• Login
HIRE WRITER NOW

Hillsides Operations Expansion: A financial perspective

Pages:10

Executive summary

Capacity Expansion is a vital cog for any business that is essentially looking to grasp opportunities through market satisfaction by conquering the gap hence gaining financial impetus. Indeed, better non-financial performance drives better financial performance.

 

Company here looks forward to boost production volumes by as much as 60% which puts it up against its fair share of opportunities such asbeing able to venture further into a market that has been growing consistently and increasing market share whereas threats such as response from market forces, increased marketing costs, working capital and liquidity elements with it looking forward to push sales through extended credit in order to utilize the spare capacity generated ultimately this leads to an increase in receivable period by 15 days amid increasing total costs and operations.

 

Furthermore, for any investment and growth to go ahead, it is vital to measure specific investment indicators that are relevant. For the investment, Project’s IRR stands at 16.22%, NPV standing at $91,440.80 and Payback Period of 3 years & 8 months with Company’s WACC being 6.5%.

 

Thereby, project may show healthy signs going into however there needs to be scepticism over concerns and risks that surround including the accuracy of forecasts available, reaction to changes that might be in the market and internal issues to go alongside funding requirements.

 

There is risk involved in every project and it remains the case with the company and its investment however, return is a direct positive variable to risk and with all things being as per outlook, the project can well and truly be an effective risk to take.

Introduction

This report talks through the company’s planned expansion for production unit to increase production capacity from 12,500 to 20,000 units per annum in light of which it talks through the financial perspective & rationales for the operational expansion, working capital requirements that would be in consideration and any change in working capital, break-even point, capital budgeting considerations & funding options whereby finally moving to project feasibility and ending with a conclusion note.

Hillsides Operations Expansion: A financial perspective

The business is essentially looking forward to increase its financial returns including profits, revenue growth, lower operating gearing through increased customer satisfaction by lowering customer turn-down rate & fulfilling market gap which would be achieved by increased production capacity resulting in greater production, lower lead time and greater flexibility as capacity is being increased to 20,000 units per annum from 12,500 through new plant. However, business foresees increasing demand and its ability to gain additional sales by penetration and increased marketing expenditure where it expects to increase demand/ sales level by 5,000 above market figure of 15,000 units.

 

Working Capital Requirements

Cash conversion cycle increased from 18 days to 33 days by 15 days due to increase in receivable days as result of increasing credit being given. This is deliberate as to fetch increased sales however there shall remain the risk of bad debts being there and hence further deterioration in cash position, also increased settlement discounts or recovery costs. Considering an output of 60 units per day with material cost of each unit being $30, at least $1,800 per day of raw material cost is needed/consumed. With increased cash conversion cycle, the raw material cost funding may need a further inflow $32,400 to $59,400 reflecting an increase due to raised cash conversion cycle whereby production per day and amount of raw material consumed stays at 60 units & $1,800 respectively. Hence with increased cost of sales due to scale of operations being expanded and simultaneously the receivable payback period being increased, the working capital demands shall notch upon.

Break Even Point

It is interesting to look over that additional costs of $40,000 are being incurred which shall generate sales of 5,000 additional units leading to cost per sale acquired being $8. Considering the additional marketing costs and material costs being only variable costs, contribution turns out as $70 with added fixed costs being covered by merely 572 units. Primary issues with increased sales are associated with the strategy of penetration as if the added amount of cost shall drive results & value. So, considering there is ability to generate additional 5,000 units of sale through marketing expenditure and the Sale Price & Material Cost being $100 & $30 respectively, business shall be able to cover up the increased marketing costs. However analysis is required if there are any further costs involved or if the value/output that would be generated through the marketing expenditure is not stated through an over-optimistic approach as there are things to look forward to including market in future, competitor response and other market threats particularly considering that business is at back-foot if capacity is under-utilized and there might be the case that prices may also have to be reduced if things are unfavourable which would reduce contribution.

