The Examiner's Answers F3 - Financial Strategy

Transcription

1 The Examiner's Answers F3 - Financial Strategy Some of the answers that follow are fuller and more comprehensive than would be expected from a well-prepared candidate. They have been written in this way to aid teaching, study and revision for tutors and candidates alike. SECTION A Answer to Question One REPORT TO THE BOARD OF DIRECTORS OF F PLC SUBJECT: Strategic plans for future financing requirements From: Finance Director, F plc Date: 1 October 2011 Purpose The purpose of this report is to address the concerns of the directors regarding the possible impact of exchange rate movements and liquidity requirements in general on the financial and strategic decisions of the company. In particular, the report will focus on: the possible impact of a weakening of the euro against British pounds on future performance and share price sustainability of the current dividend policy future financing requirements and possible sources of finance The report will conclude with advice on whether the planned product launches in Europe are sustainable in the light of the above analysis. The latest cash flow forecast is attached at Appendix A of the report and the results of this forecast will be referred to throughout this report. 1

2 Possible impact of exchange rate movements on cash flow and share price (Requirement (b)(i)) Impact on annual and cumulative cash flow The cash flow forecasts attached at Appendix A demonstrate the significant impact that a decline in the value of the euro over a three year period from GBP/EUR at 1 January 2011 to GBP/EUR at 31 December 2013 could have on the future results of F plc. With a growing proportion of revenue forecast from the eurozone, we would expect a growing disparity between the two forecasts over time and, indeed, the forecasts support this. Comparing the results for the 2 nd forecast against those for the 1 st forecast, purely as a result of changing the assumption on how the exchange rate will behave we can make the following comments: By 2013, operating cash flows would be GBP 54 million lower at GBP 43 million rather than GBP 97 million. The first forecast shows a positive total cash flow after tax, interest and dividends. This is in stark contrast to the second forecast which shows a cash loss after tax, interest and dividends in 2012 and 2013, even before deducting the capital investment and RCF repayment cash flows. Under the 2 nd forecast, by the end of 2013 borrowings net of cash are forecast to be 30% greater at GBP 285 million rather than GBP 220 million under the first forecast. The cash forecasts do not build in any adjustment for the possibility of increasing export prices to compensate for a fall in value of the euro. However, the volumes that we are able to sell could be reduced if we were to increase euro prices as our products become less competitive. On the other hand, if our competitors are facing similar pricing pressures, there may be a general increase in prices that will help reduce the impact on our performance of a fall in the value of the euro. It is important that we understand the exchange risk faced by our competitors. Impact on share price Any impact of exchange rate movements on future cash flows will clearly also impact on our share price. A fall in net cash inflows could see a reduction in the share price again despite the recent gains. The share price is determined by the market according to the perceived value of the company. One method used to value the company is on the basis of predicted future cash flows. Under the semi-strong form of the efficient market hypothesis, we would expect share prices to move to reflect publicly available information such as movements in exchange rates and the proportion of export sales a figure that is publicly available in the notes to F plc s financial statements. Sustainability of proposed dividend policy and possible alternative dividend policies (Requirement (b)(ii)) As we are a quoted company it is important that our dividend policy is consistent in order to keep the market happy. Any sudden changes in the policy could have a detrimental effect on the share price. The latest dividend for the year ended 31 December 2010 of GBP 16 million represents a dividend yield of 4.8% (= GBP 16 million/(gbp 0.60 x 560m). 2

