How To Value A Potential Acquisition Of Hf.Com

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1 Strategic Level Paper F3 Financial Strategy March 2014 exaination Exainer s Answers Question One Rationale Question One focusses on an external party a hotel chain, which is hoping to set up a hotel in the vicinity of the Gaes Park in advance of the Gaes. It requires an evaluation of a possible takeover candidate and associated consideration package, taking into account the ipact on the acquirer and also the shareholders of both the acquirer and the target copany. The question concludes with advice on the risks and opportunities that the acquisition ight create. Question One tests syllabus areas A2(d), C1(c),(d) and C2(a). Suggested Approach Part (a)(i) requires a valuation of the target copany on a nuber of different bases. Efficient use of EXCEL can help with this process. Keep workings siple and, preferably, build the into the spreadsheet itself. Reeber that forulae can be typed straight into a cell arkers ark on PC and can therefore uncover the forula used. When carrying out the DCF analysis using certainty equivalents, either pick up the net cash flow figures fro the first DCF calculation and use this as your starting point, or, possibly quicker still, copy and paste the whole of the initial DCF calculation and then ake appropriate changes to that table. Don t forget to deduct borrowings fro your DCF result to obtain the equity value. In part (a)(ii), consider the validity of each ethod in turn. Then identify two alternative valuation approaches which take risk into account. In part (b)(i), begin by carrying out appropriate calculations such as gearing under payent structures A and B and the value of the share offer at today s share price as copared to the cash offer. Then consider each bullet point in turn. In part (b)(ii), suarise your findings in (b)(i), stating which schee would be preferable and why. Then think about any possible alternatives, e.g. a cobination of the two schees where H s shareholders are offered a choice of cash or shares in the hope that at least soe of the would choose shares. In part (c), consider the bigger picture and longer tiefrae, picking out three (and no ore than three) key financial and strategic iplications of the proposed acquisition of H. Don t forget to consider real options in this section. Financial Strategy 1 March 2014

2 REPORT FORMAT To: The Directors of P Fro: Consultant Subject: Evaluation of the proposed acquisition of H Purpose: The purpose of this report is to evaluate the proposed acquisition, including the acceptability of the offer price provided by H, possible fors of consideration and the wider financial and strategic iplications of the acquisition to infor the board of the risks and potential benefits of this acquisition to proote discussion and a decision on how best to proceed. (a)(i) Valuation of H 1. Recent private sale 1 illion shares in issue ties C$ 2.50 paid for each share during recent private sale. That is, C$ 2.5 illion. 2. Asset basis H s equity is worth: C$ illion Hotel building 3.8 Less bank borrowings (2.2) Asset value excl borrowings (= equity value) Bootstrapping H earnings: C$ 270,000 At P P/E of 11: C$ 2.97 illion 4. DCF Year Workings C$'000 C$'000 C$'000 C$'000 C$'000 C$'000 C$'000 Operating revenue 6,205=100x170x365/1000 6,205 9,198 6,205 5,256 4,380 3,322 Variable operating costs 2,190=100x60x365/1000 (2,190) (2,628) (2,190) (1,971) (1,752) (1,533) Fixed operating costs (1,200) (1,200) (1,200) (1,200) (1,200) (1,200) Net operating cash flow (NOCF) 2,815 5,370 2,815 2,085 1, Tax on NOCF at 30% (845) (1,611) (845) (626) (428) (177) After tax NOCF 1,971 3,759 1,971 1,460 1, Renovations (8,000) Tax relief on renovations 25% x 30% x 8, Net cash flow (8,000) 2,571 4,359 2,571 2,060 1, ,149=412/8% 5,149 Discount factor at 8% Present value (8,000) 2,380 3,736 2,041 1, ,506 NPV (C$'000) 5,858 March Financial Strategy

