Cost of Capital - Basics 1 / 2

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Question 1b

Morada Co is involved in offering bespoke travel services and maintenance services. In addition to owning a few hotels, it has built strong relationships with companies in the hospitality industry all over the world. It has a good reputation of offering unique, high quality holiday packages at reasonable costs for its clients. The strong relationships have also enabled it to offer repair and maintenance services to a number of hotel chains and cruise ship companies.

Following a long discussion at a meeting of the board of directors (BoD) about the future strategic direction which Morada Co should follow, three directors continued to discuss one particular issue over dinner. In the meeting, the BoD had expressed concern that Morada Co was exposed to excessive risk and therefore its cost of capital was too high. The BoD feared that several good projects had been rejected over the previous two years, because they did not meet Morada Co’s high cost of capital threshold. Each director put forward a proposal, which they then discussed in turn. At the conclusion of the dinner, the directors decided to ask for a written report on the proposals put forward by the first director and the second director, before taking all three proposals to the BoD for further discussion.

First director’s proposal
The first director is of the opinion that Morada Co should reduce its debt in order to mitigate its risk and therefore reduce its cost of capital. He proposes that the company should sell its repair and maintenance services business unit and focus just on offering bespoke travel services and hotel accommodation. In the sale, the book value of non-current assets will reduce by 30% and the book value of current liabilities will reduce by 10%. It is thought that the non-current assets can be sold for an after-tax profit of 15%.

The first director suggests that the funds arising from the sale of the repair and maintenance services business unit and cash resources should be used to pay off 80% of the long-term debt. It is estimated that as a result of this, Morada Co’s credit rating will improve from Baa2 to A2.

Second director’s proposal
The second director is of the opinion that risk diversification is the best way to reduce Morada Co’s risk and therefore reduce its cost of capital. He proposes that the company raise additional funds using debt finance and then create a new strategic business unit. This business unit will focus on construction of new commercial properties.

The second director suggests that $70 million should be borrowed and used to invest in purchasing non-current assets for the construction business unit. The new debt will be issued in the form of four-year redeemable bonds paying an annual coupon of 6·2%. It is estimated that if this amount of debt is raised, then Morada Co’s credit rating will worsen to Ca3 from Baa2. Current liabilities are estimated to increase to $28 million.

Third director’s proposal
The third director is of the opinion that Morada Co does not need to undertake the proposals suggested by the first director and the second director just to reduce the company’s risk profile. She feels that the above proposals require a fundamental change in corporate strategy and should be considered in terms of more than just tools to manage risk. Instead, she proposes that a risk management system should be set up to appraise Morada Co’s current risk profile, considering each type of business risk and financial risk within the company, and taking appropriate action to manage the risk where it is deemed necessary.

Morada Co, extracts from the forecast financial position for the coming year

$000
Non-current assets 280,000
Current assets 48,000
Total assets
328,000
Equity and liabilities
Share capital (40c/share) 50,000
Retained earnings 137,000
Total equity
187,000
Non-current liabilities (6·2% redeemable bonds) 120,000
Current liabilities 21,000
Total liabilities
141,000
Total liabilities and equity capital
328,000

Other financial information
Morada Co’s forecast after-tax earnings for the coming year are expected to be $28 million. It is estimated that the company will make a 9% return after-tax on any new investment in non-current assets, and will suffer a 9% decrease in after-tax earnings on any reduction in investment in non-current assets.

Morada Co’s current share price is $2·88 per share. According to the company’s finance division, it is very difficult to predict how the share price will react to either the proposal made by the first director or the proposal made by the second director. Therefore it has been assumed that the share price will not change following either proposal.

The finance division has further assumed that the proportion of the book value of non-current assets invested in each business unit gives a fair representation of the size of each business unit within Morada Co.

Morada Co’s equity beta is estimated at 1·2, while the asset beta of the repairs and maintenance services business unit is estimated to be 0·65. The relevant equity beta for the new, larger company including the construction unit relevant to the second director’s proposals has been estimated as 1·21.

The bonds are redeemable in four years’ time at face value. For the purposes of estimating the cost of capital, it can be assumed that debt beta is zero. However, the four-year credit spread over the risk free rate of return is 60 basis points for A2 rated bonds, 90 basis points for Baa2 rated bonds and 240 basis points for Ca3 rated bonds.

A tax rate of 20% is applicable to all companies. The current risk free rate of return is estimated to be 3·8% and the market risk premium is estimated to be 7%.

Required:

(b) Prepare a report for the board of directors of Morada Co which:

(i) Estimates Morada Co’s cost of equity and cost of capital, based on market value of equity and debt, before any changes and then after implementing the proposals put forward by the first and by the second directors; (17 marks)

(ii) Estimates the impact of the first and second directors’ proposals on Morada Co’s forecast after-tax earnings and forecast financial position for the coming year; and (7 marks)

(iii) Discusses the impact on Morada Co of the changes proposed by the first and second directors and recommends whether or not either proposal should be accepted. The discussion should include an explanation of any assumptions made in the estimates in (b)(i) and (b)(ii) above. (9 marks)

Professional marks will be awarded in part (b) for the format, structure and presentation of the report. (4 marks)

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Question 1b

Cigno Co is a large pharmaceutical company, involved in the research and development (R&D) of medicines and other healthcare products. Over the past few years, Cigno Co has been finding it increasingly difficult to develop new medical products. In response to this, it has followed a strategy of acquiring smaller pharmaceutical companies which already have successful products in the market and/or have products in development which look very promising for the future. It has mainly done this without having to resort to major cost-cutting and has therefore avoided large-scale redundancies. This has meant that not only has Cigno Co performed reasonably well in the stock market, but it has
also maintained a high level of corporate reputation.