3 Our proposed policy for 2011 onwards is to pay a dividend which grows at a rate of 8% per annum. This is ambitious but as our first forecast shows, it is achievable if exchange rates do not change significantly. Inflation rates are also relevant when assessing how achievable such nominal growth is if inflation is running at 5%, dividend growth of 8% in nominal terms is only 3% in real terms. The cash forecast shows that, if exchange rates move against the company and inflation remains unchanged, the 8% growth in dividends would appear to be unsustainable. Given that the proposed policy has already been released to the market care must be taken to keep our shareholders and the market informed about any potential further change in the policy to guard against a sudden drop in the share price. An alternative could be to undertake a residual policy, whereby we only pay a dividend after all investments have been made. This would mean in 2012 and 2013 that we possibly would not pay a dividend at all as we are heavily investing in those years. However, the market does not react well to such a policy and therefore it is not relevant for us to consider further. Another alternative could be to reduce the rate of growth from 8% down to say 2%. This is a significant drop but as long as investors are given sufficient information by us about our plans and future investments then they may be happy to accept this in the short term. Financing requirements of F plc (Requirement (b)(iii)) An analysis of financing requirements has been added to the foot of each table at Appendix A. The first forecast indicates that we will have a shortfall in cash of GBP 60 million at the end of 2013 due to the repayment of the RCF. It therefore shows that despite the growth in the business we will need to either secure some long term finance (which given that the shortfall is temporary would not be sensible) or better still re-negotiate the RCF at the end of 2013 when it is up for renewal. It is possible that we could reduce the amount under the facility to say GBP 70 million, thereby still retaining headroom of GBP 10 million, hence reducing the commitment fee payable on the unused portion of the facility. The picture is quite different, however, in the second forecast. This indicates that the company would already have insufficient financing in place by the end of 2012, even after drawing down the maximum GBP 80 million under the RCF. This financing requirement keeps growing each year to GBP 125 million by the end of Gearing would be expected to rise significantly even assuming that the share price remains at 2010 levels. It may therefore prove to be difficult to raise the necessary funds and, indeed, the survival of the company itself could be under threat. In terms of sources of finance, there are a number of options as well as the RCF. These are: In terms of financing the investments, F plc could seek to raise new equity through a rights issue. The share price is recovering and investor confidence in the company seems to be returning therefore as long as investors were fully informed of the benefits of the investments and the issue price was appropriate, then this could be a good source of long term finance to support these long term investments. 3

4 A bond issue is unlikely to be successful in the 2 nd scenario if falling cash flows lead to a fall in the company s credit worthiness and credit rating. It could be considered in the first scenario but would not provide the flexibility to pay back funding no longer required from positive cash flows. A bank loan or an RCF would therefore be a more suitable source of finance for F plc at this time as it already has long term fixed borrowings in place and requires a more flexible instrument to meet fluctuating short term liquidity requirements. In terms of the operations we could consider an overdraft facility rather than an RCF, especially under the first scenario when there is a lower borrowing requirement. Although an overdraft is cheaper to set up, it does not give the protection of a committed facility and can be withdrawn at any time. An RCF would therefore be the preferred option. F plc should consider the use of EUR denominated finance to provide a natural hedge against movement in the value of the euro. Advice on the overall impact of possible exchange rate movements and liquidity constraints on the financial and strategic decisions of F plc (Requirement (c)) This report has highlighted the significant risks to cash flow, share price and liquidity of a significant and continuing weakening in the value of the euro against the British pound over the next three years. Based on this intial analysis, there is a clear risk that unfavourable exchange rate movements could potentially have a major impact on company performance. However, further analysis is required to evaluate other relevant factors that should be taken account in the preparation of these forecasts. Relevant foreign exchange issues include: Other possible exchange rate outcomes and the probability of each. Price elasticity of demand and whether it would be possible to increase euro prices if the euro were to weaken. Competitive position would competitors profits also be hit by a weaker euro and hence also want to increase euro prices? Is there a link between the strength of the euro and volume of sales? The possible liquidity issue identified above cannot be easily resolved without either: Significant cuts to the planned dividend. Obtaining additional finance. Cutting investment. Additional finance is likely to be hard to obtain due to our high gearing ratio and poor projected cash flows. A reduction in dividend is therefore likely to be necessary. It would, in any case, be hard to justify strong growth in dividend which is not matched by strong growth in cash flows and profits. However, a cut in dividend is unlikely to be sufficient and we also have to consider the more fundamental question of whether the company has the necessary financial strength to be able to support the proposed product launches at this time. Indeed, it may prove to be a time to reduce operations in Europe rather than invest further if we consider that we do not have sufficient resources to support such expansion in the event of a decline in the value of the euro. 4

