International Finance - Debt and Equity Financing - Coursework Example

?a) The weighted average cost of the Vagabond plc, before consideration of the project, is calculated as follows. Market Value of Equity Type of instrument Total Number of Shares Current Market Value Market Value of equity (?) Cost of Equity (ke) Equity Shares 2,000,000,000 0.36 720,000,000 9.50% Calculation of Cost of Equity (ke)     Table 1     Ke = Rf + (Rm-Rf) x Beta   Ke 9.50%       Where Rf = 5 Rm= 10 Beta=0.9 Market value of Debt Type of instrument Current Market Value (?) Cost of Debt (kd) Bank Overdraft 169,800,000 6% Redeemable bond 310,200,000 3.52% Calculation of Cost of debt (kd)  Table 2 Current Market Value (94) Coupon Payment   Dec-11 4 Dec-12 4 Dec-13 4 Dec-14 4 Dec-15 4 Redemption at premium 102     IRR (Pre tax) 4.88% IRR (Post tax) 3.52% Weighted Average Cost Of Capital Table 3 Instrument Market Value (?) Rate of return Weightage(?) Equity Shares 720,000,000 9.50% 68,400,000.00 Bank overdraft 169,800,000 6% 10,188,000.00 Redeemable bond 310,200,000 3.52% 10,905,381.42  Total 1,200,000,000 89,493,381.42 WACC 7.46% Current Debt to Equity ratio Debt 480,000,000 Equity 720,000,000 Ratio 0.67 The weighted average cost of capital of the company is the weighted average of the various sources of finance used by the company. Debt is cheaper than equity finance as it lower risk prone and there is always a tax incentive. Increasing amount of debt in the capital structure of the company has its disadvantages as well. Increasing level of debts increases the financial risk of a company which eventually increases the cost of equity as well. The weighted average cost of capital of highly geared company is higher as compared to the others. In the given case study, the company, vagabond plc, is not a highly geared company as against every ? 0.67 worth of debt, the company has ? 1 worth of equity. In order to calculate the weighted average cost of capital of the company, the market value of equity and debt instrument is need to be calculated. The shares of Vagabond plc are currently traded at 36 pence which makes the total market value of the equity to ?720 million. In order to calculate the cost of equity (ke) we use the formula as enumerated in table 1. In the mentioned formula Rf is the risk free rate of return where Rm is the current market rate. Rm-Rf represents the market premium. Beta measures the systematic risk (associated with the environment in which the entity operates) of the company in relation to the current market risk. The company currently has debt through two resources i.e. through bank overdraft and an issuance of redeemable debt bond. For bank overdraft the cost of debt is the rate on which the company pays interest. For the redeemable bond, the cost of debt can be calculated as mentioned in Table 2. Since interest (Coupon x Face value of the debt) is the only cash flow, the IRR of the cash flows is the cost of the debt kd. The weighted average cost of capital (WACC) of the company is calculated by considering all the sources of capital and their rate of return. b) The revised weighted average cost of capital for Vagabond Plc, after consideration of the project is as follows. Calculating the revised capital structure Current Debt to Equity ratio Debt 480,000,000 Equity 720,000,000 Ratio 0.67 Investment required ? 300,000,000 Let the investment raised through equity be 'x' Thus in order to maintain the current debt equity ratio, the company’s revised capital structure should be as follows (480 + x) / (720 + (300-x) = 0.67 Solving the equation, the value of 'x' is ? 121.5 million Revised Debt to Equity ratio Table 4 Debt ? 601,500,000 Equity ? 898,500,000 Ratio 0.67 Calculating Beta equity (Geared) of the project  Table 5     Beta (asset) = Beta (equity) x Equity/[Equity +Debt(1-tax rate)] Where   Beta (asset) of the project is 1.9   Revised debt is 601.5 million   Revised equity is 898.5 million       Substituting all the values in the equation, Beta(equity) is 2.81 Calculating revised cost of equity    Table 6 Using the formula Ke = Rf + (Rm-Rf) * Beta (equity)   Ke 19.05%     Calculating revised weighted average cost of capital Table 7 Instrument Market Value Rate of return Weightage Equity Shares 898,500,000 19.05% 171,164,250.00 Bank overdraft (current) 169,800,000 6.00% 10,188,000.00 Bank overdraft (additional) 121,500,000 4.80% 5,832,000.00 Redeemable bond 310,200,000 3.52% 10,905,381.42   1,500,000,000 198,089,631.42 WACC 13.21% In order to calculate the revised WACC of the company after the consideration of the project, the foremost decision is to decide the capital structure in which the project will be financed. The management of vagabond plc has decided to finance the project in its existing Debt to equity ratio i.e. 0.67. The table 4 mentions the revised capital structure of the company after consideration of the project. Since Vagabond plc is venturing into a new industry thus it is required to calculate Beta equity (geared) of the project in the current debt to equity ratio of the project. After calculation of the Beta equity (geared) substitute the values in the table 6 to arrive at the revised cost of equity. The company has decided to raise the rest of the ? 