Corporate Finance 2009/10 MSc & MA Programmes

SUMMATIVE ASSIGNMENT 2009/10

Background

Riverside Electronics Plc (RE) has been facing increasing competition on the international markets. To improve its competitive position, RE is considering two 留學(xué)生dissertation網(wǎng)alternative strategies. The first one is to embark upon an expansion project, which has the potential of increasing sales by about 30% per year over the next 5 years. The additional capital needed to finance the project has been estimated at £500 million. The alternative to this internal organic growth is to conduct a takeover.

Recent events in both the stock market and product markets have severely depressed RE’s value and there are no signs that the downward pressure on the share price is easing. The main shareholders have been asking for the company to take measures to improve its value, otherwise the slide in its stock price could make it a potential takeover target.

John Smith, the CEO of RE is evaluating the following alternative decisions:

a) Whether, he should recommend investing in the expansion project and, if so, burden the firm with fixed rate debt or issue common stock to raise the needed funds.

b) He should recommend a dividend cut and partly finance the project with internal funds.

c) He should give in to the shareholders’ pressure and consider implementing an aggressive takeover to boost the value of the company.

He had presented these alternatives at last week’s board meeting, but having had no luck with getting the Board of Directors to make a decision, John calls on Susan Campbell, his Chief Financial Officer, to shed some light on the matter. Susan had joined the company about two years ago from another publicly traded manufacturing company. She holds an MSc in Finance and an MBA from a prestigious Business School, and had recently completed her Chartered Financial Analysts’ certification. http://www.400190.com/dissertation_writing/Finance/Susan knew that she was in for a challenging task. She felt however that this was a good opportunity to prove her worth to the board. John reminds her that two of the non-executive directors are top professors of finance from High Goals University and are always very critical of decisions not reflecting the latest academic thinking.

Financing the Expansion Project

John still remembers how uneasy he had felt 10 years ago about the company’s debt burden and the 14% per year rate of interest that the bank had been charging him. He remembers distinctly how relieved he had been after paying off the loan one year earlier than its five-year term, and the surprised look on the bank manager’s face.

Business had been good over the years and sales had doubled about every 4 years. As sales began to escalate with the booming economy and thriving stock market, the firm had needed additional capital. Initially, John had managed to grow the business by using internal funds. However, about 5 years ago, when the need for financing was overwhelming, John decided to take the company public via an initial public offering (IPO) in the over-the-counter market. The issue was very successful and oversubscribed, mainly due to the superb publicity and marketing efforts of the investment underwriting company that John had excellent relations with. The company sold 50 million shares at £30 per share. The stock price had grown considerably over the first two years. Then, the stock market downturn had hit and, although RE’s stock had done reasonably well in relation to the sector, it was currently trading at its book value of £45 per share.#p#分頁標(biāo)題#e#

Based upon the estimates provided by the marketing department, the expansion project has the potential of increasing revenues by between 10% (worst case scenario) and 50% (best case scenario) per year. The project’s internal rate of return is expected to far outperform the company’s hurdle rate. Ordinarily, the project would have been financed by using internal funds. However, at this juncture all internal equity has already been committed. Thus, John and his colleagues are hard pressed to make a decision as to whether long-term debt or equity should be the chosen method of financing the project.

Upon contacting their investment bankers, John learned that they could issue 5-year notes, at par, at a rate of 9% per year. Conversely, the company could issue common stock at its current price of £45 per share. Being unclear about what decision to make, John had put the question to a vote by the directors. Unfortunately, the directors were equally divided in their opinion of which financing route should be chosen. Some of the directors felt that the tax shelter offered by debt would help reduce the firm’s overall cost of capital and prevent the firm’s earnings per share from being diluted. However, others had heard about “homemade leverage” and would not be convinced. They were of the opinion that it would be better for the firm to let investors leverage their investments themselves. They felt that equity was the way to go, since the future looked rather uncertain and being conservative they did not agree in burdening the firm with interest charges.

