Corporate Finance of Aviva Company - Case Study Example

Corporate Finance Paper: Introduction: Aviva is one of the FTSE 100 companies listed in London Stock Exchange. Aviva is the world’s fifth largest insurance group. In U.K. it is the biggest insurance group. Over the years its operation has been extended to a large number of countries. Currently it serves around 50 million customers across the world. It is one of the most profitable firms in the United Kingdom. Reviewing its recently published annual report for the year 2008, it has been found that it has maintained strong operational performance. Its operating profit before tax for the year 2008 was increased by 4 percent and has become 2,297 million pounds. It was also able to maintain total dividend per share at the level of 33.00p. Even in the turbulent market scenario, it managed to increase its sale of life and pensions by 11 percent. Total life and pensions sale became 36,283 million pounds. Sale of general insurance also increased. (Aviva Plc. 2009; Annual Report of 2008) a) Weighted average cost of capital: Cost of capital to a firm is generally defined as the opportunity costs of investors for making their investment in the firm. When an investor invests his fund in a particular firm, he actually looses other opportunities of investing his funds in other securities having risks equivalent to risks of the security of the firm he is actually investing his fund in. hence, if a firm fails to earn a return on capital at least equal to its weighted average cost of capital (WACC), it actually destroys its value. If a firm manages to earn a return that is greater than its weighted average cost of capital, it becomes successful to create value. On the other hand, if it manages to earn a return exactly equal to its weighted average cost of capital, then it neither loose nor create any value. WACC can be defined as the rate that a firm is expected pay for financing its asset. It is actually the minimum level of return that a company needs to earn on its existing asset base for satisfying its creditors, its owners, as well other providers of capital.( (Miles and Ezzell, 1980; “Weighted average Cost of Capital”) b) WACC can be represented by the following formula: (Miles and Ezzell, 1980) WACC = were + wdrd Where we is defined as the weight of equity, re is defined as the cost of equity, wd is defined as the weight of debt, rd is defined as the cost of debt. The weight of equity can be defined as the ratio of market capitalization to the market value of the firm and the weight of debt can be defined as the ratio of market value of debt to the market value of the firm. Total market value of firm is generally measured by summing total market value of equity and total market value of debt. (Miles and Ezzell, 1980; Fama, 1970; Fama, 1991) Cost of equity is generally treated as the return that the investors expect to be paid by the firm for compensating them for the variability in returns which is generally caused by fluctuating earnings and fluctuating prices of shares. Cost of equity can be presented by the following formula: (Miles and Ezzell, 1980) Cost of Equity = risk free return to yield on long run government bonds + market risk premium * Beta variant for the company. It is known that people are generally risk averse. Therefore, in capital market there always exists a risk-return trade off implying that investors will be willing to invest in risky ventures, if investment in risky financial instrument promises to provide a higher return compared to risk free rate of return. The addition amount of return over risk free rate of interest, which a firm needs to pay to its investors for attracting capital towards it, is known as risk premium. Market risk premium generally gives average rate of premium prevailing in the capital market. Beta of a company generally measures the risk associated with the share of the firm. Beta is actually a relative measure of risk associated with the company’s share against the market as a whole. (Sullivan and Sheffrin, 2003; Yee, 2006) Cost of debt, on the other hand, is generally taken at the effective rate of interest applicable to an AAA rated company in the market with an appropriate mix of short, medium and long term debt, net of taxes. In the present case WACC can be calculated by collecting information on all the variables included in its formula, that is market value of equity of Aviva at 31st December, 2008, market value of debt of Aviva at 31st December, 2008, total market value of the firm 31st December, 2008, cost of debt facing Aviva at 31st December, 2008, and cost of equity associated with Aviva at 31st December, 2008. Information on market value of equity of Aviva at 31st December, 2008, market value of debt of Aviva at 31st December, 2008, total market value of the firm 31st December, 2008, can be gathered from the consolidated balance sheet of Aviva for the year 2008. Table 1 presents important items of consolidated balance sheet of Aviva for the year ended 31st December, 2008. (Annual Report of 2008) Table 1: Important items of consolidated balance sheet of Aviva for the year 2008   2008 £m Assets   Total assets 354,562 Equity attributable to ordinary shareholders of Aviva plc 11,052 Preference share capital 200 Direct