Managing Corporate Finance - MBA Programme - Research Paper Example

 Table of Contents Table of Contents 2 Task1. 4 Income Pattern- 4 Strategic investments/ divestments- 6 Dividend Policy- 7 Expenditure position- 9 Analysis of capital structure- 10 Restructuring 11 Task 2. 12 Shareholders and creditors- 12 Conflict of interest between the shareholders and creditors- 13 Society- 13 Conflict of interest between society and company motives- 14 Task 3. 16 Financial Services Authority- 16 European Union Competition Commission- 17 Task 4. 18 Reference 24 Bibliography 31 Task1. Identify and assess the major corporate financial developments at British Energy over the past twelve years (to include key income streams, strategic investments/divestments, expenditures and other disbursements). To what extent have these been influenced by general economic trends, sector specific trends, political and other issues, including internal organizational factors. British Energy is the largest electricity producer in UK with a nuclear output of 51.2TWh in 2007. The company is also the lowest emitter of carbon in the country. British Energy was formed as a result of the privatization policy implemented by the British government in 1996 through the merging of Scottish Nuclear and Nuclear Electric. Income Pattern- From the very early days of its formation, the company was performing better than most of its peers. This is evident from the sales performance of the company between the periods 1996 to 2001. The gross margin earned by the company in the year of its formation was £130 million. It was able to generate £130 million as Profit Before tax in the first year itself. This was mainly due to the financial assistance of £1304 million (Competition Commission-a, 1996 to 2000; Competition Commission-b, 1996-2000). With a net debt component of £679 million in the capital base and £700 million as equity capital the interest coverage ratio of the company was comfortably placed at 46.0 times in 1996. (Competition Commission-a, 1996 to 2000; Competition Commission-b, 1996-2000). However, this ratio could not be sustained for long as in the immediate year it fell to 6.7. This may be due to the additional debt of £262 million issued by the company in 1997. But in the following two years it discharged its debts worth £10 million and £176 million respectively. Interestingly, even after the discharge of this debt, the interest coverage ratio declined to 6.7 times. This may be due to the influence of macroeconomic factors like increase in interest rates. The interest rates prevailing in UK in 1996 was in the range of 6 - 6.25 %. For most part of the year the monetary authority kept reducing the interest rate by 0.25 percent. But thereafter the interest rates in UK started moving upwards. It reached up to 7.25 percent by the end of 1997. This was an increase of 100 basis points over the last year (Houseweb, 2009). This appears to be the main reason for the high interest amount paid by British Energy in 1997. Despite the outstanding increase in the profits compared to the last year the interest expense of £50 million put a pressure on the earnings of the company reducing the interest coverage ratio from 46.0 in 1996 to 6.7 which was the lowest for the period of five years. The ratio was 23.7 in 1998 and again went down to 7.2 in the next year, moving up to 60.1 in the year 2001. The revenue of the company moved up to £2124 million in 2001 but it started a downward trend thereon. It reached to its lowest level of £482 million in the financial year ended 31 March 2005. The impact of the lowered revenues was also felt on the pre-tax profit margins which kept falling successively and reached up to £57 million in 2001. This could be mainly due to the deregulation of the sector in March 2001. Besides this the overcapacity reduced the wholesale prices to below the costs of production. BE had to bear a levy on climate change even though its nuclear plants did not emit any CO2 (World Nuclear Association, 2009). After this the company was running in losses till the next two years. It recorded a loss of £4292 million in the financial year 2002-03. The Executive Chairman tried to assure the investors of the financial stability of the company but this did not pay off as in the Financial Services authority suspended the dealing of British Energy shares. This forced the company to seek government support of £650 million. The shares of the company got delisted in October 2004. The profit position of the company started improving from the same year. It reported an operating profit of £135 million in 2005 (ABCmoney.co.uk, 2005). This was mainly due to an increase in the wholesale price of power that nearly doubled over the previous year. Its impact was seen in the financial year 2006-07 as the pre-tax profit of the company moved to £796 million The company got listed again in January 2005 owing to capital restructuring. This pushed up the valuation of the company to £1.46 billion as the shares of the company reached £286p. Strategic investments/ divestments- The company invested £32 million in a joint venture in 2000. In 2001 the company entered into a £500 million joint venture with Amec in Outer Hebrides (UK Business Park, n.d.). This increased its net investment in joint venture to £46 million. The company entered into an alliance with British