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Professional Exams CIMA Paper F3

Financial Strategy

SUPPLEMENTARY EXAM KIT

November 2014

i i KAPLAN PUBLISHING

© Kaplan Financial Limited, 2014

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Contents Page

Section 1:

Pre-seen material 1

Section 2:

Unseen material for Question 1 7



Section 3:

Answer 1 17

Answer 2 25

Answer 3 33

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Section 1

PRE-SEEN MATERIAL

NOTE: This Pre-seen material should be read before attempting any of the three questions in this Supplementary Exam Kit.

PRE-SEEN CASE STUDY

Y was formed in 1900. It manufactures and sells top quality confectionery. For many years, Y was and remains a successful company and has become a household name particularly throughout Europe. Its fame is built on the very high quality confectionery products it sells through its own high street stores (some of which it owns and some which it leases). Y has just over 3,500 employees.

All of Y’s products are manufactured in its factory in the European country in which it is based (which is in the eurozone). The products are distributed through a multi-channel network comprising of Y’s own stores and ‘online’ business, franchises and retail partners. In addition, Y has now started to supply confectionery to large retail stores and supermarkets on a contract basis. These stores sell Y’s products and also ‘own brand label’ confectionery that Y manufactures for them.

Y’s product range includes a wide variety of milk, white, plain and diabetic chocolate products. Previously Y’s main sales had been chocolate products but now the company has expanded into producing other forms of confectionery which do not contain chocolate in any form, for example cakes and other sweets (candies). Y’s customers continue to have strong regard for the quality of its products.

Although Y exports its products throughout the world, its largest market is within Europe. Y’s customers vary from individuals to corporate clients which purchase Y’s products to present to their own clients as corporate gifts. Although individual customers buy from Y’s stores, franchises or online, corporate clients purchase goods directly from Y on a contract basis.

Business structure

Y has a simple business structure. It has a head office (which includes its corporate treasury function) and two divisions: Direct Customer Sales (DCS), and Manufacturing and Commercial (MC). The activities of each division are as follows:

DCS

DCS has the following sales outlets:

• Y’s own stores

• Franchises

• Online sales

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MC

MC undertakes all purchasing of ingredients and manufacturing of Y’s products. It then supplies these products internally to:

• DCS for its sales through its own outlets

and externally to:

• Corporate clients

• External retail stores and supermarkets which sell Y’s products under Y’s own label and also under the stores’ own labels.

Both divisions are investment centres but have limited capital investment authority, for expenditure up to EUR 10,000 per item. Major capital investments, above EUR 10,000 per item, have to be authorised by head office.

DCS does not allow any of its outlets to make any capital investment at all without its prior approval. Each of DCS’s sales outlets is regarded as a profit centre, including online sales which is a single profit centre in its own right. Brand development is carried out by both of the divisions. Any brand development costs, such as promotion, above EUR 10,000 must be approved at head office.

The decline of high street sales has led Y to reduce the number of its stores and expand other sales outlets. This has resulted in some staff being re-trained and re-deployed. Y currently has just over 300 of its own stores and just less than 200 franchises. It also has developed its own website. This has been very popular and has enabled its international business to grow. In addition, as internet shopping has become more popular, Y has been able to develop its online sales business and has introduced ‘click and collect’ services using its stores and franchise businesses as the collection points.

Mission, Aim and Objectives

Y’s mission statement, agreed by the Board of Directors last year is:

“To delight customers by providing luxurious products which strengthen the brand.”

Y’s overall aim is to increase shareholder value by improving profit margins through increased sales and reduced costs. Despite the difficult economic conditions in Europe, the chocolate market has continued to grow in the last five years. Y’s customers engage particularly with chocolate products in response to austere economic conditions seeing them as an affordable alternative to higher priced gifts. Y is now placing greater emphasis on trying to ‘de-seasonalise’ its sales by not being reliant on the seasonal peak sales periods. Y is encouraging customers to buy its products throughout the year through all of its sales channels. This demands a strong focus on developing brand awareness.

Y intends to achieve the continued development and growth of its business by meeting two strategic objectives which are to:

1 Engage with the widest range of customers through the development of Y’s markets and products through a wide variety of sales channels. The focus of this is on the delivery of products the customer demands, where they are required and when they are wanted.

2 Enhance the customer experience through strong and effective customer relationship management. The focus of this is on clear and consistent branding and marketing to encourage customer retention and loyalty all the year round.

PRE-SEEN MATERIAL : SECTION 1

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Y’s Board and Divisional Management

The Board comprises a non-executive Chairman, a newly appointed Chief Executive, the Managing Directors of the two divisions, the Finance Director and three non-executive directors. The company applies good corporate governance principles and practice and the Board has a committee structure which includes an Audit Committee.

The divisional structures reflect their different activities. The Managing Director of each division has a team comprising three divisional directors covering the functions of Finance, Human Resources and Information Technology. In addition, the DCS division has three divisional directors, one each responsible for Y’s stores, franchises and online sales. In addition to the divisional directors for Finance, Human Resources and IT, the MC division has three divisional directors, one responsible for procurement, one for manufacturing and one for commercial clients, retail stores and supermarkets. The structure for Y’s Board and its divisions is presented at Appendix 1.

Financial overview

Extracts from the statement of profit or loss for the year ended 31 December 2013 and statement of financial position as at 31 December 2013 are shown in Appendix 2. They show that in the last financial year, Y achieved an operating profit margin of 12% and a profit after tax of 7.7%.

Despite its best efforts in heavily re-investing in the business, Y’s bottom-line profit has stagnated. The Board is concerned that the expected actual profit for the year ended 31 December 2014, when compared to the forecast, is not looking as promising as was first thought. The Board is also mindful that some of Y’s borrowings are due for re-payment in 2015.

In response to these concerns, the Board of Directors has determined the following financial objectives for Y:

• That it should operate on a sound financial basis in order to increase profit and shareholder value

• That it should pay a regular and consistent dividend each year.

Environmental and Corporate Social Responsibility

Y aims to carry out its business with as little damage to the environment as possible and to operate in a fair manner with regard to all its stakeholders. It is keen to ensure that each of its suppliers adheres to high ethical and environmental standards with regard to sources of materials and treatment of employees.

Y imports cocoa from Africa and Indonesia. Y has initiated schemes to encourage sustainable farming of cocoa and farmers are being trained in effective agricultural methods. The introduction of an industry approved certification programme has enabled farmers to achieve higher levels of income from increased production and to access additional training directed at improving their production yields. All raw materials sourced from Africa and Indonesia are priced in US Dollars (USD).

All of Y’s products contain only the ingredients listed on the packaging. The packaging also shows nutritional content and gives advice on recommended volumes of consumption. Y tries to ensure that the packaging used for its products is recyclable and kept as minimal as possible to balance concerns over material usage with commercial marketing requirements.

Environmentally friendly lighting has been introduced in Y’s factory which has reduced consumption of electricity and emission of carbon dioxide.


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Y has introduced annual independent health and safety audits in its factory and retail outlets. All factory staff have undertaken food safety and health and safety in the workplace training at the required industry standard level. Workplace benefits, such as life and medical insurance, staff discounts and membership of local gymnasia, as well as competitive salaries and wages are offered to all of Y’s employees.

Strategic developments

In order to achieve its overall mission, aim and objectives, Y intends to expand its online channel to increase its sales to corporate clients and external retail stores and supermarkets. These sales yield a higher margin than that achieved through sales in Y’s own high street stores. The Board also intends to further rationalise the number of its high street stores.

Appendix 1 STRUCTURE CHART FOR Y

Non-Executive Chair Chief Executive

Finance Director Managing Director (DCS) Managing Director (MC)

3 Non-executive directors

Managing Director DCS Divisional Directors of: Finance Human Resources Information Technology Y’s Stores Franchises Y’s Online Sales

Managing Director MC Divisional Directors of: Finance Human Resources Information Technology Procurement Manufacturing Commercial clients, retail storesand supermarkets

Board of Directors

Direct Customer Sales Division Manufacturing and Commercial Division

PRE-SEEN MATERIAL : SECTION 1

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Appendix 2

Y’s statement of profit or loss and statement of financial position

Statement of profit or loss for the year ended 31 December 2013 EUR 000 Revenue 248,589 Cost of sales (128,523)

––––––– Gross profit 120,066 Operating costs (90,239)

–––––– Operating profits 29,827 Finance income 120 Finance costs (5,008)

–––––– Profit before tax 24,939 Tax (5,736)

–––––– PROFIT FOR THE YEAR 19,203

––––––

Statement of financial position as at 31 December 2013 EUR 000 ASSETSs Non-current assets 2,407 Intangible assets: goodwill 158,822

––––––– Property, plant and equipment 161,229

––––––– Total non-current assets Current assets Inventories 44,856 Trade and other receivables 21,348 Cash and cash equivalent 12,368

––––––– Total current assets 78,572

––––––– Total assets 239,801

––––––– EQUITY AND LIABILITIES Equity Share capital (EUR 0.5 shares) 31,122 Share premium 12,120 Retained earnings 42,101

––––––– Total equity 85,343

–––––––


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Non-current liabilities Borrowings 116,484 Provisions for liabilities 2,294

––––––– Total non-current liabilities 118,778

––––––– Current liabilities Trade and other payables 33,936 Provisions and liabilities 1,744

––––––– Total current liabilities 35,680

––––––– Total Liabilities 154,458

––––––– Total equity and liabilities 239,801

–––––––

End of Pre-seen Material

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Section 2

QUESTIONS – UNSEEN MATERIAL

1 This material should be read in conjunction with the Pre-seen material for the November 2014 regarding Y. Unseen material for Case Study

Background

Today is 20 November 2014.

