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Financial Management- Capital Structure
Transcript of Financial Management- Capital Structure
528 Financial Management
424, 425, 426, 528, 529 Introduction Aditya Kaushik
Position Hutchison Whampoa : Present Position Diversified global interests
Major Projects Property Development and Holding:
Beijing oriental plaza : USD 2 Billion.
Other projects underway in Shanghai, Chongquing, Guangzhou.
Ports and related services :
JV terminal operations in China, Myanmar, Bahamas, Panama. Recently acquired90% stake in major ports in the UK.
A.S Watson : Over 500 retail outlets. 80 new retail outlets opened in 1995. Adding 70 new stores a year.
Fortress, with 25% market share in electronics retail in China, is also looking to expand. Major Projects Telecommunications
Company's telecom operations included a cellular service provider, national paging network and a digital wirefree network.
Witnessed immense growth : 3.7 million subscribers in numerous countries. Greater growth expected.
Energy and Infrastructure:
Interests in 9 power plant projects in mainland china.
Husky Oil : Exploration and development of crude oil and natural gas.
Prevalent Financial Practices In HK Companies parlay their revenue and subsidiary incomes into funds required for expansion. (Cash on hand, internal cash generation)
Companies tend to minimize debt financing, but when required, they rely entirely on short to medium term bank loans.
HK Banks are often constrained by internal control policies as to the max they could lend.
Hutchison Whampoa’s Situation Cash commitment : HK$ 26 billion debt and HK$ 30.205 billion capital commitment.
Looking for long term financing (more than 10 years) by
Issuing more equity
Issuing bonds in attractive, new markets.
US$ 5 billion ( HK$ 39 billion @ exchange of 7.8 HK$ to 1 US$) over next five years to maintain growth rate.
Theory Financial Leverage Definition
the degree to which a firm is using borrowed money to fund its growth. It is the use of relatively cheap debt to increase expected ROE.
It is measured by a few ratios:
Debt to total assets ratio : Debts / Debts + Equity
Long term debt to capitalization : Long term debt/ (long term liabilities + Equity)
Long term debt + equity is called the capitalization and defines the permanent capital structure of the firm.
EBIT vs EPS : Effect of Leverage Effects of Financial Leverage:
Increases Return on Equity for the Likely business result.
Increases variability in ROE (Financial risk increases)
Effect on firm value depends whether rd (Cost of debt) and re (Cost of Equity) rise with leverage.
Effect of Debt on Cost of Capital Modigliani – Miller theorem
This theorem addresses the topic of a firm adding debt and the effect of this activity on the cost of debt and the cost of equity.
In perfect capital markets (where there are no taxes or transactions costs and there is a free flow of information), value of the firm is defined by its asset structure (i.e right side of the balance sheet) and not by its left side i.e Debt and Equity.
Required return on equity increase in proportion to D/D+E (i.e the Debt to total assets ratio) M&M Theorem Implications of these propositions:
In perfect capital markets, there is no optimal structure.
Hence to find an optimal capital structure, find imperfections (like taxes) Proof of Proposition II :
On rearranging terms :
M+M relation between Re and D/A ratio Abhishek Rathi
425 Debt Criteria for Debt selection When to increase debt:
Income tax deductibility of interest expense
Access to tax-exempt debt
When to take less debt:
Less liquidity of assets
Benefits of Using Debt Income Tax deductibility of Interest expense
Cost of Capital
Tax Shield or TS = rD * mtr * D
PV(TS) = (rD * mtr * D ) / rD
The firm value = Value of All Equity Firm + PV Tax Shield
Cost of Debt- Financial Distress Causes-
High business risk
High financial risk
Cost of Financial Distress
Distorted business decisions
Covenants imposed by lenders
High interest rates
Trade-off Theory Bond Yield Rates WACC WACC of Hutchison Whampoa for 1995 Prarthna Patel
529 Bonds What Are Bonds? A bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest (the coupon) and to repay the principal at a later date, termed maturity.
Thus a bond is like a loan: the issuer is the borrower (debtor), the holder is the lender (creditor), and the coupon is the interest.
Bonds provide the borrower with external funds to finance long-term investments.
Raising capital by issuing bonds is a popular alternative to selling shares, as it allows a company to avoid relinquishing ownership of part of the business. Importance Of Bond Rating Every bond carries the risk that a promised payment will not be made in full or on time. As uncertainty of repayment rises, investors demand higher levels of return in exchange for assuming greater risk.
Potential bond investor’s assess an issuer's ability to meet its debt obligations by considering the bond rating assigned by agencies such as Moody's Investors Service or Standard & Poor's.
