TPG Telecom Limited Capital Structure Relative to Comparable Companies - Example

2. Capital Structures Capital structure is defined as the mix of equity and debt finances. When the equity and debt finances are combined they give the real picture about the value of the company. In this regard, the debt to equity ratio gives the composition of the company in terms of financial position. In the second proposition postulated by Modigliani and Miller’s (1958), the risk of the firm thus increases with the increase in the debt to equity ratio (Wall Street Survivor, 2009). When such a scenario occurs in the company, the firm is faced with negative pressures related to financial distress and bankruptcy. Similarly, when equity and debt are mixed in right ratios, the value of the firm is increased considerably. This makes capital structure a vital consideration used by the firm’s management to provide an insight into the ways and means of maximising the shareholders’ wealth (Wall Street Survivor, 2009). From the above issues, it is evident that the most important decision the management seeks to make in the firm is the choice that should be made regarding the debt-equity ratio. Thus, depending on whether debts are maintained in the firm or not, the firm can be unlevered or levered. It is worth noting that the capital structure that yields the highest value for the firm is the most desirable and beneficial to the shareholders and the firm’s management should always strive to make a choice that maximises the wealth of the shareholders. In the following sections, the analysis of TPG Telekom Limited’s capital structure will be provided. The specific objective is to analyse the company’s historical and current leverage policy, compare the leverage policy of the firm to that of its competitors, analyse the firm’s financing of its capital expenditure and finally, analyse the firm’s optimality, costs and risks. 2.1 Analysis of the firm’s leverage level 2.1.1 Current status of TPG leverage Table 1: Key accounts from TPG Telecom Limited Financial Statement, Fin analysis. For the purpose of this analysis, the financial statements will be drawn from the year 20120and 2011 which are the most current financial statements. Accounts ($million)/periods 2010 2011 Short-term debt 76.60 76.21 Long-term debt 245.88 149.47 Total debt 322.48 225.68 Contributed Equity 478.81 502.87 Reserves 56.33 55.33 Retained Earnings 68.31 22.96 Outside Equity 0.00 0.00 Total Equity 445.44 515.86 Total Assets 959.0 914.74 Interest Expense -15.08 -28.56 EBIT 171.05 234.03 (Source: Financial Analysis) Table 2: Ration Analysis from TPG Telecom Limited, 2010, 2011 Ratios/Periods 2010 2011 Financial Leverage 215.3% 177.32% Gross Gearing (D/E) ratio 72.39% 43.75% Net Gearing 68.55% 41.90% Net Interest Cover 11.34 8.19 ROE 12.51% 15.15% Current ratio 0.25 0.27 Quick Ratio 0.25 0.27 Source: Financial Analysis Formulas In the above table the formulas for getting the individual items are as follows; Financial leverage- Total assets/shareholder’s equity Gross gearing (D/E) ratio- (short term debt+ long-term debt)/shareholder’s equity Net gearing- (short term debt+ long term debt-cash)/shareholder’s equity Net interest cover- Earnings before interests and tax (EBIT)/interest expense Return on Equity (ROE)- Net Profit After Tax ( NPAT) before abnormals/ (shareholder’s equity-outside equity interest) Current ratio- current asset/current liability Quick ratio- (current asset-inventory)/current liability In order to carry out a proper analysis of the current level of leverage for TPG Telecomm Limited, data from 2010 and 2011 have been referenced. In Table 1, key accounts that reveal the values of the leverage level of the company are shown. It can be found that there are several elements with significant variations between the two years. Such elements include the long term debt that decreased significantly from $245.88 in 2010 to $ 149.47 in 2011 representing a 39.2% decrease (TPG Telecom Limited, FinAnalysis). The effect of the drastic reduction in the long term debt is clearly reflected in the ratios contained in Table 2. Due to the reduction in the long term debt in 2011, the Gross Gearing Ratio decreased significantly 72.39% to 43.75%. A low gross gearing ratio will bring low amount of risks to TPG Telkom Company (John 2008) The reason for this is that a low gross gearing ratio helps in mitigating against volatile earnings caused by additional interests expenses. In other words, TPG Telecom Limited is on the safe side due to the less risks that can easily affect the company’s operations (John, 2008). Even