The Report of Hubbard Computers Using Dell Computers as Pure Play Company

Introduction

In estimating the weighted cost of capital of a company that is not listed in the stock exchange for purposes of initial public offer industrial average figures is used. A company in the same industry will be used. The ratio is used to guide the firm to the price that the shares can be offered at in the market. Individual capital structure elements will be used in estimating

Ordinary shares

There too are similar to loan stocks in the basic calculation of the cost of capital. Ordinary shares have a value because they are expected to yield dividends.

Ex-dividend and cum dividend

Before e start the detailed discussion of dividends and hw they are linked to share prices, a few words need to be said about the basis on which shares are traded in the secondary capital market. Normally shares are traded cum dividend, which means that anyone who buys the shares will receive dividends paid by the business concerned. When a dividend does go to those shareholders appearing on the list not the buyer it is said to be ex-dividend and means that anyone buying the shares after the date will not receive that particular dividend. It will be paid to the previous shareholders who have sold their shares since the close date, despite the fact that those investors will no longer own the shares on the dividend payment day. Not surprisingly, the price of the share falls, by the amount of the forthcoming dividend, as the share moves from being traded cum dividend to being traded ex-dividend.

Whenever the current market price of a share, P0, is used in any equation relating to dividends and the cost of equity, one must use the ex-dividend, we need to deduct the amount of the forthcoming dividend per share to arrive at the equivalent ex-dividend price.

Dividend model

A dividend model will be used to analyze the company in question. This measures the cash flows that is available to equity and debt holders.

P_O = Ke(1+g)/r-g

But in this company there is no growth for the to use and I do make an assumption that there is no growth. But we don’t have all the information to give us growth.

Also retained profit is also used as source of capital when book values are used. It has an opportunity cost to shareholders because, if such profits were to be distributed, shareholders could use them to make revenue-generating investments. It would be incorrect however to deal with retained profit separately in deducting its cost. Of a share used in dividend valuation model would reflect any retained profits attaching to the particular share. Thus provided that the cost of equity is properly derived the fact that the equity is part of share capital and part retained profit will automatically be taken into account. From the case of Dell the cost of equity using dividend growth will be

P_O = D₀(1+g)/K_e-g

P_O = market price which is 8.39

D₁ = Dividends which is 0

This means this model will not be used since they have not paid dividend sometime now.

Capital asset price model

This leaves that the capital pricing model to estimate the cost of equity. The CAPM proposes a higher rate of risks than dividend growth model. CAPM or Capital Asset Pricing Model is introduced by Jack Treynor, William Sharpe, John Linther and Jan Mossin. CAPM is a model for pricing an individual’s security or a portfolio. The investor has a higher rate of risk since he invest in the form of assets. An asset or portfolio may be in the form of bonds, stocks, options, warrants, real estates and all its other forms.

In this kind of model, investors were risk averse. Given two asset with the same expected return, it is expected that they rather choose the less risky one. Investors can lower their risks by holding non-diversifiable risk portfolio. Diversification allows the same portfolio return with reduced risks. By using the formula we will know how much risks we put in investing;

Individual security’s / beta Reward-to-risk ratio = Market’s securities (portfolio) Reward-to-risk ratio

Or

Ke = Rf + Bs (Rm – Rf)

Where: Ke – cost of equity capital

Rf– the return that can be earned on a risk – free investment

The model assumes that an expected return, investors would likely prefer lower risk than higher risks. Given a certain level of risk will prefer higher returns to lower ones. Investors are not allowed to accept lower returns for higher risk. The model assumes that all investors agree about the risk and possible returns of all assets. The model also assumes that there are no taxes or transaction costs.

Ke = Rf + Bs (Rm – Rf)

Where: Ke – cost of equity capital

Rf– the return that can be earned on a risk – free investment (e.g US treasury bill)=2.5.%

Rm – the average return on all securities (e.g , S & P 500 stock index)

Bs – the securities beta (systematic) risk. = 1.31 as at 6^th march 2009.

And it is normally assumed that the difference between the market rate and the market free rate is 7% therefore, (Rm – Rf) which is the premium is 7% this will be used in calculating the cost of capital.

Ke = 2.5% + 1.31(7%) = 11.67%

Loan term debt

With quoted loan stocks we should know the current market value of the loan stock, the contracted interest payment and dates, and the contracted amount and date of the repayment of the principal. Thus in the valuation expression above we should know all of the factors except k. Solving for k will give us the cost of capital figure that we require. One should remember that our purpose of calculating the cost of capital is to derive a discount rate to apply to valuation of the company that is not listed. This means either the saving that would follow from repaying the capital source, or the cost of further finance raised from the source.

Perpetual loan stocks are occasionally issued by businesses. These are loan stocks that have no repayment date and which will, in theory, continue paying interest for ever. Their cost of capital calculation is similar to, though simpler than, the calculation for redeemable loan stocks.

