Page 165 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes

Case Study BCC – Better?

S mall Cement Company (SCC), Efficient Cement Company (ECC) and Big Cement
Company (BCC) are three cement companies.

SCC has a small capacity and hence its earnings improve dramatically after cement prices
cross a threshold price. ECC, on the other hand, has a very efficient process and hence its
earnings improve sharply with any rise in cement prices. The biggest of them all, BCC, is
not so sensitive to cement prices, thanks to its size. In other words, BCC's bottom line
moves in a more sober manner to the changes in cement prices.
The earnings of these companies are sensitive only to cement prices. Hence, cement prices
determine the returns from investing in these stocks.
Mr. Savvy Investor needs to pick the best investment option from these three companies.
Luckily, a cement expert and a stock market analyst have made life for our friend a little
simple.
The cement expert has assigned the following probabilities for the change in cement
prices over last year. The stock market analyst has given his assessment of the expected
returns from these three stocks for the respective changes in cement prices.
Returns
Event Probability
SCC ECC BCC
5% decline 20% –5% 0% 5%
Flat 30% +05% +05% +05%
5% increase 40% +25% +20% +15%
05% increase 05% +35% +30% +25%

Mr Savvy Investor had to make a wise choice with just these details.
He calculated the average returns that he expected to make for each company. He had the
probabilities associated with each return. Hence, all he had to do was multiply each
probability with the associated return and add all of them together. For example, the
average return that one can expect on SCC worked out to:
20%*-5%+30%*05%+40%*25%+05%*35% = 15.5%. This way, he calculated the expected
returns for these three companies as follows:

SCC ECC BCC
Expected Returns +15.5% +14% +12.5%

Questions
1. Do you think the choice was very easy for Mr Savvy Investor?
2. What do you analyse as the reason behind investor's choosing BCC over the others?

2. EBIDTA: EBIDTA is an abbreviation for Earnings Before Interest, Taxes, Depreciation and
Amortization. It is an approximate measure of a company's operating cash flow based on
data from the company's income statement.
EBIDTA is calculated by looking at earnings before the deduction of interest expenses,
taxes, depreciation, and amortization. It is also sometimes also called EBITDA or operational

160 LOVELY PROFESSIONAL UNIVERSITY