The Dividend Decision

As a private company, RE had never paid dividends, and it had continued not to pay dividends in the first two years of being publicly quoted. However, 3 years ago it had given in to market pressure and, with falling stock prices, had started to pay ordinary dividends at 50 pence per share increasing it steadily to the current 80 pence per share. During this down period, the stock price went from a high of £60 to a low of £30. It is currently trading at £45 per share with a P/E ratio of 16.67.

As the directors considered how to finance the project, John knew that as soon as he would mention the possibility of cutting dividends, the different personalities and beliefs of each director would show. No sooner had he popped the question regarding the dividend policy issue than Adam Giggs remarked abruptly: “Why fix it, if it ain’t broke? We owe it to our shareholders. They may vote with their feet if we don’t pay any dividends.” John knew that he had opened a can of worms. He could just feel the room begin to erupt. Right enough, Peter Ferguson replied: “I think that we should retain all our earnings and use the money to finance the project. I think that it would be financially imprudent for us to pay dividends when we know that we are going to have to raise £500 million for the expansion project. Why pay the floatation costs? Besides, don’t stock prices almost always drop after the payment of dividends?” Joe Perry was more cautious and suggested: “We should identify our existing shareholder groups and make a decision based on what the majority prefers.”#p#分頁標(biāo)題#e#

Jennifer Sinclair, who had an MSc in Finance from Long Study University and had read about Miller and Modigliani’s ‘dividend irrelevancy’ proposition, couldn’t hold back any longer. “Gentlemen,” she said. “Isn’t this much ado about nothing? I think that we are wasting our time arguing whether or not dividends should be paid and if so, how much. I think it really doesn’t matter one way or the other as far as stock prices are concerned. Those shareholders who don’t like our dividend policy can create ‘homemade dividends’ for all I care. I think that we need to move on to more important issues, like what we are really going to do to sustain our market value.” “I think that we should use the ‘residual dividend’ approach”, said Paul Roberts. “That way we can keep our shareholders happy and maintain our target capital structure. I tend to agree with Adam. The shareholders are expecting some kind of dividend and if we don’t deliver, we could be hurting the stock price. But we have to be able to continue supporting whatever dividend payout ratio we go with, or else the negative information backlash could come back to haunt us.”

John, who had kept silent through much of this discussion, finally broke in, “I have somewhat of a different suggestion,” he said. “Why don’t we figure out how much we can afford to pay out based on our immediate investment needs and target capital structure, and then repurchase stock at the prevailing market price with what’s left over? That way there would be less of a tax disadvantage to our rich clients and it wouldn’t be bad for our EPS either. What do you all think?” There was a long pause in the room. The directors had not considered this option - not even Jennifer! - and were stumped. “Let’s all go back and rework the numbers,” said John, eager to break the silence. “We need to move on to the next issue on the agenda”

The Potential Target

The situation was further complicated by an issue that had been discussed before in the boardroom. In an increasingly competitive market and under pressure from its main shareholders to sustain the declining share price, the overwhelming consensus in RE’s board was that the firm should look for suitable acquisition candidates so as to better utilise its resources and diversify risk. About 3 months ago John set up the M&A committee to research possible acquisition candidates and present its findings at the quarterly board meeting. He asked the committee members to consider firms in related as well as unrelated industries and explain the rationale for their recommendations.

After considerable research, data gathering and analysis, the committee had narrowed their choices down to three possible candidates. At the last board meeting, the directors had ruled out two of the three candidates and asked the committee to conduct further valuation and analysis on the third candidate – Soluciones Economicas SA (SE). The board members were particularly interested in the fact that this is a Spanish company with an established market in Southern Europe, while RE’s market is mainly concentrated in Northern Europe and North America. They were also curious about the low P/E ratio that SE was trading at. In fact, one board member had heard about ‘relative P/E magic’ and was wondering whether by acquiring SE the firm could boast its P/E ratio and possibly its earnings per share.#p#分頁標(biāo)題#e#

Soluciones Economicas was a mid-size company with assets of €1 billion. The firm’s earnings per share had been steadily increasing each year and were currently €0.6 per share. Surprisingly, however, the committee found that although the firm had a fairly well diversified customer base, its P/E ratio was rather low at 7, much below the average P/E ratio for the industry. The committee felt that the reason for the low P/E ratio might have been the recent retirement of their CEO, who had managed the company in a very centralized manner. All managers reported directly to him and he made most of the strategic decisions. His experience and vision had been well rewarded in the market.

