Corporate Financial Management at AstraZeneca Plc - Case Study Example

Question One

The hypothesis for testing

In detecting the random walk of the stocks returns the first approach will be to get the autocorrelation. This will measure the relationship between the return of the portfolio at the current period with its value in the previous period. Autocorrelation is given by:

Where Pk is the autocorrelation of the return of the portfolio. K and N are the observation numbers, rt is the logarithmic return of the portfolio over period r t + k is the return of the portfolio over period t + k and r is the sample of the portfolio and k is period lag. Statistically, the weak market efficiency hypothesis should be rejected should the stock returns (changes in price) are observed to be series correlated Pk is significantly from zero. At 5% level of significance accept the null hypothesis for the portfolio of 5 companies with the steepest positive slope of the regression line representing daily share price movement and conclude that the weak does not exist. The rejection region is on the negative side of the normal table for one-tailed test. For the randomly selected companies, at 5% level of significance fail to reject the null hypothesis and conclude that the weak exist. On the other hand, fail to reject the alternate hypothesis and conclude that the weak form of efficiency exists at 5% level of confidence (as illustrated in excel attached).

Question Two

• WACC for AstraZeneca PLC

WACC

=

E / (E + D)

*

Cost of Equity

+

D / (E + D)

*

Cost of Debt

*

(1 - Tax Rate)

Weight of debt = D / (E + D) (Farber, Gillet & Szafarz, 2006)

Weight of equity = E / (E + D)

Cost of Debt = Interest Expense/ latest two-year average debt

Cost of Equity: RF + b (Mp)

For AstraZeneca PLC cost of equity

The risk free rate = 1.79% (10-Year Treasury Constant Maturity Rate)

Market premium is assumed to be 7.5%

The beta for the AstraZeneca PLC is 0.75

= 1.79% + (7.5% * 0.75)

= 7.415%

The following table indicates the WACC of AstraZeneca Plc. From 2011 to 2015

Year

2011

2012

2013

2014

2015

cost of equity

7.42%

7.42%

7.42%

7.42%

7.42%

debt (billion)

10.14

8.55

9.69

11.11

10.09

Equity (billion)

15.1

14.73

14.04

12.6

12.56

Total capital (billion)

25.24

23.28

23.73

23.71

22.65

cost of debt (billion)

0.27011

0.26884

0.26422

0.25386

0.25658

Average Tax Rate

4.40%

4.40%

4.40%

4.40%

4.40%

WACC

4.8

3.39

7.58

8.57

7.54

• Correlation Analysis Of The WACC And Debt

The correlation between AstraZeneca Plc. WACC and debt is 0.77782616.

• Results Interpretation

This shows that the two variables have a strong positive linear relationship. The traditional theory of capital structure stipulates that optimal capital structure exists when the WACC is minimized, and assets market value is maximized. The theory considers the value of the firm to increase with the level of debt capital up to a certain pint after which it will remain constant and afterward start to decline (Brusov, et al., 2015). This is in line with the strong correlation established between debt level and WACC. The higher the level of debt, the higher the cost of capital and the low the value of the firm. This is also supported by the MM II theory which stipulates that the level of debt in a firm’s capital structure increase leads to increase the return on equity in a linear fashion (Brusov, et al., 2013). As such, higher debt level makes investing in a firm riskier making shareholders demand higher risk premium on the stock of the company.

• AstraZeneca Plc. Planned Acquisition of WuXi AppTec Company

AstraZeneca Plc. plans to acquire WuXi AppTec company manufacturing unit at estimated total price of $100 million. WuXi AppTec is a Chinese partner of AstraZeneca Plc. in research and development. The investment is expected to help the company to tap into the Chinese market with innovative medicines. The acquisition of the company is expected to add $ 15 million in revenue to the AstraZeneca Plc. that is expected to increases at a rate of 17% for the next 8 years. WACC can be used to appraise this project by evaluating whether it will have a positive NPV and an IRR that is higher than the current cost of capital (Zhao, Papanastassiou, & Tan, 2015). For example, with this projected level of revenue, and assuming that the project will have the following expanses,

Annual purchases $0.5 million

Selling and administration expense $2 million

Other income 2 million

Working 5 million

Terminal value 3.2 million

And assuming that the above items will increases by 15 % annually (except terminal value), the NPV and IRR for the project for a period of ten years and using the present WACC of 7.54 would be:

