• The forecast level of cash flow, and a tax rate of 33 per cent, will continue indefinitely — plc manufactures machine tools has issued two million ordinary shares quoted 168
RH plc manufactures machine tools. It has issued two million ordinary shares, quoted at 168 pence each, and £1 million 10 per cent secured debentures quoted at par. To finance expansion, the directors of the company want to raise £1 million for additional working capital.
Cash flow from trading before interest and tax is currently £1 million per annum. It is expected to rise to £1.3 million per annum if the expansion programme goes ahead. To simplify placing a valuation on the company’s equity, you should assume that:
• The forecast level of cash flow, and a tax rate of 33 per cent, will continue indefinitely.
• The required rate of return on the market value of equity, 18 per cent post-tax, will be unaffected by the new financing.
• There is no difference between taxable profits and cash flow.
The company’s directors are considering two forms of finance – equity via a rights issue at 15 per cent discount to current share price, or 12 per cent unsecured loan stock at par.
Required
(a) Calculate for both financing options, the expected
(i) Increase in the market value of equity
(ii) Debt/(debt + equity) ratio
(iii) Weighted average cost of capital.
(b) Assume you are the financial manager for RH plc. Write a brief report to the board advising which of the two types of financing is to be preferred. Include in your report brief comments on non-financial factors which should be considered by the directors before deciding how to raise the £1 million finance.
SOLUTION
(a) (i) The current market capitalisation = (2m shares × £1.68) = £3.36m.
The present value of the cash flows from the investment project is (£0.3m [1 − 33%]/18%) = £1.12m (i.e. the NPV is (£1.12m − £1m) = £0.12m). Under all-equity financing, market capitalisation should rise by the full value of the project as it involves additional financing, i.e. to (£3.36m + £1.12m) = £4.48m.
If the finance is raised via borrowing at 12% p.a., the net cash flow will be:
(£0.3m − interest on £1m at 12%) [1 − 33%] = £0.12m p.a.
At 18%, this has a PV of (£0.12m/0.18) = £0.67m. On the assumptions given, this would be the increase in the market capitalisation (i.e. the project is debt-financed). The new capitalisation is (£3.36m + £0.67m) = £4.03m.
At our recent meeting, you had instructed me to examine alternative ways, and consequences, of raising an extra £1 million for working capital investment. Using the assumptions we discussed, and assuming that the aim of the exercise is to maximise Market Value-Added, i.e. the excess of market capitalisation over funds provided by shareholders, the borrowing alternative is superior. This offers an increase in the net value of equity of £0.67 million, compared with only using equity of £0.12 million. (See attached computations).
Reservation
However, the equity enhancement may be moderated by the stock market’s possible adverse reaction to the increased level of capital gearing. As you know, increased gearing pre-empts a greater proportion of earnings before interest and tax for interest payments, thus increasing the volatility of the net after-tax earnings available to the shareholders. In an efficient financial market, rational investors will demand higher rewards for bearing greater risk, i.e. the cost of equity will increase, possibly negating or reversing the decrease in the WACC implied in my calculations. However, the increase in the discount rate applied to shareholder earnings that would be required to eliminate the potential increase in the market value of equity, would be implausibly substantial.
Other issues
Debt may carry restrictions in the form of covenants. Long-term finance may be unnecessary to fund working capital. The ‘Golden Rule’ of finance argues that short-term assets should be financed by short-term means, for example, a bank overdraft facility that has greater flexibility so far as interest is only paid on any balance overdrawn. A revolving credit facility may be more suitable, as this is, in effect, a medium-term overdraft, and our requirement is for medium-term finance.
Non-financial factors
Given that our need is for working capital, we should consider ways of shortening the operating cycle and thus reducing our investment in working capital. This involves close scrutiny of stock management and consideration of the extent to which, and how, we can speed up collections and slow down payments to suppliers.
We would need to canvass the views of our major shareholders, especially concerning the acceptability of a rights issue, given that it could dilute control. The future prospects for the economy have an important bearing on our prospective level of sales, and hence ability to meet the interest payments out of the operating cash flows. Volatility in cash flows will also depend on our level of operating gearing. We might consider ways of eliminating some fixed operating costs, for example, by outsourcing some activities.
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