The Benefits Behind All Debt Financing Finance Essay - Free Essay Example

This report aims to provide professional suggestions for Riverside Electronics concerning the type of financing for the expansion project, the relative change of dividend policy as well as the implementation of the proposed takeover, with the purpose of improving its competitive position over the post-depression period. Project financing In the face of the new expansion project requiring an amount of  £500m as additional capital, the source of financing, and thus the target capital structure is of crucial importance to the management of the company. This report will evaluate different target capital structures with respect to their influence on the value and profitability of the firm. All-debt financing The benefit of debt Provided that required capital is raised by issuing debt, shareholders of the firm are capable of enjoying the deductibility of interest expenses from the companys tax base, resulting in the increase of the enterprise value. Specifically, the tax saving for Riverside Electronics will be  £18 million  [ÃÆ' ¢Ãƒ ¢Ã¢â€š ¬Ã‹Å"  ]  if all required capital is financed by debt. Applying the cost of debt to discount the value of the tax shield, the present value will be  £200m  [ÃÆ' ¢Ãƒ ¢Ã¢â€š ¬Ã‹Å"  ]  . Hence, tax savings increase shareholders wealth by  £200m. The value of equity will also be increased by 8.9% to  £2450m (200+2250). The enterprise value of Riverside Electronics will thus increase as well. Key profitability ratios With regard to the key profitability ratios in response to the change of capital structure if the firm were to raise all of the capital by issuing 5-year notes, ROE  [ÃÆ'à ‚ ¢Ãƒ ¢Ã¢â€š ¬Ã‹Å" ¡]  and ROCE  [ÃÆ' ¢Ãƒ ¢Ã¢â€š ¬Ã‹Å" ¢]  have been calculated at the current period, before and after implementing the investment. Table 1 ROE ROCE Before 6% 6% After 5.51% 5.19% From table 1, it can be seen that both ROE and ROCE have declined after taking on the project, indicating lower profitability of the firm if all capital needed are financed by debt. The impact of capital structure on the value of the firm Having proved that burdening the firm with debt can add value to the company through tax shield, it is worthwhile to investigate the influence of a change in the debt to equity ratio on the weighted average cost of capital (WACC) of RE, while exploring whether there is a particular capital structure that maximises the enterprise value. In theory, maximising the enterprise value is identical to minimising the cost of capital (Modigliani and Miller, 1958). Table 2 Debt=0 Debt=100 Debt=20 0 Debt=300 Debt=400 Debt=500 Equity=500 Equity=400 Equity=300 Equity=200 Equity=100 Equity=0 VD 0 100 200 300 400 500 VE 2750 2690 2630 2570 2510 2450 VD+VE 2750 2790 2830 2870 2910 2950 WACC 12.1% 11.8% 11.5% 11.3% 11.1% 10.9% Table 2 reflects the effect of leverage on the WACC of the firm. The required rate of return for REs equity is 12.1%  [ÃÆ' ¢Ãƒ ¢Ã¢â€š ¬Ã‹Å"  ]  based on CAPM. It can be seen that the increase on the debt to equity ratio has led to a decrease in the cost of capital of the firm, together with an increase in the value of the firm. Therefore, the optimal capital structure of RE that maximises the value of the firm can be obtained by raising all the required capital by issuing debt. However, the conclusion drawn above is on the basis of one indispensable assumption. Theoretically, it is evident that adding debt to the composition of ca pital structure would help reduce the cost of financing since debt is always cheaper relative to equity. However, the use of leverage will also increase the risk for shareholders, resulting in higher required rate of equity. Consequently, the increase of the expected rate of return on equity will cancel out part, and eventually all of the positive impact in cost arising from the incorporation of debt, leading to the optimal level of financial leverage (Vernimmen, 2009, p.684). In practice, the WACC computed above is under the assumption that the cost of each component stays constant regardless of the level of leverage. Thus the expensive equity is continuously replaced by cheap debt along with the increase of the Debt/Equity ratio, leading to the optimal capital structure lying in the combination of debt and equity of  £500m and  £0m, respectively. Application of Modigliani and Millers Propositions with corporate taxes The first proposition of Modigliani and Miller with co rporate taxes implies that the value of a levered firm is always higher than an unlevered one. Table 3 presents the computation of the enterprise value of unlevered RE over the next five years after taking on the investment. Table 3 Year 1 Year 2 Year 3 Year 4 Year 5 EBIT 292.5 380.25 494.33 642.62 835.41 Corporate income tax at 40% 117 152.1 197.73 257.05 334.16 Depreciation and amrtization 195 253.5 329.55 428.42 556.94 Capital expenditure 0 0 0 0 0 