Fundamentals of Finance - Essay Example

FUNDAMENTALS OF FINANCE Swindon Plc. is a company that drills oil from the North Sea for a wide base of industries and also processes oil-related products (i.e. kauchuc) for a wide range of industries ranging from toy-makers to car industries. A new project idea came in from the Chief Operating Officer that proposes that the company moves to new, much more efficient and sophisticated, floating drilling platforms (high specification drills and their platforms) that will allow for the drills to travel relatively quickly around the seas for drilling their own oil and thus expanding to other markets. The company’s current drill and platform was purchased 3 years ago for £10M. The firm depreciates the machine using MACRS over a 5 year recovery period, when the assets are replaced due to very high maintenance costs. The company’s management estimates that after removal costs are taken into consideration, this platform can be sold for £3.5M. The company can also buy a new high specification platform at a cost of £14M plus installation costs of £1M and still has an estimated life of 5 years. If they decide to go ahead with this purchase then the company’s working capital needs will change; accounts receivable will increase to £1.5M, accounts payable will also increase to £1M and inventory will increase to £2M. Swindon is expected to be able to sell the new, proposed machine at the end of the 5-year period for £4M while the present machine at the end of the same period is expected to generate £2.5M. All else equal, the company expects to recover their Net Working Capital Investment at the end of the same period. The company’s tax rate is at 40%. The existing machine is expected to net £3,500,000 each year for the next 5 years. Along with the C.F.O, the Operations Officer has also laid down the estimated cash flows of the company from the new drilling platform as follows: YEAR CASH INFLOWS 1 £3,500,000 2 £4,000,000 3 £6,000,000 4 £8,000,000 5 £12,000,000 The company is financing its operations through a mixture of sources namely equity, bonds and also has set some earnings aside. More specifically: 1) DEBT: the company can raise an unlimited amount of debt by selling £1,000 par value, 6.5% coupon interest rate, 10 year bonds on which annual interest payments will be made. To sell the issue, an average discount of £20 per bond needs to be given. There also is an associated flotation cost of 2% of par value. 2) PREFERRED STOCK: the company can raise an unlimited amount of preferred stock under the following terms; (a) the security has a par value of £100/share, (b) the annual dividend rate is 6% of the par value, (c) the flotation cost is expected to be £4 per share. The preferred stock is expected to sell for £102 before cost considerations 3) COMMON STOCK: the current price of IOWA Corporation’s common stock is £35/share. The cash dividend is expected to be £3.25/ share next year. The firm’s dividends have grown at an annual rate of 5% and it is expected that the dividend will continue at this rate for the foreseeable future. The flotation costs are expected to be approximately £2/share. IOWA can sell an unlimited amount of new common stock under these terms. 4) RETAINED EARNINGS: the company expects to have available £100,000 of retained earnings in the coming year. Once these retained earnings are exhausted, the firm will use new common stock as the form of common stock equity financing. REQUIRED: A) Calculate the specific cost of each form of financing The following are the costs of financing over the period: B) Calculate the single Break Point associated with the firm’s financial situation. This point results from exhaustion of retained earnings. It is a very short period: C) Calculate the weighted average cost of capital under 2 scenarios: C1): WACC associated with total financing below the break-point calculated above in part (B) C2): WACC associated with total financing above the break-point calculated in above in part (B) D) What happens when WACC is computed using Book Value Weights instead of Market Value Weights? Why? Explain. In the case of debt financing, there is no effect, with the assumption that the debt rating does not change. That is because the market value is set at the beginning of the debt assumption, and will not change afterwards. In the case of preferred stock or common stock, the WACC is also not changed, as there is no change in market value of stock in the assumptions. Once the WACC has been calculated, estimate: a) The project’s Initial Investment The initial investment is £17.4MM. This investment includes the upfront capital cost (£14MM) plus installation charges, plus the changes in working capital (plus A/R change, plus Inventory change, minus A/P change). This investment is net of the financing costs, which will increase the amount that needs to be raised (see the model). b) The project’s Operating Cash Flows (inflows) Inflows are as follows, before infusion from investment c) The project’s Terminal Cash Flows Discussion This case illustrates the relative costs of capital, but it does so in a bit of a vacuum. This essay will cover the analyses of the various cost alternatives, as well as additional assumptions that might have to be introduced in order to make this a more real-world example. Concerns about the Assumptions The assumption is that a company has been in operation for 3 years, and has saved only 100K in retained earnings despite earning a pre-tax 3.5MM every year. It is likely that such a firm, facing a major acquisition, would have saved more. The only use, therefore, for the assumption of purchase 3 years ago is in order to calculate the tax effects of the remaining depreciation. In a more real-world example, there would have been more retained earnings; in all likelihood, such earnings would have been required for subsequent bank or stock financing: no bank would consider a 17.4MM investment with such a low equity cover. The second problem with the assumptions is the time period involved. A preferred stock offering is in effect a payment of a given dividend rate in perpetuity. In order to calculate the true cost of the investment in preferred stock, one would have to calculate the present value of all the future payments of 6% interest to a significant number of years. The third problem is the