Corporate Finance - Case of Aviva Plc - Research Paper Example

Corporate Finance Assignment Aviva plc April 2009 Contents Sl No Page No 0 Introduction ..... 3 2.0 Weighted Average Cost of Capital ..... 4 3.0 Cash Flow Report .. 7 4.0 Hurdle Rate .... 9 5.0 Conclusion . 11 6.0 Appendix . 12 7.0 Bibliography ....... 20 Section-I Introduction The aim of this report is to calculate the Weighted Average Cost of Capital of Aviva plc. This report also analyses the cash flow statement of the company, and recommends the hurdle rate to be used by the company for appraisal of its new projects and investments. 3605 Section-II Weighted Average Cost of Capital The Weighted Average Cost of Capital (WACC) of a company is the weighted average cost of fund from all its sources. This comprises of equity, preference equity, and long term debts. There are several methods of defining the weights as detailed below (Arnold, 2002, p 737). A long-term target debt and equity ratio The present market values of debt and equity Balance sheet ratios of debt and equity For the purposes of this calculation, balance sheet ratios of debt and equity have been used. The proportion of the different types of capital as per 2008 balance sheet is given below. Table 2-1 Proportion of Capital In million Equity incl minority interests 15,925 64.34% Preference shares/ Direct Capital Instrument 1,190 4.81% Debts 7,635 30.85% The cost of each type of fund is calculated as below. Cost of Equity: Firms calculate their cost of equity using several methods, the most popular method being Capital Asset Pricing Model (CAPM). This method assumes that shareholders expect a rate of return equivalent to the risk free rate plus a risk premium, and is expressed as - ke = rf + x (rm - rf), where ke = Cost of Equity rf = Risk free rate of return = Variability of stock return in relation to the market return rm = Market return The current UK T-bill average yield was taken as the risk free rate. The recent T-bill average yield varied from 0.6725% (on Apr 3) to 0.6220% (on Mar 27) as per Financial Times (2009). The extract of the data is given in the Appendix as Exhibit 6-3. The average of these two figures (0.65%) was considered as the risk free rate. Beta for Aviva is 2.2664 (Yahoo Finance 1, 2009) FTSE-100 was considered as the indicator of market return. The data range considered was between Jan 1, 2003 to Jan 1, 2009. The compounded annual growth rate (CAGR) of FTSE-100 during this period was 2.55%. The relevant FTSE-100 data during this period is given in Table 6-1 of Appendix (Yahoo Finance 2, 2009). It is assumed that this is the rate of return that the market will expect in future. Therefore, the cost of equity (ke) works out to [0.65% + 2.2664 x (2.55% - 0.65%)], i.e., 4.96%. Owing to high volatility in the financial market, it was decided to test the above cost of equity using Gordon's growth model (Arnold, 2002). As per this model, the cost of equity is given by - ke = d1/ P + g, where ke = Cost of Equity d1 = Dividend in the next time period g = Growth rate in dividend The historical dividend growth rate of Aviva works out to 6.20%. The divided payout details are given in Table 6-2 of Appendix (Aviva, 2009). It is expected that this growth rate will continue in future. A total dividend of 33 pence per share was paid for the year 2008. This amount is expected to be 35.05 pence per share during the year of 2009 using the current dividend growth rate. The share price of Aviva as on January 1, 2009 was 361.84 pence. The cost of equity as per this method works out to (0.33 x 1.0620/ 361.84) + 6.20%, i.e., 15.89%. There is substantial difference between the cost of equity calculated using the two methods. Both methods use several assumptions and approximations. Therefore, it was decided to take the arithmetic mean of both these figures