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Tutor: Dr. Fara Madehah Ahmad Farid

Accounting and Managerial Finance (AMF)

SIA SIN PEI A 4036224

AMF Written Coursework Assignment


AMF Written Coursework Assignment

Introduction This assignment required us to value the Henkel Company based on the year 2009 annual report. The company profile Henkel is a Germany based company founded in 1876 and operating worldwide with few leading brands and technologies in three business areas. Henkel now has three globally operation business sectors which are laundry & home care, beauty care and adhesive technologies. As stated in Henkels corporate website, the company is currently headquartered in Dsseldorf, Germany, with approximately 47,000 employees worldwide and counts among the most internationally aligned German-based companies in the global marketplace. In fiscal 2009, the company generated sales of 13,573 million euros and operating profit of 1,364 million euros. According to Kasper Rorsted (2009), Chairman of the Management Board in Henkel, he stated that Henkel had reduced their net debt to 2.8billion euros and the Management Board, Shareholders Committee and Supervisory Board had proposed an unchanged dividend of 0.53 euros per preferred share and 0.51 euros per ordinary share in the company Annual Report. All these information are essential to use in valuing the company. Based on the company annual report 2009, Henkel management uses a modern system of metrics to calculate the company value-added and return rations in line with capital market practice. They uses economic value added (EVA) to assess growth to date and to appraise future plans of the company. In Henkel, the company EVA is a measure of the additional financial value created by a company in a given reporting period. A company creates economic value added if its operating profit exceeds its cost of capital, the latter being defined as the return on capital employed expected by the capital market. The cost of capital employed is calculated as a weighted average of the cost of capital (WACC) comprising both equity and debt. (Henkel, 2009)(pp.37) The Assignment Discounted Cash Flow (DCF) There are many methods to estimate the value of a company, but one of the most fundamental and frequently used is Discounted Cash Flow (DCF) analysis. The general idea behind the
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AMF Written Coursework Assignment

method is this: the value of a company is the sum of all future cash flows that the company will generate discounted back to today. (The Opinion Leaders, 2012) According to McClure (2013), DCF analysis requires you to think through the factors that affect a company, such as future sales growth and profit margins. It also makes you consider the discount rate, which depends on a risk-free interest rate, the company's costs of capital and the risk its stock faces.


FCF1 (1+r)1

FCF2 (1+r)2

+ ...... +

FCFn (1+r)n

Generally, DCF are calculated as model below:

Equation [1]

Equation [1] indicates that the value of the discounted cash flow is the present value of the free cash flows (FCF) that the Henkel Company will generate, discounted with the weighted average cost of capital (r), and also called WACC. Weighted Average Cost of Capital (WACC) The WACC represent the opportunity cost that investors face for investing their funds in one particular business instead of others with similar risk. (McKinsey, et al., 2010)(pp. 231) In discounted cash flow analysis, for instance, WACC is used as the discount rate applied to future cash flows for deriving a business's net present value. (McClure, 2010) According to McKinsey (2010), to determine the WACC for a particular enterprise, you need to estimate the WACCs three components: the cost of equity, the after-tax cost of debt, and the companys target capital structure. (pp.232) As abstract from the (McKinsey, et al., 2010) Valuation: Measuring and managing the values of


D E (1 ) + V V

= target level of debt to enterprise value using market-based (not book values) = target level of equity to enterprise value using market-based value


= cost of debt = cost of equity = compan's marginal income tax rate SIA SIN PEI

AMF Written Coursework Assignment

companies, WACC are calculated as model below:

Equation [2]

