Funding through debt, interest expenses will raise correspondingly. Since interests would be paid before taxation, the interest expenses are excluded from the tax base. Thus, a leveraged firm could increase its enterprise value from 2250m to 2320m. The gap between firm values with debt and without debt can be attributed to tax shield. The increased enterprise value also boom the wealth of shareholders. Besides, as interest rate is fixed, the benefit could be offered to creditors is constant. Therefore, all tax shied will be enjoyed only by shareholders (Vernimmen, 2005).
It is obvious that available earnings to pay dividends to shareholders could be reduced due to the higher debt/equity ratio, causing that the value of equity decreases from 2250m to 1820m. Moreover, shareholders hold more cost when financing by debt, because they bear not only the operating risk, but also the risk of leveraging. Another reason in explaining the declined value of equity is that if all capital needed is financed by debt; it is more possible to put the firm on the position of bankruptcy (Vernimmen, 2005). Shareholders hold the highest risk, because they have the latest claim rights after meeting the obligation of debt.
(b)
Before
Capital employed=BV of equity + BV of debt=45-50m+0=2250m
ROCE==
After
(EBIT-debt interests)-(EBIT-debt interests)-tax rate=net income
(EBIT-500-9%)-(EBIT-500-9%)-40%=135m
EBIT=270m
Value of tax shield of debts=70m
Book value of equity=BV of equity+ BV of tax shield=2250+70=2320m
Value of the leveraged firm=value of unleveraged firm+ tax shields= 2250+70=2320m
ROCE===6.98%
From the calculation above, before investing in the programme, both ROE and ROCE equal to 6%, but these two profitability ratios experience a slight decrease and increase to 5.82% and 6.98% respectively after financing all capital by debt. The increase in ROCE implies that the capability of the firm using financial resources to generate profit and create value for shareholders is strong. But, since ROCE (6.98%) is lower than cost of debt (9%), it implies that the return produced by using borrowed funds cannot cover the higher rate of leverage, which causes the decline in ROE. The fall of ROE represents that the rate of return brought about by book value of equity will be reduced (Vernimmen, 2005).
(c)
VD
value of tax shield
=
VL=VU+ tax shield
VE=VL-VD
Cost of capital=
0
2250
2250
KE=0.1210
100
=14
2264
2164
0.121-2164/2264+0.09-(1-0.4)-100/2264=0.1180
200
=28
2278
2078
0.121-2078/2278+0.09-(1-0.4)-200/2278=0.1151
300
=42
2292
1992
0.121-1992/2292+0.09-(1-0.4)-300/2292=0.1122
400
=56
2306
1906
0.121-1906/2306+0.09-(1-0.4)-400/2306=0.1094
500
=70
2320
1820
0.121-1820/2320+0.09-(1-0.4)-500/2320=0.1066
Value of debt
0
100
200
300
400
500
Cost of capital
12.10%
11.80%
11.51%
11.22%
10.94%
10.66%
With the increase of debt/equity ratio, cost of capital will decrease reversely. Therefore, when all required capital is financed by debt, the cost of capital reaches the lowest level (10.66%) and the value of the firm could be maximised (2320m). In this case, the optimal capital structure can be obtained.
However, under computing WACC by the indirect calculation method, it assumes that the cost of debt and cost of equity will remain the same even if the higher leverage. Actually, rearrangement of debt/equity ratio results in the change on cost of equity and cost of debt. The increase of debt leads to more expensive cost of equity, so that the assumption will cause the understatement of WACC. Furthermore, since all data used in calculation come from financial statements, it assumes that the cost of capital is based on the book value rather than the market value, which will mislead the cost of capital (Vernimmen, 2005).
