Riverside Electronics Plc (RE) has been facing increasing competition on the international markets. To improve its competitive position, RE is considering strategies, internal organic growth by embarking upon an expansion project and conducting a takeover. In real world, companies don't have unlimited capital to seize every opportunity to expand. The choice to make will depend on many factors such as funding, return, risks and investors attitude etc. Companies must compare the advantages and disadvantages of opportunities available and consider what the imminent needs are, so that a decision can be made. This process involves trade-offs of benefits and costs. Fortunately, with the development in academic and practical research of corporate finance, we have proper tools to conduct such analyses. In this case study, we aim to conduct miscellaneous analyses and evaluations to reach a conclusion and recommend it to the board of RE.
Background
At the last board meeting, John Smith, CEO, raised questions regarding potential expanding opportunities, a. embarking upon an expansion project and b. a takeover. John has called on me to give my evaluations and recommendations.
As I review the minutes of the last board meeting, the main issues regarding which decision to go for are as follows:
Expansion Project
The main issues regarding the expansion project is financing. Since all internal funds have been committed, financing the project comes down to two options, long-term debt or equity. If debt is chosen, related tax shield, interest charge and company leverage are to be considered. Directors also raised various questions about dividend. There are basically three suggestions: 1. cease paying dividends for current period; 2. pay residual dividends; 3. repurchase shares after project investment. I have conducted analyses on these three suggestions and given my recommendations. See below for details.
Takeover
A target company is chosen by the M&A committee, Soluciones Economicas (SE). Soluciones Economicas is in a different industrial sector, so it would be a conglomerate. A series of issues on acquiring SE are discussed such as offer price, payment method, etc. Also, details are discussed below.
Calculations and Analyses
Raising all of the capital required by issuing debt.
Assuming RE raises all the funds by issuing 5-year notes:
Balance sheet of RE (ï¿¡millions)
Cash 650 Accounts Payable 450
Accounts Receivables 450 Accruals 300
Inventories 600 -----
-------
Current Assets 1,700 Current Liabilities 750
------- -----
Long-term debt 500
Net Non-Current Assets 1,800 Paid in Capital 750
Retained Earnings 1,500
------- -------
Total Owner' Equity 2,250
Total Liabilities
Total Assets 3,500 & Owner's Equity 3,500
==== ====
By issuing 5-year notes, RE transforms from a firm financed entirely by equity capital to one that is levered. The benefits of this shift are widely argued in academic researches. Modigliani and Miller (1958) assert that in perfect financial market in absence of taxation, the value of a levered firm is exactly the same as the value of an unlevered firm. However, they recognize that in the real world where there is taxation, there are benefits to enjoy when levered since interest payments are tax-deductible. Since tax-savings are savings of corporate financial resources, they accrue to the shareholders of the firm. Myers et al. (1984) asserts that taxes play an important role in the hierarchy of corporate decisions. Furthermore, with presence of taxation, increasing leverage can improve the weighted average cost of capital, which we will visit later in this report. Plus, a proper level of debt gives the management incentive to run the business more responsibly. Ofek (1993) asserts that firms with more leverage react faster to crises.
Tax savings in the first year: 500*9%*40%= 18 million pounds
Since the level of long-term debt will not change in the five-year period, we use cost of debt to discount tax savings for the period: 18*3.8897= 70 million pounds
Thus, the present value of the tax shield is 70 million pounds.
Profitability ratios before and after the debt issue
Before the issue of debt,
ROE= Net income/ Total equity= 135/ 2250= 6%
ROCE= Net income/ (Total equity + Long-term debt) = 135/ (2250 + 0) = 6%
Since RE is unlevered before the debt issue, ROE is equal to ROCE.
After the issue of debt and investment in the expansion project, (we assume that EBIT will increase by 30% due to the investment)
There is one more item in the income statement because of the interest payment due every year. Corporate tax rate is 40%
Interest payment= 500*9%= 45
ROE= (225*(1+30%) - 45)*(1-40%)/ 2250= 6.6%
ROCE= (225*(1+30%))*(1-40%)/ (2250+ 500) = 6.4%
The effective interest rate: 9 %*( 1-40%) = 5.4%.
From the calculation above, the performance is improved after taking on the investment. Even with the interest burden, RE still manages to create surplus value. After the issue of debt, the debt/equity ratio= 500/ 2250= 22.2% which is quite moderate. Such level of debt will not hurt the overall value of the firm so that shareholders are threatened by the pressure of insolvency. On the contrary, Jensen (1988) believes that higher level of leverage is good for the creation of firm value. After the debt issue, financial performance of RE is boosted instead of maintained or even destroyed. This will reassure both the shareholders and creditors that managers of RE is making efficient use of the funds which sends a signal to the market causing a raise in the share price.