5 Appendix A (the table below has been extracted from Excel and therefore contains rounding differences) (a) - Cash flow forecasts 1 January 2011 to 31 December 2013 (i) Constant Exchange rate at GBP/EUR Base data EUR m EUR m EUR m EUR inflows GBP/EUR exchange rate GBP m GBP m GBP m Converted to GBP Net GBP cash outflows (148.00) (218.00) (241.00) Net operating cash flow (OCF) Interest received on cash b/f 3% Interest paid on borrowngs b/f 7% (16.38) (15.24) (16.28) OCF after interest Deduct tax at 35% (18.06) (18.19) (28.62) OCF after tax and interest Dividend growing annually at 8% (17.28) (18.66) (20.16) Investment net of tax (30.00) (20.00) Net CF (14.88) Cash balance Borrowings brought forward Adjust net CF through borrowings (16.26) (13.00) Borrowings carried forward Comprising: RCF Bank loan Extra financing needs/(cash) (ii) The euro weakening against British Pounds by 6% a year Base data EUR m EUR m EUR m EUR inflows GBP/EUR exchange rate GBP m GBP m GBP m Converted to GBP Net GBP cash outflows (148.00) (218.00) (241.00) Net operating cash flow (OCF) Interest received on cash b/f 3% Interest paid on borrowngs b/f 7% (16.38) (15.80) (18.29) OCF after interest Deduct tax at 35% (13.79) (7.04) (8.92) OCF after tax and interest Dividend growing annually at 8% (17.28) (18.66) (20.16) Investment net of tax (30.00) (20.00) Net CF 8.34 (35.59) (23.59) Cash brought forward Borrowings brought forward Adjust net CF through borrowings (8.34) Borrowings carried forward Comprising: RCF Bank loan Extra finance needs

6 Answer to Question Two (a) Calculation of financial benefit to the shareholders of MMM and JJJ assuming synergistic benefits are realised. BEFORE AFTER SHARE OFFER AFTER CASH OFFER Number of shares (million) Price per share ($) Total value ($ million) Number of shares (million) Total value ($ million) MMM ($6.98 per share) JJJ ($6.98 per share) Number of shares (million) Total value ($ million) ($7.06 per share) Cash 67.5 Synergies 8.0 Total Workings MMM s market cap is: $207.0 million = 30m shares x $6.90 per share JJJ s market cap is: $64.2 million = 5m x $12.84 per share $209.4 million = 30/40 x $279.2 million The cash offer is worth $67.5m (= 5m x $13.50 per share) $211.7 million = $279.2 million cash offer of $67.5 million The above table shows that the bid offer is advantageous to both JJJ and MMM shareholders assuming that synergistic benefits are realised. MMM shareholders can expect to make a higher financial gain under the cash offer than under the share offer. Under the cash offer, the share price is expected to increase from $6.90 to $7.06, a gain of $0.16 per share and $4.7 million in total. Under the share offer, a lower rise in the share price is expected, from $6.90 to $6.98 per share, a total of $2.4 million. JJJ shareholders can expect to benefit from an immediate and certain financial gain of $3.3 million ($67.5 million - $64.2 million) under the cash offer. They need to weigh this up against a theoretical gain of $5.6 million ($69.8 million - $64.2 million) from the share offer. However the share offer carries greater risk for the shareholders of JJJ because they are exposed to the risk of a fall in the share price of MMM if the market fails to respond to the merger favourably and/or the potential synergistic benefits are not realised. They are also accepting a shareholding in a company with lower growth prospects than JJJ and lower growth in value could wipe out any short term gains. The value of JJJ assumes a growth rate of 9% which is considerably higher than MMM s growth rate of 6%. It is important that MMM s management is able to manage business activities acquired from JJJ efficiently in order to protect the higher growth rate associated with these activities. If JJJ s activities are simply merged into MMM s business structure, there is a danger of the growth rate associated with JJJ s business area dropping to something closer to MMM s previous growth rate of 6%. That would clearly have a serious impact on shareholder value. The cash offer has the advantage of protecting the proportionate ownership of the current shareholders of MMM. After the share offer there would be 40 million shares on issue, including 10 million held by the previous shareholders of JJJ. 6