Change in working capital 0 0 0 0 0 Free cash flow 370.5 481.65 626.15 813.99 1058.19 Present value of FCF 330.51 383.28 444.49 515.46 597.77 Sum of present value     2271.51 Present value of TV 5918.54  [ÃÆ' ¢Ãƒ ¢Ã¢â€š ¬Ã‹Å"  ] Value of the unlevered firm     8190.05 According to the MM Proposition I, after accounting for the corporate tax, the value of the levered company is the sum of the unlevered firm and the present value of tax shield, which can be expressed as VL= VU+TC*VD. It can be seen in table 4 that the enterprise value of RE does increase as taking on more debt in its capital structure. Table 4 Debt=100 Debt=200 Debt=300 Debt=400 Debt=500 Equity=400 Equity=300 Equity=200 Equity=100 Equity=0 Tax Shield 40 80 120 160 200 Value of levered firm 8230.05 8270.05 8310.05 8350.05 8390.05 The MMs Proposition II presents the computation of cost of equity after accounting for corporate tax. The formula is given by: In the case of RE, the cost of equity and coat of capital can be computed under different capital structure scenarios  [ÃÆ' ¢Ãƒ ¢Ã¢â€š ¬Ã‹Å"  ]  . As table 5 shows, the cost of equity of RE rises as the debt/equity ratio increases. This tendenc y can be justified by the fact that shareholders tend to demand a higher rate of return along with the increase in debt, since higher leverage implies higher risk for them. By contrast, WACC has been witnessed a downward trend when the proportion of debt in capital structure increases. Therefore, despite the growth in cost of equity, RE will be better off if taking on more debt in its capital structure. Table 5 Debt=0 Debt=100 Debt=200 Debt=300 Debt=400 Debt=500 Equity=500 Equity=400 Equity=300 Equity=200 Equity=100 Equity=0 Debt/Equity 0.0% 1.2% 2.5% 3.7% 5.0% 6.3% Value of equity 8190.05 8130.05 8070.05 8010.05 7950.05 7890.05 Value of debt 0 100 200 300 400 500 Value of the firm 8190.05 8290.05 8390.05 8490.05 8590.05 8690.05 Cost of equity 12.10% 12.12% 12.15% 12.17% 12.19% 12.22% Cost of debt 9% 9% 9% 9% 9% 9% WACC 12.10% 12.08% 12.07% 12.06% 12.04% 12.03% Dividend policy The dividend paid by a listed firm is closely related to the performance of its stock price. Hence, corporate managers tend to place much emphasis on the formulation and modification of the dividend policy. In this report, an evaluation of alternative dividend polices is incorporated so as to ensure the most appropriate one that best fits the status quo of the company can be identified. Residual dividend policy Residual dividends refer to the amount of dividends that can be paid out of earnings after all project capital needs are met. Concretely, table 6 presents the dividend per share that RE can afford to pay when the expansion project is advanced. Different target capital structures are considered in the analysis. Table 6 Debt=0 Debt=100 Debt=200 Debt=300 Debt=400 Debt=500 Equity=500 Equity=400 Equity=300 Equity=200 Equity=100 Equity=0 Retained earnings 135 135 135 135 100 0 Dividends can be paid 0 0 0 0 35 135 Dividend per share(DPS) 0 0 0 0 0.70 2.7 New stock issued 365 365 365 365 0 0 As shown in the table, when the value of debt ranges from  £0m to  £300m, no dividends can be paid since all earnings have to be retained to finance the project. In contrast, when the debt value rises to  £400m and  £500m, DPS increases to  £0.70 and  £2.7 per share, respectively. Why not stop the payment of dividends Apart from the residual dividend policy, stopping the payment of dividends so as to fulfil the capital needs of the project can be another sensible option for the company. For RE, stopping the payment of dividends with the purpose of financing part of the project internally seemingly corresponds to the interests of both managers and shareholders. Specifically, managers of the firm will favour internal financing since this may offer them greater freedom in action. They can avoid dealing with the capital market of complication to some extent. As to shareholders, given the fact that capital gains are taxed less heavily than dividends, they would rather receive returns in the form of capital gains as a result of profit investments instead of dividends (Vernimmen, 2009, p.775). Nevertheless, stopping the payment of dividends may impart potential danger to the firm. First and foremost, numerous empirical studies have shown that there is a significantly positive relationship between dividend changes and stock returns (Woolridge, 1983). It is foreseeable that the stock price of RE will drop dramatically once releasing the announcement of stopping the payment of dividends. Similarly, as Adam Giggs suggested, shareholders are expecting dividends from stocks. They are inclined to reward those more generous shares by willing to pay higher price (Baker and Wurgler, 2004). Paying no dividends goes against shareholders w ishes. Besides, it is widely accepted that the stability of the payout ratio should be given priority with regard to the dividend