The Investment of FUSE Plc - Case Study Example

The investment of FUSE Plc According to the investment criteria set by FUSE Plc, (a) investments are to be appraised initially over a ten year period and the assumption is that they will grow at a constant rate of 5% thereafter. Its directors have agreed that FUSE’s current debt-equity ratios should remain unchallenged even as the investment in Pajistan is carried out. The current debt/equity ratios for FUSE is as follows: Debts: Secured bank loan of 6.5% of £200 million. Since this loan is charged at 6.5% per annum and the period of the initial investment is envisaged to be about ten years, FUSE PLC would also be paying an interest amount on this loan of £72,515,145.33 in interest over this period. Hence the total amount of this debt over a 10 year period actually works out to roughly 2726 million pounds. The second debt to be taken into account is the Eurodollar bond of £3740 million, which in terms of pounds works out to a sum of £2239.52 million or roughly £2240 million pounds. As a result, combining both of these debt figures raises the total amount of present debt to million pounds or roughly 4966 million pounds. Equity: In terms of its equity, the company has 1200 million ordinary shares that have a current market value of 350 pence, or 3 pounds and 50 pence, which works out to an amount of 4200 million pounds, which is the market value of its ordinary shares. The actual value of these shares is however 50 pence, which brings the value of the shares to 600 million. These are potentially the highest and lowest values for the shares, taking present market conditions into account. As a result, the average value of the ordinary shares would be 2 pounds per share, which brings the average value of the shares to 2400 million pounds. Since the present market value of the shares is however 3 pounds and 50 p, the market value will be taken into account and the total equity is taken as £4200 million. These are the present values of its equity and its debts; as a result the debt equity ratio would work out to £4966 million divided by £4200 million pounds or a debt/equity ratio of 1:4 FUSE Plc has now proposed to finance its investment in Pajistan in terms of equity by raising a rights issue and in terms of debt by securing an unsecured bank loan but without raising its debt/equity ratio significantly. The debt is proposed to be raised through an unsecured loan for a ten year period at an interest rate of 7.5% per annum. Assuming that FUSE opts for an additional loan of 200 million pounds, this indicates that including the interest FUSE will be paying on this unsecured loan at higher interest over the ten year period, the amount repayable would be £2848 million pounds. The equity is proposed to be raised through a rights issue of shares, which at a 15% discount to the current market price of the share, works out to an amount of £297.50p per individual share. The discounted market value of the shares is likely to make it attractive for investors, because of the high dividend of 5.75% being paid which is also projected to rise further. Assuming that 1200 million ordinary shares are sold in this way, the Company could raise an amount of £3570 million pounds. The debt/equity ratio in this instance would be £2848 divided by £3570 million, which is roughly a ratio of 2:3. Hurdle rate is to be 5% of capital cost. In this instance, the capital cost calculations are shown below: the marginal tax rate in Pakistan, i.e, the input = 20% The formula for the after tax rate is given by: After-Tax Cost of Debt Capital = The Yield-to-Maturity on long-term debt x (1 minus the marginal tax rate). Hence this equates to: 7.5% X (100% minus 20%) which is equal to 0.0014%. Since Pakistan is waiving withholding tax and offering this preferential rate for investors which is below the rates in UK, the debt costs may have a minimal effect on the company’s weighted cost of capital. In terms of cost of equity capital, the CAPM model can be applied, i.e., cost of equity capital = risk free rate + Beta times market risk premium. The risk free rates need to be ascertained first. The risk rate for the dollar weighted bond has increased dramatically in recent months because the default rate has dropped from 10.3% in the last quarter to 3.1% in this quarter. The risk free rate is assumed be 10% and the market risk premium can be taken as Beta multiplied by the market risk premium, i.e, 5.75% (Fuse’s dividends), with market risk being assumed to be between 3% to 10% or say 6. This roughly works out to an equity capital cost of 0.103, which is also quite a small amount. As a result, the after tax cost of debt capital and equity capital costs are not significant and the hurdle rate, estimated at roughly 5% of the total cost would not be very significant. There are some limitations associated with this approach however, because with the present volatility in the market due to the fluctuations in the Euro after Greece’s debt, there is no guarantee that the rates which have been assumed are likely to be fairly stable over a ten year period, there could be some very strong fluctuations which would affect the hurdle rates significantly. In terms of debt/equity ratios however, it may be noted that the plans being made to raise debt and equity are not quite feasible because they cannot remain unchanged. The company presently has a surplus of cash that can be used, but since the loan it has taken is unsecured, there is a danger that if the investment is not profitable, the company would be saddled with huge interest payments. While the present positive net value criterion for investment is satisfied, the high inflation rates of 15% in Pajistan could mean that the value of equity raised may not be able to sustain the operations of the company and the projected payback period of seven years may not be feasible. (b) and (c) The risks associated with FUSE plc’s proposal to invest in Pajistan are similar to the risks that would be faced by any energy company in a developing nation. One of the barriers that developing countries face in realising their potential for energy efficiency is the lack of access to the appropriate financing mechanisms. Painuly et al (2002) have discussed energy service companies, which is in essence, a market oriented mechanism that has been successful in improving energy efficiency in countries such as the USA and Canada. In developing countries however, such market based mechanisms which have the objective of improving energy efficiency face barriers such as poor energy pricing policies, high transaction costs, market, finance and institutional barriers. Applying this in the context of Pajistan, there are some limiting factors which could raise the levels