Abu Dhabi Islamic Bank - Limitless Vision



CORPORATE FINANCE PROJECT Abu Dhabi Islamic BankNational Bank of Abu DhabiByDanial Wahaj KhanPage Number1Corporate Governance Analysis32Stockholder Analysis113Risk and Return124Measuring Investment Returns235Capital Structure Choices296Optimal Capital Structure367Mechanics of Moving to the Optimal418Dividend Policy559A Framework for Analyzing Dividends6410Valuation69References and Bibliography75TABLE OF CONTENTSCORPORATE GOVERNANCE ANALYSIS:The Chief Executive Officer:Abu Dhabi Islamic Bank:Mr.Tirad Mahmud is the CEO of Abu Dhabi Islamic Bank. He has been working as the CEO since March 2008. ADIB is a publicly traded company with major shareholding of UAE citizens and Emirates International Investment Company. The company was founded in 1998 and it has major shareholding of Abu Dhabi Royal Family. Tirad was appointed directly as the CEO by Chairman and Board of Directors. Prior to joining ADIB, Tirad served as the General Manager of Samba Financial Group from 2004-2007 and CEO at the Citibank Romania where he worked for 22 years.ADIB doesn’t disclose the remuneration and share options information regarding the CEO.(Business Week, n.d)National Bank of Abu Dhabi:Michael H. Tomalin is the CEO of National Bank of Abu Dhabi. He has been serving as the Group CEO of NBAD since 1999.NBAD was founded in 1968 and its major shareholding is held by Abu Dhabi Investment Council (Government entity).NBAD is not a family based business. Micheal joined the company in 1999 as the Group CEO.Micheal was trained as an investment manager at N.M Rothschild in London then he joined Barclays as CEO in 1992.No information regarding the remuneration and share options of the CEO (in particular) is disclosed. (Business Week, n.d)The Board of Directors:Abu Dhabi Islamic Bank:Name of the directorPositionYears served as a directorHE Jawaan Awaidha Suhail Al KhailiChairman4 YearsKhaled Abdulla Neamat KhouriVice Chairman5 YearsAbdulla Bin Aqueeda Al MuhairiDirector2 YearsJuma Khamis Mugheer Al KhailiDirector8 YearsDr Sami Ali Al AmriDirector3 YearsKhamis Mohamed BuharoonDirector5 YearsRagheed Najeeb ShantiDirector5 Years CITATION Abu111 \l 1033 (Abu Dhabi Islamic Bank, 2011)Majority of the board members of ADIB are independent and non-executive directors who are serving in different organizations. Khaled Khouri is a director at ADIA.Khamis Buharoon is a board member of Abu Dhabi National Hotels Company, Emirates Institute for Banking and Financial Studies and its Human Resources Committee, Arqaam Company and Board Member of the General Council for Islamic Banks and Financial Institutions.Juma is a Member of the Boards of ADIC and AGTHIA Group in the UAE. He is also Board Member at the General Holding Corporation, Arab International Bank and the Joint Arab Investment Corporation in Egypt. He is an active member of the Administration, Investment and Scholarship Committees at ADIA.Dr. Sami is President of Quantum Consulting.Jawaan Awaidha Suhail Al Khaili holds 43,941,108 shares interest in the company but this is not a significant holding as it represents 1% holding.(Business Week)National Bank of Abu Dhabi:Name of the directorPositionH. E. Nasser Ahmed Khalifa AlsowaidiChairmanH. E. Dr. Jauan Salem Al DhaheriDeputy ChairmanH.E. Mohammed Omar AbdullaDirectorMr. Khalifa Sultan Al SuwaidiDirectorMr. Hashim Fawaz Al KudsiDirectorMr. David BeauDirectorH.E. Sultan Bin Rashed Al DhaheriDirectorSheikh Ahmed Mohammed Sultan Al DhaheriDirectorSheikh Mohammed Saif Mohammed Al NahyanDirectorMr. Matar Hamdan Al AmeriDirectorMr. Michael H. TomalinCEO CITATION Nat11 \l 1033 (National Bank of Abu Dhabi, 2011 )Nasser Ahmed Khalifa Alsowaidi also serves as Chairman of the Department of Economic Development, the Abu Dhabi Securities Exchange, Abu Dhabi Ports Company and National Bank of Abu Dhabi. He is the chairman of both the Union Railway Company and ZonesCorp. H.E. Alsowaidi is the Chairman of the Department of Planning and Economy.Mohamed Omar Abdulla serves as a Director National Drilling Company.Bin Rashed Al Dhaheri serves as Board Member of Abu Dhabi National Insurance Company.Mr. Hashim Fawwaz Al Kudsi serves as a Director Al Wathba Company for Central Services and AD Invest. Mr. Al Kudsi serves as an Executive Director of Abu Dhabi Investment Council (ADIC).ADIC is a major shareholder of National Bank of Abu Dhabi.Mr. David Beau serves as Chief Investment Officer at Abu Dhabi Investment Council. He serves as an Executive Committee Member at Abu Dhabi Investment Company.He is also connected to a major shareholding entity of the bank, ADIC.Mr. Matar Hamdan Al Ameri serves as a Director of National Drilling Company. He serves as a Board Member of Abu Dhabi National Tanker Company, ADNOC Marketing International, Singapore, Excel London (subsidiary of ADNEC) and Al Ain Sports Club. He serves as a Member of ADNOC Group. He serves as Chairman of ADCO Audit Committee, ADNOC Distribution Audit Committee, Advisory Committee at ESNAAD, Finance Committee at GASCO and Finance Committee at Al Hosn Gas Company. He serves as a Member of Audit Committee at Adu Dhabi National Exhibition Company. He serves as Chairman of FINCO of Petroleum Institute.(Business Week)Share Voting Structure:Abu Dhabi Islamic Bank:ADIB doesn’t have multiple classes of shares with different voting rights. Shareholders can exercise their power at AGM where one share is equal to one vote.National Bank of Abu Dhabi:NBAD doesn’t have different classes of shares. One share is equal to one vote at AGM.Financial Market Concerns:Abu Dhabi Islamic Bank:ADIB is currently listed in Abu Dhabi Stock Exchange. There are currently 5 analysts following the company.AnalystInstitutionMurad Ansari EFG HermesRadwa El SwaifyBeltone FinancialKhalid Al Sahli Global Investment HouseJaap Meijer Arqaam CapitalNisreen Assi Arqaam Capital CITATION Abu12 \l 1033 (Abu Dhabi Islamic Bank Official )National Bank of Abu Dhabi: AnalystInstitutionKhaled AklADCB Wealth Management GroupJaap MeijerAl Futtaim HC SecuritiesVishal GuptaBank MuscatSara BoutrosBeltone FinancialMunir ShahinBoA Merrill LynchKato MukuruCiti Investment ResearchRahul ShahDeutsche BankMurad Ansari / Shabbir MalikEFG HermesNaveed AhmedGlobal Investment HouseWaleed MohsinGoldman Sachs InternationalAybek IslamovHSBC Bank Middle East LimitedNaresh BilandaniJP MorganDaniel CowanMorgan Stanley & Co.May El HaggarNaeem HoldingRaja GhoussoubNBK CapitalChiradeep GhoshSICO, BahrainSaket ChowdhuryTAIB ResearchSanyalak ManibhanduAbu Dhabi Financial Services (NBAD) CITATION Nat12 \l 1033 (National Bank of Abu Dhabi Official)Societal Constraints:Abu Dhabi Islamic Bank:ADIB is a well known Islamic bank around the globe. It was the first Islamic bank in Abu Dhabi and second in UAE.ADIB enjoys a good reputation among society which is evident from the continuous growing customer base. The bank knows its responsibility as a corporate citizen and took a number of CSR initiatives to prove it. ADIB provides a number of employment opportunities to the locals through college placement and internship programs. The bank has started programs to provide free education of Islamic finance to fresh graduates of UAE. The bank continues to promote the high standards of Islamic banking and ethical practices at all levels of the business. There are a number of awards that ADIB received in recent years:Best Islamic Bank in the UAE for 2011 by Global Finance MagazineBest Islamic Bank by Business Banking and Finance Magazine GloballyBest Overall Bank in the UAE in customer service for 2011 by Ethos ConsultancyHuman Resource Development Award for 2011 organized by Emirates Institute of Banking &Financial StudiesBest Islamic syndicated facility Majid Al Futtaim Properties AED1.14bn facility by EMEA awardRated amongst the best 10 companies in the UAE by Forbes Magazine (Middle East) CITATION Abu12 \l 1033 (Abu Dhabi Islamic Bank Official )National Bank of Abu Dhabi: National Bank of Abu Dhabi is the number one bank in the UAE with more than 120 branches all over the country. The bank has been ranked as one of the 50 safest banks in the world by Global Finance magazine. The positive reputation of the bank is evident by the continuous growing business of the bank. The bank has CSR policy in place to make it a better place to work for and to make Abu Dhabi more sustainable in the future by providing economic stability. The bank has received a number of awards in previous years, some of them are mentioned below:Best CSR Programme in Middle East 2010 by EMEA Finance.Human Resources Development Award in Banking Sector by Emirates Institute of Banking & Financial Studies.Safest Bank in the Middle East by Global Finance.Best Bank in the UAE by Euromoney.Best Asset Manager in the UAE by Global Investor/isf – Euromoney.Best Pre-paid Card - NBAD Ratibi Card by Smart Card Awards. CITATION Nat12 \l 1033 (National Bank of Abu Dhabi Official)STOCK HOLDER ANALYSIS:Abu Dhabi Islamic Bank:ADIB has AED2365m issued share capital. The major shareholder of the bank is Abu Dhabi Royal Family who owns 41% the company through wholly owned holding company Emirates International Investment Company LLC. Members of the Abu Dhabi Royal Family further holds 9% as individual interest in the bank. The Government of Abu Dhabi owns 8% shares through its investment company Abu Dhabi Investment Council. Over 47000 of UAE citizens (general public) own 38% shareholding in the bank. Other shareholders include National Bank of Abu Dhabi and UAE General Pension and Social Security Authority. ADIB is only listed in Abu Dhabi Stock Exchange without any international stock listing and its shareholding is entirely UAE based. CITATION Abu111 \l 1033 (Abu Dhabi Islamic Bank, 2011)National Bank of Abu Dhabi: NBAD has AED2870m issued and fully paid up capital. The major shareholding is UAE based which is around 97.5% of total shareholding. Abu Dhabi Investment Council, a government entity of Abu Dhabi holds significant shareholding of 70%.UAE nationals own 27% shareholding while foreigners own only 2.5% in the bank. The bank is only listed in Abu Dhabi Stock Exchange. CITATION Nat11 \l 1033 (National Bank of Abu Dhabi, 2011 )RISK AND RETURN ANALYSIS:Abu Dhabi Islamic Bank:Estimating Historical Risk Parameters:Businesses usually face two kinds of risk. One is a systematic risk that affects every business operating in a particular jurisdiction though the effect maybe higher or lower for different industries; second is a non systematic risk or a company/industry specific risk. Shareholders can eliminate non systematic risk by diversifying their portfolio but they can’t eliminate systematic risk.Systematic risk can be an increase/decrease in interest rates, legislative changes affecting all businesses, political instability, changes in tax laws, country specific risk and deteriorating law & order situation.Beta