Corporate Finance of Touristik Union International - Case Study Example

Executive Summary Touristik Union International (TUI) is a multinational German company that was established in 1968. The company offers scheduled and chartered passenger airlines, resorts and hotels, cruise ships, holiday package as well as travel agencies. According to the balance sheet of 2010, 62 percent of the total assets were funded through debt.Modigliani-Miller theorem does not apply to the capital structure of TUI AG. This is because there is a discrepancy generated by Modigliani-Miller theorem. The actual equity of TUI AG is €2434.2 million while equity under Modigliani-Miller theorem is €1081.90 million. Therefore, the most appropriate financial theory that is applicable to the company is the trade-off theory. The company is trying to balance cost and benefits associated with both equity and debt. Source of capital in the company is equity, bonds, bank loans and finance leases among other financial liabilities. Each of the above sources of capital has both advantages and disadvantages. It is possible to compute value of the company by calculating weighted average cost of capital (WACC) and shareholder value. WACC refers to an average rate of interest at which a company is expected to pay all its providers of capital. The seven drivers of shareholder value are growth in sales, operating profit margins, tax rate, working capital growth, fixed capital growth, cost of capital and the period of competitive advantage. The total value as estimated by the shareholder value drivers of the company was €16603.7 million in 2019. When the shareholders drivers are increased by 5 percent the company value of the company will increase to €21,443.61 million. The disadvantages of shareholder value analysis include difficulty in computations, difficulty in implementation, failure to include social needs and possibility of making errors in calculation of shareholder value analysis. Introduction Touristik Union International (TUI) is a multinational German company that was established in 1968. It is listed at the Frankfurt stock exchange and has its headquarters in Hanover, Germany. TUI AG is the world largest tourist firm globally. The company offers scheduled and chartered passenger airlines, resorts and hotels, cruise ships, holiday package as well as travel agencies. Capital structure According to Taylor and Sansone (2007), capital structure is determined by the composition of target collateral pool, investment flexibility, condition existing in the market for the collateral, weighted average cost debt capital and the desired ratings of the bonds in the capital structure. Capital structure can be analysed by comparing company’s debts and equity used to purchase company’s assets. The capital structure of TUI AG is defined by shareholders funds, various categories of corporate bonds, finance lease as well as bank loans. To understand the theory behind the capital structure, it is important to explain the various sources of finance and the impact on the company. Leverage ratio of TUI AG is 62 percent (figure 3: in the appendixes). This indicates that 62 percent of the total assets were funded through debt. Table 3- Sources and Amount of capital of TUI AG for 2010 Source of capital Amount in million € Equity 2434.2 Bonds 3038.3 Bank loans 1001.5 Finance leases and other financial liabilities 472.1 Source: TUI AG 20104; CIA 2011; TUI AG (20106) Finance theory There are a number of theories that have been used to discuss capital structure in companies. There are Modigliani-Miller theorem of capital structure (capital structure irrelevance), the pecking Order Theory and Trade-off theory of Capital Structure. Modigliani-Miller theorem of capital structure states that in absence of bankruptcy, transaction costs and taxes in an efficient market and asymmetric information, the value of the company is not affected by how it is financed. This theory is not applicable at this time because there are taxes. There are tax benefits because the value of the firm is decided after tax has been deducted. Table 1; Comparing the actual capital structure and capital structure under Modigliani-Miller theorem Actual capital structure of TUI AG Capital structure according to Modigliani-Miller theorem Debt in millions € 4039.80 4039.80 Equity in millions € 2434.2 1081.90 Total Capital in millions € 6474 5121.70 Source: TUI AG 20104 CIA 2011; TUI AG (20106) Therefore, under the Modigliani-Miller theorem of capital structure equity is computed as follows. = (Net profit (2010) ×100) ÷ cost of capital =113.6×100)/10.5 =1081.90 =1081.90 Where; Cost of capital is 10.5% and Net profit is 113.6 million (TUI AG 2011). Table 2; Comparing the actual debt-equity ratio and debt-equity ratio under Modigliani-Miller theorem   Actual capital structure of TUI AG Capital structure according