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 BRIEFING PAPER FOR THE BOARD OF DIRECTORS OF M PLC From: Financial Director Date: 1 April 2012 Purpose: To consider issues arising in relation to the proposed takeover bid for GG, including an appropriate bid value and issues relevant to the decision on whether or not to go ahead. Valuation of GG Preliminary cost of capital calculations used as a basis for the discounted cash flow valuation of GG. (a) (i) Use the formula ke = Rf + [Rm – Rf]ß So: M plc’s current cost of equity is 1.1% + 4.0% x 1.8 GG’s current cost of equity is 3.0% + 4.0% x 2.5 Adjusted cost of equity for M plc using GG’s beta is
= 8.3% = 13.0% 1.1% + 4.0% x 2.5 = 11.1%
Note that: • It is not necessary to adjust the equity beta of GG for financial risk as both GG and M plc have the same level of gearing and hence face the same financial risk. (a) (ii) The difference of 4.7% between the unadjusted costs of equity for the two companies can be subdivided as follows: •
Firstly, a difference of 1.9% arises due directly to the difference in the risk free interest rates in the UK and the USA. It simply represents the difference between a USD discount rate and a GBP discount rate and is eliminated when GG’s cost of equity is converted into a GBP basis in the form of the adjusted cost of equity. This highlights the significant exchange risk that M plc is taking on when acquiring GG if GBP/USD exchange rate movements fail to mirror interest rate differentials.
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•
Secondly, a difference of 2.8% due to the higher returns expected by GG’s shareholders due to the more risky nature of GG’s business, as indicated by its higher equity beta. This 2.8% difference is equivalent to the difference between M plc’s current cost of equity and the adjusted cost of equity based on GG’s business risk and is, effectively, the restatement of GG’s cost of equity on a GBP basis. It indicates the extent to which GG’s business is riskier than M plc’s current business.
(b) (i) Valuation based on market capitalisation GG: 40 million shares x USD 7.50 = USD 300.0 million (that is, GBP 184.0 million or GBP 4.60 per GG share). This compares with a market capitalisation for M plc of GBP 527.8 million (where GBP 527.8 million = 140 million x GBP 3.77) and this takeover therefore represents a huge change of focus for M plc. Valuation based on discounted cash flow analysis of free cash flow: Free cash flow = 60% of earnings = 60% x USD 30 million = USD 18 million for last year. Use M’s cost of equity adjusted for GG’s beta in the calculation. Extract taken from EXCEL working (please note that there may be rounding differences).
base
Free cash flow Exchange rate
8.0%
18.00 1.630
Sterling CF CF in perpetuity
1
2
3
USDm 19.44 1.6626 GBPm 11.69
USDm 21.00 1.6959 GBPm 12.38
USDm 22.67 1.7298 GBPm 13.11
from year 4 onwards USDm 1.7298 GBPm 456.74
( = 13.11(1.08) / (0.1110 – 0.0800))
Discount at PV Total PV
11.10% (Note 1)
1
0.9001
0.8102
0.7292
0.7292
10.52
10.03
9.56
333.02
GBP 363.14 million
Note 1 The appropriate discount is11.10%, that is, M’s risk-adjusted cost of equity based on GG’s beta. At that discount rate, the present value of GG’s free cash flows is GBP 9.08 per GG share. Note that:
• •
There is insufficient information provided in the question to calculate an asset value. A P/E bootstrapping approach is not valid in the context of this scenario, since GG is a completely different type of business to M plc and it is unreasonable to expect that M plc will be able to boost the performance of GG to mirror its own P/E ratio. Indeed, the opposite is more likely to be the case due to the lack of experience of M plc management in running a business such as GG.