3 5. DCF adjusted for certainty equivalents: Year After tax cash flow fro earlier DCF valuation (8,000) 2,571 4,359 2,571 2,060 1, ,300=412/4% 10,300 CE 90% 80% 70% 60% 60% 60% Apply CE (8,000) 2,313 3,487 1,799 1, ,180 Discount rate 4% Present value (8,000) 2,224 3,224 1,600 1, ,080 NPV (C$'000) 5,677 The valuation results show the following values for H s equity: Method Value of H s equity (C$ illion) 1. Private sale Asset Bootstrapping DCF using P s WACC 3.7 = 5.9 less debt of DCF using CE 3.5 = 5.7 less debt of 2.2 (a)(ii) Validity of valuation ethods used We will first consider the validity of the results obtained in (a)(i) 1. Private sale This is a ore realistic value, being the value placed on the shares by private individuals in a recent private sale. As the sale was copleted just last onth, the price ust have been agreed in full knowledge that the Gaes would be located in the area and therefore took that into account. However, this private sale was for a very sall parcel of shares and therefore to acquire the entire share capital P will be expected to pay a preiu above C$2.50 per share to reflect that fact that control of the copany is being acquired. The current owners ay also hope to benefit fro the additional earnings that P would hope to achieve by upgrading the hotel. 2. Asset basis As expected, the asset basis valuation is the lowest as it only takes into account the arket value of the tangible assets. It does not consider intangible assets such as the value of the custoer base or potential future revenue strea that can be generated and therefore is inappropriate when valuing a going concern such as H. In addition, the last valuation was ade before the location of the Gaes was announced. This would have generated additional value and hence this valuation is likely to be understated even further. Financial Strategy 3 March 2014

4 3. Bootstrapping 4. DCF Bootstrapping takes into account the higher level of returns that P is accustoed to obtaining fro its investents copared to H. Applying P s P/E ratio to H s earnings gives a rough indication of the value of H s earnings strea to P. However, this is only a rough approxiation because the earnings strea is expected to change due to the Gaes and the resultant regeneration of the surrounding area. In addition, H s P/E ratio would only be appropriate if the custoer base is expected to be typical of hotels that H already owns, especially during the period in which the hotel guests are predoinately associated with the running of the Gaes. DCF is based on actual forecast cash flows fro the business and also takes into account the tie value of oney and required returns by discounting at WACC. In this case, the outcoe is likely to be highly unreliable due to the unusual circustances. There is unlikely to be reliable historical data on earnings potential of such a hotel during a one-off event of the sae profile as the Gaes. In addition, the unusual negative growth prediction in years 3 to 6 followed by zero growth in perpetuity ay need to be revisited to deterine whether they are reasonable assuptions and whether any changes can be ade to the business odel to iprove longer ter prospects for Hotel Lodge. 5. Certainty equivalents (CE) Certainty equivalents (CE) are not an appropriate ethod here. CEs are used by copanies in a capital budgeting context rather than in valuing an acquisition target. To quote CIMA s Official Terinology: It involves expressing risky future cash flows in ters of the certain cash flow which would be considered, by the decision aker, as their equivalent, that is the decision aker would be indifferent between the risky aount and the (lower) riskless aount considered to be its equivalent. In addition, there is no autoatic adjustent to increase risk for later tie periods. The 60% CE applied in year 6+ is a flat adjustent for all subsequent years even though the risk to cash flows in year 20 ust be significantly greater than the risk in year 6. This distortion is evident when coparing the results for DCF and CE. Note that the NPV in years 1 to 5 is significantly saller under CE than under the original DCF calculation but is higher for years 6+. Adjusting for risk There are uch ore appropriate valuation approaches for adjusting for risk in the context of valuing an acquisition target. Select any two of the following three alternative approaches when answering this requireent: DCF using a risk-adjusted discount rate Sensitivity analysis Decision tree analysis Risk-adjusted discount rate. A risk-adjusted discount rate provides a ore appropriate approach than CEs, increasing the risk adjustent exponentially, that is, in a copound anner in each year of analysis. Sensitivity analysis can be carried out to evaluate the ipact of a change in one or ore of the input variables. This can be extended into a worst case analysis, looking at the ipact of the worst expected possible outcoe using worst case values for input variables. Decision tree analysis can be used to evaluate the effect of different input variable values, assigning a probability of outcoe to each value. This ethod is best with variables which have discrete values, which is unlikely to occur in practice in the context of a copany valuation. March Financial Strategy