Year

0

1

2

3

4

5

6

7

8

9

10

Initial investment ($ million)

-100

0

0

0

0

0

0

0

0

0

0

Revenue ($ million)

15

18

21

24

28

33

38

45

53

62

Working capital ($ million)

5

6

7

8

9

10

12

13

15

18

Annual purchases ($ million)

0.5

1

1

1

1

1

1

1

2

2

Selling and Admin expenses ($ million)

2

2

3

3

3

4

5

5

6

7

Other income ($ million)

2

2

3

3

3

4

5

5

6

7

Terminal value ($ million)

0

0

0

0

0

0

0

0

0

3.2

Net Cash flow ($ million)

-100

9.50

11.23

13.26

15.66

18.49

21.82

25.76

30.39

35.85

45.48

Discounted cash flow $ million)

-100

8.83

9.71

10.66

11.71

12.85

14.11

15.48

16.99

18.63

21.98

NPV ($ million)

40.96

IRR

8.6%

The evaluation indicates that the NPV is positive, and thus, the project should be undertaken, and the IRR is higher than the coat of capital. As such WACC plays a critical role in project appraisal

Essay 1

Effects of capital structure and cost of capital on returns that Avago Shareholders

Capital structure is a combination of debts, preference shares, and equity. The mix should be appropriately selected when funding a given project to avoid exposing the company into financial difficulties. For example, if a significantly higher proportion of debt is selected it may as compared to the percentage of equity; the company may face liquidity problems. Such problems may also lead to financial distress and consequently reduces the value of the firm. It may make the company less attractive to financiers because most financial institution and suppliers are unwilling to deal with a heavily indebted firm due to the fear of default. On the other hand, when the company has used a significant proportion of its equity in financing a given project such as acquisition project, such company may face two common problems.

The first issue is attributed to tax. Whenever a company has committed a significant proportion of its equity in funding projects, it may heavily tax by the relevant authorities because equity is part of the capital. Secondly, the company may face problems in raising additions funds from the equity market. The problem may arise because most investors may not be ready to buy equity securities from a company that has so many equity stockholders. Investors tend to fear that the share will be diluted and may not have much value. On the contrary, a firm containing a significant proportion of debt financing is more likely to enjoy low taxation because debts are considered as liabilities and tend to reduce the taxation cost. It is prudent for the company to evaluate its capital structure critically and decide an appropriate capital structure. On the other hand, the cost of capital is the rate of return required to carry out capital budgeting decision such as the acquisition of a new firm like in this case of Avago and Broadcom (Merced and Bray, 2015).

The shareholders of Avago, a Singer-pore based company, are more likely to obtain higher returns when their business engages in mergers and acquisition. The company was established in 1961 and operates in the semiconductor industry. It also listed its shares on the stock market in the year 2009. Avago Corporation has been very aggressive in its growth and expansion strategy. One of its key strategies for expansion is via mergers and acquisition. The company is focusing at sticking an acquisition deal to acquire Broadcom at a value of thirty-seven 37 billion dollars by the end of the year 2016. The deal will help shareholders of Avago to obtain a higher rate of return in the future given that the acquired company has sound financial and marketing position than the acquire, Avago. The deal will also help Avago shareholders to be ranked among the top manufacturers of semi-conductors in the industry. It can be observed that the acquisition of Broadcom, a U.S base manufacture of chip established in 1991 will help Broadcom to gain a significant market share and increase shareholders value by 68%. It has been reported that the acquisition of Broadcom will contribute to shareholders of Broadcom to achieve a value of 32 percent which implies that the remaining 68% will be the value that Avago shareholders will gain from the acquisition deal. Besides, research indicates that last year,

Broadcom had a significant market share of 8.4 billion dollars while Avago had a market share of 4.9 billion dollars in the chip making industry (Gumport, 2015). Based on such data, one can observe that Avago shareholders will be the biggest beneficiaries of the acquisition deal which is in line with their company growth and expansion strategy. Also, the combined company is anticipated to increase the value of Average shareholders by maximizing revenue and minimizing the cost. Research indicates that the combined company will cut down its annual cost by seven hundred and fifty million. Besides, the revenues of the combined company per year will amount to fifteen billion dollars (Atallah, 2015).

