General Overview of United Utilities Group Plc - Term Paper Example

………………………………………………………………………….xxxxxx …………………………………………………………………….xxxxxx …………………………………………………………………………xxxxx ………………………………………………………………………..xxxxx @2012 Equity and Fixed Income Part 1 1. a. General Overview of United Utilities Group Plc United Utilities Group Plc is a company which operates and also regulates the distribution of electricity, wastewater networks and water in North West England which includes Liverpool and Manchester. It is part of the company’s responsibility to manage other infrastructure assets in the United Kingdom and other countries across the globe. By doing this, the company helps in the smooth flow of about 7 million people as well as 200,000 businesses in the North West and it does this by the provision of fresh and clean water on a daily basis. The company also takes away and treats the North West waste water which then helps in keeping the beaches and rivers quite clean. The company plans to finance its operations using debt securities instead of conventional bonds. This plan matches the market trends as the market, or the sector across the globe has been opting for the issuance of conventional debts due to the low interest rates attracted by bonds. Bonds usually pay a fixed income and the issuance of bonds in the utilities sector in the United Kingdom only account for half of the total funds raised in the equity capital markets. Firms in this sector just like the United Utilities Group Plc are opting for the issuance of debt securities even though it has high risks of threatening the market viability. Data also showed that only 8.7% of the funds raised were through equity capital markets while the remaining portion being raised through the use of debt securities. Therefore, the plan by United Utilities Group Plc to finance its operations through the use of debt securities is in line with the sector which has highly employed the use of the debts. The company also has price setting limits where the capital base is adjusted for capex in setting this limits. The gearing net debt as a percentage of the Regulatory Capital Value forms the basis for the price setting. b. General Overview of the issued debt Debt security is an instrument which can be sold or bought between two different parties and include corporate bonds, collateralized securities, preferred stock and zero-coupon securities (Fabozzi et.al 2003). The interest rate on a debt security is usually determined by the borrower’s repayment ability. Debts securities are quite safer than equity securities as the principal amount is usually returned to the lender upon the maturity of the security. This is what United Utilities Group Plc plans to use as it mode of raising finance. 2. Evaluation using the Annual Financial Reports and accounts a. The position of the company to issue debt securities The annual profits for the company have decreased from ?909.20 million in March 2008 to ? 316.5 million in March 2012. Its EBITDA has been fluctuating over the period with an increase only being recorded on March 2009 after which the company recorded a continued decline. The company has also recorded a decrease in its Free Cash Flows for the Firm (FCFF) from ? 562.7 million in 2011 to ?559.8 million in 2012. The company borrowed ?215 million during the 2012 financial year in order to offset the dividends of ?209 million. Free Cash Flow to Equity (FCFE) is low for the firm as the firm’s equity is higher than the free cash flow. From the March 2012 annual statement, it is quite evident that the company has made maximum use of debt securities as it net debt is quite higher than the one recorded during the previous year which then reflects the additional borrowing done by the company as a way of funding its capital investment programmes. The gearing ratios for the company are also quite high, and this is an indication of how risky the company is. Gearing ratios measure the degree to which the activities of a firm are funded by owner’s funds or creditors funds. The high gearing ratio in the company means that the company is quite vulnerable to the business cycle downturns as it must continue in the servicing of its debts regardless of the bad sales. For example, the company recorded a consolidate debt/equity ratio of 3.25 which is a clear indication that the company heavily uses debts in the financing of its assets. The company also recorded high total liabilities to equity ratio of 4.68 and interest cover of 2.24 both which indicates of its heavy reliance on debts. However, the company profits and financial flows is not adequate to the extend of servicing these debts. Since 2008, the company has recorded a fluctuation on its net gearing ratio with the highest increase being recorded on March 2009 at 432.84%. Free Cash Flow ?m (Continuing operations) Year ended 31 March 2012 31 March 2011 Underlying operating profit1 594.1 596.4 Underlying profit before taxation1 327.0 329.2 