The Examiner's Answers â€“ F3 - Financial Strategy Some of the answers that follow are fuller and more comprehensive than would be expected from a well-prepared candidate. They have been written in this way to aid teaching, study and revision for tutors and candidates alike.
SECTION A Answer to Question One (a) Forecast net cash flow Base data 2011 D$m
13.77 (=12.26x1.08 x1.04)
4.05 (= 3.51x1.05x1.10)
4.81 (= 4.05x1.08x1.10)
9.27 (= 8.66 x 1.07)
9.92 (= 9.27 x 1.07)
23.40 20.45 (=25.45 â€“5) 2.95
25.58 21.27 (= 20.45 x 1.04) 4.31
28.50 22.12 (= 21.27 x 1.04) 6.38
2.84 (0.85) 0.23
5.00 (1.50) 0.17
Year ended 30 June: Aviation income (flex by increase in passengers and also uplift by 4% pa) Car parking (flex by increase in passengers and also uplift by 10% pa) Other income, including retail concessions (apply increase of 7% pa) Total income Operating costs after deducting depreciation of D$5million Net operating cash flow Interest receivable on cash at 4% (see W2) Interest payable on borrowings at 7% (unchanged) Net finance costs Net cash flow after interest but before tax Tax at 30% Add tax relief on tax depreciation allowances (see W1) Estimated net cash flow for the year
Alternative method based on passenger numbers: Base data Year ended 30 June: : Passenger numbers Aviation income Per passenger In total Car parking Per passenger In total
3.675m (=3.5 x 1.05)
3.969m (= 3.675 x 1.08)
D$3.21 (=11.23/3.5) D$11.23m
D$3.34 (= 3.21x1.04) D$12.27m (= 3.675 x 3.34)
D$3.47 (=3.34x1.04) D$13.77m (= 3.969 x 3.47)
D$1.00 (=3.51/3.5) D$3.51m
D$1.10 (= 1.00x1.10) D$4.04m (= 3.675 x 1.10)
D$1.21 (=1.10x1.10) D$4.80m (= 3.969 x 1.21)
W1 Calculate tax depreciation allowances D$million 3.00 (0.75)
Opening balance 1.7.11 less 25% reducing balance allowance Brought forward 1.7.12 less 25% reducing balance allowance
Tax relief at 30% 0.23
2.25 (0.56) 1.69
W2 Long term borrowings and cash and cash equivalents balances and interest on those positions Year ended 30 June:
Cash and cash equivalents Opening balance* Net cash flow in the year
*Interest at 4% on opening balance Long term borrowings Opening and closing balance
REPORT TO THE DIRECTORS OF DEF AIRPORT From: X, external consultant Date : November 2010 EVALUATION OF POSSIBLE SALE TO TUV AIRPORT The purpose of this report is to consider issues arising from a potential sale of DEF Airport to TUV Airport. The report will conclude with a recommendation on how to proceed.
(b)(i) Valuation of DEF Airport The valuation of a non-listed entity is not straightforward as no market share price is available. Estimates can be compiled using methods such as discounted cash flow (DCF) analysis. Valuation based on DCF analysis of forecast future earnings Year ended 30 June: Cash flow before synergistic benefits One-off synergistic benefits Cash flow after synergistic benefits Discount rate @ 11% PV
2012 D$m 2.22
2013 D$m 3.67
2014 D$m 6.00
2015 D$m 8.00
2016 D$m 9.00
2017+ D$m 9.45
3.00 9.45 for 2017 157.5 in perpetuity (=9.45/(11%-5%) 0.593 93.4
Total NPV 116.1 million Value WITH synergistic benefits is D$116 million. Value WITHOUT synergistic benefits is D$113million ( = 116million â€“ (3.0million x 0.901)).