for the purpose of calculating the WACC. The arithmetic mean works out to 10.42%. Preference Shares/ Direct Capital Instrument: The Aviva has issued several types of hybrid instruments at different rates of return. The details of these sources of fund is given in Table 2-2 below. Table 2-2 Preference Shares/ Direct Capital Instrument In million Rate of Return Preference share 1 100 8.3750% Preference share 2 100 8.7500% Direct Capital Instrument 1 500 5.9021% Direct Capital Instrument 2 490 4.7291% The weighted average cost of hybrid capital works out to 5.8662% Long term debt: The cost of long term debt for Aviva was calculated from the annual report. Aviva has a structured debt of 7,635 million on which Aviva paid an interest of 286 million. Therefore, Aviva's total cost of debt works out to 3.75%. Interest is a tax deductible expense. The current income tax rate in the UK is 30%. Therefore, the post tax cost of debt works out to 3.75% x (1-35%) = 2.62%. Therefore, the Aviva's WACC works out to (64.34% x 10.42% + 4.81% x 5.8662% + 30.85% x 2.62%) = 7.80%. Section-III Cash Flow Report The cash flow report of a company records the actual inflow and outflow of cash during a particular time period. This statement includes all cash flows in both current and capital account. Aviva has segregated its cash flows into three major parts, viz., cash flow occurring from its operating activities, cash flow occurring from its investing activities, and cash flow occurring from its financing activities. Each of these components of the cash flow are explained below. Cash flow from operating activities: Though Aviva plc has reported net loss in the profit and loss statement of 2008, it has reported a healthy cash generation during the same period. The book losses are owing to tax deductible non-cash expenses like fair value of gains/ losses, unrealized gains/ losses, depreciation, impairment of goodwill, amortization expenses, etc.. The cash generated from operations is 78% higher in 2008 than the earlier year in spite of positive book profit in 2007. This appears to be owing to lesser tax shield from non-cash expenses in 2007. There was a significant increase in working capital in 2008 as compared to the year before. The cash generated from operations in 2008 is 8,795 million. During the corresponding period, the tax on profit works out to 642 million. The fact that Aviva has a healthy operation is also demonstrated by this tax paid by the company. Cash flow from investing activities: Aviva has invested in acquisitions during 2008 and has almost sold off equal number of businesses during the same period. However, the net acquisitions in 2007 were higher by 486 million. Aviva also invested in group companies to the tune of 65 million in 2008. Aviva paid back loans amounting to 130 million in 2008. During 2007, Aviva had taken on loans amounting to 33 million. Aviva also acquired tangible assets worth 157 million in 2008 and 134 million in 2007. The acquisition of intangible assets during the corresponding periods were 60 million and 48 million respectively. Net investment reduced the cash by 395 million in 2008 and 635 million in 2007. Cash flow from financing activities: New issue of equity capital raked in 20 million in 2008 and 48 million in 2007. Aviva spent 29 million in 2008 and 10 million in 2007 for buying back equity shares. During the corresponding years, Aviva borrowed 298 million and 322 million respectively. The higher borrowings and higher working capital resulted in increase of interest expenses to 1,537 million by 46%. Dividends and returns on other instruments resulted in an outgo of 911 million in 2008 as against 636 million in 2007. Lease payment to the tune of 14 million was made in 2008 as against 7 million in 2007. There were significant investments in the company by