 

Capital Budget Considerations

Overall, the cost of debt is 5% (yield to maturity) whereas the cost of equity is 11% (CAPM) that leads to WACC being 6.5% considering 60:40 ratio between debt & equity. Using the WACC of 6.5%, the Net Present Value turns out to be $91,440.80

Net Present Value as an investment measure can be particularly worthwhile for evaluation of the project since it is based upon the cash flows and is devoid of accounting assumptions & mechanisms such as depreciation. It reflects the positive value the project adds to the company and thereby illustrating the value to the shareholders & future financial indicators while being a nominal measure. NPV is also generally well recognized to evaluate investment and is regarded as key to conclude over independent projects. NPV accounts for the risk factor as well since it discounts back the cash flows and considers time-value of money. Discount rate which is being used could be well and truly taken up as per company’s debt-equity structure through the use of WACC and thus evaluating how the project shall deliver considering the charge for use of capital being company-specific. All in all, it can very well on nominal terms be choice to select independent projects as it would show where the greatest positive value is in nominal terms as a measure.

 

Funding Options

The Internal rate of return (IRR) for the project is 16.22% whereas cost of equity & debt (pre-tax) are 11% and 5% respectively, hence project being worthwhile anyways. However, Company’s funding resources are led by debt with 60% which may notch up further if the project is funded through debt thereby increasing the gearing and financial risk of the company as project cost is $270,000 which is likely to be highly material with respect to total balance sheet value as it shall increase the production capacity by 60%, debt funding may as well alienate investors who may want returns over their investments as well. Company would be liable to pay off debt obligations regardless of results and this can stress financial and cash resources whereas in expansion phase where financial results would take time as the plant develops & installs whilst starting production while dividends are unlike and may not be paid where the cash or financial resources are strained and growth is expected in the future. Hence, equity being the better choice although a small chunk of project could be debt financed to ensure stable debt-equity structure.

 

Project Feasibility

On paper, the project looks feasible, through both metrics including IRR & NPV as discussed earlier while payback period is approximately 3 years and 6 months. However, it remains to be seen that if the growth for the market is to continue or the external business environment may change which might result in stunning of the growth or affect sales adversely hence putting up question about accuracy of the forecasted inflows for which a zero based approach is required to cater. Furthermore, Capacity is being enhanced further by 5,000 units which shall translate into utilization and sales through a penetration-based approach hence the problem of inflows being under the radar for evaluation as spare capacity would be a waste. Also increased working capital requirement may put up concerns for short-term financing and to increase short term loans or finances may put up an impact on overall risk exposure, cost of capital. There could be other non-financial factors in consideration such as quality of the output which could influence returns as if there are expertise, resources and internal strengths to manage the new plant successfully alongside external factors such as competitor response.

 

 

Conclusion & Recommendations

Overall, the project, considering if there is market potential and gap available, looks to be financially viable as illustrated by investment metrics as well. Innovation & Growth are the roots of financial success & value generation which is essentially what the company is headed towards through expansion-oriented strategy. Although, care is required to evaluate the prospects and selections to execute the project with success whereby achieving desired objectives such as financial value, market share & flexibility.

Appendix 1

Particular Amount ($)
Sale Price 100
Variable Cost (Materials) 30
Contribution (Sale Price – VC) 70

 

Particular Amount ($)/Units
Fixed Cost (Marketing) 40,000
Contribution 70
Break Even Point (Fixed Cost/Cont.) 572

 

Appendix 2

CAPM
Risk Free Rate (X) 1%
Beta of the Security (Y) 2
Expected Market Return (Z) 6%
CAPM {X + Y(Z – X)} 11%

 

Cost of Debt
Par Value 1,000
Market Value 896
Annual Rate 4%
Maturity in Years 15
Cost of Debt (YTM) 5%

 

 

Weighted Average Cost of Capital (WACC)
Cost of Equity 11%
Cost of Debt 5%
Tax Rate 30%
Post-Tax Cost of Debt 3.5%
Debt-Equity Structure 60 : 40
WACC 6.5%

 

Net Present Value (NPV)