policy. Thus the extreme action-that is, no dividend is paid-will add uncertainty to the performance of REs stock price. Nevertheless, some other studies have proved that the effect of dividend change on stock price is merely temporary, so corporations can choose their policy in accordance with real needs (Black and Scholes, 1974). Therefore, the suggestion of stopping the payment of dividends should be considered more seriously and comprehensively. The hidden danger of no dividend may pose a threat to the development of the company. Residual dividend policy with stock buyback Johns suggestion of a residual dividend policy accompanied by a repurchase of stock is a proposition worthy of consideration. In an effort to maintain the current payout ratio, table 7 shows figures regarding the amount of dividends and repurchase in line with this divid end policy under different capital structure scenarios. Table 7 Debt=0 Debt=100 Debt=200 Debt=300 Debt=400 Debt=500 Equity=500 Equity=400 Equity=300 Equity=200 Equity=100 Equity=0 EBIT 225 225 225 225 225 225 Interest expenses (9%) 0 9 18 27 36 45 Taxes (40%) 90 86.4 82.8 79.2 75.6 72 Net income 135 129.6 124.2 118.8 113.4 108 Amount of dividends  [ÃÆ' ¢Ãƒ ¢Ã¢â€š ¬Ã‹Å"  ] 40.00 38.40 36.80 35.20 33.60 32.00 Amount of repurchase  [ÃÆ' ¢Ãƒ ¢Ã¢â€š ¬Ã‹Å"  ] 95.00 91.20 87.40 83.60 79.80 76.00 No. shares repurchase  [ÃÆ' ¢Ãƒ ¢Ã¢â€š ¬Ã‹Å" ¡] 2.11 2.03 1.94 1.86 1.77 1.69 No. shares outstanding  [ÃÆ' ¢Ãƒ ¢Ã¢â€š ¬Ã‹Å" ¢] 497.89 497.97 498.06 498.14 498.23 498.31 DPS 0.84 0.80 0.77 0.73 0.70 0.66 To illustrate, the pa yout ratio applied in the computation is a constant of 29.6%  [ÃÆ' ¢Ãƒ ¢Ã¢â€š ¬Ã‹Å" £]  . The remainder out of net income after paying off dividends is utilized to buy back stocks at the prevailing market price ( £45). DPS are based on the number of shares left after excluding the quantity of shares bought back. From the table, we can see that higher value of debt in the capital structure will result in lower DPS, together with smaller amount of dividends and repurchase. Empirical studies show that repurchasing stocks from shareholders may add value by facilitating the transfer of cash from the business to investors in a more tax-efficient way (Grullon and Ikenberry, 2000). Concretely, if shares are bought back from shareholders by the company, the tax is treated as the capital gains tax, which is much cheaper than the dividends tax. This tax incentive of buying back shares corresponds to the interests of rich clients of the company, as proposed by John at the mee ting. Furthermore, repurchase of shares by the company generally leads to an increase in EPS whenever the reciprocal of P/E is greater than the after-tax rate of interest paid on incremental debt (Vernimmen, 2009, p.802). For RE, E/P is 0.06 (1/16.67), larger than the after-tax rate of interest paid, 0.054 (9 %*( 1-40%)).Thus as John suggested, buying back stocks would not be bad for the EPS of the firm. Additionally, the flexibility inherent in repurchase programmes can be another reason for managers to distribute excess capital by repurchase rather than dividends (Vernimmen, 2009, p.800). In summary, the suggestion of following a residual dividend policy together with a repurchase of stock is fairly sensible and can be considered as the ultimate dividend policy. Takeover proposal To confront the severe competition and increasing pressure from main shareholders, RE is advisable to implement an aggressive takeover so as to boost the value of the company. An analysis and evaluation regarding the relative prospects of the acquisition and the takeover candidate-Soluciones Economicas SA (SE) is presented in the following report. Whether acquisition is a wise choice Analysis of different attitudes towards the acquisition The proposal concerning the takeover towards Soluciones Economicas can hardly reach a consensus in the board of RE. Theoretically, the most convincing motive for companies to participate in MA is to implement synergy. In other words, higher efficiency and effectiveness can be obtained by the combination of two operating units through appropriate allocation of scare resources (Lubatkin, 1983). For RE, the acquisition is intended to realize better utilization of resources through the takeover of suitable targets. Besides, companies are able to take advantage of opportunities for diversification, such as exploiting new markets and managing risk for undiversified factors (Andrade, Mitchell and Stafford, 2001). However, opponents may also present reasons against RE taking over SE. The profitability of acquiring company after the takeover is rather questionable. According to the study of Bradly, Desai and Kim (1988), over half of the acquiring firms studied have negative returns over post-acquisition period. In addition, mergers contribute to the value of target companies while ending up being value decreasing transactions for acquiring firms (Malatesta, 