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(b) (ii) Validity of results Market capitalisation GG is a listed entity in the US and therefore has a share price. This is likely to be the best indicator of value as it represents the market’s current view. One slight note of caution though is that any share price will only reflect the price of a small parcel of shares as typically this is what is bought or sold on the market. Therefore M plc should expect to pay a premium above this market value to reflect the fact that it is buying the whole entity. Currently GG’s share price stands at USD 7.50 (equivalent to GBP 4.60 at the spot exchange rate). The share price has recently risen in speculation of a potential takeover which is typical in a deal of this nature where the market senses that the potential target is unwilling (ie: there is anticipation that the shareholders of GG will only sell for potentially an overly high price). DCF valuation based on free cash flow A DCF valuation based on free cash flow provides an indication of the underlying value of GG. However, the result cannot be expected to be very accurate in this case as it depends on too many uncertain underlying assumptions. Key input variables such as future business growth rate, future movements in GBP/USD spot rate are only estimates. In addition, the DCF valuation is likely to be overstated since the 1.9% interest rate differential between GBP and USD and anticipated appreciation of GBP against USD has not been taken into account in the exchange rate movements beyond the 3 year time horizon. Initial offer price An offer will need to be at a premium in order to: • Recognise the additional value of the whole business over and above a small parcel of shares. • Be sufficiently attractive to GG’s shareholders. • Overcome a possible hostile reaction from the Board of GG. If the takeover ends up being very hostile, the publicity of a hostile response could well flush out unwelcome rival bids and M plc may have to pay an even higher premium. Indeed, there is a risk that M plc could pay too high a price for GG in the end. The DCF valuation indicates a possible value per share as high as GBP 9.08, which is GBP 4.48 higher than the GBP equivalent of the current share price for GG. However, this is based upon bullish growth prospects and a strengthening of British pounds against the US dollar - both of which could well prove to be overly optimistic. It is therefore unlikely that a valuation of GBP 9.08 per share is realistic, and M plc should resist any temptation to negotiate up to that level. In conclusion, M plc may be best advised to make an initial offer of the order of USD 8.63 (GBP 5.29) per share, representing a premium of 15% on the current share price. Alternatively, M plc could begin negotiations at a lower price. The danger, however, is that it might need to return with a higher offer at a later date and may then have to go higher than USD 8.63. Terms of the offer At an offer based on a value of GBP 5.29 per share for GG’s shares and a current market price of GBP 3.77 per share for M plc’s shares, a share exchange of 7 M plc shares for every 5 GG shares would appear to be an appropriate starting point. Other key issues that might influence whether or not to proceed with the takeover bid
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(c) Impact of the takeover on the attainment of M plc’s financial objectives: 1. GG has an expected growth rate of 8% but the USD is expected to depreciate by 2% a year, so the net growth rate in sterling terms is only expected to be 6%. However, this is still comfortably 2% above M plc’s overall growth target for revenue and profit of 4%. It is therefore likely that GG would help M plc achieve Financial Objective 1. 2. With a growth rate for GG above that of M plc, the acquisition of GG would also be expected to help increase dividends. 3. The gearing target of 40% should still be met. GG has approximately the same gearing level as M plc of 32% (= GBP 250m / GBP250m + (GBP3.77 x 140m)) and so M plc should remain within the gearing target immediately following the acquisition of GG assuming the purchase consideration is in the form of a share exchange. The longer term effect on gearing would largely depend on the future success of the acquisition. Other relevant factors: M plc would increase its risks significantly due to: • Increased business risk. Acquiring a new business in an unfamiliar business sector – do the Directors of M plc have the necessary experience and expertise to be able to manage this business effectively? • Increased beta. GG has a higher beta and hence higher risk than M plc and this will be reflected in an increase in M plc’s overall beta following the takeover. • Increased foreign exchange risk. GG is a US-based business and therefore introduces significant exchange rate exposure to M plc. Problems may also arise during the implementation stage, when merging systems of management styles/culture, especially as GG is located in an unfamiliar foreign country. All the normal risks associated with setting up in a foreign country apply - such as lack of familiarity with regulations, customer preferences, infrastructure and cost of management support from M plc. The shareholders of M plc will suffer dilution of control – GG’s shareholders will end of with approximately 29% (56/(140 + 56) shares) of the combined business. M plc shareholders who are not happy about the deal may sell their shares, leading to a significant fall in M plc’s share price. Overall advice: The proposed takeover carries a huge risk. GG is so large in comparison with M plc, that it would change the whole nature of the group’s business. There are major risks that M plc will not be able to manage the new business effectively and that the group could suffer major losses from movements in the value of the US dollar against GB pounds. This could prove to be a very dangerous strategy and best avoided. I would therefore recommend that M plc does NOT proceed with the takeover of GG. (d) Actions that the Board of GG could take in defence of what it considers to be a ‘hostile’ bid: • Appeal to its own shareholders – aggressive publicity to explain the potential future value of the company under its present ownership. This may include good research ideas, management potential, or being made more aware of the company’s achievements.