to Modigliani-Miller theorem Debt-equity ratio 165.96% 373.40% leverage ratio 62.40% 78.88% Refer to note 6 and 7 in the appendix From the above figures, it is evident that TUI AG does not apply the Modigliani-Miller theorem of capital structure. This is because the actual equity of TUI AG is €2434.2 million while equity under Modigliani-Miller theorem is €1081.90 million. Trade-off theory of Capital Structure Since Modigliani-Miller theorem of capital structure, the company chose the Trade-off theory. Trade-off theory states that a company chooses a capital structure that balances both the costs and benefits of equity and debt. This is because each source of capital has own advantages and disadvantages. The disadvantages and advantages of different source of capital is discusses below. First, the company’s capital structure is made up of Shareholders equity. Shim and Siegel (2008) stated that shareholders funds are the total value that accrues to shareholders of the company as reported in the balance sheet of the company. TUIAG (20102) stated that the company has issued 251,688,045 shares worth €643,430,270.01. TUI AG (2011) revealed that shareholder’s funds were worth € 2434.2 million as at September 30, 2010. Of the total shareholder’s funds, €643.1million, €913.5million, €489.5 million, €294.8 million and €93.3 million were subscribed capital, capital reserves, revenue reserves, hybrid capital and non- controllable interests respectively. The main advantage of equity financing is that the company saves money that could have been used to pay the loans to grow the business. On the other hand, the disadvantage of using equity funds as source of finance to the company is that, shareholders may lose ownership interest and control of their company if they share business ownership with other investors. The second source of capital to the company is the corporate bonds. Johnson (2010) defines a bond as a formal agreement between the issuer (company) and the investor, where the issuer promises to repay borrowed money in future with a fixed interest. It also issued senior fixed rates notes to raise additional finance to purchase company’s assets. According to TUI AG (2011), the company issued senior fixed rates notes worth €625 million and €450 million in May 2004 and December 2005. The total senior fixed rate of the company is €1075 million. TUI AG issued convertible and hybrid corporate bonds. The company issued convertible bonds worth €694 million in January 2007 and convertible worth €217.79 million and €338.96 million in November 2009 and March 2011 respectively. Furthermore it issued perpetual hybrid bonds worth €300 million in December 2005. The interest rates of the convertible bonds varied between 2.75 percent and 5.5 percent while that of hybrid bonds was 8.625 percent. The total convertible bonds for TUI AG are €1250.75 million (TUI AG, 2011). TUI AG (20111) indicated that the company plans to issue more convertible bonds worth €250 million. The €250 million bonds will mature in five years. Corporate bonds have some liquidity premiums because they are not traded heavily as compared to government bonds. The extra interest charged on bond makes bonds the most expensive source of corporate finance. Faerber (2008) stated that corporate bonds pay higher than treasury and agency bonds of similar quality. However, bonds are more likely to be bought than stocks because they guarantee steady flow of income. Bonds are convertible to stock at the end of the lending period. Hence can be in the process it removes that risk though it is sold at the market value of the stock Arnold (2007). Corporate bonds provide high interest as compared to government bonds. This is because it includes inflation and liquidity premiums, default risks premiums as well as maturity risk premiums. The costs of bonds are higher because the high premiums cover the higher risks investors assumed by purchasing them. Corporation can go bankrupt and they need to offer high interest rates to compensate investors for higher risk taken. Corporate bonds are backed by corporation. Therefore, they are less secure. Raising finance through bonds can be difficult and required finance may not be raised. This is because investors fear the likelihood bond’s illiquidity if the company fails. For example, if ratings of the issue declines or there is bad news concerning the issuers’ financial position, holder may have difficulty in trading the bonds without sacrificing large price concessions. The third source of capital to the company is finance leases. According to TUI AG (20113), as at September 30, 2009 financial liabilities from operating lease, rental and charter agreements were €2.9bn. Aircraft constituted the largest proportion of the lease at €1.2billion. The remaining leases constituted operating lease, rental and charter agreements. Other leases included