Section A – This ONE question is compulsory and MUST be attempted
Morada Co is involved in offering bespoke travel services and maintenance services. In addition to owning a few hotels, it has built strong relationships with companies in the hospitality industry all over the world. It has a good reputation of offering unique, high quality holiday packages at reasonable costs for its clients. The strong relationships have also enabled it to offer repair and maintenance services to a number of hotel chains and cruise ship companies.
Following a long discussion at a meeting of the board of directors (BoD) about the future strategic direction which Morada Co should follow, three directors continued to discuss one particular issue over dinner. In the meeting, the BoD had expressed concern that Morada Co was exposed to excessive risk and therefore its cost of capital was too high. The BoD feared that several good projects had been rejected over the previous two years, because they did not meet Morada Co’s high cost of capital threshold. Each director put forward a proposal, which they then discussed in turn. At the conclusion of the dinner, the directors decided to ask for a written report on the proposals put forward by the first director and the second director, before taking all three proposals to the BoD for further discussion.
First director’s proposal
The first director is of the opinion that Morada Co should reduce its debt in order to mitigate its risk and therefore reduce its cost of capital. He proposes that the company should sell its repair and maintenance services business unit and focus just on offering bespoke travel services and hotel accommodation. In the sale, the book value of non-current assets will reduce by 30% and the book value of current liabilities will reduce by 10%. It is thought that the non-current assets can be sold for an after-tax profit of 15%.
The first director suggests that the funds arising from the sale of the repair and maintenance services business unit and cash resources should be used to pay off 80% of the long-term debt. It is estimated that as a result of this, Morada Co’s credit rating will improve from Baa2 to A2.
Second director’s proposal
The second director is of the opinion that risk diversification is the best way to reduce Morada Co’s risk and therefore reduce its cost of capital. He proposes that the company raise additional funds using debt finance and then create a new strategic business unit. This business unit will focus on construction of new commercial properties.
The second director suggests that $70 million should be borrowed and used to invest in purchasing non-current assets for the construction business unit. The new debt will be issued in the form of four-year redeemable bonds paying an annual coupon of 6·2%. It is estimated that if this amount of debt is raised, then Morada Co’s credit rating will worsen to Ca3 from Baa2. Current liabilities are estimated to increase to $28 million.
Third director’s proposal
The third director is of the opinion that Morada Co does not need to undertake the proposals suggested by the first director and the second director just to reduce the company’s risk profile. She feels that the above proposals require a fundamental change in corporate strategy and should be considered in terms of more than just tools to manage risk. Instead, she proposes that a risk management system should be set up to appraise Morada Co’s current risk profile, considering each type of business risk and financial risk within the company, and taking appropriate action to manage the risk where it is deemed necessary.
Morada Co, extracts from the forecast financial position for the coming year
Explain how business risk and financial risk are related; and how risk mitigation and risk diversification can form part of a company’s risk management strategy.
The owners or shareholders of a business will accept that it needs to engage in some risky activities in order to generate returns in excess of the risk free rate of return. A business will be exposed to differing amounts of business and financial risk depending on the decisions it makes. Business risk depends on the decisions a business makes with respect to the services and products it offers and consists of the variability in its profits. For example, it could be related to the demand for its products, the rate of innovation, actions of competitors, etc. Financial risk relates to the volatility of earnings due to the financial structure of the business and could be related to its gearing, the exchange rate risk it is exposed to, its credit risk, its liquidity risk, etc. A business exposed to high levels of business risk may not be able to take excessive financial risk, and vice versa, as the shareholders or owners may not want to bear risk beyond an acceptable level.
Risk management involves the process of risk identification, of assessing and measuring the risk through the process of predicting, analysing and quantifying it, and then making decisions on which risks to assume, which to avoid, which to retain and which to transfer. As stated above, a business will not aim to avoid all risks, as it will want to generate excess returns. Dependent on factors such as controllability, frequency and severity of the risk, it may decide to eliminate or reduce some risks from the business through risk transfer. Risk mitigation is the process of transferring risks out of a business through, for example, hedging or insurance, or avoiding certain risks altogether. Risk diversification is a process of risk reduction through spreading business activity into different products and services, different geographical areas and/or different industries to minimise being excessively exposed by focusing exclusively on one product/service.
