The company selected is Kier Group plc listed on London Stock exchange. The concepts learned from study material were applied to understand the financial overview, capital structure & evaluating DCF for Kier Group. Kier is a leveraged company using equity and debts for financing capital needs.
Kier Group plc has annual revenue of £2.09bn, net cash balances of £175.2m with strong forward looking construction service order books of £2.04bn (Kier Annual report and accounts, 2010).
The Free cash flow (FCF) to firm calculation shows that the company has got very promising future prospect. The FCFF calculation demonstrates that the company shares can appreciate by 76% over current share price in next 5 years time frame.
(a)
Select a company which is listed on a stock market. Provide a brief financial overview of your company and explain its core line of business.
Answer:
The UK construction industry consists of over 250 000 firms, as per the department for business, innovation & skills (BIS). The sector employs 2.1 million people in several jobs. As per BIS, the sector consists of the materials supplier, manufacturer, home building services, skilled and unskilled labours and professionals (Department of Business, Innovation & Skills, 2010)
Kier Group plc with annual revenue of £2.09bn, net cash balances of £175.2m, construction service order books of £2.04bn and support service order books of £2.128b is one of the FTSE-250 elite companies. Kier Group plc is a leading construction, development and service group, specialising in building and civil engineering, support services & commercial and home building (Kier Annual report and accounts, 2010).
Kier's Business Activities
Kier group has its root in Hanson group in 1992. The company was successfully listed on the London stock exchange in 1996. The core line of activities spans from strong foundation in building and civil engineering to turnkey infrastructure projects. The group is growing their presences into the support service, housing building, property development and infrastructure segment (kier.co.uk, 2010).
Organisation structure is mainly divided based on type of service offered by the business units. Their solutions to meet customers` requirements are manifested in several different business unit combinations. Kier provides fully integrated solutions to the customers' needs (Kier Annual report and accounts, 2010).
Construction line of business provides comprehensive building service based on nationwide network of locally operated units. The units are formed based on region, called kier regional, like Kier eastern, Kier London etc. (Kier.co.uk, 2010). Kier construction also deals with international major projects. The key customers are Ministry of Justice, NHS, Network rail, United utilities, EDF energy, Overseas projects in Abu Dhabi, Jamaica, Saudi Arabia, Hong Kong (Kier Annual report and accounts, 2010).
Support Services; provide services like facilities management, building maintenance, consultancy & compliance testing service for both private and public sectors. Key contracts secured are Sheffield city council, homes for Islington, North Tyneside council and many more (Kier Annual report and accounts, 2010).
Kier Partnership Homes, specialising in private and affordable homes (Kier Annual report and accounts, 2010).
Developments division specialise in development projects like developing commercial, office, retail, industrial property, assets partnership program targeting local authority property management and development. The key projects are ordnance survey HQ, Network rail joint venture station developments, Norfolk & Suffolk police investigation centres (Kier Annual report and accounts, 2010).
Question (b)
(b) Present and analyse your chosen company's capital structure in the light of the academic literature.
Answer:
Capital Structure
The main objective of any financial manager is to create value for a firm's shareholders. The value can be created by buying assets worth more than its paid cost and appropriately using it to realise benefit. These types of decisions are called investment decisions. The other decisions called financial decisions, involves the selecting right capital structure for a firm so that the firm can maximise its valuation. The firm valuation (V) can be defined as a sum of its value of debt (D) plus the value of equity (E) i.e V= E+D as illustrated in the following diagram (Durham Business school, 2003).
Figure 1 Firm value
Based on the above diagram, the valuation of firm can be alerted by changing size of equity & debts of the firm. The financial manager has limited option around choosing mix of equity and debts and maximising the firm's valuation (Durham Business School, 2003). The equity and debts are the avenues to create the finance for the firms. The method of blending debts and equity used to finance a firm is called as firm's capital structure. Therefore, the manager should choose the capital structure that can maximise the total firm valuation. A firm financed only by equity is known as an unlevered firm where the financed by a mixture of equity and debt is referred to as a levered firm (Durham Business School, 2003).
There are various forms of debts available in a financial market depending upon financial instruments suitable for an organisation. The long term-borrowings, long-term note payable, debentures, syndicated loans are some of examples of the commonly used financial instruments. The examples of equity are common stocks, preferred stocks or retained earnings.
Kier Capital Structure
The latest 2010 annual report of kier group plc, revealed that the firm using both equity and debts financial instruments for funding its operation and growth. Therefore the firm is considered to be a levered firm.
Table 1 Capital Structure
The Group has long term borrowing of £30.3m. The borrowings are a ten-year U.K. & U.S Private placement of loan notes made in February 2003. It bears interest on a fixed rate basis at 6.4% per annum. It also makes use of short-term debts for any short-term working capital requirement. The group's capital structure can be illustrated in the following figure.