of FUSE investment, as well as some aspects that could be advantageous to the Company when it initially set up its operations. One of the limitations for the long term is the higher rate of corporation tax of 35 percent charged in Pajistan, over and above which 6% of the profits made by FUSE’s subsidiary in Pajistan will also be withheld. (c) As Painuly et al (2002) have suggested however, such risks can be mitigated through the development of the markets with the Governments taking an active role as customer, information provider and policy maker, so that the existence and thriving of Energy Service Companies can be promoted. The Pajistan Government appears to be taking an active role in promoting investment; firstly, it is offering a preferential corporation tax rate of 20% for the first three years, which is even lower than the UK tax rate of 30 percent. In this context, it is clear that huge investments of capital would be required in order to successfully execute any renewable energy initiatives in developing countries, but FUSE could request the Government of Pajistan to introduce more concessions to offset its risks. In financing the Pajistan project, FUSE proposes to raise money from discounted shares. This could be an excellent move, especially since FUSE’s shares have a high current market value and investors would perceive this as a good deal. FUSE’s debt financing may however not be as good a strategy because the Company is using an unsecured loan; as a result its interest rates are higher and there is a greater risk to the Company of potentially being heaped with huge debt if it is unable to make its loan payments for any reason. 2. The spot rate for the Euro/pound is 1 Euro is equal to 0.835103 sterling. When assessing the change in the exchange rates of the euro versus the pound over the past one month period, it may be noted that the spot exchange rate has remained more or less constant with only a few fluctuations , but there was a somewhat sharp drop on June 28th. There is a good possibility that this drop occurred because of the revelation of the high deficits of both Spain and Greece, which affected the value of the Euro. It appears likely that the spot rates may continue to drop, albeit not as sharply, because as mentioned below, the exchange rates between the United States and Canada also reveal a forward discount, which is likely to impact upon the forward spot rates of the Euro to the pound and pull down the exchange rate. The spot rate for the US dollar to the pound is 0.65555. In examining the spot exchange rates between these two countries for the past month, it may be noted thta the value of the dollar has been falling steadily. The forward premium or discount is determined by the interest rate differential between the United States and Canada. The forward rate for a 30 day period is 0.9670, which is a negative value or a discount of -3, thereby indicating that the value of the dollar has dropped over the 30 day period. As a result, this suggests that the forward spot rates for the U.S. dollar are likely to drop still further. The reasons for this drop may well lie in the BP crisis, which has affected the economy of the United States by creating a disaster of unprecedented proportions. (b) FUSE’s Italy subsidiary has a surplus of 8 million euros for 30 days, while the United States has a surplus amount of 7 million dollars available for 30 days. In considering investments under two different scenarios, for the surplus funds that these subsidiaries have gained, two different scenarios are posed. Under the first scenario, the funds are invested locally in the country’s own currency. Thus, in the case of FUSE’s subsidiary in Italy, it has a surplus of 8 million euros and this would be invested as Euros for a 30 day period at a bank deposit interest rate of 3.4% per annum. As a result, if the 8 million Euros are invested, the subsidiary would earn 8,000,000 X 3.2/100 and /12 = 22,666 euros in one month, bringing it a total amount of 8,021,333 euros, which at the current exchange rates is $10,217,774.38. In the case of the United States, the amount available to invest is $7 million, invested at a bank deposit rate of 1.9%, the earnings for the US would be as follows: 7,000,000/12 X 1.9/100 = 11,083 dollars, bringing the total earnings in a month to 7,011,083 dollars. Thus, by using this option, the FUSE subsidiaries would have a net amount of $17228857.38. Under the second scenario, all cash balances are converted into sterling. Therefore 8 million euros would be equivalent to 6,677,285.56 pounds. Similarly, 7 million dollars is equal to 4,587,307.24 pounds, thereby bringing it to a total amount of 11,264,592.8 pounds. If this amount is invested in a bank for a 30 day period when the given interest rate is 3.4%, the interest earnings for a month would be £31,916.34, thereby leaving FUSE with a total amount of £11296509.14 or $17,232,403.18. It may be noted from the above that the total amount yielded by the first option is $17228857.38, while the second option yields $17,232,403.18. It appears that the company can earn more by converting the monies into pounds and then investing them, as compared to investing them in their local currencies. However it is worth noting that the difference in the amounts obtained are not that significant, the difference in the amounts is $3545.60, therefore it doesn’t appear to make that much of a difference. However, the possible reason for higher earnings from investing in the pound could be because the pound is a more stable currency as compared to the United States dollar which has been affected by the BP crisis while the strength of the Euro has also been affected by the financial crises in the economies of Greece and Spain. As a general principle, it would appear that FUSE might do better to invest in pounds, but there is one important limiting factor that must be borne in mind, i.e., the fines being imposed by health and Safety in the UK, which have produced a cash deficit of £4 million during the same period. From an operational point of view therefore, since subsidiary investment in local currency appears to have the potential to generate almost as much income as investing in pounds, any advantage gained by the higher exchange rates in pounds would be negated by health and Safety fines, so FUSE might be safer allowing subsidiaries to invest in their local currency, in order to avoid the fines. References: Canadian Dollar Forward Rates. Retrieved July 11, 2010 from: http://fx.sauder.ubc.ca/CAD/forward.html Painuly, J.P., Park, H, Lee, M.K. and Noh, J, 2002. “Promoting energy efficiency financing and ESCOs in developing countries: mechanisms and barriers”, Journal of Cleaner Production, 11(6):659-665. Read More