Underlying profit after taxation1 240.9  239.2 Underlying earnings per share1,2 (pence) 35.3 35.1 Source: http://corporate.unitedutilities.com/full-year-results-year-ended-2012.aspx From the above information, it is quite evident that United Utilities Group Plc is not a good financial position of issuing debt securities and is therefore unable to service its debt payments. The use of debt securities to finance its operations may lead to increased earnings, but the cost of the financing of these debts is too much for the company to handle and may lead to bankruptcy. The company should consider the use of equity as a greater proportion of equity will provide the company with a cushion from continued debts. b. Issuance of a bullet bond A bullet bond is a debt instrument in which the full face value of the bond is paid only once and at the maturity date. These bonds are non-callable and cannot be redeemed earlier by the issuer and this makes them to pay a very low interest rate due to the exposure of the issuer to the risk of the interest rate (Fabozzi et.al 2003). That is, bullet bonds are the type of bonds which has a fixed interest rate and amortizes fully on the maturity date. Advantages and disadvantages of issuing a bullet bond One advantage of bullet bonds is that they offer a variety of maturities which range from short to long term. Bullet bonds are quite risky than an amortizing bond as they give the issuer a larger repayment obligation on one day instead of a series of smaller repayment obligations spread over many days (Frank and Fabozzi 2001). The issuer cannot redeem the bonds earlier than the maturity date and they have a low interest. Those issuers of bullet bonds who are quite new in the market or those with low credit ratings may attract more investors into the market with an amortizing bond than a bullet bond How a bullet bond is priced, how a credit spread involved is Bullet bonds are priced based on the sum of the present values of all expected coupon payment in addition to the present value of the par at the date of maturity. In bullet bonds, the credit is spread through out the bond period until the maturity of the bond. What are the risks and costs to the company of issuing such debt? Issuance of a bullet bond as a debt is less risky and is considered as a low risk investment. In bullet bonds, it is not possible to call the bond before its date of maturity and this creates no opportunity for any applied interest rate to either fall or rise. Another risk associated with the issuance of bullet bonds by any company is that the bonds have a high possibility of being highly impacted by the failure in the market interest rates (Fabozzi et.al 2003). However, the maturity date for a bullet bond is fixed and there is guaranteed interest rates which reduce the risks associated with this bond. The costs associated with bullet bonds make it quite expensive than callable bonds. Since bullet bonds costs more, it leads to a higher interest rate. c. Should the bond be callable or puttable? A callable bond is a bond where the bond issuer has the full rights to call the bond away from the investor for a determined price during the time of bond issuance. That is, a callable bond can be defined a debt obligation in which the company is permitted to redeem the bonds before the maturity dates (Fabozzi et.al 2003). The amount paid is usually higher than the principal amount of the bond. A puttable bond on the other hand gives the investor an opportunity to sell the bond back to the issuer before the maturity date at a specified price which is usually specified at the time of issuing the bond. That is, the holder can sell the bond back to the issuer before the date of maturity. In the case of a callable bond, those individual with a long position in the security will be long in the bond and short in embedded call option. For United Utilities Group Plc, the bond should be puttable. Callable bonds are highly affected by negative convexity and especially with the fall in the interest rates. That is, it represents a drawback to the investors which then causes the price behavior of this bond security to exhibit negative convexity (Frank and Fabozzi 2001). Puttable bond is a reverse of the callable bond as if the prices of an equivalent straight bond fall below the already put a price, the price of the puttable bond will still remain at the put price and this enables the holder of the security or gives the holder the right to sell the bond back to the issuer of the bond at that particular price. It would not be a good idea for the company to use callable bonds. The call feature of this bond is positive to the issuer as it allows him or her to essentially refinance the debts at favorable terms in times of low interest rates (Fabozzi et.al 2003). However, it limits the potential of capital appreciation of the bond whenever the interest rates fall. Investors must be compensated for the drawback through a greater