F3 Financial Strategy. Examiner s Answers

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1 Strategic Level Paper F3 Financial Strategy November 2014 examination Examiner s Answers Question One Rationale Question One focuses on the key influences on company value and shareholder wealth in respect of a confectionery company. It considers the possible impact on performance and hence company value arising from a change in focus from selling through its own stores to selling through external supermarkets. The consequences for lender assessment of creditworthiness is also examined, together with the evaluation of possible alternative sources of finance. Question One tests syllabus areas A1 (b), 2 (c) & (d), B1 (e) and C1 (c). Suggested Approach In part (a), begin by extracting the 2013 revenue from the preseen and increase this by the forecast increase in sales revenue. Then proceed to calculate the cost of sales based on the gross profit margin provided and calculate the resulting gross profit. The finance income can be copied across from 2013 figures as both the interest rate and the cash balance are unchanged. However, the finance charge needs to be changed in line with the increased level of borrowings. Apply the interest rate provided to the new borrowings figure to arrive at the finance charge for Finally apply the tax rate and arrive at a figure for profit after tax. The new share price can be calculated by simply multiplying the PE ratio provided by the profit after tax figure for 2014 that has just been calculated and then dividing by the number of shares in issue. In part (b)(i), list the main types of intangible asset and consider which apply to Y and the nature and importance of each item to Y. Then advise on the risk to Y in terms of profit and, hence, company value as a result of the possible reduction in brand value and returns arising from the shift in focus to the sale of products through external supermarkets. In part (b)(ii), consider the key influences on share prices and which might apply in this scenario, explaining each in turn. Financial Strategy 1 November 2014

2 In part (b)(iii) begin by calculating key ratios that are of interest to lenders such as gearing, interest cover and debt/operating profit for both the years ending 31 December 2013 and Compare your results and use this as the starting point for an evaluation of lenders possible reaction. Then consider other factors that are of interest to lenders such as long term prospects and the quality of the management team. In part (b)(iv), evaluate each of the possible alternative financing schemes, considering the benefits and drawbacks of each and summarising your findings in a conclusion or recommendation. It would be useful to start your answer with an analysis of the interrelationship between investment, dividend and financing decisions before considering each of the options in turn. (a) Year ended 31 December 2013 Year ending 31 December 2014 Revenue (increase 20%) 248, ,307 Cost of sales (128,523) (184,950) Gross profit (38% in 2014) 120, ,357 Operating costs (up 5%) (90,239) (94,751) Operating profit 29,827 18,606 Finance income (unchanged) Finance costs (4.3%) (5,008) (5,169) Taxable profit 24,939 13,557 Tax at 23% (5,736) (3,118) Profit after tax 19,203 10,439 Before profit warning After profit warning Profit after tax 19,203 10,439 Market cap at P/E of , ,829 Share price EUR 3.39 EUR 1.84 (a fall of approximately 46%) Report to the board of directors From: Finance Director Date: 20 November 2014 Purpose of Report To evaluate some of the key issues arising from the recent change of sales focus from own stores to external supermarkets. (b)(i) Nature of unrecognised intangible assets Y relies heavily on a number of important intangible assets to fulfil its mission statement To delight customers by providing luxurious products which strengthen the brand. As stated in the mission statement, the most important unrecognised intangible asset is the brand itself and Y s reputation for quality and excellent service. The value of the brand relies heavily on: Quality of the product. Perception as a luxury product. Excellent customer service/experience when purchasing the product. November Financial Strategy

