Corporate Finance Project: Construction Industry, Term Paper Example

Abstract

This paper is based on the project of Corporate Finance and the industry selected for the analysis if Construction industry. Three firms are selected in this indsutry which are Granite Construction Company (GVA), Fluor Corporation (FLR) and Tutor Perini Corp (TPC). The paper will first analyze the risk and return of these three companies using CAPM model and Beta evaluation. The second step is to anayze these companies using investors returns where the cost of capital, ROE and ROA of these companies will be calculated. Third step is the capital structure of the firms in this industry. The construction industry is capital intensive and the firms rely more on the long term financing of the projects. The fourth step for the analysis if the dividend poliy of the three companies. This is done using the stock valuation and the dividend yiled of the companies. The last step calculates the sustainable growth and intrnal grwoth of the three companies. In the end, conclusion will summarize the results and will identify which firm is better for investment.

Introduction

The paper is based on the Corporate Finance project and it gives a descriptive analysis of the Construction industry. The companies of this group are represented by the SIC code 1700. In order to thoroughly analyze the financial performance of the industry I have selected three firms which are Granite Construction Company (GVA), Fluor Corporation (FLR) and Tutor Perini Corp (TPC). These three companies are involved in the construction works and heavy civil contractors in the United States and are listed in the NYSE. Throughout this report, these three companies will be compared and contrasted on the basis of their financial performance. Also, the entire scope of the industry and its potential for the future will also be discussed. The analysis of these companies is divided into different parts. One is the return and risk, capital returns, growth rates of firms, investment returns, WACC and the future performance of the construction industry.

Risk and Return

Investment in the construction industry is risky. These industries are capital intensive so they are riskier as well. Due to the huge amount of borrowings these firms have in order to finance the machineries and projects the risk tends to incline. There is a constant change in the construction industry as there is innovation and technology changing. The construction industry companies are mostly involved in investing more money into various projects to stay ahead in the market. The profits potentials in this industry is also high because of the high risk. The construction industry is capital intensive and the earning potential is also based on that. When analyzing the risk return tradeoff of these industries we can say that the investors should concentrate more on the cash flows. If there is an adequate cash flow coming in the firms to pay off their liabilities and adjust their working capital, the companies are in a robust shape then.

Although the companies which are new in this industry are mostly risky as there are huge market players already in the market. So, it becomes very hard for these companies to enter into the market. The big companies in this industry are also far less risky than the new firms. The selected three firms will be analyzed in accordance to their beta. As the selected firms have been operating in the market for a long time, they are far less risky than the market overall.

By looking at the beta of all three firms, we can see that Granite Corporation is less risky than the other companies.  Tutor Perini company is very risky and is not a stable company for investment. This company is most likely to be impacted by the small shifts in the market. Granite Construction Company seems to be a sound company in regards to the returns and risk. As it has low beta as compared to the other two companies, it is most likely to be a better choice for investment for risk averse investors.

In each of the companies listed above, if I had invested in them on 1^st July, 2010, the results according to Yahoo Finance are;

None of the companies selected outperformed in the S&P 500 in regards to percentage. This doesn’t show profitability but the investors could have made huge gains if they had over the time period invested in these companies. The construction industry is a highly risky industry that is the reason of the fluctuations. The price of Fluor Corporation is the highest which is around $ 60 whereas of the Granite Corporation the price averages $ 35. The CAPM model is the one that shows the risk and expected return relationship. This model helps in taking the concept of time value of money in the form of a risk free rate and the other factor is beta. The returns expected are shows in the chart below:

Major Calculations

E(r)  = ? (R_m – R_f) + R_f , where (R_m – R_f) = Risk Premium of the Market

Given = Premium Market Risk = 6.0%

GVA:  .047 + 1.50 ( .06 ) =   11.7%

FLR:   0.045 + 1.74 ( .06 ) = 14.99%

TPC:   .051 + 2.34 ( .06 ) =   19.14%

After the calculation of the expected return of all these three companies, it is found out that all have higher returns expected than the risk free rate. When the model of CAPM is used, of the returns expected increases or meets the return required, the investment should be selected. All of these returns, needs to be plotted on the X-axis as Betas and the Y-axis as the returns which will determine the Line of Security Market. If the point of graph falls above the Line of security market, then the value of the asset is undervalued. This indicates that the assets provides a big return for the risk associated. On the other hand, if the SML line falls below, it indicates that the asset is overvalues and it gives a less return for the risk associated.