The Finance Director of Y is concerned because the company’s profit for 2014 is likely to be 10% lower than in 2013. At the recent Board meeting, he proposed that Y should aim to acquire a competitor company in order to expand its online sales quickly and to give a positive signal to the market.

Y is a listed company and its share price is currently EUR 2.25.

Notes from the Board meeting

At the recent Board meeting, all the directors agreed that Y is unlikely to achieve its stated financial objective “to increase profit” in 2014.

The Finance Director identified an existing online gifts company, Fancy Things (FT), as a possible acquisition candidate. Although Y has no previous experience of acquisitions, having always grown slowly and organically in the past, the directors can see the attraction of acquiring an existing company.

The Finance Director explained that FT has four founding Directors, each of whom owns 20% of the company. The other 20% of the share capital is owned by a variety of small investors. The FT Directors are looking for ways to realise their investment and have expressed an interest in selling the company to Y. They have the backing of the minority shareholders. The FT Directors would be prepared to work for Y after the takeover if sufficiently attractive terms of employment were offered.

The other directors of Y agreed that acquiring FT would enable Y to expand its online sales quickly, and that the expertise of the existing FT Directors should ensure that the acquired business would be able to help Y to achieve its profit growth objective easily in 2015.

At the end of the meeting, it was agreed that the Finance Director of Y should prepare some initial analysis, to enable the Board to decide how much Y should offer to acquire FT.

More details on the target company, Fancy Things (FT)

FT is a private limited company, based in country A, a country just outside the Eurozone, whose currency is the country A dollar (A$). It has been trading for five years and has seen rapid growth in its reported profits. However, the cash flows are lagging behind the growth in profits.


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In many respects, FT is considered to be a good ‘fit’ with Y’s business. It has no retail outlets, but a strong web presence throughout country A and the Eurozone, and it offers a wide range of gift products, including chocolates, flowers and toiletries. It is considered that many of Y’s customers may be interested in FT’s products (and vice versa).

FT’s profit after tax is forecast to grow at a rate of 8% a year for the next 3 years and then at a steady rate of 3% in subsequent years.

Should the acquisition go ahead, the Finance Director expects the combined business to achieve synergistic benefits that will result in an increase in FT’s current estimate for a year-on year growth in profits from 8% a year to a growth rate of 14% a year in each of the next 3 years. Growth would then revert to a steady state of 3% a year from year 4 onwards. However, there are also expected to be exceptional one-off up-front costs arising from the integration of the two businesses in A$ of approximately A$ 1 million (that have no impact on the underlying operating profit).

Extracts from the latest annual financial statements for FT are as follows:

Statement of profit or loss for FT for the year ended 31 December 2013 A$million Revenue 7.7 Operating costs (3.9) Finance costs (0.6) ––––– Profit before tax 3.2 Income tax expense (1.0) ––––– PROFIT FOR THE YEAR 2.2 –––––

Statement of financial position for FT as at 31 December 2013 ASSETS A$million Non-current assets 2 Inventories and receivables 12 Cash and cash equivalents 1 –––– Total assets 15 –––– EQUITY AND LIABILITIES Share capital 1 Retained earnings 5 Non-current liabilities (bank borrowings at floating rate) 8 Current liabilities 1 –––– Total equity and liabilities 15 ––––

Latest estimates for the year ending 31 December 2014 show profit for the year of A$ 2.5 million.

QUESTIONS – UNSEEN MATERIAL : SECTION 2

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Being a privately-owned company, there is no share price available for FT. However, a 5% parcel of shares was sold by private arrangement for A$ 0.5 million six months ago.

A similar sized company to FT in the same market, Indigo Moods Co (IM), has been identified for use as a proxy company for the purpose of valuing FT. IM has a P/E ratio of 6.6, an equity beta of 1.8 and the same gearing as FT. IM is, however, a somewhat more mature company than FT and has largely passed the early days of extraordinary returns and high risk. It is therefore considered appropriate to increase IM’s cost of equity by a factor of 25% in order to arrive at an appropriate cost of equity for FT. (For example, a discount rate of 10% for IM would be increased to 12.5% for FT). Debt beta can be assumed to be zero, the risk-free market rate is 2% and the market premium above the risk free rate is 6%.

Pricing the bid

The Finance Director of Y has suggested that an initial offer of A$ 12.5 million should be made for the acquisition of FT for transfer of ownership on 1 January 2015.

Financing options

The Finance Director is unsure whether the acquisition should be financed by debt finance, equity finance, or a mixture of the two. If debt finance were to be used, he has not decided whether the debt should be denominated in EUR or in A$, or whether bank borrowings or any other type of debt should be used. Similarly, if equity finance were to be used, he is unsure what options are available.

Additional information:

• The spot exchange rate is expected to be EUR/A$ 0.5000 (that is EUR1 = A$ 0.5000) on 1 January 2015 and the A$ is expected to weaken against the EUR at approximately 3% a year thereafter.

• The present bank borrowings of FT are subject to a bank covenant that would require the borrowings to be repaid as part of any acquisition agreement.

• Corporate tax will be payable by both Y and FT at 30% for the year 2014 onwards and there is a double tax treaty in place under which no additional tax would be payable by Y on profits generated by FT.

Required:

(a) (i) Calculate a range of values for FT as at 1 January 2015 using: • The price achieved in the recent sale of a 5% parcel of shares. • P/E basis. • Discounted cash flow basis, ignoring potential synergistic benefits and

integration costs. (11 marks)

(ii) Explain briefly the suitability of each method used in part (a)(i). (6 marks)

(b) Assume you are an external consultant engaged by Y to evaluate the proposed acquisition of FT. Write a report, suitable for presentation to the Directors of Y, in which you:

(i) Evaluate the proposed initial offer price of A$ 12.5 million from the viewpoint of both the shareholders of FT and the shareholders of Y, concluding with advice on an appropriate adjusted offer price. (11 marks)

(ii) Discuss the potential problems and issues that could arise from the integration of FT into Y. (7 marks)


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(iii) Advise on issues that affect the choice of finance to fund the acquisition (i.e. debt or equity or a mixture of the two) and discuss the options for Y if it chooses to raise debt and/or equity finance. (12 marks)

Note: Calculations in part (b) count for up to 7 marks.

Additional marks for structure and presentation throughout. (3 marks)

(Total: 50 marks)


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2 This material should be read in conjunction with the Pre-seen material for the November 2014 regarding Y.

Unseen material for Case Study

Assume that today’s date is 20 November 2014

The views of the new Chief Executive

The newly appointed Chief Executive of Y has been performing a review of Y’s operations and she has made two key proposals:

First Proposal

The Chief Executive has expressed concern that the financial objectives of Y are too restrictive. She has questioned how Y can hope to grow and be successful when the financial objectives place an arbitrary constraint on the company’s dividend policy. She has proposed that the financial objectives should be changed to allow the directors to find a better balance between the company’s financing, dividend and investment policies.

Second Proposal

Y’s bottom-line profit has stagnated, so the Chief Executive is keen to implement a growth strategy. She feels that acquisition is often a very expensive way of developing the business, so she has proposed that Y should adopt a policy of organic growth as it tries to expand its operations. She has identified an opportunity to buy a new factory in Northern Africa, where labour costs are much lower than in Europe, but there is a huge nearby corporate market for Y’s confectionery products.

Recent Board meeting

At last week’s Board meeting, the directors had a lengthy discussion about these two proposals of the Chief Executive, and how they could be implemented to ensure that Y improves its performance in future. Some of the key points raised at the meeting are listed below:

Non Executive Chair:

“I’m happy to look again at our financial objectives. I think we should set a limit of 40% (debt to (debt + equity) by market value) on gearing level, to prevent Y’s shares being viewed as a risky investment. It would be reckless to increase the gearing beyond 40% in any circumstances.”

