Corporate Financial Strategy - Case Study Example

CORPORATE FINANCIAL STRATEGY Introduction Two cases on corporate financial strategy were assigned to be analyzed based on the principles of corporate finance. The first case was on making choices as to where to invest given several options of mutually exclusive events. The second case was on analyzing dividend policy as practiced by the company and how well this policy contributed to the overall wealth of the stockholders. Two sets of questions were answered after analyzing each case, applying whatever principles were learned during the course. 2. The case of Chesterfield Wanderers The company was considering investing an excess fund of £1 million. Its choices were on the acquisition of a star player who could increase gate receipts, and on improving its facilities which could offer premium audience section to corporate clients. Both options were mutually exclusive events, and each option has corresponding advantages and disadvantages. Consider the following facts of the case: Option 1: Acquire Bassa Ramsey, a central defender, at the cost of £1 million. Such investment will increase gate receipts by 250,000 on the first year and 130,000 on the succeeding years. It will also increase sponsorships and advertisement revenues. Moreover, the company will receive 220,000 for releasing Vinnie Smith to a rival company. This incremental increase on the cash inflow of the company is compared against the incremental increase in the cash outflow, which included increase in the annual salary paid to players to the tune of 40,000 (Ramsey will be paid 80,000 while Smith is being paid 40,000). Loyalty bonus for Ramsey at the end of the five-year contract will also cost 20,000 more (Smith to receive 20,000 while Ramsey will be paid 40,000). These figures are tabulated below to analyze the net cash flow: Option 1 - Acquire Bassa Ramsey Y0 Y1 Y2 Y3 Y4 Y5   Cash Inflow Gate Receipts 250,000 130,000 130,000 130,000 130,000 Advertisement and sponsorships 120,000 120,000 120,000 120,000 120,000 Transfer Fee 100,000 Sale of Vinnie Smith 220,000 Total Cash Inflow 220,000 370,000 250,000 250,000 250,000 350,000   Cash Outflow Cost to acquire Bassa 1,000,000 Net increase in annual salary – Bassa 40,000 40,000 40,000 40,000 40,000 Net loyalty bonus 20,000 Corporate Tax - 10% 37,000 25,000 25,000 25,000 35,000 Total Cash Outflow 1,000,000 77,000 65,000 65,000 65,000 95,000   Net Cash Flow (780,000) 293,000 185,000 185,000 185,000 255,000 Cumulative Net Cash Flow (780,000) (487,000) (302,000) (117,000) 68,000 323,000 NPV 62,942 IRR 13.23% At the end of the fifth year, investment on acquiring Ramsey would have produced a cumulative net cash flow of 323,000. Considering the time value of money, this project would have a net present value (NPV) of 62,942, and an internal rate of return (IRR) of 13.23%. Since this option produced a positive NPV and an IRR that is higher than the project’s 10% cost of capital, it would be recommended that this project is a viable investment. But that is only viable if there are no other options available. Will the £1 million investment on acquiring Ramsey the best option available to Chesterfield Wanderers? Consider option 2: Invest the accumulated funds of £1 million in improving the ground facilities. This investment involves the construction of an “all-seated area and ‘executive boxes’” which would help realize an additional stream of income in the amount of 400,000 beginning the second year of the project. Unlike the first option where cash out of £1 million is immediate (beginning of the project), the second option requires only the entire cash out at the end of the first year of the project. The figures for the second option are tabulated below: Option 2 - Improve ground facilities Y0 Y1 Y2 Y3 Y4 Y5   Cash Inflow Increase in gate receipts - 400,000 400,000 400,000 400,000   Total Cash Inflow - - 400,000 400,000 400,000 400,000 Cash Outflow Construction cost 1,000,000 Corporate Tax - 10% - - 40,000 40,000 40,000 40,000 Total Cash Outflow - 1,000,000 40,000 40,000 40,000 40,000 Net Cash Flow - (1,000,000) 360,000 360,000 360,000 360,000 Cumulative Net Cash Flow - (1,000,000) (640,000) (280,000) 80,000 440,000 NPV 141,152 IRR 16.37% The second option produced a net cumulative cash flow of 440,000, an NPV of 141,152, and an IRR of 16.37%. All are positive indicators to suggest the acceptability of the second option. However, comparing these figures to the first option, it would be clear that the second option is the better option, considering that the second option will produce the higher NPV and IRR. The above computations considered the two cash flow components – the initial investment of £1 million and the subsequent operating cash inflows. According to Gitman (1987:436), these two components