3 Another significant unrecognised intangible asset is the skill and experience of the staff in developing and delivering quality products that customers want to buy and which they believe to be luxurious. Risks to Y s market value from the increasing focus on the sale of products through external supermarkets rather than Y s own stores Greater focus on sales through external supermarkets will potentially have an impact on the strength of the brand as Y will no longer be able to provide the same high level of customer service that it aims to provide to people who visit its own stores. In addition, the purchasing experience will not be the same for the customer and hence Y will have to be more dependent on quality and perception as a luxury product in terms of driving the brand value. There is a real danger that association of the product with the everyday, basic food products typically found in supermarkets could damage the brand image. A gift of a box of chocolates that can be purchased in a supermarket as part of a weekly food shop may not be valued by the recipient in the same way as a box of chocolates that required a special visit to one of Y s own stores. The increasing focus on sales through external supermarkets also creates other important risks to Y s bottom line, which is likely to have an impact on its market capitalisation value. For example: Lower profit margin (higher sales volumes therefore do not necessarily translate into higher profits, the additional volume of sales would have to be significant to achieve this). Additional promotional costs (eg paying for prominent end of aisle displays and for TV advertising). Reorganisation costs arising from the closure of stores and development of infrastructure to support sales through supermarkets. However, balanced against these added costs is the significant gain by eliminating the major cost of operating dedicated own stores, which will only begin to be realised in the current year as the store closure programme continued throughout the year. (b)(ii) Possible reasons why Y s share price did not fall as low as predicted by the result in (a) on 1 November 2014, the day the profit warning was announced. Shares are valued on expectation of future results rather than solely on the next set of accounts. Shareholders are interested in long term investment prospects and shares are said to represent the present value of all future shareholder returns. The market was clearly not anticipating such a reduction in profits as confirmed by the profit warning because the share price fell by 35% on the day of the announcement. However, Y s share price did not fall as low as predicted by the result in (a). Possible reasons for this are as follows: Investors recognised that Y incurred significant one-off costs in 2014 to close some of its own stores and in promoting sales of own products through external supermarkets via a major marketing campaign. These costs will not be repeated indefinitely in the future. Investors may expect Y s prospects to improve in 2015 onwards, after the refocusing of the business has been completed and volumes of sales through external supermarkets have increased further. Increase in the P/E ratio to reflect the lower risk profile of the restructured business. Financial Strategy 3 November 2014

4 (b)(iii) Key performance measures and other factors that the banks are likely to consider when reviewing Y s refinancing request Potential lenders are primarily concerned about the ability of the borrower to pay interest and repay the principal on the due dates. The lenders would carry out thorough research into Y s creditworthiness. This would include looking at: Cash flow forecasts. Arguably the most important data, to help determine whether the company can be expected to be able to make the payments due under the terms of the borrowing. Financial position (capital structure and current debt portfolio). Gearing is important. The bank and, indeed, the credit agencies will have set criteria on how gearing affects the interest rate or whether they are willing to lend at all. Financial ratios (such as interest cover, debt to EBITDA) also provide important information on creditworthiness. Acceptable levels of interest cover and debt to earnings ratios will also depend on the type of industry and the sensitivity of revenue and cost streams to changes in economic conditions. Credit ratings issued by specialists in the field of assessing creditworthiness provide a useful benchmark. Indeed, there is empirical evidence of a strong correlation between credit rating and interest charged. However, these would not be relied on exclusively. The banks will carry out their own credit assessment. External credit ratings are likely to be one of a number of factors that are taken into consideration when assessing creditworthiness. Growth prospects are a particularly important element of cash forecasts to warrant separate review. Industry trends and competitor information are relevant here. An experienced and competent management team is necessary for a company to achieve its objectives. A change in CEO, for example, can have a significant impact on company value. Control of risk has moved up the agenda since the recession. Banks are looking for companies that can demonstrate a thorough understanding and robust policies for identifying and mitigating risk. Uncontrolled risk is often a key factor in the demise of businesses, leading to default on borrowings. Covenants that exist on other borrowings and could be imposed on the new borrowings. Some of the key ratios that lenders would be interested in are shown below: Gearing (D/D+E) at market values Gearing (D/D+E) at book values Interest cover (operating profit / interest) Debt / operating profit Based on 2013 figures and share price of EUR % =116,484/(116, ,007) 57.7% =116,484/(116,484+85,343) 6.0 times = 29,827 / 5, times = 116,484 / 29,827 Based on forecast 2014 figures and share price of EUR % =120,220/(120, ,937) 58.7% =120,220/(120,220+85, ) 3.6 times = 18,606 / 5, times = 120,220 / 18,606 Based on forecast 2014 figures and calculated share price of EUR % =120,220/(120, ,829) 58.7% =120,220/(120,220+85, ) 3.6 times = 18,606 / 5, times = 120,220 / 18,606 Workings: 211,007 = 3.39 x 31,122 x 2 114,829 = 1.84 x 31,122 x 2 136,937 = 2.20 x 31,122 x 2, where 2.20 is 65% of 3.39 (765) = 10,439 (profit after tax for 2014) 0.18 x 31,122 x 2 (dividend) Examiner s note: Calculations based on net debt and/or net interest were given full credit. November Financial Strategy