5 (b)(i) - Structuring the consideration The two alternative fors of consideration under review are: A: Pay C$ 4.9 illion cash. B: Exchange 2 P shares for every 1 H share held plus pay C$ 2.2 illion in cash. In this section we will evaluate these fro the viewpoint of the ipact on: P s debt covenant P s shareholders H s shareholders First, soe preliinary calculations underpin the evaluation. Note that these calculations assue that any cash payent is financed by increased borrowings: Asking price for H: C$ 4.9 illion = 2.7 (equity) + 2.2(debt) Market capitalisation C$ 2.7 illion of H: Market capitalisation of P: C$ 23.8 illion (= 9 ties greater than H) = 17 illion shares x C$ 1.40 Nuber of P shares: In issue now: 17 illion New shares under consideration A: 2 illion Total post acquisition under consideration A: 19 illion Gearing calculations Current C$ illion Consideration A C$ illion Consideration B C$ illion Debt Equity Shares (noinal) 8.50 (= 17 x 0.5) (= 19 x 0.5) Reserves Share preiu 1.80 (= (noinal) Total equity Gearing (D/D+E) 46.4% 53.0% 46.1% EPS calculations Current C$ illion Consideration A C$ illion Consideration B C$ illion Earnings C$ 2.16 illion = arket cap / P/E ratio = (17 x 1.4) / 11 C$ 2.31 illion = *4.5% C$ 2.43 illion = Nuber of shares 17 illion 17 illion 19 illion EPS C$ C$ C$ Note: Extra interest only adjusted on the C$ 2.7 illion borrowings on the assuption that P pays the sae interest on the first C$ 2.2 illion borrowings as H and that this is therefore already taken into account within the extra C$270,000 earnings generated by H. Financial Strategy 5 March 2014

6 Ipact on P s debt covenant The debt covenant would not be breached under either for of consideration A or B. However, it would be close to being breached under for A if the cash payent is financed by debt. This ay create probles for P and ay propt P to look at strengthening its capital base by raising ore equity finance, for exaple, in the for of a rights issue. Ipact on P s shareholders A share based offer would be very helpful to P in that it would avoid such a cash squeeze and the potential need to raise ore equity finance. There would, however, be a sall dilution of shareholder control arising fro the issue of P shares to H s shareholders. The dilution effect would, however, be sall since P is approxiately 9 ties the size of H. There would also be a loss in shareholder wealth as copared to the cash offer: The cash payent would be C$ 2.7 illion. 2 illion P shares are worth C$ 2.8 illion. A cash offer would protect P s shareholders wealth and also earnings per share if financed by borrowings. Ipact on H s shareholders A share based offer is unlikely to be accepted by the ajority of the shareholders of H who are said to be keen to realise their investent and are retired or nearing retireent age. They are therefore unlikely to wish to take on the added risk that a share-based offer would bring unless they are confident that they could sell the shares at C$ 1.40 each on receipt. (b)(ii) Recoendation how P should structure the bid offer A cash offer would increase the risk of breach of P s debt covenant and ight create liquidity probles for P and propt the need for additional equity funding. If so, it would be sipler and quicker to offer a share exchange if H s shareholders were willing to accept shares rather than cash. There is a sall sweetener to encourage the to do so, but possibly not sufficient to ensure the success of a share offer. A possible alternative would be to offer a choice of shares or cash, at the shareholder s choice, but with a sufficient financial advantage built into the share offer in the hope that sufficient shareholders would accept the share offer. March Financial Strategy

7 (c) Key financial and strategic iplications of the takeover Strategic location/follow on option. The Gaes provides an opportunity for P to further proote the Park hotel brand by association with successful Gaes. Indeed, with copetitors drawn fro 9 surrounding countries, this provides an excellent opportunity for raising the profile of the hotels internationally and ight be used as a platfor for expanding abroad at a future date. By acquiring H, P would also be well placed to benefit fro the expected regeneration of the area. The up-arket hotel chain should be a good fit within the new business and higher incoe household neighbourhood. Uncertainties. There are huge uncertainties that ipact on the success of the acquisition. These include any factors outside P s control such as the success of the Gaes theselves and of the legacy plans for the area. It ay not attract new businesses and higher incoe households as hoped. As the Gaes only coe to this country every 10 years, it is unlikely that there is any precedent to use to derive or test the estiated future cash flows and profit enhanceent. P needs to assess the axiu risk associated with the worst case scenario and ensure that it could absorb the potential loss that could arise. Absence of a viable abandonent option. If the hotel fails to eet expectations, it could prove extreely difficult, if not ipossible, for P to sell the hotel on to another business. Especially if there are other siilar planned hotel projects in the area with the risk that there is excess hotel roo capacity after the Gaes. Financial Strategy 7 March 2014