represented the project’s “relevant cash flows”. He further elaborated that these cash flows are viewed as the “incremental, after-tax cash flows attributable to the proposed project”. Considering the figures in the two tables, these therefore represented “how much better or worse off the firm will be” in each option the company chooses to implement (Gitman, 1987:436). Since the firm has only limited funds to invest, it must make a decision by ranking independent or mutually exclusive investment options. In the case above, Chesterfield Wanderers must ranked the projects in order to choose the best option. If there were only one project being considered, it only has to make an “accept-reject decision” based on certain financial criterion (Gitman, 1989:437). Taking into account the above figures, it is recommended that Chesterfield Wanderers rank the second option, invest in ground facilities, as the best option, while investing in acquiring Ramsey as the second best option only. Both options produced positive NPV and IRR higher than the cost of capital of 10%. However, the second option produced better NPV and IRR compared to the first option. The second option also produced a higher net cumulative cash flow at the end of the fifth year compared to the first option. The above recommendations to Chesterfield Wanderers are based on financial principles or decision rules when one is choosing options among mutually exclusive projects. Brealey et al summarized the following principle: When you need to choose among mutually exclusive projects, the decision rule is simple: Calculate the NPV of each alternative, and choose the highest positive-NPV project. (Brealey et al, 2007:186) Companies also prefer to compute the IRR alongside with the NPV. According to Brealey et al, “companies…ask whether the project’s return is higher than the opportunity cost of capital (2007:188). Thus the second rule where the recommendation above is based is given by Brealey et al, Invest in any project offering a rate of return that is higher than the opportunity cost. If the opportunity cost of capital is less than the project rate of return, then the NPV of your project is positive. If the cost of capital is greater than the project rate of return, then NPV is negative. Thus the rate of return rule and the NPV rule are equivalent. (Brealey et al, 2007:189). Thus it is recommended to the Board of Directors of Chesterfield Wanderers to invest on improving its ground facilities since it will give a better pay-off after five years compared to investing in the acquisition of Ramsey. 3. The case of Dambata PLC Dambata PLC operates a chain of supermarkets in Scotland and is listed in the stock exchange in the last five years. Eighty percent of the company is publicly owned while the remaining 20% is owned by the management and a venture capital organization. In the last five years from 2002 to 2006, it has posted an erratic trend of dividend pay-off, while its profit after tax steadily increased in the last four years. Year Profit After Tax (£ 000) Dividend (£ 000) No. of Shares (000) 2002 4200 220 1000 2003 530 140 1000 2004 650 260 1500 2005 740 110 1500 2006 880 460 1500 However, one would also see that while the company posted a consistent after tax profit growth, it is not doing well in terms of growth rate. From 2003 to 2004, profit after tax increased by 22.64%. The following year, it only increased by 13.85%. And on the last year, while it grew by 18.91% compared to preceding year, it is still below the growth rate posted in 2004. While in absolute figures profit after tax is progressive, it did not do so in a sustainable growth rate. In terms of dividends, one would see at first glance the erratic nature of its growth rate. Dividends fell from 2002 to 2003, then it increased by almost 100% by 2004, fell more than 50% by 2005, and recovered by more than 300% by 2006. It would seem that the company has no consistent dividend policy, and the company probably subscribes to the theory that dividend policy is irrelevant to the value of the firm judging by the way it declared its yearly dividends. In 2002, the number of shares was only 1,000,000 up to 2004, when it increased by 50%. And since then, the number of shares remained unchanged for the last three years. Even with the erratic performance of dividends over the years, shareholders have remained consistent in their subscription. It would seem that shareholders are indifferent on the level of payoffs received each year. Based on the residual theory of dividends, “dividends paid by a firm should be viewed as a residual – the amount left over after all acceptable investment opportunities have been undertaken” (Gitman, 1987:509). If this theory were to be applied to the case of Dambata PLC, it could be speculated that