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Strategic and Corporate Finance and Investing
Part One
Investing is one of the most sensitive areas of a business. Choosing the right asset class to invest in requires a lot of market analysis. Many investors target the high performing assets classes and forget those that are not attractive. However, many fail to realize that the lowly performing markets provide a good opportunity in the future for those willing to take up the risk. Such markets trade at a lower price that gives the investor a chance to buy large stocks that appreciate in the future. The Nigerian stock exchange is one of the investment asset classes that have been performing poorly for a few years since 2008. It has been struggling to recover from its downturn that happened in 2008 where 70% of its value was wiped off. Its low performance was caused by a political turmoil and a crisis in domestic banking. Since 2008, the Nigerian stock exchange has been low. However, it has seen growth from last year to this year. Although many investors have not been investing in this market, its potential for growth is higher in the long-term compared to developed markets. This is one of the main reasons for investing in Nigerian stock exchange.
The market capitalization is quite attractive despite the recession that hit in 2008. The value of total market capitalization by 266 securities in 2008 was N9.563 trillion. This dropped by 26.5% in 2009 to close at N7.03 at the end of 2009. This decline resulted from a decline in price of equity losses and delisting of 53 fixed income securities and 11 equities. In 2008, it had also declined by 28.1%.
Between 2008 and 2009, the All-Share Index of Nigerian Stock Exchange dropped by 33.8%, which represented 10,623.61 points closing at 20,827.17. In 2008, it had dropped by 26,539.44, closing at 31,450.78 that represented 5.8%. The performance reflected a significant drop in prices in equities of the year. In 2008, 78 stocks in the All-Share Index had recorded appreciation while 111 stocks had declined. 24 stocks remained constant during the year. Towards the end of 2009, only 23 stocks recorded appreciation with 159 dropping while 35 maintained. The figures presented resilience expectations where it dropped by 25.44 points only, which represented 3% drop to close at 827.99. This was caused by reliance on a broad-based index structure and limited contact to a particular sector that are key requirements for products within the stock market such as derivatives and Exchange Traded Funds.
In the year 2010, the market continued to perform poorly. The All-Share Index stood at 24,770.52 compared to 2009 that was 20,827.17. Although this was an improvement, the next year it dropped again to 20,730.63. Market capitalization in 2010 was N7.92 trillion but dropped in 2011 to N6.54 trillion that represented a 17.42% decline. At the end of 2010, the total value was N797.55 billion while in 2011 it was N634.92 billion. The average daily value was N3.23 billion in 2010 compared to N2.58 billion. In dollars, it represented $21.78 million and $16.99 million respectively, which offers a great opportunity for investment.
The turnover ratio of Nigerian stock exchange in 2011 was 8.36 compared to 12.36 in 2010. This represented a 33.17% decline. Despite this decline, the number of new issue rose from 31 in 2010 to 34 in 2011. The value of new issues for 2010 and 2011 was N2.44 trillion and 2.03 trillion respectively. Number of listed companies had dropped from217 to 198. Compared to 2010, 2011 had seen a decline that saw delisting of some companies. However, the market has shown tremendous growth in 2012 and 2013 although it is yet to regain its complete stability.
In 2012, the Nigerian stock exchange recorded an appreciation of 34.7%. Five months after 2013, it recorded another growth of 34.6%. The All-Share Index closed at 28,078.80 in 2012, which is a gain from 20,730.63 in 2011. This year the All-Share Index has grown again from 28,078.80 at end of 2012 to 37,794.75 in end of May. As All-Share Index grew by 34.6% this year, some sectors have realized a higher growth. An example is presented by index of top 30 firms listed in the exchange that grew by 35.4% within the first five months of this year. Industrial goods index grew by 52.2% while Lotus Index appreciated by 61.3%. Comparing this growth to the same time in 2012, growth was a mere 6.4%. The new growth is expected to go on the whole of this year as more investors gain confidence in the market although many are still afraid because of 2008 looses caused by a combination of factors such as political turmoil and a crisis in the domestic banking.
Since May after the high growth was recorded, the market has maintained its performance but such growth has not been recorded again. Towards the end of august, All-Share Index closed at 36,345.33. For the first half, the market has recorded a growth of 28.80 which is quite an improvement compared to the first half of the previous year that appreciated by 4.19%. The second half of this year has not recorded much growth compared to the first.
Over the last few years since 2008, the Nigerian stock exchange has seen its downturn that led to delisting of many firms. Prices continued to drop as more investors experienced low economic performance. Several reasons such as instability of the market, crisis in the domestic banking and increasing unemployment led to poor performance of many firms. As a result, prices had dropped. Nigerian market has shown signs of growth. Considering it has surpassed some emerging market, Nigerian stock exchange has a good opportunity of growth in the long-term compared to developed markets. This provides a good opportunity for International Investment New Zealand Limited.
Part Two
Evaluation of the Projected Cash Flows
From the projected cash flows, it is evident that investing in the Nigerian stock exchange will yield profits considering the net present value at the end of this project. The bet present value of this project 20 years from now is positive with a value of $7,516,400.00 as represented in the appendix 1. The NPV is inclusive of the final cash flow that will result from selling of the investment at the end of its life. Without this final figure, the project will not be viable considering the NPV will be negative.