WACC and relevant issues
We have been provided with several scenarios in which funds from debt issue vary. In order to find an optimal capital structure, we need to find out the relations between cost of equity and cost of debt, and the implication on weighted average cost of capital. Before going into details, we will make two different assumptions: A. raising debt will not cause any change in cost of any component whatsoever. B. raising debt has a marginal effect. Under assumption a, it is easy to conclude that since raising debt will not affect stakeholders' perception of the firm, it is best to raise debt as much as possible because it is cheaper and its interests are tax-deductible. However, that is never the case in the real world. Modigliani and Miller (1977) asserts that in a perfect capital market, where there is no taxes or transaction costs etc, the value of the firm is independent of its capital structure, which is to say that there exists no optimal capital structure. In the real world, the financing decisions of a firm are affected by many factors which all contribute to changes in cost of financing. Myers (2001) asserts that the optimal capital structure is one that maximizes firm value. There is a trade-off between equity and debt. Let's look into the details.
We are to raise 500 million pounds for the investment project. Under different scenarios, we raise funds from debt and equity in different proportions, thus we have different debt to equity ratio as follows.
Using the CAPM, we can derive at the cost of equity: cost of equity= 3%+ 1.3*(10%- 3%) = 12.1%
WACC= Ke* Ve/ (Ve + Vd) + Kd* Vd*(1-T)/ (Ve+Vd)
Due to lack of information of market value of the debt, we use book value of debt and equity for unity.
Under different scenarios:
Debt
0
100
200
300
400
500
D/E
0
3.8%
7.8%
12.2%
17.0%
22.2%
WACC
12.1%
11.9%
11.6%
11.4%
11.1%
10.9%
The graph indicates that when RE raises all funds required by issuing debt, an optimal capital structure for this instance can be achieved.
Modigliani and Miller's Proposition I and II with corporate taxes.
Proposition I:
Modigliani and Miller's Proposition I and II with corporate taxes (1963) asserts that since interests are tax-deductible, there are advantages to be levered for firms.
VL= VU+ TcD, where VL is the value of a levered firm, VU is the value of an unlevered firm, TcD is corporate tax rate multiplied by the value of debt. According to Cooper Ian A. and Nyborg Kjell G. (2005), value of the tax shield is equal to the present value of the tax shields; in this case it is TcD.
Proposition II:
The MM proposition II states that cost of equity rises with leverage, because the risks of insolvency to equity holders rises. It is clearly demonstrated in the formula below.
re= r0 + D/E*(r0- rd)*(1- Tc), where re is the cost of equity, r0 is the cost of capital for all equity firm, rd is the cost of debt, D/E is the debt to equity ratio, Tc is the tax rate.
In our case, using MM's proposition I and II, we can derive at the firm value of RE.
(1) We assume that sales; cost of goods sold; selling and administrative expenses; and depreciation increase at 30% per year, and change in working capital and capital expenditure are both zero in each of the 5 years, and capital expenditure are both zero in each of the 5 years. We also assume that the long run growth rate for the firm is 2% (from year6 to perpetuity) and that the normalized free cash flow is the same as the FCFF at the end of the 5th year.
Year1
Year2
Year3
Year4
Year5
Sales
1950
2535
3295.5
4284.2
5569.4
Cost of goods sold
1365
1774.5
2306.9
2998.9
3898.6
Gross profit
585
760.5
988.6
1285.2
1670.8
Selling and Adm. Exp
97.5
126.8
164.8
214.2
278.5
Depreciation
195
253.5
329.6
428.4
556.9
EBIT
292.5
380.2
494.3
642.6
835.4
Tax (40%)
117
152.1
197.7
257.0
334.2
Net Income
175.5
228.1
296.6
385.6
501.2
Depreciation add back
195
253.5
329.6
428.4
556.9
FCFF
370.5
481.6
626.1
814.0
1058.2
Discount Factor 12.1%
0.8929
0.7972
0.7118
0.6355
0.5674
PV
331
384
446
517
600
PV of the FCFF from year6 and on: 1058.2/ (12.1%-2%)*0.5674= 5945
The net present value of RE operation is 8223 (=331+384+446+517+600+5945). This is the value of RE when it is all equity financed.
(2) Now we add the value of the tax shield when in different scenarios.
Debt issue
0
100
200
300
400
500
D/E
0
3.8%
7.8%
12.2%
17.0%
22.2%
Value of equity
2750
2650
2550
2450
2350
2250
re
0
12.17%
12.25%
12.33%
12.42%
12.51%
WACC
12.1%
11.9%
11.6%
11.4%
11.1%
10.9%
PV of tax shield
0
14
28
42
56
70
Value of levered firm
8223
8237
8251
8265
8279
8293
The results are in accordance with MM's propositions that in this case, there is an optimal capital structure when funding the project all by raising debts.