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•
• • •
Attack M plc (the bidder) – criticising M plc’s management style, overall strategy, lack of capital investment etc as appropriate in the circumstances – this is especially useful where a share exchange (full or partial) is being offered. White Knight strategy – attempt to identify an alternative, more friendly, bidder; for example, a US company with which GG might be more comfortable. Counterbid – make a counterbid offer for M plc. Competition authorities –get the bid referred to the Competition Authorities in order to delay and, possibly, block the takeover.
Actions that the Board of M plc could take in the face of hostile reception by GG include: • Use publicity to advertise its strengths. • Offer a sufficiently high share price to attract less enthusiastic shareholders. • Include a cash alternative to the share exchange in the offer, although this would have an adverse impact on gearing.
__________________________________________________________________________ SECTION B
Answer to Question Two (a) If an announcement is made that no dividend is to be paid, there are two aspects to be considered. Firstly, the speed of any reaction and secondly, how the market will react. •
The speed of reaction of the market will be dependent upon its efficiency level. If the market is only weak form efficient then the share price is unlikely to react straight away (because in such a market the share price reacts very slowly to any new information released about a company). If however the market is semi-strong form efficient then the market will react instantly to the announcement of a zero dividend (because, by definition, semi-strong form means that there will be an instant reaction to any new information). If the market is strong form efficient then the market will in effect have already reacted to the news about a zero dividend prior to it being realised and hence there would be no further share price impact. Markets are generally found to be semi- strong form efficient and therefore we would expect the market to react straight away to the announcement.
•
In relation to whether the share price will go up, down or stay the same there are a number of considerations to bear in mind: o
Dividends simply move cash from cash owned by the shareholders in the company to the shareholders’ own pockets. Theoretically therefore the value of the company does not change and therefore, all things being equal the share price should not change.
o
From a behavioural finance standpoint, it is known that investors prefer dividends, if they are paid, to be stable or increasing. In most developed markets dividend payments are often seen to signal the health of a company and there is an expectation that for most companies the markets expect to see a stable dividend policy. Therefore if QRR, having previously paid a substantial dividend, announces that it will not pay a dividend this year, it is likely that the market will react unfavourably and hence the share price will fall (possibly quite significantly) as investors sell shares.
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o
However, markets are a little more sophisticated than that and it’s possible that given the credit crunch, drop in profits and the expectation of stricter funding requirements for banks in the future, the market may have already built in an expectation of either a zero dividend or a vastly reduced dividend. If this is the case then the drop in share price would be reduced if indeed it drops at all (some investors may even perceive the lack of a dividend as evidence of sound management in such an economic climate which could in fact bolster the market.)