178.5 million through unsecured sterling bank loan at an interest rate of 4.8% per anum. Table 7 represents the revised WACC of the company after consideration of the proposed project. c) Vagabond plc is a UK based multinational having subsidiaries in various countries of Asia and Europe. As mentioned in the case study, the prevailing inflation rate in the UK is 2 percent which is expected to remain constant in the foreseeable future. The nominal discount rate for Vagabond plc can be calculated by considering the following formula (1 + m) = (1+r) x (1+i) Where m is the nominal rate of return r is the real rate of return of the company which is 13.21% i is the current inflation rate which is 2% Substituting the values in the above equation the nominal discount rate of vagabond plc for the evaluation of the project is calculated to be 15.47% d) In million ? Years 2011 2012 2013 2014 2015 2016 2017 onwards Real profits 36.67 56.67 68.33 83.33 106.67 120.00 Inflation impact 10.00% 6.00% 4.00% 4.00% 4.00% 4.00% Discounted 1.100 1.124 1.125 1.170 1.217 1.265 Nominal profits 40.33 63.67 76.87 97.49 129.78 151.84 Depreciation (120.00) (45.00) (33.75) (25.31) (18.98) (14.24) Taxable profits (79.67) 18.67 43.12 72.18 110.79 137.60 Tax (@ 10% for first three year and @ 24 percent for the rest of the project) 7.97 (1.87) (4.31) (17.32) (26.59) (33.02) Profit after tax (? ) (79.67) 26.64 41.25 67.86 93.47 111.01 701.71 Add back depreciation 120.00 45.00 33.75 25.31 18.98 14.24 40.33 71.64 75.00 93.18 112.45 125.25 701.71 Investment (180) (120) Working capital changes (16.50) (16.85) (16.87) (17.55) (18.25) (18.98) Cash (out flow) / inflow (156.17) (65.22) 58.13 75.63 94.20 106.27 701.71 Withholding tax - - (2.91) (3.78) (4.71) (5.31) (35.09) Net Cash (out flow) / inflow (156.17) (65.22) 55.22 71.85 89.49 100.96 666.63 Present value factor 1.155 1.333 1.540 1.778 2.053 2.370 2.737 Present value (180.33) (86.96) 85.02 127.73 183.71 239.30 1,824.60 Net Present Value 2,193.08 In the above calculation, the real profits from the year 2011 till 2016 are converted into ? based on the spot rate that prevails as at December 31, 2010. Since there are no future rates available, thus it is assumed that the current party between the Sterling and Malaga $ remains the same throughout the life of the project. The impact of inflation is incorporated in order to arrive at the real profits for the projects. As mentioned in the scenario, the government of mala allows initial depreciation at 40% of the cost of the plant and machinery. It is assumed that although only 60% of the total investment outlay occurred in the first year, the initial allowance is allowed for the entire amount of ? 300 million. Subsequent to the year 2011, the depreciation is allowed on reducing balance method. The deduction of depreciation from the nominal profit gives the taxable profits for the year. The applicable tax rate is 10% for the first three years and then 24% for there on. Since the tax is payable in arrears, the tax is deducted from the taxable profits of the next year. The deduction of tax gives the after tax profit for the first six years. In the above calculation, it is assume that the Office of Independent transport services (OITS) approve of the company performance and investment and thus allows a further ten years for the project to continue. Thus the impact of reimbursement by the government of Malaga of property and equipment and recoupment of investment in working capital is also disregarded. Since it is assume that the project will further continue for a period of ten years, the after tax profits for the year 2016 are utilized in order to calculate the total earning for the period of ten year i.e. till 2026. The total earning is calculated by implementing the following formula P =R x [{1 – (1+i) ^ -n} / i ] Where; R is the annual taxable profits I is the constant growth rate i.e. 8% n is the number of years i.e. 10 P is the present value of the total earnings Depreciation is added back to the profits as it is a non-cash item and is used in order to calculate taxable profits. Working capital changes is ?15 million in the first year and the additional requirement rises with the rate of inflation of Malaga. In the financial year 2011 and 2012 the project does not have any cash surplus but in the further years, the withholding tax of 5% is applicable on the cash surplus at the year end. The net cash inflow or outflow is multiplied with the discounting factor in order to arrive at the present value of the cash flows. Since the