Managing Director (Direct Customer Sales):

“I think the financial objectives are fine. In order to satisfy investors, we need to focus on dividends. As long as we can maintain the level of dividends paid to our shareholders, they will be satisfied.”

Finance Director:

“Y is a large, listed, well-established company, but it has very little cash at the moment which could be used for expansion. I suggest that we consider a rights issue of equity, or a bond issue in the stock market, to strengthen our financial position and to enable us to make the investment in North Africa.”

Non-executive director appointed by PP Pension Fund (“PP”), one of Y’s institutional shareholders – currently PP owns 10% of the shares in Y:

“I shall advise PP not to subscribe for any rights shares if a rights issue is announced. Instead, I shall advise PP to sell the rights, to make sure that there is no reduction in its overall wealth.”



Currency information

The currency in North Africa is the North African dollar (NA$) and the expected exchange rate on 1 January 2015 is EUR/NA$2.6000 (that is EUR 1 = NA$ 2.6000).

The currency to be used when invoicing sales to North African corporate customers is the US dollar (USD). The expected exchange rate on 1 January 2015 is EUR/USD1.2000 (that is EUR 1 = USD 1.2000).

The Euro (EUR) is expected to strengthen by 1% per year against the NA$, and keep a constant value against the USD.

Details on the North African investment opportunity

The Chief Executive has identified a factory in North Africa which Y could purchase for NA$ 260 million, on 1 January 2015. No tax depreciation allowances would be available, but the local government would give Y a grant, on 1 January 2015, worth 20% of this initial investment. The grant would not be repayable as long as Y continued to employ local workers in North Africa for at least five years.

The factory was vacated by another large, multinational confectionery manufacturing firm recently, as it moved to bigger premises nearby to support its growing business. The Chief Executive feels that this factory would enable Y to generate post-tax income from African corporate customers of USD 20 million in the year ended 31 December 2015. This amount would be expected to grow by 10% per year until 31 December 2019.

Staff costs and other operating costs in North Africa are expected to be constant at NA$ 20 million for five years. These would not be tax deductible, since Y would have no NA$ denominated income to offset them against.

The Chief Executive estimates that the factory will be worth NA$ 250m after five years, on 31 December 2019.

Follow-up to the Board meeting

Following the Board meeting, the Chief Executive and the Finance Director have been discussing the potential expansion into North Africa, and the likely finance requirement. The Finance Director has estimated that EUR 80m of finance would be required to buy the North African factory. He is keen to investigate the following two financing options:

• a rights issue of shares at a subscription price of EUR 2.70 per share

• a 10 year bond issue on the stock market

Other useful information

• The appropriate cost of capital for the North African project is 15%.

• The shares of Y are trading at EUR 3 per share at the moment. The Finance Director feels that the rights issue of shares would have to be offered at a discount of 10% to the current share price in order to attract investors.

• If Y were to choose to issue bonds on the market, the Finance Director has suggested that a coupon rate of 4.4% per annum should be paid, in common with the rate of interest paid by Y on its existing borrowings. The bonds would be redeemed at par in 10 years’ time.

• Y is an A rated company according to the major credit rating agencies. The yield to maturity on 10 year bonds for A rated companies is currently 6% per annum.



Required:

(a) Calculate the NPV of the North African project in EUR on 1 January 2015. (7 marks)

(b) Assuming that Y chooses to proceed with the rights issue to raise EUR 80m on 1 January 2015, calculate:

(i) the theoretical ex-rights share price, incorporating the impact of the new project evaluated in part (a) above.

(ii) the value of a right.

(iii) the wealth of the PP shareholder in the following three situations:

• before the rights issue;

• after the rights issue, and assuming that PP takes up its rights;

• after the rights issue, and assuming that PP sells its rights.

Comment on your calculations in parts (a) and (b) in relation to the comments made by the non-executive director at the Board meeting. (10 marks)

(c) Assuming that Y chooses to proceed with the bond issue, calculate the issue price for EUR 80m nominal 4.4% coupon 10 year bonds which would ensure that the debt investors received their required yield to maturity from these A rated bonds.

(4 marks)

(d) Assume you are an independent financial adviser employed by Y to advise on the various issues discussed at the Board meeting. Write a report to the directors of Y in which you:

(i) Discuss the links between Y’s dividend policy, financing policy and investment policy. Recommend how the Board of Directors should address these policies to ensure that the Y shareholders remain satisfied. (8 marks)

(ii) Discuss the relative advantages of acquisition and organic growth strategies in the context of the North African investment. (8 marks)

(iii) Discuss the advantages and disadvantages of the two financing options suggested by the Finance Director. Your discussion should incorporate the results of your calculations in parts (a), (b) and (c). (10 marks)

Additional marks available for structure and presentation: (3 marks)

(Total: 50 marks)



3 This material should be read in conjunction with the Pre-seen material for the November 2014 regarding Y.

Unseen material for Case Study

Today is 20 November 2014.

The directors of Y are considering establishing a chain of retail outlets (“stores”) in Country Z, an Asian country where Y has never traded before. Y’s existing stores in other countries have historically performed well, so it is considered that the same sort of business model will help Y to build its reputation in Country Z. Y intends selling many of its own confectionery products in the stores, as well as other gift products sourced from local suppliers.

Country Z is a large country with a rapidly developing economy, so the directors consider the move into Country Z to be strategically very important to Y. The functional currency of Country Z is the Z dollar (Z$).

An opportunity has arisen for Y to purchase and develop 50 empty retail properties. The properties are considered to be of an appropriate size and location for Y’s new stores.

The price, Z$ 30 million for all 50 of the retail properties, is also very attractive.

Details of proposed project

A project team has been set up to manage the project. The project would commence on 1 January 2015 and is to be evaluated over a four year time period from that date.

The stores would be empty when acquired and would need to be re-fitted at an approximate one-off total cost of Z$ 10 million for re-fitting all 50 stores.

Both the purchase cost of the properties and the cost to renew the store fittings can be assumed to be paid on 1 January 2015.

The store fittings are estimated to have a residual value of Z$ 4 million on 31 December 2018. There is some uncertainty over the value of the stores themselves on that date. The project team has decided to evaluate the project on the basis that the properties, excluding fittings, could be sold for cash on 31 December 2018 at a price that is 20% greater, in nominal terms, than the original purchase cost.

The Direct Customer Sales (DCS) division’s director of finance has produced some estimates of the total expected revenue and cost figures for the first year of the project as shown below. Note that these are aggregated figures across all 50 stores.

Revenue Z$ 90 million

Purchase costs Z$ 35 million

Other operating costs Z$ 40 million

Each of the above revenue and costs is expected to grow by 12% a year for the duration of the project.

The project team is planning to adopt an aggressive strategy for managing working capital. Target working capital days for the project are given below, together with historical data for Y for comparative purposes. Both accounts payable and inventory days are based on purchase costs. Note that it has been assumed that the cost of sales figure shown in Y’s most recent financial statements (shown in Appendix 2 to the pre-seen material) is equal to Y’s purchase costs.



Working capital days Project Y

Accounts receivable Nil 31 days

Accounts payable 60 days 96 days

Inventory 40 days 127 days

Additional information:

• Working capital values for accounts payable and inventory at the beginning of each year are to be calculated by applying the target working capital days to the appropriate forecast revenue and/or cost figures for the coming year.

• Working capital adjustments should be assumed to arise at the start of each year.

• The final accounts payable and inventory balances at the end of the project should be assumed to be realised in full at that time.

• After working capital adjustments, project revenue and costs should be assumed to be cash flows and to be paid or received at the end of the year in which they arise.

• Corporate income tax is payable at 33% at the end of the year in which it is incurred. Tax depreciation allowances are available on the store fittings costs on a reducing balance basis at 25% a year. No corporate capital taxes apply to the purchase and sale of the properties.

• The EUR/Z$ spot rate is expected to be EUR/Z$ 1.1000 on 1 January 2015 (that is, EUR 1 = Z$ 1.1000). Interest rates for the EUR and Z$ are 3% and 5% respectively and the EUR/Z$ spot rate is expected to move in line with the interest rate differential for the duration of the project.

A discounted cash flow approach is to be used in evaluating the project, based on Y’s EUR based weighted average cost of capital of 11%.