hotels, travel agencies, administrative buildings, yachts, motorboats and others. Liabilities from lessees was €320.2 million in 2010 September 30. Ogilvie (2009) ascertained that the lessee has its own advantages. One of the advantages of lessees is that a company can obtain an asset without borrowing a loan from a bank. This is because there is no need to make large initial amount of payments to purchase equipment needed. In addition, if the finance for leasing is lower than the bank loans, the company stands to benefit. The asset leased is not normally shown in the lessee’s balance sheet. Therefore, the balance sheet of the lessee does not increase the gearing ratio. Lease is beneficial for high technology equipments that become obsolete before the end of its expected life. Asset is only used when there is a need. Therefore, the lessor bears the risk and not the lessee. According to Atrill and McLaney (2008), lease financing has fixed financing rate and is also inflation friendly. Furthermore, there is an option to purchase an asset at the end of the lease period. Finally, leasing enhance borrowing status of the company because it improves debt-to-equity as well as earnings-to-fixed assets ratios. The disadvantages of leasing include continued payments of leases until the original term is completed even when there is business is not performing well. In addition, there is no equity until the equipment is purchase at the end of the lease term when the asset has depreciated significantly. The other disadvantage is that the cost of maintaining the asset falls squarely on the lessee. The fourth source of finance to TUI AG is loan (credit) from the bank. A company that borrows loans from the bank must pay interest and other cost of capital. According to CIA (2011), the prime lending rate of commercial banks in Germany is 4.96%. Tuller (2007) ascertained that bank loans are easily accessible. This is because banks are conveniently located. For example, each street has a bank. The other advantage of bank loans is that a good credit established through a bank is a good reference. Furthermore, once a company is established with a bank, the company benefits from other bank services. In addition, borrowers can quickly secure a bank loan in hours or less than a day. Loans can be borrowed for wide variety of purposes. The disadvantages of bank loans include delays caused by busy bank personnel and bureaucracies in getting the loans. This could disadvantage the person seeking for a loan. Furthermore, loans are only available to customers with excellent credit scores and star-up entrepreneurs may not qualify. Bankers are also poor business people because they always give bad operating advice. The other disadvantage of a bank loan is that bank demand excessive collateral, including personal guarantees. In addition, nearly all loans agreements are Unilateral. This gives the bank a right to call the loan on demand. Bank loans also carry prepayment penalties. Finally, borrowing too much money may decrease cash flows and may exceed the income (Brealey et al 2009). Task 2: The market valuation of TUI AG Estimating the market valuation of TUI AG is not a simple task. However, by computing the weighted average cost of capital (WACC) and shareholder value, it is possible. Weighted Average Cost of Capital (WACC) WACC refers to an average rate of interest at which a company is expected to pay all its security holders (shareholders, corporate bond holders and bank loans) for the capital they provided to finance company’s assets. Therefore, WACC represents the least rate of return that a company must earn to justify the use of its assets. The cost equity for TUI AG is 0.048 (refer to note 1 in the appendix).Therefore, WACC expresses the opportunity cost of the assets that the company uses in its operations (Graham and Harvey 2001). If the company cannot earn the WACC in its operations, then it advisable to invest the capital received in other places to avoid losses. According to TUI AG (20106), the cost of capital of TUI AG was 10.5% in the year 2009/2011. To compute WACC, it is mandatory to identify all the cost of capital for all the source of finances availed. The average cost of TUI AG corporate bonds and bank loans received by the company is 4.98 percent and 4.96 percent respectively. According to TaxRates.cc (2011), in Germany, companies are taxed differently depending on the geographical location. However, the total tax rate is computed after taking into consideration corporate tax (15%), surtax (5.5%) and trade tax ranging between 7% and 17.5% depending on the municipality. According to London Stock Exchange (2011), beta for TUI AG is 0.83. Beta is used to calculate the cost of equity (refer to note 3 in the appendix). Shareholder Value Analysis Lomax (2006) asserts that shareholder value analysis is a method of financial