project has a positive Net Present Value (NPV), the project is feasible and Vagabond plc should make the investment. e) Debt financing i.e. acquiring funds in the form of loans and advances is usually acquired when the organization wants total control and discretion over the operations of the entity. There are several types of business loans that can be sanctioned through banks or other financial institutions but they are broadly divided into two major categories secured loans and unsecured loans. [1] Secured loans are further categorized into mortgage loans, non-recourse loan and foreclosure. Unsecured loans are the exact opposite of secured loans since they are not supported by any collateral. When it comes to unsecured loans, the credit rating of the entity matters, which is a measure of the entity’s ability to repay the loan in future. Unsecured, which is quite cheaper than the secured loan, is further divided into start-up loans, business only loans and business acquisition loans. [1] Debt financing allows the management to have full autonomy over the utilization of the funds. Since they do not have any investors or partners to answer to, they are entitled to exercise their discretion and the profits earned are totally theirs. [2] Another interesting point which is observed when obtaining debt financing is that it lowers the tax liability of the entity. The finance charge paid by the company on the financing acquired is deductable for tax purposes, thus reducing the tax liability. [2] However, the disadvantages associated with debt financing are great. If you are unable to make timely payments, to the commercial banks or any other financial institution form where the loan had been acquired, it spoils your credit ratings and thus you are unable to acquire such facilities in the future. [3] Loans are not always easy to acquire when it comes to start up businesses. The banks usually require the entities to pledge their assets, and in case the business does not turns out to be successful, there is a possibility that the pledged asset will be lost. [2] The chance of bankruptcy is higher when you acquire debt financing, this can be calculated through debt to equity ratio. Higher the ratio, higher is the risk of bankruptcy. [2] Alternate of raising funds through acquiring loan, is through equity financing or through issuance of bonds. Funds can be raised through equity financing by issuing or floating shares in the stock market where the company is currently listed. There are several advantages of raising funds through equity financing especially for start up business, where the initial investment by the investors can be utilized for the start-up cost, instead of acquiring loan from commercial banks and pledging any assets. The downside of acquiring financing through issuance of equity is that the procedure is quite complicated as compared to acquiring funds by approaching any bank. In most cases, a loan is acquired from any bank or financial institution by filing an application for the sanctioning of the loan. Whereas in the case of raising finances through issuance of equity shares, the company has to fulfill several requirements such as issuing a pre defined number of shares, issuing shares to the existing shareholder in proportion to their existing shares and appointing a financial advisor for conducting a due diligence of the entity’s operations. Although these statutory rules and requirements are enforced by the relevant authorities in order to safeguard the interest of the organization and general public, complying with them can be quite troublesome when the requirement of the fund is urgent. There is no burden bankruptcy or payment of finance charge involved in acquiring funds through equity financing. Company, before issuing shares to the shareholders, prepare a prospectus which explains that the investment is subject to business risk, thus they are aware if their investment is eroded subsequently. There are drawbacks of raising equity financing as well. There is always an uncertainty that the shares will not be completely subscribed by the public, whenever they are floated in the market, and thus the company would not be able to raise the required funds. Whereas, in the case of loan, the financer usually communicates to the organization about the sanctioning of the loan. In contrast, in equity financing, the company has to wait for a considerable longer period of time for the funds to become available for their utilization. The cost of acquisition of funds, in the form of loan, is quite less if compared to the cost of raising financing through shares or bonds. Initial cost pertaining to the raising of equity financing includes printing of shares, cost of listing of shares on the stock market and professional charges paid to financial advisor for conducting the due diligence of the issuance of shares. Whereas, no or very