Riverside Electronics Plc: Financial Report

Introduction

One option that the company has of raising the finance required to expand its project is the fixed-rate debt or issue common stock. Preferred stock, also called preferred shares, preference shares, or simply preferreds is a unique equity security that is similar to finances offered both equity and a debt instrument and is regarded as a hybrid instrument. Preferreds are superior to common stock but are subordinate to bonds. Preferred stock normally bears no voting rights, but may have priority over common stock in the issuing of dividends and upon liquidation (Meyer, 2004).

Preferred stock may have a dividend that is paid out before any dividends being paid to common stock holders. Preferred stock may bear a convertibility feature into common stock. The conditions for a preferred stock are stipulated in a Certificate of Designation. Just like the bonds, preferred stocks are highly acknowledged credit rating organizations. The rating for preferreds is usually inferior because preferred dividends do not have similar guarantees as benefit payments from bonds and they are low-ranking to all creditors (Gordon, 2002). Below is an illustration to show the benefit of using fixed-rate debt or common stock to finance the expansion of a project:

Capital components: debt, preferred stock, and common stock.

Any raise in total assets must be financed by a raise in one or more of these capital components

• Kd: the interest rate on the firm’s new debt
• Kps: the cost of preferred stock
• Ks: the cost of retained earnings
• A: the cost of common equity (equity calculated by issuing new common stock as opposed to retaining earnings

The cost of debt

Kd(1-T) is the after-tax cost of debt. This represents the appropriate cost of new debt, taking into account the tax-deductibility of interest. In conclusion, the government spends part of the cost of debt since interest is deductible. This calculation assumes that the cost of debt is the interest rate on new debt, not the interest rate paid on current or old debt.

A 15-year, 12% semiannual bond sells for $1,153.72.

Component Cost of Debt

Interest is tax deductible, so

k_{d AT} = k_{d BT}(1 – T) = 10%(1 – 0.40) = 6%.

The cost of preferred stock (Kp)

The rate of return financiers require on the organization’s preferred stock.

Preferred stock is a continuity that pays a fixed dividend (Dp) forever.

Kp = Preferred dividend / the current price of the preferred stock cost of preferred stock P_p = $111.10; $10 dividend/share

Assumptions of the above calculation

• Preferred dividends are taxed so no tax adjustments are made Just k_p.
• Nominal k_p is used.
• Our calculation ignores flotation costs.

Cost on retained earnings

• Earnings can either be reinvested or issued out as dividends.
• Investors could purchase other securities, earn a return.
• Therefore, there is an opportunity cost if earnings are retained.
• Opportunity cost: this is defined as the return stockholders could earn on alternative investments of equal risk.
• They could purchase the same stocks and earn k_s, and therefore k_s is the cost of retained earnings. The rate of return required by stockholders on a firm’s common stock

Three ways to determine cost of common equity, k_s:

What’s the cost of common equity based on the CAPM?

k_RF = 7%, RP_M = 6%, b = 1.2.

The DCF cost of common equity, k_s

Given: D₀ = $4.19;

P₀ = $50; g = 5%.

Suppose the corporation has been getting 15% on equity (ROE = 15%) and retaining 35% (dividend payout = 65%), and this state of affairs is likely to continue.

the expected figure is:

Retention growth rate:

g = (1 – Payout)(ROE) = 0.35(15%) = 5.25%.

Here (1 – Payout) = Fraction retained.

Find k_s using the own-bond-yield-plus-risk-premium method.

(k_d = 10%, RP = 4%.)

• This RP = CAPM RP.
• Produces ballpark estimate of k_s

A reasonable final estimate of k_s

Why is the cost of retained earnings (k_s) cheaper than the cost of issuing new common stock (k_e)?

Two approaches that can be used to account for flotation costs (Beddow, 2006):

• Include the flotation costs as part of the project’s up-front cost. This reduces the project’s estimated return.
• Adjust the cost of capital to include flotation costs. This is most commonly done by incorporating flotation costs in the DCF model.
• Ke = [D1/Po(1-F) ] + g

F is the percentage flotation cost required to sell the new stock. So, Po (1-F) is the net price per share received by the company.