(d)
Income statement (increase 30% per year)
Year
0
1
2
3
4
Sales
1500
1950
2535
3295.5
4284.15
Cost of goods sold
1050
1365
1774.5
2306.85
2998.91
Gross profit
450
585
760.5
988.65
1285.24
Selling and administrative expenses
75
97.5
126.75
164.78
214.21
Depreciation
150
195
253.5
329.55
428.42
EBIT
225
292.5
380.25
494.32
642.61
Taxes
90
117
152.1
197.728
257.044
Net income
135
175.5
228.15
296.592
385.566
Valuation by discounted cash flows
Year
0
1
2
3
4
EBIT
225
292.5
380.25
494.32
642.61
+ Depreciation
150
195
253.5
329.55
428.42
- corporate income tax
90
117
152.1
197.728
257.044
- change in working capital
0
0
0
0
0
- capital expenditure
0
0
0
0
0
= free cash flow
285
370.5
481.65
626.142
813.986
Calculating the value of unleveraged firm:
cost of capital with no debt=KE=0.121
present value of cash flow to the firm ==++++
=2556.51
As normalized free cash flow= FCFF at the end of the 5th year
When the long term growth rate=2%
Terminal value ===10477.09
PV of terminal value==5279.67
Enterprise value without debt = PV of free cash flow + PV of terminal value
=
Value of equity =enterprise value-net debts=7836.18-0=7836.18
Calculating the value of leveraged firm:
When VD=100
Value of tax shield=
Value of the leveraged firm= value of the unleveraged firm + the value of tax savings
VL=VU+ Tc-KD =
Value of equity=value of the firm-value of debt=
Cost of equity=KE=KEU+(KEU-KD)-(1-TC)-VD/VE
KE=
Cost of capital=
k=
When VD=200
Value of tax shield==28
Value of the leveraged firm=7836.18+28=7864.18
Value of equity=7864.18-200=7664.18
Cost of equity=
Cost of capital=
When VD=300
Value of tax shield==42
Value of the leveraged firm=7836.18+42=7878.18
Value of equity=7878.18-300=7578.18
Cost of equity=
Cost of capital=
When VD=400
Value of tax shield==56
Value of the leveraged firm=7836.18+56=7892.18
Value of equity=7892.18-400=7492.18
Cost of equity=
Cost of capital=
When VD=500
Value of tax shield==70
Value of the leveraged firm=7836.18+70=7906.18
Value of equity=7906.18-500=7406.18
Cost of equity=
Cost of capital=
VD
0
100
200
300
400
500
Value of the firm
7836.18
7850.18
7864.18
7878.18
7892.18
7906.18
Value of equity
7836.18
7750.18
7664.18
7578.18
7492.18
7406.18
Cost of equity
12.10%
12.12%
12.15%
12.17%
12.20%
12.23%
Cost of capital
12.10%
12.03%
11.98%
11.91%
11.86%
11.80%
In terms of MM theory I with taxation, the value of a firm with debt excesses the value of a firm without debt, because it includes the value of tax shield generated by leverage (Vernimmen, 2005). As more debt will enhance interest payments, which can be deducted from taxation, thereafter it contributes more tax savings to benefit the enterprise value. Besides, under the function of taxation, the firm value will be distributed among three parties, which are shareholders, creditors and government; therefore, part of the market value of equity is cut off and transferred from shareholders to government, (Megginson, 1997). Thus, shareholders pursue to reduce the value to the government.
MM theory II with taxes indicates that cost of debt remains the same for depending on the systematic risk. However, cost of equity increase accompanying by higher gearing ratio, while cost of capital decreases reversely. Both of them are influenced by taxation and the changeable capital structure (Amaro de Matos, 2001). On one hand, the rising cost of equity implies that there are more risks from higher leverage for shareholders, who have to require higher rate of return to compensate it. But the marginal cost of equity increases less due to the taxation (Vernimmen, 2005). On the other hand, because tax shields have influences on net income and dividend payments, there is also an increase trend in total cash flows functioning by leverage and taxation, which bring about lower cost of capital. Considering lower cost of capital and higher value of the firm, the firm will be driven by using more debt instead of equity to finance (Vernimmen, 2005).
(e)
Income statement with each value of debt
VD
0
100
200
300
400
EBIT
225
225
225
225
225
Debt interests=VD-KD (9%)
0
9
18
27
36
Taxes=(EBIT-debt interests)-TC
90
86.4
82.8
79.2
75.6
Net income=EBIT- interests-taxes
135
129.6
124.2
118.8
113.4
The dividend per share that the firm can afford to pay
Financed by debt
0
100
200
300
400
Financed by equity
500
400
300
200
100
Net income (earnings)
135
129.6
124.2
118.8
113.4
Dividend paid=net income - financed by equity
0
0
0
0
13.4
Number of shares
-
-
-
-
50
Dividend per share=dividend paid/number of shares
0
0
0
0
0.268
Under the residual dividend policy, when the value of debt is no longer than 400m, all net income has been distributed to cover the capital needed by the project, so that there is no earnings left to pay the dividends. Dividend per share equals to zero.