Required:

Assume you are a member of the project team and are preparing a briefing paper for the DCS division’s directors regarding the proposed project in which you:

(a) (i) Describe two possible reasons, other than the use of an aggressive strategy to manage working capital levels, for the differences in working capital days between those expected for the project and historical data for the whole of Y. (3 marks)

(ii) Discuss the benefits and potential drawbacks of the proposed aggressive strategy for managing working capital for the project. (6 marks)

(iii) Calculate the forecast accounts payable and inventory balances for each year of the project. (5 marks)

(b) (i) Calculate the forecast project net present value (NPV), in EUR, as at 1 January 2015. (14 marks)

(ii) Calculate the change in the project NPV if the value of the properties, excluding fittings, on 31 December 2018 is 20% lower than the original purchase cost of Z$ 30 million. (3 marks)

(c) Advise whether or not to proceed with the project, taking into account:

• Your results in (b) (i) and (b) (ii) above.

• The reasonableness of the key input variables used in the NPV appraisal.

• The potential risks to Y of establishing a new business in a foreign country. (16 marks)

Additional marks available for structure and presentation: (3 marks)

(Total: 50 marks)


Section 3

ANSWERS

1 (a) (i) Business Valuation

Based on recent sale of 5% of shares Recently, 5% of the shares sold for A$ 0.5m. This suggests that the total equity value should be A$ 0.5m x (100/5) = A$ 10m or (at an exchange rate of EUR/A$ 0.5000) EUR 20m Note: However, it is likely that if Y wanted to buy 100% of the equity, then a premium would be payable. This point is discussed in more detail in part (a) (ii).

P/E basis Equity value = P/E ratio x Profit after tax

FT is unlisted, so has no P/E ratio. Therefore we use the P/E of the similar quoted company IM (a P/E ratio of 6.6) as a proxy. The expected profit for the year ended 31 December 2014 is A$ 2.5m. Therefore, equity value = 6.6 x 2.5m = A$ 16.5m or (at an exchange rate of EUR/A$ 0.5000) EUR 33m However, it is questionable whether the proxy company’s P/E should be used like this with no adjustment. We are told that the proxy company is past the initial high growth stage in its life cycle, so this suggests that its P/E ratio may well be lower than one which is appropriate to FT. However, it is also often argued that the P/E of a private company will be lower than the P/E of a listed company because of the lower marketability of its shares. On the basis that these arguments would require us to both increase and decrease the proxy company’s P/E ratio (by unknown amounts) before applying it to FT, the calculation has been performed just using the existing P/E ratio for simplicity. Discounted cash flow (DCF) basis (ignoring synergy for now – see further calculations in part (b))

Tutorial note To value the equity in FT, there are two recognised approaches: (1) discount free cash flow (after interest costs) using the cost of equity (2) discount cash flows before deducting interest costs using the WACC, then

deduct the value of debt afterwards. Only the first method is shown here, because it is arguably the simpler approach since the cost of equity can be estimated more easily than the WACC, and because the given figure for profit (after interest) has been used as an approximation to cashflow.



We are not told what the cash flows of FT will be in the future, so we shall use profit as an approximation to cash flow i.e. assume cash flow in the year ended 31 December 2014 will be A$ 2.5m.

2015 2016 2017 2018 onwards A$m A$m A$m A$m

Cashflow (after interest and tax) showing 8% per annum growth for 3 years 2.70 2.92 3.15

Cashflow after interest and tax (3% per annum growth thereafter) 3.24

Discount rate at 16% (W1) 0.862 0.743 0.641 641.0

03.016.01 ×−

NPV 2.33 2.17 2.02 15.98

Total NPV (A$m) 22.50 or (at an exchange rate of EUR/A$ 0.5000) EUR 45m (W1) Cost of equity for FT

It is difficult to identify a cost of equity for the private company FT. However, we do have information about a similar quoted company (IM), so we can use IM’s details to approximate a cost of equity for FT as follows: IM has an equity beta of 1.8. Since IM is in a similar industry to FT and because it has similar gearing, this equity beta will also be appropriate to FT. Hence, using the CAPM model, IM’s cost of equity is: ke = Rf + (Rm – Rf)ß

ke = 2% + 1.8 x 6% = 12.8% However, we are told that FT’s cost of equity is likely to be 25% higher, so 12.8%x1.25 = 16%. Therefore we shall use 16% to discount FT’s post interest and tax cash flows.

(a) (ii) Suitability of each valuation method

Recent sale of 5% of shares In one way this is the best of all valuation methods. It gives a practical third party valuation of the shares. However, the previous sale was 6 months ago, and since then the value of FT may have changed, if future expectations have changed. Also, Y intends to purchase all the equity of FT, and for this a premium is likely to be payable. Owning 100% of the equity gives the investor total control of all the assets and cash flows of the business, and enables the shareholder to make any decisions about the future strategy of the firm. Owning only 5% gives no such benefits to an investor. In fact a 5% shareholder is only entitled to receive a dividend from the shares at the discretion of the directors. For this reason, a 100% shareholder will normally be willing to pay a significant premium over the scaled up 5% value.

ANSWERS : SECTION 3


P/E method The P/E method is very simplistic, but gives a useful, quick idea of what the shares might be worth. The use of proxy company information can be problematic. We are told in this case that IM is similar to FT, but we are also told that its risk and hence cost of equity are slightly different. This may mean that its P/E ratio is different too. Arguably, the P/E ratio should have been adjusted before using it to value FT, but it is difficult to know by how much. DCF basis Theoretically, the DCF method is the best valuation method, since it calculates the present value of the cash flows which FT will generate, and hence gives the wealth generated for shareholders by holding the shares in FT. The problem with the DCF method is that it relies heavily on assumptions. For example we have assumed here that cash flows are equal to profits, that growth will be 8% per annum then 3% per annum, and that the proxy information from IM is appropriate when calculating the discount rate. If any of these assumptions turn out to be incorrect, the actual value may be very different from that calculated. The main problem is that we are told that cash flows “are lagging behind the growth in profits” but without further information it is difficult to know by how much the profits and cash flows differ.

(b) REPORT

To: The Board of Directors, Y

From: Consultant

Date: 20 November 2014

Subject: Proposed FT purchase

Introduction

This report has been prepared at the request of the Board of Directors to examine the proposed FT purchase. In particular, it covers the value of FT, the potential problems with integrating FT, and the choice of financing.

Offer price (part (i)) The Finance Director has suggested an initial offer price of A$ 12.5m.

FT’s shareholders’ likely response This offer puts a higher value on the shares than the recent sale of 5% did, so initially it is likely that the FT shareholders will be pleased with the size of the offer. Also, the offer of A$ 12.5m comfortably exceeds the net assets value of A$ 6m. However, the other two valuations presented in the Appendix (part (a)) show that the value of 100% of the equity in FT is actually likely to be much higher than this initial offer. The information used to prepare the valuation calculations in the Appendix is readily available information, so FT’s shareholders will presumably be aware of these valuations.



Y’s shareholders’ perspective Given the three calculations shown in the Appendix, it appears that the Y shareholders will benefit greatly if the initial A$ 12.5m offer is accepted. However, as explained above, the FT shareholders are unlikely to accept this initial offer. The key question is then: by how much can Y raise its offer and still generate wealth for the Y shareholders? From the calculations in the Appendix, it appears as though a maximum offer of A$ 22.50m is possible (the DCF valuation). However, because of the synergies which are likely to be generated by the integration of Y and FT, it could be that the value of FT to Y is even higher than the A$ 22.50m already calculated, so arguably Y’s maximum bid could be even greater than this. The following DCF calculation attempts to value FT and the likely synergy if it is taken over by Y. It is similar to the calculation presented in the Appendix, but it incorporates the initial integration costs and also the higher expected growth rate for the first 3 years (14%):

1/1/15 2015 2016 2017 2018 onwards

A$m A$m A$m A$m A$m Cashflow (after interest and tax) showing 14% per annum growth for 3 years

2.85 3.25 3.70 Cashflow after interest and tax (3% per annum growth thereafter)

3.81

Integration costs (1)

Total cashflow (1) 2.85 3.25 3.70 3.81

Discount rate at 16% (as before) 1 0.862 0.743 0.641 641.003.016.0

1 ×−

NPV (1) 2.46 2.41 2.37 18.79

Total NPV (A$m) 25.03 or (at an exchange rate of EUR/A$ 0.5000) EUR 50.06m i.e. the gain in shareholder wealth for Y if it takes over the FT business is likely to be A$ 25.03m, so this is the absolute maximum offer which Y should make to acquire the equity of FT. Note that the weakening A$ will cause the future receipts from FT to reduce in EUR terms. This may be an issue when deciding what currency to use for any finance raised – see discussion below in part (iii). Conclusion It is likely that FT’s shareholders will reject the initial offer of A$ 12.5m. Based on their calculations (replicated in the Appendix), they will be looking for a value in the region of A$ 22.5m, the DCF value of FT’s forecast cash flows. However, for its initial offer, Y should not go up to this figure. Many of the figures in the DCF valuation are based on estimates (in particular we have assumed that profit = cash flow, but we are specifically told that cash flows are lagging behind profits), so Y should be able to argue that the actual value of FT may well be less if the forecasts are not achieved. Y should start with an offer of round about A$ 16.5m (the P/E valuation). Hopefully FT’s shareholders will accept this, along with Y’s arguments concerning the forecasts.