Valuation based on net assets Net assets value is D$131million (= 162.68million –32.15million). Other valuation methods It may also be useful to calculate a valuation using a P/E ratio if suitable data is available. Summary These methods give a range of values from approximately D$113million (DCF basis without synergistic benefits) to a maximum of D$131million (using net asset values). The net asset value is the highest. Indeed, it would appear that the company would be worth more to the shareholders if it were to be closed down and the assets sold. However, this figure should be interpreted with care. The forecast statement of financial position as at 30 June 2011 includes a very significant revaluation reserve of D$89million and without this the net asset value would be D$42million. Given the DCF valuations of D$113-116million, the net asset valuation at D$131million may indicate that there are impairment issues within the non-current assets which may require a write down in their value. The forecast figures may not therefore be correct or final. In addition, the location of the airport is an important factor, as is the nature of the buildings. It is unlikely that an alternative use could be found for the assets and it may only be the land that is valuable. If considering a break-up value, possible alternative uses of the land may need to be considered. It is estimated that a reasonable offer price might be of the order of D$100 - 120million based on the DCF calculations, depending on how optimistic the growth forecasts are considered to be.
(b)(ii) The main differences in financial objectives of public and private sector organisations with reference to stated financial objectives of each airport. Private sector: Standard objective is to maximise shareholder wealth. This is achieved by dividend payments and capital growth by both internal growth and by acquisition. Both of these are clearly illustrated in TUV Airport’s main financial and strategic objectives: ‘….overall financial objective of maximising shareholder wealth. Its strategic objectives support this financial objective by focussing on opportunities for growth, both internally and by expansion through acquisition’. Public sector: Public sector organisations are still required to demonstrate value for money for investments. However, this is a less onerous objective than one of maximising shareholder wealth. There is normally a range of non-financial objectives that are also important and these may conflict with maximising financial return.
The LSGs have made it clear to the Board of Directors that the airport must be at least financially self-sufficient. The overall financial objectives of the airport are to ensure that: 1 2 3
The airport does not run at a loss. All creditors must be paid on time, and Gearing levels must not exceed 20% where gearing is net debt to net debt plus equity and any long term borrowings must be financed from sources approved by the four LSG’s.
It could be argued that these financial objectives are very conservative and would not be acceptable to a wider shareholding constituency if the company was to be quoted on a stock exchange. Financial Objective 1 could be acceptable in the short term, for example, if the airport was recovering from making losses. However, as a long-term objective, say for the development plan time horizon of twenty years this objective would be too unambitious for many shareholders. Financial Objective 2 is laudable but does not suggest any ambition such as growth in profits, share price or shareholder wealth. Financial Objective 3 is very conservative and would restrict DEF’s ability to grow using debt financing. Current gearing levels: • using book values: debt/debt+equity = 22.7/(22.7 + 130.5) = 14.8% • using market values based on a valuation of D$113m: 22.7/22.7 + 113) = 16.7% If D$113 million is a fair value for the Airport under present market conditions, it can be expected that the non-current assets will need to be devalued to reflect impairment before finalising the accounts for the current financial year. The gearing using market values is therefore more likely to represent the current position and indicates that, at 16.7%, gearing is dangerously close to the target maximum level of 20%.
(b)(iii) Strategic implications of the proposed sale on each of the major stakeholder groups, including the LSGs, and advise the LSGs whether or not to negotiate with TUV Airport. LSGs Based on an estimated equity value of, say, D$113million plus funds loaned by the LSGs to DEF of D$16.4million, the LSGs have approximately D$130 million tied up in DEF Airport. For this investment they receive interest of 7% on D$130 million, that is, interest of D$1.15million. In the absence of any dividend payouts in recent years and assuming a steady share price, this represents a return of just 1% (=1.15/130) based on market values.
This is unlikely to be acceptable to the LSGs over a long period of time. Advantages of being able to provide a good local amenity are likely to be out-weighed by the poor value for money and, in addition, the high risk that this investment represents. There is a high risk that more borrowings or equity will be required by 30 June 2013. Indeed, the airport business may fail altogether and the LSG’s may incur loss of capital. This is unlikely to be a risk that the LSGs are willing or advised to retain.
