation Services is consistent to industry in every aspect whether it is capital structure or corporate strategies. In competitive business environment every organization must pursue stable growth with focus on risk of management take over. Management take over happen when one shareholder or institution hold more than 50% of total shares issued. Alliance Aviation is following a very safe strategy to avoid management take over. Only 27% of shares are owned by large a shareholder that is evidence that Alliance Aviation Service is secure from management takeover by shareholders (Financial Times, 2017).
References
Australian Taxation Office., 2016. Company tax rates. Australian Taxation Office Official. Data retrieved from https://www.ato.gov.au/Rates/Company-tax/
Bloomberg., 2017. Australian Rates & Bonds. Bloomberg Official. Data retrieved from https://www.bloomberg.com/markets/rates-bonds/government-bonds/australia
Financial Times., 2017. Alliance Aviation Services Limited. Financial Times Official. Data retrieved from https://markets.ft.com/data/equities/tearsheet/profile?s=AQZ:ASX&mhq5j=e7
Freed, J., 2016. Virgin Australia looks to Alliance Aviation deal amid mining downturn. The Sydney Morning Herald. Data retrieved from https://www.smh.com.au/business/aviation/virgin-australia-looks-to-alliance-aviation-deal-amid-mining-downturn-20160429-goid82.html
Haas, A., 2017. How Financially Strong Is Alliance Aviation Services Limited (ASX:AQZ)?. Simply Wall. Data retrieved from https://simplywall.st/news/2017/09/29/how-financially-strong-is-alliance-aviation-services-limited-asxaqz/
Miao, J., 2005. Optimal capital structure and industry dynamics. The Journal of finance, 60(6), pp.2621-2659. Data retrieved from https://people.bu.edu/miaoj/IndustryJF.pdf
Morrell, P.S., 2013. Airline finance. Ashgate Publishing, Ltd. Data retrieved from https://books.google.com.pk/books?hl=en&lr=&id=VszVCQAAQBAJ&oi=fnd&pg=PR9&dq=debt+financing+in+australian+airline+industry&ots=sXaoeG30FQ&sig=C_HlNbLf8oU_aFM5w33adzjmF6s#v=onepage&q=airline%20industry%20debt&f=false
Reuters., 2017. Alliance Aviation Services Ltd (AQZ.AX). Reuters Official. Data retrieved from https://www.reuters.com/finance/stocks/overview/AQZ.AX
S&P Dow Jones., 2017. S&P/ASX 300 (AUD). S&P Dow Jones official. Data retrieved from https://asia.spindices.com/indices/equity/sp-asx-300
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