All companies need sources of finance, either debt or equity. The balance of debt to equity is important as well as need for enough capital to operate effectively. Debt can be a quick source for large sums and higher levels of debt can reduce the weighted average cost of capital. However, debt can increase repayment risk. Money borrowed needs to be repaid along with the interest. If the company has a bad year for sales this can determine the company's ability to repay debt. The 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 are repaid earlier than shareholders. Although shares may seem less risky the company still has a cost, which is the rate of return, this can be affected by risks in a business. Issuing more shares will effectively reduce the company's control.
Weighted Average Cost of Capital (WACC)? This can determine the discount factor for projects, company's value and shareholder's wealth. WACC accounts for the costs involved from financing. Cost of equity 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. Market value calculations provide realistic results compared with book value. The same applies to debt.
Kingfisher Plc (KGF), market leader in United Kingdom and Europe need to acknowledge their capital structure and constantly reassess their financing strategy. This report will evaluate the capital structure of KGF in comparison with the sector using two methods. One method is Capital Gearing, discussing benefits and limitations of different formula comparing the level of gearing against the sector. The other method is Weighted Average Cost of Capital, provided with explanation for different methods of calculation. In addition to this evaluation the report refers to recent events and financial theory. Discussing sources of finance employed by KGF and whether KGF should amend its capital structure and their ability to do so in current economic climate.
Contents
Executive Summary 2
1.0 Introduction 4
2.0 Capital Gearing 4
2.1 KGF Gearing Ratios 4
2.2 KGF vs. Sector 4
3.0 Weighted Average Cost of Capital 5
3.1 Cost of Equity 5
3.2 WACC 6
3.3 KGF WACC vs. Sector 6
4.0 Should KGF's Capital Structure Change? 6
5.0 Conclusion 7
Calculations 8
Capital Gearing Calculations 8-9
Cost of Equity Calculations 9-10
WACC Calculations 11-12
Reference 13
Extracts From Annual Reports 14+
1.0 Introduction
How effective is Kingfishers capital structure? This report evaluates Kingfishers capital gearing and analyses the methods used to determine gearing levels and mix of debt to equity. Gearing levels are compared against the sector through two competitors; Travis Perkins and The Home Retail Group. Once able to determine the weighting of debt and equity, cost of equity can be calculated using both Dividend Growth Model and Capital Asset Pricing Model. Cost of debt can also be realised through the company's annual reports. After cost of equity and debt are known weighted average cost of capital can be determined using book and market values. Discussing how different levels of gearing might affect the weighted cost of capital. Examining different theory in relation and suggesting whether Kingfishers should change their cost of capital. (All calculations are shown fully at the end of this report).
2.0 Capital Gearing
2.1 KGF Gearing Ratios
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 realistic result.
One method is Long-term debt divided by Shareholder funds. A weighting of debt to financing is not provided as it only shows the amount of long-term debt as a percentage of equity. Kingfisher's gearing using this method equalled 39.9% seen in calculations section. A commonly used formula in gearing is Long-term debt over (Long-term debt + Shareholder funds). This method tells users the weighting; however, there are limitations. When a company current borrowings, e.g. bank loans and bank overdrafts, amount to a fair percentage of the debt it is ignored. Short-term debt is still a source of finance which needs to be repaid. Kingfisher's ratio showed 28.5%, provided in the calculations section.
The most preferred and widely used method of gearing accounts for ALL borrowings. Therefore short-term and long-term borrowings such as bank loans and medium terms notes. The formula is All Borrowings divided by (All Borrowings + Shareholder funds). This method is commonly used by analysts, researchers and investors as it provides a realistic ratio, therefore has been used for this report.
Kingfisher's current borrowings include bank loans, overdraft and finance leases totalling £389m plus non-current borrowings; bank loans, medium term notes and finance leases with a total of £1907m equals £2296m. Shareholder funds are found in the annual report by taking liabilities and minority interest from total assets. For Kingfisher this equalled £4783m. Kingfisher capital gearing therefore, is 2296/ (2296+4783) = 32%. Other liabilities such as deferred tax and provisions, have not been included in the calculations as they are not means of financing, they are liabilities.
2.2 KGF vs. Sector
Kingfisher is relatively low geared with 32% of financing being borrowings. This shows Kingfisher are financed mostly through shareholders. In the current economy, considering the recession, Kingfisher probably has a medium to high level of business risk. It is theorised that when a company has higher business risk there is a low financing risk because it is assumed the company issues less debt (Arnold, 2008). Financing risk is minimised as there is less chance that Kingfisher does not have the money repay its debt. Debt can have a lower cost as the amount repaid is fixed and predetermined. Shareholder equity however, will have less repayment risk because they are the last to their money returned if a company become bankrupt. Financial risks involved can affect cost of capital because if a business were to hold more debt chance of default or bankruptcy increases. Therefore, shareholders require a greater return (Arnold, 2008).
Figure 1
Comparing gearing of kingfisher against competitor Travis Perkins (TVP) and Home Retail Group (HOME) seen in figure 1. TVP had gearing of 35.8%, very similar with Kingfisher, even though the amount was significantly different. This may suggest lower gearing levels appear to be an optimum point in the sector, considering the recession. HOME's level of gearing showed more abnormal results since the group does not have any borrowings. HOME's annual reports' showed 100% equity therefore a gearing of 0%. The result may be due to a demerger from GUS plc which affected their capital structure back in 2006 (HOME media, 2008). However this cannot be confirmed.