The members of the M&A committee felt that if SE were to be acquired by RE, production and marketing costs could be significantly reduced due to RE’s technical and marketing expertise. The incremental net cash flows of the combined company were estimated to be at least £15 millions per year for the foreseeable future. Moreover, since PR is involved in a totally different industrial sector, there are some significant diversification benefits to be realised.

Requirement

You are the Chief Financial Officer of Riverside Electronics, Susan Campbell, and you are required to write a report for consideration at the next meeting of the Board of Directors. The aim of your report is to make a clear and well-argued recommendation, based on the information in the case, and critically supported by the relevant academic literature, on the decisions concerning the investment’s choice and type of financing. More specifically, the report should contain answers to the following specific questions (in the indicated order):

a. Assuming that Riverside Electronics were to raise all of the required capital by issuing debt, calculate the impact on the firm’s shareholders and comment on your results.

b. Calculate how the key profitability ratios of Riverside Electronics would be affected if the firm were to raise all of the capital by issuing 5-year notes, and comment on your results.

c. What effect would a change in the debt to equity ratio have on the weighted average cost of capital of Riverside Electronics? Assume that RE’s beta is estimated at 1.3; Treasury Bills are yielding 3%; the expected rate of return on the market index is estimated to be 10% and the corporate tax is 40%. Using various combinations of debt and equity, under the assumption that the cost of each component stays constant, calculate the effect of increasing leverage on the weighted average cost of capital of the firm. Is there a particular capital structure that maximises the value of the firm? Critically assess how the assumptions made affect your findings.

d. Using suitable diagrams and the data in the case to explain Modigliani and Miller’s Propositions I and II with corporate taxes.

e. Under a residual dividend policy, calculate how much dividend per share Riverside Electronics can afford to pay if it decides to go ahead with the expansion project, and under different capital structure scenarios.#p#分頁標(biāo)題#e#

f. Discuss the suggestion of stopping the payment of dividends. What can we learn from the literature to help us make a decision in this case?

g. Critically evaluate the suggestion of following a residual dividend policy accompanied by a repurchase of stock.

h. Critically evaluate the reasons for and against Riverside Electronics taking over Soluciones Economicas.

i. Comment on the suggestion of playing the ‘relative P/E game’. Illustrate your answer by assuming that: (i) Soluciones Economicas’ shareholders have agreed to an exchange ratio of 1 share of Riverside Electronics for every 7 shares of Soluciones Economicas, and (ii) the combined net income of the two firms is the sum of their net incomes prior to the completion of the deal.

j. Using the free cash flow method of valuation, calculate the maximum offer price that Riverside Electronics would be justified in making for Soluciones Economicas.

k. Discuss whether cash or stock should be used as the acquisition‘s payment mechanism, assessing the advantages and disadvantages of each method.

l.留學(xué)生dissertation網(wǎng) Would you expect the share price of Riverside Electronics to be affected by the decision to bid for Soluciones Economicas? Discuss whether the academic literature can help in answering this question.

m. Critically comment on the suggestion that the takeover would offer diversification benefits.

n. Given the answers to the questions above, you should make and sustain the final recommendations to the board concerning the major decisions at stake:

a. Whether Riverside Electronics should grow internally by investing in the expansion project, or whether it should grow externally by taking over Soluciones Economicas.
b. Discuss the financing of both the expansion project and the takeover, assessing the impact on capital structure and dividend policy of the two alternative growth opportunities.

