Section A – This ONE question is compulsory and MUST be attempted
Lirio Co is an engineering company which is involved in projects around the world. It has been growing steadily for several years and has maintained a stable dividend growth policy for a number of years now. The board of directors (BoD) is considering bidding for a large project which requires a substantial investment of $40 million. It can be assumed that the date today is 1 March 2016.
The BoD is proposing that Lirio Co should not raise the finance for the project through additional debt or equity. Instead, it proposes that the required finance is obtained from a combination of funds received from the sale of its equity investment in a European company and from cash flows generated from its normal business activity in the coming two years. As a result, Lirio Co’s current capital structure of 80 million $1 equity shares and $70 million 5% bonds is not expected to change in the foreseeable future.
The BoD has asked the company’s treasury department to prepare a discussion paper on the implications of this proposal. The following information on Lirio Co has been provided to assist in the preparation of the discussion paper.
Expected income and cash flow commitments prior to undertaking the large project for the year to the end of February 2017
Lirio Co’s sales revenue is forecast to grow by 8% next year from its current level of $300 million, and the operating profit margin on this is expected to be 15%. It is expected that Lirio Co will have the following capital investment requirements for the coming year, before the impact of the large project is considered:
1. A $0·10 investment in working capital for every $1 increase in sales revenue;
2. An investment equivalent to the amount of depreciation to keep its non-current asset base at the present productive capacity. The current depreciation charge already included in the operating profit margin is 25% of the non-current assets of $50 million;
3. A $0·20 investment in additional non-current assets for every $1 increase in sales revenue;
4. $8 million additional investment in other small projects.
In addition to the above sales revenue and profits, Lirio Co has one overseas subsidiary – Pontac Co, from which it receives dividends of 80% on profits. Pontac Co produces a specialist tool which it sells locally for $60 each. It is expected that it will produce and sell 400,000 units of this specialist tool next year. Each tool will incur variable costs of $36 per unit and total annual fixed costs of $4 million to produce and sell.
Lirio Co pays corporation tax at 25% and Pontac Co pays corporation tax at 20%. In addition to this, a withholding tax of 8% is deducted from any dividends remitted from Pontac Co. A bi-lateral tax treaty exists between the countries where Lirio Co is based and where Pontac Co is based. Therefore corporation tax is payable on profits made by subsidiary companies, but full credit is given for corporation tax already paid.
It can be assumed that receipts from Pontac Co are in $ equivalent amounts and exchange rate fluctuations on these can be ignored.
Sale of equity investment in the European country
It is expected that Lirio Co will receive Euro (€) 20 million in three months’ time from the sale of its investment. The € has continued to remain weak, while the $ has continued to remain strong through 2015 and the start of 2016. The financial press has also reported that there may be a permanent shift in the €/$ exchange rate, with firms facing economic exposure. Lirio Co has decided to hedge the € receipt using one of currency forward contracts, currency futures contracts or currency options contracts.
The following exchange contracts and rates are available to Lirio Co.
With reference to purchasing power parity, explain how exchange rate fluctuations may lead to economic exposure.
Purchasing power parity (PPP) predicts that the exchange rates between two currencies depend on the relative differences in the rates of inflation in each country. Therefore, if one country has a higher rate of inflation compared to another, then its currency is expected to depreciate over time. However, according to PPP the ‘law of one price’ holds because any weakness in one currency will be compensated by the rate of inflation in the currency’s country (or group of countries in the case of the euro).
Economic exposure refers to the degree by which a company’s cash flows are affected by fluctuations in exchange rates. It may also affect companies which are not exposed to foreign exchange transactions, due to actions by international competitors.
If PPP holds, then companies may not be affected by exchange rate fluctuations, as lower currency value can be compensated by the ability to raise prices due to higher inflation levels. This depends on markets being efficient.
However, a permanent shift in exchange rates may occur, not because of relative inflation rate differentials, but because a country (or group of countries) lose their competitive positions. In this case the ‘law of one price’ will not hold, and prices readjust to a new and long-term or even permanent rate. For example, the UK £ to USA $ rate declined in the 20th century, as the USA grew stronger economically and the UK grew weaker. The rate almost reached parity in 1985 before recovering. Since the financial crisis in 2009, it has fluctuated between roughly $1·5 to £1 and $1·7 to £1.