is the measure of systematic risk which can’t be eliminated by diversification. Beta can be calculated by using regression analysis.We have calculated the beta of ADIB using regression analysis and graph is shown to demonstrate the volatility of returns. The returns of ADIB have been compared against ADX (Abu Dhabi Stock Exchange) Index returns. (Asmainfo)Regression model gave these results:InterceptSlope(Beta)R Square-.0007.152.013The intercept (alpha) represents the return in excess of the risk borne by investors if its value is positive and if its value is negative it represents the lesser returns for the risk borne. Intercept of ADIB is quite low here so it doesn’t affect the returns too much.The slope is the beta of ADIB stocks which is .152. Beta can be interpreted as the change in return of ADIB stocks due to change in Index return. The value of beta is quite low for ADIB thus ADIB stock return is not very much dependent upon market returns.R Square is the coefficient of determination. It tells us the level of stock return dependency on the market return. In other words it measures the level of systematic risk. The systematic risk is quite lower for the ADIB stocks due to lower R Square value. Company specific risk or non systematic risk can be found by 1-r square, which is .987 or 98.7%. This means that most of the beta risk is defined by business and financial factors of the business not the market. The above beta is actually levered beta which means it has two components in it; one is the risk due to financial leverage and second is the risk due to business factors. Beta asset (unlevered beta) can be calculated as follows:βasset=β(equity)EE+D(1-T)Where β (equity) is levered beta calculated using regression analysis, E and D are weights of Equity and Debt respectively and T is the effective tax rate.Since UAE doesn’t have any tax for corporate entities we can calculate it more simply.Market value of ADIB share is 3.16AED/share and no. of shares is 2365m so total market capitalization is 7500m AED. Total value of long term debt is 4591m AED. Beta (equity) has already been calculated as .152 using regression analysis. CITATION Abu12 \l 1033 (Abu Dhabi Islamic Bank Official )Using all the required data we have calculated Beta Asset (Unlevered beta) which is .094. By subtracting asset beta from equity beta we can have the beta figure that represents the risk due to financial leverage; this can be found as .152-.094=.058.This means .058 of beta is due to financial leverage and .094 is due to operational risk.Estimating default risk and Cost of Debt:Default risk is the risk that company may fail to make the payments of interest or principal. The default risk is of vital importance to loan providers. They charge more premium on high risk fixed income securities. The credit/default risk is usually estimated through the ratings by institutions such as Moody’s and Fitch.Credit rating of ADIB:Rating AgencyLong TermShort TermOutlookMoody's Investor Services A2P1StableFitch RatingsA+F1StableThe long term bond rating is A2 by Moody’s which means it is an upper medium rated security with low credit risk and thus lies in investment category not speculative. The bond lies in upper medium rated according to Fitch ratings also. The long term bond rating is overall good and there is low credit risk involved in ADIB bonds. CITATION Abu12 \l 1033 (Abu Dhabi Islamic Bank Official )The short term bond rating lies in high grade category according to Moody’s but according to Fitch rating it is in upper medium category. Overall ratings for short term bonds are good and it has low risk involved.ADIB has 3 types of long and medium term debts; amount due to financial institutions, sukook and tier 2 Wakala Capital that is issued to the federal government. The cost of debt is estimated on Sukook and Wakala capital since no information was given regarding the interest rates on the amount due to financial institutions cost of debt is 3%.Cost of Capital:The cost of capital is the cost that a company is expected to pay to the providers of capital. The cost of capital is usually higher for risky companies as investors and lenders expect higher returns for the higher level of risk. Companies usually use weighted average cost of capital (WACC) to appraise the investment projects. The weighted average cost of capital can be calculated as: Kc=EE+D×Ke+DD+E×Kd(1-T)Where E and D are weights of market value of equity and debt, T is the effective tax rate, Ke is cost of equity and Kd is cost of debt. The values of equity and debt have already been calculated in beta calculation. E=7500m AEDD=4591m AEDIn order to calculate the cost of capital of ADIB we must first calculate the cost of equity. Cost of equity can be calculated using capital asset pricing model (CAPM). The formula of return on equity according to CAPM is:Ke=Rf+(Rm-Rf)βeWhere Rf is risk free rate of return, Rm is market return and βe is beta equity (levered beta) of firm. Rm-Rf is called risk premium. Risk free rate is 2% in UAE and risk premium is 6.75%.Using these rates and levered beta we calculated the cost of equity 3.03%.(Newyork University,n.d;UAE Deposits,n.d) Now using all the required data we have calculated WACC 3.02%.National Bank of Abu Dhabi: Estimating Historical Risk Parameters:Businesses usually face two kinds of risk. One is a systematic risk that affects every business operating in a particular jurisdiction though the effect maybe higher or lower for different industries; second is a non systematic risk or a company/industry specific risk. Shareholders can eliminate non systematic risk by diversifying their portfolio but they can’t eliminate systematic risk.Systematic risk can be an increase/decrease in interest rates, legislative changes affecting all businesses, political instability, changes in tax laws, country specific risk and deteriorating law & order situation.Beta is the measure of systematic risk which can’t be eliminated by diversification. Beta can be calculated by using regression analysis.We have calculated the beta of NBAD using regression analysis and graph is shown to demonstrate the volatility of returns. The returns of NBAD have been compared against ADX (Abu Dhabi Stock Exchange) Index returns. Regression model gave these results:InterceptSlope(Beta)R Square.0022.510.089The intercept (alpha) represents the return in excess of the risk borne by investors if its value is positive and if its value is negative it represents the lesser returns for the risk borne. Intercept of NBAD is a positive figure which represents the higher return against the level of risk borne.The slope is the beta of NBAD stocks which is .510. Beta can be interpreted as the change in return of NBAD stocks due to change in Index return. The value of beta is less than 1 which means the value of NBAD stocks is not perfectly correlated with the index returns. In simple words it means if ADX index increases/decreases by 10% then NBAD stocks will only increase/decrease by 5%. The level of systematic risk of NBAD is lower than the market.R Square is the coefficient of determination. It tells us the level of stock return dependency on the market return. In other words it measures the level of systematic risk. The systematic risk is quite lower for the NBAD stocks due to lower R Square value. Company specific risk or non systematic risk can be found by 1-r square, which is .911 or 91.1%. This means that most of the beta risk is defined by business and financial factors of the business not the market. The above beta is actually levered beta which means it has two components in it; one is the risk due to financial leverage and second is the risk due to business factors. Beta asset (unlevered beta) can be calculated as follows:βasset=β(equity)EE+D(1-T)Where β (equity) is levered beta calculated using regression analysis, E and D are weights of Equity and Debt respectively and T is the effective tax rate.Since UAE doesn’t have any tax for corporate entities we can calculate it more simply. The tax was only paid on oversees income which is negligible.Market value of NBAD share is 10.95AED/share and no. of shares is 2867m so total market capitalization is 31400m AED. Total value of long term debt is 22516m AED. Beta (equity) has already been calculated as .510 using regression analysis. CITATION Nat12 \l 1033 (National Bank of Abu Dhabi Official)Using all the required data we have calculated Beta Asset (Unlevered beta) which is .297. By subtracting asset beta from equity beta we can have the beta figure that represents the risk due to financial leverage; this can be found as .510-.297=.213. This means .213 of beta is due to financial leverage and .297 of beta is due to operational risk.Estimating default risk and Cost of Debt:Default risk is the risk that company may fail to make the payments of interest or principal. The default risk is of vital importance to loan providers. They charge more premium on high risk fixed income securities. The credit/default risk is usually estimated through the ratings by institutions such as Moody’s and Fitch.Credit rating of NBAD:Rating AgencyLong TermShort TermOutlookMoody's Investor Services Aa3P1StableFitch RatingsAA-F1+StableS&PA+A1StableRAMAAAP1StableRIA+A+Stable CITATION Nat12 \l 1033 (National Bank of Abu Dhabi Official)The long term bond rating is Aa3 by Moody’s which means it is a higher grade rated security with very low credit risk and thus lies in investment category not speculative. The bond lies in higher grade rated according to Fitch ratings also. The long term bond rating is overall good and there is very low credit risk involved in NBAD bonds.The short term bond rating lies in prime category according to Moody’s and Fitch rating. Overall ratings for short term bonds are good and it has very low risk involved.NBAD broadly has 3 types of debts. These are medium term notes, subordinated notes and medium term borrowings. There are more than 20 types of loans further with in the category with different maturities and interest rates. Some of the loans are mentioned without interest rates so in order to simplify the calculation of cost of debt we have calculated the average according to the weightage. The calculated cost of debt is 4.32%.Cost of Capital:The cost of capital is the cost that a company is expected to pay to the providers of capital. The cost of capital is usually higher for risky companies as investors and lenders expect higher returns for the higher level of risk. Companies usually use weighted average cost of capital (WACC) to appraise the investment projects. The weighted average cost of capital can be calculated as: Kc=EE+D×Ke+DD+E×Kd(1-T)Where E and D are weights of market value of equity and debt, T is the effective tax rate, Ke is cost of equity and Kd is cost of debt. The values of equity and debt have already been calculated in beta calculation. E=31400m AEDD=22516m AEDIn order to calculate the cost of capital of NBAD we must first calculate the cost of equity. Cost of equity can be calculated using capital asset pricing model (CAPM). The formula of return on equity according to CAPM is:Ke=Rf+(Rm-Rf)βeWhere Rf is risk free rate of return, Rm is market return and βe is beta equity (levered beta) of firm. Rm-Rf is called risk premium. Risk free rate is 2% in UAE and risk premium is 6.75%.Using these rates and levered beta (.510) we calculated the return on equity 5.44%.