return potential, and this is because the callable bonds are usually prices at a discount. Generally, the truncation effect which occurs from callable bonds due to the price yield curve of the bond creates the negative convexity when the price is approaching the call price, and this makes not a good option for the company. d. Should United Utilities Group Plc consider a convertible bond issue United Utilities Group Plc should consider the use of convertible bond issue. Convertible bonds are bonds which are issued by a company and which can be converted into shares in the future. There are several factors which determine the decision of a company to issue convertible debts as a way of raising funds (Werner 2010). One of these factors includes the funds which are generated internally relative to the financial needs of the company. With convertible bond issue, the company will be assured of receiving limited and fixed income until the bonds are converted. This is quite advantageous to the company as more operating income will be made available for the common stockholders (Frank and Fabozzi 2001). The bond interest from convertible bond issue is considered a deductible expense for the company and 30% of the convertible bond issue will be deductible in the calculation of tax expense. The convertible bond will also offer the company with interest which is the yield to investors. The longer the time in which the company holds the bond, the higher will be the yield. The interest accrued will then be paid to investors as yield. The convertible bond also gives flexibility to investors (Schoutens and Spiegeleer 2011). With the success of the company, the investors have the opportunity to convert these bonds into stocks which are usually valued higher than the bonds. The utilities sector is highly faced by market fluctuations and the use of the convertible bonds will help to protect the company against adverse market fluctuations while providing market gains at the same time. The company should also use convertible bonds because of the following advantages: It reduces dilution It has fewer impacts on profit and loss statement Has reduced impacts on the current market share price than it has on share issue It has lower coupon vs straight bond It raises the effective price making it to be sold at a premium to the current price Mechanics of convertible bonds The mechanics of convertible bonds include the needs to issue convertible bonds from the point of the issuer and the need to purchase the bonds from the point of view of the investors. A convertible bond must be worth at least the value of those shares into which it converts (Schoutens and Spiegeleer 2011). To the investors and the company, convertible bonds have high cost and payoff implications which include: The bonds offer lower risks It protects the investors in risky markets It has higher running yield than the ones obtained from share dividends e. Should United Utilities PLC consider an inflation linked bond? Inflation linked bonds are those bonds which provide protection against inflation. These types of bonds are highly linked to inflation which help in the minimization of inflation risks. Examples of inflation linked bonds are the Canadian “Real Return Bond”, the new US Treasury “inflation-protected security” and the British “Inflation linked Git”. United Utilities Group Plc should make a decision on whether to use this type of bond as the principal amount of the bond increase with inflation and this would make the company to pay higher for the bonds principal amount (Mark et.al 2004). That is, the principal amount paid at the maturity period is inflated and this makes it quite expensive for the company. The interest rates applied leads to an increase in the principal amount. However, the advantages of these bonds outweigh the disadvantages making it worthy to be used by the company. Mechanics of inflation linked bonds For United Utilities Group Plc, consumer price index usually uplift works in a capital indexed bond. The mechanics of inflation linked bonds also include the real yield which are expected to the holder and what this means to them. The inflation linked bonds are designed with the main aim of hedging the investors as well as the company against inflation. That is, they are high correlated to inflation and usually offer the long term investors with some protection in times of high inflation (Mark et.al 2004). Inflation linked bonds are quite advantageous to investors as it provides them with long term assets which are free from any inflation risks. With the use of these inflation linked bonds, both the investors and the company will enjoy more advantages ranging from high returns and also offers then a high level of safety. Simply, this kind of securities highly provides them with higher returns than the inflation rates. The price setting limits by the company also helps it to cushion itself or to prevent adverse effects of inflation