Corporate Finance and Financial Accounting - Essay Example

? CORPORATE FINANCE Introduction During the first meeting with the boardof directors of the XYZ Corporation, diversification of idiosyncratic risk formed the main subject of discussion. Currently, corporations and other business organizations expand their operations to expand the client base and attract additional profits within the company. Any form of venture undertaken by an organization entails additional capital; hence an increment in the level of risks (Perks & Leiwy, 2010). However, it is the responsibility of the organization to formulate and implement appropriate strategies to deal with risks. For this case, the management of XYZ opted for acquisition of the company. XYZ sold itself to ABC International in exchange for $8.2 billion. After the acquisition, XYZ estimated that the worth of its shares would be placed at $100 per share. After the acquisition, ABC would take the sole responsibility of selling the XYZ’s stock exchange ventures situated in different countries that include Netherlands, Belgium and Portugal. ABC International’s operations ABC International is a leading global operator that deals with exchanges and the market for various forms of contracts ranging from agriculture to equity index. The corporation is based in the United Kingdom with its operations in Russell, Europe and some parts of the United States. The company operated under ABC Int’l as the trade mark and name. The company is managed by a board of directors, who set high standards that help in day-to-day management of the company. However, there exist guidelines and regulations of the organization that must be followed from time to time, subject to modification by the board of directors. This ensures a fulfillment of the best interests of the organization in line with the rules and regulations of the company. Complaints in relation to the management of finances within the company can be launched by an individual or a group. Currently, the company’s shares trade at $150 depicting a 1.20% growth rate annually. Investments and the capital structure of ABC Int’l ABC Int’l has been into operation since early 2000. During a review of the last financial year, the company’s revenues totaled to $1.4 billion, posting a net income of $551.58 billion and a growth rate of 2.7%. The company’s financial analysis is as presented below: Valuation ratio P/E Current 20.27 P/E Ratio (with extraordinary items) 20.27 P/E Ratio (without extraordinary items) 16.46 Price to Sales Ratio 6.61 Price to Book Ratio 2.46 Price to Cash Flow Ratio 12.39 Enterprise Value to EBITDA 11.19 Enterprise Value to Sales 8.02 Total Debt to Enterprise Value 0.13 Efficiency Revenue/Employee 1.27 Income per Employee 0.51 Receivables Turnover 10.34 Total Asset Turnover 0.04 For the liquidity ratio, the current and the quick ratio both stand at 1.04 while the cash ration remains at 0.05 Profitability ratio Gross Margin 70.00 Operating Margin 60.00 Pretax Margin 57.50 Net Margin 40.00 Return on Assets 1.20 Return on Equity 16.30 Return on Total Capital 12.50 Return on Invested Capital 12.88 Capital Structure Total Debt to Total Equity 30.00 Total Debt to Total Capital 20.50 Total Debt to Total Assets 3.00 Long-Term Debt to Equity 26.50 Long-Term Debt to Total Capital 20.00 Rationale for the acquisition The acquisition would ensure improvement in the ranking of the XYZ Corporation in the stocks exchange market. This is because of the strengthening of products and leadership (Ehrhardt & Brigham, 2011). After the completion of the acquisition, the new company will focus on the improvement of financial services, leading to high growth potential. Diversification of risks will attract more investors to invest in the company, hence growth and expansion of the company (Nofsinger, Kim & Mohr, 2010). In addition, existing investors will be certain of their investments, whereas the same venture will aim at increasing shareholder’s wealth through improved profitability. Acquisition means an increment in the size of the organization, hence the increment in the size of the balance sheet (Ogilvie, 2008). This adds an advantage to the wholesale and retail clients since the organization attains an advanced capacity to give credit services to them. Acquisition of XYZ Corporation will also lead to optimization in the utilization of resources. This is the case because of the introduction of synergies both to employees and various branches of the organization all over the world. Description of acquisition transaction of XYZ by ABC International The board of directors of XYZ agreed to sell their corporation to ABC International at a cost of $8.2 billion. The board of directors from both companies agreed that the reorganization of the share capital scheme would take place as stipulated by the UK laws and legislations. After the completion of the payment price, ABC should absorb XYZ by way of a formal scheme within 12 months after the date at which all the amount was settled. The existing shareholders from the XYZ would retain 10% of the company’s total shares as at the date of acquisition. However, every shareholder shall be entitled to a single share for every 8 shares held in the previous company. Governance of XYZ after acquisition The corporation would be guided and managed by the governance framework of ABC International. The corporation’s board shall not be