(b) (i) Shareholder who accepts the shares A typical shareholder with 1000 shares will receive an entitlement to one new share for every 50 held. That is, the right to acquire 20 new shares (where 20 = 1,000/50). This may give the shareholder the illusion of increased “value” as he now holds 1,020 shares. However, the company itself has not changed in value and so the total value that those shares represent is unchanged. The share price can be expected to fall to the extent that the 1,020 shares will have exactly the same value as the original 1,000, that is INR 396,000.This implies a fall in the share price to INR 388.24 (= INR 396,000/1,020). (ii) Shareholder who sells the rights If the rights are sold, a typical shareholder should receive INR 7,000 in total (where INR 7,000 = 1,000 x INR 7). If the remaining 1,000 share are worth INR 388.24 each, the shareholder’s total worth can be estimated to be INR 395,240 (= INR 388,240 + INR 7,000). This is marginally less than in (i) above, indicating that it is better for the shareholder to accept the new shares rather than sell the rights. Note, however, that it is likely that arbitrage activity in the market will close out any discrepancy between (i) and (ii) and so the shareholder should be largely indifferent between the two options. Again, there is an impression of increased “value” as a result of the INR 7,000 receipt, but this is largely illusory due to the likely corresponding fall in the share price. (c) In theory, shareholders should be indifferent between a zero dividend and a scrip dividend and the decision should have no impact on company value. However, it is important for the board of QRR to fully understand how the market is likely to react to the news. Assuming that the market is already anticipating some change in the dividend policy because of the economic environment (as discussed already in part (a)) then it’s possible that it will react better to Director B’s suggestion of a scrip dividend rather than no dividend at all, as at least investors feel that they are getting something. However, the larger and more sophisticated the investor the more they will understand that the scrip dividend has no bearing on the overall value of their investment. Indeed, there are a number of disadvantages with the scrip dividend from QRR’s point of view. Firstly, a scrip dividend will incur significant administrative costs whilst a zero dividend will not. Secondly, a greater number of shares in circulation may increase the pressure for dividend payouts in the future as the dividend per share would be lower for the same total dividend payment. Thirdly, a scrip dividend has the effect of moving reserves from distributable to non-distributable by increasing share capital. This reduces the reserves available for distribution as dividends at a future date. However, despite the drawbacks associated with a scrip dividend, in practice many companies, including banks, have chosen the scrip dividend route in recent years in order to give the impression that they are giving a payout to investors.
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(d) Alternatives to a zero dividend or a scrip dividend to improve liquidity include: • Raising additional equity via a rights issue or a new issue. The success of this though will be very dependent upon the state of the market and the enlarged share capital would require higher dividends in future years in order to maintain the current level of dividend per share. • Issuing new debt via a bond issue. This might be better than an equity issue, depending on investor risk appetite. • Reduce costs – for example, make staff redundant • Sell assets – for example, close branches of the bank • Raise interest rates offered on investments to encourage more deposits.
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Answer to Question Three Part (ai) Premium on conversion: Share price now Share price in 4 years’ time Forecast conversion value
GBP3.60 GBP4.54 GBP104.42
4)
(GBP3.60 x 1.06 (23 x GBP4.54)
Part (aii)
0 1-4 4
Year
Cash Flow
DF@7%
Loan capital Annual Interest Capital Redemption
-93.00 3.00 (0.70) 104.42
1.000 3.387 0.763
DF@5%
DCF
1.000 3.546 0.823
-93.00 7.11 79.67
Totals
DCF -93.00 7.45 85.94
-6.22
0.39
Post tax Kd by interpolation = 5% + 2% [0.39/(0.39+6.22)] = 5.12%
Note: the result will be slightly different depending on the two rates chosen. Here, the NPV at 5% is fairly close to zero so in practice no further calculations would be necessary. Part (aiii)
Calculation of WACC WACC =
E D P k eg × D + E + P + k d (1 − t ) D + E + P + k p × D + E + P
This is most easily calculated in columar form as follows:
Ordinary shares Preference shares Debt TOTAL
Market value GBP m (MV) 1,008 205 250 1,463
Cost of capital (k) 11.56% 5.71% 5.12%
MV x k GBPm 116.52 11.71 12.80 141.03
So WACC is GBP 141.03m/GBP 1,463m = 9.64% Workings for cost of capital: Calculation of ke Formula for cost of equity for a company with constant growth and recently paid dividend is Ke =
d1 +g po
D1 = (GBP 0.45 x 50% x 1.05) = GBP 0.23625 per share Ke =
(GBP 0.23625 / GBP 3.60) + 0.05 = 0.1156 ie: 11.56%
Calculation of kp
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Kp = (GBP 0.06 / GBP 1.05) = 0.0571, ie: 5.71% Kd was calculated earlier. Workings for market values
Ordinary shares Preference shares Debt
GBP 1,008m = 280m x GBP 3.60 GBP 205m = GBP 195m x GBP (1.05/1.00)
Equal to the amount to be raised of GBP 250m
