Accounting and Managerial Finance of Henkel AG Company - Case Study Example

Managerial Finance “Business Performance of a Company: Henkel AG”. Introduction Henkel A.G. is a German manufacturing company that has some of the world’s leading brand and technology that is focused on three business areas: adhesive technologies, laundry, and beauty care. Henkel A.G. intends to leverage the full potential in their product diversities so that the company attains more shares and hence perform better than their rivals, besides increasing their market. This paper through its various sections including company appraisal shall focus on the capital asset pricing model (CAPM), market rate, and cost of capital, cost of equity, beta, risk free rate, and the treasury rate that becomes perfect in valuation of the company. This paper shall also discuss and determine the corporate beta, both unlevered and levered. Further, the paper shall study the company’s financial issues that include the debt to equity, cost of debt at the company and marginal tax of its businesses. Assessment of Henkel A.G (a) First, the cost of equity can be described as the rate of return that is needed by the owners of the company, and it is calculated in two dissimilar ways, as either divided by dividend valuation model or through the capital asset pricing model. For the cost of equity to be calculated, the parts: risk free rate, market rate, and beta have to be determined. Stowe, Robinson, and Pinto (2008) provides a summary and asserts that the cost of equity capital must be known as the expected return to investors, and that the investors cannot purchase a security if their expectation of the return on the particular security is not above the risk free rate as they can get the return at risk free rate. Risk Free Rate Brigham and Houston (2004) defines the risk free rate as the return on a portfolio or security that does not have a covariance with the market, and conventionally, this is shown by capital asset pricing model beta of 10. This is the commonly used method for estimating the cost of equity capital, and when estimating the risk free rate is vital that one should look into the treasury set risk free bonds, as the treasury bonds come in different maturities. The risk free shows three parts: the rental rate, inflation, and maturity risk. The last is known as the investment rate risk that is every economic factors that are found in the yield to maturity for any given maturity time. Market Rate of Return This is the floor rate needed by investors at all the levels of investment risks, and rather than use the return from the market most finance experts would use the equity risk premium that is the difference between the return from the capital market and the risk free rate of return. This is because it stands for the extra return that is needed for investing in stocks more than investing in risk free assets. Beta An indirect quantifier that a compares the systematic risk linked with a company’s stocks with the systematic risk of the entire capital market. Additionally, beta has been defined as the index of responsiveness of the returns of a company’s stocks against the returns of the entire market. A beta value of one for a company reflects a systematic risk with the stock, and is the similar to the systematic risk of the entire capita market. The value of beta is arrived through the application of capital asset pricing model on regression analysis to evaluate the return on stocks with that of the capital market. Pratt and Grabowski (2008) asserted that the beta from shares is the standards of the stock’s market risk, plus a standard to the level of which the stock’s returns move relative to that of the market. Stowe, Robinson, and Pinto (2008) provided a restrictive relationship between beta and realized returns by dividing periods of positive and negative market excess return, and in their report, they realized there is a significantly positive correlation between the realized returns and beta when their excess returns in the market is non-positive. The calculation of the cost of capital applicable in very many situations, especially in investment appraisal is the weighted average cost of capital (WACC), though this is only applied when a company is involved in a project that is similar to their normal activities. When a company then diversifies, and operates in a business that is significantly different from the present operations, then the capital pricing asset model must be applied ahead of the WACC, and is so that the financial risk of the company, that the beta shall be considered is removed. The capital asset pricing model is a method that is used in the calculation of the required return on investment based on the appraisal of the risk. Pratt and Grabowski (2008) have pointed out that the capital asset pricing model is used in estimating the cost of the retained earnings. To consider the application of the capital asset pricing model in the financial system, the risk free rate of return, which is the yield on short government debt, shall change and this depends on the country’s capital market that is being taken into consideration. The consideration of Henkel A.G implies that for which the maturity and treasury rate is sufficient for its valuation. Considering the yield maturity for United States and Germany’s treasury rates, the rate 3.88 and maturity of ten years is sufficient. This is because when valuation of a European company is being done, it is vital to take into consideration the ten years Germany’s bond as the Germany’s bond given high liquidity, and very low credit risk of any other European economy. In addition, the bond yield is similar to the currency as that of the company’s cash flow, and it is important to consider that in the years 2009, the ten year treasury bonds were trading at 3.9 % while Germany’s zero coupon bonds were doing a 3.38 percent in the market. (b) Capital Asset Pricing Model (CAPM) and Beta The capital asset pricing model is tool that is applied when determining the relative risk, and the system to CAPM is the adoption of portfolio theory by investors. The notion that is Capital asset pricing model is an instrument used in measuring relative risk. The approach to CAPM is the adoption of portfolio theory by investors. The idea behind portfolio theory is that an investor