ANSWERS : SECTION 3


Particularly with their company being a private company, they have few alternatives if they want to sell their shares. Showing an interest in selling their company to Y has already weakened their negotiating position somewhat. However, if the FT shareholders decide to hold out for a better offer, Y can afford to go up to an absolute maximum valuation of A$ 25.03m. Of course, this is unlikely to be necessary, since the FT shareholders will be unaware of this value, since they will not be aware of the Y forecasts for synergy.

If Y starts the bidding at A$ 16.5m, it is likely that the final price will settle somewhere between that and A$ 22.5m.

Issues arising on integration of FT and Y (part (ii)) If Y does take over FT, there are likely to be several key issues which may cause problems if not managed carefully. Upfront cost of A$ 1 m We are not told what this cost represents. If it includes redundancy payments or other closure costs for parts of FT’s business, this will demotivate the FT staff. Congruent objectives Y has two stated financial objectives – relating to profit growth and dividends – and a mission and some strategic objectives. We are not told what objectives FT has previously been targeting. Therefore, the directors of Y need to discuss the two companies’ objectives with the FT managers to ensure that goal congruence between the two businesses is achieved after the acquisition. Synergy It is forecast that synergies will enable FT’s profits to grow at 14% per annum for 3 years. We need to question how these figures have been arrived at and are they achievable and in the timescales given. Are there clearly defined items which make up this number or is it a management estimate, and have the costs relating to these synergies been accounted for? The synergies will certainly not be achieved unless the employees and managers of both Y and FT work hard and have clear objectives presented to them. It will be extremely important to develop goal congruence across the new business.

Eurozone v Country A culture Y is a Eurozone based company and FT is a much smaller company based in Country A. Therefore the cultures of the two companies are likely to be very different. The directors and employees of FT have previously worked in an environment where they had to satisfy their own objectives and few other shareholders. They will need to quickly get used to the culture at the larger company Y, where the primary focus is to generate wealth for a wider group of shareholders, perhaps with different objectives from what they are used to. Political / legal factors There are also political factors to take into account, such as government subsidies and taxes. Will any favourable subsidies fall away if FT is under foreign ownership? Are there any legal requirements on Y re: acquisition of FT? Are there any separate laws governing companies in Country A that we are unfamiliar with and therefore, may incur legal fees if we do not adhere to them?



FT directors’ terms of employment FT’s directors are keen to work for Y if they are offered “attractive terms of employment”. It is not clear what terms they currently work under for FT, but it could be the case that levels of pay they have been used to are different from than those in Y. Y’s business may benefit from having the existing managers of FT working for the company post-acquisition. Their expertise will mean that Y’s directors won’t need to spend lots of their time working in the new part of the business, and risking taking their eyes off the main products. Repayment of FT bank loan As soon as Y takes over FT, it will have to repay the bank loan of A$ 8m (EUR 16m). Coming at the same time as the purchase of FT’s shares, this will put an extra strain on Y’s cash position (which is already going to be stretched due to some of the existing long term debt finance being repayable in less than two years’ time). It is likely that when finance is raised to fund the purchase of FT’s shares, an increased amount will be needed, to enable Y to repay FT’s debt too.

Financing options (part (iii)) If Y purchases FT, it will need to raise some new finance to pay for the shares of FT, and also to pay off FT’s existing borrowings (according to an existing covenant). In order to assess the options available to Y, it is first necessary to make an assumption about how much finance will be needed. Given that we suggested above that the opening bid should be A$ 16.5m, but the final price would probably settle somewhere between this bid and A$ 22.5m, let us assume that approximately A$ 20m will be needed to purchase FT’s shares. Along with A$ 8m needed to repay FT’s debt finance, this means that Y will need to raise approximately A$ 28m, or (at the expected exchange rate of EUR/A$ 0.5000) EUR 56m on 1 January 2015. Issues to consider when deciding between debt and equity finance (or a mixture of the two) Gearing Y’s current gearing level is: • (by book value): (116,484/(116,484+85,343))x100% = 57.7% • (by market value): (116,484/[116,484+(62,244 x EUR 2.25)] = 45.4% This looks quite high, but given a lack of comparative figures, it is difficult to say for certain. However, it is pleasing to note that Y’s interest cover is quite high at 6 times (29,827/5,008), and that Y’s non-current assets figure is much bigger than its current borrowings, suggesting that there may be more scope to use non-current assets as security for debt. It seems unlikely that lenders would want to lend Y the entire EUR 56m, given that current borrowings are already 116.484m, but there might certainly be scope for Y to raise part of the funds from debt and part of the funds from equity. Cost of finance Generally, the cost of servicing debt finance is cheaper than the cost of servicing equity, partly due to the lower risk to the investor of debt finance, and partly due to the tax relief generated by the borrower paying interest. Therefore, it is generally accepted that debt finance should be used if possible, to try to reduce a company’s overall cost of finance.

ANSWERS : SECTION 3


Optimal gearing level According to the Traditional View of gearing, all companies will have an optimal gearing level, where they are using enough cheap debt finance to ensure they receive the benefit of the cheap cost of debt and the tax relief on interest, but not too much debt so that risk and the threat of bankruptcy start to increase. Although there is no scientific way of finding this optimal gearing level, it does mean that a company should not be over-reliant on either debt or equity finance.

Conclusion In these circumstances, it appears that Y would be well advised to use a mixture of debt and equity finance to fund the acquisition. Perhaps Y should approach lenders and discuss how much more debt can be raised first, bearing in mind the availability of security and the fact that some of the existing loans are repayable in less than two years. Then, consideration could be given to how the rest of the funds should be raised as equity. Equity finance options To raise equity finance, Y has three basic options: a rights issue to existing shareholders, a private placing, and a public issue of shares. Rights issue Here, the existing shareholders would be asked to invest more money, to buy new shares in proportion to their existing shareholdings. Therefore, the existing shareholders would be able to maintain their existing stakes, and control of the company would not be diluted by new shareholders coming in. Private placing In a private placing, some new Y shares would be issued to a wealthy new investor, perhaps a venture capitalist. If Y’s directors can find a suitable investor, this would be a good option for Y. However, the existing shareholders’ control would be diluted by bringing the new shareholder in, and there is a danger that the new shareholder’s objectives may be different from the existing shareholders’, so there might be conflict in future shareholder discussions. If a supportive investor can be found, with plenty of money and similar objectives to the other shareholders, this would be a good equity financing option for Y. Public issue of shares A public issue of shares would mean that a wide variety of new investors would be able to invest in the company. As with a private placing, there would be a dilution in the existing shareholders’ holdings, and the potential problem of conflicting objectives. Y is a listed company though, so it probably already has a wide range of investors with different objectives. As a listed company, Y would find it relatively easy to undertake a public issue of shares. Debt financing options Type of debt finance – bank borrowings or other types of debt The most commonly used source of debt finance is a bank loan. However, since Y is a listed company, it also has the option to issue bonds on the stock market. A bank loan would be very quick and easy to arrange, since it would involve negotiation with only one third party (the bank). By contrast, arranging to issue bonds can be a drawn out process as a company has to try to attract many different investors from the market.



Y is listed but it is not clear whether it has ever issued bonds before. To issue bonds, the directors would have to prepare a detailed prospectus for potential investors to publicise the issue. This would probably be a costly process, especially if Y has never issued bonds before and if the directors need to pay for external advisors to help with the process. Y would be well advised to renegotiate the existing loans at the same time as negotiating the new loan, to try to avoid the problem arising in the relatively near future of having to repay some of the existing debt in less than two years. Raising the new finance as a bank loan would make the whole renegotiation process easier. One other factor to consider is that bonds generally have fixed interest rates but bank loans can have fixed or variable rates. Depending on Y’s view of what is likely to happen to interest rates in the future, this could be important. For example, if Y feels that rates are likely to fall, it might be better to negotiate a variable rate on a bank loan. As an alternative to a loan from a bank, Y could try to source a loan from another private investor. If Y’s directors are already in negotiation with a venture capitalist regarding equity finance, it would be worth discussing the possibility of the venture capitalist providing some debt finance too.