Investment Returns

ROA = Net Income / Assets Total

GVA: $16,976,000 / $1,620,494,000 =        1.04%

FLR:   $510,909,000 / $8,194,429,000 =      6.23%

TPC:   $ 27,722,000 / $3,773,315,000 =       0.735%

The calculations shown above represents each corporation’s profitability. In major calculations, the corporations are comparable. However, if we look at the sections of ROE we can say that Fluor Corporation is the one performing better in terms of ROE. If we talk about ROA as well, we can see that Fluor Corporation performs exceptionally well then the other two companies. ROE and ROA is the major tool for measuring profitability of the company. If both ROE and ROA of the company are high it indicates that the company is a good investments. Lower ROE’s shows that the company is not profitable. Same is the case with ROA, if it is higher the company is a sound investment. If it is lower it means that the company is earning less on the amount it has invested. According to CNN in the year 2012, the average sector for the ROA in the construction industry stood around 2.5%. The numbers now are around 3% which is still lower. So, I feel that the companies selected are performing above average than the industry especially Fluor Corporation.

Capital Structure

The industry of construction requires huge amount of infrastructure investment which in turn means huge capital amounts. In order to get the finance for these projects, the industry needs to borrow extensively to finance. Huge amounts of borrowings prevents more market competition and which is the entry barrier to be served. After the research conductance on the structure of capital on the firms in this industry, there was a theme which was recurring. The two top companies Fluor Corporation and Granite Construction Company has survived for a longer period because of their frequent changes in the capital structure. The following table shows the companies long term position of each company;

Fluor Corporation and Tutor Perini Corporation are the one with huge debt amount. However, GVA fell quite short of both of these companies in terms of long term debt. This is a very surprising figure for GVA. So, for this reason I researched more on this company. The section of the capital structure I found by reading the GVA article which shows that GVA takes pride in attracting long term debt to the profile of maturity. Moreover, the company claims to have no debt near term requirements and are persistently involved in the enhancement of debt cost. The debt of Long term is a good path for bringing the capital structure flexibility. Although the long term debt downside is that the interest payment and the interest with tax is deductible. This shows that the firms incentives to finance the long term debt. However, the debt which is long term is very risky for the company as there are payments that needs to be given at date specified and the debts needs to be fixed at the date of maturity.

Another significant way for financing is to use the common stock. In relation to the ownership of the firms, common stock also comes as a tool of finance. This is one of the fastest ways to finance the project for the company. In relation to the construction industry, it can be noticed that the common stock is offered by most of the firms but not the preferred stock. This is the reason for selecting these two firms as they offer no preferred stock and only common stock. This helps us view both spectrum sides and will offer a more good perspective in relations to financing equity.

One of the attractive way to increase capital is equity financing. The debt financing is shared with the new investors or owners. Moreover, there is no requirement of fixed payment in this mode of financing. The raised capital from the financing equity leads to the reinvestment which is in the form of retained earnings and help firms grow. However, in the case of construction industry, we can see that it is more financed by debt than equity. As mentioned earlier, financing with equity is giving up a portion of the ownership of the company. This is the major drawback of this mode of financing and decision making goes up to the new investors.

Dividend Policy

We can see from the table below that two of these three firms pay out dividends. The following table shows the dividend payout along with yield and cash on hand.

As we can see that TPC doesn’t pay any dividends whereas the two companies i.e. the Fluor Corporation and Granite Construction Company pay dividends. As the construction industry relies more on debt financing, equity financing is less and so dividend payout is also less. We can see from the figures of the two companies that the average dividend payout is 1-2%. This is the industry average size of the payout of dividends. The arguments regarding the policy dividend policy lies in the excessive cash in hand of these three companies. I do not deem GVA and FLR as having excessive cash at hand. These amounts are substantial fairly when talking about the construction industry. It is enough to finance the project of construction in the coming future.

If we look at TPC it doesn’t pay any dividends and having 179,953 $ millions cash in hand. This is excessive extremely. In the reports of the analyst regarding the infrastructure expansion, this number is not outrageous. FLR has huge amount of cash in hand and at this amount the dividend payout is very less. So, the company needs to change its dividend policy to attract more investors. Every investor would like to have a high dividend and the company that pays a high dividend is the one to be selected for investment. Even a slight increment in the share price, FLR needs to have huge amounts of cash to finance its coming construction projects.