the payoffs given to shareholders became erratic because they were only the residual amount from the retained earnings distributed to shareholders after the firm’s investment opportunities have been undertaken. Gitman further added that “the required return to investors, k, is not influenced by the firm’s dividend policy – a premise that in turn suggests that dividend policy is irrelevant” (Gitman, 1987:509). Hence the consistency of the number of shareholders despite the erratic payoff levels. The ‘clientele effect’ of the company’s dividend policy seemed to have attracted a special class of investors wherein dividend levels do not affect decisions of investors to hold on to their shares. Shareholders of Dambata were not worried about payoff cuts in 2003 and 2005, when they continued to hold on to their shares. The ‘clientele effect’ suggested that firm would “attract stockholders whose preferences with respect to the payment and stability of dividends correspond to the payment pattern and stability of the firm itself” (Gitman, 1987:509). This is exactly what has been demonstrated in the case of the Dambata PLC. A certain type of dividend policy, the fixed-payout-ratio policy, has been adopted by a number of firms. This payout policy pays stockholders with dividends in a regular fashion computed from a certain percentage of the firm’s current earnings. Applying this to Dambata PLC’s pattern of payoffs, one could see that this has not been the dividend policy adopted by the firm, as evidenced by the irregular pattern of profit to dividend ratio for the last five years. Another type of dividend policy is the constant dividend payout policy, and the steadily increasing dividend payout policy. Both policies are not applicable to Dambata PLC, since these two policies assume a regular dividend in each period and dividend are “almost never decreased” (Gitman, 1987:509). Dambata PLC has experienced substantial payout cuts in 2003 and 2005. As cited by Cayanan (1998:207), there are two main thoughts on dividend policies. The theory of Miller and Modigliani (MM Dividend Irrelevancy Hypothesis) suggested that “dividends are irrelevant”, while there are those who believe that dividends “affect the value of the firms” as suggested by the Bird-in-the-Hand theory of Gordon and Lintner, and other theories such as the Signaling Hypothesis. While Dambata PLC probably subscribes to the ‘dividend policies are irrelevant to the firm’ school of thought, it is also worth considering that most companies are better off with the other school of thought, which believes that dividends are relevant to the firm. The Bird-in-the Hand theory suggested that “a dividend received today is preferred to an uncertain dividend expected in the future” (Gordon and Lintner, as cited by Cayanan, 1998:212). Relating this to the record of the business over the past five years of Dambata PLC, it would seem that prospective shareholders run the risk of uncertainty for future dividend payouts due to the erratic, as against a more stable dividend level of the firm. Shareholders, who are generally risk-averse, are expected in this school of thought to “discount the dividends received in the future at a higher rate that incorporates an appropriate risk premium” (Cayanan, 1998:212). The Signaling Hypothesis, on the other hand, proposed that firms “give importance to the dividend decisions because of its information value to investors” (as cited by Cayanan, 1998:213). In other words, dividends indicate or “signal” the “profitability information and growth prospects of the firm.” Applying this theory to analyze the performance of Dambata PLC, one would notice the propensity of the company to cut dividends into almost 50% of previous level, then doubling it up in the next year. Firms are expected to maintain a “pattern of dividends that reflects …long term financial performance of the business” (Cayanan, 1998:213). In the case of Dambata, it has not established a sustainable level of dividends over time, considering the less than variable level of profit after tax of the company. Only a certain type of investors would probably hold on to the shares at Dambata, such type of investors who are more concern on the stability of the firm rather than on stability of dividends. Managers of Dambata PLC are better advised to maintain a dividend policy that could sustain a payoff level, if it is to attract mainstream investors. Stockholders may not be concerned at all on what dividend level is maintained, but on the dramatic increase or decrease of dividends on succeeding years. A stable dividend policy would indicate information to prospective shareholders about how managers of the firm will ensure how shareholders’ wealth can be attained in some future time. 4. Share repurchases or buybacks Firms engage in