Other relevant issues: • Risk losing control of an important transport service in the area. • This could lessen the attractiveness of the region for inward investment in the future. • In relation to land based access (Strategic Objective 4), the LSGs are still likely to be in a position to contribute to this aspect of the development plan. Employees • TUV might reduce the head-count and combine jobs, contrary to Strategic Objective 6. Passengers • Passengers could face reduced services and destinations and /or increased prices. • Services have already been cut by TUV Airport at another airport following an earlier acquisition. • Financial stability is more likely under TUV Airport’s expert management and this is in the long term best interest of the passengers (see Strategic Objective 3). Local residents • Lower priority may be given to keeping noise levels to a minimum and to other environmental considerations now that profits are a top priority (contrary to current Strategic Objectives 2 and 5). Although this could be mitigated by the abundance of legislation in these areas. Airlines • TUV Airport may be able to use links already established with certain airlines or be able to use its strength to negotiate new agreements to encourage the use of DEF Airport by key airline companies. • In the pre-seen material it comments that a North American airline is interested in running routes from DEF Airport – although it will only pay in US$. If TUV Airport were to take over it is more likely to be in a position to hedge currency risk effectively and hence may accept the airline’s business.
Conclusion: Whether or not to negotiate a sale of the business to TUV Airport. On purely financial grounds, any offer, as long as it includes repayment of debt, would appear to be attractive from the viewpoint of the LSGs. The total return on investment is very poor and the LSGs are likely to be able to find alternative ways to use the funds invested. The takeover approach could be regarded as a timely rescue from a troublesome investment. It is unlikely that the LSGs can justify tying up large sums of money in DEF Airport. One important advantage of ownership of the airport is the ability to protect air routes and also protect the local environment. However, it may be possible to achieve both of these policy objectives by alternative legislative processes, e.g. adding conditions to the sale. The investment would be unlikely to meet government criteria for value for money and the LSGs are therefore likely to be very interested in selling to TUV Airport, given a reasonable offer.
Answer to Question Two (a) Calculations (i) Cost of equity Calculate as EPS/Price per share: EPS for GUC is P$1.10 (P$864m/785m shares) Share price is P$7.70 Ke is therefore EPS/Price per share = P$1.10/P$7.70 = 14.3%. Alternative method also given credit: Use Dividend Valuation Model based on a reasonable assumption about dividend payout level.
(ii) Yield to Maturity (YTM) Premium on conversion Share price now Share price in 5 yearsâ€™ time Conversion premium
Year 0 Capital Expenditure 1 â€“ 5 Annual Interest 5 Capital Redemption
P$7.70 P$10.30 P$13.30 per P$100 nominal
Cash Flow P$ -100.00 3.00 113.30 (P$100 + P$13.30)
(P$7.70 x 1.06 ((11 x P$10.30) - P$100)
DF@6% 1.000 4.212 0.747
DCF P$ -100.00 12.64 84.64
DF@4% 1.000 4.452 0.822
YTM by interpolation:4% + 2% [6.49/(6.49+2.72)] = 5.41%
DCF $ -100.00 13.36 93.13 6.49
(b) – Evaluation There are a number of factors to be considered within this evaluation which are included here as bullet points. In an examination it would be expected that these points would be discussed in full. As an introduction comments could be made concerning GUC in general. • In particular, the make-up of the investors could be important in any evaluation of finance. • Also with a P/E ratio of 7 (P$7.70/P$1.10), GUC is below the market P/E of 8.4. which might suggest there are better opportunities elsewhere for equity investors. This might have a negative impact on the take up of a rights issue. However, industry averages will contain a very broad spectrum of companies within the definition of “utilities” and a direct comparison is difficult. • The gearing ratio is currently below the industry average and is relatively low. • The share price has fallen by 6% in the last two months.
The three sources of finance to be considered are: 1. New equity using a rights issue. 2. A 5 year “straight” bond at a coupon rate of 6%. 3. A convertible bond with a coupon rate of 3% - convertible in 5 years’ time.