In such cases, where a company receives substantial amounts of revenue from companies based in countries with relatively weak economies, it may find that it is facing economic exposure and its cash flows decline over a long period of time.
Prepare a discussion paper, including all relevant calculations, for the board of directors (BoD) of Lirio Co which:
(i) Estimates Lirio Co’s dividend capacity as at 28 February 2017, prior to investing in the large project; (9 marks)
(ii) Advises Lirio Co on, and recommends, an appropriate hedging strategy for the Euro (€) receipt it is due to receive in three months’ time from the sale of the equity investment; (14 marks)
(iii) Using the information on dividends provided in the question, and from (b) (i) and (b) (ii) above, assesses whether or not the project would add value to Lirio Co; (8 marks)
(iv) Discusses the issues of proposed methods of financing the project which need to be considered further. (9 marks)
Professional marks will be awarded in part (b) for the format, structure and presentation of the discussion paper. (4 marks)
Discussion paper to the board of directors (BoD), Lirio Co
Discussion paper compiled by
Date
Purpose of the discussion paper
The purpose of this discussion paper is:
(i) To consider the implications of the BoD’s proposal to use funds from the sale of its equity investment in the European company and from its cash flows generated from normal business activity over the next two years to finance a large project, instead of raising funds through equity and/or debt;
(ii) To assess whether or not the project adds value for Lirio Co or not.
Background information
The funds needed for the project are estimated at $40,000,000 at the start of the project. $23,118,000 of this amount is estimated to be received from the sale of the equity investment (appendices 2 and 3). This leaves a balance of $16,882,000 (appendix 3), which will be obtained from the free cash flows to equity (the dividend capacity) of $21,642,000 (appendix 1) expected to be generated in the first year. However, this would leave only $4,760,000 available for dividend payments in the first year, meaning a cut in expected dividends from $0·27/share to $0·0595/share (appendix 3). The same level of dividends will be paid in the second year as well.
Project assessment
Based on the dividend valuation model, Lirio Co’s market capitalisation, and therefore its value, is expected to increase from approximately $360 million to approximately $403 million, or by just under 12% (appendix 3). This would suggest that it would be beneficial for the project to be undertaken.
Possible issues
1. The dividend valuation model is based on a number of factors such as: an accurate estimation of the dividend growth rate, a non-changing cost of equity and a predictable future dividend stream growing in perpetuity. In addition to this, it is expected that the sale of the investment will yield €20,000,000 but this amount could increase or reduce in the next three months. The dividend valuation model assumes that dividends and their growth rate are the sole drivers of corporate value, which is probably not accurate.
2. Although the dividend irrelevancy theory proposed by Modigliani and Miller suggests that corporate value should not be affected by a corporation’s dividend policy, in practice changes in dividends do matter for two main reasons. First, dividends are used as a signalling device to the markets and unexpected changes in dividends paid and/or dividend growth rates are not generally viewed positively by them. Changes in dividends may signal that the company is not doing well and this may affect the share price negatively.
3. Second, corporate dividend policy attracts certain groups of shareholders or clientele. In the main this is due to personal tax reasons. For example, higher rate taxpayers may prefer low dividend payouts and lower rate taxpayers may prefer higher dividend payouts. A change in dividends may result in the clientele changing and this changeover may result in excessive and possibly negative share price volatility.
4. It is not clear why the BoD would rather not raise the required finance through equity and/or debt. The BoD may have considered increasing debt to be risky. However, given that the current level of debt is $70 million compared to an estimated market capitalisation of $360 million (appendix 3), raising another $40 million through debt finance will probably not result in a significantly higher level of financial risk. The BoD may have been concerned that going into the markets to raise extra finance may result in negative agency type issues, such as having to make proprietary information public; or being forced to give extra value to new equity owners; or sending out negative signals to the markets.