8 Question Two Rationale Question Two tests understanding and application of CAPM to derive a WACC in the context of a project. A particular focus is the eaning and interpretation of the equity beta value used in CAPM. The question tests analytical ability by requiring candidates to review a given coputation and identify and correct the errors it contains. Question Two tests syllabus areas B1(c), B2(a) and C3(a). Suggested Approach In part (a), begin by explaining the significance of an equity beta greater than 1 in connection with the arket as a whole. Then identify and then explain the key factors which deterine a copany s beta. In part (b)(i), work through the trainee accountant s coputation to identify the four errors it contains and list these. Explain each error as if addressing the trainee accountant. In part (b)(ii), re-produce the WACC calculation, correcting each individual error identified above. In part (c), consider the ain roles of the treasurer and how each ight be required during both the evaluation and ipleentation stages of the project. Consider first the evaluation stage and then the ipleentation stage. (a) An equity beta value above 1 indicates that a copany s shares have MORE systeatic risk than the stock arket average. That is, that the share price is likely to ove in response to general econoic or arket forces to a greater extent than the arket as a whole. Note that systeatic risk is arket risk and should not be confused with unsysteatic risk which relates instead to copanyspecific risk and, as such, can be diversified within a well-balanced portfolio. Key factors that deterine a copany s beta value include: The nature of the industry and the business risk associated with that industry or industry sector or individual business. A copany s gearing. Higher gearing results in higher financial risk. (Note that the equity beta is ade up of both financial and business risk.) (b) (i) Line 1 No adjustent has been ade in respect of debt beta. Unless debt beta is zero, an adjustent is required. The riskiness of the debt will affect the quoted equity beta and this needs to be taken into account when calculating the asset/ungeared beta. Line 1 The debt figure has not been adjusted for tax. Note that the forula has not been stated correctly. The value of debt should be the post tax value, ie adjusted by ultiplying by (1-t). If you revisit the forula sheet, you will notice that this tax adjustent has been built into the forula shown there. Line is incorrect. The beta used in this forula is the ungeared beta fro the proxy copany rather than VV s equity beta. That is, use the result fro line 1 here. Line 3 Reserves of A$ 2.2 illion should not have been included in the denoinator, since the arket value of equity is siply A$ 6.90 illion (= A$ 2.30 x 3 illion). Note that the arket value of March Financial Strategy

9 a copany s equity is siply the share price ties the nuber of shares. Reserves are only relevant when calculating the book value of equity. Instead, debt of A$ 2.8 illion should have been included as the denoinator of L is the su of debt and equity. (b) (ii) The corrected calculation is as follows: V V [1 t ] E D Line 1 ß u = ß g + ß d V + V [1 t ] E D V + V [1 t ] E D 65 35[1 0.30] = [ ] [1 0.30] = 1.3 x x = Line 2 k eu = r f + ß u (r r f ) = 2% + ( x 5%) = 7.68% Line 3 WACC = k eu [1 tl] = 7.68% x (1 (30% x )) = 7.01% or, alternatively, 7.68% x (1 (30% x 29%)) = 7.01% Exainers note: Full credit was given for an approach involving re-gearing beta at line 2 and using the re-geared beta to calculate a geared cost of equity using CAPM and then calculating WACC based on this geared cost of equity and cost of debt. This gives the sae result. The key roles of the Treasurer are: Cash anageent cash forecasting and efficient anageent of short ter liquidity Funding arranging funding and advising on capital structure Hedging - anaging and advising on foreign exchange, interest rate and coodity risks At the evaluation stage, the treasurer can therefore expect to advise on the financing choices and how these ight ipact on the copany s cost of capital used in the project appraisal. The Treasurer would also evaluate the foreign exchange risks arising fro the project and advise on how best to anage these risks and take account of the residual risks arising in the evaluation of the project At the ipleentation stage, the treasurer would be involved in anaging the day-to-day liquidity deands of the project. This would include ensuring the availability of short ter funds to eet obligations as they fall due, forecasting future cash needs and ensuring that sufficient cash is ade available to eet those needs. In addition, the treasurer would take the lead role in arranging any new long ter funding required, deterining an appropriate source of funds and negotiating ters and covenants. The treasurer would also be responsible for setting up a hedging prograe to anage foreign exchange risk. Financial Strategy 9 March 2014