Firm Rates of Growth and Expectations for the Future

When we look at the next year, all of these three companies are expected to have an increased and positive growth. There has been a prediction by the analysts that the two stock namely GVA and FLR will perform well in the average sector (Yahoo Finance). The table below shows the predictions of growth;

After the analysts’ reports, estimates and opinions, I would feel more comfortable in investing in FLR and GVA as these have the potential to be profitable in the future as well. These two companies demonstrated themselves to be the leader of the market in this changing dynamics of the market.

Major Calculations;

            Stock Value = D / ( k – G )

GVA:  .46 / ( 0.12 – .09 ) =    $35.64

FLR:   .53 / ( 0.25-0.12 ) =    $60.11

TPC:   0 / ( 0.12-0.09 ) =       $0

This model of growth takes into account the growth model which is constant and is a good tool for the companies that are mature. Two of the three companies are in the mature state whereas one company is not growing at all. The value which is intrinsic needs to be valued and is extremely useful when taking into account the prices of stock which are traded currently.

As we can see from the figures, that the highest growth is that of Granite Construction Company. It is performing well beyond the market but in contrast to this, Fluor Corporation is also growing. So, the two companies have strong growth rate and for this reason they have captured the major chunk of the market and are big players. The growth rate which is sustainable shows that the growth maximum which the company is able to sustain without increasing the leverage of finance. As we can see that the construction industry is highly finance by long term debt and less equity finance, so that is the reason the sustainable growth rate comes out to be low. If the company wants to exceed this rate, then it has to borrow more to facilitate the expansion and growth. The growth sustainability is sometimes misleading for the construction industry. This is because this is an industry which is highly intensive with capital and requires a large amount of investment to finance the projects. On the other hand, these firms have a good sustainability growth rate as compared to the industry expect TPC. This is a better tool for indicating the financial leverages of the company. When talking about the growth rate internally, the highest growth level which the firm obtains without financing externally. This ratio is where the actual colors of the construction industry comes into place. These rates internally are very less as compared to the past growth rates of sustainability. This shows that the companies in this industry are in constant need of seeking finance externally and requires massive amount of investment in the long run. So, they need to require on long term debt and to re structure their capital structure.

Conclusion

When figuring out the future expectations of the company, it is crucial to look into various factors. In this report, more focus will be on the stock prices, risk return tradeoff, internal and sustainable growth rate of the companies selected.  To initiate with, Granite Construction Company is performing good. It shows less risk as compared to the other two companies in this industry. Fluor Corporation is the company I am more interested to invest because of its increased profitability. It has a robust stock price of $ 60 and has good ROE of 16%. This shows that the company is better for the point of view of investors and also it has average risk. The stock of this company has a beta of 1.74 which is a slight risk but also covering up with good ROA and ROE. Other two companies, TPC and GVA are not profitable because of less ROE and ROA. However, the sustainable and internal growth of the two companies namely FLR and GVA is good and it shows that the company has assets and equity to finance the construction projects in the future. According to the reports on Reuters and Nasdaq, this company is a good investment and the stocks of this company should be bought. I agree with the Reuters and Nasdaq researchers and analysts. The two remaining companies are not worth buying as they are not profitable and stick still hadn’t have a chance to improve. I don’t see room for enhancement for TPC Company. GVA on the other hand is the second option for investment. Fluor Corporation due to its strong growth, profitability and payouts, this is a better investment.

Works Cited

Finance.yahoo.com,. ‘GVA Income Statement | Granite Construction Incorporat Stock – Yahoo! Finance’. N.p., 2015. Web. 26 Apr. 2015.

Finance.yahoo.com,. ‘GVA Key Statistics | Granite Construction Incorporat Stock – Yahoo! Finance’. N.p., 2015. Web. 26 Apr. 2015.

Google.com,. ‘Granite Construction Inc.: NYSE:GVA Quotes & News – Google Finance’. N.p., 2015. Web. 26 Apr. 2015.

NASDAQ.com,. ‘Tutor Perini Corporation (TPC)’. N.p., 2015. Web. 26 Apr. 2015.

Reuters.com,. ‘Fluor Corp (FLR.N) Quote| Reuters.Com’. N.p., 2015. Web. 26 Apr. 2015.