(Newyork University,n.d;UAE Deposits,n.d)Now using all the required data we have calculated WACC 4.97%.MEASURING INVESTMENT RETURNS:Abu Dhabi Islamic Bank:Accounting Returns:Return on equity is the measure of return generated on shareholders’ common equity. The return on equity is an important investor ratio that is widely used to assess the performance of a company. Return on equity can be calculated asReturn on Equity (ROE) = Net Income/Shareholders’ equityReturn on equity of ADIB for 2011 is 13.48%.Based upon this result ADIB is picking profitable projects.Return on capital is the measure of return generated on overall capital of a company. Overall capital includes book value of shareholders’ equity and book value of debt. Return on capital is calculated as:Return on Capital = Net Income/Total CapitalReturn on capital of ADIB for 2011 is 11.85%. By comparing this to the WACC (3%) we can conclude that ADIB performed well.Return on equity for previous year (2010) was 12.62% and comparing this figure to current year figure we can see a slight favorable change in performance. In 2009 ROE was drastically low at 1.5% which was abnormal return due to overall economic crisis in Middle East. Return on capital shows a stable trend with very low growth as it was 11.6% in 2010. Except for 2009 the trend is a growing trend as the bank is expanding its operations and putting profitable strategies in place.()The use of above accounting ratios as a measure of return is not a very good approach. These ratios use accounting returns (profits) which are highly subjective and arbitrary. Before reaching to an accounting profit a number of non-cash expenses are deducted such as depreciation and amortization which are just accounting estimates not real (cash) expenses. The accounting returns base on judgments of accountant as accounting standards provide different ways to account for the financial information. Accounting profits can be manipulated by business managers to improve these ratios such as cutting Research and Development expenditure to improve ratios in short term but it puts the long-term stability of a firm at stake. These ratios use book values of equity and debt which is not a fair approach. These ratios also don’t include the investing decisions that do not alter the capital side of balance sheet such as operating leases rather than finance leases. These ratios do not show good figures in short term if a company is investing more because the value of these ratios fall as capital or equity value increase.To make it fairer, accounting returns should be replaced with cash flows that actually are the returns and expenditure in ‘cash’ and discounting them using relevant discount rate (WACC). All the expenditure related to invested capital should be included in the calculation and book value of capital should be replaced with more updated values. Economic Value Added:Economic value added is the measure of increase/decrease in shareholders’ wealth that is in excess or less than the cost of capital. Economic value added uses ‘economic profit’ rather than accounting profit thus it’s a more fair measure of company’s performance as compared to other measures that use accounting profits. EVAEconomic Value Added=NOPAT-(WACC×Capital)NOPAT here is the economic profit earned by a firm. Ideally there are some 160 adjustments that should be made to reach this NOPAT but due to lack on information available and no tax world (UAE has no corporate tax) we are using EBIT. Capital is the total book value of capital employed; capital employed is the long term debt and shareholders’ equity in balance sheet.EVA for ADIB is calculated as follows:EVA=2042m-3.02%×13159mEVA=1645m AEDEVA of ADIB is a positive figure which means 1645m AED economic value has been added to the investors’ value in 2011. This amount is in excess of the cost of capital of the bank.National Bank of Abu Dhabi:Accounting Returns:Return on equity is the measure of return generated on shareholders’ common equity. The return on equity is an important investor ratio that is widely used to assess the performance of a company. Return on equity can be calculated asReturn on Equity (ROE) = Net Income/Shareholders’ equityReturn on equity of NBAD for 2011 is 14.05%.Based upon this result NBAD is picking profitable projects.Trends on return on equity can be seen as:Return on equity was highest in 2008 with 21% and it fell significantly in 2009 to 15% and remained stable in 2010 but slightly fell by 1% in 2011. The trend can be regarded as stable since 2009 however major decrease in return from 2008 to 2009 was primarily due to the overall economic crisis in Middle East. CITATION Asm \l 1033 (Asmainfo)The use of above accounting ratios as a measure of return is not a very good approach. These ratios use accounting returns (profits) which are highly subjective and arbitrary. Before reaching to an accounting profit a number of non-cash expenses are deducted such as depreciation and amortization which are just accounting estimates not real (cash) expenses. The accounting returns base on judgments of accountant as accounting standards provide different ways to account for the financial information. Accounting profits can be manipulated by business managers to improve these ratios such as cutting Research and Development expenditure to improve ratios in short term but it puts the long-term stability of a firm at stake. These ratios use book values of equity and debt which is not a fair approach. These ratios also don’t include the investing decisions that do not alter the capital side of balance sheet such as operating leases rather than finance leases. These ratios do not show good figures in short term if a company is investing more because the value of these ratios fall as capital or equity value increase.To make it fairer, accounting returns should be replaced with cash flows that actually are the returns and expenditure in ‘cash’ and discounting them using relevant discount rate (WACC). All the expenditure related to invested capital should be included in the calculation and book value of capital should be replaced with more updated values. Economic Value Added:Economic value added is the measure of increase/decrease in shareholders’ wealth that is in excess or less than the cost of capital. Economic value added uses ‘economic profit’ rather than accounting profit thus it’s a more fair measure of company’s performance as compared to other measures that use accounting profits. EVAEconomic Value Added=NOPAT-(WACC×Capital)NOPAT here is the economic profit earned by a firm. Ideally there are some 160 adjustments that should be made to reach this NOPAT but due to lack on information available and no tax world (UAE has no corporate tax) we are using EBIT. Capital is the total book value of capital employed; capital employed is the long term debt and shareholders’ equity in balance sheet.EVA for NBAD is calculated as follows:EVA=5317m-4.97%×48905mEVA=2886m AEDEVA of NBAD is a positive figure which means 2886m AED economic value has been added to the investors’ value in 2011. This amount is in excess of the cost of capital of the bank.CAPITAL STRUCTURE CHOICES:Abu Dhabi Islamic BankCapital structure of a company consists of debt finance and equity finance. Companies can choose to have different levels of debt in their capital structure however debt finance and equity finance both have their advantages and disadvantages. To assess the level of debt finance in capital structure firms have to consider few important aspects.Capital structure of a firm or gearing level can be assessed by Debt/Capital ratio which shows the value of debt as a percentage of total capital (debt plus equity) of a firm. D/C ratio of ADIB is 35%. A decision whether to add further debt is dependent upon the cost and benefits of debt to the bank. Debt finance has a cost which is finance cost that is paid to the lenders of debt. The tax advantage of this is a fact that this is a tax deductible expense unlike the dividend payments by a company that is non-tax deductible. Debt finance is also considered a cheaper finance to corporate finance managers. In case of ADIB this is irrelevant because UAE is a no tax zone and it doesn’t charge any tax to local corporate entities. Consequently ADIB has no ‘tax advantage’ in using debt finance. Free cash flows analysis is also very much important before increasing debt of a firm. Free cash flows are cash flows available for distribution among securities holder. Free cash flows can be calculated as: Free cash flows=EBIT1-T-Net Capital ExpenditureNet Capital expenditure is equal to capital expenditure less depreciation and amortization.The figure of free cash flows of ADIB for 2011 is 1832m AED. The level of free cash flows is high enough to pay off further interest however ADIB is an Islamic bank which has to pay profit to the Sukuk holders and also high level of dividends to investors. The volatility of operating profit should also be considered before giving final words on cash flows. The operating profit graph of ADIB is given below: CITATION Abu111 \l 1033 (Abu Dhabi Islamic Bank, 2011)The trend in operating profit is a positive trend which means ADIB can afford having more debt in its capital structure but managers should consider risk profile of shareholders because the bank is already geared and introducing more debts will make the bank more risky. The increasing level of operating profits tells us that bank invested in profitable opportunities in past and will continue to do so. According to pecking order theory the cheapest source of finance is the retained earnings and bank is retaining its earnings for future growth rather than relying on further debt finance.Retention of profits to finance future projects, giving higher level of dividends and timely information in the form of investors’ presentation on website mean the managers of ADIB are actually in line and performing in the interest of shareholders. ADIB board of directors also has a number of independent and non executive directors who scrutinize the bank’s performance in the best interest of shareholders. Debt holders can find relevant information regarding shareholders on ADIB’s website and recent developments. The bond rating of ADIB is high and they have low credit