3.0 Kingfishers Weighted Average Cost of Capital
Calculations for Kingfisher's weighted average cost of capital required particular assumptions and estimations. These have been made within this section of the report and shown in the calculations and appendix where necessary.
3.1 Cost of Equity
Kingfisher's equity financing only consisted 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 and unsystematic risk. Systematic risk is very difficult to reduce if possible as it is related to the entire market. Unsystematic risk or specific risk can be avoided or reduced through diversification.
Different risks combined and formulated create CAPM, Rf+Bj*(Rf-Rm). The risk free rate (Rf) can be estimated based on government bond or gilt rate of return. Bank of England website provides Rf as a 2.76% average for 2009 (BOE, 2010). Return on the market (Rm) or Risk premium (Rm-Rf) are harder to determine, therefore an assumption was made based upon a report by Alan Gregory, (2007). The risk premiums over past periods gave an average of 4.678%, which is reasonable regarding the current economy. For this calculation a risk premium of 5% has been assumed. Beta is the risk of the business in comparison to the market, market being 1 therefore beta < 1, is less risky business > 1 means higher risk. Beta is provided as a quarterly figure in London business school risk measurement service journal (LBS, 2007-10). A yearly average of 0.94 in 2009 was easily worked out. Cost of equity (Ke) can now be reach using the CAPM method = 2.76% + 0.94* 5% = 7.44%.
The Dividend Growth Model was unreliable for Kingfisher as there was negative growth rates over the past two years, therefore calculations resulted in unreliable, low rates.
3.2 WACC
Cost of debt (Kd) can be taken as the interest rate for each particular borrowing i.e. bank loans interest rate. The interest rate needs to account for corporate tax, for KGF was 32%. Kd would be the interest rate multiplied by 1-0.32 or 0.68. Once this figure is known it can be multiplied against the weighting of debt. This process is then repeated for all sources of borrowings. Ke is also multiplied with the weighting of equity and can be added together with each result giving the weighted average cost of capital. Kingfisher's WACC equalled 6.07% using book values, and 5.91% using market values, for particular debt and equity.
3.3 KGF WACC vs. Sector
Kingfishers' weighted average cost of capital of 5.91% can be used as a hurdle rate for investment decisions or can determine a company's value. WACC is designed to account for systematic and unsystematic risks involved in the capital structure of a business. Comparing against Kingfishers competitors WACC is similar with Travis Perkins at 5.68%.
Even though the amount of money involved was significantly different the cost of capital balanced out according to the level of risks the business had. Gearing of about 30-35% for both Kingfisher and Travis Perkins, seen early in the report and could be another reason why results were similar. Home Retail Group again showed interesting results as they were only financed by equity i.e. ordinary shares, therefore WACC could only be based upon cost of equity giving 7.86%. This result is higher than KGF or TVP as cost of equity is normally higher than costs involved with debt.
4.0 Should KGF's Capital Structure Change?
Kingfisher has a WACC of 5.91% which compared with the sector seemed to be reasonable. In the current economic climate business risk could be presumed higher than normal as chance of having insufficient cash flows to repay debt due to not having the level of sales as consumers will be tightening their spending. However, most company's strategy involves shareholder wealth maximisation. This can be achieved through a lowered WACC increasing company value, therefore shareholder wealth. WACC can be decreased if more debt to equity is issued.
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. Assuming there is a perfect capital market and there is no tax. The theory states that the change in WACC by the increase in debt is balanced by the increase in risk to shareholders, therefore the cost of equity increases due to financial risk (McLaney, 2006). This proposition can be argued as it is very unlikely there be no tax. If there is tax then there is tax advantages to debt as firms are taxed on profits, therefore debt reduces the amount taxed. The theory also assumes no transactional costs however there will always be broker costs upon stock exchange (Watson, 2009) and smaller charges applied to debt.
If attempting to reach an optimal capital structure increasing levels of debt or reducing shares can help. An awareness of how debt levels can increase without affecting financing risk should be clear. As lower business risk can mean financial risk can be higher because there is little doubt on cash flow required to cover debt. If financing risk cost of equity will increase (ACCA, 2009). A theory which can suit this is the Pecking Order theory. By analysing costs related to debt financing a preferred order has created in how to finance the business. Firstly use retained earnings as this is money available to the business without issuing anything. Next issue debt as there is low cost involved with debt. Then finally issue ordinary equity as by issuing debt the financial risk increase however there are is no capital in the form of shares, therefore even if risk increases it will not affect WACC (Arnold, 2008). Shares are considered a last resort because when issued financial risk is already high. This theory allows companies to minimise costs and save time from issuing shares.
Conclusion
Kingfisher's gearing ratio of 32% using the all borrowings considering the business risk and comparing against other competitors. The same can be applied to the weighted average cost of capital. Increasing debt to reduce WACC in order to reach an optimum capital structure maximising Kingfisher's value has high risks. This is because increasing debt especially when the company as higher business risk will mean financial risk will be high and hard to control. A higher cost of equity will result decreasing the value of the company. In order to determine the perfect level Kingfisher needs to analyse how different levels of debt affect the risk applied to each source of finance. Currently weighted average cost of capital is an acceptable level in relation to the sector.
Calculations
Formulas referenced from corporate financial management by 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.
Market Value of Borrowing isn't any different assuming bank loans are equal to book value.
(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. 2010. Average annual yield for British government securities. [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=DV1&Filter=N&html.x=23&html.y=21 [Accessed 15/2/2010].
BOE, Stats. 2010. 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.