A rating indicating a high likelihood of repayment will allow an issuer to issue its bonds with a lower coupon rate than one that received a poorer rating.
According to Standard and Poor’s long-term debt ratings Hutchison Whampoa Limited falls under the credit category of A rated. Since Hutchison Whampoa has a fairly good credit rating it would face the advantage of receiving bonds at a lower coupon rate.
Different Types Of Bonds Hutchison Whampoa had to also decide which bonds to issue that would prove to be most profitable to the organisation. The different options available were:
Straight Debt: The most obvious option was a straight bond issued in Hong Kong, denominated in Hong Kong dollars.
Pros: There would be no need to restructure financial statements or provide extraneous data.
Cons: Peoples Republic of China (PRC) borrowers had begun to offer high yield rate. As a result, the market for Hong Kong based debt was becoming strained with increasing upward pressure on pricing.
Euro Bonds: The international bond market (commonly called as euro bond market) included issues with several features.
Pros: 1) Market was large, sophisticated and increasingly looking for new areas of growth.
2) Less disclosure requirement
3) Speed and simplicity of issuance.
4) Euro bonds would be issued in HK dollars, so no currency conversion hassle.
Yankee Bonds: Yankee bonds were issued by a foreign firm denominated in U.S. currency on the U.S. foreign market..
Cons- 1) All transactions would be performed in U.S. currency.
2) Disclosure of financial and other information mandatory
Analysing the pros and cons of all the available bond options Hutchison Whampoa figured that it would be best to go for Euro Bonds.
Bond Markets Hutchison Whampoa had decided to raise funds by issuing long term bonds. Another critical decision to make was which bond market to issue the bonds from. The six largest bond markets were United States, Japan, Germany, Italy, France and United Kingdom. Each bond market had its pros and cons, on a comparison among all it was found that the Japanese bond market appeared to be the best choice.
Japan had the highest growth rate for euro bonds compared to the other bond markets.
It had one of the lowest interest rates.
A major obstacle to arranging long-term, fixed rate debt was the relatively low profile that Hutchison Whampoa had outside Asia particularly in the U.S. so Japan stood and advantage here too.
The Japanese market have sufficient liquidity too.
424 Structure Current Scenario The total debt amounts to 26.174 HK$ as compared to its equity 57.935 HK$.
Now Debt/ Equity ratio: 0.45
Currently Hutchinson has expansion plans in Europe, Asian Continent. Projects related to Infrastructure, Telecom and Energy are in the pipeline. Heavy investments are required in order to maintain the current growth rate.
Shareholders in the Firm are not interested in diluting the equity.
Also Hutchinson has never raised debt through 10+ years bond and has relied on Internal Sources of Financing.
Hutchinson Whampoa is a long established conglomerate with sound reputation in the market and among investors.
The general Industry convention is to have a Debt/Equity ratio of 1.5-2.5. This is permissible and has no enormous risk bearing. Currently D/E being very low suggests that the entire 5 Billion U.S $ which amounts to 38.65 Billion HK $ can be taken as Debt.
Now D/E ratio is: 64.824/57.935 = 1.11 which is well within the Industry averages and risk limits.
Moreover going for Equity as source of raising capital has some disadvantages:
The Shareholders are not in motion for the dilution of equity so raising through capital markets is not a wise option.
Cost of equity is more than debt (Tax Shield). So it’s advisable to go for cheaper source of Financing.
Based on growth rate and future projections we have structured the 5 B amount in 3 slots.
The First Slot that is a 20 year Fixed Rate Eurobond issued by the firm in Japan having a Face Value of 1.5 B. Issued in 1996.
The second slot is again a 20 Year Eurobond because the Firm plans to invest in Telecommunication Projects and expand its existing domain. This bond will be issued in 1998.
The third slot corresponds to maximum amount required that is 2 B since we assume that the Firm will go cross borders and expand its core business in other continents. This bond is issued in year 2000.
Hutchinson Whampoa should go for Debt Financing.
Should issue bonds in other countries to take advantage of Liquidity and Regulatory Norms.
Japan is the most favourable location for issuing bonds.
Hutchinson should go for Eurobonds as compared to Foreign Bonds.
The entire Debt amount should be structured in accordance with the growth rate and Interest Expense: 1.5 B, 1.5 B, 2 B.
All Fixed rate Bonds since when compared with Floating Options the reference LIBOR rates prove to be more costly than the Fixed Rate option in JAPAN.
Thank You Results :
- Re increases with leverage.
- WACC is Independent of Leverage.
- Firm value is unaffected by financial structure Naive view of leverage and WACC Financing cost can be minimized through full use of debt.