minimal cost is expended in the acquisition of short term or long term financing. Raising finance through issuance of bond is another method usually adopted by the entities. A bond is basically a loan in the form of a debt security [3]. The authorized issuer owes the bondholder a debt and has an obligation to repay the principal and the coupon (interest) on the maturity of the loan. [3] The advantage of issuing a bond is that it is quite cheaper than raising capital through loan or equity and is a very useful tool in identifying the overall financial outlook of the organization, since if the company is able to repay the debt and interest to the bondholder on time, means the organization has going concern ability. From a governance point of view issuing bonds can be quite useful for the companies who do not want their controls to be resigned. Usually, in several regulatory environments, the creditors do not have any right to exercise their discretion when it comes to running the operations of the company, whereas the statute provides such right to the bond holders. Evaluating the disadvantage, the company has to pay timely payment of principal and interest to the bond holders according to the terms of the bond. This can create solvency problem for the company when they are going through cash flow problems. Whenever a bond is issued, the equity holder fears the most risk. This is due to the fact that according to the general company laws, in case of liquidation, the claims of bond holders and equity holders are serviced primarily, thus equity holders might have a change of losing their equity. Question Number 2 The global economy is becoming more and more integrated and countries are now exploring ventures in other parts of the globe for sustainable and lucrative investments. Direct foreign investment (FDI) is one of the strategies which have lately been adopted by various MNCs in order to make the most of the foreign economic environments. FDI encompasses a broad spectrum of investment ranging from investment in existing companies, real estate, equity and capital market and even investment in the development of infrastructure. In the mentioned case scenario, Vagabond Plc is conducting a massive FDI in the African country of Malaga in order to facilitate the development of infrastructure of railway network. In the discussed venture, the element of risk is comparatively higher as compared to the previous investment expeditions of Vagabond in Europe and Asia. This is due to the fact Vagabond Plc might not be able to correctly forecast the political, social technological and legal environment of Malaga. Considering the situation as mentioned in the case study, Vagabond plc is likely to face several threats while venturing into Malaga. The first and foremost threat the company is likely to face is the devaluation of the Malaga $. Since Malaga is a young country, it is likely that due to the external economic instability, the currency will devaluate as compared to the Euro. In order to safeguard its financial interest, Vagabond plc should preserve its foreign currency receipts through currency risk hedging. Other barriers which Malaga may impose on Vagabond Plc to restrict FDI are through implementing various regulations. The government of Malaga may make its tax structure stringent and rigid which could prove to be a major hurdle for Vagabond Plc in appraising long term foreign investment. In addition, the government of Malaga can impose additional restrictions relating to currency conversion, remittance of currency outside the country, employees rights etc. There could be certain ethical differences which could cause certain difficulties for the management of Vagabond Plc. There are certain business practices which might be ethically accepted in certain parts of the world but not in others. For example, giving monetary incentives to government authorities in China is considered as gift or grease money to speed up the administrative process, whereas the same act would be labeled as bribe in any other part of the world. If any such culture is practiced in Malaga, Vagabond Plc might refrain from investing, although ethically justified in Malaga; such practice would be in contrast with the business culture of the company. Another important risk that Vagabond Plc is likely to face pertains to human resource management. Human resource is considered to be the most important resource when it comes foreign direct investment. Since Malaga is a young country, with its socio economical conditions still under development, it would be difficult for Vagabond Plc to find a suitable skilled labor overseas. It is quite likely that the company might have to spend a considerable sum of money on basic training. In addition, human resource issues related to career management, appraisal schemes and communications is another subject which requires the management’s