However, there are some earnings left when the level of value of debt are 400 and 500, so that the dividend payments are 13.4 and 108 respectively. Dividend per share is 0.268 and 2.16 accordingly.
(f)
Some directors suggest that if the firm stops paying dividends, all the earnings could be retained and can meet the need for financing a project. Vernimmen (2005) advocates that there is negatively related between dividend policy and stock return. If the firm pays out fewer dividends, the value of shares will be increased because there has more retained earnings to reinvest in the profitable programme. In the research of Denis and Osobov (2008), there exists a positive link between dividend policy and the ratio of retained earnings to total equity. If the ratio is negative, stopping paying dividends could be accepted. Furthermore, shareholders who have been paid large amounts of dividends will bear more burdens of taxes (Copeland et al., 2005).
While in other directors' opinion, dividends should be paid to shareholders. As Miller and Rock (1985) indicate, paying dividends is an effective method for a firm to communicate private information with its investors, especially in imperfect market. It signals that dividends paid can eliminate the information asymmetry.
DeAngelo and DeAngelo (2006) provide a life cycle theory. In this theory, they suggest that the optimal dividend paying is closely related to their investment opportunities. During the start-up of a firm, it prefers to stop paying dividends and use this retained capital to reinvest due to the rate of return of investment chances is larger than the internal capital used. While the firm becomes more mature, it has a reversal in rate of return. Consequently, the firm should pay out more dividends in order to avoiding the waste of cash flows.
Furthermore, dividend policy is associated with specific factors in each firm such as economic condition and shareholders' behavioural power (Frankfurter and Wood, 1997). According to illustrations above, there has a potential revenue increase between 10% and 50% per year if the firm takes the opportunity of this project. Therefore the optimal choice for dividend policy of the firm is to pay no dividends, at least in first years.
(g)
As illustrated above, only when value of debt are 400 and 500, the firm could pay dividends, so that both dividends and share repurchases equal to zero when equity value is no longer than400.
Payout ratio==
When VD=400
When VD=500
Amount of dividends = residual net income - payout ratio
= (113.4-100)-0.3=4.02
=108-0.3=32.4
Amount of repurchase=residual net income-dividends paid
= (113.4-100)-4.02=9.38
=108-32.4=75.6
Number of shares repurchased
=
=9.38/45=0.208
=75.6/45=1.68
DPS=
=4.02/(50-0.208)=0.081
=32.4/(50-1.68)=0.671
It is obvious to see that dividend per share keeps a positive relation with share repurchases. Because share buybacks will reduce the number of shares issued, total dividends paid will be divided by less number of shares, leading to larger DPS. In addition, comparing with residual dividend policy without share buyback, dividend payment and DPS both experience a decline trend under the function of stock repurchases.
In the research of Vernimmen (2005), without considering taxes, share repurchases and dividends paying serve the same purpose. On the contrary, taking taxes advantages into account, Copeland et al. (2005) suggests that share repurchases, which transfer cash to shareholders, consume less tax expenses as capital gains than paying with dividends. It is more efficient for dividend policy with share buyback.
Furthermore, stock repurchases signal that share price of the firm is underestimated in the market (Dittmar, 2000). Through this method, the firm can rearrange a better capital structure to alter this understatement by gearing on share buyback. Also, share buyback indicates that there exist excess cash flows could not find profitable chances (Vermaelen, 1981). It is a way to prevent the waste of non-operating cash flows.
(h)
To certain extent, some directors in RE support the merger of SE, partly due to different market distributions and customers' components, the combined firm can get access to more resources and diversified profits; partly due to its marketing and technical skills available for the new firm, which contributes to reduced costs and boomed EPS. Since the P/E ratio of RE is greater than that of SE, Vernimmen (2005) suggests that higher P/E ratio will drive shareholders of the acquiring firm to approve the merger because EPS could be boomed automatically. Besides, as managers generally believe that if the size of firms becomes larger, more competitive advantages could be acquired. Approval for merger is to pursue economic of scale, which hopes to divide fixed costs by larger amount of output (Brealey et al., 2004).
In the opposite view, Brealey et al. (2004) imply that merger happens when having surplus cash but no profitable investment chances. But, there provides a programme with more increasing revenues each year, so that it is sensible to invest in the project rather than conducting a merger. Especially, the attraction of takeover is reduced because the P/E ratio of target firm is lower than the industry average.