To arrive at the interest factor used in discounting the cash flows, the weighted average cost of capital was calculated as indicated in appendix 2.
Although the firm will be making huge investment for the first five years, it will earn good returns in the long term considering it will generate earnings for a period of 15 years. The benefit of using net present value is consideration of future value of money. It also considers the risks associated with future cash flows. Although this method suggest that the investment should be undertaken, some of its weaknesses include lack of specifying when the net present value becomes greater than zero. Additionally, it assumes capital is abundant.
With the projected cash flows, it shows that the investment will pay back in 13.63 years after the initial investment. After the investment starts earning returns from the sixth year, it will take another 8.63 to pay back the initial outlay of $19,000,000. Considering the payback is calculated from the initial investment even without profits, it will take too long to payback. However, this is in assumption that no earnings were received for the first six years. In such an investment, earning could start coming in after the first year. Considering the company has not set a cutoff period for its investment, it is still a viable investment.
To valuate the cash flows further, the profitability index is used. It was calculated by dividing present value of future cash flows with the required initial investment as indicated below
The rule on profitability index suggests that any project with profitability equal to or greater than 1 should be accepted. Considering the profitability of this project is greater than 1, International Investment NZ Limited should undertake it. The profitability index calculated above means that each dollar invested would generate another $1.44. One advantage of using this method it that it provides results consistent with the NPV where it will be greater than 1 as long as NPV is positive.
Internal rate of return is another method used for evaluating projected cash flows. It seeks to show the rate at which an investment will bring in returns. In this investment, the internal rate of return is 9.04%. The greater the internal rate of return the more desirable the project. To find out its desirability, it can be compared to other options or rates of return in the market. Comparing to the rate of return in the Nigerian market, it is higher and likely to generate profits. Therefore, the investment is worth taking.
The IRR is calculated in the table in appendix 4
Assumptions
In evaluation of the projected cash flows, it was assumed that the returns would not be affected by other factors. The evaluation did not consider market volatility that could cause losses in the investment such as the one faced by 2008 Nigerian Stock Exchange. It was assumed that cash flows would continue flowing without and irregularity, which is not very likely. This poses substantial risk especially if the market is not stable since the investment could incur big losses even before it has paid back.
The projected cash flow assume that payment will always come at the end of the year while this may not be the case considering dividends are not always issued on definite periods. This poses risks such as making wrong conclusions on the value of future cash flows. In addition, it assumes that the firm is not limited to funds and can invest in all projects as long as they have a positive net present value.
In calculating NPV, it is assumed that cash flows are always reinvested at the required rate of return while the IRR assumes that such cash flows have to be reinvested at the internal rate of return, which is not always realistic. For instance, if the internal rate of return is 30%, cash flows will have to be reinvested at the same rate, which may not be possible to find within the market. This poses a risk when it comes to deciding on projects to invest in considering IRR and NPV are among the main appraising methods.
Another assumption that was made concerns administration expenses of the investment. Making such an investment will require administration within the stock exchange, which requires to be paid for. The evaluation did not consider this risk in analyzing the viability of the project. Such assumptions because increased expenses that were not thought of before investment. In calculation of cost of debt capital, tax was assumed to be 35%. This affected the outcome of the cost of debt that also affected the weighted average cost of capital. This was further used as the discounting factor in calculating present value of the projected cash flows.
Each of the projected cash flows has several risks that need to be considered especially during forecasting and estimating the costs of projects. Using a formal method of risk identification is quite important because it enables better capital budgeting. One of the risks associated with failing to establish proper forecasts is that projected cash flows are uncertain. Another risk is the discounting rate applied in evaluation of cash flows. Normally, it is the weighted average cost of capital, which is determined by a company’s individual circumstances. It does not consider environmental and market issues.
Recommendations to the CEO
Projected cash flow evaluations indicate that this investment is viable and will earn the firm returns in the long term. From the net present value calculations provided earlier, it is evident the project will be profitable. The internal rate of return is above the market average of Nigerian stock exchange, which is an indication of its profitability. In addition to NPV and IRR, payback period and profitability index indicate viability of the investment. Therefore, it is a worth project to invest in.
The internal rate of return is higher than the cost of capital, which indicates that creation of wealth for the shareholders. Specifically, it surpasses the cost of equity and debt that stand at 7.11% and 7.05% respectively. From the figures provided, the expected market returns of International Investment NZ Limited are 4.1 %. It is evident that the expected market returns of the company are high. Compared to the Nigerian stock exchange where the investment will happen, it is guaranteed. As of May 7, 2013, Nigerian market returns were among the highest with industrial goods sector standing at 30.82% while oil and gas were at 21.11%. This is an indication that the company has a guarantee of generating returns from this stock market.