Currency of debt finance – A$ or EUR A$

If Y decides to use A$ denominated debt finance, there will be a hedge against exchange movements created by using the A$ inflows from FT to pay off the A$ interest and debt repayments. However, it will be more difficult to arrange A$ finance for Y – it is generally easier to raise debt finance in a company’s own currency. EUR

Raising debt finance in EUR to fund the purchase of FT in A$ would expose Y to exchange rate risk. Income from the FT business, denominated in A$, would have to be translated into EUR in order to make the debt interest payments. With the A$ forecast to weaken against the EUR, it is likely that the FT cash flows will in fact be worth less as years go by, thus making it more difficult to pay the EUR interest with the translated FT amounts. Conclusion It is recommended that Y increases its opening offer to purchase FT to approximately A$ 16.5m. If this offer is not accepted, Y should be prepared to increase the offer, but must be mindful of the fact that the Y shareholders will only gain from the purchase of FT if the purchase price is less than A$ 25.03m and if the integration of the two businesses is carefully managed. In order to fund the purchase, Y should use a mixture of debt and equity finance. If the directors can find a willing venture capitalist financier, this might be the simplest way of arranging all the necessary finance from a single investor.

ANSWERS : SECTION 3


2 (a) Present value of forecast cash flows for the North African project NA$m 1/1/15 31/12/15 31/12/16 31/12/17 31/12/18 31/12/19Staff costs - (20) (20) (20) (20) (20) Purchase factory (net of 20% grant)

(208)

Disposal of factory 250 Total NA$ CF (208) (20) (20) (20) (20) 230 Exchange rate (EUR1=NA$..) (↑1% pa)

2.6000 2.6260 2.6523 2.6788 2.7056 2.7326

Total in EURm (80) (7.616) (7.541) (7.466) (7.392) 84.169 USD m Income (↑10% pa) - 20.000 22.000 24.200 26.620 29.282 Exchange rate (EUR1 = USD...)

1.2000 1.2000 1.2000 1.2000 1.2000 1.2000

Total in EURm - 16.667 18.333 20.167 22.183 24.402 Overall EURm CF (80) 9.051 10.792 12.701 14.791 108.571 DF at 15% 1 0.870 0.756 0.658 0.572 0.497 PV (80) 7.874 8.159 8.357 8.460 53.960 NPV = EUR 6.810m

(b) (i) The easiest way to calculate the TERP when incorporating the impact of a new project is:

sharesofnumbertotalNew

projectofNPVproceedsRightstioncapitalisamarketcompanyOriginalTERP ++=

If EUR 80m is to be raised at a rights issue price of EUR 2.70 per share, this amounts to (EUR 80m/EUR 2.70 =) 29.630 m new shares.

Therefore

share2.977perEUR91.874m

273.542m29.630m62.244m

6.810m80m3)EUR(62.244mTERP ==+

++×=

(ii) Therefore, the value of a right = EUR 2.977 – EUR 2.70 = EUR 0.277 per new share offered.

(iii) The PP shareholder holds 10% of Y’s shares i.e. 10% x 62.244m = 6.224m shares.



Wealth calculations

Before the rights issue: EURm

6.224 m shares worth EUR 3 each

18.67

After the rights issue – assume rights taken up

Cost of 10% of new shares purchased

(10% x 29.630m x EUR 2.70) (8)

Value of enlarged holding at TERP

(EUR 2.977 x [6.224 m + (10% x 29.630m)])

27.35

Net wealth 19.35

After the rights issue – assume rights sold

Value of shares held (6.224m x EUR 2.977) 18.53

Proceeds from sales of rights attached to 10% of new shares

((10% x 29.630m) x EUR 0.277) 0.82

Net wealth 19.35

The project has a positive NPV, so is an acceptable project which will increase the wealth of Y’s shareholders.

The non-executive director representing PP is mistaken to say that that PP’s wealth will reduce if it takes up its rights.

The calculations show that the wealth of the shareholder will be the same irrespective of whether it takes up the rights or sells them on. This is because the wealth is only impacted by the positive NPV of the new project – in fact we can see here that PP’s wealth will rise in each case by EUR 0.68m, which is PP’s share (10%) of the NPV of the new project. A rights issue in itself does not change the shareholders’ wealth.

Admittedly, all these calculations rely on perfect market assumptions, so the results may differ slightly in the real world. However, if Y communicates its intentions effectively to the stock market, this will help to ensure that the perfect market conditions are approximated as closely as possible.

(c) For investors to receive the required yield to maturity from these A rated bonds (6%), the present value of the future receipts (interest and redemption amount) when discounted at 6% must be equal to the amount invested (i.e. the issue price).

Present value of receipts from the EUR 80m nominal value 4.4% coupon bonds which are redeemable at par is

= (EUR 80m x 4.4% x Annuity factor for 10 years at 6%)

+ (EUR 80m x Discount factor for 10 years at 6%)

= (EUR 3.52m x 7.360) + (EUR 80m x 0.558)

= EUR 70.55m

ANSWERS : SECTION 3


This shows that the bonds would need to be issued at a discount to their nominal value.

EUR 70.55m compared to the nominal value of EUR 80m is a discount of approximately 12% (i.e. each EUR 100 bond would be issued for approximately EUR 88).

Alternative calculation: The issue price for each bond (approximately EUR 88) could be calculated directly by presenting all the workings for a single EUR 100 bond rather than the full EUR 80m, as follows:

Present value of receipts from a EUR 100 nominal value 4.4% coupon bond which is redeemable at par is

= (EUR 100 x 4.4% x Annuity factor for 10 years at 6%)

+ (EUR 100 x Discount factor for 10 years at 6%)

= (EUR 4.40 x 7.360) + (EUR 100 x 0.558)

= EUR 88.18

(d) REPORT

To: Board of Directors, Y

From: An independent financial adviser

Date: Today

Subject: Financing and investment issues

1 Introduction

This report has been prepared to advise on the issues discussed at the recent Board meeting in relation to the proposals put forward by the Chief Executive. It covers:

• investment, financing and dividend policies

• acquisition and organic growth

• financing – rights issue v bond issue

2 Dividend policy, investment policy and financing policy

The Chief Executive has proposed that Y’s financial objectives should be changed. She is concerned that they place an arbitrary constraint on Y’s dividend policy.

This is certainly a valid point. The Chief Executive is right to say that there is a balance between a company’s dividend, financing and investment policies. Shareholders will ultimately be satisfied if the company raises finance to invest in positive NPV projects and then pays out returns to shareholders in the form of dividends.

In the case of Y, setting specific objectives for dividends before considering the link to investment and financing policy is unlikely to be beneficial to shareholders. Setting a gearing limit (as proposed by the Non Executive Chair) would constrain financing policy too, so would arguably make things worse rather than better.

It is very important to understand the links between the company’s dividend, investment and financing policies.



Financing policy

Currently, Y’s gearing measured as debt to (debt + equity) at market value is:

116.484 / [116.484 + (3 x 62.244)] = 38.4%

The Non Executive Chair would like to introduce a new 40% limit for gearing. Although high levels of gearing can often cause a company’s shares to be viewed as a risky investment, the Non Executive Chair is wrong to state that increasing gearing beyond 40% would be “reckless...in any circumstances”.

A balance sheet percentage is not the only way of assessing the level of gearing risk in a business. For example, here the balance sheet gearing level is 38.4% but interest commitments can easily be met by the company (interest cover is 29.827 / 5,008 = 6.0 times). Therefore, the level of gearing should not be a cause for concern.

Furthermore, in order to fund positive NPV investments, it is likely that Y will have to raise some finance. This is likely to affect the firm’s cost of capital – theoretically, Modigliani and Miller proved that (in the presence of tax) raising debt finance reduces cost of capital, whereas raising equity finance increases the cost of capital.

In practice, it is generally accepted that a balance of debt and equity finance is likely to lead to a minimum cost of capital. It cannot be proved scientifically where this optimum point is – it can only be found by trial and error. The main concern is that for Y, the optimum gearing level may actually be higher than 40% but the company will be prevented from finding the optimum point by the suggested financial objective.

The key point is that the cost of capital is used in investment appraisal, so clearly the financing policy of the firm is linked to the investment policy – a low cost of capital will generally lead to higher NPVs, and greater shareholder wealth.

Dividend policy

It is unclear why Y has set an objective to maintain the level of dividend per share.

In theory, shareholders should be indifferent between receiving returns in the form of dividends or capital gains – as long as the firm has an investment policy which chooses positive NPV projects, the shareholders’ wealth will increase. (Note that Y’s first strategic objective is to expand ( “… development of Y’s markets…”), which will only be achieved if the company retains some of its earnings for reinvestment.)