Prepare a report for the board of directors of Morada Co which:
(i) Estimates Morada Co’s cost of equity and cost of capital, based on market value of equity and debt, before any changes and then after implementing the proposals put forward by the first and by the second directors;(17 marks)
(ii) Estimates the impact of the first and second directors’ proposals on Morada Co’s forecast after-tax earnings and forecast financial position for the coming year; and (7 marks)
(iii) Discusses the impact on Morada Co of the changes proposed by the first and second directors and recommends whether or not either proposal should be accepted. The discussion should include an explanation of any assumptions made in the estimates in (b)(i) and (b)(ii) above. (9 marks)
Professional marks will be awarded in part (b) for the format, structure and presentation of the report. (4 marks)
Report to the board of directors (BoD), Morada Co
This report provides a discussion on the estimates of the cost of equity and the cost of capital and the impact on the financial position and the earnings after tax, as a result of the proposals put forward by the first director and the second director. The main assumptions made in drawing up the estimates will also be explained. The report concludes by recommending which of the two directors’ proposals, if any, should be adopted.
Discussion
The table below shows the revised figures of the cost of equity and the cost of capital (appendix 1), and the forecast earnings after tax for the coming year (appendix 2), following each proposal from the first and second directors. For comparison purposes, figures before any changes are given as well.
Under the first director’s proposal, although the cost of equity falls due to the lower financial risk in Morada Co because of less debt, the cost of capital actually increases. This is because, even though the cost of debt has decreased, the benefit of the tax shield is reduced significantly due to the lower amount of debt borrowing. Added to this is the higher business risk, reflected by the asset beta, of Morada Co just operating in the travel services sector. This higher business risk and reduced tax shield more than override the lower cost of debt resulting in a higher cost of capital.
Under the second director’s proposal, the cost of equity is almost unchanged. There has been a significant increase in the cost of debt from 4·7% to 6·2%. However, the cost of capital has not reduced significantly because the benefit of the tax shield is also almost eroded by the increase in the cost of debt.
If no changes are made, then the forecast earnings after tax as a percentage of non-current assets is 10% ($28m/$280m). Under the first director’s proposal, this figure almost doubles to 19·3% ($37·8m/$196m), and even if the one-off profit from the sale of non-current assets is excluded, this figure is still higher at 12·9% ($25·2m/$196m). Under the second director’s proposal, this figure falls to 8·8% ($30·8m/$350m).
Assumptions
1. It is assumed that the asset beta of Morada Co is a weighted average of the asset betas of the travel services and the maintenance services business units, using non-current assets invested in each business unit as a fair representation of the size of each business unit and therefore the proportion of the business risk which business unit represents within the company.
2. The assumption of the share price not changing after either proposal is not reasonable. It is likely that due to changes in the business and financial risk from implementing either proposal, the risk profile of the company will change. The changes in the risk profile will influence the cost of equity, which in turn will influence the share price.
3. In determining the financial position of Morada Co, it is assumed that the current assets will change due to changes in the profit after tax figure; therefore this is used as the balancing figure for each proposal.
Recommendation
It is recommended that neither the first director’s proposal nor the second director’s proposal should be adopted. The second director’s proposal results in a lower return on investment and a virtually unchanged cost of capital. So there will not be a meaningful benefit for Morada Co. The first director’s proposal does increase the return on investment but results in a higher cost of capital. If the reason for adopting either proposal is to reduce risk, then this is not achieved. The main caveat here is that where the assumptions made in the calculations are not reasonable, they will reduce the usefulness of the analysis.