Anatra Co is involved in two business areas: the first area involves the R&D of medical products, and the second area involves the manufacture of medical and dental equipment. Until recently, Anatra Co’s financial performance was falling, but about three years ago a new chief executive officer (CEO) was appointed and she started to turn the company around. Recently, the company has developed and marketed a range of new medical products, and is in the process of developing a range of cancer-fighting medicines. This has resulted in a good performance in the stock market, but many analysts believe that its shares are still trading below their true value. Anatra Co’s CEO is of the opinion that the turnaround in the company’s fortunes makes it particularly vulnerable to a takeover threat, and she is thinking of defence strategies that the company could undertake to prevent such a threat. In particular, she was thinking of disposing some of the company’s assets and focussing on its core business.

Cigno Co is of the opinion that Anatra Co is being held back from achieving its true potential by its equipment manufacturing business and that by separating the two business areas, corporate value can be increased. As a result, it is considering the possibility of acquiring Anatra Co, unbundling the manufacturing business, and then absorbing Anatra Co’s R&D of medical products business. Cigno Co estimates that it would need to pay a premium of 35% to Anatra Co’s shareholders to buy the company.

Financial information: Anatra Co
Given below are extracts from Anatra Co’s latest statement of profit or loss and statement of financial position for the year ended 30 November 2015.

2015
$ million
Sales revenue 21,400
Profit before interest and tax (PBIT) 3,210
Interest 720
Pre-tax profit 2,490
2015 
$ million
Non-current liabilities 9,000
Share capital (50c/share) 3,500
Reserves 4,520
Anatra Co’s share of revenue and profits between the two business areas are as follows:
Medical products R&D Equipment manufacturing
Share of revenue and profit 70% 30%

Post-acquisition benefits from acquiring Anatra Co
Cigno Co estimates that following the acquisition and unbundling of the manufacturing business, Anatra Co’s future sales revenue and profitability of the medical R&D business will be boosted. The annual sales growth rate is expected to be 5% and the profit margin before interest and tax is expected to be 17·25% of sales revenue, for the next four years. It can be assumed that the current tax allowable depreciation will remain equivalent to the amount of investment needed to maintain the current level of operations, but that the company will require an additional investment in assets of 40c for every $1 increase in sales revenue.

After the four years, the annual growth rate of the company’s free cash flows is expected to be 3% for the foreseeable future.

Anatra Co’s unbundled equipment manufacturing business is expected to be divested through a sell-off, although other options such as a management buy-in were also considered. The value of the sell-off will be based on the medical and dental equipment manufacturing industry. Cigno Co has estimated that Anatra Co’s manufacturing business should be valued at a factor of 1·2 times higher than the industry’s average price-to-earnings ratio. Currently the industry’s average earnings-per-share is 30c and the average share price is $2·40.

Possible additional post-acquisition benefits
Cigno Co estimates that it could achieve further cash flow benefits following the acquisition of Anatra Co, if it undertakes a limited business re-organisation. There is some duplication of the R&D work conducted by Cigno Co and Anatra Co, and the costs related to this duplication could be saved if Cigno Co closes some of its own operations. However, it would mean that many redundancies would have to be made including employees who have worked in Cigno Co for many years. Anatra Co’s employees are considered to be better qualified and more able in these areas of duplication, and would therefore not be made redundant.

Cigno Co could also move its headquarters to the country where Anatra Co is based and thereby potentially save a significant amount of tax, other than corporation tax. However, this would mean a loss of revenue for the government
where Cigno Co is based.

The company is concerned about how the government and the people of the country where it is based might react to these issues. It has had a long and beneficial relationship with the country and with the country’s people.

Cigno Co has estimated that it would save $1,600 million after-tax free cash flows to the firm at the end of the first year as a result of these post-acquisition benefits. These cash flows would increase by 4% every year for the next three years.

Estimating the combined company’s weighted average cost of capital
Cigno Co is of the opinion that as a result of acquiring Anatra Co, the cost of capital will be based on the equity beta and the cost of debt of the combined company. The asset beta of the combined company is the individual companies’ asset betas weighted in proportion of the individual companies’ market value of equity. Cigno Co has a market debt to equity ratio of 40:60 and an equity beta of 1·10.

It can be assumed that the proportion of market value of debt to market value of equity will be maintained after the two companies combine.

Currently, Cigno Co’s total firm value (market values of debt and equity combined) is $60,000 million and Anatra Co’s asset beta is 0·68.