other shareholders in 2007. This amount reduced from 307 million in 2007 to 36 million in 2008. The net cash outgo from financing activities was 2,137 million in 2008 versus 1,184 million in 2007. The net increase in cash was 5,681 million in 2008 as compared to 2,324 million in 2007. There was a significant gain from exchange rate variation in 2008 as compared to 2007. Section-IV Hurdle Rate for New Investments In most organized companies, new investment decisions usually need to go through a rigorous investment appraisal process. Typical investment decisions involve an upfront negative cash flow, which yields a stream of positive cash flows in the future. The future cash flows have lesser value for investors and are discounted using an agreed fixed discounting rate to arrive at the present value of the stream of positive cash flows. The investment is accepted if the present value of the positive cash flows is greater than the investment. There are several opinions regarding the discount rate to be used during such investment appraisal process. Some insist on using the weighted average cost of capital for discounting, while some insist on using the marginal cost of capital. The argument of using the marginal rate is that this rate determines the incremental return to the firm for taking on the new investment. A study by Arnold and Hatzopoulos (2000) in a study of 96 UK firms found that 61% of large firms use WACC as the discount rate while appraising major capital projects. The other discounting rates used include cost of equity, cost of debt, and other less scientific information. The data collected by Arnold and Hatzopoulos is given in Table 4-2 below. Table 4-2 Basis of Discount Rate Category of Company Method Used Small % Medium % Large % Composite % WACC 41 63 61 54 Cost of Equity (CAPM) 0 8 16 8 Interest Payable on Debt Capital 23 8 1 11 Arbitrary figure 12 4 3 6 Cost of Equity (Dividend Yield plus Estimated Growth Rate) 0 0 3 1 Earnings Yield on Shares 3 0 0 1 Other 12 8 11 10 Blank 9 8 5 7 Arnold (2002) maintains that the textbook procedure for arriving at the target discount rate (also referred to as the "hurdle rate") is WACC plus a margin. The margin is often the rate of inflation. Sometimes, the hurdle rate is the mid-point between WACC and the lowest rate of return required by venture capitalists. Gregory and Rutterford (1999) found that the average base hurdle rate was 0.93% higher than the average WACC. It is recommended that Aviva follow the WACC plus a safety margin model as the hurdle rate for evaluating large capital projects. The relative weights of the different components of capital should be guided by the target capital structure of the company, and not by its current gearing ratio. The cost of equity should be derived using the CAPM, and should use T-bill yield as the risk free rate of return. The safety margin should be a function of the investment and would depend on the "riskiness" of the investment. This should factor in the country risk, industry risk, exchange rate fluctuation risk, or other risks typical to the investment. The risk premium should be determined by objective risk analysis. The balance sheet and cash flow statement of Aviva is given in the Appendix. Section-V Conclusion For the purpose of calculation of the WACC for Aviva plc, the balance sheet proportion of different capital was used. The cost of equity was computed using both CAPM and Gordon's Dividend Yield plus Estimated Growth model. The overall WACC of Aviva plc was computed to be 7.80%. The cash flow of Aviva plc was studied for the year 2008, and the different components of the cash increase were examined with respect to the earlier year. The commonly accepted methods of determining the hurdle rate were examined, and an optimum method of calculation of hurdle rate was