Strategies for Financial Success: Vestas Wind Systems - Essay Example

? STRATEGIES FOR FINANCIAL SUCCESS – VESTAS WIND SYSTEMS Table of Contents Question 4 Introduction 4 Business Strategy & R&D 4 Merger & Acquisition6 Financial Statement Analysis 6 Branding & Positioning 8 Financing 9 Sources of Finance 9 Financial decision Analysis 10 Dividends 11 The Clientele Effect 12 Question 2 12 Capital Structure of Vestas 12 Factors Influencing Capital Structure 13 Optimal capital structure 14 Question 3 15 Developing ad Justifying Value Drivers 15 CAPM Model for Vestas Wind Systems 17 Calculating WACC for Vestas Wind Systems 18 Developing SVA Model 19 Gordon Growth Model 20 Market Efficiency and EMH 20 Sensitivity Analysis 21 Findings and Discussions 22 References 24 Bibliography 27 Appendices 29 Question 1 Introduction Vestas Wind system is Danish electrical equipment manufacturer and distributer of wind turbines. The company was founded in the year 1945 and is a publicly traded company. The company has experienced tremendous growth in the 90s which then gradually declined due to competition in the sector. In the year 2007, the company’s market share was 28% which then came down to 12.6% in 2009. The company operates globally including countries like Italy, Britain, Sweden, Germany, United States, Australia, China, India, Norway, and of course Denmark. Business Strategy & R&D The company has over 30 years experience in the field of wind power. The company has successfully installed wind turbines in over 70 countries and during the year 2012, it conceded and installed wind capacity of 50 GW positioning itself as the world’s leading wind power generator. (Source: Dolcera, 2010) (Source: Dolcera, 2010) As the supply of non-renewable energy is declining, it is expected that wind power will represent a significant portion of combined energy supply. This makes the company’s future position attractive for investors. The company also plans to position itself as the leading brand in the renewable energy segment. The future of wind power looks bright as the sector is financially competitive as the price of fossil fuels will rise in the coming years with supply constraint. Also the volume of wind power is predictable and available at cheaper cost. Unlike fossil fuels wind power can be generated and controlled at local units which makes it faster compared to nuclear or goal power plants. The most notable property of wind power is that it is clean energy. The company last reported a profit of €156 million for the year ending 2010 form total revenue of €6.9 billion. The total asset of the company is over €7 billion with total equity of about €2.75 billion. In the year 2011, the company won ?940,000 Energy prize in Abu Dhabi (Rudolph, Schlegelmilch, and Bauer, 2012, pp.253-270). The company’s latest investment decision is to expand its business in US. It plans to hire about 3500 new employees in US. The investment strategy is expected to benefit the investors in US since with the expansion of the company, the sales revenue of the company would increase which will help the company to distribute wealth to their equity shareholder. Investors in US comprise nearly one-third of equity shareholders base for the company. Merger & Acquisition The company acquired WEIER Electric in the year 2005, NEG Micon A/S in the year 2004, and Windcast Group A/S in the year 2002 as a part of global expansion strategy to increase their market share. The company has adopted M&A strategy to remain competitive, to share technology, to benefit from tax incentives, to experience synergy effect in their operations. Also in the year 2011, the company acquired minority stake in the company C&C Energy Srl after picking the minority stake in Gamesa Eolica SA (GE) in 2001. Vestas also divested stakes in Volund Staalskorstene in the year 1995 due to poor performance and bleak future outlook in that company (Emmerhoff and Partyka, 2009, pp.4-15). Financial Statement Analysis During the mid of the year 2009, the company was able to bag two new orders in China with aggregating capacity of 75 MW power generation. The company is very prudent regarding investment decisions and it never disclosed publicly the value of the deals. The economic slowdown has depressed the company’s order volumes since the customers are focusing on cost cutting techniques to save bottom their lines. The general contracts of the deal include manufacture, installation, delivery and maintenance of wind turbines. (Source: Dolcera, 2010) The intangible assets of the company have significantly grown during the previous year, 2011, and now constitute for about 50% of non-current assets. The proportion of intangible assets of the company is much higher compared to the fixed assets. The company’s non-current assets include deferred income taxes, equity and other investments. The total assets of the company have increased by 8.82% compared to 2011 and the same has increased at 15.66% annual growth rate. The non-current assets of the company has experienced a compounded annual growth rate 31.34% Year on year (Y-O-Y) where as the total intangible assets of the company has increased by 25.13% during the same period. The company is planning to invest in China and US even during the slowdown. For the same reason, it has significantly reduced the cash outflow by reducing payment of taxes. The increase in deferred income taxes was 21.26% Y-O-Y. The company has deferred tax payments to finance the working capital requirements of the new projects. Due to such cash management strategies, the company was able to increase its long term assets by over 36% during five year period. Another reason for the company to defer taxes is that the company has a very weak cash position (Graham, 2003, pp.1075-1129). Due to shortage of cash for various investments into projects the company has also adopted zero dividend policy. The inventory position of the company is manageable and the account receivable of the company also has not increased significantly. This implies that the company is prompt in debtor collections and has shorter product life cycle (Emmerhoff and Partyka, 2009, pp.17-39). Branding & Positioning The company’s vision is to provide at least 20% of global electricity supply whose demand is increasing at 4.5% annually. The company plans to transform wind energy into major contributor of energy source. The mission statement of the company it can be said that Vestas maximises the value proposition of all its stakeholders through providing services at cost efficient model which is based on latest technology. Currently the US is facing economic slowdown and most corporations are focusing on cutting cost and lay-offs to manage shrinking bottom lines. The investment strategy of Vestas is contradictory to other corporations since the company operates in a line of business that is clean and has great potential to replace fossil fuels in future that contributes to global warming. Thus, regardless of global slowdown in the economy, the company expects to earn profit of over $9 billion achieving a growth in sales of over 18%. The slow pace in the growth rate is due to entry of competitors which reduces the company’s global market share. The investment decision is favourable for the company since if it does not invest in research and development and at the same time in technology, the cost of the manufacturing might increase which will be passed on to the customers. In such a scenario, the demand for the company’s products will decline in future since there is a negative gloom in the economy and consumers are cutting spending. In order for the company to stay competitive in the market, it is very important for the company to identify the key areas for investment along with key markets that hold hidden potential for the company to reap benefits of investment in future and hen attain the financial objective of optimisation of shareholders’ wealth (Emmerhoff and Partyka, 2009, pp.11-12). Financing The financing decision in the corporations deals with taking monetary decisions regarding raising finances in such a combination that maximises shareholders’ value. Various tools and techniques are used to analyse the expected return from investment and the cost of financing. A financial source will be considered as viable if its cost of finance is less than the expected return from investment. In case when the company has more than one option to raise funds and all such options have expected return greater than the cost of finance, then from these sources of funds only those will be selected which maximises the shareholders’ wealth (Chandra, 2011, p.8). Sources of Finance The dynamic environment where business exists and operates may require funds every now and then to finance projects. Project financing is concerned with the activities related to planning, controlling, raising, and administering funds required for projects. Depending on the nature and size of the project, the sources of funds can be broadly classified into long-term sources and short term sources of funds. The long term financing are also known as fixed capital that are used to purchase fixed assets. For instance, the projects that require purchase of plant and machinery, land, furniture, etc. requires fixed capital investment. On the other hand, the short term financing are more concerned with utilisation of funds for carrying out day to day operations. In order to maintain a good financial position, the firm’s would need to maintain an optimal balance between short term and long term funds (Banerjee, 2005, pp.47-55). Both the internal and external sources of funds have individual characteristics that determine their requirements at different situations. For instance, when company wants to earn higher EPS for their share holders, they can leverage their balance sheet with debt capital to finance projects. Again consider situation when the company’s balance sheet is already highly leveraged, then the company will have limited choice to debt finance since over exposure to debt capital raises financial risk of firms (Graham, 1996, pp.41-74). The long term debt of the company has increased to ?5.5 m which represents less than 4% of Net assets of the company. The company has followed the policy of investment through debt as the debt financing is cheaper than equity financing. The long term debt of the company is unsecured since most of the retained earnings of the company have invested into projects. Due to this reason the cash position of the company has weakened over the years. Financial decision Analysis The management of Vestas Wind System believes in investment and growth opportunities. Vestas is one of the fastest growing companies in the renewable energy segment and as the supply of non-renewable energy is declining, it is expected that wind power will represent a significant portion of combined energy supply. This makes the company’s future position attractive for investors. The company also plans to position itself as the leading brand in the renewable energy segment. The future of wind power looks bright as the sector is financially competitive as the price of fossil fuels will rise in the coming years with supply constraint. Also the volume of wind power is predictable and available at cheaper cost. Unlike fossil fuels wind power can be generated and controlled at local units which makes it faster compared to nuclear or goal power plants. The most notable property of wind power is that it is clean energy. (Cook and Tang, 2010, pp.73-87). Dividends The dividend decisions are generally taken by the board of directors of the company. It is the amount of cash received by the owners of the company for the investment they have already made and the risk they have taken to make the company. Dividend decisions influence the stock price of the company as well as its capital structure (Myers, 1977, pp.147-175). Dividends are normally paid twice a year namely interim and final dividend and they are paid out of accumulated profit as dividend represents the absolute claim of the shareholders. Thus, in case a company has huge amount of outstanding loans, then the company may prefer paying off loans instead of dividends. But if there are opportunities for growth via new projects which will increase company’s revenues