risk so there is a less risk involved for debt holders. The level of cash maintained in previous years may be a sign of concern for lenders due to high level of volatility in the level however they are enough to service the debt. For example in 2011 the profit paid to sukuk holders (debt holders) was 886mAED and cash level was 11273m AED. CITATION Asm \l 1033 (Asmainfo)The bank sets its targets for futures which are apparently feasible because it does include the level of competition, overall economic environment including recent financial crisis and market needs. Bank is planning to grow its operation in retail banking, diversifying the sources & structure of its revenue and entering new markets. CITATION Abu12 \l 1033 (Abu Dhabi Islamic Bank Official ) National Bank of Abu Dhabi:Capital structure of a company consists of debt finance and equity finance. Companies can choose to have different levels of debt in their capital structure however debt finance and equity finance both have their advantages and disadvantages. To assess the level of debt finance in capital structure firms have to consider few important aspects.Capital structure of a firm or gearing level can be assessed by Debt/Capital ratio which shows the value of debt as a percentage of total capital (debt plus equity) of a firm. D/C ratio of NBAD is 46%. A decision whether to add further debt is dependent upon the cost and benefits of debt to the bank. Debt finance has a cost which is finance cost that is paid to the lenders of debt. The tax advantage of this is a fact that this is a tax deductible expense unlike the dividend payments by a company that is non-tax deductible. Debt finance is also considered a cheaper finance to corporate finance managers. In case of NBAD this is irrelevant because UAE is a no tax zone and it doesn’t charge any tax to local corporate entities. Consequently NBAD has no ‘tax advantage’ in using debt finance. Free cash flows analysis is also very much important before increasing debt of a firm. Free cash flows are cash flows available for distribution among securities holder. There are different methods of calculating free cash flows. Free cash flows can be calculated as: Free cash flows=Cashflow from Operations-Capital ExpenditureThe figure of free cash flows of NBAD for 2011 is 3852m AED. The level of free cash flows is high enough to pay off further interest however NBAD pays high level of dividends and already has higher gearing levels so it will not be profitable to introduce more debts.The volatility of operating income should also be considered before giving final words on cash flows. The operating income graph of NBAD is given below:(Gulfbase)The trend in operating income is a positive trend which means NBAD can afford having more debt in its capital structure but managers should consider risk profile of shareholders because the bank is already geared and introducing more debts will make the bank more risky. The increasing level of operating income tells us that bank invested in profitable opportunities in past and will continue to do so. According to pecking order theory the cheapest source of finance is the retained earnings and bank is retaining its earnings for future growth rather than relying on further debt finance.Retention of profits to finance future projects, giving higher level of dividends and timely information in the form of investors’ presentation on website mean the managers of NBAD are actually in line and performing in the interest of shareholders. NBAD board of directors also has a number of independent and non executive directors who scrutinize the bank’s performance in the best interest of shareholders. Debt holders can find relevant information regarding shareholders on NBAD’s website, through analyst’s covering the bank and recent developments. The bond rating of NBAD is very high and they have lowest credit risk so there is very less risk involved for debt holders. We can further look to the level of cash balances maintained in previous years. The high level of cash balances is a good sign from debt holders’ perspective and it may also means that a firm is not using all resources on risky and bad projects. The level of cash maintained in previous years was higher as compared to a significant decrease in 2011. The decreased level of cash may put doubts on the credit risk of the bank in future and thus the ratings however as long as the bank is using these resources in profitable opportunities they will earn better returns. CITATION Asm \l 1033 (Asmainfo)The bank has set a number of targets for the future which includes entering into new markets such as India, Iraq and Brazil to increase the geographical diversification, investing in SME segments and achieving 16bn Net Profit in 10 years time at the growth rate of 16%. The targets are exaggerated and don’t have too much flexibility since UAE Banking sector has growth of 3.8% and bank believes that it would be able to grow at the rate of 16%. CITATION Nat12 \l 1033 (National Bank of Abu Dhabi Official)OPTIMAL CAPITAL STRUCTURE:Abu Dhabi Islamic BankThe optimal structure is ideally the structure where firm’s value is highest. As we know that market value of a firm is the present value of its future cash flows, discounted using WACC. Mathematically the value of a firm will be highest once we find the lowest WACC.The level of capital structure where WACC is lowest can be effectively called the optimal capital structure of a firm. Debt is regarded as a cheaper source of finance than equity due to two reasons; one is tax advantage of debt and second is the lower cost due to low risk. If we introduce more debt into a capital structure it will reduce the WACC as equity holders always require more returns than debt holders. By this introduction of debt, the WACC will fall but WACC is actually the weighted average of cost of debt and cost of equity so when we introduce more debt it will increase the gearing levels and thus the risk for shareholders. Shareholders will require more returns consequently and at very high levels of gearing risk for debt holders will also increase and they also will also require high returns. Lowest WACC can be achieved somewhere between the highest and lowest levels of gearing.In our case the bank is based in no tax world so no advantage can be made of debt. The beta of company is also lower which resulted in lower cost of equity; in fact cost of equity is still very close to the cost of debt and if we incorporate more debt it will rise. Cost of debt also rises as gearing level increases; this is because of increased credit risk and firm’s ability to pay interest on time. Current cost of capital of the bank is 3.02% and it will increase if more debt is introduced. The WACC will be lower at lowest possible gearing level however since it’s a financial entity(bank) we can’t eliminate long-term debt altogether but can conclude that it should keep the gearing level as low as possible.If we incorporate more debt at this point in this company ideally the share price will fall as the company becomes more risky to risk-averse investors however some investors believe that incorporation of debt in capital structure is a cheaper source of finance which can earn better return at lower cost so they might invest more money. Abu Dhabi Stock Exchange is not a very efficient market so we can expect that share price will not show significant change in short term if the incorporates more debt.ADIB’s current rating according to moody’s is A2 and A+ according to fitch’s. For under leveraged firms the ratings go downside pattern if optimal capital structure is reached through more debt incorporation however ADIB’s position is in contrast with that since it’s over leveraged if we reach the lowest gearing levels it would reach better rating. Ratings are also dependent upon the volatility of operating income. The operating income of ADIB shows a positive trend as it’s a growing bank. The relative analysis can be made with other banks operating in the same jurisdiction and listed in Abu Dhabi Stock Exchange. CITATION Asm \l 1033 (Asmainfo)ADIB’s gearing ratio is lower relative to these banks except for Sharjah Islamic Bank. The high gearing ratio is not profitable for these banks because of the no tax advantage as we mentioned previously.National Bank of Abu DhabiThe optimal structure is ideally the structure where firm’s value is highest. As we know that market value of a firm is the present value of its future cash flows, discounted using WACC. Mathematically the value of a firm will be highest once we find the lowest WACC.The level of capital structure where WACC is lowest can be effectively called the optimal capital structure of a firm. Debt is regarded as a cheaper source of finance than equity due to two reasons; one is tax advantage of debt and second is the lower cost due to low risk. If we introduce more debt into a capital structure it will reduce the WACC as equity holders always require more returns than debt holders. By this introduction of debt, the WACC will fall but WACC is actually the weighted average of cost of debt and cost of equity so when we introduce more debt it will increase the gearing levels and thus the risk for shareholders. Shareholders will require more returns consequently and at very high levels of gearing risk for debt holders will also increase and they also will also require high returns. Lowest WACC can be achieved somewhere between the highest and lowest levels of gearing.In our case the bank is based in no tax world so no advantage can be made of debt. The beta of company is also lower than the market which resulted in lower cost of equity; in fact cost of equity is still very close to the cost of debt and if we incorporate more debt it will rise. Cost of debt also rises as gearing level increases; this is because of increased credit risk and firm’s ability to pay interest on time. Current cost of capital of the bank is 4.97% and it will increase if more debt is introduced. The WACC will be lower at lowest possible gearing level however since it’s a financial entity(bank) we can’t eliminate long-term debt altogether but can conclude that it should keep the gearing level as low as possible.If we incorporate more debt at this point in this company ideally the share price will fall as the company becomes more risky to risk-averse investors however some investors believe that incorporation of debt in capital structure is a cheaper source of finance which can earn better return at lower cost so they might invest more money. Abu Dhabi Stock Exchange is not a very efficient market so we can expect that share price will not show significant change in short term if the incorporates more debt.NBAD current rating according to Moody’s and Fitch are very high. For under leveraged firms the ratings go downside pattern