Strategic corporate finance case study

Strategic corporate finance case study
Executive summary
This paper analyses the financial condition of two publicly traded companies, British Petroleum (BP) (LON: BP), in the oil industry, and Costain in the construction industry (LON: COST) with a focus on making a recommendation to a potential investor about the feasibility of buying both companies’ shares. The first two sections of the paper analyse BP’s financial situation in the context of investing. There were some changes to the assets of the company, which had to be adjusted to arrive at the new and accurate net asset value per share. After rectifying the asset situation, the paper analyses the cost of capital of the company, by calculating the cost of equity and the cost of debt. The cost of debt was included in the analysis because it affects the amount available to the shareholders. High interest rates for example, culminate into high interest expenses, which in return, reduce the net profit which is available to the shareholders.
The last part of the paper analyses the stock of Costain PLC and how it is affected by the efficient market hypothesis. After a 4 month tracking of the share, it has become apparent that the market in which Costain operates is semi-strong efficient. There is a strong positive correlation between the changes in the share price of the company and the type of new information which becomes available about the company.

Net asset value per share for BP PLC
= Net assets/Number of shares outstanding
= 69,919,000,000 -18,260,000,000
Net asset value per share for BP PLC = £3.8
Cost of capital
Cost of equity capital using the capital asset pricing model
CAPM =
Expected return = rrf + B * (rm-rrf)
Where:
rrf = the rate of return for a risk-free security
rm = the broad market’s expected rate of return
Ba = beta of the asset
Therefore,
= 1% + 1.54*(6% – 1%)
Cost of equity = 8.7%
Calculate the cost of debt capital (assume a taxation rate of 20%).

Cost of debt = Par value * (1 – tax rate)
= 4% * (1 – 20%)
Cost of debt = 3.2%

Calculate the weighted average cost of capital (WACC). (Use the share price as at 31 January 2014 for the value of equity)
Weighted average cost of capital = WACC = ((E/V) * Re) + [((D/V) * Rd)*(1-T)]

E = Market value of the company’s equity
D = Market value of the company’s debt
V = Total Market Value of the company (E + D)
Re = Cost of Equity
Rd = Cost of Debt
T= Tax Rate
= ((87470305156/224801915156) * 8.7%) + [((68355100000/224801915156) * 3.2%) * (1-20%)]
= Weighted Average Cost Of Capital = 4.16%
Note: At GBX 479.02 per share for 18.26 billion shares, the market value of BP’s equity is £87,470,305,156. Moreover, the bonds are valued at par value, so they must be converted back to the market value, which is £110 for each bond and then divided by the total number of issued bonds in order to arrive at the market value of debt of £68,355,100,000.
Dividend growth model
Using the constant growth dividend model the following equation should be applied to get the theoretical price of a share;
Stock Price = D1 ÷ (k – g)
Where:
D1 = expected dividend of the coming year
k = the required rate of return
g = growth rate of dividends
g = 0%
= 24.3/ (8.7 – 0%)
Theoretical price = GBX 279.4 / £2.79
g = 2%
= 24.3/ (8.7% – 2%)
Theoretical price = GBX 362.8 / £3.63
Note: The dividend grew by 1.92% from 2013 to 2014, and this is the rate which has been applied to acquire the expected dividend of 2015, which is GBX. 24.3 Or 24.3 pence, a figure which has then been substituted into the equation to get the aforementioned theoretical prices.
Value per share using the price earnings (P/E) ratio
Calculate the price earnings ratio using the share prices as at 31 December 2013 (488p) and 31 December 2014 (409p) and the EPS figure for 2013.
P/E ratio 2013 = 488/75.12
Price / Earnings ratio = 6.49