7 However, the cash offer has the problem of accessing the required funds. $67.50 million is a material value to raise for a company that has a market capitalisation of just $207 million. MMM would need to consider the impact on gearing levels and earnings per share of the new borrowings. The share offer also has cash flow implications in paying future dividends on a larger number of shares. This could have an even greater call on cash over time but has a delayed impact on cash flow. (b)(i) Assuming no synergistic benefits, the combined entity would be worth $8 million less at $271.2million. BEFORE AFTER SHARE OFFER AFTER CASH OFFER Number of shares (million) Price per share ($) Total value ($ million) Number of shares (million) Total value ($ million) MMM ($6.78 per share) JJJ ($6.78 per share) Number of shares (million) Total value ($ million) ($6.79 per share) Cash 67.5 Total If synergistic benefits fail to be realised, the takeover would ONLY be beneficial to JJJ s shareholders. MMM s shareholders can expect to see a fall in share price under both the share offer and the cash offer (in the order of $3.6 million for the share offer and $ 3.3 million for the cash bid). The acquisition will therefore only be attractive to MMM s shareholders if additional benefits can be realised such as the synergistic benefits arising from improved IT/IS systems or enhanced future growth throughout the business. JJJs shareholders would expect to benefit from an immediate and certain financial gain of $3.3 million ($67.5 million - $64.2 million) under the cash offer and a higher theoretical gain of $3.6million ($67.8 million - $64.2 million) under the share offer. However, the share offer carries greater risk for the shareholders of JJJ because they are exposed to the risk of a fall in the share price of MMM if the market fails to respond to the merger favourably and are also accepting a shareholding in a company with lower growth prospects than JJJ. (b) (ii) The realisation of synergistic benefits will depend upon a smooth and efficient integration process. Key issues to discuss: Careful planning detailed timetable, allocated responsibilities, interim targets. Retention of key personnel (programmers and operators) possibly by offering enhanced packages and by keeping these personnel fully informed. Building good relationships between staff transferring from JJJ to MMM. Training of key personnel on how to operate the system. Parallel running of the systems and possible test data before going live. Looking at post completion audit reports of any such projects that have happened before to see if any lessons can be learnt. Proper management control via regular meetings and involvement of key personnel throughout. 7

8 Answer to Question Three (a) (i) NPV of project at CIP s existing WACC of 10% Year Cash Flow EUR Discount 10% PV EUR 0 (6,500,000) 1 (6,500,000) 1 750, , , , ,400, ,051, ,100, x0.751= ,922,800 NPV: (59,350) (ii) NPV of project at a risk adjusted WACC To establish the risk adjusted discount rate firstly, it is necessary to establish an appropriate beta for the project. PPP has been identified as an appropriate proxy and has an equity beta of This firstly needs to be de-geared and then re-geared to give an equity beta that reflects the business risk of the project and the existing financial risk of CIP. De-gear ß u = ß g V E V E + V [1 t ] D So, ß u = 1.95 x ( 4/(1(0.7) + 4 ) ) = 1.66 Re-gear ß g = ß u + [ß u ß d ] V [1 t ] D V E So, ß g = x ((1 x 0.7 ) / 3 ) = 2.05 k e = R f + [R m R f ]ß So, k e = 4% + (9% - 4%) x 2.05 = 14.25% WACC = k e V E V E + V D VD + k d [1 t ] V + V E D So, WACC = 14.25% x (3/4) +6% x (0.7) x (1/4) = 10.69% % = 11.74%, therefore use 12% Alternative approach using formula K adj = k eu [1 tl] k eu = R f + [R m R f ] ß u So, k eu = 4% + (9% - 4%) x 1.66 = 12.30% K adj = k eu [1 tl] So, K adj = 12.30% x [1 (0.3 x (1/4))] = 11.38%, therefore it would be acceptable to use 11% as the discount rate 8

9 NPV calculation at a discount rate of 12% Year Cash Flow EUR Discount 12% PV EUR 0 (6,500,000) 1 (6,500,000) 1 750, , , , ,400, , ,100, x0.712 = ,591,000 NPV: (485,300) (iii) APV of project at a base-case discount rate of Keu Base case discount rate Under APV to discount the project cash flows we need a discount rate that assumes that the project is fully funded by equity. Therefore the discount rate should be the cost of equity for an all equity financed company. To establish this we need an asset beta appropriate to the project, which we have already calculated above as This then needs to be applied to the CAPM formula to establish the ungeared cost of equity. k eu = R f + [R m R f ] ß u So, k eu = 4% + (9% - 4%) x 1.66 = 12.30% We will round this to the nearest whole number therefore a rate of 12% should be applied to the cash flows to establish the base case. Given that this is the same discount rate as above the base case NPV is therefore negative at EUR (485,300). Financing side effects The financing side effects need to be discounted at a rate that reflects the systematic risk of the cash flows. It is normally assumed that this will be the pre-tax cost of debt, which in this instance is 6%. PV of tax relief on loan interest Subsidised loan EUR 6,500,000 x 40% x 1% x 0.3 x = EUR 38,353 Bank loan EUR 6,500,000 x 20% x 6% x 0.3 x = EUR 115,058 Giving a total of EUR 153,411 PV of subsidy: Interest saving EUR 6,500,000 x 40% x [( )(1-0.3)] x = EUR 447,447 Issue costs EUR 6,500,000 x 60% x 0.01 = EUR 39,000 APV can now be calculated as: EUR Base case NPV (485,300) PV of tax relief on loan interest 153,411 PV of subsidy 447,447 Issue costs (39,000) APV 76,558 9