in future, then also the BOD may postpone dividend distribution. However, this does not imply that the shareholders wealth will not be maximised if BOD invests in new projects or expansions. The reason is that the shareholders wealth will be maximised through long term capital appreciation in the stock price. Thus, many theories such as M&M state that dividend decisions are irrelevant as the investors can create their own wealth by selling appreciated shares in future or by reinvesting unwanted dividends (Modigliani and Miller, 1963, pp.433-444). The dividend policy of Vestas Wind System is dependent on the growth opportunity and liquidity requirements. Hence, from the above discussion it can be said that the company follows zero dividend policy due to growth opportunities and weak cash position. The dividend decision is dependent on three important factors – Free-cash flow, dividend clienteles, and signalling. Under the free-cash flow theory of dividends, the firm will pay dividends only if the company has surplus funds available after investing into all projects with positive NPVs. Such a decision will maximise shareholders’ wealth. The Clientele Effect Under the clientele effect of dividend theories, the dividend requirements vary from one shareholder to another. For instance, a retired individual might prefer consistent and regular dividend payments where as a highly paid young shareholder might cash avoid dividends in order to reduce tax implications on current incomes. Hence, according to this theory, if clienteles exist in the firm then it will distribute dividends according to preference of clients. But such dividend policy must ensure minimisation of cost of capital and maximisation of shareholders’ wealth (Lumby, 1988, pp.45-462). Question 2 Capital Structure of Vestas The capital structure of a company refers to the total investment in the company. The term structure denotes the manner in which the long term finances are raised in the company. For instance, long term funds can be raised through equity or debt or a combination of both. Thus, capital structure refers to the composition or constituent of long term financing of the organisation (Baker and Wurgler, 2002, pp.1-32). Capital structure involves decision making regarding the type of security to be issued and the relative proportion of each chosen security. Basically, Vestas can issue securities such as common equity, preferred equity, debentures, or term debt or a combination of all the above. But the concept of capital structure represents the mixture of equity capital and long-term debt capital issued by company to finance its operations. The capital structure should be chosen in such a proportion that maximises the shareholders’ value and minimises the overall cost of capital for Vestas wind system (Byoun, 2008, pp.3069-3096). Factors Influencing Capital Structure Trading on equity – As long as the fixed rate of debt is lower than the earnings of the company, the shareholders will benefit by earning additional profits. This process is known as trading on equity. In case of Vestas the total interest payable on the outstanding debt € 66 million where as its total earning for the year was over € 6000 million. Thus, the shareholders of Vestas benefited from the issue of debt capital. Desire to control the business – A company cannot issue equity capital in large proportion if it wants to retain control since by issuing common equity the company will have to dilute ownership stake. Then the options that will be left for the company is debentures or preference shares issue which does not involve the dilution of ownership stake in the company (Baker and Martin, 2011, pp.19-30). Purpose of financing – The time period and the purpose of financing must be taken into consideration before making the decision of capital structure. For instance, Vestas is planning to expand globally into the emerging economies and in such case it is evident that no extra earnings would be received for some times except for increased capacity. Hence, such expenditures must be financed by following the pecking order theory of financing (Frank, and Goyal, 2003, pp.217-248). Cost of financing – It is the most important factor for determining the capital structure. The ultimate objective is to maximise the shareholders’ value in the organisation which is achieved through minimising the overall cost of capital. The debt securities are cheaper than the other forms of capital and are hence preferred. Raising the entire capital by issue of one particular security often makes the cost of capital expensive. Hence, the company favours a combination of securities that minimises the overall cost of capital (Tennent, 2008, pp.87-91). Optimal capital structure From the above discussion it can be said that the company’s capital structure is influenced by inclusion of debt capital and that the shareholders’ experience higher returns in the form of increased EPS (Fischer, Heinkel, and Zechner, 1989, pp.19-40). By including debt capital in the capital structure, the company will be able to achieve optimal capital structure and reduce the overall cost of capital. The above summary taken from the financial reports of Vestas Wind System shows that EPS of the company has decreased from 0.98 to 0.26 during 2010 to 2011. This is because the company used retained earnings and long term unsecured debt to finance its upcoming projects in addition to use of equity capital. Question 3 Developing ad Justifying Value Drivers The simplified model for Shareholder value analysis of Vestas’ cash flow requirement is based on the following variables: Operating profit margin Sales growth rate Required rate of return (Cost of capital determined using CAPM) Tax rate Working capital investment Fixed capital investment Planning horizon Other assumptions: Investment in fixed assets may for replacement or expansion Depreciation is equal to replacement investment Free cash flows will be used in decision making The sensitivity analysis will be performed by varying the different variable used in SVA model The Shareholders’ value analysis can be justified on the fact that the model is