Report compiled by:
Date:
(Note: Credit will be given for alternative and relevant points)
Appendix 1: Estimates of cost of equity and cost of capital
Before either proposal is implemented
Cost of equity (Ke) = 3·8% + 1·2 x 7% = 12·2%
Cost of debt (Kd) = 3·8% + 0·9% = 4·7%
Market value of equity (MVe) = $2·88 x 125 million shares = $360m
Market value of debt (MVd)
Per $100 $6·20 x 1·047–1 + $6·20 x 1·047–2 + $6·20 x 1·047–3 + $106·20 x 1·047–4 = $105·36
Total MVd = $105·36/$100 x $120m = $126·4m
Cost of capital = (12·2% x $360m + 4·7% x 0·8 x $126·4m)/$486·4m = 10·0%
If the first director’s proposal is implemented
MVe = $360m
BVd = $120m x 0·2 = $24m
Kd = 4·4%
MVd per $100 $6·20 x 1·044–1 + $6·20 x 1·044–2 + $6·20 x 1·044–3 + $106·20 x 1·044–4 = $106·47
Total MVd = 106·47/$100 x $24 = $25·6m
Morada Co, asset beta
1·2 x $360m/($360m + $126·4m x 0·8) = 0·94
Asset beta of travel services = [0·94 – (0·65 x 30%)]/70% = 1·06
Equity beta of travel services = 1·06 x ($360m + $25·6m x 0·8)/$360m = 1·12
Ke = 3·8% + 1·12 x 7% = 11·6%
Cost of capital = (11·6% x $360m + 4·4% x 0·8 x $25·6m)/$385·6 = 11·1%
If the second director’s proposal is implemented
MVe = $360m
The basis points for the Ca3 rated bond is 240 basis points higher than the risk free-free rate of interest, giving a cost of debt of 6·2%, therefore:
MVd = BVd = $190m
Equity beta of the new, larger company = 1·21
Ke = 3·8% + 1·21 x 7% = 12·3%
Cost of capital = (12·3% x $360m + 6·2% x 0·8 x $190m)/$550m = 9·8%
Appendix 2: Estimates of forecast after-tax earnings and forecast financial position
Morada Co, extracts from the forecast after-tax earnings for the coming year
(Amounts in $ 000s)
Morada Co, extracts from the forecast financial position for the coming year
(Amounts in $ 000s)
Discuss the possible reasons for the third director’s proposal that a risk management system should consider each risk, before taking appropriate action.
[Note: This is an open-ended question and a variety of relevant answers can be given by candidates depending on how the question requirement is interpreted. The following answer is just one possible approach which could be taken. Credit will be given for alternative, but valid, interpretations and answers therein.]
According to the third director, risk management involves more than just risk mitigation or risk diversification as proposed by the first and second directors. The proposals suggested by the first and the second directors are likely to change the makeup of the company, and cause uncertainty amongst the company’s owners or clientele. This in turn may cause unnecessary fluctuations in the share price. She suggests that these changes are fundamental and more than just risk management tools.
Instead, it seems that she is suggesting that Morada Co should follow the risk management process suggested in part (a) above, where risks should be identified, assessed and then mitigated according to the company’s risk appetite.
The risk management process should be undertaken with a view to increasing shareholder wealth, and therefore the company should consider what drives this value and what are the risks associated with these drivers of value. Morada Co may assess that some of these risks are controllable and some not controllable. It may assess that some are severe and others less so, and it may assess some are likely to occur more frequently than others.
Morada Co may take the view that the non-controllable, severe and/or frequent risks should be eliminated (or not accepted). On the other hand, where Morada Co is of the opinion that it has a comparative advantage or superior knowledge of risks, and therefore is better able to manage them, it may come to the conclusion that it should accept these. For example, it may take the view that it is able to manage events such as flight delays or hotel standards, but would hedge against currency fluctuations and insure against natural disasters due to their severity or non-controllability.
Theory suggests that undertaking risk management may increase the value of a company if the benefits accruing from the risk management activity are more than the costs involved in managing the risks. For example, smoothing the volatility of profits may make it easier for Morada Co to plan and match long-term funding with future projects, it may make it easier for Morada Co to take advantage of market imperfections by reducing the amount of taxation payable, or it may reduce the costs involved with incidences of financial distress. In each case though, the benefits accrued should be assessed against the costs involved.
Therefore, a risk management process is more than just mitigating risk through reducing financial risk as the first director is suggesting or risk diversification as the second director is suggesting. Instead it is a process of risk analysis and then about judgement of which risks to hedge or mitigate, and finally, which risk-reduction mechanisms to employ, depending on the type of risk, the cost of the risk analysis and mitigation, and the benefits accruing from the mitigation.