Corporate Finance of GlaxoSmithKline - Assignment Example

a) Calculate the company’s weighted average cost of capital and explain/justify your calculation. The calculation of GSK’s WACC for the year 2008 is stated below: WACC (WEIGHTED AVERAGE COST OF CAPITAL): WACC = Debt % (Cost of debt) + Equity % (Cost of Equity) (1-T) = 79% (5%) + 21% (10.04%) (1- 29.2%) = 5.44% SUPPORTING CALCULATION AND ASSUMPTIONS: Ks = Dp/Pp+g 0.57/12.85+10% 10.04% Business growth in the year 2008 with reference to the annual report is 10% (GSK Annual Report, 2008, p.15). Dividend per share is 57p in the year 2008 (GSK Annual Report, 2008, p.03). Price of the stock in the year 2008 is £12.85 (GSK Annual Report, 2008, p.94). Overall weighted average cost of debt is 5% as mentioned in the financial report (GSK Annual Report, 2008, p.145). Tax rate applied in the year 2008 for 12 months operation is 29.2% (GSK Annual Report, 2008, p.188). GSK is highly dependent on debt financing with a percentage of 79% to be accurate, which shows the fact that there is a high leverage cost being bore by the management in order to run its business smoothly and efficiently. The management not only takes the short term borrowing but also the long term borrowing in the shape of Commercial paper, current bank loans and overdrafts. The average interest rate of GSK is 5.0% in the year 2008. Due to the sound business operation strategies that the management has adopted, a reflection on the net profit of the company is evident and the company has declared a relatively high dividend of 57p per share in the year 2008 which is a significant improvement as far as last 3 year dividends declared are concerned. All in all, our mathematical method of computing WACC suggests that GSK is highly inclined towards debt financing, which is a prime reason behind the increment in WACC. We also conclude the fact that floating interest rate due to the current economic condition reduces the WACC and also consider the company’s performance which reflects on the net income which ultimately reflects on the dividends declared. It is prime evidence of the fact that the management takes all necessary measures to reduce the cost of doing business which is a major consideration for any and every business. b) Write a brief report on the company’s cash flow over the period covered by the accounts. The operating, investing and financing activities of a company are very handy and useful information for the users of financial infrmation, such as creditors, investors, financial analysts, etc, because these activities change the financial position of the company. Let us now look upon some of the important activities that make some impression on GSK’s financial position. OPERATING ACTIVITIES: GSK’s management has adopted sound business strategies in order to ensure smooth and efficient running of its operational activities. These strategies have expanded the cash generation from operations to £ 9,055m in the year 2008 in comparison to previous years. The reason behind this high figure of £9,055 million are the two reclassifications; the cash generated from operations is £106 million lower than that given in GSK’s unaudited or projected accounts issued on 5th February 2009. Also keeping in view that drop-off in liquid investments for the current year has been reclassified from financing activities to investing activities. Some accounting heads that create changes in the trade payables may have been a result of the growth of products that the company introduced. GSK management computes inventories on a first in, first out basis. By adopting effective inventory management strategies, the inventory level of £4,056 million in 2007 has increased by £994 million during the year. The majority of this increase arises from a strengthening of overseas currencies, and also due to the strategic stock building policies that supports the growth in specific products. Also keeping in view that changes in trade receivables include £14 million (2007 – £8 million) due from associates and joint ventures. And the fact that net cash inflow from operating activities after payment of taxes was £7,205 million, an increase of £1,044 million over 2007 primarily due to the major restructuring programmes, has collectively improved the working capital management which reflects the management policies towards its operational activities. INVESTING ACTIVITIES: GSK’s business is highly scientific, i.e. it requires a very advanced technological support and infrastructure in order to meet the business demands. Renewal and maintenance of its property, at a minimum cost while bearing minimum risk without disruption in the output of the company is required in order to ensure that all the necessary standards are duly satisfied. The total cost of GSK’s property, plant and equipment at 31st December 2008 was £18,987 million, with a net book value of £9,678 million (GSK Annual Report, 2008, p.43). Company is acquiring more land and buildings, which is part of the company’s business expansion program and also acquisition and disposal of property, plant and equipment due to the technological advancements and the need to stay ahead of the competition by employing and investing in state-of-the-art technology. Main factor behind the acquisition of the property are the large number of projects that enforces the management to consider renewal, improvement and expansion programmes at various worldwide segments. At 31st December 2008, GSK had capital contractual commitments for future expenditure of £489 million and operating lease commitments of £448 million. GSK believes that its facilities are adequate for its current needs. (GSK Annual Report, 2008, p.43) Goodwill has increased during the year from £1,370 million at 31st December 2007 to £2,101 million (GSK Annual Report, 2008, p.148). The increment in the goodwill arises due to the acquisition of Sirtris Pharmaceuticals Inc. for £242 million and also due to the acquisition of Bristol Myers Squibb (BMS) Egypt business for £52 million as well which really strengthens the outlook of the company. Other intangible assets include the cost of intangibles acquired from third parties and computer softwares. There is a significant improvement which is due to the addition of £847 million and currency movements partly offset by the amortisation and impairment of existing intangibles (GSK Annual Report, 2008, p.148). The most significant element is the addition of £106 million relating to the acquisition of Sirtris Pharmaceuticals Inc which covers the patent applications in the area of sirtuin biology. On 5th June 2008, the