though the net interest cover ratio has dropped from 11.34 in 2010 to 8.19 in 2011, the difference is not large which explains the fact that the company is still capable of “serving” its debt, though not as more times as it did in 2010. An interest cover ratio of 8.19 means that TPG Telecom Limited is capable of serving its debt 8.19 times in the current year as compared to 11.34 times in the year 2010. The increase in Return on Equity from 12.51% in 2010 to 15.15% in 2011 is an indication that TPG Telecom is generating normal profits in relation to the funds invested by the shareholders. However,, it is worth noting that current ratio and quick ratio are not strong enough to cover the issue of liquidity in the company. 2.1.2 Recent history of leverage level- 5 years period Table 3. Key accounts from 2002 to 2009 Accounts (millions)/periods 2002 2003 2004 2005 2006 2007 2008 2009 Total debt 2.99 3.21 1.50 45.92 79.88 39.15 159.92 66.96 Total equity 31.75 37.602 132.71 294.675 318.263 232.50 306.65 324.79 Total assets 39.1 45.2 141.2 465.2 543.2 380.2 618.0 523.8 EBIT 2.50 7.28 10.86 23.85 15.67 10.79 -20.28 35.26 Source: Financial Statements 2002-2009: Financial Analysis Table 4: Key ratios from TPG Telecom Limited 2002-2009 Ratios/Periods 2002 2003 2004 2005 2006 2007 2008 2009 Financial Leverage 123.15% 120.21% 106.64% 157.87% 170.5% 163.53% 201.53% 161.26% Gross gearing (D/E) ratio 9.41% 8.54% 1.13% 15.58% 25.09% 16.84% 52.15% 20.62% ROE 6.99% 15.45% 7.28% 5.59% 2.57% 5.62% -6.12% 5.44% Source: Financial Statements from 2002-2009: Fin Analysis It is clear from the above table that in the last 8 years, TPG Telecom Limited has witnessed a steady rise in total assets with 2007 and 2009 recording a small drop in the value of the company’s total assets. Total equity has also recorded a smooth trend with an increase from $31.75 in 2002 to more than $300 in 2009 (Fin Analysis, 2002-2011). However, this is not adequately reflected by the financial leverage which was not in a similar trend because financial leverage dropped from 2002 to 2004 before picking up again in 2005. The financial leverage trend was not also reflected by the total assets tendency because total assets kept on increasing from 2002 to 2006 before falling in 2007. The trend in total debt reveals a different tendency because the total debt was maintained at a record low between 2002 to 2004 before shooting drastically between 2005 to 2009. Consequently, the gross gearing ratio fluctuated between 1.13% to 52.15% which reflects the fact that TPG Telecom Limited strived to maintain low levels of debts between 2002 to 2004 before raising the level of debts from 2005 to 2009 (Fin Analysis, 2002-2011). This shows that TPG Telecom Limited borrowed heavily between 2005 to 2009. This can be attributed to the rising trend in profitability in 2005 which put the company at a more stronger position to repay its debts without struggling. There are no significant variances between EBIT and ROE for TPG Telecom Limited except for the year 2006 and 2008. In both years EBIT and ROE dropped with EBIT dropping to a negative number in 2008. This could be attributed to the negative profitability trend witnessed during the 2008 trading period by the company. This can also be associated with the world financial crisis (recession) that affected the global economy. 700 600 500 400 300 200 total debt 100 2002 2003 2004 2005 206 2007 2008 2009 2010 2011 2.2. Capital expenditures and its financing Table 5: 5 years data of property, plant and equipment of TPG Telecom Limited. B/S account (millions) 2007 2008 2009 2010 2011 PP& E 120.784 137.594 135.408 312.671 314.440 Total NCA 193.68 503.84 461.30 901.87 856.70 Weighted Percentage 62.36% 27.30% 29.35% 34.40% 36.70% (Source: Financial statement, 2007-2011) Capital expenditure can be defined as the funds which the company uses to upgrade, repair, maintain, and purchase/acquire physical assets such as property, equipment and industrial building (Investopedia, 2011). As a telecommunication company that provides data solutions, internet and voice to a wide range of customers, TPG Telecom Limited must maintain and have well conditioned PP&E in order to deliver quality and effective services to its customers. Out of the total NCA, it is evident that TPG maintains a low level of PP&E. In the last 5 years, the company has maintained as low as 27.30% of its PP&E which is a low value of PP&E required to maintain its infrastructure in the provision of internet and other services to its customers (Investopedia, 2011). However, how does TPG Telecom Limited finance its