5 (b)(iv) A company has finite cash resources which are likely to change each year as a result of cash generated by the business, cash outflows (e.g. dividends, investment and repaying borrowings) or cash inflows (e.g. sale of assets and new sources of finance). Investment, borrowings and dividend activities are therefore interlinked. Cash can be generated by borrowings but it can also be generated by disposals (negative investment such as sale and leaseback) or by holding back a dividend (e.g. pay a scrip dividend). In the case of Y, there is a need for cash resources to pay back borrowings. The key choice here is whether to release cash for use in this manner by replacing a cash dividend with a scrip dividend and/or by sale and leaseback of assets. Scheme A would generate EUR 11.2 million cash (where EUR 11.2 million = 0.18 x million shares). This would make a significant contribution (37%) towards the EUR 30 million required. Scheme B is expected to generate EUR 20.0 million. So, together, these two schemes could be used to provide the full EUR 30.0 million financing required. The key benefits of raising funds using this approach are that this creates a permanent cash resource. Unlike borrowings, these funds will not need to be repaid at a future date. Both schemes also reduce gearing since the sum raised is to be used as a means of reducing the borrowing requirement. Additional benefits and drawbacks of Scheme A - Scrip dividend Benefit: A cost effective method no costs of refinancing or selling properties. Drawbacks: Shareholders rely on dividend income. Shareholders prefer regular dividend payouts. More shares in issue and therefore possibly a greater pressure on total dividend payments in the future. It could create liquidity problems in the future if the dividend per share is maintained since there would be more shares in issue. Additional benefits and drawbacks of Scheme B - Sale and leaseback Benefit: Leasing protects the company from direct exposure to a future fall in the value of the property and from liability for large, unforeseen repairs to the building. It therefore reduces business risk arising from property holdings and provides greater certainty in terms of planning cash resources. Leasing also frees up management time from property issues to focussing on the core business, transferring management of the property portfolio to experts in that area. Drawbacks: From a simple financial viewpoint, it would normally be more expensive to lease properties than to retain the properties and borrow against them. The lessor requires payment for the service provided and risks taken and so the additional cost of leasing of EUR 818,000 is not unexpected. Leasing prevents the company from benefitting from any increase in property prices over and above the forecast increase implied by a break even lease versus buy calculation. However, the company is in the business of selling chocolates, not investing in property, and shareholders would expect the majority of profits or losses to arise from this core business rather than be affected to a significant extent by changes in property prices, whether favourable or unfavourable. Financial Strategy 5 November 2014

6 Question Two Rationale Question Two tests understanding of issues arising on an acquisition of a company that operates in a similar business area. In particular, arriving at an appropriate valuation of a target company taking potential synergistic benefits and integration and transaction costs into account. It also tests understanding of the factors that should be taken into account when deciding on an appropriate offer price and whether or not to proceed with the proposed acquisition. Question Two tests syllabus areas C1 (a) & (c) and C2 (a). Suggested Approach In part (a), first value each company ignoring the possible acquisition. For Company G, this is a simple market capitalisation calculation based on the current share price. For Company H, discounted cash flow analysis is required. Next, repeat these calculations using post acquisition values. Then deduct transaction costs and the costs of integration to obtain a valuation for the combined entity post acquisition. Finally, deduct the value of each company G and H before the acquisition to determine the additional value that is expected to be created by combining the two entities. In part (b)(i), identify ways in which value might be created simply by combining two entities and discuss each in turn in the context of the scenario provided. In part (b)(ii), consider the challenges in realising each of the potential areas of added value identified in (b)(i) above, taking into account any costs and risks arising in each case. In part (c), the simplest approach is probably to draw up a table to show pre and post acquisition values and compare these with the purchase price in order to determine how synergistic benefits are divided between the shareholders of companies G and H. Finally, consider factors other than profit that might affect shareholder value. (a)(i) Pre acquisition Company G: Company H: Total value: Post acquisition Company H: Company G: $ 735 million = $ 4.90 x 150 million shares $ 250 million = $ 15 million / ( ) $ 985 million $ 315 million = $ 15 million x 1.05 / ( )) $ 735 million Deduct costs: ($ 9.85 million) = $ 8 million + $2 million x Total value: $ 1, million This gives a total increase in value of $ million. November Financial Strategy