if optimal capital structure is reached through more debt incorporation however NBAD’s position is in contrast with that since it’s over leveraged if we reach the lowest gearing levels it would reach better rating. Ratings are also dependent upon the volatility of operating income. The operating income of NBAD shows a positive trend as it’s a growing bank. The relative analysis can be made with other banks operating in the same jurisdiction and listed in Abu Dhabi Stock Exchange. CITATION Asm \l 1033 (Asmainfo)NBAD’s gearing ratio is higher relative to these banks except for Abu Dhabi Commercial Bank. The high gearing ratio is not profitable for these banks because of the no tax advantage as we mentioned previously.MECHANICS OF MOVING TO THE OPTIMAL:Abu Dhabi Islamic BankImmediacy Question:ADIB isn’t under-levered as far as the optimal capital structure according to cost of capital is concern however according to prevailing gearing levels of banks in the similar sector it’s under levered. Being under levered doesn’t mean a firm is a potential takeover target. We must analyze firm from different perspectives to conclude whether it’s really a potential takeover target from a hostile firm.ADIB is a leading bank of UAE and has been ranked as the fourth largest Islamic bank of the world which means it’s not a small entity and not vulnerable due to its size. ADIB is under the significant control of Royal Family of Abu Dhabi who owns 41% of the bank. Other holdings include 8% by the government and 38% by UAE based individuals. Royal family has their representatives on board which means any hostile takeover is not an easy option, the family also has strong financial position and they enjoy holding major shareholding in UAE based companies. CITATION Abu111 \l 1033 (Abu Dhabi Islamic Bank, 2011)The returns of ADIB are quite impressive as we calculated and interpreted the accounting returns previously. The level of dividend paid remained quite good in previous years. The wealth of shareholders is represented by market capitalization. The market capitalization was also increased which can be seen as follows: CITATION Asm \l 1033 (Asmainfo)Due to the powerful ownership structure and satisfaction of shareholders in terms of increased market capitalization and dividend level the bank is not a potential target for hostile takeover.Alter Financing Mix Or Taking Projects:ADIB has 6 operating business segments as of 2011. The performance of these business segments can be seen as: CITATION Abu111 \l 1033 (Abu Dhabi Islamic Bank, 2011)The retail banking of ADIB is a major component of bank’s operating profit. During the year 2011 the Central Bank put more strict guidelines in place which were welcomed by ADIB and resulted in more responsible credit and service culture in UAE. Since it’s a vital component of ADIB’s profits the bank increased the number of ATM and braches to 460 & 69 respectively. The bank also initiated gold and diamond banking for affluent customers. The division also had geographical expansion as it opened branches in Saudi Arabia and UK. UK is a major market and ADIB is the first retail bank to open in UK. The performance of retail banking remained good in previous years and knowing the recent investments in new markets we have strong reasons to conclude that this segment will continue to grow at better pace in future.Wholesale banking segment focuses on Corporate Banking, Public Sector Banking, Financial Institutional Clients, Investment Banking, Transaction Services and Corporate Finance. In 2011 the bank managed to increase the operating profit despite of too much competition in the market. ADIB reached the status of approved major oil supplier due to increase of transaction services focus in this area. The Corporate Finance and Investment Banking departments launched a dedicated project finance/capital-raising advisory unit which is expected to reach full proficiency in 2012. The Sukuk (debt finance) is a popular product of this segment which will grow at better pace in future due to increased use of Islamic products by corporate entities. Due to all the growth factors mentioned and results achieved in past we can conclude that the bank will achieve great growth in this segment.Private Banking is an emerging segment of the bank. The bank separated the operation of Private Banking by establishing a dedicated private bank. Major marketing events are planned in 2012 which will approach corporate families in UAE. The Real Estate business is a loss making segment which remained loss making in 2011 too. The overall Real Estate industry is in turbulent times and it will continue to incur losses in 2012 and in future. This is a bad investment sector and further investment in this sector means non-profitable decisions. Fortunately the weightage of this segment is quite low on overall returns.Overall the bank has produced great returns on investment in past which is evident by the returns calculated previously. By performing analysis on each segment we can conclude that overall the bank has many profitable opportunities which will produce excess returns in future with greater pace.The majority of shares belong to the Royal Family of Abu Dhabi and they don’t want to realize their investment in future as they look more interested in dividends rather than selling their shares back to the bank. The shareholders proffered dividend in past and this is evident by high level of dividend payments. The individuals also want dividend payments as there is no share buyback transaction in bank’s financials. CITATION Abu111 \l 1033 (Abu Dhabi Islamic Bank, 2011)Financing Type:Macro economic factors such as interest rates, currency movements, inflation and overall economy affect every business. The degree of affection can be higher or lower for different business. Financial entities such as banks’ income and costs are highly dependent upon such macroeconomic changes. Changes in these factors change the interest rates and returns demanded by investors. Consequently it changes the WACC and capital structure of a firm.ADIB is an Islamic bank which doesn’t pay Riba (interest) apparently but Sukuk is a debt finance instrument and return is also dependent upon prevailing interest rates. The bank essentially pay interest/profit on fixed income securities and receive it from customer financing so the effect of change in interest rate would ideally be nil but it’s necessary to look the cost/income ratio of a bank and if it’s higher it means bank is highly exposed to interest rate risk.Cost/income ratio of ADIB can be seen as follows: CITATION Abu12 \l 1033 (Abu Dhabi Islamic Bank Official ) Cost/Income is quite stable except for 2009. Cost/Income ratio of 39% is considered quite lower and good for banks. The major operating income of the bank is derived from Murabaha, Mudaraba, Ijara and other Islamic financing from customers. This income further has categories of goods, vehicle, share and commodities. If inflation is increased the purchasing power of customer will change and also prices of commodities. The bank may not be able to alter the agreements already made and may face losses if such changes happen. Foreign exchange risk is also there for the bank however since bank doesn’t have too much geographical diversification the impact would be lower of any such changes. CITATION Abu111 \l 1033 (Abu Dhabi Islamic Bank, 2011)UAE doesn’t have high inflation currently although it used to have high inflationary pressure but that pressure relaxed in 2009 and now it’s standing at 3%.(Export Finance and Insurance Corporation)Considering all the macroeconomic factors and level of volatility due to changes in macroeconomic factors we can finally discuss the financing type that the firm should use. Ideally firms should use internally generated earnings to finance their future projects as these earnings do not have any cost of capital. Debt and equity holders both want return on their investments but we must know that interest on debt should be paid whether company makes profit or not in a specific period. Equity holders’ return in contrast is not mandatory to be paid and firm can defer dividend payment in turbulent times. Analyzing the volatility of earnings and their dependency upon macroeconomic factors we can conclude that firm should use internally generated earnings to finance the projects or issue more shares in future as it also doesn’t have tax advantage of debt. National Bank of Abu Dhabi:Immediacy Question:NBAD isn’t under-levered according to the optimal capital structure according to cost of capital and the prevailing gearing level. Being under levered doesn’t mean a firm is a potential takeover target. We must analyze firm from different perspectives to conclude whether it’s really a potential takeover target from a hostile firm.NBAD is a leading commercial bank of UAE and has been ranked as the largest bank of Abu Dhabi which means it’s not a small entity and not vulnerable to takeover due to its size. NBAD is under the significant control of the Government of Abu Dhabi who owns 70% of the bank. Other holdings include 27% by UAE based individuals. Government has its representatives on board of director that means any hostile takeover is not an easy option.The returns of NBAD are quite impressive as we calculated and interpreted the accounting returns previously. The level of dividend paid remained quite good in previous years. The wealth of shareholders is represented by market capitalization. Market capitalization can be seen as follows: CITATION Asm \l 1033 (Asmainfo)The market capitalization remained volatile during previous five years which is due to similar change in the ADX market. It could have been a risk of hostile takeover but in the case of NBAD it is still not a risky point because the Government owns the majority shares and we all know that Governments don’t invest to realize their investment. Alter Financing Mix Or Taking Projects:NDAB has 7 operating business segments as of 2011. The performance of these business segments can be seen as: CITATION Nat11 \l 1033 (National Bank of Abu Dhabi, 2011 )The Domestic Banking is responsible for three major customer segments: Consumer Banking, Business Banking group and Elite Banking. In 2011 new regulations by central bank caused few challenges though but bank managed to grow the income. Initiatives were taken to enhance customer services, seven new branches and 128 new ATMs were added to the segment, 25% growth in elite banking and a number of new products were launched in this segment. In business banking group NBAD focused on SME and launched 6 tailor made products for businesses to capture SME market. Due to strong historical results and recent growth opportunities in this segment we believe that the bank will continue to grow in this area with better pace in future.The International