grounded; rather, they shall be answerable and accountable to the management of ABC International. Upon capital restructuring of the company, a new board will be created for the XYZ Corporation. This would entail an inclusion of top managers from ABC in XYZ’s managerial structure, and an inclusion at least two independent directors. The post acquisition program to facilitate successful integration will be executed in two phases in both corporations. The first part shall entail definition of the project and planning and is estimated to last for three months. The second phase entails implementation of integrated systems and would take nine months. However, there exists some form of integration efforts between the two companies as depicted by the early signing of the memorandum of understanding. The exercise took place in the presence of all members of board from the two companies. During this time, a team of 40 employees from both companies was unveiled and mandated with the identification of other synergies apart from the main diversification of risks. Assumptions 1. Minimization of risks would be through the identification and management of major risks and development of appropriate mitigation measures. 2. Both companies shall retain 75% of the executive members to address any gap that may arise in skills. 3. Retention and expansion of the client base would be through a clear definition of a comprehensive retention plan through a focus on high value but at risk segments. 4. Cost reduction would be through the rationalization of branches, consolidation of some operations and de-duplication of some effective corporate functions. Changes in the XYZ’s capital structure after acquisition Currently, authorized the company has 12 million shares amounting to a total of $1.2 billion share capital. The current issued and fully paid up ordinary shares total 11 million amounting to $11 billion share capital of $100 per share. Unissued shares add up to 1 million shares of $100 each. Following the acquisition, there shall be a cancellation of 10 million ordinary share of $100 each in the share capital account of XYZ Corporation. BCA shall retain 1 million share of $100 each in the share capital account to cater for the existing shareholders. XYZ’s share premium account shall also be reduced to zero to offset any remaining negative earnings retained by the organization. Capital expenditure summary Fixed costs $ ‘000’ $ ‘000’ Implementation team commission 4,000 Variable costs Migration of desktops 8,000 Centralization of servers 15,000 Consolidation of routers 20,000 Consolidation of security systems 15,000 58,000 Total cost 62,000 Financial analysis of the acquisition project In the determination of the viability of any venture, analysis of the net present value of the venture (Arnold, 2008). The net present value depicts a stream of discounted incomes that are expected by an organization from its investments (Das, 2012). After the acquisition, the company is expected to generate a net present value of $115 million additional profit. This depicts an additional earning to the shareholders (Pratt & Grabowski, 2010). In calculating the NPV of this project, it was assumed that each sub project would generate equal cash flows for the four years. Returns are also expected at a rate of 10%. This was calculated as follows: NPV=R*- initial investment, where R refers to annual net cash flows expected to be received at the end of each year after full implementation of the project (Alexander & Nobes, 2010). i denotes the required rate of return expected from the project, while n denotes the number of years during which the project is expected to operate and generate the cash to the company. The required rate of return is an equivalent of the company’s cost of capital (Alexander & Nobes, 2010). Scenario 1: all sub projects would generate equal but individual cost savings (incomes) Consolidation of routers: 8,517,618.85*-29,000,000=-2,000,000 Consolidation of security systems: 9,148,553.58*-15,000,000=14,000,000 Migration of 50,000 desktops: 54,260,386.76*-89,000,000=83,000,000 Centralization of servers: 10,410,423.04*-13,000,000=20,000,000 Total project’s NPV 115,000,000 Scenario 2: the cost of capital remains constant while the entire company generates differential cash flows. Under this scenario, cash inflows are considered as a whole and not form individual sub projects. Year 0 1 2 3 4 Cash flows $“000” (150,000) 82,337 80,000 83,000 85,000 NPV= (+++)-150,000=$111,382,792.80 Under the two scenarios, the project should be accepted since the NPV is positive. With regard to NPV as a project evaluation technique, the decision rule is based on whether the NPV of the cash inflows to be expected is positive or negative (Alexander & Nobes, 2010). Under this technique, the decision rule is that projects with positive NPV should be accepted, while those with negative NPV should be rejected. The company is expected to generate a net present value of cost savings amounting to $115 million under scenario 1, while scenario 2 would amount to $111,382,792.80. This shows that there is a likelihood of the company generating lower cost savings than anticipated. The fluctuation also depicts that there are some aspects of the project that are conflicting, are likely to add more costs instead of cutting on costs and the fact that it may face some or strong opposition from the company’s employees (Baker & Powell, 2005). However, after the period incomes generated by the company are expected to grow evenly at $85,000 For the cost of capital used in the calculation of the net present value, the rate was obtained from application of the capital pricing model (CAPM). There exist different risks in the market (Pratt & Grabowski, 2010). A systematic risk is one that cannot be diversified, whereas unsystematic risk is specific to the company’s stocks and easily diversified (Rice, 2011). Among all industries operating in the UK, the beta value is equal to 1.2. The company’s risk free rate of return is 4% while the market risk premium rate at 5%. Using the CAPM: E(ri) = Rf + ?i(E(rm) - Rf) (Rice, 2011) = 4 + (1.2 x 5) =10%, hence the company’s cost of capital. For companies that have different sources of finance, it would be crucial to determine the weighted average cost of capital. The parameter depicts the weight assigned to relevant components in the market (Weaver & Weston, 2008). Together with the capital asset pricing, the two models determine the growth rate of financial assets of a company in the market (Pratt & Grabowski, 2010). After the acquisition, XYZ Company shall maintain 1 million shares of common stock trading at $100 per share. Currently, the risk free rate is at 4%, market risk premium at the rate of 8% and the beta of 1.2. In addition to this, the company owns 50,000 bonds with a face value of $1,000. The bond has annual coupon rate of 10% maturing in 20 years and trading at $950. The company’s tax rate is 35%. Market Value of Equity = 1,000,000 ? $100 = $100,000,000 Market Value of Debt = 50,000 ? $950 = $47,500,000 Total Market Value of Debt and Equity = $147,500,000 Weight of Equity = $100,000,000 / $147,500,000 = 67.80% Weight of Debt = $47,500,000 / $147,500,000 = 32.20% Weight of Debt can be calculated as 100% minus cost of equity = 100% ? 32.20% = 67.80% Second step is the calculation of the cost of equity. With the data analyzed above, the capital asset pricing model (CAPM) can be used to calculate cost of equity as follows: Cost of Equity = Risk Free rate + Beta ? Market Risk Premium (Ho & Yi, 2004). = 4% + 1.2 ? 8% = 13.6% We also, need to calculate the cost of debt. Cost of debt is equal to the yield to maturity of the bonds. With the given data, we can find that yield to maturity is 10.61%. After tax cost of debt is hence 10.61% ? (1 ? 30%) = 7.427% WACC = 38.71% ? 13.6% + 61.29% ? 7.427% = 9.8166% Recommendations The acquisition of XYZ by ABC International is recommended for companies wishing to merge and form one larger company, while at the same time, diversifying risks. While undergoing a merger process, most companies may find it difficult to control their costs (Das, 2012). This leads merging companies spending a lot finances on meeting expenses that have increased due to business expansion, hence the additional risks (Watson & Head, 2011). However, these challenges can be overcome through initiating proper consolidations on the business infrastructure of the two companies. XAC intercompany Net project consolidates various structures of ABC and XYZ to come up with one simple structure that ensures cost-saving and diversification of risks (Brealey & Myers, 2010). It is expected that the project has an initial investment capital amounting to $150 million. It is expected that the company will generate incomes amounting to $200 million from costs saved due to implementation of the project. Although the project has a net present value amounting to $115 million, the company anticipates that $85 million will be amount of savings from other activities. For instance, cost of hiring additional employees. Reference list Arnold, G. (2009). The Financial Times Guide to Investing. USA: Pearson. Alexander, D. and Nobes, C. (2010). Financial Accounting: An International Introduction. NY: FT Press. Baker, H. K., & Powell, G. E. (2005). Understanding Financial Management a Practical Guide. Oxford: Blackwell Pub. Http://Public.Eblib.Com/Eblpublic/Publicview.Do?Ptiid=243549. Brealey, R. and Myers, S. (2010) Principles of Corporate Finance—Global Edition. NY: McGraw-Hill. Das, S. (2012). Extreme Money: The Masters of the Universe and the Cult of Risk. NY: Pearson. Ehrhardt, M. C., & Brigham, E. F. (2011). Corporate Finance: A Focused Approach. Mason, Oh: South-Western Cengage Learning. Nofsinger, K., Kim, J.R. and Mohr, D.J. (2010). Corporate Governance, International Edition. NY: Pearson. Ogilvie, J. (2008). Management Accounting - Financial Strategy. Oxford: CIMA. Ho, T. S. Y., & Yi, S.-B. (2004). The Oxford guide to financial modeling: applications for capital markets, corporate finance, risk management and financial institutions. New York: Oxford University Press. Watson, D. and Head, A. (2009). Corporate Finance Principles and Practice.USA: Pearson. Perks, R. and Leiwy, D. (2010). Accounting: Understanding & Practice. NY: McGraw-Hill. Pratt, S. P., & Grabowski, R. J. (2010). Cost of Capital Applications and Examples. Hoboken, N.J.:John Wiley & Sons. http://public.eblib.com/EBLPublic/PublicView.do?ptiID=624423. Rice, A. (2011). Accounts Demystified: The Astonishingly Simple Guide to Accounting. USA: Pearson. Watson, D. and Head, A. (2011). Corporate Finance Pass notes.USA: Pearson. Weaver, S. C., & Weston, J. F. (2008). Strategic financial management: applications of corporate finance. Mason, OH: Thomson/South-Western. Read More