and this is the main reason as to why the inflation linked bonds together with the price limits to prevent adverse inflation risks. Part 2 Introduction The word GBP is the acronym for the British pound sterling; this is the official currency of the United Kingdom among other countries like Zimbabwe. It is symbolized by the mark (?) and is also called “guid.” This is because stocks are traded in pennies (Sercu 2009). Bond is a money owing venture in which a financier lends money to a unit that is either corporate or governmental. This unit borrows money for an agreed time and a fixed interest rate. Bonds are used by these units to finance their projects (Wiley 2011). In this research, we are going to use the Z-spread method to price a 5 year GBP bullet bond issue for the united utilities PLC (Wiley, 2011). The Z-spread is the theoretically intimately related to YTM. It has a true meaning of spread than an easy distinction between two figures. For similar rationale, YTM is a more precise gauge than flat yield: principally varies with rates over time (Dubil 2012). The Z- spread is the sum by which the discount rate would have to surpass the gain of risk free bonds so that the present value can be the same as the market price (Dubil 2012). In simple terms, the Z-spread is an IRR. On the other hand, instead of discounting each coupon payment using similar rate, every coupon payment is discounted by the rate over that period. This is the formulae used in calculating annual coupon payments; P = c0 + c1/(1+r1 + z) + c2/(1+r2 + z)2 + c3/(1+r3 + z)3 ... t(1+rn + z)n Where p is the value of the bond c1 is the coupon payment, c1 the second etc., r1 is the risk free rate for the next year, r2 for the next two years, etc., t is the terminal value — the total payments in the year the bond matures, and z is the z-spread. Let us presume that the face value is 1 dollar except otherwise. Assuming that at a particular date t a zero – coupon bond whose maturity T-t is sold in the markets at a price of BT. If there are several zero-coupon bonds which have diverse prime time being traded, we can deduce the function T 7! BT (t). We will name it the market function existing at time t. Note down that Bt where t=1, because the cost of acquiring 1 dollar immediately is 1 dollar. Assuming that all the financiers would rather get a dollar at a current time T rather than at a potene time S, the market function should decline, that is 1-BT T - Bs T - 0; T < S: In our case, a bullet bond whose face value is 100 will be used, a coupon rate with a rate of 4.5%, annual payments, and exactly five years to maturity. Assuming zero-coupon bonds are sold with a face value of 1 dollar and period to maturity of 1, 2, 3, 4, 5 years, respectively. Let’s assume that the values of these zero-coupon bonds are Bt+1; t= 0.94 Bt+2; t=0.90 Bt+3; t=0.87 Bt+4; =0.79 Bt+5;=0.73 The price of the bullet bond will therefore be Bt=4.5 _ 0:94 + 4.5 _ 0:90 + 4.5 _ 0:87 +4.5 _0.79+104.5 _0.73=102.70 If the price is lower than 102.70, risk free gains can be protected by purchasing the bullet bond and selling 4.5 for the first year, 4.5 for the following years and 104.5 five-year zero-coupon bonds. If the price of the vanilla bond is higher than 102.70, trade the vanilla bond and purchase 4.5 for the following year other than the last one which is the 104.5 five year zero-coupon bonds (Sercu 2009). On the other hand, to evaluate the enormity of an interest rate, we need to be aware of the compounding frequency of that rate. It is given by the value Bt at time t on a zero-coupon bond whose prime time t, the applicable discount rate between time t and T is the capitulate on the zero-coupon bond, which is therefore the yield spot rate for date (Wiley 2011). The zero-coupon rates as a purpose of maturity are known as the zero-coupon yield curve or merely the yield curve. It the only way to articulate the words structure of interest rates. Whereas a spot rate reflects the value of a loan connecting present and a specified potential date, a forward rate reflects the value of a loan connecting two potential dates (Dubil 2012). In several markets where they sell bonds, only a few zero-coupon bonds are issued and sold. Most of the time, such zero-coupon bonds have a short maturity. In order to gather information of the zero-coupon yields for longer maturities, we gather the materials from the value of the traded coupon bonds (O’connell 2012). In economics, the yield curve is a curve representing many interest rates of the same debt covenant. The curve shows the relationship between the interest rate and when they mature, commonly known as the term of the liability for a given loaner in given money. In economics this relationship is known as the term structure of interest rates but casually called the yield curve. Its shape indicates the collective priorities of all loaners relative to a loanee. Normally, loaners are fretful of the appreciating rates of inflation, so they