Nuclear Fuels in 2002 for the replacement of its old nuclear plants with the latest power stations. This increased its net venture investment to £87 million in 2002 In November 2002, British Energy planned to wrap up its nuclear power operations in Canada. This was followed by a sale of 82 percent of its stake in Bruce Power of Canada in December 2002. As a result of this divestment the company’s net investment in ventures fell to £71 million in 2003. The disposal of Canadian venture resulted in sale proceeds of £262 million for the company. For the financial year 2004-05, the company realized £109 million from the sale of its subsidiary undertaking. Since, then the company continuously reduced its venture investments. This resulted in a regular cash flow for the company which was used for acquiring properties and equipments. From the cash realized due to the sale of the subsidiary, fresh acquisitions of £10 million were made in 2005, followed by purchase of property and plant worth £215 million in the next year (British Energy Group plc, 2005-06; British Energy, 2002-03). Dividend Policy- The company paid its first dividend of £13.7 in 1998. It recorded the highest pre-tax profit in the year at £532 million. Despite the fall in the EPS of the company from £71p per share in 1996 to £26.6 p in the next year it kept on increasing the dividend payout ratio in the following years. The DPS went up to £14.7p and £16.0p in the next two years. In 2000 it paid a dividend of £8p per share and maintained the same ratio for the coming two years even though its profits fell sharply from £225 million in 2000 to £57 million in 2001. Even when the company incurred losses of £493 million in 2002, it continued with the DPS of the previous two years of £8p (British Energy, 2000-2001; British Energy, 2001-2002). The reason for this can be the fear of a fall in the share price. It has been seen that the share prices dip in the event of any reduction in the DPS of a company. This is called the signaling effect. The investors view dividend reduction as a negative sign. An increase in dividends is presents a rosy picture about company prospects whereas a dividend reduction is seen as a gloomy forecast (Stern, Chew, 2003). To avoid this, the managers of the company try to keep a stable payout ratio. It seems that the management of British Energy was guided by the same belief and hence declared a dividend even during the lean phase to keep its market value intact. The company did not declare any dividend in 2003 as it incurred a loss of £4292 million in that year. In the following year it made a pre-tax profit of £232 million but no dividends were declared by the company. The following graph suggests that the company did not declare any dividends after this period. . Figure-DPS Trend over the last 12 years. The EPS of the company started recovering from financial year 2005 and remained positive in the following years. It slipped in the negative region for the financial years 2002 and 2003 as is evident from the graph below. Figure- EPS Trend over the last 12 years. Expenditure position- The company invested nearly £5348 million in the fixed assets in the year of its formation and maintained nearly the same level of fixed assets over the next few years. However, there was a marked decline in the amount of fixed assets in 2003 with a fall to £686 million and £931 million in 2003 and 2004 respectively (British Energy, 2003-2004). But the following year witnessed an increase in the fixed assets to £1994 million with the company acquiring nearly £35 million worth of tangible fixed assets. In the financial year 2005-06 the company made a fresh capital expenditure of £220 million increasing its fixed asset base to £1539 million. The company made renewed investment of £235 million in the fixed assets in 2007. In this year the fixed asset investment of the company stood at £ 1541 million. It purchased Property and equipment worth £224 million in this year and disposed off intangible assets resulting in a cash inflow of £21 million. Analysis of capital structure- British Energy had started its operations in 1996 with an equity capital base of £700 million and debt (Creditors due after one year) of £2486 million. It maintained high levels of debt for all the following years. This increased to £2807 million in 2001. There was no significant decrease in the debt position of the company over the next two years. The shareholders fund of the company was £1542 million in 1996. There was no significant decrease in its value over the next three years. In 2000, the company brought back shares worth £82 million which decreased the shareholders fund to £1313 million. There was no fresh issue of equity keeping the shareholders fund stable in the next year. But the high loss of 2002 reduced it significantly. During this period the company incurred a heavy loss which nearly halved the value of shareholders fund. This remained negative over the next two years as a result of high losses. The called up equity share capital of the company reduced from £277 million to just £56 million in 2005 and remained roughly at the same level in 2006. It reached £58 million in 2007 with an increase in the shareholders fund from £1538 million in the last year to £2056 million in 2007. The rising profits of the company increased the shareholders fund from £1615 