The LEGO Group Corporate Financial Analysis

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About the company

The LEGO Group, founded in 1932, is a privately owned company. The company is based in Denmark. It operates in the toy industry. Further, the company engages in the learning and development of children’s creativity through the production of toys and learning materials. The product brand of the company is Lego. The company was established by Ole Kirk Christiansen. Currently, the Chief Executive Officer is Jorgen Vig Knudstorp while the Vice Chairman is the Kjeld Kirk Christiansen. The company had 10,500 full-time employees at the end of 2013 (The LEGO Group 1a). The paper seeks to carry out a corporate financial analysis of the LEGO Group.

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Corporate governance analysis

The LEGO Group is a family business that is privately owned by the Kirk Christiansen family. Despite being privately owned, the company has reached a point where there is a clear separation of ownership and management. The management board comprises four members and none of them is a family member. The management team is charged with the responsibility of providing high-quality products and facilitating the growth of the business. Further, they report to the board on a periodic basis. The owners of the company sit on the Board of Directors. This keeps them close to the daily operations of the entity. Besides, the board of directors is independent (The LEGO Group 1b).

The company prepares audited financial statements on a periodic basis. The reports are available for scrutiny on the company website. Thus, the company interacts with the financial markets by reporting the financial results. The company is keen on managing its image in society. The social responsibility of the entity focuses on health and safety, equal opportunities, and local community engagement. Further, in 2012, the company came up with strategic targets that are expected to last until 2015. These targets focus on the health and safety of employees and consumers, sustainability, and the use of renewable energy. This has greatly improved the corporate image of the LEGO Group.

Shareholder analysis

The business is entirely owned by the family. Thus, the investor, in this case, is the Kirk Christiansen family. Thus, the company does not have marginal investors. As of the end of 2012, the total number of shares was 205. The shares are divided into three categories these are, A-share, B-share, and C-share. The three categories have different voting rights.

Risk and return

The LEGO Group has a moderate risk profile. The major risk that the company faces is financial. The three risks under this category are foreign exchange, credit, and interest rate risk. Credit risk arises from the financial instruments that the company purchases and trade receivables. Foreign exchange risk arises from the sale of goods to other parts of the world. Interest rate risk arises from fluctuations in the interest rate of the debt instruments. Apart from financial risk, the other risks are market risk, liquidity, and capital risk management. All the risks are managed centrally. Besides, the company has put in place measures to ensure that all transactions have minimal risk. The measures put in place are likely to reduce the risk profile of the company to low (Berk and Demarzo 169). The table presented below shows a summary of the financial results for 2011 and 2012.

2011 2012
Gross margin 70.5% 71.1%
Operating margin 30.2% 34.0%
Net profit margin 22.2% 24%
Return on equity 66.8% 66.7%
Return on invested capital 133.4% 140.2%
Equity ratio 54.1% 60.3%

The operating profit margin improved from 30.2% in 2011 to 34.0% in 2012. Similarly, the net profit margin rose from 22.2% in 2011 to 24.0% in 2012. An improvement in the two ratios indicates that the profitability and efficiency improved over time. It also indicates that the efficiency of the management team in running the business improved. The return on equity declined from 66.8% in 2011 to 66.7% in 2012. Despite the decline, the return on investing in the stock of the company is higher than the industry average. More than 40% of the return on investment in stock can be attributed to the efficiency of the management (Damodaran 76).

A high amount of debt in the capital structure increases the risk of equity. The equity ratio improved significantly over the past five years. The ratio rose from 31.8% in 2008 to 60.3% in 2012. This gives an indication that the risk level of equity has declined significantly. Using the capital asset pricing model, the calculation of the cost of equity is presented below.

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Cost of equity Risk free rate + (beta * risk premium)
Risk free rate 3.52%
Beta 1.1
Risk premium 5%
= 3.52% + (1.1 * 5%)
= 9.02%

The cost of equity for the company is 9.02%. The table presented below shows the calculations for the cost of debt.