1983). Last but not least, some people assert that the high possibility of failure in the implementation of acquisition is worth considering since approximately one out of two fail due to overestimation of the synergies and underestimation of the cost and time they require. In short, although the action of RE taking over SE may bring potential synergy and diversification, empirical studies regarding the post-takeover performance of the stock returns for acquiring companies put forward the possibility of negative impact from the takeover, leading to the ne ed of further consideration of the issue. relative P/E game The relative P/E magic can be another motivation for RE taking over SE. It refers to the phenomenon that an instant gain can be obtained if a company with a high P/E ratio acquires another one with rather low ratio. In our case, the target company-SE-does have a rather low P/E ratio at 7, and this can be attributed to the recent retirement of their CEO, which enables RE to have the possibility to enjoy the benefit from the undervaluation of SE. Table 8 Net income Stock price (GBP) P/E No. of shares EPS (GBP) Capitalization RE 135 45 16.67 50 2.7 2250.45 SE 26.91 3.77 7 50 0.72 188.37 New firm 161.91 47.18 16.67 57.14 2.83 2574.37 Note: 1. Exchange rate: 1 EUR= 0.897 GDP  2. Exchange ratio: RE/SE=7  Specifically, In the table 8, it can be seen that, after the takeover, if the new group is able to maintain a P/E ratio of 16.67, then the implied value of SEs earnings will become 448.58 million (16.67*26.91): an instant gain of 260.22million (448.58-188.37). The total capitalization obtained from earnings multiplying P/E ratio for the new firm is 2574.37 million, larger than the sum of the two separate firms prior to the takeover. The instant gain is achieved although no true wealth has been created. Besides, the new group has an EPS of 2.83, higher than both RE and SE before the takeover. Therefore, as the board members suggested, acquiring SE enables RE to boast its EPS while enjoy the benefits generated from the relative P/E magic. Offer price evaluation It is essential to evaluate the maximum offer price that RE would be justified in making for SE in this report. The valuation of the target company-Soluciones Economicas SA based on the free cash flow method is presented in the table 9 below. Exchange rate has been considered throughout the calculations. Table 9 Year 1 Year 2 Year 3 Year 4 Year 5  Free cash flow 55.37 70.37 85.37 100.37 115.37  Present value of FCF 49.39 56 60.6 63.56 65.17  Sum of present value      294.72 Present value of TV  645.27 Value of the firm      939.99 After excluding the long-term debt from the enterprise value, the total equity has an amount of  £670.89m (939.99-300*0.897). Hence, the maximum offer price should be  £13.42(670.89/50) per share. The payment mechanism of acquisition The payment mechanism of acquisition is of crucial importance to both companies involved since cash takeovers are sufficiently different from non-cash deals (Carleton, Guilkey and Harris, 1983). This report will analysis the pros and cons of all-share deals and cash payment in order to give a proper recommendation regarding the payment mechanism of the underlying acquisition. Specifically, an all-share transaction creates a new group with financial means which incline to be the sum of that of the two constituent firms. Thus from the point of view of RE, its financial power will be increased by a share exchange compared with a cash acquisition (Vernimmen, 2009, p.902). Furthermore, In terms of acquisition risk, shareholders of RE alone a ssume business risks in a cash acquisition, while the risks are shared among shareholders of both RE and SE in an all-share transaction (Vernimmen, 2009, p.903). More importantly, cash takeovers are taxable whereas security exchanges should be treated as tax free transactions because no cash outflow involved in an all-share deal. Shareholders of SE may defer capital gains tax until new securities are sold (Wansley, Lane, and Yang, 1983). Apart from that, the advantage of paying in shares can also be reflected in the management of the company. In detail, managers in the hope of changing the ownership structure of the firm in order to dilute unwelcome shareholders stakes can achieve this end by means of acquisition with stock exchange. Paying in shares also enables the firm to avoid financing and merger with large companies (Vernimmen, 2009, p.903). In spite of these advantages that all-share deals process, criticism still exists by arguing that shares are funny money paid in ac quisitions. But this may depend on the liquidity of shares and the ability of the merged firm to utilize anticipated synergies while creating value (Vernimmen, 2009, p.903). Interestingly, given all those benefits from shares exchange in takeovers, Carleton, Guilkey and Harris (1983) indicate that there is an upward trend in consummating