10 (b) The results of the calculations in part (a) are: EUR 000 Decision (i) NPV at CIP s existing WACC (59) Reject (ii) NPV at a risk-adjusted WACC (485) Reject (iii) APV 77 Accept Based on considering only the financial benefits, the project would be rejected under the two NPV methods but accepted under the APV method. Therefore before making a recommendation we need to consider the appropriateness of each of the methods in turn. NPV at existing WACC The company s existing WACC is not appropriate here as both the business risk and financial gearing of the project are different from those of the company itself prior to the project. The proposed project carries a higher level of risk than CIP s current business activities. In addition, the benefit to the company of the subsidy on the government borrowing and access to higher levels of debt (leading to higher tax relief) is project-specific have not been taken into account. NPV at risk adjusted WACC The risk adjusted WACC is superior to the existing WACC in that it provides an adjustment to reflect the business risk specific to the project. A proxy company s beta is used for this purpose. However, this method does not solve the financing issues identified previously in the discussion of the use of the existing WACC. APV APV can be used in situations where a project has special financing features such as providing access to subsidised financing or where the financing structure of the project is more relevant to the project appraisal than the financing structure of the company itself (e.g. where the project represents a new area of business for the company where a different capital structure is appropriate). For CIP, the APV approach has the advantage of taking into account: The NPV of the subsidy on the government borrowing (net of issue costs). Greater tax benefit due to the higher level of debt funding supported by the project. By using the ungeared cost of equity derived from the proxy company, APV is correctly based on the project risk rather than CIP s current business risk. (c) Advise on whether to proceed with the project Based on APV we should accept this project. We should, however, recognise that this decision relies on the underlying assumptions of APV analysis, including the important assumption that it is appropriate to use the actual gearing level for the project where different projects support different levels of debt, as appears to be the case here. 10

11 Answer to Question Four Briefing notes For use in: TS Management Team meeting Date prepared: 1 October 2011 Prepared by: X, independent advisor to the management team of TS Subject: Possible MBO (a) Mr. A - Managing Director of TS Mr A is concerned that the directors of YY will not see the benefit to them of an MBO and hence would firstly like to identify how the MBO management team would increase the returns of the business and secondly how to convince the Board of YY to accept an MBO rather than a trade sale. A balance is required here between making YY an attractive offer but without revealing forecast bullish returns that could result in a higher price and greater interest from other interested parties. Greater returns are likely to be achieved by the management of TS under an MBO for the following reasons: 1 The managers and employees of TS understand the telecommunications industry probably better than the YY board. They can identify their own objectives and long term strategy which do not have to be subject to review and possible censure by a holding company that views it as peripheral. 2 There is likely to be more flexibility in day to day decision making as top management and decision makers will only have one company on which to focus. 3 The TS cost base is likely to be lower as there will no longer be any centrally administered management charges. However, it is possible that some economies of scale could be lost as a result of no longer being part of a larger group. 4 If the managers and employees own 20% of the company with the eventual possibility of owning a greater percentage they have greater personal motivation to succeed. In respect of an MBO versus a trade sale, the main benefits to YY are that the administrative costs of the MBO would be borne by the management of TS and valuable management time would not be taken up in finding a suitable trade purchaser. Also, the managers of TS are aware of its financial strengths and weaknesses which might allow a speedier agreement on the sale price. (b) Ms B - Financial Manager of TS Ms B is concerned about the involvement of a venture capital company and wishes to identify alternative methods of finance. The advantages and disadvantages of venture capital finance can be summarised as follows: Advantages The main advantage of a venture capitalist is that this type of investor shares in the risk in fact takes most of the risk and has money readily available. VC s can also provide valuable support and advice to the management team (especially in the early days and in the run up to any potential IPO in the future) on matters such as dealing with banks and markets. 11