Comments about flotation costs:

• Flotation expenses depend on the risk of the company and the kind of capital being sought.
• The flotation costs are largest for common equity. However, since most company’s award equity infrequently, the per-project cost is relatively small.
• flotation costs are regularly ignored when computing the WACC.

Weighted Average Cost of Capital (WACC)

If all new equity will come from retained earnings:

• WACC = Wd [Kd(1-t)] + Wp(Kps) + Wc(Ks)

Wd, Ws, Wc are the weights used for debt, preferred stock, and common equity.

Assume that the firm has established such a target and will finance all new investments so as to maintain a constant target capital structure (Markides, 2004).

Weights should be based on the market value.

The company’s WACC (ignoring flotation costs)

• The firm has a target capital configuration of 40 percent debt and 60 percent equity
• Bonds cost 10% coupon (semiannual), mature in 20 years and sell for $849.54
• The firm’s stock beta is 1.2
• rf = 10%, market risk premium = 5%
• The firm is a constant growth firm that just paid a dividend of $2, sells for $27 per share, and a development rate of 8%
• Marginal tax rate is 40%.

Factors that influence a firm’s composite WACC

• Market situation (the level of interest rates, tax rates…)
• The firm’s capital structure and dividend policy
• The company’s investment policy is also considered. Organizations with riskier projects normally have a higher WACC.

WACC Estimates for Some Large

U. S. Corporations. 1999.

The corporation should not use the composite WACC as the barrier rate for every project it runs. The composite WACC shows the risk of an average project undertaken by the company. Thus, the WACC only represents the “barrier rate” for a typical project with average risk.

• Different projects have diverse risks. The project’s WACC should be accustomed to reflect the project’s risk.
• Procedures used to determine the risk-adjusted cost of capital for a specific project or division
• Biased adjustments to the organization’s composite WACC.
• Calculations on what the cost of capital would be if the project were an individual firm. This requires calculation the project’s beta.

Calculate division’s market risk and cost of capital founded on the CAPM, provided with the following inputs:

• Target debt ratio = 40%.
• k_d = 12%.
• k_RF = 7%.
• Tax rate = 40%.
• beta_Division = 1.7.
• Market risk premium = 6%.
• Beta = 1.7, so division has added market risk than average.

Division’s required return on equity:

k_s = k_RF + (k_M – k_RF)b_Div. = 7% + (6%)1.7 = 17.2%.

WACC_Div. = w_dk_d(1 – T) + w_ck_s = 0.4(12%)(0.6) + 0.6(17.2%) = 13.2%.

How does the division’s market risk compare with the firm’s overall market risk?

• Division WACC = 13.2% versus company WACC = 11.1%.
• Indicates that the division’s market risk is greater than firm’s average project.
• “Typical” projects within this division would be accepted if their returns are above 13.2%.

Expansion projects using a divided cut

Dividends are expenses made by a company to its shareholders. It is the portion of company profits paid out to stockholders. When a business makes a profit or surplus, that money can be utilized in two ways: it can either be re-invested in the company in a procedure referred to as retained earnings or it can be rewarded to the shareholders as a dividend. Many companies retain a portion of their profits and pay the remainder as a dividend (Subramanian, 2003). The company can opt to finance its expansion project through this procedure. This can best be illustrated by an example. The cash flow of new investment can be determined as follows:

Determining a Project’s Cash Flows

When beginning capital-budgeting analysis, it is important to determine the cash flows of a project. These cash flows can be segmented as follows:

1. Initial investment outlay
2. Operating cash flow over a project’s life
3. Terminal year cash flow

Initial Investment Outlay

These are the costs that are needed to start the project, such as new equipment, installation, etc.

Operating Cash Flow over a Project’s Life

This is the extra cash flow a new project generates.