New Equity using a rights issue: Factors to consider are: • This is the most expensive source of finance at an estimated cost of equity of 14.3% . • The discount offered (15%) might be insufficient to attract investment. 20% might be considered more typical. • 28% of the equity share capital is owned by small investors or employees of GUC who might not have the funds available to take up the rights. Therefore the cost of underwriting could be significant. • The share price has fallen over the last two months. No explanation is given for this. It might be market or industry-wide factors. If the price falls further then GUC will need to issue more shares to raise the necessary funds, which might also cast doubt on the success of the issue. • A rights issue will improve the company's gearing but will almost certainly dilute EPS in the short term. Control may also be diluted but this might not be an issue for a company of this size. • The announcement of rights must be accompanied by strong signals to the market that the money is needed for profitable long term investment. • Dividends might have to be paid on the increased number of shares unless GUC keeps the total dividend payout constant – which might send adverse signals to the market. ‘Straight’ bond with a 6.0% coupon Factors to consider are: • This bond has a YTM of 6% and therefore a cost to the company after tax of 4.2%. This is obviously cheaper than the equity finance but is actually more expensive than the convertible bond discussed below. • The yield on the bond is less than that required on similar bonds available to other utilities companies, indicating that the market views GUC as less risky than the average utilities company. This could be because of its relatively low level of gearing at present.
Convertible bond • •
The convertible bond has a yield to maturity of 5.41% which is lower than the pre tax yield of 6% for the straight bond, a saving of 0.59% a year. Not quite as advantageous as you might expect from the low coupon rate of 3%, but still a significant saving. The tax relief on the convertible bond will be the same as that for the straight bond due if the tax calculations are based on the accounting treatment set out in IAS 39. The after tax difference is therefore also 0.59% pa based on the future share price assumptions given in the question. The coupon rate of the convertible proposed by GUC suggested it was “cheap” finance, but it has proved to be more expensive once the capital gain on the shares has been taken into account. Of course, the share price may not grow as expected and the convertible could therefore still prove to be the cheaper source of finance in practice. In order to be sufficiently interested in the offer to invest in the convertible bond, buyers must be confident that the share price will increase as forecast or they would prefer to invest in straight debt which is less risky. From year 5 onwards GUC will need to pay dividends on the shares created on conversion and this is likely to prove to be more costly than servicing the debt.
Conclusion Ultimately the decision on which source of finance is most appropriate will depend on how much GUC is seeking to raise and its target gearing level. Currently GUC is modestly geared compared with the industry average, and therefore has considerable scope to take on more debt if it wishes to do so. Unless the amount needed to be raised was very large it is unlikely that equity finance via a rights issue would be appropriate because of the higher ke and also the higher issue costs. The question therefore is likely to be a comparison of straight debt against convertible debt. The convertible has attractions as it has the lowest overall cost to GUC and at a coupon rate of 3% means that the drain on cash flow in the next 5 years will be less than with the straight bond. However, the convertible will result in additional equity in 5 years’ time resulting in dilution of share ownership and EPS, which may not be acceptable.
Answer to Question Three (a)(i) Exchange rates for project C (A$ weakening against GBP by 1.5% per annum) 1 Jan 2011 2.00 End 2011 2.03 End 2012 2.06 End 2013 2.09 End 2014 2.12 End 2015 2.15 Calculations of NPV and PI for each project PROJECT A
Initial Investment Net Operating Cash Inflows Residual Value NPV PI
-15.50 1.75 0.00
Initial Investment Net Operating Cash Inflows Yr1 Net Operating Cash Inflows Yrs2-7 Residual Value NPV PI
-10.20 1.15 3.10 2.50
1.000 0.926 4.280 0.583
-10.20 1.06 13.27 1.46 5.59 54.8%
-9.50 4.58 4.51 4.45 4.39 4.33 0
1.000 0.917 0.842 0.772 0.708 0.650 0.650
-9.50 4.20 3.80 3.43 3.11 2.81 0 7.85 82.6%
Initial Investment Net Operating Cash Inflow 2011 Net Operating Cash Inflow 2012 Net Operating Cash Inflow 2013 Net Operating Cash Inflow 2014 Net Operating Cash Inflow 2015 Residual Value NPV PI
DCF GBPMillion -15.50 21.88 0.00 6.38 41.1%
(a)(ii) The profitability index (PI) shown above is the NPV expressed as a percentage of the initial investment, this is the “net” method. The GPV or “gross” method would be equally acceptable, where the PI is the NPV expressed as a percentage of the sum of the NPV and the initial investment. PI is most appropriate when projects are divisible. However, it is technically acceptable to apply the profitability index alongside other analysis when determining the best combination of non-divisible projects in a capital rationing situation. Although PI may lead to an incorrect ranking, it still provides useful information. Indeed, in many cases a PI analysis will identify the optimum combination of projects.
