a)Discuss various methods of estimating growth rate as a value driver? (120Mks)

Question

a)Discuss various methods of estimating growth rate as a value driver? (120Mks)

b)Identify and discuss two approaches to forecasting freee cash flow to the firm FCF and Free Cash Flow to equity (FCE)(10 Mks)

c)Identify and discuss in detail three areas in particular where traditional DCF comes up short versus options theory (10 Mks)

QUESTION THREE Serena Group of Hotels (SGH) is a major hotel chain in East Africa. The group hotels of which 5 are owned by it and the rest are owned by others but managed by the group operates 20 SGH operating revenues and expenses for the most recent financial years (2014) were as follows: Sh. Millions ASSETS FIXED ASSETS Accumulated Depreciation NET fixed Assets 2110 (600) 1510 CURRENT ASSETS 516 2026 LIABILITIES AND EQUITY EQUITY DEBT 1126 900 2026 Assume the company did not have non-operating Assets.

Explanation / Answer

Various methods of estimating growth rate are:

1. Looking at past performances and then forecasting the growth for future.

2. Estimating growth from using the retention ratio and ROE. The amount that is not paid or retained as dividend are assumed to be ploughed back in business and ROE when applied to that gives us growth rate.

3. Using market approaches: when we are aware of our cost of equity, we can use Ke for deriving growth. This is the growth rate assumed by the investors.

4. Estimating growth rate from management projections which provide sufficient details in the projected financial information.

Approaches for predicting FCFF & FCFE:

FCFF is Free Cash flow for firm: the cashflow that is available for all stake holders of the company.

FCFF= EBIT(1- tax rate)+ depreciation- FCInv- WCInv

FCFE = FCFF- interest- net debt proceeds.

1. We can assume a constant growth rate and apply that to the historical FCFF on year to year basis, assuming the fundamentals are unchanged.

2. Forecasting all the components of FCFF and FCFE individually. This relates sales growth to future capex, depreciation expenses, and working capital changes.

C. Options theory versus DCF:

DCF doesn't considers the value of postponing or abandoning the project which is many a times critical in valuing a project. So the DCF gives us only the value of capitalised cashflows over a period of time. It also involves complex process of estimating the growth rate of a company which is hard to ascertain.

2. Options theory gives correct valuations for different outcomes with different chances of occuring or probablities whereas DCF doesn't use probablity in its calculation.

3. DCF doesn't value options that are exclusive premium opportunities that come from significant competitive edge or government regulation.

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