may reduce risk with no impact on return as a result of holding a mix of investment. This theory introduces two types of risk associated with a company, systematic and unsystematic risk. According to Eugene F. Fama and Kenneth R. French (2004), the attraction of the CAPM is that it offers powerful and intuitively pleasing predictions about how to measure risk and the relation between expected return and risk. Company proxy betas In order to find a project specific discount rate using CAPM, It is important first to obtain the information on the companies with business operations similar to those of the propose investment project. These companies are referred to as proxy companies. Since their equity betas will represent the business risk of the proxy company’s business operations, they are referred to as proxy equity betas which represent the business risk of the proposed investment project. Business risk and Financial risk. The systematic risk represented by equity beta has both business and financial risk .In order to start calculating the project specific discount rate, it is important to remove the effect of the financial risk (gearing) from each of the proxy equity betas so as to get the asset betas which reflect the business risk alone. The debt beta is considered zero due to the assumption that the debt beta is usually very small when compared with equity beta and the tax efficiency of debt that further reduces the weighting of the debt beta leaving asset beta. Since this procedure removes the effect of the financial risk or gearing of the proxy company from the proxy beta it is always referred to as ungearing the equity beta. Averaging asset betas Ungearing equity beta of proxy companies it is observed that the resulting asset beta value will be slightly different values. This is because two proxy companies cannot have the same business risk. In order to remove the effect of the slight differences in business operations and business risk that are reflected in the asset betas, we average the betas. Regearing the asset beta This can be done by using the ungearing formula and inserting the gearing and the tax rate of the investing company and the average asset beta, and leaving the equity beta as the only unknown variable. Bloomberg adjusted beta The Bloomberg adjusted beta is defining an estimate of a security’s future beta which is derived from the historical data but is modified by the assumption that a security’s true beta will move towards the market average over time. Stock betas can be presented as either an adjusted beta or as a raw beta. A raw beta also known historical beta is the observed relationship between the security’s return and the returns on an index. The adjusted beta is an estimate of a security’s future beta. Adjusted beta initially derived from historical data but modified by assumption that a security’s true beta will move toward the market average of 1 over time. Adjusted beta has higher correlation than calculated beta and lower correlation than beta equals 1. For an investor to invest in stocks it is important to understand how risky the stock is in the market. Beta determines how risky the stock is in the market and gives the market risk of other stocks where comparism can be made easily. The standard value 1 of beta acts as a reference point for the investors to decide whether to invest in a portfolio or not. The beta value that is more than 1 means the stock price is moving in the same direction as the market. Beta relates to the market in various ways, a negative beta (gold and gold stock) this can be explained that the stock does better only when the stock market moves down. Furthermore when beta is zero and there is no inflation, the money value is the same (unchanged). Beta between 0 and 1 indicates that the risk is below the market (Most utility companies fall within this range). When beta is more than 1, the risk is greater than the whole market. Being aware of the various risk associated with stock market, investors can choose on what stock to invest in. Some investors prefer stock with less risk while others prefer those with higher risk. However investors now understand and are able to make decision on which investment will match the risk they are comfortable with. Investors should note that beta values for stock volatility in 2009 should not be used to predict or forecast the beta for 2010 because of its instability. Another point of concern is that beta only measures systematic risk, i.e. the risk the whole market is facing but not the risk the company is facing. To determine Henkel corporate beta using the Excel as shown in the table at last page, it show that the corporate beta for Henkel is 0.64 this value is less than 1 indicating that the risk is less than the market. If we consider the unlevered beta across the companies doing the same business with Henkel and compare, it is observed that Henkel is doing better than other company like Oriflame with a beta of 1.24 indicating that its risk is greater than the market as a whole. If we also compare companies that are using the same currency as Henkel, we still can conclude that Henkel is performing well. Taking a critical look at the beta values, the beta value of Henkel is the same as the average beta this indicate how better Henkel is performing. In conclusion is worth noting that the company performance is influence by the currency and the market situation at that time. However if all these companies are subjected to just one currency in the same market situation the result will differ. Henkel Financial issues Cost of debt The cost of debt according to the financial times definition is actual rate companies pays on currents loans, bonds and other form of debt. Almost all firms use debt to finance their business operations despite the cost charged for each type of debt. Most firms will want to borrow low since there is no risk to debt as bondholders have enough asset cover. Terek S. Z. (2010) argued that a company without debt mean that company is able to grow and add more business that will generate surplus cash. When borrowing rises, the risk increases proportionately on bondholders in paying debt interest and the asset cover. Terek S.Z. (2010) further claim that high debt level may restrict firm’s ability to payment of dividend since more cash shall be required to pay debt. Traditional view (trade off theory) Robert S. & Steve J. (2011) argued that the trade-off theory provides an explanation of the benefit of cautious use of debt and the dangers of excessive use of debt. This theory makes use of both the substitution and financial risk effects to give an explanation of how debt and cost of equity relates. Robert S. & Steve J.