7 (b)(i) Value can be created by combining two companies through the achievement of synergies and economies of scale. In most business combinations there are likely to be savings generated from combining operations and reducing the amount of resources needed to fund central functions such as human resources, finance and treasury. The cost savings are likely to have an almost immediate impact on the cash flow and hence are likely to be reflected in 5% growth in free cash flow in the first year. Synergies might also arise in respect of the cross-selling of services between the two companies to their respective client bases. It s possible that the directors of Company G anticipate that there are opportunities to enhance the cash flows of Company H by utilising the expertise of Company G, leading to a higher growth rate of 3% a year compared to 2%. (b)(ii) Key challenges in realising the potential added value after the merger: Success depends on the extent that Company H s management and staff accept the transfer of ownership and remain committed to servicing Company H s clients to the best of their ability. Consider introducing an incentive scheme such as a bonus payment or employee share option scheme. It also depends on whether Company H s clients are happy with the new arrangement and are confident of receiving the same level of service as before. The reliability of the forecast improvement in earnings and growth is also key to successful realisation of the potential added value. (c) Consideration paid: $7 x 40 million shares = $ 280 million Comparison of shareholder wealth before and after the acquisition: Company G Company H Total value Before the acquisition $ 735 million $ 250 million $ 985 million After the acquisition $ 760 million $ 280 million $ 1,040 million (= $ 1,040 million - $ 280 million) (proceeds) Share of synergistic benefits $ 25 million $ 30 million Company H s shareholders perspective: Very attractive. Company H s shareholders can expect to receive 55% of the synergistic benefits of the merger which does not seem to be a fair split considering: Company H is the smaller company and contributing less to the merger Company H s shareholders do not carry any of the risks that the synergistic benefits cannot be realised. Company H is unlisted and it is therefore very difficult for the shareholders to realise their investment at all, let alone at such a generous price which is above the company s own bullish value estimates derived from discounted cash flow analysis. Company G s shareholders perspective: Possibly too high a price for comfort. The main reasons for this conclusion are as follows: The reverse of the above: Company G s shareholders take all the risk and contribute most value to the combined business and yet only expect to receive 45% of the increase in value. It is likely that Company H has a higher business risk than Company G despite being in the same industry because of the different client profile. If one customer were to be lost by Company H then this could have a significant impact on cash flow and hence the variability of Company H s cash flows is likely to be higher than for Company G. Therefore it is possible that a higher discount rate should be used to value Company H which would have the effect of reducing its value. Conclusion: The price needs to be reduced. The proposed price is not fair to Company G s shareholders and Company H is potentially over-valued at a discount rate of 8%. Financial Strategy 7 November 2014