P/E ratio 2014 = 409/75.12
Price / Earnings ratio = 5.44

Comment on your answers if the retail industry sector Containing Morrison’s has an average P/E ratio of 12.8 (http://biz.yahoo.com/ic/120.html, accessed 13 April 2015).
The price earnings ratio displays the measure of confidence which the investors have in the company. However, for this measure to be effective, in is used in comparison with other companies’ ratios, or those of the industry, or it can be measured against the company’s historical performance on this measure. On this basis, BP performed worse in 2014 than it did in 2013, with its PE ratio declining to 5.44 from 6.49.
When compared with the industry, if the PE ratio of the industry is 12.8, then BP performed far worse than the industry did, with a PE ratio which is 7.36 points lower than that of the industry. Therefore, there are companies in the industry with higher PE ratios, which are more recommendable investments than BP, if the PE ratio is the only basis upon which the stock is being evaluated. Moreover, the stock’s PE declined from year to year, and this is indicative of continuous poor performance, so it is not recommendable to invest in BP’s stock if this is the sole decision parameter.
Task 2 (60 marks, you may use any information for this section)

Calculate the value of a BP share and advise your client. Use the information from your calculations above and any information other you deem appropriate to arrive at the valuation of a BP share. In doing so critically evaluate the Price-Earnings and Dividend Growth models used in your calculations and relate your calculations to the current and historic share price information as appropriate.

The price to earnings ratio of BP has drastically declined, as indicated prior. This indicates that the investors are losing faith in the stock of BP, so the share price of the company will continue declining for the foreseeable future. BP operates in a very price inelastic industry, and this should be promising to the shareholders, because the company qualifies for the blue chip mature industry category.

Consequently, the technical analysis indicates that BP should be performing better than this. However, from the same analysis, it is apparent that the company was drastically affected by the events in the Gulf of Mexico. The oil spill exposed a weakness in BP that makes investors think that it could happen again, and expose them to the same clean up expenses which the company underwent, and is still incurring the debt. In fact, that spill cost BP $43 billion in 2014 alone (Bakhsh, 2014), four years after the spill. Consequently, the revenues declined from £23,451 million in 2013, to £3,780 million in 2014. In the first quarter of 2015, this trend has continued, as manifested in the fact that the net income from this quarter is 41% less than it was the previous year in the same quarter (Zacks Equity Research, 2015). This indicates that the investors are still very sensitive about BP’s stock, and it might in fact, hit the bottom if the trend materialises. As long as the investors are still sensitive, the drive to sell may continue increasing, and the market will be flooded with bargain shares of BP.

It should be noted that of all the major oil and petroleum companies, BP is the only one which witnessed a reduction in its market capitalization. The decline market capitalisation amounted to 0.01% but it still indicates that BP is not favoured by the investors, because the reduction in the market capitalization must have resulted from the decline its share price (Titman & Martin, 2014). On the other hand, Shell’s market capitalization rose by 0.65% and that of Total Oil rose by a more conservative 0.05%. However, there is a positive end to this, because the share price will rise again once the crisis has been averted, so those who are buying the shares now are doing so at a bargain and they can earn a higher margin on the sale of the shares when they are corrected back to their primary upward trend as shown in the ascension of the short term moving average over the long term moving average in the figure below.
Figure 1: BP’s stock price and moving averages from January to April 2015