million in 2005 to £2056 million which is a rise of nearly 33 percent (British Energy Plc, 2004-2005). Restructuring In response to the financial assistance asked by the company, the Department of Trade and Industry in 2004 decided to take up a large portion of the company’s liabilities. The main aim behind this was to restructure the company so that the maximum amount could be provided towards meeting the liabilities. The creditors of the company acquired the majority of the shares in the company under the restructuring process. (National Audit Office, 2006). The deteriorating profits of the company nearly pushed the company to the brink of insolvency. Instead of spending money on the upkeep of its plants it was trying to pacify the investors by paying dividends during the lean phase, adding on to its debts (London Evening Standard, 2009). For rescuing the company from the near bankruptcy position, a massive amount of its debt was swapped for equity and the company once again got listed in 2005. From the above analysis, it shows that the company was relying heavily on debt. This excessive exposure to debt increased the financial risk of the company. If a company keeps on increasing its debt ratio the financial risk of the shareholders increases (Brealey, 2007). As a result of the financial burden, the profits of the company started falling. It eventually started incurring losses due to which it approached the government for financial assistance. The restructuring process that ended in January 2005 uplifted the profit position of the company to some extent. Task 2. Classify the major stakeholder groups involved with British Energy and assess their situation throughout the period in question. Identify and review areas where conflicts of interest may exist. The stakeholders of the company include the shareholders, creditors, society, etc. All of them have an interest in the company and are impacted by its activities. Shareholders and creditors- In the initial years of its formation the company tried to keep its shareholders happy by announcing higher dividends. Even after the fall in its profits in 2001 the company maintained the previous year’s dividend of £8p per share. In the following year the company incurred a loss of £493 million but it still continued with its past payout ratio. For this the company went on increasing its borrowings which ultimately put the company in a near bankruptcy position. It sought government assistance to come out of the crisis. Its share eventually got delisted in 2004 when the market capitalization of the company dropped to £32 million. The profitability of the company improved considerably after restructuring and it once gain got relisted in 2005. Since, then the EPS of the company reached the record level of £81.5p in 2007. (British Energy Group Plc, 2006-07). The company maintained a high level of creditors from the very beginning and went on increasing it. This increased the interest obligations of the company putting a pressure on its earnings capacity. Its interest expense kept on mounting from £50 million in 1997 to £67 million in 1999 bringing down the interest coverage ratio to 7.2. The level of creditors consistently remained high for all the years signifying the company’s increased reliance on debt. Conflict of interest between the shareholders and creditors- The overexposure of debt is detrimental for the shareholders resources as both the classes of investors have different aspirations. While the shareholders demand for a cautious approach in investing because their capital is at stake in the company, the creditors on the other hand want the company to undertake risky projects so that it can earn higher profits. So there is a conflict of interest between the shareholders and the creditors. They get a priority over the shareholders in payment and as such remain protected (Kaen, 2003). As the debt component of the company increases it puts the company into serious financial bindings. While the company is legally bound to honor its debts irrespective of its profitability but there is no such legal compulsion on the company towards the shareholders. It pays dividends only when it is able to earn sufficient amount of profits. In case of a loss no dividend is declared by the company. Society- The company has been responsible towards the society as is evident from its image as the lowest emitter of carbon dioxide. It has consistently worked towards improving its environmental policies. Its activities are guided by the following- Minimizing the impact of its activities through pollution control, waste reduction and efficient utilization of resources. Developing a sense of responsibility among its workers. The company assesses the effect of its activities on biodiversity and continuously thrives towards improvement. Besides following the regulations the company has set high standards for itself (British Energy, 2009). Studies have shown that nuclear has a very low carbon content compared to coal or gas. So the activities of the company are comparatively less harmful to the environment (British Energy, n.d.). Conflict of interest between society and company motives- However, the environmental friendly activities put a pressure on the earnings of the company as it has to continuously conduct new studies for the development of more advanced technologies. This