Equation [2] indicates that the WACC equals the weighted average of the after-tax cost of debt and cost of equity. (McKinsey, et al., 2010)(pp. 232) However, none of the variables such as cost of debt and cost of equity as stated in WACC equation [2] is directly observable. Therefore, in order to calculation company WACC, we need to employ various assumptions, models and approximations available to estimate each of the components. In this paper Section 1, I will demonstrate how to derive the cost of equity of Henkel Company by using the most commonly used model which is Capital asset pricing model (CAPM) provide with the most suitable risk free rate, appropriate market beta and the provided market risk premium. Also, in Section 2, I will also demonstate the calculation in getting company cost of debt by using Henkel Company financial information and provided rate and yields in the provided Select Market Date spreadsheet. 1.0 Company Cost of Equity For more than 30 years, financial theorists generally have favoured the notion that using Capital Asset Pricing Model (CAPM) as the preferred method to estimate the cost of equity capital. Inspite of many criticisms, it is still one of the most widely used models for estimating the cost of equity capital, especially for larger companies (Pratt & Grabowski, 2008)(pp.79). Therefore, I will be usinh CAPM as per requested in calculating the Henken Company cost of equity. As support by McNulty, et al. (2002), they stated that the formula of CAPM has remained fundamentally unchanged for almost four decades, which is equal to risk-free rate of return (typicall the yield on a ten-year treasury bond) plus a premium to reflect the extra risk of the investment in the market multiplied by an adjusting number to reflect the colatility of the stock and the degree that has historically moved up or down with th market. Therefore, the formula for the model is produced as below: CAPM = + ( )
Where: SIA SIN PEI = Risk-free rate = Risk premium = beta

AMF Written Coursework Assignment

Equation [3]

Equation [3] derives the cost of equity by adding the risk-free rate with the additional premium for risk multiply with the company beta. 1.1 Risk-Free Rate The first component of CAPM the risk-free rate- represents the returns an investor can achieve on the least risky asset in the market (Ogier, et al., 2004) As defined by both Damodaran (2010) and Ogier, et al. (2004), a risk-free asset should always be equal to the expected return and also, the investment should have returns that are uncorrelated with risky investment in a market. Which mean in other words, for an investment to be risk free, it has to have no default risk and no reinvestment risk. In practice, there are two major issue that we have to consider when estimating risk free rates. The first one is whether to use a short- or long-term rate; the second is how to estimate a longterm risk-free rate. (Armitage, 2005)(pp.278) It is difficult to measure the real risk-free rate precisely, but most experts think that risk-free rate has fluctuated in the range of 1%-5% in recent years. The best estimate of risk-free rate is the rate of return on indexed Treasure bonds (Eugene F & Joel F., 2009)(pp. 169)

Regarding what is done in practice, several authors state that practitioners tend to use a yield on long-term term government bonds as the risk-free rate. (Armitage, 2005)(pp.278) In her book, Armitage (2005) stated that Rutterfords, (2000) evidence supports the above statement with reports that, of fourteen large UK companies she interviewed that use CAPM, twelve use the nominal yield on a UK government bond as the risk free rate, choosing a maturity between seven and twenty years. Also, Bruner, Eades, Harris and Higgins (1998) report that, of the twenty-three US firm they interviewed that use the CAPM, nineteen use the nominal yield on Treasury bonds.

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AMF Written Coursework Assignment

Besides that, Damodaran (n.d.) also stated that When doing investment analysis on longer term projects or valuation, the risk free rate should be the long term government bond rate. If the analysis is shorter term, the short term government security rate can be used as the risk free rate. He mentioned in one of his report paper that The only securities that have a chance of being risk-free are government securities, not because governments are better run than corporations, but because they control the printing of currency. (Damodaran, n.d) As for choosing the country of government bonds treasury rate, Damodaran (n.d.) mentioned that The risk free rate used to come up with expected returns should be measured consistently with the cash flows are measured. Thus, if cash flows are estimated in nominal US dollar terms, the risk free rate will be the US treasury bond rate. In particularly, the currency which risk-free rate is denominated should be determined by the currency in which the cash flows are estimated. As for example, The risk free rate (for a U.S. company) is generally considered to be the yield on a 10 or 20 year U.S. Treasury Bond (Annabelle Joule LLC, 2007-2013) Henkels Risk free rate: Since Henkel (Germany based company) is using Euro currency in publishing their company annual report and financial statement, the most appropriate government bond to use in calculating company cost of equity will be the Euro-denominated bonds. For euro risk-free rate, we looked at ten-year euro denominated government bonds and noted that at least twelve different European governments have such bonds outstanding, with wide differences in rates. (Damodaran, 2010) Therefore, to determine the risk-free rate for Henkels corporate valuation, I will be using the 10years Euro-Denominated Bonds treasury rate which is 3.38 available in the Market Data spreadsheet with abstract below: Treasury Rating U.S. DollarDenominated Bonds Euro-Denominated Bonds Source: Bloomberg, December 2009
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1Y 0.49 0.85