Pursuing synergy is one of the goals of takeover. However, it is difficult to ensure the combined firm can realise the synergy because it relies on corporate integration after merger (Watson and Head, 2004). It is possible that a dilution of value will be occurred so that shareholders of RE cannot get profits.
Furthermore, the cost of funding a merger should be considered. If the capital is raised all by shares, the ownership structure of the combined firm will experience some changes. While if the money is financed by issuing debt, the leverage ratio will increase, which causes higher cost of equity and greater risk of bankruptcy (Watson and Head, 2004). Besides, since SE is a Spanish company, the cross-country takeover has to face cultural shock, exchange rate fluctuation, complex issues on law and expensive advisory fees (Watson and Head, 2004).
(i)
Assume Exchange ratio=1/7, it means that 1of SE receive 0.14 share of RE.
(1)EPS
The number of new shares in RE=50+0.14-50=57.14
EPS of RE==135/50=2.7
Earning of SE= EUR30-0.897=GBP26.91m
EPS of the new group==(135+26.91)/57.14=2.83
(2)P/E
P/E of RE= ==16.67
Market value of equity of SE= EPS-P/E-number of shares
=188.37
Market value of equity of combined firm=2250+188.37=2438.37m
P/E ratio for the combined firm===15. 06
According to Vernimmen (2005), P/E ratio can be adjusted after conducting a merger accompanying by redistributing value among shareholders in the new group. Relative P/E game is aiming for booming the P/E ratio and EPS through a merger. However, from the calculation above, EPS of the bidding firm experiences a slightly increase from 2.7 to 2.83 after completing the acquisition because it has higher P/E ratio than the target firm; while P/E ratio of the new group declines from 16.67 to 15.06. Therefore, the relative P/E game cannot achieve a success to improve both EPS and P/E via an acquisition. Besides, because higher P/E ratio is regarded as an incentive to make a takeover, the decreased P/E ratio of the combined firm implies that it is unsuitable to take a merger of SE (Vernimmen, 2005).
(j)
Free cash flow method to calculate the maximum offer price for SE
When t=0, Free cash flow to the combined firm=combined EBIT + combined Depreciation-combined corporate income tax-combined change in working capital-combined capital expenditure
=(225+58-0.897)+(150+7-0.897)-(90+20-0.897)-0-0=325.37m
As FCFF of the group will increase by 15m per year, FCFFs to the following 5 years are 340.37, 355.37, 370.37, 385.37, and 400.37 respectively.
Enterprise value=PV of FCFFs+ PV of terminal value=1644.92+1997.59=3642.51m
Value of equity =enterprise value-net debts of SE=3642.51-0=3642.51m
Paying amount= value of combined firm- value of RE=3642.51-2250=1392.51m
Therefore, 1392.51m is the value created by the merger and determines the maximum price that RE could pay for the acquisition of SE.
(k)
Paying acquisition in shares has advantages. Ownership structure changes will occur, eliminating the proportion of unwelcomed shareholders and boosting the prospects of the firm. It also can avoid the difficulty of lacking of cash and even allow to achieve larger transaction (Vernimmen, 2005).
However, some argue that the success of share payments heavily rely on whether shares can be easily and quickly traded on the secondary market (Vernimmen, 2005). Share offers are more expensive than cash payments since stock prices fluctuate during the process of merger. Besides, it causes more shares circulating in stock market, which may dilutes shareholder's power of control (Watson and Head, 2007). Thus, it becomes unwelcomed to shareholders in bidding firms, leading to more disapproval of merger.
Comparing with shares acquisition, the essential drawback of paying merger in cash is that the bidding firm has no enough cash to a huge transaction, which forces the firm to hold higher leverage ratio and higher risk of bankruptcy (Watson and Head, 2007). Others include lacking of any financial power of the combined firm and lacking of boost in value of equity. In addition, shareholders in the merging firm burden the whole business risks alone rather than sharing with those in the target firm (Vernimmen, 2005).
However, cash offers have advantages also. Cash method can attracts more target firms, partly because the cost can be ensured when selling stocks, and partly because of no extra tax obligation on capital gains. Moreover, both the number of common stocks outstanding and the ownership structure of the bidding firm will not be influenced, and EPS can avoid of dilution (Watson and Head, 2007). Therefore, combined with the drawbacks and benefits, both cash and stock offers could be adopted to pay the acquisition.