capital instrument 990 Minority interests 2,204 Total equity 14,446 Liabilities   Gross liability for insurance and investment contracts 282,409 Unallocated divisible surplus 2,325 Net asset value attributable to unitholders 6,918 Borrowings 15,201 Other liabilities 33,263 Total liabilities 340,116 Total equity and liabilities 354,562 From table 1 it can be seen that total market value of equity which takes into account common stock as well as preferred stock is equal to 14,446 million pound, whereas total debt is equal to 15,201 million pounds. Therefore total market value of the firm is (14,446 +15,201) = 29647 million pound. Now cost of equity of Aviva at 31st December , 2008 was 8.1 percent which was based on a risk free rate of 3 percent, an equity market risk premium equal to 4 percent and a market beta of 1,3 percent. On the other hand, a cost of debt 8.6 percent was effective on Aviva at 31st December, 2008. Putting all these values in the formula of WACC, it would be quite easy to obtain the value of WACC of Aviva. (Annual Report of 2008) Hence, WACC of Aviva at 31st December, 2008 = [(8.1)*(14446/29647) + (8.6)*(15201/ 29647)] percent = 8.3 percent. Therefore, at end of 2008, the weighted average cost of capital of Aviva stood at the level of 8.3 percent. c) Table 2 presents some important components from the consolidated cash flow statements of Aviva for the year 2008. (Annual Report of 2008) Table 2 : Important Components of cash flow statement Long-term business operations £m Non-long-term business operations £m Total 2008 £m Cash flows from operating activities       Net cash from operating activities 7,526 627 8,153 Cash flows from investing activities       Net cash used in investing activities (164) (231) (395) Cash flows from financing activities       Net cash from financing activities (878) (1,259) (2,137) Net increase in cash and cash equivalents 6,484 (863) 5,621 Cash and cash equivalents at 31 December 20,141 3,928 24,069 Table 2 gives information on net cash flows from various activities of Aviva during 2008. Three main categories that generate cash flows for any firms are operating activities, investment activities and financing activities. Cash flow from Long term business operation: From its long term business operation in 2008, Aviva generated a cash flow of 7,526 million pounds net of taxes. In 2008, Aviva, however, generated a negative cash flow from its investment activities related to its long tem businesses. Cash flow statement of Aviva of the year 2008 shows that net cash used in investment activities for long term business purposes of the firm stood at a level of -164 million ponds at the end of the year of 2008. Finally, from financing activities related to long term business activities also Aviva generated a negative cash flow. At the and of the year of 2008, net cash flows from financing activities stood at a level of at a level of -878 million pounds. All these three main categories of activities associated with long-term businesses of the firm caused net cash and cash equivalent to rise by an amount of 6484 million ponds at the end of 2008. (Annual Report of 2008) At the end of 2008, total amount of cash and cash equivalent associated with its long term business ventures stood at a level of 20,141 million pounds. Cash flow from non long-term business operations: From its non long-term business operation in 2008, Aviva generated a cash flow of only 627 million pounds net of taxes. In 2008, Aviva, however, generated a negative cash flow from its investment activities related to its non long tem businesses. Cash flow statement of Aviva of the year 2008 shows that net cash used in investment activities for non long term business purposes of the firm stood at a level of -231 million ponds at the end of the year of 2008. Finally, from financing activities related to non long term business activities also Aviva generated a negative cash flow. At the and of the year of 2008, net cash flows from financing activities related to non long term businesses stood at a level of at a level of -1,259 million pounds. All these three main categories of activities associated with non-long term businesses of the firm caused net cash and cash equivalent to decrease by an amount of 863 million ponds at the end of 2008. (Annual Report of 2008) At the end of 2008, total amount of cash and cash equivalent associated with its non-long term business ventures stood at a level of 3,928 million pounds. Cash flow from total business activities: From its long term as well as non long-term business operation in 2008, Aviva generated a cash flow of 8153 million pounds net of taxes. In 2008, Aviva, however, generated a negative cash flow from its investment activities related to its long term as well as non long tem businesses. Cash flow statement of Aviva of the year 2008 shows that net cash used in total investment activities of the firm stood at a level of -395 million ponds at the end of the year of 2008. Finally, from financing activities related to long term as well as non long term business activities also Aviva generated a negative cash flow. At the and of the year of 2008, net cash flows from financing activities related to long term as well as non long term businesses stood at a level of at a level of -2,137 million pounds. All these three main categories of activities associated with long term as well as non-long term businesses of the firm caused net cash and cash equivalent to rise by an amount of 5621 million ponds at the end of 2008. (Annual Report of 2008) At the end of 2008, total amount of cash and cash equivalent stood at the level of 24,069million pounds. d) When deciding on major capital investment projects, Aviva should use WACC (wighted average cost of capital) after adjusting for tax. During making a decision regarding whether to invest in a capital project, a company needs to evaluate prospects of that investment projects. A company makes an investment in any projects only if the project seems to be profitable to it. In accounting terms, a company will make an investment in a capital investment project if Net Present Value of the project is greater than zero. Net present value is calculated by deducting total value of current investment in the project from present value of future cash flows that the project is expected to generate in future. (Lin and Nagalingam, 2000 ) calculate present value of future cash flows, it is necessary to discount those future cash flows using some appropriate discount rate. Discount should to capture time value of money as well as the risk of the projected cash flows. WACC after adjusting for tax serves as an appropriate discount rate for the purpose if evaluating potentials of an investment project. WACC actually measures the amount of interest that the company has to pay for every dollar it finances on its assets by issuing debt or equity. WACC of a firm can be treated as the overall return on the firm and hence, it is often used by the policy makers of the firms as a discount rate for determining economic feasibility of a capital investment project, particularly for those projects that contain a risk similar to that of the over all firm. (Taggart, 1991; Rubak, 1986; Myers, 1974; Luehrman, 1997; Black, 2002 In the present case WACC of Aviva is equal to 8.3 percent. Now, corporate tax rate in U.K. for the year 2008 stood at a level of 28 percent. (OECD, 2008) After adjusting for tax, WACC of Aviva is as follows: WACC after tax = [(8.1)*(14446/29647) + (8.6)(1-0.28)*(15201/ 29647)] percent = 7.04 percent. (Taggart, 1991) Therefore, Aviva should use a discount rate of 7.04 when deciding on major capital investment projects. Conclusion: Annual report of Aviva for the year 2008 shows its consistent performance even in turbulent market environment. When economic recession has attacked many firms, Aviva has been able to strongly survive in this unstable economic condition of the domestic as well as international market. Its cash flow statements indicates that the company has managed very well to increase its cash and cash equivalent even when capital as well as goods market as a whole does not seem to favor performance of any company. Reviewing Aviva’s recently published financial statements it can therefore be concluded that, the firm has well managed to maintain its performance at desired level even in not-so-good economic scenario. It only reflects the firm’s financial and managerial strength. References 1. Rubak, R.S. 1986. Calculating the Market Value of Risk-free Cash flows. Journal of Financial Economics 15: 323-339. 2. Taggart, R.A. 1991. Consistent Valuation and Cost of Capital Expressions with Corporate and Personal Taxes. Financial Management, 20:8-20. 3. Miles, J. and Ezzell, R. 1980. The Weighted Average Cost of Capital, Perfect Capital Markets and Project Life: A Clarification. Journal of Financial and Quantitative Analysis, 15: 719-730. 4. Myers, S.C. 1974. Interaction of Corporate Financing and Investment Decisions – Implications for Capital Budgeting. Journal of Finance, 29:1-25. 5. Luehrman, T.A. 1997. Using APV: A Better Tool for Valuing Operations. Harvard Business Review, 75: 145-154. 6. Aviva Plc. 2008. Annual Report of 2008. retrieved on 29th April, 2009 from http://www.aviva.com/files/reports/2008ar/index.asp?pageid=55 7. OECD. 2008. Corporate Income tax rate 2008.Retrieved on 29th april, 2009 from http://micpohling.wordpress.com/2008/08/07/oecd-corporate-income-tax-rate-2008/ 8. Weighted average Cost of Capital. Retrieved on 29th april, 2009 from http://www.investopedia.com/terms/w/wacc.asp 9. Fama, E.F. 1970. Efficient Capital Market: A Review of Theory and Empirical Work. Journal of Finance, 25:383-417. 10. Fama, E.F. 1991. Efficient Capital Market II. Journal of Finance, 25:383-417. 11. Lin, G. C. and Nagalingam, S. V. 2000. CIM justification and optimisation. London: Taylor & Francis. 12. Black, J. 2002. Oxford Dictionary of Economics. London: Oxford University Press. 13. Sullivan, A. and Sheffrin, S. M. 2003. Economics: Principles in action. New Jersey: Pearson Prentice Hall. 14. Yee, K. K. 2006. Earnings Quality and the Equity Risk Premium: A Benchmark Model. Contemporary Accounting Research,23 ( 3):833-877. 15. Aviva Plc. 2009. About Us. Retrieved on 29th April, 2009 from www.aviva.com Appendix: Consolidated Balance sheet: Consolidated cash flow statements of Aviva of 2008 Note Long-term business operations £m Non-long-term business operations £m Total 2008 £m Restated Total 2007 £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 Read More