2Y 1.15 1.38

5Y 2.71 2.53

10Y 3.92 3.38

20Y 4.61 4.23

AMF Written Coursework Assignment

1.2 Corporate Beta According to Houston and Brigham (2004, pp.189), Beta coefficient, a measure of market risk, which is the extent to which the returns on a given stock move with the stock market. Market risk, also called systematic risk or undiversified risk are the risks has relationship with market conditions such as interest rate risk and inflation risk. These risks can affect all companies and cannot be eliminated with diversification. Sari & Hutagol (2011) and Scott, Martin, Petty, and Keown (2005, p199) defined beta as Beta, a measure of the relationship between an investments return and the markets returns. This is a measure of the investments non diversifiable risk. In practice, a companys beta is estimated from its share returns in the fairly recent past, on the assumption that its past beta provides a good forecast of its future beta (Armitage, 2005) Finance theory calls for a forward-looking beta, one reflecting investors uncertainty about the future cash flows to equity. Because forward-looking betas are unobservable, practitioners are forced to rely on proxies of various kinds. Most often this involves using beta estimates derived from historical data and published by such sources as Bloomberg, Value Line, and Standard & Poors. (Bruner, et al., 1998) In practice, the best way to estimate the beta of a firm is to calculate the historical covariance between the returns on the firms equity and the returns from the stock market as a whole, and use this as a proxy for the future beta. (Ogier, et al., 2004) Henkels corporate beta: To estimate Henkels beta, Clayman, Fridson & Troughton (2011) suggest to use a common method which is the pure-play method. This method requires using a comparable publicly traded companys beta and adjusting it for financial leverage differences. The companies I will be using as comparable company in getting Henkels corporate beta will be Beiersdoft, Givaudan SA, LOreal, Oriflame Cosmetics and others. In estimating the beta in pure-play method, we make adjustments to account for differing degrees of financial leverage which requires a process of unlevering and relevering the beta.

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AMF Written Coursework Assignment

According to Henkels beta, Clayman, Fridson & Troughton (2011), the beta of the comparable is first unlevered by removing the effects of this financial leverage. Then, the unlevered beta will be adjusted to the Henkels company structure as called levered the beta to arrive an estimation of the equity beta for the company of interest. Therefore, to estimate beta of Henkel corporate, I will determine the OLS market beta by regressing 10-year monthly return of the comparable companies against the MSCI world index denominated with same currency in the Market Data spreadsheet provided. Firstly, as the returns of MSCI has provided in the spreadsheet, I will calculate the percentage of change in companies monthly return based on the company stock price in Excel Returns sheet. Then, the equity beta was obtained using the SLOPE formula where slope-Y is the changes comparable companies historical return and slope-X is the changes of price in MSCI Index up

to 10 years. Source: Select Market Data Returns Sheet. (Appendix) After the formulation of linear regression above, the equity beta has copied into the beta spreadsheet as below:

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AMF Written Coursework Assignment

Source: Select Market Data Beta Sheet. (Appendix) Abstract: (1) These are the most appropriate companies chosen in the same industry with Henkel as comparable company. All of these company have similar business risk to Henkel which could help in identifying the Henkels corporate beta. (2) These are the equity beta resulted from the linear regressions above. (3) As refer to Bloomberg (2011), Raw Beta is obtained from the linear regression of a stocks historical data. Raw Beta, also known as Historical Beta, is based on the observed relationship between the security return and the returns on an index. The Adjusted Beta is an estimate of a securitys future Beta. Adjusted Beta is initially derived from historical data, but modified by the assumption that a securitys true Beta will move towards the market average of one, over time. The formula used to adjust beta is: (0.67) X Raw Beta + (0.33)(1.0) (Bloomberg Finance L.P., 2011) Therefore, the equity beta obtained from above are adjust as performed in the table. (4) Debt-to-equity ratio is the measure of companys financial leverage calculated by dividing companys net debts by companys market capitalization in Capital sheet.