analysis that measures shareholders value by estimating the total net value of a company. According to Bowhill (2008), shareholder value analysis is based on the principle of computing discounted future cash flows to determine the value of the company for a given period. The discounted future cash flows is then divided by the number of company’s shares to obtain shareholder value. The underlying principle of shareholder value analysis is that a company adds value for its shareholders when equity returns are more than the equity costs. Arnold (2007) stated that Alfred Rappaport created seven factors that drive shareholder value. The seven drivers of shareholder value are growth in sales, operating profit margins, tax rate, working capital growth, fixed capital growth, cost of capital and the period of competitive advantage. Development of value drivers can be a daunting task as it involves estimation of the seven drivers. The principal value drivers as identified by Rappaport (1986) and assumption Revenue growth is -0.003%. The value is obtain by computing average growth rates (year on year) of six years (from 2005 to 2010). Operating profit margin is 0.147%. It is an average operating profit margin for six years (from 2005 to 2010). Investment rate for fixed assets is -0.026%. The value is obtain by computing average fixed asset growth rates (year on year) of five years (from 2006 to 2010). Investment rate for working capital is -0.103%. The value is obtain by computing average working capital growth rates (year on year) of five years (from 2006 to 2010). The tax rate is 33%. The tax rate is obtained from considering the Germany’s tax rate, where corporate tax is 15%; surtax is 5.5% trade tax is 12.5% (median of values between 7% and 17.5% (TaxRates.cc, 2011). 33% = corporate tax (15%) + surtax (5.5%) + trade tax 12.5% Cost of capital is 0.048 (refer to note 1 in the appendix) Figure 1: Shareholder Value Analysis (SVA) model for TUI AG using Excel for 10 years The total value of the company ion 10 years time (2019) is €16603.7 million. The effect of changes in key assumptions in the model If all assumptions are increased by 5%, the new assumptions will change as follows Revenue growth will increase from -0.003% to 0.047%. The revenue of the company will grow by 0.5 annually for the next ten years, thus increasing shareholder value after ten years. Operating profit margin will increase from 0.147% to 0.155%. This will increase shareholder value by the end of ten years. Investment rate for fixed assets will increase from -0.026% to -0.027. This will increase shareholder value. Investment rate for working capital will increase from -0.103% to -0.107. This will increase shareholders value. The tax rate will increase from 33% to 35%. This will reduce the shareholder value. Cost of capital will increase from 0.048 to 0.051. This will reduce the shareholders value. Due to increase by 5% of all the drivers, the company will increase shareholder value The resulting share value of the firm will be increased from €16,603.7 million to €21,443.61 million as shown in figure 2 below. Figure 2: Shareholder Value Analysis (SVA) model for TUI AG using Excel for 10 years following increase of key values by 5%. Shareholder value analysis disadvantages Shareholder value analysis is an important technique o establishing the shareholder value. However, it has its own disadvantages. The first disadvantage is that estimation of future cash flows can be extremely difficult and cumbersome. This is because before commencing on the calculation, it is important to determine the revenue and investment growths. This could be a daunting task especially when data is not readily available. Second disadvantage is that it may be difficult to implement the shareholder value analysis. Managers in corporations do not have the time to understand how shareholder value analysis operates because the method is long and complex. Third disadvantage about shareholder value analysis is that it does not consider societal needs. Shareholder value analysis only considers the interest of shareholders and does not factor in the interest of other members of the society such as the community where the company operates or the employees of the company. On the other hand, it does not take into consideration the environmental issues. Fourth, shareholder value analysis is prone to mathematical (clerical) errors. Errors in calculation can lead to wrong (incorrect) projections hence sub-optimum decision making on company’s value. Finally, shareholder value analysis has been too simplified. Therefore, it lacks practicability. References: Tuller, WL 2007,Finance for Non-Financial Managers: And Small Business Owners, 2nd edn, Adams Media, AVON, MA. Ogilvie, J 2009, CIMA Official Learning System Financial Strategy, 6th edn, Butterworth-Heinemann, Jordan Hill, Oxford. Arnold 