Executive Summary
All companies need sources of finance, either debt or equity. The balance of debt to equity for companies is important as is the need for enough capital to operate effectively. Companies need to make decisions on how to finance themselves. Debt can be a quick means of sourcing large sums and higher levels of debt can reduce the cost of capital, however, debt has a great risk, money needs to be paid back along with interest. Turnover for the year can determine the company's ability to repay this debt. The less risky alternative is equity in the form of shares, which can be a good option as shareholders are the last to receive their money back. Banks would be paid much earlier than the shareholders, although shares may seem less risk the company still has a cost, which is giving away a part of the business. To give away part of a business means to reduce the company's control.
Capital Structure can also be analysed through the companies Weighted Average Cost of Capital (WACC). This can account for the level of risk a company may have compared with the market. Cost of capital can be calculated using two methods; one uses the dividend growth model and the other uses the capital asset pricing model. These allow us to make an informed estimation for cost of equity and a book value for the cost of debt can be taken from the company's annual reports allowing WACC to be calculated.
Kingfisher Plc (KGF), a multinational company, market leader in United Kingdom and Europe and a part of the FTSE 100 need to acknowledge their capital structure and constantly reassess their financing strategy. This report will evaluate the capital structure of KGF and compare with the sector using two methods; one method is Capital Gearing, discussing benefits and limitations of different formula and comparing the level of gearing against the sector, the other method is Weighted Average Cost of Capital, with explanation for both methods of calculation and why KGF could not use the dividend growth model. In addition to this evaluation the report refers to recent events and financial theory, discussing current sources of long term finance employed by KGF and whether KGF should amend its capital structure and their ability to do so in current economic climate.
Introduction
An evaluation of Kingfishers capital structure, calculating capital gearing and analysing the methods used to determine gearing levels and mix of debt to equity with comparative figures of competitors. Weighted average cost of capital for Kingfishers is determined using book and market values looking at different models for calculating cost of equity. Discussion on how different levels of gearing may affect the weighted cost of capital. Examining and suggesting whether Kingfishers should change their cost of capital and if there is an optimal capital structure looking into related theory.
Capital Gearing
KGF Gearing Ratio
Calculating the Capital Structure for Kingfisher Plc can be difficult, there are several methods that can be used to work out capital gearing. It is hard to say which formula produces the most accurate and realistic results.
One method is Long-term debt/ Shareholder funds. A weighting of debt from total financing is not provided as it only shows the amount of long-term debt as a percentage of equity. For Kingfishers the equalled 39.9%, however this is not useful in determining a weighting. A commonly used formula for Gearing is Long-term debt/ (Long-term debt + Shareholder funds). This method provides users with a weighting, however, there are limitations especially when a company has large amounts of current borrowings, e.g. bank loans and bank overdrafts. Although only short-term it may make up a fair weighting of the debt, and these are still means of finance which need to be repaid. Kingfishers' ratio was 28.5%.
The most preferred and widely used method accounts for ALL borrowings. Therefore short-term and long-term borrowings such as bank loans and medium terms notes etc. The formula is All Borrowings/ (All Borrowings + Shareholder funds). Commonly used by analysts and investors as it accounts for all financing within the organisation and can provide a more realistic ratio, therefore has been used for this report.
Kingfishers' entire borrowings figure is made up current bank loans, overdraft and finance leases totalling £389m plus non-current bank loans, medium term notes and finance leases with a total of £1907m. Shareholder funds can be found in the annual report simply taking liabilities and minority interest from total assets. For Kingfisher this equalled £4783m. Kingfisher capital gearing equals 2296/ (1296+4783) = 32%. Other liabilities such as deferred tax and provisions, have not been included in calculation as these are not means of financing, they are only liabilities.
KGF vs. Sector
Kingfisher is relatively low geared with 32% of financing being borrowings, showing the business is mostly financed via shareholders. Debt is the least risky choice of financing as the amount repaid is fixed and predetermined. Shareholder equity however has less repayment risk if a business were to liquidate as shareholders are the last to have the money returned therefore risk is placed upon them, however, risk can change along with the capital structure, if a business acquires more debt, financing risk increases and shareholders expect a greater return (Arnold, 2008).
Comparing gearing against competitor Travis Perkins who had gearing of 35.8% are very similarly geared, may suggest lower gearing levels appear to currently be an optimum point in the sector. Looking at Home Retail Groups level of gearing it is difficult to confirm this as the group does not have any borrowings, annual reports show 100% equity therefore a gearing of 0%. A recent demerger from GUS plc has affected their capital structure back in 2006 (HOME media, 2008) and could be the potential cause of such abnormal results, however cannot be confirmed.
