Hutchison Whampoa Company’s Capital Structure Decision

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Hutchinson Whampoa (HW) uses a mixture of debt and equity financing (exhibit 2), where the proportion of debt is almost less than 30 percent of capital employed, hence a low debt-to-equity ratio. Since the firm currently employs low financial leverage, the return on capital is likely to be minimal (Brigham & Houston 2009). Though using high financial leverage poses a higher risk, academics such as Modigliani and Miller have proposed using debt as a means of increasing firm value. Debt has several advantages such as a tax shield, which leaves more cash available for shareholders, as the weighted average cost of capital (WACC) drops.

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Like other Hong Kong firms, Hutchinson has relied to a great extent on internally generated funds, comprising mainly of retained earnings. in terms of long-term financing, the company has realized that long-term debt will hamper financial flexibility in the future. The company has floated 50.1 percent of its ordinary shares in the Hong Kong Stock Exchange, which might give an opportunity for a hostile takeover should a given firm acquire all the shares in the market. Hutchinson does not have a credit rating by Standard and Poor’s and Moody’s since the Company does not use international debt financing.

Future capital needs

Investment analysts have suggested that Hutchinson would require over US$5 billion (exhibit 10) over the next five years for the company to maintain its current growth trajectory. The long-term nature of the projects would require Hutchinson to source for long-term financing, hence making good on the obligations after the projects are completed. The Hutchinson finance group has recognized the need for a favorable interest rate, over a 10 year period.

The decision has ruled out the use of syndicated bank financing, which would have lent funds for an average period of 5-7 years on a floating interest rate basis. In Hong Kong, these banks would have provided a limited amount of funds which would not have been sufficient to meet Hutchinson’s requirements. Hutchinson would have issued additional equity, but this would have resulted in dilution of shares and loss of control.

Bond-rating from Standard and Poor’s and Moody’s

Hutchinson’s credit rating can be attained through a vertical analysis of key ratios with other firms in the same industry, or use of the Standard and Poor’s long-term debt rating methodology (exhibit 8). Through the use of vertical analysis, it can be noted Hutchinson has performed almost similarly to Swire Pacific Ltd. And Wharf Holdings Ltd. (exhibit 6), which are both comparable firms thus Hutchinson could also attain the A credit rating. Conversely, the Standard and Poor’s methodology gives a different result, as illustrated below.

Ratio HW median AAA AA A BBB BB B
EBIT 4.1 X
EBITDA 6.15 X
Funds from operations/total debt (%) 32.8 X
Free operating cash flow/total debt (%) 9.35 X
Pretax Return on capital (%) 12 X
Operating income/sales (%) 16.35 X
Long-term debt/capital (%) 29 X
Total debt/capitalization (%) 40.8 X

From the above demonstration, it can be noted that Hutchinson’s scores average the BBB long-term credit rating. Therefore, from the above discussion, Standard and Poor’s are likely to award Hutchinson’s with either an A credit rating or BBB, depending on the credit firm’s evaluation of the company.

Debt financing options

There are several ways in which a multinational firm like Hutchinson can acquire debt, depending on the duration of the financing. Short-term debts can be acquired from bank loans, bank overdrafts,or account payables. For purposes of raising working capital, companies can raise funds through the issuance of bonds, bills or notes, rather than issuing equity. In the case of bonds, Hutchinson could issue Euro or Yankee bonds, which can be used to acquire funding from international debt markets (Brigham & Ehrhardt 2008).

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Yankee bonds are foreign bonds issued in the United States, denominated in US dollars. Foreign companies can benefit immensely from the issuance of Yankee bonds, where they can advantage of the favorable low-interests in the US, therefore providing a low cost of capital to the issuing entity. The company will also benefit from the dollar-denominated bonds, since it will be able to earn foreign exchange which could be used for international trade or foreign reserves. The US also has an advanced bond market, which would provide liquidity for the issuing company’s bonds. Another major benefit for foreign companies using Yankee bonds is that they will experience the advantages of US’s bond market, while in some way being protected from the expensive and strict regulation by the SEC (Securities and Exchange Commission) required for local US companies.

Several factors should be considered before the choice of an optimal capital structure, such as regulations and the cost of capital. Financial leverage could be encouraged, so as to derive higher returns on capital, while managing the risks involved such as the bankruptcy cost. The company could still use its retained earnings but this would drain Hutchinson out of future funds, whereby it will experience higher costs to acquire financing. If Hutchinson gets a favorable credit rating from S&P, then it should go ahead with the Yankee bonds since it would benefit from the low interest rates.

References

Brigham E. F. & Houston J. F. (2009). Fundamentals of Financial Management. New York, NY: Cengage Learning.

Brigham, E. F. & Ehrhardt M. C. (2008). Financial management: theory and practice. New York, NY: Cengage Learning.

Hutchinson Whampoa Limited: (2010) The Capital Structure Decision (Case number Ivey 9A99N021) Kirkland, WA: Hutchinson Whampoa.

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