10 Question Three Rationale Question Three tests understanding of the trade-off between investent, financing and dividend policies. It also tests the ability to interpret arket price oveents and hence copany value as a result of the iposition of a regulatory constraint. This scenario allows candidates to evaluate alternative strategies for financing the capital expenditure forced on the copany by a regulatory change, considering waiving a dividend versus a scrip dividend. Question Three tests syllabus areas A1 (b), (c) and 2 (d). Suggested Approach In part (a), there is a hint in the question that calculations are required and it is best to start with these. LL s arket capitalisation can be calculated at the start and end of business on 21 February and also on 28 February. It is then a siple step to copare this with the extra cost arising fro the regulatory change. This shows that the fall in arket capitalisation exceeds the expected increental costs. This observation should be clearly stated and then explained. Part (b)(i) can be addressed in a nuber of different orders. Perhaps the ost logical is to look at each of the dividend strategies in turn. For each dividend strategy, begin by calculating shareholder wealth before and after the dividend and explain your findings. Next, consider the iplications for LL, focussing particularly on the ipact on its cash position. Dividend irrelevancy theory and the effect of tax differential between gains and incoe and also signalling issues can be useful when exaining the ipact on a typical shareholder. Avoid repetition by just covering these in detail once and just aking reference to the in other parts of your answer. In part (b)(ii), suarise your findings in b(i) focusing on the ipact to LL and provide a recoendation. (a) Following the governent announceent, the share price fell fro $2.20 to $1.95 iediately and then to $1.90 a few days later. With 1,500 illion shares in issue, this is equivalent to a fall in arket capitalisation of $375 illion ( = 1,500 illion shares x ($2.20-$1.95)) iediately and a further $75 illion (= 1,500 illion shares x ($1.95-$1.90)) within a few days of the announceent, a total of $450 illion. That is, a fall in share price of 13.6% (= ($2.20 $1.90)/$2.20) in a single week. The rapid response of the share price to the announceent indicates a sei-strong for of the efficient arket, that is, that the share price should ove after the announceent in order to reflect all publicly available inforation on a copany. However, the arket capitalisation has fallen $450 illion, which is $100 illion ore than the estiated cost of the work which is $350 illion. Possible explanations are that either the arket considers that the final cost will exceed the original estiate or that it anticipates that additional constraints will be iposed on LL in future years. In addition, it could be that the arket perceives that this investent could have a detriental effect on the current productivity of LL, which could daage future profitability. Or, alternatively, this could be an over-reaction in the arket that ay subsequently correct. Herd behaviour can create such an over-reaction, as investors follow the exaple of other investors in selling shares and creating a fall in the share price. March Financial Strategy

11 (b)(i) Waive dividend versus cash dividend Under Modigliani and Miller s dividend irrelevancy theory, shareholder wealth should not be affected by the copany choosing to waive rather than to pay a dividend since there is no difference in overall shareholder wealth. The only difference is that the increase in wealth reains within the value of the share rather than being paid out in cash, which has the effect of reducing the value of equity by the sae aount. This assues that capital gains and incoe are taxed at the sae rate for all individuals and for individuals and copanies and ignores any signalling effect of dividend payents. This can be illustrated by calculation as shown below. The value of the copany reduces by $200 illion, or $0.133 per share on payent of the dividend. The theoretical post dividend cash price is therefore $1.767 per share (= $1.90 $0.133). That is, a fall in shareholder value of $16.0 fro $228 (= 120 x $1.90) to $212 (= 120 x $1.767) for a typical shareholder who holds 120 shares. However, the fall in the value of the shares held of $16.0 is exactly atched by the value of the cash dividend received, also $16.0. If the dividend is waived, shareholder wealth for a typical shareholder holding 120 shares would reain unchanged at $228 (= $1.90 x 120), all other things being equal. That is, overall shareholder wealth is the sae whether or not the dividend is waived. In practice, however, other factors coe into play such as tax differentials between capital gains and incoe and between investors and LL. Market expectations also play an iportant part. One of the arguents for continuing to pay a dividend even if the cash is needed elsewhere is to signal to investors that it is business as usual. However, this would not work in this instance. The large and sudden drop in the share price indicates that investors are expecting lower profits and dividends in the future and shareholders ay not react favourably to the payent of a dividend if they know that this ust lead to either higher gearing or a rights issue shortly afterwards. Scrip dividend of 1 share per 12 held Firstly, soe calculations to deonstrate that, in theory, shareholder wealth is also unaffected by a scrip dividend. Consider a typical shareholder with 120 shares. Under the ters of the scrip dividend, this shareholder would receive an entitleent to one new share for every 12 held. That is, the right to acquire 10 new shares (where 10 = 120/12). This ay give the shareholder the illusion of increased value as he now holds 130 shares. However, the copany itself has not changed in value and so the total value that those shares represent is unchanged. Nuber Unit value Total value Before scrip dividend: 120 $1.90 $228 After scrip dividend: 130 balancing figure, that is, $1.754 (= 228/130) (= $1.90 x 120) $228 (unchanged) That is, shareholder value reains unchanged at $228. Only the nuber of shares held changes: 120 before the scrip dividend and 130 after the scrip dividend. Financial Strategy 11 March 2014