8 Question Three Rationale Question Three tests the ability to interpret the impact of a planned rights issue on share price, shareholder wealth and gearing. Question Three tests syllabus areas B1 (b) & (e). Suggested Approach In part (a)(i), calculate the current position and then calculate the TERP at an issue price of both 20% and 30% discount to the current share price. Then calculate shareholder wealth before and after the proposed rights issue based on the TERP calculated above and demonstrating that shareholder wealth remains unchanged. Finally, calculate gearing using the market value of shares together with the value of debt net of the issue proceeds. In part (a)(ii), consider the implications of the proposal on both the company and the shareholders. Then repeat this exercise, this time focussing on the choice of discount rate. In both cases, it is helpful to refer to the results obtained in (a)(i). Part (b) suggests that it is important to re-read the question at this point for additional information on current economic and financial market conditions. The two alternative sources of long term funds can then be considered in turn with that context scenario in mind. (a)(i) 20% discount: Number of shares Value per share Value 600 million $ 1.50 $ 900 million million = 600 million / 3.6, or $ 200 million = $200 million/($1.50 x 0.8) million = ( ) million, or = 600 million x 4.6/3.6 Balancing figure: $1,100 million / million = $1.43 per share $ 1,100 million 30% discount: Number of shares Value per share Value 600 million $ 1.50 $ 900 million million $ 200 million ( $200 million / ($1.50 x 0.7)) million Balancing figure: $1,100 million / million = $1.39 per share $ 1,100 million Overall result: Pre rights issue Post rights issue at 20% discount Post rights issue at 30% discount Share price $1.50 $1.43 $1.39 Shareholder wealth $ 900 million $ 900 million $ 900 million Market value of equity $ 900 million $1,100 million $ 1,100 million Debt value $ 900 million $ 700 million $ 700 million Gearing (D/D+E) 50.0% 38.9% 38.9% November Financial Strategy

9 (a)(ii) Impact of rights issue plus debt repayment Company J Lower risk of default on borrowings. Higher credit rating. Shareholders Increased exposure to the company $1,100 million equity investment (before: $900 million). Reduced risk of insolvency due to lower gearing level and lower level of debt to be serviced. According to Modigliani and Miller, lowering gearing can be expected to increase the cost of capital due to the lower tax shield and greater proportion of more expensive equity finance. However, if gearing before the rights issue was considered to be very high with a high level of insolvency risk perceived by shareholders then it is possible in practice that the cost of capital could actually fall (and therefore company value increase) due to the reduction in this insolvency risk. Choice of discount rate Company J Advantages of 20% discount rate over a 30% discount rate: Fewer shares in issue. Hence lower demands on liquidity to pay dividends in the future. A lower fall in the share price and therefore less of a negative signal to the market. Advantages of 30% discount rate over a 20% discount rate: Lower risk of failure as shares cost less and hence appear to be more attractive at a higher discount rate. Possible reduction in underwriting costs due to the lower risk of failure. Shareholders: No difference in terms of shareholder wealth but a lower purchase cost (resulting from a higher discount rate) may give the appearance of being a better deal. (b) Private placement of shares Appropriateness in current market conditions: In the current shortage of liquidity in the financial markets, there is a risk that a rights issue would fail. This would be a public embarrassment to the company and could lead to a fall in confidence in the company together with a fall in the share price. A private placement avoids this risk. Appropriateness for Company J in general: It also looks beyond the current shareholders, providing a potentially broader investor base and easier access to funds. It eliminates future refinancing risk in relation to this portion of finance equity is permanent finance. As with a rights issue, it is in line with the company s objective of reducing the level of gearing. However, it dilutes the control of present shareholders. If it breaches pre-emptive regulations, the placing could only occur if current shareholders agree. Redeemable preference shares Appropriateness in current market conditions: To the investor, preference shares carry lower risk than ordinary equity as dividend payments and capital repayments rank ahead of ordinary shareholders in the event of failure of the company. This means that they may be a more attractive investment under current difficult economic circumstances. Appropriateness for Company J in general: The company would normally have to pay a fixed dividend due regardless of profit made, so preference shares are more risky for the company if it is facing liquidity issues. Redeemable preference shares are likely to be classified as debt in the financial statements and hence will not ultimately reduce the level of gearing as required by the directors. Financial Strategy 9 November 2014