developed. It was recommended that Aviva plc use WACC plus a risk premium as the hurdle rate for evaluating large capital investments. The risk premium should be a function of the "riskiness" actual investment and should be objectively determined. Section-VI Appendix Table 6-1 FTSE-100 data Date Open High Low Close Volume Adj Close 2-Jan-09 4,434.20 4,675.70 3,956.70 4,149.60 1,381,094,300 4,149.60 1-Dec-08 4,288.00 4,456.20 3,973.30 4,434.20 967,711,700 4,434.20 3-Nov-08 4,377.30 4,639.50 3,734.10 4,288.00 1,386,575,900 4,288.00 1-Oct-08 4,902.50 5,052.00 3,665.20 4,377.30 1,788,654,400 4,377.30 1-Sep-08 5,636.60 5,646.50 4,671.00 4,902.50 1,628,366,000 4,902.50 1-Aug-08 5,411.90 5,649.10 5,299.70 5,636.60 1,230,898,300 5,636.60 1-Jul-08 5,625.90 5,625.90 5,071.10 5,411.90 1,735,849,400 5,411.90 2-Jun-08 6,053.50 6,074.50 5,470.90 5,625.90 1,542,828,100 5,625.90 1-May-08 6,087.30 6,377.00 6,041.10 6,053.50 1,248,136,200 6,053.50 1-Apr-08 5,702.10 6,134.50 5,670.40 6,087.30 1,201,736,300 6,087.30 3-Mar-08 5,884.30 5,884.30 5,414.40 5,702.10 1,663,850,600 5,702.10 1-Feb-08 5,879.80 6,104.50 5,681.50 5,884.30 1,453,034,900 5,884.30 2-Jan-08 6,456.90 6,534.70 5,338.70 5,879.80 1,649,831,500 5,879.80 3-Dec-07 6,432.50 6,610.90 6,251.80 6,456.90 1,043,486,400 6,456.90 1-Nov-07 6,721.60 6,723.70 6,026.90 6,432.50 1,552,055,200 6,432.50 1-Oct-07 6,466.80 6,751.70 6,413.40 6,721.60 1,876,738,600 6,721.60 3-Sep-07 6,303.30 6,512.40 6,123.10 6,466.80 1,893,980,400 6,466.80 1-Aug-07 6,360.10 6,406.30 5,821.70 6,303.30 1,812,830,100 6,303.30 2-Jul-07 6,607.90 6,754.10 6,186.20 6,360.10 1,846,057,500 6,360.10 1-Jun-07 6,621.40 6,751.30 6,451.40 6,607.90 1,982,709,100 6,607.90 1-May-07 6,449.20 6,675.00 6,395.50 6,621.40 2,005,402,100 6,621.40 2-Apr-07 6,308.00 6,516.20 6,293.90 6,449.20 1,733,620,500 6,449.20 1-Mar-07 6,171.50 6,355.30 5,989.60 6,308.00 1,937,028,700 6,308.00 1-Feb-07 6,203.10 6,451.40 6,166.20 6,171.50 1,763,028,400 6,171.50 2-Jan-07 6,220.80 6,335.10 6,130.20 6,203.10 1,774,774,900 6,203.10 1-Dec-06 6,048.80 6,271.40 5,985.20 6,220.80 1,366,647,500 6,220.80 1-Nov-06 6,129.20 6,256.80 6,011.80 6,048.80 1,690,671,800 6,048.80 2-Oct-06 5,960.80 6,244.60 5,897.30 6,129.20 1,661,140,200 6,129.20 1-Sep-06 5,906.10 6,002.90 5,774.50 5,960.80 1,593,479,500 5,960.80 1-Aug-06 5,928.30 5,949.80 5,752.60 5,906.10 1,416,730,100 5,906.10 3-Jul-06 5,833.40 5,982.50 5,654.60 5,928.30 1,403,843,000 5,928.30 1-Jun-06 5,723.80 5,865.70 5,467.40 5,833.40 1,709,102,100 5,833.40 2-May-06 6,023.10 6,133.50 5,510.50 5,723.80 2,008,162,400 5,723.80 3-Apr-06 5,964.60 6,137.10 5,964.60 6,023.10 1,801,112,900 6,023.10 1-Mar-06 5,791.50 6,047.00 5,783.90 5,964.60 1,991,586,200 5,964.60 1-Feb-06 5,760.30 5,893.30 5,681.90 5,791.50 1,974,727,800 5,791.50 3-Jan-06 5,618.80 5,796.10 5,618.80 5,760.30 1,966,761,500 5,760.30 1-Dec-05 5,423.20 5,647.20 5,423.20 5,618.80 1,463,333,100 5,618.80 1-Nov-05 5,317.30 5,554.90 5,304.90 5,423.20 1,868,493,800 5,423.20 3-Oct-05 5,477.70 5,515.00 5,130.90 5,317.30 1,739,025,000 5,317.30 1-Sep-05 5,296.90 5,508.40 5,296.90 5,477.70 1,553,471,300 5,477.70 1-Aug-05 5,282.30 5,386.40 5,228.10 5,296.90 1,359,418,800 5,296.90 1-Jul-05 5,113.20 5,308.60 5,022.10 5,282.30 1,791,884,100 5,282.30 1-Jun-05 4,964.00 5,138.20 4,964.00 5,113.20 1,585,016,100 5,113.20 3-May-05 4,801.70 5,004.30 4,801.70 4,964.00 1,613,726,200 4,964.00 1-Apr-05 4,894.40 4,994.10 4,773.70 4,801.70 1,626,241,100 4,801.70 1-Mar-05 4,968.50 5,042.00 4,886.50 4,894.40 1,736,076,300 4,894.40 1-Feb-05 4,852.30 5,077.80 4,852.30 4,968.50 1,740,831,400 4,968.50 4-Jan-05 4,814.30 4,879.50 4,765.40 4,852.30 1,640,281,900 4,852.30 1-Dec-04 4,703.20 4,826.20 4,675.00 4,814.30 1,362,204,300 4,814.30 1-Nov-04 4,624.20 4,823.80 4,624.20 4,703.20 1,612,545,100 4,703.20 1-Oct-04 4,570.80 4,732.90 4,551.60 4,624.20 1,624,433,400 