Banking segment manages the overseas banking network and credit derivative book. It primarily comprises of both Arab world banking (in Bahrain, Egypt, Oman, Kuwait, Jordan, Sudan and Libya) and international banking (in France, Malaysia, Hong Kong , the United Kingdom and the United States of America). The bank has recently expanded the operations in this segment by opening new units in 11 countries. The business in Arab world didn’t grow up well due to recent political and social unrest in this part. The bank has recently started business in Chinese and Malaysian markets. The segment enjoyed great growth in past and the recent opportunities in new markets have great potential of growth nevertheless the Arab turmoil may continue to be there so we conclude that bank may grow in this segment but not with extra ordinary pace.The Financial Markets segment is the Group’s key access point to the global markets; it also ensures the liquidity for the entire bank. The managers focused on Japanese markets and issued notes of 130m US dollar. The sales in this segment were increased and a number of new agreements have been made with Islamic investors and corporate entities in commodities hedging. The segment continued to grow however derivatives expose firms to greater risks and the bank will grow in this area as historical patterns and recent developments suggest however the level of risk should be reconsidered. Corporate and Investment Banking segment provides corporate and investment clients with strategic advice and bespoke solutions. The segment comprises six units: Corporate Banking, Investment Banking, Wholesale Banking, Abu Dhabi National Leasing, Abu Dhabi National Properties and Special asset advisory. Corporate banking managers focused on the Government and public sector entities while investment banking got a couple of great M&A and advisory tasks. The properties business faced the adverse effects of major downturn in real estate business in UAE however the unit has a growth perspective because it recently got associated with UK based property company Knight Frank. Overall the segment is quite critical for the bank as it makes nearly half of the bank’s profit. Due to the average level growth and good historical returns we conclude that bank will continue to invest in this segment and grow at ordinary rates since the segment is highly competitive. Overall the bank has produced great returns on investment in past which is evident by the returns calculated previously in investment returns section. By performing analysis on major segments we can conclude that overall the bank has many profitable opportunities which will produce excess returns in future with greater pace.The majority of shares belong to the Government of Abu Dhabi and they don’t want to realize their investment in future as they own the bank as a bank for state activities and may want dividend to run meet the state expenditures. The shareholders preferred dividend in past and this is evident by high level of dividend payments. The individuals also want dividend payments as there is no share buyback transaction in bank’s financials. CITATION Nat11 \l 1033 (National Bank of Abu Dhabi, 2011 )Financing Type:Macro economic factors such as interest rates, currency movements, inflation and overall economy affect every business. The degree of affection can be higher or lower for different business. Financial entities such as banks’ income and costs are highly dependent upon such macroeconomic changes. Banks also have a number of derivatives and floating rate products which are highly sensitive to such changes. Changes in these factors change the interest rates and returns demanded by investors. Consequently it changes the WACC and capital structure of a firm.NBAD has a diversified business portfolio which has a number of assets, liabilities, costs and income sensitive to the interest rates fluctuations, currency changes and overall economy. Due to presence in different geographical sectors the bank has exposed itself to the increased level of currency risk plus there is also credit risk involved with different kind of loans, debt securities, commitments, OTC derivatives and other off balance sheet. Total gross credit exposure by different instruments is 689bn AED which can be segregated as:The highest level of credit risk faced from the OTC Derivatives. The bank faces high level of credit risk due to all these instruments.The bank further faces currency risk due to geographical diversification which can be seen as follows:The major currency risk arises from the European side and due to the recent Euro zone debt crisis this is a major concern. The bank has high currency risk involved.Cost/income ratio of NBAD can be seen as follows: CITATION Nat11 \l 1033 (National Bank of Abu Dhabi, 2011 ) Cost/Income is volatile with increasing trend which is unfavorable and it means bank’s cost is rising in comparison to its income.The bank’s major operating income is from interest. Other operating income is from Islamic finance contracts and bank fees. Foreign exchange gains and losses also alter the pattern of income. Some of the bank’s investments carry floating interest and others carry fixed interest. In either case the income is highly sensitive to the level of interest rates changes however a bank’s costs also move with interest rates though not in similar proportion. CITATION Nat11 \l 1033 (National Bank of Abu Dhabi, 2011 )UAE doesn’t have high inflation currently although it used to have high inflationary pressure but that pressure relaxed in 2009 and now it’s standing at 3%.(Export Finance and Insurance Corporation)Considering all the macroeconomic factors and level of volatility due to changes in macro economic factors we can finally discuss the financing type that the firm should use. Ideally firms should use internally generated earnings to finance their future projects as these earnings do not have any cost of capital. Debt and equity holders both want return on their investments but we must know that interest on debt should be paid whether company makes profit or not in a specific period. Equity holders’ return in contrast is not mandatory to be paid and firm can defer dividend payment in turbulent times. Analyzing the volatility of earnings and their dependency upon macroeconomic factors and current gearing levels we can conclude that firm should use internally generated earnings to finance the projects or issue more shares in future as it also doesn’t have tax advantage of debt. DIVIDEND POLICY:Abu Dhabi Islamic BankHistorical Dividend Policy:ADIB paid 24.4% (as a percentage to the face value) dividend per share in 2011. This makes total payment of 578m AED. The bank didn’t buy back any shares in the previous 2 years. The levels of historic dividend payments, as a percentage to face value of shares, are shown below: CITATION Abu12 \l 1033 (Abu Dhabi Islamic Bank Official )The level of cash dividend remained unstable as in 2007 and 2009. The reason was low level of earnings in these years however bank paid 20% bonus to shareholders in 2007 and 2009.Firm Characteristics:Dividend policy decides the level of dividends that should be paid to investors of a firm. There are different theories that do exist and a famous one of them is Modigliani and Miller theory. The theory suggests that in a perfect capital market the shareholders are indifferent whether their wealth is increased due to dividends or share price increment and as long as the firm invests in positive NPV projects it increases the wealth of shareholders. The theory actually has assumption of ‘perfect’ capital market which is not possible practically. Shareholders in practical are not indifferent of capital gains and dividend due to a number of reasons. The main reasons include the level of taxation on capital gains and dividend income; dividend is taxed at lower rates as compared to the capital gains. The need of current income by shareholders is also important; they want that to meet their expenses and lastly liquidity requirements of shareholders.Another aspect of dividend policy is dividend signaling. The shareholders do not have access to the insider information and thus they can only analyze the true value of a firm by market information and more importantly firm’s actions and results. Dividend is practically regarded as a signal to the market that the firm has enough cash to pay its investors and they are not forecasting any major financial distress in future that restrict them to pay dividends. Historically it has been seen that share price increases after excess dividends announcement and falls with the decrease in the level of dividends. Too much dividend payment may be seen as a negative signal and investors might think that firm doesn’t have future growth potential as they are not keeping funds to finance their growth. The internally generated funds are best way to finance any future investments due to the fact that they do not have any cost of finance but due to above mentioned reasons dividends can’t be too low so a trade off is actually needed.In case of ADIB the information is available to investors widely through its website under investor relations section however Abu Dhabi Stock Exchange, in which the company is listed, is actually not a big exchange and thus analysts do not cover it usually so investors might lack the analysts’ opinion on this stock. Due to this reason the bank must use dividend as a signal (good signal) to investors.The major shareholding of ADIB is in the hands of Royal Family of Abu Dhabi and individual investors of UAE. Both of them do not seem to be interested in realizing their investments rather want ongoing income in terms of dividend which is evident by historical dividend payments and no share buybacks.Financial flexibility of a firm can be defined as the ability and choices to get additional finance. The flexibility in finance is broadly important to every firm and especially financial firms like banks but a firm can’t enjoy such flexibility if its earnings are volatile plus it has higher debt/capital ratio. Due to stable pattern of earnings generated by ADIB it can forecast its financing needs and keep necessary reserves; ADIB is not very much dependent upon flexibility when fluctuations in market occur however due to its business nature it’s essential to have such flexibility. ADIB is actually flexible to the rapid changes as it can use more debt due to low debt/capital ratio as compared to the market. Covenants by lenders usually put restrictions on firms to pay dividends to investors as the lenders do not want all cash to be drained paying dividends. This is usually the case with high level of gearings and bad credit ratings. ADIB doesn’t have any such covenants.The level of dividend paid (DPS) by other banks in the market and ADIB can be seen