However, the Managing Director’s comments suggest that the Y shareholders expect to see a consistent level of dividends each year. This is known as the “clientele effect” – investors will be attracted to a company by its dividend policy, because it suits their particular circumstances (for example their tax position).

Changing this established dividend policy in practice might upset the shareholders and cause them to consider selling their shares.

Investment policy

Companies should always aim to invest in projects which increase shareholder wealth, i.e. those which have a positive NPV when discounted at an appropriate cost of capital.

In the case of Y, this means that the new North African project (appraised in the Appendix - part (a) above) should be undertaken, even if the financing and dividend policies need to be adapted accordingly.

ANSWERS : SECTION 3


Recommendations for dividend/investment/financing policies for Y

The Chief Executive is right that the financial objectives should be amended, because they may constrain Y’s investment policy.

The key point is that if an investment project has a positive NPV, Y should go ahead with it, even if the objectives for dividends and financing need to be adapted.

When financing the investment, the impact of the new source of finance on the cost of capital should be considered carefully – if possible, raising the new finance should move Y to a lower cost of capital position.

Y should try to maintain the current dividend policy if possible, to keep shareholders happy. However, Y has relatively little cash available at the moment (only EUR 12m in the recent statement of financial position), so if the policy needs to be changed in the short term to release funds for a new investment, careful communication with shareholders will hopefully enable them to see that the new investment will in fact benefit them in the longer term.

3 Acquisition and organic growth

The two most common methods by which a company can grow are acquisition and organic growth.

Acquisition is when one company takes over another, and organic growth is when a company sets up a new business from scratch.

The relative advantages of the two methods in the context of the North African investment project are:

Advantages of organic growth (Disadvantages of acquisition)

• Organic growth is usually cheaper than acquisition. When a business is acquired, a premium often has to be paid to cover the intangible assets (e.g. goodwill, brand) of the target company. If the target company is well established in its own country, these intangible assets could be significant.

• Organic growth avoids the culture clashes which often arise if a business is acquired and two firms are integrated. In fact organic growth enables a company to maintain a much greater degree of control over the new operations.

• Organic growth can be planned very carefully to fit in exactly with the company’s objectives. Sometimes when a new business is acquired, it may have some operations in different regions or industries that the acquiring company did not plan to enter.

• Acquisition can sometimes be a long, drawn-out process. If the shareholders of the target company view the bid as hostile, they will try to defend their company against the takeover. Organic growth avoids such complications.

• In this case, there is a government grant available to Y if it expands by means of organic growth. It is not clear whether this grant would be available if Y were to undertake an acquisition instead.



Disadvantages of organic growth (Advantages of acquisition)

• Acquisition usually leads to quicker growth, since the new business is already set up and fully functioning. Y would arguably be able to “hit the ground running” more quickly in North Africa if it acquired an existing company. With organic growth, it may take longer to build up a reputation, so sales in the short-term may be lower than they would be after an acquisition.

• Acquisition helps to reduce the risk of failure which is always associated with setting up a new business from scratch. This might be a key issue in this case, since the culture and working practices in North Africa are likely to be significantly different from those in Y’s existing operations.

• Acquisition can eliminate a competitor from the market place, thus reducing the risk attached to future earnings. In this case, another multinational confectionery manufacturing firm has operations in North Africa, and it recently vacated Y’s target factory. This firm will potentially be a strong competitor in the region. An acquisition would have reduced the level of competition.

• When one firm acquires another, synergies (value gains) are often achieved, so that the combined firm is worth more than the two firms individually. For example here, there could be savings in management and administration costs if Y acquired a North African company instead of setting up from scratch.

4 Alternative financing options

The Finance Director has suggested two alternative financing options:

• a rights issue of shares, or

• a bond issue on the stock market.

Common points

Before looking at the two options separately, it is worth noting that a benefit of both options is that they will allow Y to invest in the new, positive NPV North African project.

Also, because both financing options involve raising finance through the Stock Market, it is likely that either proposal would succeed in raising the necessary finance, since there are likely to be a huge number of potential investors in the market who would be happy to invest in a well-established profitable company undertaking a positive NPV project. Even in the case of the rights issue, where shares are (initially) offered to existing shareholders, the rights can be sold on to other investors even if the existing shareholders, such as PP, don’t want to take up their rights.

However, there is a potential problem with raising EUR 80m in either of these ways.

EUR 80m is exactly the amount required for investment in the new project, so these financing options will not further “strengthen the financial position” of Y as stated by the Finance Director. This is potentially a concern, since Y is due to repay some of its EUR 116.484m of borrowings relatively soon (during 2015) and has very little cash in the business at present.

ANSWERS : SECTION 3


Rights issue of shares

Advantages

• The share issue at EUR 2.70 per share is likely to be attractive to shareholders since the issue price is 10% below the current share value. Therefore, the full EUR 80m finance required should be raised by this method. Even if an existing investor cannot afford to invest more funds, the rights can be sold for EUR 0.277 per new share to ensure the shareholder’s wealth is not reduced. (Note: the potential problem of PP not wanting to take up its rights is dealt with under “Disadvantages” below.)

• Servicing of equity finance is very flexible, since dividends are paid at the discretion of the directors (however, see also comments on dividend policy above).

• The finance raised will never have to be repaid.

• Rights issues are simple and cheap to organise because initially a company only needs to contact its existing shareholders. However, if some investors choose to sell their rights, the cost of underwriting and finding alternative investors may be high.

• Raising equity finance will reduce the firm’s gearing level, thus reducing financial risk to shareholders.

Disadvantages

• The non-executive appointed by PP has said that he will advise PP not to take up its rights. If this were to happen, it might give a negative signal to other shareholders. However, the director might change his mind when he sees the calculations in the Appendix (part (b) above) which show that the wealth of PP will increase after the rights issue irrespective of whether the rights are sold or taken up. It is true that Y’s share price will reduce slightly after the rights issue (from EUR 3 to EUR 2.977), but this does not mean that the shareholder’s wealth will be reduced, as proved in the Appendix (part (b)(iii) above).

• Although the equity issue will reduce the firm’s gearing level it is questionable whether this will be beneficial. We do not know where Y’s optimum gearing position is, which corresponds to its minimum cost of capital, but it may well be that a reduction in gearing causes an increase in cost of capital.

• Equity holders face more risk than debt holders, so the cost of servicing the equity finance will be higher than the servicing costs on debt.

Bond issue

Raising EUR 80m as bonds would increase Y’s gearing. This is not necessarily a problem since Y is using the funds for a positive NPV project and it can afford to pay the extra interest (being 4.4% x EUR 80m = EUR 3.52m) as long as profits stay relatively stable.

Advantages

• Debt finance is generally cheaper to service than equity finance, partly due to the lower risk faced by investors and partly due to the tax relief on interest payments.

• Increasing gearing should reduce the overall cost of capital and therefore increase the value of any future projects undertaken.



Disadvantages

• Raising bond finance in the market is a very expensive process (e.g. high direct cost of issue (underwriting fees) as well as management time / effort). A prospectus will have to be prepared in an attempt to attract investors, and there will be costs of accountants, lawyers and underwriters. It is not clear whether Y has issued bonds before, but if not, the directors will probably need to pay for the help of lots of advisors.

• The bond interest will have to be paid every year whether or not Y makes a profit.

• The bonds are to be redeemable in 10 years. Although this is a long time away, it does add an additional consideration which would not be an issue with equity.

• As calculated in the Appendix (part (c) above), in order to give the investors the level of required yield (6%), the bonds would have to be issued at a discount of approximately 12% on nominal value. This means that only EUR 70.55m would be raised from the issue of EUR 80m nominal value of bonds. This could be unacceptable if it means that Y won’t be able to afford to repay the existing borrowings in 2015 and invest in North Africa. In order to raise the full EUR 80m now, Y should consider either issuing more than EUR 80m (nominal value) of bonds or paying a higher coupon rate so that the bonds could be issued at par.

ANSWERS : SECTION 3


3 (a) Briefing paper

To: The directors of Y’s DCS division

From: Mr X, Project team for Country Z store project

Date: 20 November 2014

Investment appraisal as at 1 January 2015

Purpose: To provide a progress report and initial investment appraisal for the above project and an initial assessment on whether or not to proceed.

(i) Working capital strategy

Z stores Y group Difference Accounts receivable Nil 31 days – 31 days Accounts payable 60 days 96 days – 36 days Inventory 40 days 127 days – 87 days The Country Z stores’ figures are likely to differ from the overall Y group’s for the following reasons:

• In general, the overall Y figures are an amalgamation of figures for both divisions of Y, and for all of Y’s activities (i.e. sales to both corporate clients and consumers, and through retail outlets and online). Therefore, a comparison with the Country Z figures (just for retail sales direct to consumers) is bound to show some differences.