Source: BP p.l.c Chart (2015)
Moreover, if the current dividend growth rate is anything to go by, the growth in the dividends of BP are expected to grow at such a narrow margin that it would take a substantial amount of growth for the investor to actually earn any substantial income from their shares. Because of the aforementioned circumstances, it is logical to expect that the dividend growth will continue on its slow upward growth, with its only enabling factor being the inelasticity of demand of the commodity in which BP deals.
The profit margin of BP is extremely volatile, yet it is from this profit that the investors derive their dividends. The net margin has hit a ten year low of a net loss of 1.23% in 2010 after the oil spill, which is the worst performance which the company has witnessed in the past 10 years, followed by the 2014 performance when the net margin fell to 1.05%, yet the highest performance was in 2005 when the company’s net margin rose as high as 9% (BP PLC, 2015). This volatility is consistent with the volatility of the company’s stock, which has an average beta of greater than 1. Moreover, if the beta exceeds 1, then the stock is more volatile than the market (Berk et al. 2013). With such volatility, comes a higher level of risk, and therefore, the cost of equity of 8.7% which is higher than the market’s required rate of return is justified. Higher levels of risk must be compensated with higher returns if they are to attract investors. Depending on the risk aversion of the investor, this higher rate of return is attractive to the investors with low risk aversion, so they should invest in it.
The enterprise value of BP is $154.5 billion/£105.6 billion , which is higher than its market capitalization of $130.67 bilion / £88.9 billion (BP p.l.c, 2015). This indicates that the company’s stock is presently under valued, and eventually, as the investors notice this, the demand for its stock will rise, and resultantly, its share price will follow suit.
Discuss whether you would advise your client to purchase shares in BP on the 5th May 2015.
I would recommend for my client to purchase the stock of BP as soon as possible because it has a higher return than the market, a higher enterprise value than its market capitalization, and has nearly hit the bottom line. This indicates that it will only rise from here, in tandem with the other discussed traits such as the inelasticity of the price of oil, which is expected to be fueled by increasing industrialisation as the emerging economies transform their economies towards industrial economies as opposed to subsistence agricultural ones. However, BP’s dividends are paid out on May 22 of every year, so buying the shares on 5 May makes sense because even if the client decided to sell the shares later, they will have earned some money from the dividends and will also earn from the sale of the shares.
Task 3 Share price tracking and the EMH (20 marks)
Critically analyse the movement of your allocated share during the period it was being tracked (Jan 2015 – April 2015). You may choose any length of time within that 4 month period from 1 day and up.
Refer to relevant theories and academic literature to explain why and to what extent the share moved in response to new information.
Costain Group’s results for the year which ended on 31st December 2014 were announced in March of 2015, and the details of these reports picked up the price of the company’s shares from February 2015, as shown in Figure 2. The company’s revenue rose by 16.9% to £1,122.5 million (Beaufort Securities, 2015), and this substantial growth and its announcement led to a rise in the price of Costain’s shares in March. 30% of this revenue was contributed by supporting activities and joint ventures with other companies. These joint ventures might have contributed to the efficiency which enabled Costain to increase its revenue so drastically. However, this increase in the share price is consistent with the semi-strong efficient market which is described in the theory of efficient markets hypothesis (Brown, 2011). Under the semi-strong form of efficiency, the share price behaviour quickly reflects the changes in the publicly available information. For example, in the case of Costain, on the day when the financial statements were announced, the share price immediately rose.
Figure 2: Costain group’s share trends and moving averages from January to April 2015

Source: Costain Group PLC (2015).
The details of the financial statements which influenced the share price included a 4.7% increase in operating revenue to £28.7 million. However, the earnings per share of the company declined by 32.2% to 27.8p because Costain divested off some of interests in three small joint ventures which had contributed to the income which had boosted the 2014 earnings per share. In the financial statements which were published in March 2015, there was information pertaining to the forward orders which the company had for 2015, and these forward orders were worth approximately £1 billion (Beaufort Securities, 2015), which is considered as revenue for 2015. With such a revenue, the investors have more confidence in the company, and on the basis of the technical analysis, the price rose accordingly.
At the end of March, a joint venture between Costain and Vinci won a £750 million contract to upgrade the M4 New Port corridor (Moby, 2015). This deal added to the forward orders of £1 billion which Costain ended 2014 with, and is reflected in the change of share price from 314p to 321p on the 23rd of March, immediately after this was announced (Yahoo Finance, 2015).
The share price of Costain continued to grow in April 2015, with a month to month growth, as shown in Figure 2.This is still in consistence with the semi-strong form aspect of the efficient market hypothesis, because the growth responded to a series of publically available news about various companies renewing their contracts with Costain. Phoenix IT Group is one of the companies which renewed its contracts with Costain in April (Unsted, 2015).
Additionally, when Costain announced a dividend of 6.25 in on March 3rd (Pearson, 2015), its share price increased from 296p at closing that day, to 309p at the close of the next day, consolidating the validity of the fact that the market is semi-strong form efficient.
These changes in share price in response to new information can be classified as a result of the changes in the demand and supply of the shares of the company. The rises in share price reflect the optimism of the market, pursuant to the events which the investors believe will increase the value of their shares and dividends. On the other hand, the decline in the stock is a reflection of the pessimism of the investors when they receive negative information about the company.