Areas for further discussion by the BoD
Each of these issues should be considered and discussed further by the BoD. With reference to point 1, the BoD needs to discuss whether the estimates and the model used are reasonable in estimating corporate value or market capitalisation. With reference to points 2 and 3, the BoD needs to discuss the implications of such a significant change in the dividend policy and how to communicate Lirio Co’s intention to the market so that any negative reaction is minimised. With reference to point 4, the BoD should discuss the reasons for any reluctance to raise finance through the markets and whether any negative impact of this is perhaps less than the negative impact of points 2 and 3.
Appendix 1: Expected dividend capacity prior to large project investment
Appendix 1.1: Dividend remittances expected from Pontac Co
Appendix 2: Euro (€) investment sale receipt hedge
Lirio Co can use one of forward contracts, futures contracts or option contracts to hedge the € receipt.
Forward contract
Since it is a € receipt, the 1·1559 rate will be used.
€20,000,000 x 1·1559 = $23,118,000
Futures contracts
Go long to protect against a weakening € and use the June contracts to hedge as the receipt is expected at the end of May 2016 or beginning of June 2016 (in three months’ time).
June contracts will be closed out one month before expiry, therefore expected futures price (based on a linear narrowing of basis) is:
0·8638 + (2/3 x (0·8656 – 0·8638)) = 0·8650 [This can also be done using the spot rates or forward rates] Expected receipt = €20,000,000/0·8650 = $23,121,387
Number of contracts bought = $23,121,387/$125,000 = approximately 185 contracts (resulting in a very small over-hedge and therefore not material)
[Full credit will be given where the calculations are used to show the correction of the over-hedge using forwards]
Option contracts
Purchase the June call option to protect against a weakening € and because receipt is expected at the end of May 2016 or beginning of June 2016.
Exercise price is 0·86, therefore expected receipt is €20,000,000/0·8600 = $23,255,814
Contracts purchased = $23,255,814/$125,000 = 186·05, say 186
Amount hedged = $125,000 x 186 = $23,250,000
Premium payable = 186 x 125,000 x 0·0290 = €674,250
Premium in $ = €674,250 x 1·1618 = $783,344
Amount not hedged = €20,000,000 – (186 x 125,000 x 0·8600) = €5,000
Use forward contracts to hedge €5,000 not hedged. €5,000 x 1·1559 = $5,780
[Full credit will be given if a comment on the under-hedge being immaterial and therefore not hedged is made, instead of calculating the correction of the under-hedge]
Total receipts = $23,250,000 + $5,780 – $783,344 = $22,472,436
Advice and recommendation
Hedging using options will give the lowest receipt at $22,472,436 from the sale of the investment, while hedging using futures will give the highest receipt at $23,127,387, with the forward contracts giving a receipt of $23,118,000.
The lower receipt from the option contracts is due to the premium payable, which allows the option buyer to let the option lapse should the € strengthen. In this case, the option would be allowed to lapse and Lirio Co would convert the € into $ at the prevailing spot rate in three months’ time. However, the € would need to strengthen significantly before the cost of the option is covered. Given market expectation of the weakness in the € continuing, this is not likely to be the case.
Although futures and forward contracts are legally binding and do not have the flexibility of option contracts, they both give higher receipts. Hedging using futures gives the higher receipt, but futures require margin payments to be made upfront and contracts are marked-to-market daily. In addition to this, the basis may not narrow in a linear fashion and therefore the amount received is not guaranteed. All these factors create uncertainty in terms of the exact amounts of receipts and payments resulting on a daily basis and the final receipt.
On the other hand, when using forward contracts to hedge the receipt exposure, Lirio Co knows the exact amount it will receive. It is therefore recommended that Lirio Co use the forward markets to hedge the expected receipt.
[Note: It could be argued that in spite of the issues when hedging with futures, the higher receipt obtained from using futures markets to hedge mean that they should be used. This is acceptable as well.]
Appendix 3: Estimate of Lirio Co’s value based on the dividend valuation model
If the large project is not undertaken and dividend growth rate is maintained at the historic level
Dividend history