As all three projects cannot be undertaken given the entityâ€™s capital expenditure limit of GBP 25 million, it is necessary to look at combinations of any two projects. Summary of Rankings Project A B C A+C B+C
Initial Investment GBPMillion 15.50 10.20 9.50
NPV GBPMillion 6.38 5.59 7.85
PI % 41.2 54.8 82.6
Rank using NPV
Rank using PI
2 3 1
3 2 1
The combination of projects A&C gives the highest NPV, B&C has the highest ranking using PI, and is well within the companyâ€™s investment limit, leaving just over GBP5 million to invest elsewhere. A&B breaches the limit of capital available. This combination also ranks last so PEI might not wish to even consider sourcing the additional GBP700,000 required to make both investments (although the combination has a positive NPV and in theory is worth investment if money can be raised and there are no other limitations). PI should only really be used if the projects being considered are of equal duration and equal risk. Here we are comparing A + C with B + C. Both combinations include Project C so we are really only interested in comparing the duration and risk of Projects A and B. Project B has the advantage of being both of shorter duration than Project A but the same risk and so we can be fairly confident that the top ranking PI combination of B + C is superior to the highest ranking NPV combination of A + C assuming that we can make constructive use of the unused capital. Conclusion: The best investment appears to be a combination of Projects B and C.
(b) The alternative method involves working with A$ cash flows and an A$ discount rate. The expected movements in the A$/GBP exchange rate are taken into account in the adjusted discount rate. The A$NPV result is then converted into GBP at the spot rate. In this case, we would adjust the GBP discount rate of 9% to take account of the anticipated 1.5% per annum strengthening of GBP(weakening A$). That is, the A$ discount rate is 1.09 x 1.015 = 1.106 or 10.6% per annum.
(c) Key factors to consider include: • Foreign exchange exposure arising on Project C. • Availability of suitable finance. PEI has cash available but this might not be the most appropriate type of finance in a foreign investment. Borrowing in A$, if available, would provide a natural hedge by matching (to a greater or lesser extent) income streams with interest payments and A$ denominated assets with liabilities. • Risk appetite of shareholders. This is a private company and the profile of shareholdings is not known but it is likely that at least some of the shareholders are also directors or employees of the company. • Political risks – the foreign country in which Project C will be invested is not specified but investment in any foreign jurisdiction carries some risk. • Tax implications – these might have been accounted for in the net operating cash flows but PEI needs to assess the impact of differential tax rates and/or whether a double taxation treaty exists between the two countries. • Appropriateness of the discount rate – no indication was given as to how the 9% was determined.
