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    China Fire Case Assignment

    Uploaded by

    Tony Lu
    The document discusses calculating the weighted average cost of capital (WACC) for China Fire under different leverage assumptions and compares implied share prices using various valuation multiples. Key points: 1) Under a 10% target debt-to-equity ratio, China Fire's WACC is 11.01%. With 50% leverage, the WACC remains similar at 11.01% as changing leverage does not affect WACC if tax and cash flows are constant. 2) Valuing China Fire using multiples of US-listed Chinese companies implies a much lower share price of around $3, as these companies trade at depressed prices due to accounting scandals. 3) China Industrial Technology and Global Fire Products comparables imply similar

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    China Fire Case Assignment

    Uploaded by

    Tony Lu
    475 views3 pages
    The document discusses calculating the weighted average cost of capital (WACC) for China Fire under different leverage assumptions and compares implied share prices using various valuation multiples. Key points: 1) Under a 10% target debt-to-equity ratio, China Fire's WACC is 11.01%. With 50% leverage, the WACC remains similar at 11.01% as changing leverage does not affect WACC if tax and cash flows are constant. 2) Valuing China Fire using multiples of US-listed Chinese companies implies a much lower share price of around $3, as these companies trade at depressed prices due to accounting scandals. 3) China Industrial Technology and Global Fire Products comparables imply similar

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    The document discusses calculating the weighted average cost of capital (WACC) for China Fire under different leverage assumptions and compares implied share prices using various valuation multiples. Key points: 1) Under a 10% target debt-to-equity ratio, China Fire's WACC is 11.01%. With 50% leverage, the WACC remains similar at 11.01% as changing leverage does not affect WACC if tax and cash flows are constant. 2) Valuing China Fire using multiples of US-listed Chinese companies implies a much lower share price of around $3, as these companies trade at depressed prices due to accounting scandals. 3) China Industrial Technology and Global Fire Products comparables imply similar

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    475 views3 pages

    China Fire Case Assignment

    Uploaded by

    Tony Lu
    The document discusses calculating the weighted average cost of capital (WACC) for China Fire under different leverage assumptions and compares implied share prices using various valuation multiples. Key points: 1) Under a 10% target debt-to-equity ratio, China Fire's WACC is 11.01%. With 50% leverage, the WACC remains similar at 11.01% as changing leverage does not affect WACC if tax and cash flows are constant. 2) Valuing China Fire using multiples of US-listed Chinese companies implies a much lower share price of around $3, as these companies trade at depressed prices due to accounting scandals. 3) China Industrial Technology and Global Fire Products comparables imply similar

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    © All Rights Reserved
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    of 3

    EVP China Fire Case Assignment Dongli Lu

    Question 1:
    Assume for simplicity (throughout this exercise) that the corporate tax rate is Tax = 0% (instead of
    Tax=15%) and that the cost of debt is equal to the risk free rate r D=r f =3.8 % (instead of 5.5%).
    The cost of equity for China Fire is still r E=11.73 % for an equity premium of 6.8%. What is the
    weighted average cost of capital (WACC) for China Fire under these assumptions?
    At 10% target D/E ratio,
    D E 1 10
    WACC = ∙r D + ∙ r E= ∙ 3.8 %+ ∙ 11.73 % ≈ 11.01 %
    D+ E D+ E 11 11

    Question 2:
    Assume now that Bain Capital seek a higher leverage with a debt to asset ratio of D/(D+E) = 50%.
    The (unleveraged) beta of China Fire is as previously assumed β U =1.06 . What does this new
    target leverage imply for expected return on equity?

    (
    Leveraged beta β L =β U ∙ 1+
    D
    E )
    =1.06 ×2=2.12;

    r 'E=r f + β L ∙ ( r m−r f )=3.8 %+2.12 ∙6.8 % ≈ 18.22%

    Question 3:
    Assume again that the corporate tax rate is Tax = 0% and the cost of debt r D=r f =3.8 %. What
    do we obtain for the average weighted costs of capital (WACC) of China Fire under the target
    leverage D/(D+E)=50%?
    D E 1 1
    Wac c ' = ∙r + ∙ r ' = ∙ 3.8 %+ ∙18.22 % ≈11.01 %
    D+ E D D+ E E 2 2

    Question 4:
    Compare your answer to questions 1 and 3. Which of the following statements a) to c) is correct?
    a) Higher leverage for China Fire implies that the firm is financed with less costly equity and
    more with cheap debt finance. Therefore, the weighted average cost of capital (WACC)
    decreases as more leverage is used?
    b) Under higher leverage, the risk for the equity holders increases. Therefore, the weighted
    average cost of capital (WACC) increases.
    c) As long as China Fire is managed in the same way and the higher leverage does not affect
    the cash flows, changing the mix of equity and debt financing does not change the weighted
    average cost of capital (WACC) if taxation issues are neglected (Tax = 0%).

    As per results in Q1 and Q3, we can see the WACC hardly changed on the higher leverage, so
    c is correct.

    Question 5:
    Compare the implied share prices for China Fire for different comparison groups under P/E and
    EV/EBIDA multiples:
    What do you conclude after comparing the implied prices highlighted in yellow (see Appendix)?
    China Industrial Technology comparables and Global Fire Products and Services comparables
    have close P/E and EV/EBITDA ratios and valuing China Fire with these two comparison
    groups will give similar results. However, US listed China companies have much lower ratios
    that gives a share price more than halved.

    State whether the following statements are true or false. Give reasons for your answers.
    a) Valuating China Fire based on valuation multiples implied by US-listed China companies
    yields a very low implied share prices because all these companies trade at very
    depressed share price following the accounting scandals?

    True. These US-listed China companies are trading at very low share prices
    depressed by fraud scandals, despite no significant reduction in reported earnings,
    leading to low PE ratios. Valuating China Fire based on these multiples will yield a
    low implied share price.
    b) Using the multiples of US-listed China companies may (currently) underestimate the
    intrinsic value of China Fire?

    Possibly true. Intrinsic value represents the inherent standalone value of a company
    generated from its tangible as well as intangible resources. Usually, it is estimated
    with the DCF method. Without further calculation, although the current trading
    price of $6.1 may suggest that a ~$3/share price is an underestimate (the intrinsic
    value does not necessarily equal to market value but here we take it as a reference),
    it could be an accurate estimate if China Fire’s future financial performance will be
    significantly affected by the scandals that drag its NPV down. Yet at least from Bain
    Capitals’ perspective, using the multiples of US-listed China companies will
    underestimate the intrinsic value of China Fire, hence exploiting the price
    difference.

    Question 6
    Should we use stock return data from China Fire to estimate beta? Alternative?

    Beta measures the covariance between the rate of return on China fire’s stock and the
    overall market return, i.e., the systematic risk. Since China fire is listed we can directly extract
    its stock return data to estimate beta. Alternatively, we can take the unleveraged asset beta
    of the peer group, say global Fire products and services providers, and re-leverage based on
    China Fire’s capital structure as an estimate.

    Appendix

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