consistent with shareholders’ wealth maximisation concept. Also the value drivers such as sales growth and operating profit margin can be used as benchmark against competitors. CAPM Model for Vestas Wind Systems The CAPM helps to determine the expected rate of return for an asset relative to market risk. Using the CAPM model an investor can eliminate the unsystematic risk through proper diversification by estimating the required rate of return for a given level of non-diversifiable or market risk. The practical application of the model is that the individual investor will be able to modify their investment portfolio according to their risk taking behaviour. The model also helps the individuals to analyse the risk-return profile in the portfolio (Gallagher and Andrew, 2007, pp.173-175). Beta indicates the stock volatility relative to a benchmark or market. The benchmark can be international index like S&P 500, FTSE 100, etc. The beta of market or benchmark is always one. The value of stock is stated relative to benchmark beta. The five years Beta of Vestas Wind Systems is 0.02, implying that the stocks of Vestas during last five years was less risky. However, a desirable value of beta would depend upon individual risk tolerance. Using the CAPM model, the calculated cost of capital for Vestas is 3.45%. Calculating WACC for Vestas Wind Systems Developing SVA Model Gordon Growth Model From the dividend policy of the company it was found that the company follows zero dividend policy. The Gordon Growth model is used to calculate the current stock price for a company that regularly pays dividends to their shareholders. Current stock price (Gordon’s Model) = Dividend paid at end of first year/ (constant cost of equity – Growth rate) From the SVA, the growth rate is assumed 5%, and constant cost of equity is 3.45% (using CAPM), and dividend is 0.0. Hence, Gordon growth model is not applicable for the company. Market Efficiency and EMH During the analysis of the company it was found that the company has been able to achieve operational efficiency by allocating their capital resources into long term projects that is expected to benefit over the years. According to Efficient Market Hypothesis, the security prices of the company should reflect all information in an unbiased manner. In order to test the market efficiency of Vestas, the close prices of the company from 2007 to 2012 was observed along with trading volumes. After carefully observing the rise and fall in trade volumes as well as changes in security prices, it can be said that the company’s stock prices reflects stock prices very close to its intrinsic value and hence market efficiency for Vestas holds true. Sensitivity Analysis In order to analyse the changes in corporate value or shareholder value due to change in sales growth rate, and changes in debt proportion in capital structure, the scenario manager or goal seek function of Excel can be used. The most optimistic scenario assumes the positive outcomes such as sudden increase in sales due to high demand and so on. The most pessimistic scenario assumes that the sales in the future will be subdued due to lack of demand for the products and services. Based on different assumption levels of sales and debt levels in the capital structure, the sensitivity analysis using the goal seek function can be used to test the reliability in the assumptions of key value drivers. The result of scenario analysis for Vestas Wind System can be summarised as follows: From the above discussion it can be said that the Shareholders’ value analysis can be justified on the fact that the model is consistent with shareholders’ wealth maximisation concept. Also the value drivers such as sales growth and operating profit margin can be used as benchmark against competitors. Findings and Discussions (Source: Vestas, 2013) After analysing the income statement of Vestas Wind System it can be said that even though the company made profits over the years but it did not distribute dividends due to investment in expansion opportunities, investment in new projects, global diversification, and investment opportunities in the emerging economies such as China or India. Alternatively, the shareholders’ of the company are confident about the future prospect of the company as well as its management and board of directors. The stakeholders prefer capital appreciation of the company’s stock price in the market over cash dividend distribution. The company also does not follow the clientele theory. The signalling theory is not applicable to the company since the managers are confident about future earnings of the company and hence their surplus is invested into new projects instead of paying cash dividends to shareholders (Besley and Brigham, 2008, p.606). From the above discussion it can be said that the company’s capital structure is influenced by inclusion of debt capital and that the shareholders’ can experience higher returns in the form of increased EPS. By including debt capital in the capital structure, the company will be able to achieve optimal capital structure and reduce the overall cost of capital (Carpentier, 2006, pp.4-18). The dividend policy of Vestas Wind System is dependent on the growth opportunity and liquidity requirements. Hence, from the above discussion it can be said that the company follows zero dividend policy due to growth opportunities and weak cash position from investment through retained earnings. References Baker, H. K. and Martin, G. S., 2011. 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Appendices Table 1 – Balance Sheet of Vestas Wind Systems Table 2 – Income Statement of Vestas Wind Systems Table 3 – Calculation of WACC for Vestas Wind Systems Table 3.1 – Accounting Details Extracted from Financial Statements Table 3.2 – WACC of Vestas Wind Systems Table 4 – CAPM Model for Vestas Wind Systems Table 5 – Shareholders’ Value Analysis for Vestas Wind System (Using Rappaport’s Model) Table 5.1 – Determining Key Value Drivers Table 5.2 – Financial Informations Table 5.3 – SVA Model Table 5.4 – SVA Model Summary Table 6 – Scenario Analysis and Sensitivity Test Analysis Summary Read More