expenditure to ensure that it does not encounter a leverage problem? Table 6: Investing cash flow from 2007 to 2011 (millions) Investing period 2007 2008 2009 2010 2011 Sale of plant, property and equipment 0.00 0.91 0.032 0.034 0.00 Proceeds from investments 234.191 0.00 0.00 5.781 0.00 Purchase of subsidiaries 0.00 -135.565 0.00 -371.034 0.00 Cash paid for PP&E -30.447 -21.694 -23.040 -68.203 -43.254 Loan granted 114.251 150.00 0.00 354.489 10.00 Loan repaid 119.711 55.378 83.375 119.989 110.00 Proceeds from issues 0.00 0.00 0.00 66.185 0.00 Net Investing CF 437.706 49.029 83.407 540.068 76.746 (Source: Fin Analysis) The above table shows clearly the strategy used by TPG Telecom Limited in financing its capital expenditures with an objective of maintaining a low financial leverage level. It is evident that from 2007 to 2011, the company made payments for its PP&E. The company also acquired subsidiaries in 2008 and 2010 respectively. In order to finance the acquisitions and other costs related to the company’s operations, the company relied on debts(borrowings) which were incurred in 2007, 2008, 2010 and 2011 although the amount of borrowing dropped significantly in 2011. This shows the preference of the company’s management to finance its operations from debts which increases pressure from debt repayments and interest expenses. Due to the management’s reliance on debt for capital expenditure in the company, long term debt is preferable because it is not to be paid soon and thus will give the company an adequate time to invest and repay the debt. 2.3. TPG Telecom Limited capital structure relative to comparable companies Three companies have been chosen to compare their capital structures with that of TPG Telecom Limited. The three companies chosen include TLS (Telstra Corporation Limited), SGT (Singapore Telecommunications Limited) and iiNET Limited. Gross gearing ratio Table 7: Comparison of gross gearing ratio over 4 companies from 2007 to 2011 Company/year 2007 2008 2009 2010 2011 TPG Telecom Limited 16.84% 52.15% 20.62% 72.39% 43.75% TLS 114.17% 126.57% 136.61% 114.62% 115.26% SGT 31.02% 35.91% 36.56% 29.25% 29.92% iiNET Limited 16.78% 17.53% 12.32% 23.64% 42% (Source: Fin Analysis) The gross gearing ratio is one of the most effective methods used to evaluate the capital structure of any given company. The higher the gearing ratio, the higher are the risks that face the business (Investopedia 2011). The reason for this is that the company has to incur the burden of interest expenses as well as debt repayment. From table 7, it is evident that TPG Telecom maintained a low gearing ratio for the 5 years as compared to TLS. This means that TLS faced more business risks than TPG in the past 5 years (FinAnalysis: TLS, 2007-2011). However, TPG faced more business risks as compared to SGT and iiNET limited in the past 5 years because SGT and iiNET did not experience pressure for interest expenses and loan repayment more than TPG. Financial leverage ratio Table 8: Comparison of financial leverage ratio over 4 companies from 2007 to 2011. Company/Year 2007 2008 2009 2010 2011 TPG 163.54% 201.55% 161.28% 215.32% 177.32% TLS 301.07% 309.69% 315.13% 301.98% 308.44% SGT 156.58% 165.29% 162.22% 161.39% 161.32% iiNET Limited 156.51% 161.52% 155.59% 164.64% 188.23% (Source: Fin Analysis) The importance of the financial leverage ratio is to show how much of the company’s assets are leveraged through debt and how much are owned by the company. A high leverage ratio depicts the likelihood of the company going bankrupt because is indicates that a high percentage of the company’s assets are leveraged through debt. From the table above, it is evident that TLS maintained the highest leverage ratio over the past 5 years at more than 300% meaning than it is the company is more likely to go bankrupt as compared to TPG. TPG has steadily maintained a low leverage ratio at less than 220% in order to be on the safe side as compared to TLS (SGT, 2007-2011). However, SGT and iiNET maintained a steady but a low leverage ratio at less than 200% for the past 5 years in order to mitigate against the risk of going bankrupt. Hence, SGT and iiNET are less risky businesses as compared to TPG (iiNET Limited, Annual Ratio Analysis). ROE ratio Table 9: Comparison of ROE over 4 companies from 2007 to 2011 Company/year 2007 2008 2009 2010 2011 TPG 5.62% -6.13% 5.44% 12.51% 15.15% TLS 26.38% 30.72% 32.80% 30.58% 26.76% SGT 17.06% 19.10% 18.40% 16.59% 15.49% iiNET 16.94% 10.64% 12.71% 15.34% 16.08% (Source: Fin Analysis) ROE is an effective measure of the company’s rate of return. As compared