Group acquired 100% of the issued share capital of Sirtris Pharmaceuticals Inc with a cash consideration of £376 million (GSK Annual Report, 2008, p.149). This transaction has been accounted for by the purchase method of accounting. With effect to this acquisition, goodwill has risen. Sirtris Pharmaceuticals Inc. had a turnover of £0 and a loss after tax of £25 million for the year, of which £0 of turnover and £14 million of loss after tax related to the period since acquisition and are included in the Group accounts (GSK Annual Report, 2008, p.150). In the last quarter of 2008, the Group also acquired the Egyptian mature products business of Bristol Myers Squibb (BMS) for a cash consideration of £140 million of this amount, £10 million is deferred with payments being made when alternative supply arrangements are established (GSK Annual Report, 2008, p.151). The Group also acquired 20 branded products that have a strong presence in the market and very authentic products for the four therapeutic disease areas in Egypt. Total sales of this combined mature products pharmaceuticals business in 2007 were $48.5 million. The Group will also take part in the ownership of BMS’s high quality manufacturing facility in Giza. The Group will also have an edge to export generic versions of the acquired products to markets outside Egypt. This is a great opportunity to driven the sales growth globally and increase goodwill in doing so. The business had a turnover of £25 million and a after tax profit of £4 million for the year, of which £4 million of turnover and £0.2 million of profit after tax are related to the period since acquisition, and are included in the GSK accounts (GSK Annual Report, 2008, p.151). GSK also invested £2 million in the Euclid SR Partners, LP, an associate in which the Group has a 38.6% share and also £6 million in Shionogi-GlaxoSmithKline Holdings Ltd, a joint venture in which the Group has a 50% share. FINANCING ACTIVITIES: At 31st December 2008, of the issued share capital, 128,969,260 shares were held in the ESOP Trust, all shares are fully paid off. Share capital purchased and cancelled in the year 2008 includes the cancellation of 30 million of previously acquired Treasury shares (GSK Annual Report, 2008, p.146). £3.7 billion was spent on repurchases in 2008 and a total of £6.2 billion has been repurchased under the current £12 billion share buyback programme (GSK Annual Report, 2008, p.146). Due to this programme GSK isn’t able to make significant share repurchases under the existing share buy-back programme in the year 2009. Short term borrowings which mainly comprise of commercial paper which has a value of $10 billion, of which none was in issue at 31st December 2008. GSK’s long term borrowings are worth £15.2 billion (2007 – £7.1 billion) of which £9.8 billion (2007 – £4.4 billion) falls due in more than five years. The repayment of these loans ranges from 2014 to 2042. Retained earnings and other reserves amounted to £5,190 million at 31st December 2008 (2007 – £6,834 million, 2006 – £7,030 million) of which £391 million (2007 – £218 million, 2006 – £185 million) relates to joint ventures and associated undertakings (GSK Annual Report, 2008, p.148). c) Give your opinion as to what discount rate the company should use when deciding on major capital investment projects. Justify your opinion(s) fully. The annual report of GSK discloses the fact that the Discount rate is based on GSK’s WACC and adjusted where appropriate for country specific risks. The company uses this discount rate to perform financial analysis and help out in decision making process internally through which management determines the extent at which investments cover the company’s cost of capital. From the perspective of a particular investment project, the discount rate may be adjusted to take into account country or other risk weightings. The management of GSK applies the discount rate on discounted Cash flows which are aimed at evaluating the financial aspects of a project, a company or its assets, and it uses the concept of Time Value of Money. All future cash flows are discounted and estimated to their present values. The discounting methodology is employed in determining the economic attractiveness of capital investment projects, which reduces the value of future cash receipts or payments (Houston and Brigham 2001). GSK’s management uses the discount rate (WACC) as a tool for making an appropriate investment proposal. When the company launches its new product into the market or starts its business operations in a new business segment, this discount rate helps the management in deciding the feasibility of the investment. The discount rate is used in the NPV (Net Present Value) or possibly for evaluating the IRR (Internal rate of Return). The net present value, in simple words, can be described as the present value of cash flows minus the investments (Mathur 2002). The NPV of an investment in a particular project is the present value of expected cash inflows less the present value of the project’s expected cash outflows, discounted at the appropriate cost of capital. The basic idea behind NPV analysis is that if a project has a positive NPV, this amount goes to the firm’s shareholders (Houston and Brigham 2001). As such, if a firm undertakes a project with a positive NPV, shareholder wealth is increased. While on the other hand IRR is defined as the rate of return that equates the Present value of an investment’s expected benefits (inflows) with the present value of its costs (outflows). Equivalently, the internal rate of return may be defined as the discount rate for which the NPV of an investment is zero (Helfert 2001). All in all GSK’s management should look at both the investment appraisal techniques and use the discount rate of WACC in making decisions regarding project investments. Although these techniques may give the firm a fair idea regarding the expected cashflows of a particular project, but GSK will also have to consider the macro-economic factors like monetary policies, double taxation, etc, which may also impact the viability of the decision. In this case the company might also want to revert to sensitivity analysis to determine the impact of the above mentioned macro-level factors. References Houston, Joel and Brigham, Eugene F. (2001). Fundamentals of Financial Management. Harcourt College Publishers. GlaxoSmithKline. (2008). Annual Report. Helfert, Erich A. (2001). Financial Analysis Tools and Techniques: A Guide for Managers. McGraw-Hills Mathur, Iqbal (2002). Introduction to financial management. Collier Macmillan. Read More