Figure2 Capital Structure
The group's capital structure as shown in above graph comprise of debts & equity. Kier is financed 92% by equity instruments and 8% by the debts instruments. It looks like Kier mainly rely on the equity financing options. The group has 36.7m ordinary outstanding shares as of 30th June 2010.
Top ten shareholders
The table shows the top 10 investors in Kier Group.
Figure3 Top ten shareholders
(Source: Thomson OneBanker Deals,2010)
From above table it is evident that the kier holds a strong investor base mainly consisting of investment bank and fund managers.
Key Leverage ratios
The following table presents the quick view of some of key financial leverage ratio of Kier.
(Formulas from Atrill & McLaney,2008)
(Source: Kier Annual Statement Y10,Y09)
Figure 4 Leverage Ratios
The debt ratio 2.71% (in Yr 2010) is considered to be on lower side. Therefore, it can be said that kier has managed debts reasonably well. It is less than 3 % of total company assets. This shows the company is operating with strong financials foundation. This also determine that the lender would be willing to finance the company if need arise for more debts. The lender would take this as a positive note and it would be easy to finance new debts. The access to liquidity would be obtained easily.
The group's other financial instruments comprise cash and liquid investments. The group uses an interest rate swaps mechanisms to manage interest rate risks (Kier Annual report and accounts, 2010).
In the current global economy crisis, especially construction & real estate companies facing liquidity risk. Kier has taken proactive measures by forming group wide policy to counter any financial risk. As a part of risk management, the group has formed different policies using instruments like foreign currency risk, liquidity risk and interest rate risk by hedging the part of its exposures (Kier Annual report and accounts, 2010).
According to Modigiliani and Marcus Miller (M&M) theory, in a world of perfect capital markets, the financing mix has no effect on the firm's value. The theorem provided basic frame works to study the capital structure of a firm in presence of factors like taxes, transaction costs, bankruptcy costs, agency costs, prefect information flows, and access to borrowing at the same rates. However, the study's done by experts have found that the capital structure does matter in maximising the firm valuation.
In case of Kier, as we saw earlier, equity forms 92% of the firm financing. Kier has got advantage of running its operation on its own cash flows and investor money rather than relying heavily on borrowed debts. Therefore, company does not require making large debts payments to banks. The cash flows generated from the business are straight being used for financing its own needs or passing benefits to their investors in form of dividend or share repurchasing.
Question (c)
(c) Calculate the company's cost of capital and carefully explain any models and assumptions that you use. Use discounted free cash flow analysis to calculate the value of your company and evaluate your valuation in light of the company's market capitalisation
Answer:
The discounted cash flows (DCF) as stated by Vernimmen at el, is an investment technique to determine a firm valuation. It focuses on the present value of the cash flows from investments & determines enterprise value as a whole. The value of the firm is the aggregate of the present value of after-tax cash flows over the forecast period and the terminal value (Vernimmen P. at el 2009).
DCF valuation is the most popular and widely used in corporate finance. The DCF techniques take in to account two important aspects a) Time value of money & b) Risk premium for the investments. The discount factor used in this case is weighted average cost of capital (WACC). The DCF valuation has many advantages over the other methods of the valuation. It accommodates the following advantages
The future development events can be considered while calculating cash flows.
Financing effects on valuation can be captured in the calculation of WACC.
Dividend policy does not affect WACC or cash flow calculation hence it can be omitted safely without compromising the DCF.
Kier as stated earlier in answer 2, is a levered firm, it makes use of both options viz. equity and debt financing for its operation. The Kier Capital Structure was analysed and presented in answer 2.
The key highlights of capital structure are
Debt financing i.e. long terms borrowing of £30.3m forms 8% of total capital value and are ten year U.K. & U.S. private placement of loans notes bearing fixed interest rate of 6.4% per annum.
Equity financing of £355m forms 92% of total capital value. We can also see the group has strong fund manager & investment banks as investors.
Discounted free cash flow valuation
This section elaborates the DCF technique applied to Kier and analyzes its cash flow valuation.
The appropriate model fitting to our question's requirement would be Free cash flow to firm (FCFF). The FCFF model will value the firm using DCF technique.
The basic components that are required for estimating the DCF value of the firms are
Explicit forecast period
Cost of Capital using WACC
Terminal value
Forecasting the growth, sale, COGS & other financial parameters.
Cost of Equity using CAPM
Before proceeding further, we can analysis quick SWOT of the Kier, it helps to understand the company strength, weakness, opportunity & threats affecting Kier's business in its operating environment.
Brief SWOT analysis
A quick SWOT analysis of Kier would give more insight information to its present & future business.