acute attention. The most prominent risk that which is likely to be faced by the management of Vagabond Plc is the risk of political interference or turbulence. There are several ways through which Vagabond Plc can combat the political risk and limit its effects. The first and foremost is the negotiation with the government of Malaga. This would cover matters such as the transfer of capital, remittances, access to local finance and taxation. There are several institutions which offers insurance services against various political threats such as nationalization, currency conversion problems and expropriation of assets by the government. Vagabond Plc can acquire the services of such instructions in order to protect itself from the above mentioned threats. Question Number 3 Scenario 1 Country Currency Amount in foreign currency Applicable investing decision Applicable rate Surplus / (Deficit) 30 Day forward rate Amount in Sterling(?) A B C=A x B D E=C/D Germany Euro 14,000,000 Deposit 1.90% 266,000.00 1.12 237,500.00 USA Dollar 16,000,000 Deposit 1.20% 192,000.00 1.68 114,285.71 UK Pound (12,000,000) Borrow 1.70% (204,000.00) 1 (204,000.00) Total net Surplus ?147,785.71 Scenario 2 Country Currency Amount in foreign currency Spot rate Amount in sterling (?) Applicable investing decision Applicable rate Surplus / (Deficit) A B C=A/B D E=C x D Germany Euro 14,000,000 1.18 11,864,407 Deposit 1.40% 166,101.69 USA Dollar 16,000,000 1.62 9,876,543 Deposit 1.40% 138,271.60 UK Pound (12,000,000) 1.00 (12,000,000) Borrow 1.70% (204,000.00) Total net Surplus ?100,373.30 In scenario 1, the each subsidiary of Tempo Plc acts independently and takes its own financial decisions. The balance of foreign currency in Germany and USA is in surplus, thus the subsidiaries in both the countries needs to deposit the surplus in order to earn a suitable return. The applicable 30 days deposit rate in Euro and USD is 1.9% and 1.2% respectively. By multiplying the surplus funds with the 30 days deposit rate, the return is calculated. The return as calculated in Euro and USD is further converted into Sterling at the 30 day forward rate. This is done by dividing the column C by D. Since there is a deficit balance at the parent situated in the UK, thus it needs to borrow money from the market and thus have to pay interest. The prevailing 30 day borrowing rate is 1.7% at which the parent company has to pay interest which amounts to ? 204 thousand. Considering the scenario 2, all the funds from the subsidiaries are immediately remitted to the parent company, and the balance is converted into sterling at the prevailing spot rate. The converted balance is then borrowed from or invested in. After the conversion of the balances remitted from the subsidiary in Germany and USA, the balances are deposited at the prevailing Sterling rate of 1.4%, and likewise in order to cater the deficit, borrowing at the rate of 1.7% was done for the parent’s balance. Evaluation of the above mentioned two scenarios shows that scenario 1 is beneficial for Tempo Plc as it earns surplus amounting to ?147,785.71, which is ? 47,412 higher than the surplus which could be earned by adopting the strategy as mentioned in scenario 2. Advantages and disadvantages of pooling system The advantage of having a centralized treasury department is that it avoids surplus in different bank accounts in different countries. In pooling system, large volumes of cash are available to invest, giving better short term investment opportunities. In addition, any borrowing can be arranged in bulk, at lower interest rates than for smaller borrowings Foreign currency risk management is likely to be improved with the implementation of pooling system. A central treasury department can match foreign currency income earned by one subsidiary with expenditure in the same currency by another subsidiary. A specialist treasury department will employ experts with knowledge of dealing in forward contracts, futures, options, Eurocurrency markets, and swaps. In pooling system, transfer pricing can be set centrally, thus minimizing the group’s global tax burden. The disadvantage of central pooling system is that sources of funds are not available in order to match local assets and cash flow need of the subsidiary. In decentralized system, greater autonomy is given to subsidiaries when it comes to taking financing decision. Another disadvantage of maintaining a decentralized system is that financing decisions cannot be taken promptly and quickly. References [1] Medha Godbole “Types of business loans” buzzle.com”. Buzzle.com – intelligent life on the web, n.d. Web. 28th March 2011. [2] Rosemary Peavler “Debt and equity financing”Bizfinance.about.com” About.com – a part of the New York Times company, n.d. Web. 26 March 2011. [3] “Raising capital by issuing bonds” qfinance.com. 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