12 Disadvantages VC s always require a high annual return on their investment often in the region of 25% per annum. The management of TS therefore needs to be confident in their forecasts of the future to ensure that the VC s returns can be met. VCs will always look for an exit route which will, typically, be to sell their shares on the market either via a placing or offer for sale (which would involve an IPO) or to another venture capital entity. If the exit route is by IPO, the majority of the returns will almost certainly go to the venture capitalist. Valuing shares for an IPO in, say, 5 years time is difficult and the issue could be frustrated by market factors beyond the control of either the VC or TS. Control would be surrendered as here the VC would own up to 80% of the company. Decision making could therefore become problematic. If TS performs well, the manager/employee shareholders might be able to buy back their shares via an earn-out basis. This method allows the venture capitalist to sell shares back to the owners on the basis of the entity achieving certain levels of returns, often on an annual basis. The only realistic alternatives are: 1 An investment bank. Such a company is unlikely to provide 80% of the finance. Even if it did, the servicing costs would be prohibitive. 2 Ask YY to continue to own a shareholding. This would, in effect, mean YY acting as a venture capitalist. If YY wishes to divest the subsidiary it is unlikely to want to continue to own a substantial stake. However, if YY has no immediate investment opportunity readily available, as implied by the FD, then it might be willing to consider a phased sale. 3 A combination of methods of finance. This might be difficult, costly and time consuming to arrange. (c) Mr C - Marketing Manager of TS Mr C is concerned with the valuation of TS at $1,000 million. In answer to his specific concerns: The FD s valuation is based on YY s P/E ratio as Ms B has explained and will have been applied to TS s earnings. The market capitalisation of YY based on the latest financial information is $16,380 million (525 million shares at $31.20 per share). Therefore, YY s P/E ratio is 13 (market capitalisation of $ 16,380 million divided by earnings of $1,260 million). On this basis TS s value is therefore $975 million (earnings of $75 million multiplied by 13). The book value of TS s net assets is $735 million as at 31 August This represents approximately 9% of YY s total net assets compared with only 6% of its total earnings. However, as a manufacturing company TS will have a relatively high level of tangible assets which might explain the differential. In addition, TS may have a different gearing ratio to YY. Even so, this value has little relevance (because by definition it is based upon the statement of financial position which excludes important intangible assets such as brand strength and goodwill) except in specific circumstances such as a liquidation or break up of the subsidiary. Neither of these situations applies here as YY wish to divest the entire subsidiary and it is a going concern. In addition, the net assets figure is given after deducting borrowings. If these are intra-group borrowings, these need to be added back to the net assets figure to obtain the aggregate figure that YY needs to raise by the disposal of TS. However, if the borrowings are from external sources and are to be assigned to the new owner, they do not need to be added back when arriving at a valuation of the equity for sale. 12

13 In terms of alternative valuations we could consider using a different P/E ratio. TS is in an unrelated business to YY and its shares are unlisted so a P/E of 13 might not be accurate. In the case of an unlisted entity, a P/E ratio that is representative of similar quoted entities might be used as a starting point for arriving at an estimated market value. If we use the telecommunications industry average P/E of 15 given in the scenario, TS would have an even higher value of $1,125 million (earnings of $75 million multiplied by 15). Again it could be argued that this P/E is not appropriate as TS manufactures telecoms equipment which is only one part of the telecoms industry as a whole. In addition, TS s gearing ratio may not be typical of the industry as a whole as it is a wholly owned subsidiary. In terms of alternative methods TS should undertake a valuation of its business using discounted cash flows. This involves discounting net cash flows as far into the future as reasonably possible at a discount rate that reflects the risk of the operation. Determining an appropriate discount rate can be a difficult process but TS should be able to obtain an approximation using a similar company s data. As TS is a wholly owned subsidiary, a WACC based on pre-interest free cash flows may be more appropriate than the cost of equity applied to post-interest free cash flows post-interest. It may be possible to obtain a suitable WACC from a proxy company in the same business as YY. The bid company is likely to use its own WACC when valuing TS. 13