N.B.:

(i) All calculations must be fully explained.
(ii) All arguments must be strongly supported by the appropriate use of academic literature. The use of literature must be fully referenced and a reference list must be provided at the end of the assignment. Please refer to your Programme Handbook for guidance on referencing.

Table 1
Riverside Electronics Plc

Balance Sheet (£ millions)

Cash 150 Accounts Payable 450
Accounts Receivables 450 Accruals 300
Inventories 600 -----
-------
Current Assets 1,200 Current Liabilities 750
------- -----
Net Non-Current Assets 1,800 Paid in Capital 750
Retained Earnings 1,500
------- -------
Total Owner’s
Equity 2,250

Total Liabilities
Total Assets 3,000 & Owner’s Equity 3,000
==== ====

Table 2
Riverside Electronics Plc

Income Statement (£ millions)#p#分頁標(biāo)題#e#

Sales 1,500
Cost of Goods Sold 1,050
--------
Gross Profit 450
Selling and Adm. Exp. 75
Depreciation 150
--------
EBIT* 225
Taxes (40%) 90
--------
Net Income 135
====
Dividend Paid (£0.80 per share
on 50 million shares) 40
Addition to Retained Earnings 95

Table 3
Riverside Electronics Plc

Analysis of Shareholders Groups

Investor Group No of Shareholders No of Shares Held

Pension Funds 20 12,000,000
Insurance Companies 10 3,000,000
Mutual Funds 50 6,500,000
Individuals 10,000 28,500,000

* EBIT = earnings before interest and taxes

Table 4
Soluciones Economicas SA

Balance Sheet (€ millions)

Cash 150 Accounts Payable 75
Marketable Securities 100 Notes Payable 250
Accounts Receivables 100 Accruals 65
Inventories 150 -----
---------
Current Assets 500 Current Liabilities 390

Gross Fixed Assets 700 Long-term Debt 300
Accumulated Depreciation -200
-------- Common Stock 50
Net Non-Current Assets 500 (par value=€1 per share)
-------- Capital Surplus 170
Retained Earnings 90
-----
Total Shareholders’
Equity 310
-----
Total Liabilities &
Total Assets 1,000 Shareholders’ Equity 1,000
===== ====

Table 5
Soluciones Economicas SA

Income Statement (€ millions)

Sales 750
Cost of Goods Sold 660
--------
Gross Profit 90
Selling and Adm. Exp. 25
Depreciation 7
--------
EBIT 58
Interest 8
Taxes (40%) 20
--------
Net Income 30

Dividend Paid (€0.40 per share
on 50 million shares) 20
Addition to Retained Earnings 10

This is an individual assignment.

Overall word limit 3000 words maximum.

YOUR COMPLETED ASSIGNMENT MUST BE SUBMITTED TO THE MASTERS OFFICE NO LATER THAN 4.00PM ON FRIDAY 7TH MAY 2010.

MARKING GUIDELINES

Performance in the summative assessment for this module is judged against the following criteria:
• Relevance to question
• Structure/presentation & clarity of writing
• Scope and relevance of literature review
• Rigour of argument
• Evidence of understanding
• Conclusions/Recommendations

Assignments must be typed or word-processed on A4 paper using 1.5 or double spacing and with margins of 2-3 cm. Pages should be numbered and stapled together in the top left hand corner. The word count should include all the text (plus endnotes and footnotes), but exclude diagrams, tables, bibliography, references and appendices. Guidance on referencing can be found in your year handbook.

PLAGIARISM and COLLUSION#p#分頁標(biāo)題#e#

http://www.400190.com/dissertation_writing/Finance/Students suspected of plagiarism, either of published work or work from unpublished sources, including the work of other students, or of collusion will be dealt with according to Business School and University guidelines.

You are required to submit an electronic copy of your assignment on DUO which will be put through the plagiarism detection service. The deadline for doing this is also 4PM ON 7 MAY 2010.