( 2011) summarises this view in two ways, first they claim that interest expense is tax deductible therefore as firm uses more debt the more they create wealth through lower tax payment (tax shield).But as firm add more and more debt, the tax payment become large adding value to the firm to the point where it begin to be financially distress by trying to meet interest payment obligations. Secondly, they went further by saying that as firm begins to add debt to its capital structure, WACC falls because the firm is using cheaper form of financing however the WACC will start to rise as creditors and shareholders begin requiring ever-increasing return as risk rises Robert S. & Steve J. (2011). Hence the traditional trade off theory results in a level of borrowing that is aimed at minimising WACC and Maximising the company value. Sisira R.N.C. (2007) argued that, the static trade-off theory of capital structure emphasises the balance between the tax shield benefits resulting from interest payment and the bankruptcy cost of debt. This trade-off theory was developed by Modigliani and miller to illustrate that debt is use full because interest is tax deductible and that debt brings with it cost associated with actual bankruptcy,QA23W argued by Eugene F. Brigham (1994). Modigliani And Miller Theory (M&M) The M&M proposition 1 suggest that the value of the firm will be the same irrespective of its capital structure because changes in capital structure will not change the total value of the claims that debt holders and shareholders have on cash flow. M&M went forward to suggest another model, M&M proposition 11 where they introduced tax to find the impact. They suggested that, the use of debt in a firm involves both benefit and cost. At very low level of debt the benefit is more than the cost and when there is an increased use of debt the WACC of the firm reduces. Sisira R.N.C. (2007) argued that tax issues and interest rates are theoretically important not only in determining the amount of the debt, but also in terms of broader financing decision. At some point, as the amount of debt in a firm increases the cost outweigh the benefit. But when the cost equals benefit the WACC is minimised. In summary the most important benefit of including debt in a firm is that firm can deduct interest payment for tax. Hence firm value can increased by leverage since interest payments are tax deductible. Bond Rates. The credit rating agencies like the standard and poor (S&P), Moody’s, and the Fitch assign rating to bonds. This rating reflects their chances of being default. Martin O’Donovan (2004) argued that, the ratings of company may affect the capital requirements of the bank’s lending to that company and in extreme cases a downgrade can be the final trigger that puts a borrower into default. The highest grade bond Aaa or ( AAA) are those with least default risk. The risk premium on bonds will increase if the rating becomes lower. Bonds rated from A grade to triple B grade (A to BBB) are strong enough and are called investment grade while those rates below BBB are non-investment grade and they have the highest risk of default. Down-grading a firm bond affect its ability to borrow long-term capital. Martin O’Donovan (2004) claim that credit rating agencies play an important role in the efficient operation of global capital markets since investors and lenders rely on the credit rating agencies to provide an opinion of the creditworthiness of debt issuers and borrowers. Yongtae K. (2003) also argued that bond downgrades are associated with significant declines in the stock prices of the affected firms. Maturity Date The date at which the bond expires or matures is known as the maturity date. It is noted that bonds have different maturity period which might be classed as short term or long term maturity period. The duration of the bond is determine by its date of maturity either is less than 5 years for short term bonds or above for long term bonds. But as year pass by, the maturity declines. Some bonds have provision which allows the issuer to pay them off prior to maturity date. Leonard Tchuindjo (2008), claim that as a result of a decline in credit quality of an issuer or an expectation of a major change in business condition (such as an interest rate change by central bank), the yield to maturity of a bond can increase consistently from one day to another. For Henkel, the maturity period that is most appropriate to valuing the company is 10 years and the bond rate is 4. The explanation is that Henkel is rated A- by the rating agency standard and poor (S&P) but this rating is found in the European rating system therefore the rating is got by a careful interpolation between reported portfolios in the European rating system. An interpolation between nearest rating within the European rating system gives the correspond value of 4……. that fall under a 10 years maturity period. Henkel A- rating indicate that is has a lowest default risk and classified under investment grade. Recent reporting from Henkel’s website shows that the rating has moved from A- to A showing an improvement and a likely wood that most investor and firm will want to do business with Henkel. These also indicate that Henkel has gain trustworthiness from lenders which it can use to borrow or buy more bonds to expand its business. It is important to note that a 10 years German Eurobond is preferred when one is to value a European company since German bonds have higher liquidity and lower credit risk than those of the rest of European countries. Reference List Brigham, E. F., & Houston, J. F. 2004. Fundamentals of financial management. Mason, Ohio, Thomson/South-Western. Pratt, S. P., & Grabowski, R. J. (2008). Cost of capital applications and examples. Hoboken, N.J., John Wiley & Sons. http://site.ebrary.com/id/10295880. Stowe, J. D. Robinson. R. T. & Pinto. J. 2008. Equity asset valuation workbook. Hoboken, N.J., Wiley. http://www.123library.org/book_details/?id=52024. Read More