to other three companies, it is evident that TPG does not maintain a favourable rate of return because the company has maintained most of its rate of return at below 10% with the year 2008 being the worst. This shows that even though TLS has the highest leverage ratio, it is also the most profitable company of the four companies and can therefore service its debts. However, SGT and iiNET maintains their ROE at comparable ratios but they are still profitable than TPG (iiNET Limited, 2007-2011) 2.4 Characteristics of TPG Telecom relevant to its leverage policy The trade-off theory holds that the firm should trade off its tax shield benefits against the costs of financial distress when making the selection of its capital structure. Hence, VL= VU+ PV (interest Tax Shield) - PV (financial distress costs) (Aswath, 2011). 2.4.1 Debt and Tax benefits According to the MM proposition II, the value of the company in the presence of corporate tax is positively related to its debt (Ross et al, 2010, p 504-512). Table 10: Tax shield from 2007-2011 Accounts/ (year) 2007 2008 2009 2010 2011 Total debt 39.15 159.92 66.92 322.48 225.68 Interests expense -6.86 -5.88 -9.92 0.00 -0.00 Tax shield @30% 0.88 1.02 2.68 3.96 8.20 Total tax saving 16.74 ( Source: Fin Analysis) Based on the data provided in the table above, it is evident that the total tax saving from 2007 to 2011 is $16.74 million. This could be used to offset the increased expenses that accrue from debts. 2.4.2 Assessment of bankruptcy costs and risks If the burden of debts is not met within the stipulated time, the most likely occurrence would be bankruptcy. In this situation, applying the net interest cover is an important step in assessing the TPG’s bankruptcy cost and risks. Table 11: Interest cover ratio for TPG from 2007 to 2011 Ratio/periods 2007 2008 2009 2010 2011 Net interest cover 3.67 -5.99 3.94 6.89 5.14 It is evident that in 2008, TPG Telecom Limited faced intense pressure from interest expenses as its EBIT could not cover its debt expenses. However, in other years, that is, 2007, 2009, 2010 and 2011, the pressure was not as much as that experienced in 2008. It can be assumed that the company achieved a favourable profitability level in 2007, 2009, 2010 and 2011 than in 2008. 2.5 Optimal Leverage Level for TPG Telecom Limited The optimal leverage level of the firm is determined by several factors that include profitability, taxes and asset types to mention a few. Since, TPG Telecom Limited is a company within the telecommunication industry (not capital intensive) as compared to companies in the manufacturing industry; it may not be disadvantageous or risky for TPG to maintain its gross gearing at a relatively low level (Ross, Westerfield and Jaffe, 2010). In this regard, for the company to achieve optimal level of outcomes, it should maintain its gross gearing ratio at less than 70% in order to overcome the distress that may be caused by increased costs of operations. References Ross S., Westerfield R. and Jaffe J. (2010). Corporate Finance, 9th edition, McGraw-Hill, p.488, p 504-512,p 547 Wall Street Survivor (2009). Asset to Equity Ratio, viewed 25th October 2011 http://education.wallstreetsurvivor.com/Asset-Equity-Ratio John C. Handley (2008). A Note on the Historical Equity Risk Premium, Melbourne, 25th October 2011 Investopedia (2011). Gearing Ratio, viewed 21st October 2011, http://www.investopedia.com/terms/d/debtequityratio.asp#axzz1c1qeYvi9 Investopedia (2011). Capital Expenditure- CAPEX, viewed 23rd October 2011, http://www.investopedia.com/terms/c/capitalexpenditure.asp#axzz1c1qeYvi9 Aswath D (2011). Riskfree Rates and Default Spreads, New York, 25th October 2011, http://www.econ.kuleuven.be/public/ndbae76/econometrics/discrate1.pdf TPG Telecom Limited. Annual Report. http://www.aspectfinancial.com.au.ezproxy.lib.uts.edu.au/docserver/01107997.pdf?fileid=01107997&datedir=20101014&edt=MjAxMi0wMS0xNSswMjowMzo0MCsxMjArNjQ1NTQrVVRTLUZpbnMrcmVkaXJlY3QrL2ltYWdlc2lnbmFsL2Vycm9ycGFnZXMvUERGVGltZW91dC5odG1sKy9pbWFnZXNpZ25hbC9lcnJvcnBhZ2VzL3BkZmRlbGF5ZWQuanNw Fin Analysis. TPG: Annual Ratio Analysis. http://www.aspectfinancial.com.au.ezproxy.lib.uts.edu.au/af/company/annualratios?ASXCode=TPM&xtm-licensee=finanalysis TLS. Annual Ratio Analysis. http://www.aspectfinancial.com.au.ezproxy.lib.uts.edu.au/af/company/annualratios?ASXCode=TLS SGT. Annual Ratio Analysis. http://www.aspectfinancial.com.au.ezproxy.lib.uts.edu.au/af/company/annualratios?ASXCode=SGT iiNET Limited. Annual Ratio Analysis. http://www.aspectfinancial.com.au.ezproxy.lib.uts.edu.au/af/company/annualratios?ASXCode=IIN Read More