Kingfishers Weighted Average Cost of Capital
When calculating WACC for Kingfisher Particular assumptions and estimations were required and have been made within this section of the report and shown in the calculations and appendix where necessary.
Cost of Equity
Cost of capital using book values is a simpler method however, market value is preferred. Kingfishers' equity financing only consists of ordinary shares therefore cost of equity can be calculated using the Capital asset pricing model (CAPM) or Dividend growth model. CAPM accounts for systematic risk, which is difficult to reduce if possible at all and unsystematic risk or specific risk, which can be avoided and reduced through diversification. Dividend yield calculations for Kingfisher were unreliable as negative dividend growth figures occurred therefore is ignored in the formula causing low results, seen in the calculations.
Calculating cost of equity using CAPM, Rf+Bj*(Rf-Rm). The risk free rate can be estimated based on government bond or gilt rates. Bank of England website provides 2.76% average for 2009, shown in the calculations. Return on the market or Risk premium however was harder to determine therefore an assumption was made based upon a report by Alan Gregory, (2007). The risk premiums over periods in the past gave an average of 4.678%, which is reasonable given current economic climate. For this calculation a risk premium of 5% has been assumed. Beta, which is the risk of the business in comparison to the market, market being 1 and business beta < 1, is less risky > 1 has higher risk, provided as a quarterly figure by London business schools' risk measurement journal (LBS, 2007-10). A yearly average of 0.94 in 2009 was easily worked out. Cost of equity (Ke) using the CAPM method = 2.76% + 0.94* 5% = 7.44%.
WACC
Cost of debt (Kd) can be taken as the interest rate for particular borrowings i.e. bank loans interest rate, for Kingfisher equalled 5.5%. This figure needs to account for corporate tax, for KGF was 32%. Kd is 5.5%* (1-0.32) = 4.82 and this figure can be multiplied against the weighting of debt. This needs to be calculated for all borrowings and added to Ke, which can also multiple with the weighting of equity resulting in the weighted average cost of capital. Kingfisher WACC equalled 6.07% using book value and 5.91% using market values for particular debt and equity.
KGF WACC vs. Sector
Kingfishers' weighted average cost of capital of 5.91% using market values seems to be a fair valuation. When future cash flows are divided by WACC we can market value for the company. WACC is designed to account for financial and business risks involved in the capital structure. Comparing against Kingfishers competitors, it can be said the WACC is similar with Travis Perkins 5.68%. There may be a difference in the cash flows or market value of the company, however, WACC were comparable. Gearing, showed about 30-35% for both Kingfisher and Travis Perkins, seen early in the report and could be one reason why results were similar as well as less cost on debt but more on equity. Home Retail Group however showed interesting results as they were only financed via equity i.e. ordinary shares, therefore WACC could only be based upon cost of equity giving 7.86%.
Should Capital Structure Change?
Retained earnings also have an opportunity cost equal to cost of equity and should not be considered a free source of finance.
Kingfisher has a WACC of 5.91% which compared with the sector seemed reasonable however; most company objectives involve shareholder wealth maximisation. This can be achieved by lowered WACC as a lower figure increase company value therefore shareholder wealth. This can be achieved by increasing the debt to equity ratio. If attempting to reach an optimal point by increasing levels of debt or reducing shares, awareness of how much debt levels can increase without affecting risk of default or financing as this will have an effect on interest rates on borrowings and increase risk to the shareholders, therefore change cost of debt and equity (ACCA, 2009). In the current financial crisis it can be more difficult to make the necessary returns required to pay for high levels of debt, therefore could be assumed that Kingfisher has a reasonable capital structure in today's climate.
A theory by Modigliani and Miller (pre tax) proposes that changes in the level of gearing will not affect the weighted average cost of capital on the assumption that there is a perfect capital market. The theory states that the change in WACC by the increase in debt is balance by the increase in the cost of equity due to financial risk (McLaney, 2006). This is a disputed proposition and is very unlikely as there will always be tax, therefore tax advantages. The theory also assumes no transactional costs however there will always be broker costs upon stock exchange (Watson, 2009).
Another way to reduce WACC to increase the company value and shareholder wealth is known as the pecking order theory. By analysing costs related to debt financing and has summarised an order in how to finance the business. Firstly use retained earnings, then issue debt and as a last issue ordinary equity (Arnold, 2008). This method allows companies to minimise costs and save time from issuing shares. Debt can be seen having a lower cost and is considered relatively quick to obtain. This theory does however ignore financing risk, especially risk of bankruptcy if debt levels get too high.