2007, Essentials of Corporate Financial Management, Financial Times/Pitman; London Brealey, Myers and Allen 2009, Principles of Corporate Finance, McGraw Hill-Irwin; New York. Rappaport, A 2006, ‘10 Ways to Create Shareholder Value’, Harvard Business Review, Vol. 84, Issue 9, pp66 – 77. TUI AG 20113, Risk report: Systematic detecting, monitoring and managing risk, viewed, 8 April, . Shim, KJ & Siegel, GJ 2008,Financial Management, 3rd edn, Barron's Educational Series, New York. Faerber, E 2008, All about bonds, bond mutual funds, and bond ETFs, 3rd edn, McGraw-Hill Professional, New York. TUI AG 20104, Notes on the Consolidated Statement Financial Position, viewed, 8 April, . Atrill, P. and McLaney, E 2008, Accounting and Finance for Non-Specialists, FT Prentice Hall, Cambridge. Graham, J. R. and Harvey, C. R. (2001) “The theory and practice of corporate finance: evidence from the field” Journal of Financial Economics 60: 187-243. viewed, 8 April,< http://leeds-faculty.colorado.edu/bhagat/theorypracticecorporatefinance.pdf>. London Stock Exchange 2011, TUI travel, viewed, 8 April, . London Stock Exchange 2002, A Practical Guide to Listing, viewed, 8 April, . Pettit, J 2001’ Is a share buyback right for your company?’ Harvard Business Review, Vol. 79, Issue 4, pp141-147. Rappaport, A. 2006, ‘10 Ways to Create Shareholder Value’, Harvard Business Review, Vol. 84, Issue 9, pp66 – 77. Johnson, SR 2010, Bond Evaluation, Selection, and Management, + Website, 2nd edn, John Wiley and Sons, New Jersey. Taylor, A and Sansone, A 2007,The handbook of loan syndications and trading, McGraw-Hill Professional, New York. Bowhill, B 2008,Business Planning and Control: Integrating Accounting, Strategy, and People, John Wiley and Sons, New Jersey. TUI AG 20112,1st Quarter Results 2010/11: TUI Analysts’ Conference Call, viewed, 8 April,http://www.tui-group.com/en/ir/news/2009/oktober/2009_10_28_2>. TUIAG 20102, The TUI share at Glance, viewed, 8 April, . CIA 2011, The World Fact Book: Germany, viewed, 8 April, . TUI AG 20114, TUI AG securities, viewed, 8 April, . TaxRates.cc 2011, Germany Tax rates, viewed, 8 April, . TUI AG 20106, The TUI Group, viewed, 8 April, . Lomax, W 2006, CIM Coursebook 06/07 Analysis and Evaluation, Butterworth-Heinemann, Oxford. TUI AG 2011, Financial Year 2010/11 Interim Report 1. October 2010-31Dec 2010, viewed, 8 April, . Appendixes Table3: The seven drivers and estimated values 2010 2009 2008 2007 2006 2005 Average Revenue in millions 16350.1 16594.3 13,931.80 12839.9 20514.6 18201.3 Revenue growth rate 0.01472 -0.1911 -0.08504 0.37411 -0.1271 -0.003 cost in millions 14680.1 15079.4 12,910.70 11800.4 15495.5 12900.3 profit margins ((Revenue-Cost)/Revenue) 0.10214 0.09129 0.0732928 0.080959 0.24466 0.291243 0.147 Fixed in millions 9356.7 9093.1 6005 6106.8 10141 11883 % change in fixed assets -0.029 -0.5143 0.01667 0.39781 0.1466 -0.026 Working in millions 5258.8 4367.1 3322.2 3542.6 2873 3491 % change in working capital -0.2042 -0.3145 0.062214 -0.2331 0.17703 -0.103 The tax rate (refer to note 5) 33%. WACC (refer to note 1) 4.83% Notes 1. The WACC is 4.83% as shown in the table below. Where; E- Equity Re= Cost of Equity B –Bonds Rb= cost of corporate bonds L- Bank loans Rl=commercial bank interest rates ((CIA 2011)) 2. Commercial bank lending rate in Germany is 4.96% (CIA 2011) 3. Cost of Equity (Es). According to Capital Asset Pricing Model, Cost of Equity= Es=Rf+Bs (Rm-Rf) Where Es-Return on equity Rf=Risk-free return, where 5 year German yield is 2.81 βs=Beta(The sensitivity to market risk for the security 0.83 (London Stock Exchange 2011). RM= Risk premium, where Commercial bank lending rate in Germany is 4.96% (CIA 2011) Therefore, Es (Cost of Equity) Es =Rf + Bs (Rm - Rf) Es =2.81+0.83 (4.96-2.81) =0.045945 4. Interest rates TUI AG bonds is estimated to be 0.0497 Table 4: WACC of bonds Date of issue Maturity Date Source Amount in million € Weighted  interest rate Weighted Cost of Capital May-04 May-11 Senior fixed rates notes 625 0.2380 0.06625 0.0157693 Dec-05 1-Dec-12 Senior fixed rates notes 450 0.1714 0.05125 0.0087832 Jun-07 Sep-12 Convertible bonds 694 0.2643 0.0275 0.0072684 Dec-05 Perpetual Hybrid bond 300 0.1143 0.08625 0.00985433 Nov, 2009 Nov-14 Convertible bonds 217.79 0.0829 0.055 0.00456192 Mar-11 Mar-16 Convertible bonds 338.96 0.1291 0.0275 0.00355 WAAC for bonds 0.049787147 5. The tax rate is 33%. The tax rate is obtained from considering the Germany’s tax rate, where corporate tax is 15%; surtax is 5.5% trade tax is 12.5% (median of values between 7% and 17.5% (TaxRates.cc, 2011). 33% = corporate tax (15%) + surtax (5.5%) + trade tax 12.5% 6. Leverage ratio Where; E- Equity B -Bonds L- Bank loans Actual leverage ratio = 0.624004 Leverage ratio under Modigliani-Miller theorem 7. Debt-Equity ratios Actual Debt-Equity ratio  Debt-Equity ratio under Modigliani-Miller theorem  Read More