as follows: CITATION Asm \l 1033 (Asmainfo)The DPS of ADIB is more than other banks with similar EPS however little lower than NBAD but this is due to higher EPS achieved by NBAD. The shareholders enjoyed good dividends despite low EPS as compared to other banks in the market. Nevertheless the dividend payments were not stable though in 2010 and 2011 the bank maintained payout ratio of 50% but in 2009 the bank paid bonus of 20%. Bonus share is a good alternative to dividend payments when firm does not have too much cash available especially with low earnings in a particular period. Bonus-shares do not add any value to shareholders wealth rather just increase the number of shares held by each shareholder. Bonus shares essentially pay off investors if the company pays off similar or higher dividends ‘per share’ as they enjoy more dividends in total.National Bank of Abu DhabiHistorical Dividend Policy:NBAD paid 30% (as a percentage to the face value) cash dividend and 35% bonus per share in 2011. This makes total payment of 861m AED (only cash dividend). The bank didn’t buy back any shares in the previous 2 years. The levels of historic dividend payments, as a percentage to face value of shares, are shown below: CITATION Asm \l 1033 (Asmainfo)In addition to that the bank paid bonus share in percentage of face value as follows:2007200820092010201120%10%10%20%35% CITATION Nat12 \l 1033 (National Bank of Abu Dhabi Official)The level of cash dividend per share declined which can be easily seen in the cash dividend column chart however one thing is worth noting that the level of bonus shares given in previous years actually increased the number of shares. The overall payment of dividends increased in 2010 and 2011 as compared to 2007 but DPS remained lower due to higher number of shares. Firm Characteristics:Dividend policy decides the level of dividends that should be paid to investors of a firm. There are different theories that do exist and a famous one of them is Modigliani and Miller theory. The theory suggests that in a perfect capital market the shareholders are indifferent whether their wealth is increased due to dividends or share price increment and as long as the firm invests in positive NPV projects it increases the wealth of shareholders. The theory actually has assumption of ‘perfect’ capital market which is not possible practically. Shareholders in practical are not indifferent of capital gains and dividend due to a number of reasons. The main reasons include the level of taxation on capital gains and dividend income; dividend is taxed at lower rates as compared to the capital gains. The need of current income by shareholders is also important; they want that to meet their expenses and lastly liquidity requirements of shareholders.Another aspect of dividend policy is dividend signaling. The shareholders do not have access to the insider information and thus they can only analyze the true value of a firm by market information and more importantly firm’s actions and results. Dividend is practically regarded as a signal to the market that the firm has enough cash to pay its investors and they are not forecasting any major financial distress in future that restrict them to pay dividends. Historically it has been seen that share price increases after excess dividends announcement and falls with the decrease in the level of dividends. Too much dividend payment may be seen as a negative signal and investors might think that firm doesn’t have future growth potential as they are not keeping funds to finance their growth. The internally generated funds are best way to finance any future investments due to the fact that they do not have any cost of finance but due to above mentioned reasons dividends can’t be too low so a trade off is actually needed.In case of NBAD the information is available to investors widely through its website under investor relations section and a number of analysts follow the bank but information from these analysts is not widely available. Due to this reason the bank must use dividend as a signal (good signal) to investors so they must know that bank is not foreseeing any major financial distress in the future and can afford to use its retained earnings to pay off the investors.The major shareholding of NBAD is in the hands of the Government of Abu Dhabi and individual investors of UAE. The Government sees the bank as a major entity that contributes to its economy and will not realize the investment. The individual investors of NBAD also do not look interested in realizing their investment rather in dividend income as we have seen in past patterns of dividends. Financial flexibility of a firm can be defined as the ability and choices to get additional finance. The flexibility in finance is broadly important to every firm and especially financial firms like banks but a firm can’t enjoy such flexibility if its earnings are volatile plus it has higher debt/capital ratio. The pattern of earnings of NBAD is quite stable as but it faces high level of risks which include credit risk, market risk and currency risk. NBAD is already more geared than average of the market though its bond ratings are still good. We believe that due to earnings pattern NBAD is able to forecast its financing needs which can further be seen by earnings retentions.Covenants by lenders usually put restrictions on firms to pay dividends to investors as the lenders do not want all cash to be drained paying dividends. This is usually the case with high level of gearings and bad credit ratings. NBAD doesn’t have any such covenants.The level of dividend paid (DPS) by other banks in the market and NBAD can be seen as follows: CITATION Asm \l 1033 (Asmainfo)The DPS of the bank remained highest as compared to other banks in the market however the level of DPS is quite low as compared to the EPS achieved by the bank. The bank is proposing more investments in other segments of business as we discussed earlier so we believe that bank is actually retaining its earnings for those investment projects as more debt financing can lead to more risk.FRAMEWORK FOR ANALYZING DIVIDENDS:Abu Dhabi Islamic BankAffordable Dividends:The best practical way to analyze the level of affordable dividends is free cash flow to equity. Free cash flow to equity actually calculates the level of funds available to equity holders after the deduction of interest payments (lenders’ return) and net borrowings from free cash flow to firm. As we have calculated the free cash flow to firm so we are starting calculation from that point.Amount in AED m200920102011Free Cash flows60716991832Less: Interest(978)(1045)(886)Add: Debt Issued200027542089Less: Debt Repaid-(253)(2938)Free Cash flow to Equity162934083035 CITATION Abu111 \l 1033 (Abu Dhabi Islamic Bank, 2011)(Abu Dhabi Islamic Bank, 2009)The total amount of dividend paid, payout ratio and cash balances available are also relevant and this information is given below:Amount in AED m200920102011Cash balance333198811273Total Dividend Paid-512578Payout Ratio-50%50% CITATION Asm \l 1033 (Asmainfo)Now we have all this information we can analyze the affordable dividend more effectively. The bank didn’t pay anything in 2009 due to poor earnings result and paid out 50% of its earnings in 2010 and 2011. The level of dividend that the bank actually could afford is shown by free cash flow to equity. The level of dividend that was paid by the bank was affordable which can be seen clearly from the above information.Management Trust:There is a fiduciary relationship between the owners and managers of a company. The management can’t earn the trust of owners in a day and it takes time before managers could prove themselves by earning good results and adding value to shareholders.In case of ADIB, the management has historically proven itself by earning good returns on investment though the business was adversely affected by the overall downturn in UAE economy and real estate sector. The Islamic banking is an emerging sector according to a number of market analysts. We have also analyzed the level of investments bank has recently made or planned to make. The bank has clear growth potential and earning good results due to historical patterns and future outlook both. We have no reason to believe that managers will fail to invest in such (good) projects and increase the wealth of shareholders.Changing Dividend Policy:The firm has to alter its dividend policy when it’s paying too low or too high dividends. High dividends are those dividends that a firm cannot afford and yet pay out of reserves or net positive borrowings or do not retain much to finance future projects. Lower dividends are generally those dividends that are quite lower as compared to sector dividends or if a firm’s managers failed to utilize the resources of company effectively and efficiently in past then it is better to pay off the returns rather than retaining and losing them in bad projects.For ADIB the dividend policy is quite reasonable. The level of dividend paid in past was affordable and a constant payout was maintained. The shareholders also do not prefer buyback over dividends as we have seen no such thing happening in past so it’s better to maintain this level of payout.National Bank of Abu Dhabi:Affordable Dividends:The best practical way to analyze the level of affordable dividends is free cash flow to equity. Free cash flow to equity actually calculates the level of funds available to equity holders after the deduction of interest payments (lenders’ return) and net borrowings from free cash flow to firm. As we have calculated the free cash flow to firm so we are starting calculation from that point.Amount in AED m200920102011Free Cash flows1195(14470)3852Less: Interest(2256)(2129)(2157)Add: Debt Issued91445128538Less: Debt Repaid(800)(4176)(591)Free Cash flow to Equity7283(15647)1642 CITATION Nat11 \l 1033 (National Bank of Abu Dhabi, 2011 )(National Bank of Abu Dhabi, 2010)The total amount of dividend paid, payout ratio and cash balances available are also relevant and this information is given below:Amount in AED m200920102011Cash balance37578325934254Total Dividend Paid217718861Payout Ratio7%19%23% CITATION Asm \l 1033 (Asmainfo)Now we have all this information we can analyze the affordable dividend more effectively. The bank also paid bonus shares in percentage of face value as 10% in 2009 30% in 2010 and 30% in 2011. The level of dividend that the bank actually could afford is shown by free cash flow to equity. The level of dividend bank paid was actually not affordable in 2010 however we should understand that there were significant abnormal changes in working capital in 2010 that’s why free cash flows figure look quite adverse. Management Trust:There is a fiduciary relationship between the owners and managers of a company. The management can’t