acquisitions by cash in practice. Moreover, empirical studies show that bidding firms suffer substantial losses in pure security exchange takeovers. By contrast, they experience normal returns in cash offers (Travlos, 1987). Additionally, a cash offer has a more favourable announcement impact on the stock price of acquiring firm than an all-equity bid (Franks, Harris and Titman, 1991).Wansley, Lane, and Yang (1983) explain the phenomenon of favouring cash deal using signalling effect, indicating that takeovers financed by exchange of common stocks convey negative information that the acquiring firm is overvalued. In conclusion, despite all the po tential advantages that all-share transactions may process, it is recommended by this report that RE taking over SE by cash for conservative purpose. The impact of takeover on the share price of RE The share price of Riverside Electronics would possibly be affected in response to the decision of bidding for Soluciones Economics. In general, empirical studies tend to believe that either zero or even negative performance to acquirers would be the consequence of takeover activities over the announcement period (Franks, Harris and Titman, 1991). For instance, an well-known study conducted by Roll (1986) indicates that we cannot reject a null hypothesis of zero abnormal returns for acquiring firms (Agrawal and Jaffe, 1999). In addition, Jensen and Ruback (1983) summarize seven studies reporting negative average abnormal returns of acquirers during the 12 months after the takeover. With regard to postmerger performance, significantly negative abnormal returns for acquiring firms are also found by Franks, Harris, and Mayer (1988), consistent with the finding of Limmack (1991). Even though the unfavourable performance of acquiring firms after the takeover documented in the literatures is questioned by some critics, who are inclined to attribute the zero or negative abnormal returns to benchmark error (Franks, Harris and Titman, 1991) or methodology employed (Kothari and Warner, 1997), it is sensible to infer that the share price of RE may experience downward trend, or at least stay constant, after the implementation of bidding for SE. Diversification benefit brought about by the takeover It is apparent that takeover is capable of affording diversification benefits to both acquiring and acquired companies. As mentioned by Andrade, Mitchell and Stafford (2001), acquisitions enable firms to take advantage of diversification in many aspects. In the case of RE taking over SE, a regional diversification can be achieved because SE, as a Spanish company, has already established a mature market in Southern Europe whereas RE mainly operates in Northern Europe and North America. Moreover, the well diversified customer bases that SE processes can also add diversification to the new group over postacquisition period. In addition, considering the fact that PR is involved in a totally different industrial sector, substantial diversification benefits are also present in the acquisition. Therefore, diversification benefits are fairly evident in the takeover between RE and SE. Conclusion All in all, this report has conducted a comprehensive analysis regarding the Riverside Electronics in the face of two alternative expansion opportunities. In accordance with the analysis above, Riverside Electronics is advisable to take on the expansion project so as to achieve development internally, since the aggressive takeover exerts too much risk to the firm in terms of share price and failure potential. As for the type of financing, despite the decline of profitability ratios, it is sensible for RE to raise all the needed funds by issuing 5-year notes since previous analysis has concluded that the firm with a debt value of  £500m has the highest enterprise value. With regard to the capital structure, the expansion project requiring an amount of  £500m would add leverage to the capital structure. The company can enjoy the benefit of debt through tax shield, leading to the increase of enterprise value. As to the takeover, the impact on the capital structure depends on the payment mechanism. An all-share deal would change the composition of the equity capital whereas cash payment may include debt into the capital structure if the required funds are raised by debt. Furthermore, the dividend policy will also be affected by the two alternative growth opportunities. Since both projects require additional capital, earnings can be retained to fulfil the needs of funds rather than distributing as dividends. However, an alysis above has indicated that a dividend change will impart substantial influence on the share price of the firm. Thus the best dividend policy in response to the expansion opportunities will be the residual dividend policy accompanied by a repurchase of stock, which maintains the payout ratio of the firm while enjoying the benefit of shares buyback.