Brief SWOT analysis
Figure 5 SWOT Analysis
Computation of FCFF
Analysing the annual statement of Yr 2010, 2009, 2008 of Kier, we can see that though, the company turnover remaining in the range at £2056m but the company effectively reduced the cost of sales by 6.2% in Yr 2010 compare to Yr 2009. That has increased the profitability before tax to £57.7m (Kier Annual Statement Yr 2010, 2009, 2008).
Present, global crisis is driving economy at slower pace and markets are turbulent. The liquidity and credit finance are becoming difficult. The governments across whole World are increasing financial stimulus packages to save economy by taking strict measures, easing credit in the market, ensuring availability of funds to small & big enterprises, and increasing public spending.
The construction & real estate business is at the core of financial crisis. The sector is getting special attention from governments. The governments are especially, increasing public spending and encouraging public infrastructure projects.
The building & construction sector will growth at 3.7% in 2010 and moderate growth at 1.2% as per the British Chambers of commerce (Kern, 2010). It would be safe to assume that the kier to grow at 4% during forecasting period of next 5 years.
FCFF's assumption
The following chart presents the assumption made about Kier based information analysed to presents FCFF calculations.
Figure 6 FCFF assumptions
Calculation formulas
The formula used for calculation of FCFF is
Where
The formula used for calculation of WACC
The Free cash flows to firm were calculated using following formula
Kier's Beta calculation
The data used for Beta's calculation are provided in Appendix. The weekly share price of Kier's share and FTSE-All share reference prices were taken in to consideration at the time of calculation of Beta.
Cost of equity calculation
Cost of equity
Beta
0.699840588
Risk Free
3.00%
Risk Premium
10.00%
Cost of Equity using CAPM
10%
Figure 7 Cost of equity
WACC Calculation
Kier plc
2010
Long Term Debt
(30.30)
Outstanding Shares
36.70
Current Price
13.28
Equity - Market Value
487.38
Total Asset
1,118.10
Total Liability
1,013.90
Equity - Book Value
104.20
Risk Free
3.00%
Risk Premium
10.00%
Beta Equity
0.6998
Cost of Equity
10.00%
Cost of Debt
7.50%
WACC
9.80%
Figure 8 WACC Calculation
FCFF Calculation
The following table shows the calculation of FCFF. The Kier's performance & pattern of business were analysed and understood based on financial annual reports of years 2008, 2009 & 2010.
The forecasting is based on consideration of the following factors.
Forecast of U.K. general economy.
Forecast of construction and building sector growth.
Strength, weakness, opportunity & threats (SWOT) affecting Kier business in its operating environment.
Kier current & past performance and its pattern.
Figure 9 FCFF Calculation
As illustrated above, year 2008-2009 have been used to gauge the performance and they forms basis of forecasting. The year 2011e to 2015e represents the forecasting period. The year 6th (2016) is used for calculating terminal value of a company.
Snapshot of FCFF calculation
The snapshot of final valuing Kier is as follows
Figure 9 FCFF Calculation
The aggregate free cash flow to firm (FCFF) amounts to £143.51. The future free cash flows are discounted to net present value with discount rate as that of weighted average cost of capital (WACC). The terminal value is calculated with assumption of terminal growth rate of 3% starting 6th Year onwards. The terminal value of £1153.80m discounted to net present value using discount rate as that of weighted average cost of capital (WACC). The estimated enterprise valuation works out to be £801.95m. The net estimated equity value after deducing net debts as of 30th June 2010 is £771.65m. As of 19th October 2010, the Kier share closing price on the London Stock exchange was 1218pence. Therefore, based on the above valuation, the Kier's current share price is at 72.62% discounted to its estimated share price of 2103pence. Hence, there is much potential left in share price capital appreciation point of view as well, Kier is well know for their dividend policies. The company has paid dividend even in financially troubled year of 2009.
In summary, the shares of kier are strong value buy and will give around 73% capital appreciation over next 5-years with constant growth in dividend year on year.
Question (d)
(d) Discuss any potential corporate restructuring that may benefit your company or its shareholders. For example, a carve-out, merger, debt restructuring, buyout etc. You should ensure you evaluate funding issues.
Answer:
The process of redesigning financial structure of the company is called restructuring. There could be number of factors like general economy condition, under performance as entire firm or some of line of business or subsidiary, unfavourable & volatile capital market, inefficient & unmanageable scale of organisation, technology changes, consumer awareness, and restriction from government agencies.
Many times a survival or hostile takeover bid, merger & takeover, leveraged buyout may trigger to a corporate restructuring. This changes the direction & the way organisation operates its relation with capital market, investors, agency & payout policies (Durham Business School, 2003).
Kier Restructuring
The detailed analysis of kier operating business and its past 3 years annual reports points out some of potential causes to restructure Kier.