is in the interest of the society but comes in the way of the profit maximization motive of a business. Usually the research of this nature amounts to huge capital expenditure thus wiping out a vast portion of the company’s profit. The company worked towards establishment of improved living conditions for its workers for ensuring their safety. It opened up new offices and entered into various alliances thus creating a number of job opportunities in the country. In 2000, it announced its plans of starting offices at Barnwood in Gloucester. This was expected to create 1000 new jobs (UK Business Park, n.d.). As the company started making losses in 2001-02 it announced plans to cut-off nearly 400 jobs in its UK based nuclear power generating business. In 2004, the company relocated its main office headquartered in East Kilbride to Livingston resulting in a loss of nearly 80 jobs. Once it was able to obtain financial assistance from the government, the profitability position of the company improved and it made the announcement of recruiting 230 more staff for its power plants. Task 3. Identify the regulatory bodies involved in these events and critically assess the strengths and weaknesses of their respective performances. The regulatory bodies involved in the events are Financial Services Authority and European Union Competition Commission. Financial Services Authority- The Financial Services Authority (FSA) is the regulator of UK financial markets. It is governed by four basic objectives consumer protection, putting a check to financial crime, marinating confidence among the market participants and creating awareness among the people about financial system. The responsibility of maintaining clean and orderly markets lies with the FSA and it enables the retail consumers to get a fair deal on their financial investments. The FSA was concerned about the accuracy of BE’s announcement regarding its financial condition. Despite making severe losses in 2002 the statement of the company officials about the stability of the financial conditions was doubted by the FSA. As a result the regulatory body set up an investigation team to verify the authenticity of BE’s statements and to verify whether the company had followed the Listing Rules. The investigation proved to be in favor of the company as the FSA could not find any evidence of breaching of rules. It conducted an extensive operation and assessed that the company needed to make significant changes in its policy relating to commercial environment for restoring its UK business (FSA, 2003). The regulatory body helped the company by acquitting it from the false disclosure accusations relieving the investors from the panic about the financial worthiness of the company. (Harrison, 2002). The regulatory authority failed to check the excessive financial exposure of the company which was primarily responsible for its deteriorating results. This risk was discounted off by FSA without much proper investigation. This proved to be a major weakness in the performance of FSA’s regulatory activities. European Union Competition Commission- The commission is mainly responsible for promoting competition in the country’s economy. It has to ensure that the consumers get a fair deal. Its operations are funded by Department of Trade and Industry (DTI) and it functions independently from the government. The consumers are benefited by the activities of the CC in the form of lower prices, improved quality of services and innovative products. Besides this the CC has the power to order inquiries in the transactions relating to markets and mergers (Competition Commission, n.d.). The commission was in charge of assessing the feasibility of state intervention in the financial assistance of British Energy. Such packages are governed by the subsidies rule of EU. This aid was questioned by the companies generating non-nuclear power as they viewed it as unfair (N-Base, n.d.). The commission failed to exercise price control that was in the interest of the British consumers. Task 4. What lessons can be learnt from the events at British Energy with respect to financing and regulation of major organizations in the public/ private domain? What are the implications for other organizations (refer to a specific project in either your own native country, one with which you are familiar or one that you have researched in the area of PUBLIC FINANCIAL INITIATIVE / PUBLIC PRIVATE PARTNERSHIP [PFI/PPP]? The success and growth prospects of a business depend on how the company manages its finances. Every company must thrive towards achieving an optimal capital base with an ideal mix of debt and equity. Special care must be taken by the management while designing the financial policy of the company. Any undue reliance on one source must be avoided. If the company is overexposed to debt it can prove to be a financial burden for the company. This leads to mismanagement of the liabilities. Similarly, issuing too much of equity dilutes the ownership of the company. At times the equity shareholders interfere in the affairs of the management. The financial support of the government for British Energy generated confidence in the industry. It helped to restore the company’s trading position in UK as well as abroad. The company was severely impacted by the rising fixed costs, low prices and it is mainly due