Part (b) Benefits (to CBA) of convertible bond over equity • All forms of debt would normally be cheaper than equity for the company because interest carries tax relief, dividends do not. Also, debt is (usually) less risky than equity for the providers of finance and therefore the return required by a debt provider will be less than that for an equity provider. • There is no immediate dilution of earnings if debt is issued, although debt interest has to be paid before equity dividends are declared and paid. Dilution would occur on conversion but the logic of a convertible bond would be that the money invested would increase earnings to the level where there would be sufficient to pay old and new shareholders without reducing EPS or DPS. • Costs of issue are likely to be lower with convertible debt than a new issue of equity. It is also likely to be quicker to arrange, although convertible debt might take longer than straight debt. • Assuming preference shares are classed with debt, gearing is currently low at 17% prior to the issue of the convertible debt. CBA is thus taking no advantage of the tax relief available on any interest payments. In addition given that gearing is so low it is likely that the WACC calculated in part (a) will be lower than the WACC prior to the investments and new finance. This is because it is likely that the effect of the lower cost of debt will outweigh the impact of any increase in the cost of equity as a result of adding debt into the capital structure. Disadvantages of convertible debt over equity • Interest has to be paid otherwise the company could be put into liquidation. This is the risk of all forms of debt over equity. • At high levels of debt the gearing level might rise to an unacceptable level for equity holders, increasing the cost of equity and the overall WACC. This does not seem to be an issue for CBA as gearing is relatively low at present at 17%. If debt is issued this would rise to 31%, still not unreasonable. This gearing would reduce once conversion started to take place, all other things being equal. Overall evaluation There is insufficient information in the scenario about economic and market factors and the business risk of CBA to make a full evaluation and recommendation. However, CBA is fairly lowly geared at present and an issue of debt would be unlikely to significantly increase the cost of equity. Assuming investor reaction to an issue of convertible debt is positive then this would appear the most attractive option. Part (c) Treasury is likely to be involved in: • Determining conversion ratio(s) and coupon interest rate on the instrument. • Managing the relationship with the investment bank or issuing house supporting the bond issue.
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• •
Calculating costs of capital and ensuring that new debt will not adversely affect the value of the company. Ensuring earnings are sufficient to cover interest payments and maintain dividend levels to preference and ordinary shareholders. Preparing all paperwork and a timetable for the issue.
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Answer to Question Four Requirement (a)(i) Validity of using a proxy company and CAPM to arrive at a discount rate There may be issues relating to the use of a proxy company as it may not be directly comparable with RST in terms of the nature of its business and business risk. In addition, it is not certain that the cost of equity used to calculate the WACC has been adjusted to reflect RST’s financial risk. The use of the CAPM in modern financial markets is questionable given the model’s simplifying assumptions. A beta is also more difficult to obtain and assess for a private company such as RST. However, on the positive side, this approach might be better than using rough and ready adjustments to the basic cost of capital. Validity of using NPV Using NPV in project analysis is theoretically sound and is a refinement on the analysis of the cash flows themselves as it takes into account the time value of money and the riskiness of the project. Higher risk projects can be discounted at a higher, risk-adjusted discount rate. As long as the cost of capital is appropriate and the cash flows have been accurately predicted a positive NPV means that the project will generate wealth for the shareholders in excess of the returns that they require. Requirement (a)(ii) Validity of conclusion reached by the finance manager that RST should proceed with the investment in Perth The finance manager appears to have based his decision to proceed with the investment on the fact that the overall expected NPV is positive, arrived at by applying probabiiities to a number of different possibe outcomes. This is not sufficient data on which to make a decision when it is for a one-off project of this nature. It is not appropriate to accept the project solely on the basis of the AUD 21.6 million expected NPV. Indeed this NPV is not actually achievable and hence is fairly meaningless in this context. Instead the finance manager should consider each of the outcomes separately and then consider the risk appetite of the Board. In this instance, there is an 80% chance of making a positive NPV and only a 20% chance of making a negative NPV. Ultimately, whether the project is acceptable will depend upon the Board’s attitude to accepting a 20% risk that shareholder value will fall. Therefore before making the decision to proceed it is important that the Board are aware of this risk and carefully considers further information such as sensitivity analysis and other qualitative factors.