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AMF Written Coursework Assignment

(5) These are the unlevered beta which also called asset beta where the beta of the comparable are unlevered by removing its effects of its financial leverage. To unlever beta, we divide the Adjusted Beta with one plus the companys debt-to-equity ratio. (6) This is the average total of all comparable companies beta. The figure can either obtain by sum up all the unlevered beta obtained, and divide by the number of comparable companies used or used the AVERAGE formula in excel. This amount will be used in the re-lever process where Henkel corporates debt level was differs from the average debt level of the comparable companies. (7) After the average unlevered beta is estimated, Henkels corporate beta can finally be estimated by re-levering the average unlevered beta with Henkels debt and equity ratio. The Henkels corporate beta is estimate at re-levered beta at 0.82 by multiply the average unlevered beta with Henkels debt and equity ratio. A beta at 0.82 could means the company stocks price will move less volatile than that market. Overall, the company beta can be estimated with summary as below: Source: Clayman, M. R., Fridson, M. S. & Troughton, G. H (2011), The Pure-Play Method

Figure 1

steps Henkel Corporation Segment Beta

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AMF Written Coursework Assignment

As for Henkel Corporation Segment Beta, I will repeat the process stated as above to unlevered and re-lever the beta taken from comparable company segment. The process are carry out as below:

Figure 2

As performed in Figure 2, I unlevered the Henkel comparable companies segment beta and calculate the average for each segment for Laundry & Home Care, Cosmetics & Toiletries and Adhesives. After the calculation, I re-levered the average beta by multiply with Henkels Debt-to-Equity ratio as shown below: Segment Laundry & Home Care Cosmetics & Toiletries Adhesives Debt-to Equity 28.2% 28.2% 28.2% Unlevered Beta 0.44 0.67 0.71 Levered Beta 0.56 0.86 0.91

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AMF Written Coursework Assignment

1.3 Risk Premium The last component in calculating company CAPM is the risk premium. The expected market risk premium is the premium that investor demand for investing in a market portfolio relative to the risk-free rate. When using the CAPM to estimate the cost of equity, in practice we typically estimate beta relative to an equity market index. In that case, the market premium estimate we are using is actually an estimate of the equity risk premium. (Clayman, et al., 2011) There are several ways to estimate the equity risk premium suck as historical equity risk premium approach or the bond yield plus risk premium approach. Henkel corporate risk premium: However, in this paper, we are not using either approach as the risk premium has already provided at 5%. 1.4 Henkels Cost of Equity With all the calculation and formula applied above, we now could determine Henkels corporate cost of equity be on the formula given above. Henkels cost of equity = CAPM = Risk-free rate + (Risk premium X corporate beta) = 3.38% + (5% X 0.82) = 7.48% 2.0 Cost of debt Debt is one component of the business firm's capital structure and usually the cheapest form of financing for the company. Companies usually try to use as much debt financing as possible, without raising their risk too much, because of debt is inexpensive compared to the other forms of financing. Other possible forms of financing and components of the capital structure of the firm are preferred stock, retained earnings, and new common stock. (Peavler, 2013)

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AMF Written Coursework Assignment

As mentioned by Baker and Powell (2005), normally the cost of debt focus only on estimating the cost of bonds because the lender typically determines the cost of other types of debt such as term loans and leases. In order to estimate a company cost of debt, we need to determine three components as below: 2.1 Maturity A bonds maturity refers to the specific future date on which the investors principal will be repaid. Bond maturities generally range from one day up to 30 years. In some cases, bond have been issued for terms up to 100 years. (Irish Life Investment Managers (ILIM), 2013) As mentioned by Conley (2013), Bonds dont live forever. Each of them has an expiration date, or maturity, at which time the bond issuer must return the principal to an investor. Some bonds have a very short life span. Others last for decades. As a rule of thumb, bonds that mature in less than five years are called short bonds. Those that mature in five to 12 years are called intermediate bonds. Long bonds have maturities of 12 years or more. Henkels Bonds Maturity As to determine Henkels Bond maturity, we will use the 10 years maturity rate as approximately 40% of Henkels Bonds holding are more than 5 years as stated below:

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AMF Written Coursework Assignment

Figure 3

Henkel Annual Report (2009, pp. 109) 2.2 Default spread (pre-tax) The second component is the default spread. Default spread can be determined by the company bond rating from an established agency such as S&P or Moodys. We can estimate the default spread based upon the rating. Henkels credit rating In Henkel, the creditworthiness is regularly checked by independent rating agencies. Both Standard & Poors and Moodys currently categorize Henkel in the best possible category, the Investment Grade Segment, with A- (S&P) and A3 (Moodys) (Henkel, 2009) as below:

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Henkel Annual Report (2009, pp. 47) As stated in the question, we need to interpolate Henkels rating to between the nearest is the companys rating is between the reported portfolios. Figure 4 is the Yields table in Euro Denominated Bonds provided in the Market Data Spreadsheet. As we can see, it did not provide the rating for A -. In order to obtain the rating
Figure 3

for 10 years bonds, we need to take the average between the nearest rating which is the A and

Figure 4

BBB+ rating for 10 years. The calculation is as below: 10 Years rating: [4.52 (A) + 4.74 (BBB+)] / 2 = 4.63 (A-)

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AMF Written Coursework Assignment

Therefore, the rating for Henkels cost of debt is 4.63 under A- raking. 2.3 Tax Rate The final input needed to estimate the cost of debt is the tax rate. Since interest expenses save you taxes at the margin, the tax rate that is relevant for this calculation is not the effective tax rate but the marginal tax rate. (Damodaran Online, n.d) A marginal tax rate is the tax rate that will apply to the next marginal - or incremental - amount of income (or deductions). It is calculated by dividing the amount of additional taxes that will be due based on some decision (e.g., to take an IRA withdrawal) by the amount of income involved. (Kitces, 2013) Henkels Marginal Tax Rate As mentioned in Henkel (2009, pp.94), the company reconciliations prepared on the basis of the tax rates applicable in each country and taking into account consolidation procedures have been summarised in the statement as below. Henkel Annual Report (2009, pp. 94) The estimated tax charged, based on the tax rate applicable to Henkel AG & Co. KGaA of 31 percent is reconciled to the tax charged disclosed. (Henkel, 2009) Therefore, I will determined
Figure 5

the Henkel marginal tax rate at 31%.

2.4 After-tax cost of debt

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AMF Written Coursework Assignment

The cost of debt under default spread which determined by company credit ranking is defined as before-tax cost of debt. However, we need to use the after-tax cost of debt to calculate the weighted average cost of capital. We use the after-tax cost of debt in calculating the WACC because we are interested in maximizing the value of the firms stock, and the stock price depends on after-tax cash flow. Because we are concerned with after-tax cash flow and because cash flows and rates of returns should be calculated on a comparable basis, we adjust the interest rate downward due to debts preferential tax treatment. (Eugene F & Joel F., 2009) Henkels after-tax cost of debt Hence, the after-tax cost of debt for Henkel will be calculated using the formula as below:
After-tax cost of debt = (Pre-tax cost of debt) X (1- Marginal tax rate) = 0.00463 X (1 0.31) = 3.19%

The after-tax cost of debt for most firms will be significantly lower than the cost of equity for two reasons. First, debt in a firm is generally less risky than its equity, leading to lower expected returns. Second, there is a tax saving associated with debt that does not exist with equity. (Damodaran Online, n.d) 2.5 Henkels Weighted Average Cost of Capital (WACC) After determined the Henkel cost of debt and cost of equity, I need to assign the weights for that two ingredients by taking the mix of debt and equity from Henkel Corporation provided in the Market Data Spreadsheet.

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Figure 6

According to information provided in Market Data Spreadsheet, Henkel having net debt of 3,707 million euros and 13,445.2 million euros of market capitalization (equity). Therefore, WACC of Henkel Corporation could be calculate as below: WACC = D V (1 )+ E V ( 1 )+ 1 ( +1 ) ( )

WACC = =


Conclusion Overall, Henkel Corporation data could be summarised in table below: Company/Segment Henkel Corporation Laundry & Home Care Cosmetics & Toiletries Adhesives Beta 0.82 0.56 0.86 0.91 Cost of equity 7.48% 6.19% 7.66% 7.91% Cost of debt (after-tax) 3.19% 3.19% 3.19% 3.19% Cost of capital 6.54% 5.53% 6.67% 6.87%

By referring to be table, we can estimate that Henkel stock market will be less volatile than the market as all of the corporation and segment beta are below 1. Meanwhile, we can also estimate that Henkel Corporation have a required rate of return on their equity as dividend to investor at
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AMF Written Coursework Assignment

7.48%. Which means if Henkel have their share price at 31.15 euros, investor will look for a dividend return of 2.33 euros per share. Moreover, Henkel also have an estimated of 3.19% cost of debt which represent that Henkel need to pay an overall rate of 3.19% to finance their debts. In the nutshell, Henkel Corporation have an estimate of 6.54% of overall required return on the firm as a whole.

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