Terminal-Year Cash Flow

This is the final cash flow, both the inflows and outflows at the end of the project’s life, such as potential salvage value at the end of a machine’s life.

Example: Expansion Project

A company is intending to add to its production capacity and is looking closely at investing in Machine B. Machine B has a cost of $2,000, with shipping and installation expenses of $500 and $300 in net working capital. The company expects the machine to last for five years, at which point Machine B will have a book value (BV) of $1,000 ($2,000 minus five years of $200 annual depreciation) and a potential market value of $800. Concerning cash flows, the company expects the new machine to make an additional $1,500 in revenues and costs of $200. assuming that the company has a tax rate of 40%. The maximum payback period that the company established is five years.

Calculating the project’s initial investment outlay, operating cash flow over the project’s life, and the terminal-year cash flow for the expansion project

The Initial Investment Outlay

Machine cost + shipping and installation expenses + change in net working capital = $2,000 + $500 + $300 = $2,800

Operating Cash Flow

• CFt = (revenues – costs)*(1 – tax rate)
• CF1 = ($1,500 – $200)*(1 – 40%) = $780
• CF2 = ($1,500 – $200)*(1 – 40%) = $780
• CF3 = ($1,500 – $200)*(1 – 40%) = $780
• CF4 = ($1,500 – $200)*(1 – 40%) = $780
• CF5 = ($1,500 – $200)*(1 – 40%) = $780

Terminal Cash Flow

The terminal cash flow can be calculated as illustrated:

• Return of networking capital +$300
• Salvage value of the machine +$800
• Tax reduction from loss (salvage < BV) +$80
• Net terminal cash flow $1,180
• Operating CF5 +$780
• Total year-five cash flow $1,960

To determine the tax benefit or loss, a benefit is received if the book value of the asset is more than the salvage value, and a tax loss is recorded if the book value of the asset is less than the salvage value.

Example: Replacement Project

Assuming that the company is replacing a project rather than investing in an additional machine, the firm is exploring replacing its existing machine with a newer, more competent machine. Based on the existing market, the firm can sell the old machine for $200, but this machine has a book value of $500.

Initial Investment Outlay

Computing the original investment outlay of a replacement project is to some extent different than the computation for a current project. This is basically because of the expected cash flow a company may receive on the sale of the equipment to be replaced.

Value of the old machine = sale value + tax benefit/loss

= $200 + $120 = $320

Sale of old equipment + machine cost + shipping and installation expenses + change in net working capital = $320 + $2,000 + $500 + $300 = $3,120

Operating cash flow

• CFt = (revenues – costs)*(1 – tax rate)
• CF1 = ($1,500 – $200)*(1 – 40%) = $780
• CF2 = ($1,500 – $200)*(1 – 40%) = $780
• CF3 = ($1,500 – $200)*(1 – 40%) = $780
• CF4 = ($1,500 – $200)*(1 – 40%) = $780
• CF5 = ($1,500 – $200)*(1 – 40%) = $780

Terminal Cash Flow

The terminal cash flow can be calculated as illustrated:

• Return of net working capital +$300
• Salvage value of the machine +$800
• Tax reduction from loss (salvage < BV) +$80
• Net terminal cash flow $1,180
• Operating CF5 +$780
• Total year 5 cash flow $1,960

After critically analyzing the example above, retained earnings are an option for the company. Furthermore, in many nations dividends paid back to individual shareholders imply that they suffer from double taxation. The organization pays income tax to the government while the shareholders are individually taxed by the government. This will further justify the company’s action of using the retained earnings to finance its project (lee & Caves, 2000).

Takeover

A takeover refers to the acquisition of a company by another Franko, 2005). Takeovers have been increasing in the recent past due to the ever-changing economic and financial times. This term has mostly been used to refer to the acquisition of publicly traded companies. There are several advantages of undertaking a takeover. These include the increase in the revenue of a business, an increase in the market share of a business, allows a business to venture into new markets, enlarges the brand portfolio of a business, as well as increasing the economies of scale of the acquiring company Abbasi, Hollman & Murrey, 2002).