Where each of the Cn values is identical and n goes on to infinity

PEO = ∑Cn (1-T)

N =1 (1 +KL)n

The tax rate use in this case 35%

However in this case we have yield amount and we only need to estimate effective cost of capital. The company loan capital is as follows

Weighted Average Cost of Capital

The following assumptions

• There is a known target ratio for the financing elements, which will continue for the duration of the investment project under consideration;
• The costs of the various elements will not alter in the future from the costs calculated ; and
• The investment under consideration is of similar risk to the average of the other projects undertaken by the business.

Then using the weighted average cost of capital (WACC) as the discount rate is logical.

Using opportunity cost implies looking at the savings in financing cost that would arise if finance were to be rapid instead of undertaking the investment project. Alternatively, it could be seen as the additional cost of raising the necessary finance to support the project. If there is a target, repayment of finance or additional financing would be carried out in accordance with the target.

The three assumptions stated at the start of this section are all concerned with the fact that in investment project appraisal, and in any other case where we may wish to assess the cost of capital, it is the future cost that we are interested in. The third assumption, relating to risk, perhaps needs a comment. We know from a combination of intuition, casual observation of real life and from a robust theoretical proposition that the required rate of return/ cost of capital depends partly on the level of risk surrounding the cash flows of the investment project concerned.

The cost of capital that will be used by this company in evaluating capital projects is 11.3555%. This is the weighted average cost capital. It remains valid so long as the factors are kept constant as well as assumption made are maintained.

It should be noted that the rate is the accepted rate. This rate is for the purpose of this assignment only.

Weighted Average Cost of Capital Using Market Values

The weighted cost of capital using market values is 10.955%

The weighted average cost of capital is at times called overall cost of capital. This can be used as a discount rate to calculate the projects net present value, so long as the projects risk is equivalent to the firm’s existing assets and the firm intends to maintain its target capital structure.

When using the book values the weighted average cost of capital will be

Weighted Average Cost of Capital Using Book Values

The weighted cost of capital using Book values is 9.396%.

Best option

The market values are more relevant for this company because market values are determined with market forces of demand and supply. Book value can not either undervalues or overvalued shares of the company. The New York stock exchange values all stocks efficiently and these stocks of this company which is not listed will have to value using the values of the market.

Potential problems

The stocks of this company if valued using market values a number of problems are likely to emerge, one of the problems is either overvaluation or under valuation. The market forces in the New York stock exchange values stocks using the information available about the company and the industry. Therefore in this view those shares that are not listed in the stock exchange are not valued at the right price because there are no forces of demand and supply.

For one to say that the share is price efficient, it implies that at all times the shares reflect all information available about the business available to all investors for them to make rational decisions in relation to the prices of shares. What is means is that the current price of a share listed in the stock exchange is the present value of the future economic benefit that investor of that stock will get. The stock exchange acts as an interface between the manager and investor and therefore financial decisions made by the manager are reflected in the share prices of the company.

All information that is available in relations to the company is quickly and rationally incorporated into the values of shares of the company. This is because the shares trading in the market are observed by brokers and the general public some of them who have skills and experience in move of shares and what type of motivator increases the value of shares. They buy the shares when they see the information I positive in relation to financial gain from shares. The information this people use is valid and comes from many sources which include financial statements.

The current valuation given by the market is not even close to the valuation of the company at the depths of the book value. The current price of around $8.39 per share is still high as compared to these historic market valuations. There is also a very important difference in the previous internet stock bubble as compared to the real estate meltdown the economy is currently experiencing right now. The recession has been triggered by real estate with deep repercussions on retail and manufacturing. It also affects the financial and credit capability of the economy.

The best method that can solve this problem is to analyze the valuation of peer group – create the appropriate universe of comps – please provide justification for the group you select and provide summaries and/or company descriptions for each company to support your selection. Comp selection involves researching the company, its industry and other sources of information, to allow you to select its peer group.

One of the companies that can be compared with Hubbard computer will be selected. This company also has their computer production and the only difference they have with Hubbard computer. this is what has been done.

Conclusion

All in all, when the various methods of valuing the Hubbard computer stock is to be evaluated for the decision on what to do with Hubbard computer stock points to the recommendation of holding the stock. The valuation method using the Free Cash Flow method already indicates the indifference since Dell had not issued dividends. Another computer company should be selected to issued dividends to value Hubbard computer.

References

Fischer D. E. and Jordan R.J. (2006); Security analysis and Portfolio management, Prentice-Hall, India. Pp. 559-560.

McLaney E., (2003); Business finance theory and practice; Prentice Hall. Web.

Schlosser M.;(2002); Business finance: application, Models and cases, prentice hall. Web.

Westerfield R., Jaffe, and Jordan (2007); Corporate finance core principles and applications by McGraw-Hill. Web.

White G I Sondhi E C & Fried D (1999): The analysis and use of financial statements Wiley.