Method of funding for Avago Technologies can use to bid/ buy/acquire Broadcom’s

There is a various way of funding the acquisition of Broadcom Company by Avago (Acquirer). Some of the common sources of funding include; cash in hand, debt financing from the financial institutions and via equity financing. Also, the retained profits for the acquirer may also be used to finance the acquisition. Research indicates that Avago will use both cash and equity to acquire Broadcom. The funding in the form of cash paid to Avago will be 17 billion dollars while the amount of equity financing will be twenty billion dollars which have an economic value of 140 million ordinary equity. The nine billion dollars cash funding will be generated from financial institutions such as consortium banks.

The consortium banks are preferred because they tend to provide financing for specific projects at a lower cost of interests and flexible repayment plans, unlike other financial institutions. It also helps to eliminate capital gain tax associated with issuing a high number of equity stocks. The acquisition of Broadcom via Cash financing will help Avago Company minimize liquidity risk by ensuring that the acquisition is not financed entirely through debt. Cash funding also portrays the company positive image in the sense that it shows that Avago has a sound finical base to the investors and potentials financials. However, the company also considered financing the acquisition via debt and equity (Öztekin, & Flannery, 2012).

The proportion of debt financing was 17/37*100=45.95% while the percentage of equity funding for the acquisition was 20/37*100=54.1%. It can be observed that the portion of equity financing for the acquisition was higher than that of debt by 8.15 percent. Such proportion was considered appropriate for this acquisition project by the acquirer because it could not adversely affect Avago capital structure. Equity financing was also utilized and is reported to bring various benefits to the acquirer. Some of those benefits are that the company is not obligated to pay a dividend to ordinary shareholders and hence, during the difficult time, the company may not be overwhelmed with obligations to pay a dividend. Besides, Avago cannot be sued by stockholders for not paying a dividend since the company is not obliged to do so.

On the other hand, utilization of low proportion of debt to finance the acquisition of Broadcom was important because it debt financing is an allowable deduction for tax purposes as discussed. Besides, financing via debts offered by consortium banks helps to incur minimal floatation cost as compared to the one incurred when financing through ordinary share capital. Also, debt financing was easier as compared to the equity financing since few legal formalities are involved. Besides, debt financing prevents the dilution of the Avago earning per share and hence making the company to me more appealing to the potential investors (Gumport, 2016).

Critical analysis of the possible effect on the bid structure

The possible effect of the bid was that, the value of the shares of the acquired firm, Broadcom rose by 22 percent unlike in other situation where the announcement makes the value of the shares of the acquired firm decline. A news report indicates that the announcement of the bid by the Avago made the shares rise to 51.15 dollars per share immediately after the bid was officially announced. The possible effects of the increase in the price and value of the shares of the acquired firm are attributed to other offers that were given by other companies. Also, increase demand by the shareholders to be part of the multi-billion companies could have also led to the rise in the value of the stocks during the acquisition.

The bid structure will also bring diversification among the two global manufacturers of semiconductors in the technology industry. It will also lead to the emergence of the third biggest corporation for Semiconductor in the United States and consequently increase the market share of the combined companies. However, based on the analysis it can be observed that the mergers will bring benefits to both of the two companies. However, I would advise shareholder not to support the deal because once the acquisition deal is over; the value of their investment will decline. One of the possible reasons for the decline is because there will be low demand for the company stocks. Besides, other potential bidders who may have contributed to making the company have a higher value by giving higher bids they will be no longer be available to offer more bids. It implies that the acquired company will be acquired at a higher value than its actual value. Such acquisition will make the value of the share decline after the acquisition deal is complete. Besides, shareholders will be holding an undervalued stock which in return exposes them to a huge loss in the long run. Therefore, I would urge Avago shareholders not to support the deal (Ren, 2015).

Conclusion

Conclusively, it can be observed that capital structure is a mix of debt, common equity and preference equity that will bring optimal value to the company. On the other hand, the cost of capital entails the rate of return required by an investor to attain a particular returns level. It can be observed from the Avago company capital structure the source of funding that the firm will utilize to acquire Broadcom will come from equity and debt as discussed. Also, the study has indicated the possible effect of the bid structure. It can be scrutinized that the bid structure will make the value of the company shares rise due to a many numbers of bids and the higher demand for shares. However, after the deal has been closed the value of the shares is expected to fall because during the acquisition the company was bought at a higher value that its real value as a result of numerous offers given by acquirers. Therefore, shareholders of Avago should not support the deal because they will hold over-valued stock which will expose them to risk.