Additional information
– The estimate of the risk free rate of return is 4·3% and of the market risk premium is 7%.
– The corporation tax rate applicable to all companies is 22%.
– Anatra Co’s current share price is $3 per share, and it can be assumed that the book value and the market value of its debt are equivalent.
– The pre-tax cost of debt of the combined company is expected to be 6.0%.

Important note
Cigno Co’s board of directors (BoD) does not require any discussion or computations of currency movements or exposure in this report. All calculations are to be presented in $ millions. Currency movements and their management will be considered in a separate report. The BoD also does not expect any discussion or computations relating to the financing of acquisition in this report, other than the information provided above on the estimation of the cost of capital.

Required:
(b) Prepare a report for the board of directors (BoD) of Cigno Co which:
(i) Estimates the value attributable to Cigno Co’s shareholders from the acquisition of Anatra Co before taking into account the cash benefits of potential tax savings and redundancies, and then after taking these into account; (18 marks)
(ii) Assesses the value created from (b)(i) above, including a discussion of the estimations made and methods used; (8 marks)
(iii) Advises the BoD on the key factors it should consider in relation to the redundancies and potential tax savings. (4 marks)
Professional marks will be awarded in part (b) for the format, structure and presentation of the report. (4 marks)

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Question 1iv

Pursuit Co, a listed company which manufactures electronic components, is interested in acquiring Fodder Co, an unlisted company involved in the development of sophisticated but high risk electronic products.

The owners of Fodder Co are a consortium of private equity investors who have been looking for a suitable buyer for their company for some time. Pursuit Co estimates that a payment of the equity value plus a 25% premium would be sufficient to secure the purchase of Fodder Co. Pursuit Co would also pay off any outstanding debt that Fodder Co owed.

Pursuit Co wishes to acquire Fodder Co using a combination of debt finance and its cash reserves of $20 million, such that the capital structure of the combined company remains at Pursuit Co’s current capital structure level.

Information on Pursuit Co and Fodder Co

Pursuit Co

Pursuit Co has a market debt to equity ratio of 50:50 and an equity beta of 1•18. Currently Pursuit Co has a total firm value (market value of debt and equity combined) of $140 million.

Fodder Co, Income Statement Extracts

Year Ended    
All amounts are in $’000
31 May 201131 May 201031 May 200931 May 2008
Sales revenue16146152291449113559
Operating profit (after operating 
costs and tax allowable depreciation)
5169507442434530
Net interest costs489473462458
Profit before tax4680460137814072
Taxation (28%)1310128810591140
After tax profit3370331327222932
Dividends123115108101
Retained earnings3247319826142831

Fodder Co has a market debt to equity ratio of 10:90 and an estimated equity beta of 1•53. It can be assumed that its tax allowable depreciation is equivalent to the amount of investment needed to maintain current operational levels.

However, Fodder Co will require an additional investment in assets of 22c per $1 increase in sales revenue, for the next four years. It is anticipated that Fodder Co will pay interest at 9% on its future borrowings.

For the next four years, Fodder Co’s sales revenue will grow at the same average rate as the previous years. After the forecasted four-year period, the growth rate of its free cash flows will be half the initial forecast sales revenue growth rate for the foreseeable future.

Information about the combined company

Following the acquisition, it is expected that the combined company’s sales revenue will be $51,952,000 in the first year, and its profit margin on sales will be 30% for the foreseeable future.

After the first year the growth rate in sales revenue will be 5•8% per year for the following three years. Following the acquisition, it is expected that the combined company will pay annual interest at 6•4% on future borrowings.

The combined company will require additional investment in assets of $513,000 in the first year and then 18c per $1 increase in sales revenue for the next three years. It is anticipated that after the forecasted four-year period, its free cash flow growth rate will be half the sales revenue growth rate.

It can be assumed that the asset beta of the combined company is the weighted average of the individual companies’ asset betas, weighted in proportion of the individual companies’ market value.

Other information

The current annual government base rate is 4•5% and the market risk premium is estimated at 6% per year. The relevant annual tax rate applicable to all the companies is 28%.

SGF Co’s interest in Pursuit Co

There have been rumours of a potential bid by SGF Co to acquire Pursuit Co. Some financial press reports have suggested that this is because Pursuit Co’s share price has fallen recently. SGF Co is in a similar line of business as Pursuit Co and until a couple of years ago, SGF Co was the smaller company. However, a successful performance has resulted in its share price rising, and SGF Co is now the larger company.

The rumours of SGF Co’s interest have raised doubts about Pursuit Co’s ability to acquire Fodder Co. Although SGF Co has made no formal bid yet, Pursuit Co’s board is keen to reduce the possibility of such a bid.

The Chief Financial Officer has suggested that the most effective way to reduce the possibility of a takeover would be to distribute the $20 million in its cash reserves to its shareholders in the form of a special dividend.

Fodder Co would then be purchased using debt finance. He conceded that this would increase Pursuit Co’s gearing level but suggested it may increase the company’s share price and make Pursuit Co less appealing to SGF Co.

Required:

Explains the implications of a change in the capital structure of the combined company, to the valuation method used in part (i) and how the issue can be resolved; (4 marks)

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