10 Question Four Rationale Question Four tests candidates understanding and ability to carry out cost of capital and project appraisal techniques that underpin financial management. The specific calculations tested here are investment appraisal, using a standard discounted cash flow approach and also using adjusted present value. The question also tests candidates understanding of the validity of the results obtained. Question Four tests syllabus areas B1 (c) and C1 (b) & (d). Suggested Approach In part (a), use CAPM to calculate the geared cost of equity and then de-gear the cost of equity using the appropriate formulae from the formulae sheet. Then calculate the market value of debt and equity and use the adjusted WACC formula to calculate WACC. In part (b), start by quickly calculating the project NPV. Then start methodically working through the APV calculation. Remember that this falls into 3 discrete sections. Firstly the base case, repeating the original NPV calculation but this time using the risk free cost of equity as the discount rate. Secondly calculate the tax shield and the present value of this in respect of the initial loan, the government loan and the roll-over of the government loan. Finally, calculate the present value of the interest saved in respect of the subsidised loan, on an after tax basis. In part (c), consider the validity of the results. Consider each calculation in turn to see if it reflects the appropriate business risk and/or gearing level and how the saving in respect of the subsidised loan is taken into account. (a) Geared cost of equity Using CAPM, Keg = 3% + (1.8 x 4%) = 10.2% Ungeared cost of equity Using formula Keg = Keu + (Keu Kd) x ((Vd x (1-t)) / Ve): MV of debt = EUR 300 million + (EUR 650 million x 92/100) = EUR 898 million Therefore Vd(1-t) = EUR 898 million x 0.75 = EUR million MV of equity = EUR 1.5 x 600 million shares = EUR 900 million 10.2% = Keu + (Keu 6%) x ((673.5 / 900) Re-arrange Keu = 8.4% Alternative approach, de-gearing the equity beta: De-gear the equity beta: Ungeared beta = 1.8 ( 900 / ( )) ( / ( )) Ungeared beta = 1.35 Lastly, insert into CAPM: Keu = 3% + (1.35 x 4%) = 8.4% WACC WACC = 8.4% x (1 (898/( ) x 0.25)) = 7.35% Alternatively: WACC = [10.2 x (900/( ))] + [6 x 0.75 x (898/( ))] = = 7.35% November Financial Strategy

11 (b) NPV of Project X using WACC: NPV = EUR 28 million / EUR 300 million = EUR million APV of Project X: Base case = EUR 28 million / EUR 300 million = EUR million PV of tax shield: Working EUR million Initial loan for EUR 150 million 150m x 0.05 x 0.25 x (1 / 0.05) Government loan for EUR 150 million 150m x 0.03 x 0.25 x (where = AF 5 year 5% ) Roll over of government loan 150 m x 0.05 x 0.25 x (1 / 0.05) x (where = DF 5 year 5% ) PV of subsidised interest benefit: Working EUR million PV of interest saved 150 m x 0.02 (being 5% less 3%) x Less: PV of tax relief lost 150m x 0.02 x 0.25 x (3.25) 9.74 Examiner s comment: Full credit was given for discounting at the risk free rate. Therefore total APV = EUR 33.3 million + EUR million + EUR 9.74 million = EUR million. (c) Validity of results NPV at WACC: Retail sales have a different business risk profile to the existing business and so it is not appropriate to use Company M s WACC without first adjusting the WACC to reflect the risk profile of the new retail business. The use of WACC rather than using a cost of capital that reflects the project funding is correct. It is normally appropriate to use a cost of capital based on the long term gearing target of the company in preference to the profile of the project s finance if, as in this case, the project is not expected to alter the long term capital structure of the company. However, subsidised borrowing must be taken into account in some way to give the correct picture. This can be achieved by adjusting the project cash flows by the benefit derived from the subsidised borrowings. Conclusion: Suitable if adjust for the both the difference in business risk (e.g. using a proxy beta) and the benefit of subsidised borrowing. APV: APV deals with the benefit of the subsidised borrowing appropriately. However, APV does not take into account the difference in business risk or the company s long term target gearing ratio. Still an issue with the fact that not dealing with business risk appropriately. A proxy should have been used to establish Keu for use in the base case calculation. Conclusion: APV is not useful here since the valuation is based on 100% debt finance for the project rather than the company s long term gearing target. Financial Strategy 11 November 2014