The other strategy that Riverside Electronics Plc could undertake is an aggressive or hostile takeover of another company that engages in a similar type of business as its own. A hostile takeover refers to an acquisition whereby the acquiring company does not inform the management of the target company of its intentions of buying their business beforehand. Even if the target company’s management rejects the offer, the acquiring company pursues the offer until it succeeds. To undertake this option, Riverside Electronics Plc must take into consideration the following major points.

To undertake the takeover, Riverside Electronics Plc must be able to evaluate the financial position as well as the susceptibility of the target company so that it does not make a loss in the process of the takeover it must be able to determine whether the target company’s stock is trading below or at its book value. It should also be able to determine whether the company has a low price/earnings ratio. It should also be able to determine whether the assets of the company are undervalued or having the current market prices. It should also look at the target company’s break-up value to know whether it is considerably greater than the market price of its common stock (Trifts, 2001).

Financial Factors

Financial factors are the main considerations to make deciding to make a takeover. As such, the chief executive officer of Riverside Electronics Plc should be able to determine whether the acquisition being planned is worthwhile, as well as how this acquisition will affect the different obligations of the various stakeholders of the company such as the shareholders, employees, and consumers. In doing so, the company would benefit from the acquisition as it will gain financial, operational, and strategic benefits (Markides (2004).

By undertaking the takeover, Riverside Electronics Plc will increase its profitability as it will have acquired a competitor within its market and therefore reducing competition. This move increases its profits as the target company’s market share is gained by Riverside Electronics Plc which will have a larger customer base to serve. When Riverside Electronics Plc acquires a new company, the target company will bring a more assorted collection of assets under its management and in effect being able to take hold of more opportunities.

This is because it will be in a position to utilize both tangible as well as intangible assets of the target company (Doukas & Lang, 2003). Tangible assets include machines, furniture, land, and premises. Intangible assets include better marketing skills, economies of scale, superior managerial skills, product differentiation, new technological expertise, in addition to special government regulations which help create barriers to entry.

Conclusion

In conclusion, the second option is the best option that Riverside Electronics Plc could undertake. By cutting the dividend payable to its shareholders, it will be able to plow back some of its revenues to its operating cash flows so that it can expand its business. By utilizing the revenues that it currently has, it will be able to adequately budget for the expansion project so that it carries it out in a well-planned manner with well-set achievable targets.

List of References

Abbasi, S. M., Hollman, K. W., & Murrey Jr., J. H. (2002). Merger mania: Human and economic effects. Review of Business. 13(1-2). 30-60.

Beddow, Matthew. (2006). Floored. Containerisation International. p. 34-35.

Doukas, J. & Lang, L. (2003). Foreign direct investment, diversification and firm performance. Journal of International Business Studies. 34(2). 153-175.

Franko, L. (2005). The interaction of host country policies and corporate strategies. Journal of International Business Studies. 20 (1). 19-40.

Gordon, Mark. (2002). Takeover defenses work. Is that such a bad thing? Stanford Law Review. 55(3). 819-840.

Lee, Tung-Jean, & Caves, Richard E. (2000). Uncertain outcomes of foreign investment: Determinants of the dispersion of profits after large acquisitions. Journal of International Business Studies. 29(3).563-600.

Markides, C. (2004). Shareholder benefits from corporate international diversification: Evidence from U.S. international acquisitions. Journal of International Business Studies. 25(2). 343-380.

Meyer, K. E. (2004). Perspectives on multinational enterprises in emerging economies. Journal of International Business Studies. 35(4). 259-280.

Subramanian, G. (2003). Bargaining in the shadow of takeover defenses. Yale Law Journal. 113(3). 621-660.

Trifts, J. W. (2001). Corporate takeover bids, methods of payment and the effects of leverage. Quarterly. Journal of Business and Economics. 30(3).33-60.