avail long term loans for higher interests (Wiley 2011). Bootstrapping can only give information about the discount factors for the disbursement of dates of the sold bonds. In many cases, the knowledge about market discount factors for other potential dates will be useful. The most essential theory is that the market purpose is of a known practical form with some unfamiliar variables. The amount of these parameters are then determined to obtain the finest possible concord connecting observed bond values and theoretical bond values computed using the practical form (Dubil 2012). These changes in demand and supply will then lead to a creation of a gap between the yields for the two maturities to go down. Therefore, the stability spot curve should be continuous and steady. It can be quite hard to fix a relatively simple practical form to values of a great figure of bonds with very several prime times. To improve edibility, some of the techniques suggested in the writing divide the prime time axis into subintervals and use detach functions in every subinterval. To guarantee a hysterically and steady period construction of interest rates, one must enforce certain conditions for the maturities sorting out the subintervals. Procedures of these types are called spline methods (Sercu 2009). So in this case, bootstrapping will be as below UK treasury notes (years) Coupon YTM Zero coupon rate Price T bond T-note coupon PV CF 1 4.50% 0.43% 0.430% $104.05 1.750 $1.74250722 2 2.25% 0.40% 0.400% $103.68 1.750 $1.73608355 3 2.75% 0.47% 0.475% $106.78 1.750 $1.72528599 4 2% 0.70% 0.715% $105.11 1.750 $1.70086525 5 1.75% 0.95% 0.977% $103.89 101.750 $96.92329606 $103.8280380 By using future rates, we can review the spot curve in a potentially more helpful ways. For instance, the decade spot yield can be minimized into annual year future rates over that decade prospects. Near period future rates tend to be impacted by fiscal matters, expectations and therefore recurring parameters, while lengthy period forwards otherwise are derived by factors considered as more persistent or by changes in threat preferences. The decade spot rates join these two types of influences jointly, wherever it may be (Fabozzi 2010) These gauges the width the financier would hold over the whole yield spot rate curve if the bond was held to prime time. The Z-spread is formulated as the width that will put the current amount of cash flows from the financial instruments that are not from the treasury when they are discounted at the Treasury spot rates in addition the Z-spread is the same as the financial instruments that are not from treasury . This is performed by estimation. This is different than the nominal width because the nominal width just uses one spot on the spot curve (Wiley 2011). For instance, take the spot curve and add 30 basis points to every rate on the curve. If the three year spot rate is 4.50%, the rate you should use to find the current amount of that cash flow would be 4.50%. After you have formulated all of the current amount for the cash flows, sum them up and see whether they are similar to the bonds value. If they are, then you have found the Z-spread, if not, you have to go back to the drawing board and use another width until the current price of those cash flow is the same (Fabozzi 2010). In this case it will be, Price UUL Bond Z- Spread Coupon UU PV CF+Z YTM MD 2.80% 4.5 4.3592 3.715% 4.3592 4.5 4.2253 8.4505 4.5 4.0859 12.2578 4.5 3.9215 15.6860 104.5 86.9312 434.6561 103.5231 475.4095 458.380919 References Dubil, R., Ebook Library., & Ebooks Corporation. 2012. An arbitrage guide to financial markets. Chichester, West Sussex, England: John Wiley & Sons Fabozzi et.al, 2003. Managing a Corporate Bond Portfolio. John Wiley & Sons Fabozzi, F. J., & Mann, S. V. 2010. Introduction to fixed income analytics: Relative value analysis, risk measures, and valuation. Hoboken, N.J: Wiley. Frank J and Fabozzi, 2001. Bond Portfolio Management. John Wiley & Sons Gibson Charles, 2008. Financial Reporting & Analysis: Using Financial Accounting Information. Cengage Learning Mirfendereski, Dariush, Derry, Andrew and Deacaon, Mark, 2004. Inflation-indexed Securities: Bonds, Swaps and Other Derivatives. John Wiley & Sons O'Connell, M. 2012. Catching bullets: Memories of a Bond fan. Droxford: Splendid. Record, N. 2011. Currency Overlay. Chichester: John Wiley & Sons. Sebastian, Werner, 2010. Short Selling Activities and Convertible Bond Arbitrage: Empirical Evidence from the New York Stock Exchange. Springer Sercu, P. 2009. International finance: Theory into practice. Princeton, N.J: Princeton University Press. Sundaresan, Suresh, 2009. Fixed Income Markets and Their Derivatives. Academic Press United Utilities Group Plc, http://www.unitedutilities.com/default.aspx. Accessed on 7th January 2013 Wim, Schoutens and Spiegeleer. J, 2011. The Handbook of Convertible Bonds: Pricing, Strategies and Risk Management. John Wiley & Sons Read More