Financial Daily from THE HINDU group of publications
Monday, Oct 31, 2005
An application of CAPM
XYZ Ltd is a real-estate developer. The total market value of equity shares of XYZ is Rs 7,200 lakh. The total value of its debt is Rs 4,800 lakh.
The company's chief finance manager estimates that the beta of shares is 1.4, and that the share carries a premium of 9.20 percentage points for its risk over the market. The RBI's rate is 6 per cent.
a) If you invest in the shares of XYZ, what is the return that you would expect?
b) What is the beta of XYZ's portfolio of assets?
c) What discount rate would you apply, for an expansion of the company's existing business?
d) Assume that XYZ wants to diversify into manufacture of glassware items. The beta of Rampur Glass House Ltd is 1.2. But this company has financed its operations entirely by equity funds and earnings retained. What is the required return on this diversification project if the funding structure remains unchanged.
(3+3+4+4 = 14 marks)
Solution: a) Return expected on shares of XYZ can be computed by applying the capital-asset pricing model (CAPM).
E(r) =Rf + beta (Rm - Rf)
= 6 + 1.4 (9.20)
= 6 + 12.88
E(r) = 18.88 per cent
b) Beta of the portfolio of assets of XYZ is computed as under:
beta (assets) = beta of debt (debt / debt + equity) + beta of equity (equity / debt + equity)
beta of debt = Zero
Debt + equity = 12000, therefore, Debt: Equity is 4:6
= Zero (4/10) + 1.4 (6/10)
= 1.4 x (0.6) = 0.84
beta of Portfolio of assets = 0.84
c) For deriving the discount rate, we should first arrive at the cost of capital of XYZ, computed as follows:
Step I: Cost of capital of XYZ = Rf + beta-assets x (Rm - Rf), where
Rf = 6 per cent
beta-assets = 0.84
Rm - Rf = 9.20 per cent
= 6 + 0.84 (9.20)
= 6 + 7.728
= 13.728 per cent
Step 2: Discount rate: The problem indicates that expansion is that of existing business. Hence, it is assumed that the expansion is in the same risk class.
Discount rate will, therefore, be cost of capital. That is, 13.728 per cent.
d) Return on diversification project.
Assumption: The debt/equity structure will remain unchanged. Additional funds will be raised in the same ratio.
i) Beta of Rampur Glass House Ltd is 1.2
ii) This beta represents beta of an un-levered company.
iii) Hence, we have to compute levered beta, using Rampur Glass House beta as proxy beta.
Beta (levered) = beta (unlevered) x (equity / debt + equity) of levered
= 1.20 x (equity + debt / equity) = 1.2 x (10/6) = 2
Expected return on diversification = Rf + beta x (Rm - Rf), and that is,
= 6 + 2 (9.20)
= 6 + 18.40 = 24.40
Expected return on diversification is 24.40 per cent
Delisting of securities
MEANING: Most of us are conversant with `listing', which is a process by which a company gets its shares quoted and traded on a stock exchange. Delisting is the opposite of listing, and means a process of getting the `listing' of listed securities cancelled. Once delisted, the shares will no longer be listed securities, and SEBI guidelines and the Listing Agreement would cease to apply to the company whose shares are delisted.
Types of delisting: Under SEBI Guidelines, four types of delisting are possible:
Delisting consequent to an open offer by a promoter/acquirer under SEBI takeover regulations;
Consolidation of holdings by persons in control; and
Compulsory delisting by stock exchanges on failure to adhere to certain norms, as conditions of Listing Agreement.
Voluntary delisting: Voluntary delisting of shares of a company by its promoters or management is the most popular mode of delisting. The conditions for making use of this mode are: a) the company must have been listed at least for three years; b) an exit opportunity should be provided to the shareholders; c) the exit price must be determined by way of reverse book building mechanism.
Delisting consequent to an open offer by promoter/acquirer: This mode applies to (a) any acquisition of shares of the company by a promoter or acquirer, or (b) a scheme of arrangement, consequent to which the public shareholding falls below the minimum limit specified in Clause 40A (for example, 10 per cent or 25 per cent as the case may be) of the Listing Agreement, then this process may result in delisting of securities.
Consolidation of holdings by persons in control: This mode is relevant where one or more persons in control of the company (already possessing significant voting power), desire to acquire additional shares.
If in the process of acquiring additional shares, the public holding falls below the minimum limit specified in Clause 40A of the Listing agreement, delisting will take place.
Compulsory delisting: This takes place in all cases where SEBI (after due hearing, and so on) finds that the listing norms have been violated, and the delisting is enforced by SEBI.
Also, violation of norms laid down in the Securities Contracts (Regulation) Act, 1956 will lead to delisting.
Delisting not permitted: In some cases, SEBI does not permit delisting of securities. This is particularly so when a company issues a buyback offer, and the promoters (or main shareholders) do not offer their shares got buyback.
However, the public offers its shares in the buyback arrangement.
As a result, the public holding would fall below the minimum level prescribed in Clause 40A. In such cases, SEBI does not allow delisting of securities.
Important provisions governing delisting: Among other conditions, the following are deemed important: passing of a special resolution; merchant banker being appointed; public announcement of the intention; application being filed with stock exchanges; fixation of exit price, and offer remaining open for three days; and public shareholding falling below minimum level under Clause 40A, except by way of a buyback.
PQR LTD, who paid a dividend of Rs 5 last year, has registered earnings of Rs 80 per share this year. Assuming a target payout ratio of 0.07 and an adjustment factor of 0.4, what would be the dividend per share for the current year under the Lintner's model?
Solution: Step 1: At a payout ratio of 0.07, the dividend should be 0.07 x 80 = 5.60
Step 2: Last year's dividend was Rs 5. Additional dividend contemplated will work out to Rs 5.60 less Rs 5 = 0.60
Step 3: Adjustment factor is 0.4. Therefore, the increase in dividend will be (0.60 x 0.40), Rs 0.24 per share.
Step 4: The new dividend will be 5 + 0.24 = Rs 5.24 per share.
Estimated current year's dividend under Lintner's model: Rs 5.24 per share.
(Source: Prime Academy, Chennai.)
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