Kier home an homebuilding division of Kier, construct new affordable residential buildings & private homes (Kier Annual report and accounts, 2010).The U.K home building has shrunk & generated total revenue of $41.5 billion in 2009, shrunk by compounded annual rate of change at -12% for the period 2005-2009 ( Data monitor,2010).
The UK homebuilding industry shrunk by -18.7% in 2008 compare to 2007. Again, in 2009 it shrunk by -26.9% (Data monitor, 2010).
As per the British chamber of commerce, the home construction sector will grow by 3.7% in 2010 & 1.2% in 2011 followed by 0.7% shrink in 2012 (Kern, 2010).
Therefore, the general outlook of housing market is bearish & company operating in housing market will have adverse condition ahead.
Kier home business has the written down land and work-in progress amounting to £42.5m in 2009. The business had losses of £62.4m in 2009. The losses in year 2010 stood at £3.3m (Kier Annual report and accounts, 2009).
Kier home business has made losses due to adverse housing market. Housing market is still going to remain challenging in 2010-2014. Therefore, the Kier home business may not do well in coming years.
Kier is mainly U.K. centric company. As per British chambers of commerce, the U.K. general economy will grow at slow pace with growth of 1.7% in 2010, 2.2% in 2011 and 1.8% in 2012(Kern, 2010). Kier has to change the strategy and should explore the more avenues of doing business globally.
Emerging markets economy is growing better than developed western economies. The emerging countries are investing heavily in infrastructure projects.
Future strategies
Kier can address the above problem by corporate restructuring and acquisition.
The following section elaborates the approach to future strategies
Offloading Kier Home business
The current position of Kier home business and its operating environment discussed earlier. As part of financial restructure, Kier can sell its sick and less growing home business. The following section presents the FCFF calculation after offloading the Kier home business.
Assumption
By offloading Home business, the Kier estimated sale will grow lesser but it would still be growing at 3.9% annually during forecasting period.
Cost of good sold will still grows at 2.75% of current sales.
Selling, General and Administrative Expenses (SG&A) will grow at 1.5% of the previous year.
There would be substantial cost save after offloading Home business. The save would come from land & property write-downs, home business payroll expense, and home business administrative & erating expenses.
The assumption can be summarised as below
Figure 10 FCFF Assumption
FCFF Calculation after offloading home business
Figure 11 FCFF Calculation
The snapshot of final valuation is as follows
Figure 12 FCFF snapshot
Advantages
This strategy will contribute following advantages,
The FCFF calculation shows that the strategy of getting rid of Kier home business will contribute more than 30% in company's valuation. One can see that the net gain on the share price over forecasting would be 104.47% over present value of share. The earlier calculation of FCFF with inclusion of Kier Home business shows the net gain on the present share price would be 72.62% over forecasting period. Clearly, without even considering, Kier home business sold amount, but just by getting rid of write-downs and operating expenses, Kier can make substantial profits. The net company valuation would rise more than 30% over the forecasting period.
This will contribute other benefit like Kier would effectively use its resource on more profitable business. The company could re-align it strategic resource and efforts to create more value for its shareholders.
The troubled business will be out of its operation & hence Kier would be much safer bet. The company will not get directly affected by U.K. Housing market crisis. The uncertain business would be no more worries.
Acquisition & leveraged buyout strategy:
The second strategy is to explore emerging markets like India, China, Brazil & Africa. In spite of the global recession, the GDP of most of these countries are growing at the rate more than 6%. Kier Group's core line of business is construction, infrastructure and support services. Kier group also has expertise in these domains.
The emerging markets are heavily investing in infrastructure development. Kier group should explore the synergy and economies of scale, exploring new markets & look forward geographical expansion.
The Kier has started operation in Saudi Arabia forming Saudi Comedat co. incorporated Saudi Arabia. The other overseas projects include Abu Dhabi, Jamaica, Hong Kong. In Saudi Arabia Company has successfully completed the first year of an eight-year phosphate mining contract. In the Hong Kong, Kier have been awarded a £125m tunnelling contract in joint venture (Kier Annual report and accounts, 2010).
The Kier debt ratio is the lowest in is segment & also it has got solid net cash balance of £175.2m in 2010 (Kier Annual report, 2010). It would also be wise to use leveraged buyout strategy to make an acquisition of firm in merging markets. The leverage buyout option comes with specific characteristics where in large portion of the acquisition could be financed by debt. As stated in earlier sections, the cost of debts for Kier is much lower than the equity. Therefore, financing new acquisition using debts financial instruments & debts capital market would be more profitable & tax efficient as well.
Appendix
Beta Calculation
Data used for Beta computation. Beta for Kier was calculated using SLOPE function in excel.
Source: Yahoo financials
Kier Financial data
Kier financial data 2009
Kier financial data 2010