Conclusion
Kingfishers gearing level at 32% using the all borrowings method compared against Travis Perkins seemed very reasonable however were unable to be compared fairly with Home Retail Group who operated with no borrowings. In the current economy it is advisable to keep lower levels of debt as there are repayment risks attached. If Kingfisher wanted to reach an optimum capital structure they should attempt to increase the level of gearing as there is less cost and risk attached to debt, however attention on financial risk is important as increasing financial risk or chance of default will increase the risk to shareholders. If the risk to the share holder is increased then they require a higher rate of return to compensate for this level of risk. If this increases then the cost of equity will increase. A higher cost of equity will increase the weighted average cost of capital. In order to determine the perfect point Kingfisher needs to analyse how different amounts of debt change the risk applied to each source of finance, i.e. interest rates or rate of return required. Currently weighted average cost of capital is an acceptable level in relation to the sector, however if they wish to increase shareholder wealth they should approach increasing their debt.
Calculations
Formulas referenced from corporate financial management (Arnold, 2008).
Capital Gearing
(Kingfisher plc, 2009)
(Home Retail Group, 2009)
(Travis Perkins, 2009)
(LSE, 2010)
(Kingfisher plc, 2009)
(Home Retail Group, 2009)
(Travis Perkins, 2009)
Capital Asset Pricing Model
(Bank of England, 2010)
(LBS, 2007-10)
(Gregory, 2007)
Weighted average cost of capital
Market value for long term borrowings is given as fair value in the annual report.
Cost of debt is not provided for short term loans and overdrafts therefore rates were assumed based on Bank of England and are shown in the appendix.
(Travis Perkins, 2009)
(LSE, 2010)
References
ACCA. 2009. Optimum Capital. [Online]. Available at: http://www.accaglobal.com/pubs/students/publications/student_accountant/archive/sa_junjul09_lynch.pdf [Accessed 20/3/2010].
Arnold, G. (2008) Corporate Financial Management (4th edition), London, Pitman Publishing.
BOE, 2009. Monthly interest rates for bank loans and overdrafts to public corporations. [online]. Available at: http://www.bankofengland.co.uk/mfsd/iadb/fromshowcolumns.asp?Travel=NIxIRxSUx&FromSeries=1&ToSeries=50&DAT=RNG&FD=1&FM=Jan&FY=2007&TD=1&TM=Jan&TY=2010&VFD=Y&CSVF=TT&C=INS&C=IOZ&Filter=N&html.x=26&html.y=18 [Accessed 17/3/2010].
Gregory, A. 2007. How Low is the UK Equity Risk Premium? [online]. Available at: http://xfi.exeter.ac.uk/workingpapers/0709.pdf. [Accessed 18/3/2010].
HOME, Media. 2008. Media Centre: Home retail Group News. [online] Available at: http://www.homeretailgroup.com/home/media/hrg/corpnews/2008/2008-04-30/ [Accessed 18/3/2010].
Home Retail Group. 2009. Annual Report 2009. Home Retail Group Plc. [online] Available at: http://www.homeretailgroup.com/home/investors/rrp/presentations/2009/ [Accessed 2/3/2010].
Watson D, and Head A. 2006. Corporate Finance: Principles and Practice, 4th edition, FT
Prentice Hall
Kingfisher. 2008. Annual Report 2007/8. Kingfisher Plc. [online] Available at: http://www.kingfisher.co.uk/index.asp?pageid=61 [Accessed 1/3/2010].
Kingfisher. 2009. Annual Report 2008/9. Kingfisher Plc. [online] Available at: http://www.kingfisher.co.uk/index.asp?pageid=61 [Accessed 1/3/2010].
LSE. 2010. London Stock Exchange: Home Retail Group Fundamentals. [online] Available at: http://www.londonstockexchange.com/exchange/prices-and-news/stocks/exchange-insight/company-fundamentals.html?fourWayKey=GB00B19NKB76GBGBXSET1 [Accessed 2/3/2010].
LSE, 2010. London Stock Exchange: Kingfisher Fundamentals. [online] Available at: http://www.londonstockexchange.com/exchange/prices-and-news/stocks/exchange-insight/company-fundamentals.html?fourWayKey=GB0033195214GBGBXSET1 [Accessed 2/3/2010].
LSE, 2010. London Stock Exchange: Travis Perkins Fundamentals. [online] Available at: http://www.londonstockexchange.com/exchange/prices-and-news/stocks/exchange-insight/company-fundamentals.html?fourWayKey=GB0007739609GBGBXSTMM [Accessed 2/3/2010].
LBS, 2007-10. London Business School Risk Measurement Service.
Travis Perkins. 2009. Results For The Year Ended 31 December 2009. [online] Available at: http://www.travisperkinsplc.com/investorcentre/ir.asp?page=companyReports [Accessed 2/3/2010].
McLaney (2006) Business Finance: Theory and Practice (7th ed.), London, Pitman Publishing.
Appendix
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An Evaluation of Kingfisher Plc (KGF) Capital Structure. Page 9