12 (b)(ii) Although it ay ake little difference to shareholder wealth, the waiver of a dividend would enable LL to conserve cash. It would have a significant ipact on LL s cash position. If LL pays a cash dividend of $200 illion, it would need to raise $350 illion rather than a residual $150 illion to finance the required capital expenditure. If this cannot be raised by debt, there would need to be a rights issue, effectively asking shareholders to voluntarily reinvest the aount received as dividend in the business. This could be very costly in ters of underwriting fees if there is expected to be little investor appetite to increase exposure to LL at this point in tie. A scrip dividend has a ajor benefit over a waiver in that it gives the ipression that a dividend has been paid even though no cash is actually paid out by the copany. This benefit ay well be considered to out-weigh the cost and hassle of issuing a scrip dividend rather than siply waiving the dividend altogether. On the other hand, a dividend waiver avoids the significant adinistrative and transaction costs arising fro a scrip dividend. A scrip dividend also has the following disadvantages in coparison with a dividend waiver: A scrip dividend results in a greater nuber of shares in circulation and hence increased pressure for dividend pay-outs in the future (if aintain dividend per share). A scrip dividend has the effect of oving reserves fro distributable to non-distributable by increasing share capital. This reduces the reserves available for distribution as dividends at a future date. This is avoided under a dividend waiver. It can be argued that the best strategy for LL at the current oent in tie is to declare a scrip dividend, especially if LL is heavily geared, as is typical in such industries. A scrip dividend gives the ipression that a dividend has been paid without any cash outflow fro the business. A scrip dividend ight enable soe saller shareholders to reduce their tax bill if country L taxes capital gains at lower rates of tax than incoe, depending on their individual tax position. March Financial Strategy

13 Question Four Rationale Question Four tests the ability to evaluate a lease versus buy decision. It requires a calculation of the increental benefit of leasing versus outright purchase and understanding of the rationale for that calculation in respect of the choice of discount rate. The question also tests understanding of other factors that ight affect the decision. Question Four tests syllabus areas B1 (b) and (d). Suggested Approach In part (a)(i), a preliinary calculation is required to calculate the iplied interest charge under the lease for each year. A su-of-digits approach is acceptable. However, as the question gives the iplied interest rate of 9%, it is arguably faster to apply this interest rate to the outstanding balance year on year in this instance. The next step is to set out a table, labelling coluns with ite, data and then years. Relevant cash flows, including tax relief on payents can then be included here. An increental benefit or cost is required, so payents under the buy/borrow schee should have a different +/- sign to those under the lease. Reeber to exclude actual interest costs. Only tax relief on iplied lease interest is relevant here. In part (a)(ii), explain why GG s cost of debt has been used, distinguishing this financing decision fro an investent appraisal analysis where a WACC-based discount rate would norally be ore appropriate. In part (b), distinguish the two financing schees on the basis of your results in (a)(i) and then consider other distinguishing factors. Financial Strategy 13 March 2014