References
Bakhsh, N. (2014) BP Maintains Gulf of Mexico Oil Spill Cost at $43 Billion. Bloomberg. Retrived from http://www.bloomberg.com/news/articles/2014-10-28/bp-maintains-gulf-of-mexico-oil-spill-cost-at-43-billion
Beaufort Securities. (2015) Beaufort Securities Breakfast Alert Travis Perkins, Ashtead Group, Taylor Wimpey, Costain. Beaufort. Retrieved from http://www.proactiveinvestors.co.uk/columns/beaufort-securities/17935/beaufort-securities-breakfast-alert-travis-perkins-ashtead-group-taylor-wimpey-costain-17935.html
Berk, J., DeMarzo, P., Harford, J., Ford, G., Mollica, V., & Finch, N. (2013). Fundamentals of corporate finance. Pearson Higher Education AU.
BP p.l.c Chart. (2015). Yahoo! Finance.Retrieved from https://finance.yahoo.com/echarts?s=BP+Interactive#{“customRangeStart”:1420059600,”customRangeEnd”:1430341200,”showSma”:true,”smaColors”:”#cc0000″,”smaPeriods”:”100″,”smaWidths”:”1″,”smaGhosting”:”0″,”showEma”:true,”emaColors”:”#009999″,”emaPeriods”:”50″,”emaWidths”:”1″,”emaGhosting”:”0″,”range”:”custom”}
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BP PLC. (2015). Morningstar. Retrieved from http://financials.morningstar.com/ratios/r.html?t=BP
Brown, S. J. (2011). The efficient markets hypothesis: The demise of the demon of chance?. Accounting & Finance, 51(1), 79-95.
Costain Group PLC (2015) Yahoo! Finance. Retrieved from https://uk.finance.yahoo.com/echarts?s=COST.L#symbol=COST.L;range=1d
Morby, A. (2015) Costain/Vinci wins £750m M4 Newport job. Construction Enquirer. Retrieved from http://www.constructionenquirer.com/2015/03/23/costainvinci-wins-750m-m4-newport-job/
Pearson, N. (2015) Costain Group PLC to Issue Dividend of GBX 6.25 on May 22nd (COST). WKRB. Retrieved from http://www.wkrb13.com/markets/554133/costain-group-plc-to-issue-dividend-of-gbx-6-25-on-may-22nd-cost/
Titman, S., & Martin, J. D. (2014). Valuation. Pearson Higher Ed.
Unsted, S. (2015) UPDATE: Phoenix IT Group Set To “Comfortably” Meet Market Expectations. London South East. Retrieved from http://www.lse.co.uk/AllNews.asp?code=hufy2st7&headline=UPDATE_Phoenix_IT_Group_Set_To_Comfortably_Meet_Market_Expectations
Yahoo Finance. (2015) Yahoo!. Retrieved from http://real-chart.finance.yahoo.com/table.csv?s=COST.L&a=00&b=1&c=2015&d=03&e=30&f=2015&g=d&ignore=.csv
Zacks Equity Research. (2015) BP Beats Earnings Estimates in Q1, Revenues Decline Y/Y. Zaxks. Retrieved from http://www.zacks.com/stock/news/172561/bp-beats-earnings-estimates-in-q1-revenues-decline-yy