Requirement (b) Impact of Real Options on the investment decision There are three different forms of real options that need to be considered when making investment decisions. These are – the abandonment option, the follow-on option and the wait option. The abandonment option If, once a project is undertaken, it can be abandoned for very little cost then knowing this at the outset (when a decision is being made about proceeding with a project) has a value.
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Therefore, when evaluating a project, the value of any abandonment option should be included with the NPV of the project itself. The ability to abandon a project is particularly valuable where there is significant uncertainty surrounding the results of a project. In our example we are told that there are three possible outcomes, one of which has a negative result. If the project is undertaken, but once commenced it is found that the worst case scenario is valid, then RST would like to be able to abandon the project. Therefore knowing upfront that it could be abandoned has value in the decision, because further losses can be eliminated by taking the abandonment option. The follow-on option Many projects, once undertaken can lead to further projects or opportunities. If such opportunities exist then there is an argument that they should be considered and valued whilst making the initial decision. In this situation it might be the case that even though a project on its own has a negative NPV, by including the follow on projects (which only arise as a result of doing the main project) that it is worthwhile. In the context of RST, opening up in Perth may, for example, provide new contacts at major groups of companies that have offices elsewhere in Australia and hence lead on to additional work or the development of another office in another Australian city or in another country altogether. The wait option This is the option to be able to wait and see how the market develops before commencement of the project. This is particularly important where there is significant uncertainty in the forecasts such as in the case of RST. The option to be able to wait for a period of time to see whether the worst case scenario materialises could have significant value as potentially it would stop RST taking on a negative NPV project. However, it could also lead to loss of opportunity altogether if competitor companies set up in Perth in the meantime. Therefore the wait option may have very little value to RST. (c) Response to comments from Director S Using a lower cost of capital such as the cost of debt would only be expected to increase the NPVs of the project if gearing is currently lower that the ‘optimum’ gearing based on the relationship between WACC and gearing for RST. Regardless of this issue, however, it is not appropriate to use the cost of the debt as a discount rate in project appraisal. This is because the project needs to be viewed in the context of the company as a whole and needs to satisfy the required returns of all of the providers of capital to the business not just to the debt providers. This is why the discount rate should normally be the weighted average cost of capital adjusted for the specific business risk of the project. The concern over gearing is a valid concern because as gearing increases so does the return required by the equity providers and hence the cost of equity also increases. This is particularly the case where gearing is already relatively high. In the case of RST we know that it is heavily reliant on debt and therefore it is likely that any further increase in gearing will have a significant impact on WACC. Interest payments might well be lower for USD debt than for AUD debt, especially in the early years. However, expectations theory predicts that , over the longer term, any benefit from lower interest costs would be offset by an equivalent movement in the USD/AUD exchange rate, thereby eliminating any such benefit. However, exchange rates rarely move as predicted by such theories and so the use of USD debt in the absence of any other USD cash flows arising in the business that might provide a natural offset, will produce potential very large currency risk. RST would be exposed to:
•
Transaction risk on converting interest cash flows and the final capital repayment.
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• •
Economic risk if competitor companies do not carry similar currency risks. Translation risk on accounting for the borrowing at reporting dates.
In conclusion, if the USD were to strengthen against the AUD, RST could be exposed to significant and unnecessary currency exposures and such an arrangement should be avoided.
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