With such high returns from the Nigerian stock market considering it is still struggling to get out of its downturn that happened in 2008, it is worth investing in the project as soon as possible. This will give the company a head start to other international companies that are yet to gain confidence realize the opportunity ahead. I would recommend that International Investment NZ Limited make the investment within the year before the market appreciates further, as it is likely to. In addition, the firm can invest more that $9,000,000 initially considering the earnings are high and likely to attract more investors in the future. This will also reduce the payback period because the company can start earning earlier than the sixth year. Furthermore, the projected annual returns are likely to increase if a higher investment is made earlier.
As
indicated by the cash flow evaluations and market return in the targeted stock
exchange, it is clear that this project is viable because of its ability to
generate earnings. The market risk is not high compared to the market returns.
However, this does not mean the company could not incur losses. Rather,
protecting against risk should be done through investing in a diversified portfolio
within the market. Industrial goods are yielding the highest returns followed
by oil and gas within Nigerian stock exchange. Before investing in one of these
or any other, International Investment NZ limited needs to evaluate their
stability in the long-term.
Appendices
Appendix 1: Net Present Value
| year | cash flow | PVIF 6% | P.V |
| 0 | ($9,000,000) | 1 | ($9,000,000) |
| 1 | ($1,000,000) | 0.943 | ($943,000) |
| 2 | -1,500,000 | 0.89 | ($1,335,000) |
| 3 | ($2,000,000) | 0.843 | ($1,686,000) |
| 4 | ($2,500,000) | 0.792 | ($1,980,000) |
| 5 | ($3,000,000) | 0.747 | ($2,241,000) |
| 6 | $2,200,000 | 0.705 | $1,551,000 |
| 7 | $2,200,000 | 0.665 | $1,463,000 |
| 8 | $2,200,000 | 0.627 | $1,379,400 |
| 9 | $2,200,000 | 0.592 | $1,302,400 |
| 10 | $2,200,000 | 0.558 | $1,227,600 |
| 11 | $2,200,000 | 0.527 | $1,159,400 |
| 12 | $2,200,000 | 0.497 | $1,093,400 |
| 13 | $2,200,000 | 0.469 | $1,031,800 |
| 14 | $2,200,000 | 0.442 | $972,400 |
| 15 | $2,200,000 | 0.417 | $917,400 |
| 16 | $2,200,000 | 0.394 | $866,800 |
| 17 | $2,200,000 | 0.371 | $816,200 |
| 18 | $2,200,000 | 0.35 | $770,000 |
| 19 | $2,200,000 | 0.331 | $728,200 |
| 20 | $2,200,000 | 0.312 | $686,400 |
| 20 | $28,000,000 | 0.312 | $8,736,000 |
| NPV | $7,516,400 |
Appendix 2: Weighted Average Cost of Capital
Cost of equity = Risk Free Rate + (Beta × Market Premium)
= 1.8 + (0.9 × 5.9)
= 7.11%
Cost of Debt = (interest rate of ANZ × Portion) + (interest rate of Westpac × portion)
= (8% × 35%) + (6.5% × 65)
= 2.80% + 4.23%
= 7.05%
Tax adjustment = (7.05 (1-0.35)
= 4.5825%
Weighted Average Cost of Capital
= (7.77% × 50%) + 4.5825% × 50%)
= 3.56% + 2.3%
= 5.9% rounded to 6%
Appendix 3: Profitability Index
$24,701,400
17,185,000
= 1.44
Appendix 4: Internal Rate of Return
| yr | cash flow | PVIF 9.04% | PV |
| 0 | ($9,000,000) | 1 | ($9,000,000) |
| 1 | ($1,000,000) | 0.917091028 | ($917,091.03) |
| 2 | ($1,500,000) | 0.841055953 | ($1,261,583.93) |
| 3 | ($2,000,000) | 0.771324868 | ($1,542,649.74) |
| 4 | ($2,500,000) | 0.707375116 | ($1,768,437.79) |
| 5 | ($3,000,000) | 0.648727372 | ($1,946,182.12) |
| 6 | $2,200,000 | 0.594942052 | $1,308,872.51 |
| 7 | $2,200,000 | 0.545616018 | $1,200,355.24 |
| 8 | $2,200,000 | 0.500379555 | $1,100,835.02 |
| 9 | $2,200,000 | 0.4588936 | $1,009,565.92 |
| 10 | $2,200,000 | 0.420847203 | $925,863.85 |
| 11 | $2,200,000 | 0.385955194 | $849,101.43 |
| 12 | $2,200,000 | 0.353956046 | $778,703.30 |
| 13 | $2,200,000 | 0.324609914 | $714,141.81 |
| 14 | $2,200,000 | 0.297696839 | $654,933.05 |
| 15 | $2,200,000 | 0.2730151 | $600,633.22 |
| 16 | $2,200,000 | 0.250379699 | $550,835.34 |
| 17 | $2,200,000 | 0.229620975 | $505,166.15 |
| 18 | $2,200,000 | 0.210583336 | $463,283.34 |
| 19 | $2,200,000 | 0.193124088 | $424,872.99 |
| 20 | $2,200,000 | 0.177112368 | $389,647.21 |
| 20 | $28,000,000 | 0.177112368 | $4,959,146.32 |
| NPV | $12 |