• More specifically, the new stores are aiming to attract the general public. Although the rest of Y has many corporate customers, who are allowed to take credit from Y (as evidenced by the current receivables days figure), the new Country Z stores will probably not be offering credit to its smaller, general public customers.

• Also, the most likely explanation for the lower accounts payable days estimated for the Country Z stores is that Y’s new suppliers in Country Z are able to demand more favourable payment terms than Y is used to being able to negotiate elsewhere.

(ii) An aggressive strategy with regard to the management of working capital levels will mean that inventory will be kept to a minimum and accounts payable maximised to the extent that the particular market will accept (NB: it is presumed for the purposes of this analysis that 60 days is the maximum credit Y can negotiate in Country Z).

Benefits of an aggressive strategy:

• Cash flow advantages arising from having low investments in inventory in the first place, from receiving cash immediately from customers and from paying suppliers as late as possible. This has the benefit of reducing the level of finance needed to support the working capital investment which then leads to lower borrowing costs.

• Reduced costs of holding inventory, although this might be mitigated by additional delivery costs.



Potential drawbacks of an aggressive strategy:

• Higher risk of stock outs from holding low levels of inventory – leading to customer dissatisfaction and possible loss of customers both in the short term and the longer term.

• Risk of not attracting customers, because no credit is being offered to customers. Comparison with competitors in Country Z is needed here. If competitors offer customer credit, Y really should do the same.

• Dissatisfied suppliers facing payment delays - leading to a higher risk of loss of supply or lowering of quality, especially in times of shortages.

• Attempts by suppliers to charge higher prices in order to compensate for later payment.

(iii) Working capital values Year 0 1 2 3 4

Base data Z$000 Z$000 Z$000 Z$000 Z$000 Purchases, growth: 12% 35,000 39,200 43,904 49,172 Accts payable 60 days (5,753) (6,444) (7,217) (8,083) Inventory 40 days 3,836 4,296 4,811 5,389 Net balance (for (b)(i)) (1,917) (2,148) (2,406) (2,694) 0 Movement in cash (for (b)(i)) 1,917 231 258 288 (2,694)

(b) (i) Investment

Workings: tax depreciation

Year 0 1 2 3 4 Base data Z$000 Z$000 Z$000 Z$000 Z$000 Capex and b/f balance 10,000 10,000 10,000 7,500 5,625 4,219 Tax depreciation 25% (2,500) (1,875) (1,406) (219) C/f balance 4,000 7,500 5,625 4,219 4,000 –––––––– –––––––– –––––––– –––––––– ––––––– Tax relief at 33% 825 619 464 72 –––––––– –––––––– –––––––– –––––––– –––––––

ANSWERS : SECTION 3


DCF calculations Year 0 1 2 3 4

Base data Z$000 Z$000 Z$000 Z$000 Z$000 Buy properties 30,000 (30,000) Residual value of properties 36,000 36,000 Refit (10,000) 4,000 Tax depreciation relief 825 619 464 72

–––––––– –––––––– –––––––– –––––––– –––––––– Subtotal (40,000) 825 619 464 40,072 Net operating cash, growing at 12% 15,000 16,800 18,816 21,074 Tax at 33% (4,950) (5,544) (6,209) (6,954) Working capital cash movement (a)(iii) 1,917 231 258 288 (2,694)

–––––––– –––––––– –––––––– –––––––– –––––––– Total in Z$000 (38,083) 11,106 12,133 13,359 51,498

–––––––– –––––––– –––––––– –––––––– –––––––– Exchange rate EUR/Z$ 1.1000 1.1000 1.1214 1.1431 1.1653 1.1880

EUR000 EUR000 EUR000 EUR000 EUR000 Total in EUR000 (34,621) 9,904 10,614 11,464 43,348 DF at 11% 1.000 0.901 0.812 0.731 0.659 PV (34,621) 8,923 8,619 8,380 28,567 NPV in EUR000 19,868

(ii) Change in NPV resulting from change in final property value

The cash flow in respect of the value of the properties at time 4 would change from Z$ 36 million to Z$ 24 million (i.e.: Z$ 30 million × 80%) – a difference of Z$ 12 million

Incremental approach:

Reduce NPV by

Z$ 12 million/1.1880 × 0.659 = EUR 6,657,000

Giving a revised NPV value of

EUR 13,211,000 (= EUR 19,868,000 – EUR 6,657,000)

Tutorial note:

This incremental approach is by far the quickest way to calculate the revised NPV. You would lose no marks for re-computing the whole NPV, but you would waste lots of time.



(c) Financial implications

The project is expected to generate a significant return with a positive net present value of EUR 19,868,000. Purely on this basis the project to set up 50 new stores in Country Z should be undertaken, as long as financing can be arranged for the initial investment cost.

However, the DCF results depend heavily on the reliability of the input variables, as is demonstrated by the results of the sensitivity analysis in (b)(ii). Just by changing the assumption relating to the value of the properties on 31 December 2018 from a 20% increase to a 20% decrease, the NPV would fall by EUR 6,657,000 to EUR 13,211,000, a fall of 33.5%. Given that property prices are notoriously volatile and difficult to predict, then it could be argued that an evaluation based on a 20% drop in value would be more prudent for decision making purposes.

Other input variables that may prove to be unreliable estimates include:

• The growth rate (which appears to be highly optimistic at 12%, although this is, presumably, a money rate, including any inflationary expectations, but may well be unsustainable at that level).

• Revenue (which depends heavily on having the correct business model to meet customer preferences).

• Costs (which depend on correct estimates of required staffing levels and salary costs).

• Exchange rates (see below).

• The cost of capital used of 11% is the rate applicable to Y as a whole and may not be appropriate for this investment, especially as the project is in a new country where Y has not traded before.

• It would also be more prudent to assume that annual working capital investment/cash release occurs at the end rather than at the beginning of each year since cash is released from working capital rather than absorbed in each financial year until the final year.

Expanding in a foreign country carries additional risks in terms of the following:

• Foreign exchange risk – Y has never traded in Country Z before, so it will be exposed to foreign exchange risks on the Z$ denominated operations of the new chain of stores. Economic risk could be a particular problem in this case, because the Z$ is forecast to weaken each year against the EUR, meaning the Z$ receipts are worth less as years go by.

The investment appraisal has been based on forecast exchange rates derived from the interest rate differential. These are likely to be highly unreliable predictors of future exchange rates. The result could therefore differ significantly from that shown.

• Understanding customer preferences – having never traded in Country Z before, it is vital that Y makes sure that it understands customer preferences before embarking upon this project. It is not clear whether this type of “gifts and confectionery” store will be popular with local customers.

ANSWERS : SECTION 3


Detailed market research and competitor analysis needs to be performed before a final decision is made.

There might also be local resistance from customers to foreign ownership.

• Y’s lack of knowledge of the Country Z market might also cause problems when dealing with suppliers. Even if most of the products are bought internally from Y’s existing manufacturing facilities, new suppliers will have to be found for some of the other items.

Conducting business in a different business environment requires a good understanding of local protocol and business practices.

• The local regulatory environment including taxation and reporting, plus health and safety etc may well be different from what Y is used to. Also, Y needs to make sure that it understands the demands of government and any steps required to avoid government intervention.

• Managing the business and the people from a distance and/or relocating existing staff to help set up and manage the business will be problematic (at least at the start). It will be very important to adapt the culture of the business to fit with Y’s culture while being sensitive to local differences in culture.

Communication across different time zones will contribute to this difficulty.

• Financial management in a different environment may be beyond the expertise of Y’s current, centralised treasury department. A local treasury team might need to be recruited.

Conclusion

On basis of this analysis, the project appears to be worthwhile pursuing on a trial basis, as long as financing can be arranged for the initial purchase cost. The greatest risk to success is probably the business plan itself in terms of whether the “gifts and confectionery” store concept will be successful in Country Z. Opening a few stores may be the only way of confirming that such stores will be welcomed and have the potential to be run on a profitable basis.

Regarding the financing, Y had insufficient cash at the most recent balance sheet date to fund the investment outright. Therefore, financing options will need to be explored. A further complication is that some of Y’s borrowings are due for repayment next year, so additional funds will be required for that too. On the basis that the project has a high positive NPV though, it is assumed that lenders and/or shareholders will be keen to invest, so financing should not be a problem.

In conclusion, Y should go ahead with this attractive project, which contains a valuable real option to expand into other countries too if the initial project turns out to be successful.



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