share repurchases or buybacks for a number of reason, but due mainly on the excess cash these firms have accumulated over time. A firm would engage in buybacks “to return surplus cash to shareholders; alter the gearing level to optimal level, and hence reduce WACC; increase earnings per share and share price; support share price during periods of temporary weakness; prevent or inhibit unwelcome takeover; and buy out hostile shareholders.” For example, a firm that has large amount of “unwanted cash, or wishes to change its capital structure by replacing equity with debt, will do so by repurchasing stock rather than paying out large dividends” (Brealey, 2007:436). Moreover, it is said that shareholders would generally prefer stock repurchase plans as announced by companies rather than be worried by the thought that excess cash “will be frittered away on unprofitable ventures” (Brealey, 2007:436). An example of stock repurchase as a corporate financial strategy to avoid an unwelcome takeover or buy out hostile shareholders is the one that happened with Liberty International on 5 June 2000 when its largest shareholders, Stanbic and LGL, announced that it had “entered into a conditional arrangement with British Land to sell 93.5 million ordinary shares in Liberty International to British Land” (Liberty International, 2000). For its own reason, Liberty International did not believe that selling the shares to British Land would be to the best interests of the company. Hence, it offered a deal with Stanbic and LGL for a stock repurchase, which would give Stanbic and LGL a better deal than the proposed plan to sell its shares to British Land. The Board of Liberty International has therefore put forward alternative proposals to Stanbic and LGL that Liberty International should instead repurchase for cancellation 93.5 million of the ordinary shares held by Stanbic and LGL for a cash consideration of 575 pence per share, at an aggregate cost of £537.6 million. In addition, Stanbic and LGL would be entitled to the interim dividend of 10.25 pence per share, making a total consideration of £547.2 million. (Liberty International, 2000) Among the possible effects of the stock repurchase included the following: increase pro forma net asset value per share at 31 December 1999 by over 40 pence to approximately 741 pence per share; increase by approximately 43% the proportionate interest in Liberty International of shareholders other than Stanbic and LGL. leave Liberty International with a widely spread share register in the hands of the public with no dominant shareholding, avoiding any potential value destruction from the over-hang and/or uncertainty created by a major shareholding block, whether held by Stanbic and LGL or British Land, and particularly in the case of British Land which is a competitor of Liberty International; prevent British Land from effectively blocking alternative offers for Liberty International or in due course obtaining control without paying a full control premium. Another company that recently announced its stock repurchase plan is the Morgans Hotel Group Company, which is listed in the Nasdaq and operates a hotel in London. On 7 December 2006, it announced the repurchase of up to US$50 million worth of common stock. It was the first ever repurchase program of the company, according to Ed Scheetz, its president and CEO. According to him, "Our balance sheet and existing capital resources, including capacity under our revolving credit facility and significant cash flow, give us the financial flexibility to implement a share buyback. Todays announcement reflects our Board of Directors confidence in Morgan Hotel Groups strategy and the significant opportunity to enhance shareholder value by repurchasing some of our stock based on market conditions." (Morgan Hotel, 2006) The stock repurchase plan was made in the open market and some were through private negotiations with stock holders. 5. Bibliography Brealey, R.A., Myers, S.C., & Marcus, A.J. 2007. Fundamentals of corporate finance. New York: McGraw-Hill Cayanan, A.S., Ybañez, R.C., Ilano, A.R., Echanis, E.S., Aragon, B.M., Santos-Valderrama, H.A., Bautista, C., Camba, J., Estrella, C.R., Jacinto, R.N., & Pagmolutan, R. 1998. Philippine corporate finance. Manila: Raintree Publishing Inc. Gitman, L.J. 1987. Basic managerial finance. New York: Harper & Row Liberty International PLC EGM to Seek Authority to Buy Back Shares. 2000. Liberty International. [Online]. Available: http://ww7.investorrelations.co.uk/liberty/news/release.jsp?l1=4&l2=9&ref=13 [17 August 2007] Morgans Hotel Group Announces $50 Million Stock Repurchase Program. 2006. Morgans Hotel Group. [Online] Available: http://phx.corporate-ir.net/phoenix.zhtml?c=194863&p=irol-newsArticle&ID=940307&highlight= [17 August 2007] Read More