Cost of debt Risk free rate + company spread
Risk free rate 3.52%
Company spread 0.4%
= 3.52% + 0.4%
= 3.92%
Tax rate 25%
After tax cost of debt = 3.92% * (1 – 25%)
2.94%

Thus, the after tax cost of debt is 2.94%.

The weighted average cost of capital
Cost of equity 9.02%
Proportion of equity 60%
Cost of debt 2.94%
Proportion of debt 40%
= 9.02% * 60% + 2.94% * 40%
= 5.412% + 1.176%
= 6.588%

Measuring investment returns

The company carries out research and development projects that focus on new technologies and children’s play. The expenses relating to these projects are charged to the income statement. The development projects are long-term because they are expected to generate a future stream of economic benefits. The costs of these development projects are capitalized and amortized for a period of between three to six years. At the end of 2011, the carrying amount of the costs related to the development projects amounted to DKK12 million. The value improved to DKK 37 million in 2012 as a result of the additions that were made during the year. The company calculates the return on the projects at 13.54%. The projects which the company has invested in are viable because they guarantee future streams of economic benefits. Besides, they directly relate to the core activity of the business.

Capital structure choices

An evaluation of the balance sheet shows that the company uses both equity and debt. The total amount of equity in the capital structure is DKK9,864 million, while the amount of debt is DKK6,576 million. This shows that the proportion of equity is greater than that of debt. It also implies that the company has little debt to the amount of equity.

Optimal capital structure

The optimal debt ratio is one that minimizes the firm’s cost of capital and maximizes the value of the firm. The current debt to equity ratio is 66.67%. This generates a cost of capital of 6.588%. However, the cost of capital can be reduced further by increasing the proportion of debt (Ferran 211). For instance, reducing the debt to equity ratio to 50% will result in a lower cost of capital as presented in the calculations below.

The weighted average cost of capital
Cost of equity 9.02%
Proportion of equity 50%
Cost of debt 2.94%
Proportion of debt 50%
= 9.02% * 50% + 2.94% * 50%
= 4.51% + 1.47%
= 5.98%

Thus, it can be noted that increasing the proportion of debt reduces the cost of capital. The recommended debt to equity ratio for the company is 50%. It can also be noted that there is a low amount of debt in the capital structure as compared to other companies in the sector and the market in which the company operates.

Dividend policy

The company paid dividends both in 2011 and 2012. It has not repurchased shares within the past five years.

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A framework for analyzing dividends

The table presented below shows a summary of the dividend paid by the company and cash balance.

2011
mDKK
2012
mDKK
Dividends paid to shareholders 2,500 3,000
Dividend paid to non-controlling interest 18 22
Cash balance 557 468
Retained earnings 7,321 9,888

The policy of the company is to pay dividends based on the profit earned. Thus, higher profit results in higher dividends. The dividend paid increased from DKK2,500 million in 2011 to DKK3,000 million in 2012. Further, it is the policy of the company to distribute excess cash to the parent company KIRKBI A/S. This explains why the company had a low cash balance. The retained earnings balances were high. The values rose from DKK7,321 million in 2011 to DKK9,888 million in 2012. The company needs to utilize the retained earnings. Generally, the company pays a higher amount of dividend than its peers in the industry (Ehrhardt and Brigham 72).

Works Cited

Berk, Jonathan, and Peter Demarzo. Corporate Finance, USA: Prentice Hall, 2011. Print.

Damodaran, Aswath. Applied Corporate Finance, USA: John Wiley & Sons, 2010. Print.

Ehrhardt, Michael, and Eugene Brigham. Corporate Finance: A Focused Approach, USA: Cengage Learning, 2011. Print.

Ferran, Eilis. Principles of Corporate Finance Law, New York: Oxford University Press, 2008. Print.

The LEGO Group 2014a, About Us. Web.

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The LEGO Group 2014b, Corporate Governance and Business Conduct. Web.

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