Under the residual dividend policy, the dividend per share
Under the residual dividend policy, RE pays out dividends only after it finances the project with funding from equity and/or debt of 500 million pounds. Except when raising the 500 million pounds all by debts, there is dilution in shares. RE can issue new shares at the current market price of 45 pounds per share.
Debt issued
0
100
200
300
400
500
Interest after tax
0
5.4
10.8
16.2
21.6
27
Equity issued
500
400
300
200
100
0
Number of shares issued
11.1
8.9
6.7
4.4
2.2
0
Number of shares outstanding
61.1
58.9
56.7
54.4
52.2
50
Net income after interest
135
129.6
124.2
118.8
113.4
108
DPS
2.21
2.20
2.19
2.18
2.17
2.16
This dividend per share is based on the assumption that RE pays out all its profit to shareholders. Under this assumption, the dividend per share for the current year could be 2.7, when in fact, RE pays 0.8 pounds per share. A pure residual dividend policy involves paying out all or most of the profits after funding projects. Baker, H. Kent and Smith, David M. (2006) states that there are benefits of following a residual dividend policy, one of which is the reduction in agency costs. However, market perception is not only based on agency costs (Kasim L. Alli et al. 1993), but also on long-term growth, tax etc. Baker, H. Kent et al (2006) also finds that although firms profess to follow residual dividend policy, they take other factors that might affect share price into account, which modifies the policy. In this case, even though the DPS decreases as debt increases, RE can still maintain current payout ratio with surplus free cash flow. With the surplus free cash flow, RE can maintain a healthy long-term growth. So shareholders will not be too concerned with the debt issue.
Impact of dividend cut
Under the circumstance that RE has sufficient internal funds, it is a fact that using internal funds costs less than absorbing external funds. Based on the financial statement, RE seems to have sufficient internal funds to do that. In that sense, one of the directors proposes dividend cut so that all internal funds are focused on supporting this project. However, there are many factors that might indicate that this is a rather radical policy. Gordon's (1959) research reveals that comparing to uncertain future income, investors especially individuals, rather than institutions, prefer dividends which are instant. In RE's case, individuals hold more than 50% of all the shares. Modigliani and Miller (1961) argue that in a perfect capital market, capital growth is no different with dividend so that there is no preference between the two. However, in the real world where there is market friction which causes uncertainty and cash flow implications, investors might prefer dividends over capital growth. Moreover, Bhattacharya's (1979) signaling model well explains the rationale and logic behind dividend payout. In this economy where RE is facing fierce competition, dividend cut might jeopardize investor confidence with the result that share price is suppressed. In the calculation above, we can see that with external funds, performance is improved with the perk that not only can we at least maintain current payout ratio, but boost long-term growth. Also, there are sufficient funds to smooth dividends in the long run. In light of this, I suggest that the board should consider paying dividends instead of stopping paying.
Residual dividend policy accompanied by stock repurchase
Debt issued
0
100
200
300
400
500
Interest after tax
0
5.4
10.8
16.2
21.6
27
Equity issued
500
400
300
200
100
0
Number of shares issued
11.1
8.9
6.7
4.4
2.2
0
Number of shares outstanding
61.1
58.9
56.7
54.4
52.2
50
Net income after interest
135
129.6
124.2
118.8
113.4
108
Total dividend
40.0
38.4
36.8
35.2
33.6
32.0
DPS(29.6% payout ratio)
0.655
0.652
0.649
0.647
0.644
0.64
Amount of repurchase
95
91.2
87.4
83.6
79.8
76
No. of shares repurchased
2.11
2.02
1.94
1.86
1.77
1.69
Share repurchase is a good idea. First of all, the signaling effect will be positive. Companies that conduct share repurchase are often those with surplus cash and few acceptable investments. In RE's case, share repurchase is considered viable only after the expansion project has been funded. So RE's repurchase sends out a signal (McNally, 1999) that its shares are undervalued and it has already seized profitable opportunities. It will trigger a boost in RE's share price. Second of all, by repurchasing shares issued, RE can concentrate its shares so that even when net income remains the same, EPS will still increase. Third of all, investors would be happy for the consideration that they don't have to put up with double taxation. Also, repurchase leads to reduction in free cash flows and systematic risks which is the source of positive market reaction (Grullon G., 2004). I recommend share repurchase.
Pros & cons of the takeover
A proposal of a takeover was made during the recent board meeting. The potential target is SE, a foreign mid-size company which is in a totally different industry from RE. If we proceed with this takeover, it will be a conglomerate merger. There are pros and cons about such mergers.
First of all, it offers diversification of risks. This is in some way alike the diversification in stock market when the correlation of two stocks is low. Second of all, even RE and SE are in different industries, the experience of management can be universal, which means more efficient and more effective management.