14 (a)(i) The lease versus buy decision can be evaluated by calculating the present value of the increental post tax financing cash flows at the post tax cost of debt as shown below: A B C D E F G H I J 1 Base Tie 2 data INTEREST CALCULATION 5 Balance b/f Interest at 9.0% Lease payent 1.34 (1.34) (1.34) (1.34) (1.34) (1.34) (1.34) 8 Balance c/f (0.02) 9 10 Tie 11 Base data 13 BUY 14 Purchase asset (6.0) Tax relief 30% VERSUS LEASE - 18 Tax relief on depreciation 30% x 6/6 (0.30) (0.30) (0.30) (0.30) (0.30) (0.30) 19 Tax relief on interest (0.16) (0.14) (0.12) (0.09) (0.06) (0.03) 20 (with tie delay of one year on tax relief) 21 Lease payent Net cash flow (6.0) (0.33) 23 Calculating PV for each year: 24 Discount factor at 5% 5% (= 7% x (1-30%)) 25 Discounted cash flow (6.0) (0.2) 26 Total NPV at 5% Preferred alternative approach using EXCEL NPV function: 28 NPV at 5% 0.48 Using EXCEL NPV function =(NPV(5%,E35:K35)+D35) 29 NPV at 4.9% 0.49 Using EXCEL NPV function =(NPV(4.9%,E35:K35)+D35) 30 where 4.9% = 7% x (1-30%) Conclusion: In this scenario, Schee A to buy outright is cheaper by 480,000 (based on the present value of increental cash flows discounted at the post tax cost of debt). (a)(ii) The decision to invest in the equipent being financed will have already been evaluated taking project specific risk into account. The evaluation in (a)(i) is being used to support the financing decision rather than the investent decision. Cash flows should be discounted at either WACC or project specific discount rate when evaluating the investent decision since the project is financed using the copany s debt and equity resources. However, the financing decision is a separate decision and the discount rate should be tailored appropriately In the financing decision, we can use debt as the base line and copare other fors of finance to the cost of debt by using the cost of debt as the discount rate. The post-tax cost of debt is the March Financial Strategy

15 opportunity cost of leasing and can be used to discount the increental cash flows arising fro leasing as copared to buying outright using this discount rate. Note that it would have been equally acceptable to use leasing as the base instead of debt and hence discount cash flows at the post tax iplied cost of leasing. However, it is generally sipler to discount at the post tax cost of debt. (b) Cost As seen in (a)(i), the buy/borrow approach is cheaper than a finance lease on the basis of the data provided. This is largely due to the higher iplied interest under the finance lease of 9% versus 7% for bank debt. Tax depreciation allowances are also accelerated under the bank debt, with a 100% deduction available in year 1 rather than spread over the 6 year period as in the lease. This ay not be an issue, though, if the lessor can also clai a 100% deduction in year one and builds this into the price of the lease rental. However, it is not clear whether the cost of debt quoted would apply in this case. Indeed, GG ay be able to negotiate a lower rate of interest for a loan secured against an asset. The bank ay also charge a different rate for a fixed rate 6 year loan. Tiing of funding cash flows Under the lease, the funding is built into the lease rentals and hence interest is only charged on the outstanding balance at any point in tie. If a ter loan fro a bank is for a fixed principal value for the 6 year ter, it will involve higher interest costs than shown in the analysis in requireent (a)(i). An aortising loan ay be charged at a higher interest rate. The evaluation in (a)(i) would need to be adjusted to take this into account. Ease of arrangeent A bank loan secured against the asset could be costly and tie consuing to arrange as the bank assesses the value of the asset. In this case, the vendor of the equipent is offering a finance package to ake their product ore attractive to potential purchasers. It ay therefore be quicker and cheaper to arrange a finance lease than a separate purchase agreeent and bank loan in this instance. Additional costs of the bank debt option should therefore be built into the analysis. Flexibility Under the buy/borrow approach, GG owns the equipent outright and therefore has the flexibility to dispose of or upgrade the equipent to reflect future changes and the needs of the business. Such flexibility is unlikely to be provided under the finance lease arrangeent. However, if the lease arrangeent were to include the opportunity to upgrade the equipent, a lease ight prove to be ore flexible than the buy/borrow approach. Without knowing the details of the lease arrangeent, it is not possible to draw any fir conclusions on this issue. Residual value of the equipent Under the buy/borrow approach, GG ay benefit fro residual value of the equipent at the end of the six years. Although expected to be negligible, the equipent ay perfor better than expected and have soe unexpected residual value at the end of the six year ter. This would increase the attractiveness of the buy/borrow approach. Maintenance It is not clear fro the inforation whether the leasing copany would be responsible for the aintenance of the equipent. Given the level of lease rentals it is unlikely that aintenance costs fees are included, however, it is possible that the leasing copany ight provide aintenance at an additional cost, which ight be cheaper than GG s own cost. Equally it ight be that GG would provide aintenance in both situations and therefore this would not be a relevant consideration. Financial Strategy 15 March 2014