4,624.20 1-Sep-04 4,459.30 4,630.70 4,459.30 4,570.80 1,713,718,700 4,570.80 2-Aug-04 4,413.10 4,490.10 4,283.00 4,459.30 1,435,898,900 4,459.30 1-Jul-04 4,464.10 4,487.90 4,283.20 4,413.10 1,644,811,500 4,413.10 1-Jun-04 4,430.70 4,535.10 4,400.70 4,464.10 1,616,433,300 4,464.10 4-May-04 4,489.70 4,573.70 4,363.00 4,430.70 1,818,252,400 4,430.70 1-Apr-04 4,385.70 4,601.60 4,385.10 4,489.70 1,718,814,500 4,489.70 1-Mar-04 4,492.20 4,566.20 4,291.30 4,385.70 1,927,805,000 4,385.70 2-Feb-04 4,390.70 4,556.90 4,357.40 4,492.20 2,115,330,500 4,492.20 2-Jan-04 4,476.90 4,531.40 4,390.70 4,390.70 2,000,761,400 4,390.70 1-Dec-03 4,342.60 4,491.80 4,312.50 4,476.90 1,439,725,600 4,476.90 3-Nov-03 4,287.60 4,423.60 4,270.50 4,342.60 1,803,765,400 4,342.60 1-Oct-03 4,091.30 4,393.80 4,091.30 4,287.60 1,839,532,000 4,287.60 1-Sep-03 4,161.10 4,329.60 4,081.80 4,091.30 1,938,065,000 4,091.30 1-Aug-03 4,157.00 4,286.90 4,044.90 4,161.10 1,567,267,900 4,161.10 1-Jul-03 4,031.20 4,183.00 3,951.50 4,157.00 1,663,719,800 4,157.00 2-Jun-03 4,048.10 4,218.80 4,021.60 4,031.20 1,717,265,600 4,031.20 1-May-03 3,926.00 4,096.00 3,875.30 4,048.10 1,673,469,100 4,048.10 1-Apr-03 3,613.30 3,997.30 3,612.30 3,926.00 1,549,148,500 3,926.00 3-Mar-03 3,655.60 3,881.70 3,277.50 3,613.30 1,790,568,500 3,613.30 3-Feb-03 3,567.40 3,747.00 3,535.10 3,655.60 1,744,394,900 3,655.60 2-Jan-03 3,940.40 4,027.60 3,391.50 3,567.40 1,788,060,800 3,567.40 Table 6-2 Dividend Payout of Aviva plc Year Dividend (pence per share) 2008 33.00 2007 33.00 2006 30.00 2005 27.27 2004 25.36 2003 24.15 2002 23.00 Consolidated balance sheet As at 31 December 2008 Note Restated 2008 2008 2007 m m m Assets 3,689 Goodwill N & 16 3,578 3,082 4,163 Acquired value of in-force business and intangible assets N & 17 4,038 3,197 1,791 Interests in, and loans to, joint ventures C & 18 1,737 2,576 1,285 Interests in, and loans to, associates C & 19 1,246 1,206 994 Property and equipment O & 20 964 942 14,872 Investment property P & 21 14,426 15,391 43,543 Loans U & 22 42,237 36,193 Financial investments R,S & 24 154,902 Debt securities 150,255 121,312 44,692 Equity securities 43,351 58,829 37,233 Other investments 36,116 36,269 236,827 229,722 216,410 8,138 Reinsurance assets M & 41 7,894 8,054 2,724 Deferred tax assets AB & 44b 2,642 590 641 Current tax assets 44a 622 376 10,119 Receivables and other financial assets 25 9,816 8,619 6,337 Deferred acquisition costs and other assets W & 26 6,147 4,487 3,878 Prepayments and accrued income 26d 3,762 2,986 24,929 Cash and cash equivalents X & 52d 24,181 16,089 1,598 Assets of operations classified as held for sale AG & 3c 1,550 1,128 365,528 Total assets 354,562 321,326 Equity Capital AD 685 Ordinary share capital 28 664 655 206 Preference share capital 31 200 200 891 864 855 Capital reserves 1,272 Share premium 28b 1,234 1,223 3,372 Merger reserve D & 33 3,271 3,271 4,644 4,505 4,494 -34 Shares held by employee trusts 30 -33 -10 2,175 Other reserves 34 2,110 1,469 3,924 Retained earnings 35 3,806 6,338 11,600 Equity attributable to shareholders of Aviva plc 11,252 13,146 1,021 Direct capital instrument 32 990 990 2,272 Minority interests 36 2,204 1,795 14,893 Total equity 14,446 15,931 Liabilities 180,258 Gross insurance liabilities K & 38 174,850 152,839 110,886 Gross liabilities for investment contracts L & 39 107,559 98,244 2,397 Unallocated divisible surplus K & 43 2,325 6,785 7,132 Net asset value attributable to unitholders D 6,918 6,409 3,076 Provisions Z, AA & 45 2,984 1,937 3,113 Deferred tax liabilities AB & 44b 3,020 2,532 662 Current tax liabilities 44a 642 1,225 15,671 Borrowings AC & 47 15,201 12,657 21,485 Payables and other financial liabilities R & 48 20,840 18,060 4,696 Other liabilities 49 4,556 3,765 1,259 Liabilities of operations classified as held for sale AG & 3c 1,221 