earn the trust of owners in a day and it takes time before managers could prove themselves by earning good results and adding value to shareholders.In case of NBAD, the management has historically proven itself by earning good returns on investment though the business was adversely affected by the overall downturn in UAE economy.The bank has some strong segments in which it leads the financial markets of UAE and it has geographical diversification which ensures the growing earnings opportunities in future as they achieved in past. The historical patterns do not necessarily occur in future but due to low level of inflation and stability of local economy and operational reasons we believe that bank will continue to give the historical returns.Changing Dividend Policy:The firm has to alter its dividend policy when it’s paying too low or too high dividends. High dividends are those dividends that a firm cannot afford and yet pay out of reserves or net positive borrowings or do not retain much to finance future projects. Lower dividends are generally those dividends that are quite lower as compared to sector dividends or if a firm’s managers failed to utilize the resources of company effectively and efficiently in past then it is better to pay off the returns rather than retaining and losing them in bad projects.For NBAD the dividend policy should be reconsidered. The payout ratio of NBAD is not very good as compared to the other banks operating in the market which means NBAD is retaining earnings for future growth since due to relatively high level of gearings NBAD can’t afford to look for more debts in balance sheet. NBAD historically paid bonus percentage on shareholding which doesn’t actually increase the wealth of shareholders rather no. of shares owned. NBAD should reconsider the bonus as it just increase the no. of shares and in future DPS maintenance results in higher total dividends. VALUATION:Abu Dhabi Islamic Bank:Valuation of a firm is not an exact science and practically it’s regarded as an art not science. Firms are valued from a number of methods in real world however not all valuation models are appropriate in a given situation for a given firm. P/E ratio is a valuation ratio for a stock which actually estimate the intrinsic value of a stock but there is an assumption that market is ‘actually’ valuing a stock genuinely. The assumption cannot be taken in our situation where our bank is traded in Abu Dhabi Stock Exchange which is not a very technical market and slim chances that it is valuing the stock genuinely. Dividend discount model is another model that can be used to value firm by discounting future dividends on cost of equity but reliability is also low for this model. The most popular model is free cash flow discounting model practically. The dividends of ADIB are related to the free cash flow and the leverage of the firm is expected to change as the bank is planning to issue more Sukuk (debt) to finance the future activities. Due to this reason we are using free cash flow and we will discount it using cost of capital (WACC). The inflation is not very much high in the country so we are not using real values.The growth of the earnings remained higher in previous periods for bank. The growth of the cash flows to equity also grew. Analysts’ growth rate is actually not given and we cannot estimate the value of cost of capital(WACC) in future growth periods so we can use long term growth rate due to lack of information available. The long term growth rate is estimated to be 2% and we are using it as the constant growth.Value of Firm=Value of Equity+ Value of Debt This can be seen as follow:Value of Firm=FCFF(1+g)WACC-g =1832(1+2%)3.02%-2% =AED 18142mThis value of the bank is highly due to the growth level that is supposed and due to low cost of capital the value is quite higher than the present value of the bank. The value is highly sensitive to the assumptions that are taken. The cost of capital that is supposed may be changed in future and it has ability to alter the value. The growth rate is highly subjective as practically there are a number of growth rates for example one period growth, two period growth and others can be supposed but here due to lack of information we used a single growth rate model. Any change in the level of growth can alter the value. The free cash flows in the future maybe highly different to the one that is supposed here (the historical cash flow).Overall the bank has highly qualified human resources in place who have contributed to the value enhancement of the bank in past as can be seen in profitability ratios which are quite higher as compared to other firms in the market. The operating income is showing a positive trend. The Islamic banking market overall is expected to enhance its share in the future so the bank has growth potential with positive cash flows in future. The cost of capital is lower than other market players however reaching to the optimal level of capital structure can further add value to the firm. All business segments are expected to grow at the same or higher pace except for Real Estate business which is a loss making segment however firm is not planning to increase the level of investment. Overall the investment, financing and dividend policy all look quite reasonable however for financing side the bank should try to use its own retained earnings rather than issuing more long term debts for financing purpose (business debt due to the nature of business is not included). If we successfully use this type of financing than the retained earnings used will get better cash flows and increase the equity thus wealth of shareholders. The firm is a listed firm and usually the control premium in traded firms is 30% of the value of equity.National Bank of Abu Dhabi: Valuation of a firm is not an exact science and practically it’s regarded as an art not science. Firms are valued from a number of methods in real world however not all valuation models are appropriate in a given situation for a given firm. P/E ratio is a valuation ratio for a stock which actually estimate the intrinsic value of a stock but there is an assumption that market is ‘actually’ valuing a stock genuinely. The assumption cannot be taken in our situation where our bank is traded in Abu Dhabi Stock Exchange which is not a very technical market and slim chances that it is valuing the stock genuinely. Dividend discount model is another model that can be used to value firm by discounting future dividends on cost of equity but reliability is also low for this model. The most popular model is free cash flow discounting model practically. The dividends of NBAD are related to the free cash flow and the leverage of the firm is expected to change to finance the future activities. Due to this reason we are using free cash flow and we will discount it using cost of capital (WACC). The inflation is not very much high in the country so we are not using real values.The growth of the earnings remained higher in previous periods for bank. The growth of the cash flows to equity also grew. Analysts’ growth rate is actually not given and we cannot estimate the value of cost of capital(WACC) in future growth periods so we can use long term growth rate due to lack of information available. The long term growth rate is estimated to be 2% and we are using it as the constant growth.Value of Firm=Value of Equity+ Value of Debt This can be seen as follow:Value of Firm=FCFF(1+g)WACC-g =3852(1+2%)4.97%-2% =AED 132291mThis value of the bank is highly due to the growth level that is supposed and due to low cost of capital the value is quite higher than the present value of the bank. The value is highly sensitive to the assumptions that are taken. The cost of capital that is supposed may be changed in future and it has ability to alter the value. The growth rate is highly subjective as practically there are a number of growth rates for example one period growth, two period growth and others can be supposed but here due to lack of information we used a single growth rate model. Any change in the level of growth can alter the value. The free cash flows in the future maybe highly different to the one that is supposed here (the historical cash flow).Overall the bank has good corporate governance in place who has contributed to the value enhancement of the bank in past as can be seen in profitability ratios which are quite higher as compared to other firms in the market. The operating income is showing a positive trend. The bank’s corporate banking market is quite mature so not too much growth is expected from this investments however the bank has plans to introduce itself in new segments and increase investments in those segments. The cost of capital is relatively higher for NBAD as it’s using too much debt in its capital structure and if we move to optimal this WACC can be decreased. All business segments are expected to grow at the same or higher pace. The financing side of the bank needs to be reviewed critically as the bank has high gearing than other players in the market with no tax advantage of debt. Debt should be repaid using government grant, as it is a government bank, and the bank should focus on using its own retained earnings to finance future projects. The dividend policy should also be revised as the investors are only looking for dividends and a constant payout ratio would help them to forecast their income. The bonus should also be reconsidered as it doesn’t add any value to the shareholders’ wealth rather increase number of shares. If we successfully use this type of financing then the retained earnings used will get better cash flows and increase the equity thus wealth of shareholders.The firm is a listed firm and usually the control premium in traded firms is 30% of the value of equity.REFERENCES & BIBLIOGRAPHY:Abu Dhabi Islamic Bank’s CEO.n.d.Retreived from Bank of Abu Dhabi’s CEO.n.d. Retrieved from (QTEL)%20Q.ational Bank of Abu Dhabi Board of Directors.n.d. Retrieved from Default Spreads and Risk Premiums.2012. Retrieved from Term Rates. Retrieved from Profile National Bank of Abu Dhabi.2011. Retrieved from Rating National Bank of Abu Dhabi 2011. Retrieved from Bank of Abu Dhabi Awards. Retrieved from Coverage National Bank of Abu Dhabi. Retrieved from Payments National Bank of Abu Dhabi. Retrieved from Rating.Abu Dhabi Islamic Bank. Retrieved from Coverage Abu Dhabi Islamic Bank.Retrieved from Abu Dhabi Islamic Bank.Retrieved from Annual Report.2011.National Bank of Abu Dhabi.Annual Report 2010.National Bank of Abu Dhabi.Annual Report 2009 Abu Dhabi Islamic Bank.Annual Report 2011 Abu Dhabi Islamic Bank.Other Sources Used:Charts.Asmainfo.Retrieved from Historical Data.Asmainfo.Retrieved from Historical Data.Gulfbase.Retrieved from ................
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