Answer to Question Four (a) How MM differs from the traditional model Under both the MM models and the traditional model, the cost of equity increases as the level of gearing increases. This is because the introduction of debt brings financial risk, which will cause the earnings available to the equity shareholders to become more volatile as interest has to be paid before dividends. The equity shareholders will therefore require higher returns in order to compensate for the increase in financial risk, which pushes the cost of equity up. Debt is assumed to be a cheaper source of finance than equity, as it ranks above equity for both the distribution of earnings and on liquidation and therefore carries less risk for the investor. The traditional view of gearing is that WACC will be lowest at a level of gearing that represents an “optimal” capital structure. At this optimum WACC will be minimised, which will therefore maximise the value of the firm (assuming earnings to be independent of the capital structure). The relationship between the ke, kd and WACC under the traditional theory is shown in diagram 1. Under MM’s assumptions, firms identical in all respects apart from capital structure (allowing for size), should have the same value. Value is determined by a stream of operating cash flows and the degree of business risk attaching to these, regardless of how the cash flows are shared out between different classes of investor. Under MM, and excluding taxes, WACC remains the same –as gearing increases the impact of the increasing Ke is exactly offset by the lower kd as shown in diagram 2. Note from the diagram that at very high levels of gearing MM believed that the ke would fall as equity risk-takers come into the market, although this would be compensated for by an increase in the kd resulting for the increased risk perceived by debt investors. However, this ignores the fact that, generally, interest on debt is a tax-deductible expense and the issue costs of debt are normally lower than those for equity. This tax benefit implies K e will rise and WACC will fall, as shown in diagram 3.
Limitations to “real world” applications The limitations to “real world” applications are: • • • •
Cost of capital is not likely to remain constant. MM assume personal and corporate leverage are equivalent, this is unlikely to be true as companies even of medium size are likely to have a better credit rating than most individual investors. Very high levels of gearing carry considerable dangers of corporate collapse. MM’s later model allowed for this but the main limitation still maintain. Assumes zero transaction costs.
(bi) – assume equity finance Vu =
127.1 = A$2,542m 0.09 − 0.04
(bii) – assume bond finance Value of equity V g = V ug + TB V g = A$2,542m + (A$250m x 25%) = A$2,605m Value of equity = A$2,605m – A$250m = A$2,355m Cost of equity
D k eg = k eug + (1 − t ) (k eu − k d ) E 250 ) × (9 − 5) = 9 + (0.75 × 2,355 = 9 + 0.32 = 9.32 That is, k e = 9.32%
WACC g =
E D + k d (1 − t ) k eg × D+ E D+ E
2,355 250 + 5(0.75) × 9.32 × 2 , 605 2 , 605 = = 8.43% + 0.36% = 8.79%
(c) Under MM theory with taxes, introducing debt finance reduces the cost of capital. This is supported by the calculations in part (b). It can be seen that the WACC has decreased from 9.00% to 8.79%. When the cost of capital decreases, the value of the company will increase as there is an inverse relationship between cost of capital and company value. Indeed, we can see from the calculations in part (b) that the value of the company as a whole has increased from A$2,542 million to A$2,605 million. This is an increase of A$63 million which represents the PV of the tax shield on the new debt.
When looking at the value of equity however, it appears to fall from A$2,542 million to A$2,355 million – a fall of A$187million. So why is the value of equity lower if ADS issues the undated bond rather than raising new capital using equity? The reason is that the shareholders will contribute A$250 million of equity capital if the stores are financed by equity but will not need to contribute any funds if the stores are financed by debt. Overall shareholder wealth has therefore increased when the cash contribution is taken into account. Scenario
Value of equity A$ million
Shareholder wealth A$ million
2,542 -250 = 2,292
From the table we can see that if equity is used the total value of the equity will be A$2,542 million, however to get this shareholders will need to spend A$250 million – hence overall shareholder wealth will be A$2,292 million. However, if debt is used the shareholders would not need to use any of their existing wealth and the value of their equity will be A$2,355 million. The difference in wealth is A$63 million which represents the tax benefit from debt – all of this benefit going to the shareholders. Therefore, under MM’s model with corporate tax, the fall in the value of equity should not be of concern to the Directors since overall shareholder wealth has increased by the value of the tax shield. In ‘real life’, the traditional view is more likely to hold. That is, the impact of additional debt on the WACC will depend on the current level of gearing. WACC will follow a “U” shape and, once the bottom of the curve has been passed, any increase in gearing is likely to create an increase in the cost of capital (due to the increased risk to the investors) and therefore a decrease in the value of the net assets of the company. Under certain circumstances, especially at high levels of gearing, it is therefore possible that shareholder wealth could decrease, but this is only likely to happen at exceptionally high levels of gearing.