to these factors that the company sought assistance from the government. This helped the company to recover from the reducing turnovers and falling profits. The company was assured of protection from the administration. With the government agreeing to underwrite the company’s liabilities, the company was relieved of limited exposure to such costs. As a result of the restructuring process the company had to shift its focus on the indigenous business. This gave a chance to the company to emerge as an important low cost generator with the ability to compete with the other producers. The financial support granted by the government was mainly for stabilizing the position of the company amidst the financial disturbances. There was a risk that the financial aid granted by the government could be used for paying remuneration to the Directors. In order to avoid this, necessary amendments were made in the Memorandum. The memorandum required the Board members of British Energy to evaluate the directors’ performance. This required the appointment of a partnership director. After privatization the Department of trade and industry viewed British Energy as just another company. Its approach of monitoring the activities of the company got narrowed. It viewed the special dividends declared by the company to be a positive sign and did not participate effectively in the monitoring of the company activities. Dividends on the other hand do not indicate good financial health for a company. All this highlights the necessity of a closer observation of the private sector in a PPP. This is important for protecting the tax payer from the risks. The collaboration between private companies and public bodies is referred as public-private partnership (PPP). This is undertaken by the government authorities to improve the functioning of the public services. It has been seen that the public services companies are not properly managed by the government officials. On the other hand the private companies are in the hands of highly skilled professionals who efficiently handle the affairs of the company. The only constraint for private companies is dearth of capital. Due to this they have to forego growth opportunities. The scenario is totally opposite for the public services companies. They get enough financial support from the government but are often accused of wasting the valuable resources. So PPP is the ideal method of combining the specialties of both the sectors. Nowadays there is an increasing cooperation between the two sectors. This can ensure the supply of best possible services for the consumers at the lowest possible prices. It has even been extended to hospitals and schools which were until now completely in the public domain. The advocates of PPP claim that it will improve the quality of services (BBC News, 2003). Implications of PPP for other organizations- In March 2003, the Department for Transport in UK finalized on PPP for the upkeep of London Underground stations, tracks, trains and signaling. It entered into PPP with Metronet Consortium and Tube Lines Consortium. As a part of the PPP, the responsibility of safety and operations lies with the London Underground whereas Metronet Consortium and Tube Lines Consortium are in charge of maintenance and renewal of infrastructure. The main reason for this alliance was London Underground’s inability to carry out the effective upgrades. The supporters of PPP felt that the inclusion of private sector in the public transport will remove the loopholes in the public services. They opined that the latter will be able to bear the risk effectively. But there was one section which viewed that this kind of alliance will not be in favor of the public as they felt that the private companies will be more concerned about making profits. They will negate public interest and reduce their investments in order to make financial gains. The PPP went into doldrums after the demise of Metronet. This cost the UK government heavily nearly £2 billion. The companies forming the alliance with Metronet had to bear the debt of £70 million individually for clearing the debts of the Consortium. After this a deal was struck with the government in 2003 by way of which the companies acquired protection from bearing further liability. This was ultimately borne by the tax payers of the country. After the collapse of Metronet, its responsibilities were taken over by Transport for London. The efforts of the government to find a new private firm in place of Metronet went in vain (House of Commons Committee of Public Accounts, 2004-05). Annexure Yearly performance of British Energy £m 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Turnover 1,654 1,870 1, 954 2,067 2,058 2,124 2,049 1,903 1,516 482 2593 2999 Pretax Profit 130 532 276 226 225 57 (493) (4,292) 232 54 599 796 Dividend per share - 13.7 4.7 16 8 8 8 - - - - - Fixed assets 5,348 5,158 ,945 4,743 5,224 5,045 4,714 686 931 1994 1539 1541 Stocks 762 615 566 558 587 560 514 360 350 331 - - Debtors 186 221 227 214 807 752 1,143 - - 4809 - 530 Creditors 832 792 768 637 1,358 975 1,185 1,447 3576 1 15 (British Energy, 2004) Reference Houseweb, 2009. UK Interest Rates. Available at: http://www.houseweb.co.uk/house/market/irfig.html [Accessed on December 17, 2009]. World Nuclear Association. 2009. 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