assumption that the old rig would be sold at 8 years of age rather than 5. Although the case mentions a different net salvage value at the end of 8 years, this flies in the face of the earlier assumption that the rig only lasts 5 years. The author did not consider the case of selling the old rig after 5 years, as the continued use of the rig would cost only an additional 1MM for the three-year period of time (3.5-2.5MM). The same would hold true for the new rig; i.e. if the new rig were held for 3 years longer, it might provide a higher cash flow (particularly given the assumptions of increasing revenues in out-years). This case calls for a WACC, but in fact the cost of capital is discreet. In a real-world example, the bond buyers (banks, others) would demand a certain debt/equity ratio, which would require a mix of debt and equity to raise the needed funds. It would not be as simple as taking the two lowest-cost capital sources (debt + preferred stock), because in calculating coverage ratios many debt buyers would view the Preferred Stock as a debt obligation. The “trick” of the CFO would therefore be to get as much low-cost capital as possible, while meeting the debt/equity requirements of the debt buyers. Taxes do change the assumptions. The Black-Scholes model assumes that, without the tax calculation, there is no difference between debt and equity financing costs (Lauterbach 1990). Led by the Yale School of Finance, that equity costs are actually higher than had been previously thought, partly due to the perpetuity and increasing expectations for dividends and other forms of returns (acquisition premium, etc.) (Ross 1988). A related concern is that debt and equity value risk differently, with preferred stock falling somewhat in the middle. Adding a beta to the certainty of debt and/or dividend coverage would make the pricing more related to real-world market influences (Easton 1985). Choices Made in these Models The first choice was the method of depreciation. It is obvious that the 200% DB MACRS is more advantageous than the 150% or straight-line MACRS calculation. On a summary basis, there is no difference. On a NPV basis, however, the difference is significant. The 200% basis means that there is more depreciation earlier in the life of the capital asset, which means a better tax break earlier, and therefore a higher NPV as compared to a more gradual depreciation schedule. Since the assignment did not ask for a weighting based on NPV, the author chose the more “aggressive” basis, as that would give better returns. The second choice was to recapture depreciation at the end of 5 years. It is likely that tax authorities would ask for a return of the difference between the amount depreciated (which is the total capital cost) and the amount realised through sale at the end of the period. If this is not the case, due to special tax regimes, the sale of the rig would bring even higher returns. The third choice is to look for a balloon payment of the debt at the end of the five years. Since there is no assumption of an on-going business, one cannot assume that there would be new rig purchases, rather, the debt-holders would insist that they were paid off before the company shut its doors. If such debt repayment were not required, and in the light of significant increases in rig revenues in outer years, it is more likely that the CFO would choose to keep the debt obligation open, reducing the need for additional capital as the company acquired yet more rigs. The case discusses an increase in working capital associated with the acquisition of the new rig. This makes sense, as increased revenues and costs would necessarily cause an increase in A/R and Inventory, while also increasing to some extent the offsets of A/P. In the real world, it is likely that one could obtain debt based on this increase in working capital, probably at a cost which is lower than for other debt. That is because (depending on the credit-worthiness of the payers and the market value and liquidity opportunities for the inventory), these assets are more liquid, less risky and more short-term than other forms of debt. Thus the WACC may be broken into at least two portions: working capital-related debt obligations, and rig-related debt obligations. The concept of “break point” here is used as a calculation of retained earnings against the requirement for new cash to cover expected investments. At time 0, the cover is very low—only 100K versus 17.4MM in requirements. Since the former is only ½% of the latter, the break point analysis does not lead to different conclusions than an assumption of the overall cash investment needs for the business. The case makes a fairly facile assumption that all three cash-raising strategies are available to the company at time 0. Given the higher cash flows expected from the new rig in out years, and the low amount of retained earnings, it may make more sense for the CFO to wait for 1-2 years. Under that assumption, the company has gained a net 3.5MM per year, and the revenue for the new rig per year would be on an upward slope after year 2. On a net present value basis, the following cash flows are much more interesting: Existing Case After 2 years Year 0 -15 Year 1 3.5 Year 2 4.0 -15 Year 3 6.0 6.0 Year 4 8.0 8.0 Year 5 12.0 12.0 The above case assumes, of course, that the opportunity cost for that two-year period would be covered by other, equally interesting investments. A cursory evaluation of NPV or IRR would reveal, however, that the “after two years” case would bring better time-adjusted returns than the existing case. Conclusion The Weighted Average Cost of Capital is a good way to evaluate the relative benefits of various types of financing. It does not, however, indicate the total cost and returns of investments. By introducing a time factor, and making assumptions about perpetuity, there is a significantly different outcome. Bibliography Easton, P. D. "Accounting Earnings and Security Valuation: Empirical Evidence of the Fundamental Links." Journal of Accounting Research, 1985: 54-77. Lauterbach, B. and Schultz, P. "Pricing Warrants: An Empirical Study of the Black-Scholes Model and Its Alternatives." The Journal of Finance, 1990: 1181-1209. Ross, S. "Comment on the Modigliani-Miller Propositions." The Journal of Economics Perspectives, 1988: 127-133. Read More