942 350,635 Total liabilities 340,116 305,395 365,528 Total equity and liabilities 354,562 321,326 Approved by the Board on 4 March 2009. Philip Scott Chief Financial Officer The accounting policies (identified alphabetically) on pages 125 to 139 and notes (identified numerically) on pages 146 to 277 are an integral part of these financial statements. Consolidated cash flow statement For the year ended 31 December 2008 The cash flows presented in this statement cover all the Group's activities and include flows from both policyholder and shareholder activities. Long-term business operations Non-long-term business operations Total 2008 Restated Total 2007 Note m m m m Cash flows from operating activities 52a Cash generated from operations 7,920 875 8,795 4,944 Tax paid -394 -248 -642 -801 Net cash from operating activities 7,526 627 8,153 4,143 Cash flows from investing activities Acquisitions of subsidiaries, joint ventures and associates, net of cash acquired 52b -93 -243 -336 -769 Disposals of subsidiaries, joint ventures and associates, net of cash transferred 52c 180 173 353 283 Purchase of minority interest in subsidiary -65 - -65 - New loans to joint ventures and associates -182 - -182 -126 Repayment of loans to joint ventures and associates 52 - 52 159 Net repayment loans to joint ventures and associates 18a & 19a -130 - -130 33 Purchases of property and equipment 20 -57 -159 -216 -227 Proceeds on sale of property and equipment 35 24 59 93 Purchases of intangible assets 17 -34 -26 -60 -48 Net cash used in investing activities -164 -231 -395 -635 Cash flows from financing activities Proceeds from issue of ordinary shares, net of transaction costs - 20 20 48 Treasury shares purchased for employee trusts - -29 -29 -10 New borrowings drawn down, net expenses 1,435 4,080 5,515 6,322 Repayment of borrowings -1,365 -3,852 -5,217 -6,000 Net drawdown of borrowings 47e 70 228 298 322 Interest paid on borrowings -712 -825 -1,537 -1,208 Preference dividends paid - -17 -17 -17 Ordinary dividends paid - -732 -732 -500 Coupon payments on direct capital instrument - -56 -56 -53 Finance lease payments - -14 -14 -7 Capital contributions from minority shareholders 36 - 36 307 Dividends paid to minority interests of subsidiaries -83 -23 -106 -66 Non-trading cash flows between operations -189 189 - - Net cash from financing activities -878 -1,259 -2,137 -1,184 Net increase in cash and cash equivalents 6,484 -863 5,621 2,324 Cash and cash equivalents at 1 January 11,132 4,432 15,564 12,635 Effect of exchange rate changes on cash and cash equivalents 2,525 359 2,884 605 Cash and cash equivalents at 31 December 20,141 3,928 24,069 15,564 Of the total cash and cash equivalents, 493 million (2007: 96 million) was classified as held for sale (see note 3c). Cash and cash equivalents in long-term business operations of 20,141 million (2007: 11,132 million) are primarily held for the benefit of policyholders and so are generally not available for use by the Group. The accounting policies (identified alphabetically) on pages 125 to 139 and notes (identified numerically) on pages 146 to 277 are an integral part of these financial statements. Section-VII Bibliography Arnold, G., 2002. Corporate Financial Management. 2nd ed. London: Financial Times Pitman Publishing. Financial Times. 2009. FT.com/ marketsdata. Retrieved on April 15, 2009 from http://markets.ft.com/ft/markets/researchArchive.aspreport=BILL Yahoo Finance 1. 2009. Aviva Technical Analysis. Retrieved on April 15, 2009 from http://uk.finance.yahoo.com/q/tts=AV.L Yahoo Finance 2. 2009. FTSE 100 Historical Share Prices. Retrieved on April 15, 2009 from http://uk.finance.yahoo.com/q/hps=%5EFTSE Aviva plc. 2009. Retail Shareholders/ Aviva plc Dividends/ History. Retrieved on April 15, 2009 from http://www.aviva.com/index.asppageid=430 Read More