(l)
The expected share price of RE could be influenced by the decision of bidding for SE. Franks and Harris (1989) find out that acquisition as value creating behaviours can increase stock price around the announcement date of acquisition. In the research of Amoako-Adu and Yagil (1986), they find out there are positive abnormal returns within two months of the merger announcement date, which can be regarded as the compensation for uncertainty of success about takeovers. According to Rennebog et al. (2007), they use cumulative abnormal returns to detect that there is a 30% increase in stock price on the decision of takeover from 1999 to 2003. This increase mainly results from the expectation of investors, who believe that takeovers could enhance value from the underestimation of the target firm, cooperating incentives and value of tax shields following by higher gearing ratio. However, Dodd (1980) suggests that there exist no link between stock price and merger proposal for bidding firms. Even the announcement of merger can brings about significant negative stock return for relative smaller bidding firm (Langetieg, 1978 and Asquith, 1983).
(m)
There exist three kinds of diversification benefits that merger can bring about. Firstly, it is hardly for diversified firms to encounter bankruptcy, which makes it possible to have potential higher leverage ratio in the future and then reduce the cost of capital (Berk and DeMarzo, 2007). Secondly, the acquiring firm can offer more liquidity to the target firm, which could has access to lower risk exposure by diversified reinvestment (Berk and DeMarzo, 2007). Thirdly, risk of the bidding firm could be diversified because larger size of the firm has strong power to resist risks.
However, diversification will not increase any value after conducting acquisitions. Diversification can only eliminate unsystematic risk, but there is no changes occurring in systematic risk, which solely brings about value of assets (Ross et al., 2009). Regarding that if shareholders already diversify their investment portfolios in different firms, when there is a merger conducted between these firms, shareholders will not obtain any further diversification benefit from takeovers (Ross et al., 2009). In addition, mergers out of the aim of diversification are more difficult and costly than achieving diversification through portfolio management (Brealey et al., 2004). When measuring performances of the combined firm, agency costs become higher and resources could be distributed inefficiently.
(n)
<a>
Aiming to maximize the interests of shareholders, it is reasonable for RE to choose this expansion project for internal growth. At the beginning, 30% potential increase each year of this project will bring about greater increase in free cash flow to the firm than the increase of 15m pounds per year to the combined firm after merger. It concludes that the value of the firm after the project becomes significantly larger, which could increase shareholders' wealth. Apparently, the cost of capital could also be declined, which implies that the expenditure of the firm using employed capital will become lower. Moreover, when issuing debt to finance the project, tax shields could be obtained by the shareholders.
Although RE could enjoy some benefits from taking over SE, such as declined cost and improvement on EPS, there have more weaknesses need to be considered. Financing the merger by increasing new shares would undermine shareholders' power of control. Moreover, P/E ratio of the new group encounters a fall. Besides, there exist some uncertainties of a merger, for example, differences in culture and law, volatility of synergy, and the change of exchange rate.
<b>
The firm can finance the project by issuing debt or stocks. According to pecking order theory, instead of issuing new shares, firms resort to leverage when retained earnings is not enough to satisfy the capital requirement (Myers, 2001). If all capital is raised by debt, the percentage of leverage will be increased in capital structure. Thereafter, the firm value enhancement equals to the amount of tax shields. Cost of capital becomes lower whereas it is reverse to cost of equity. In terms of financing a takeover, the choices can be divided into all cash deal, all share deal and the mixture of them (Vernimmen, 2005). Assuming adopting all share deals, the number of new issued shares will be increased. However, no debt has been issued during this process. Thus, the capital structure remains stable.
As the essential duty for fulfilling the expansion project is to satisfy the requirement of capital before paying dividend, it is reasonable to follow the residual dividend policy. The amount of dividend payment depends on the residual earnings. When all required capital is raised only by debt, entire earnings generated could be paid as dividend. However, when the lever of debt is from 0 to 300, because no earnings could be left after funding for the project, it is possible to stop distributing dividends. On the other hand, adopting stable dividend payout ratio following by using surplus earnings to proceed on share buybacks is an alternative dividend policy. Not only can improve dividend per share because of reduced shares circulating in the market; but it also prevent paying excess dividends, which could mislead shareholders to have over-optimistic perspectives about the firm's growth (Arnold, 2005). Additionally, after taking over through issuing new shares, there experience some changes in ownership structure and the old shareholders will partly loss control of the new firm. If the firm has a disperse ownership structures after a takeover, it is possible to adopt higher dividend payout policy; while the firm will agree to pay lower dividends if shares are controlled tightly in hands of several larger shareholders (Megginson, 1997).