However, there are disadvantages. Synergy can be illusory, because of the fact that two companies are in different industries, it is hard to distribute and utilize resources with efficiency. Geographical distance can also be a problem, since it increases the difficulty of proper communication which does not only mean telecommunication.
The board should have a thorough discussion about these issues before making a decision.
Relative P/E
SE's P/E ratio is much below the average P/E ratio for the industry. It might suggest that SE is undervalued.
To evaluate this issue, let's take a look at the numbers.
(1)
Net income of SE is 30 million euros, P/E ratio is 7, so that
Market Value of SE= 30*7= 210 million euros, while SE's book value is 310 million euros. It shows that SE is indeed undervalued.
(2)
P/E ratio of RE before the takeover:
P/E= 45/ (135/50) = 16.7
After the takeover, P/E
P/E = (45*(50+ 50/7))/ 135 = 19.0
There is an effect that boosts RE's P/E ratio. The rationale behind it is simple. RE made a good deal by purchasing an 'asset' which is undervalued.
Valuation and offer price
To derive at the offer price, we'll need to derive at the NPV of SE. In order to do that, assumptions will need to be made. (1) We assume there is an incremental increase in net cash flow for each year from year 1 to year5 for SE. (2) Since it's a share exchange with the rate of 1 for 7, there is substantial control.
WACC = 12.1%*45*50/ (45*50+300) +9%*300*(1-40%)/ (45*50+300) = 11.3%
Exchange rate: GBP/Euro= 0.897
Year1
Year2
Year3
Year4
Year5
EBIT
52
/
/
/
/
Tax (40%)
17.9
/
/
/
/
Net income
34.1
/
/
/
/
Depreciation add back (0.897)
6.3
/
/
/
/
Incremental net cash flow
15
15
15
15
15
FCFF
55.4
70.4
85.4
100.4
115.4
Discount (11.3%)
0.9009
0.8116
0.7312
0.6587
0.5935
PV
49.9
57.1
62.4
66.1
68.5
Also, From Year6 and on, long-term growth is 2%,
NPV = 49.9+57.1+62.4+66.1+68.5+ (115.4/ (11.3%-2%))*0.5935=1065
Maximum offer price= 1065-300(Debt) =765
We will continue discussing the possibility of the takeover.
Payment mechanism
There are basically cash and stock as payment methods. There are advantages and disadvantages associated with the two.
Cash
Paying cash is a one-off method as it puts the shareholders of the target company out of the picture. Also, cash offer provides an escape mechanism for the shareholders of the target company. However, as the amount is substantial, paying cash might put the bidder company into liquidity constraint. Plus, taxation when cash changes hands should be considered.
Stock
First advantage would be the saving of cash flow as only capital is used in such exchange. Tax saving would also be substantial. On the other hand, since new shares have to be issued, there will be dilution of control, which could be resented by institution investors. Furthermore, if the target company shareholders are looking to investing for long term, then they would try to block such offer.
Since this is an important issue, I strongly recommend that an extraordinary general meeting should be held to consult with shareholders. Personally, I am for cash offer since a downturn in EPS and dilution in holdings is the last thing we need in this economy.
Connection between bid offer and share price
Jensen and Ruback (1983) points out that in an acquisition, shareholders of target companies earn 20% abnormal gain while shareholders of bidder companies earn no abnormal gain. This research suggests that in an acquisition, it is most likely that the share price of the target company will rise. Rationale behind it is logical that only prime assets will be purchased. Premium paid for the goodwill is the incentive for the shareholders of the target company to sell the shares, thus the excess earnings. Usually the share price of the bidder company will fall because of uncertainties accompanied with the deal. So if the takeover were to go through, we could expect RE's share price falling. As to what extent it would fall still needs further investigation.
Diversification benefits
According to Markowitz (1952), an effective portfolio could diversify risks. That is what happens here when RE acquires SE. J. M. Samuels and D. J. Smyth (1968) finds out that the bigger the size of the company and the more the company is diversified, the less variable the profit is. By taking over a company in a different industry, RE reduce dependence on current operations. The knowledge and technologies bought from the deal is also significant.
Conclusion and recommendation
According to the above calculations and analyses, I recommend that we go with the expansion project. First of all, although the takeover offers diversification, we can foresee the falling of share price which is not so much of good news for we are struggling in the stock market now. Plus, if we offer cash, an enormous amount of financing will be needed which in turn could undermine company's liquidity. On the other hand if we initiate stock exchange, shareholders might resent it because it diminishes concentrated control. Second of all, the project produces a positive NPV and that is good for starter, comparing to the uncertainty of SE's future performance. Besides, after we finance the project, there is a boosting effect in the earnings which means capital structure actually gets better.
To sum up, I recommend that we go with the expansion project. In case of any enquiries, please feel free to contact me.
Susan Campbell, CFO