    Forecasted Future Free Cash Flows (Years)
0   1   2   3   4   5
($270,000) $47, 000 $61 000 $95 000 $97 000 $150 000

Projected Cash Flows used:

NPV
Cost of Capital (WACC) 6.5%
Project Cost $270,000
NPV through Discounted Cash Flows $91,440.80

 

ANALYSIS OF GOOD ENERGY

Pages:15

Glossary:

 

OFGEM Office of Gas and Electricity Markets
CAGR Cumulative Average Growth Rate
ROE Return on equity
ROA Return on assets
EBIT

 

 Earnings before interest and taxes
CR Current ratio
GPM

 

 Gross profit margin
OPM Operating profit margin
NPM Net profit margin

 

1.    Introduction – Good Energy

Good energy is a vertically integrated power generation and supply company which is listed on London Stock Exchange. Good Energy started its operations in 1999 and after 20 years of successful journey, it has more than 1400 independent power generators, producing a total of 54.5MWs of electricity, which use only renewable sources likewind, solar, hydro and bio-generation technology to generate 100% renewable electricity. Currently the fuel mix of Good Energy constitutes of 57% from wind, 20% from bio-generation, 18% from solar, and 5% from hydro. (Good Energy Group PLC, 2018)

Core Values:

With technology, people and partnerships as its core values, Good Energy aims to excel in the field of clean energy.

Good Energy believes that the usage of technological sources to generate clean and renewable energy is the future of global power industry. GE considers its leadership and the people as the core element of its success and aims to continue investing in its human resource. GE’s final core value encompasses the arena of partnerships as GE believes that the future of power industry relies on the effectiveness of partnerships among the stake holders of generators, suppliers and the technological enterprises. (Good Energy Group PLC, 2018)

 

Business Model:

Good Energy is a vertically integrated power generation company. From generation of electricity to its supply and applicable services, GE has a well control over its value chain. Good Energy’s integrated value chain also allows it to interact, connect and engage with its customers and clients directly. (Good Energy Group PLC, 2018)

Strategic Overview – Electricity Sector:

2018 was a very important and crucial year for electricity sector. The industry became more competitive with shifting dynamics, introduction of new regulations, continued development, and inception of latest technological advances. All of these factors impacted the industry where Good Energy operates.
The local market witnessed one of the most important and prominent regulatory changes in 2018. From January 2019, prices for consumer gas and electricity, supplied through various tariffs, have been regulated and capped at a price set by the energy regulator, OFGEM. The period of first capped prices would be from 1st January 2019 to 31st March 2019. A further price hike of 10% has been already implemented by OFGEM, effective by 1st April 2019. The regulator, OFGEM, will review and revise the price cap at every six month intervals. (Good Energy Group PLC, 2018)

Table 1

Profit and Loss Statement
2013 2014 2015 2016 2017 2018
Revenues 40407 57618 64281 90437 104509 116915
Cost of Goods Sold -26822 -38782 -42982 -62905 -75178 -83466
Gross Profit 13585 18836 21299 27532 29331 33449
Administration Expenses -9727 -15045 -17065 -21582 -23739 -26800
EBIT 3858 3791 4234 5950 5592 6649
Interest Income 116 87 23 18 2 16
Interest Expense -719 -2590 -4129 -4534 -4860 -4361
EBT 3255 1288 128 1434 734 2304
Tax -586 520 -323 -51 566 -660
Net Income 2669 1808 -195 1383 1300 1644

 

Table 2

Balance Sheet
  2013 2014 2015 2016 2017 2018
Current assets 32055 30559 25957 37554 61852 60687
Non-current assets 23918 48759 67604 65379 60237 58103
Total assets 55973 79318 93561 102933 122089 118790
             
Current liabilities 14104 21684 20140 40927 46565 43127
Non-current liabilities 25405 39691 56478 40961 57437 56837
Total liabilities 39509 61375 76618 81888 104002 99964
Equity 16464 17943 16943 21045 18085 18827
             
Total Liabilities & Equity 55973 79318 93561 102933 122087 118791

 

Table 3

Key Ratios
2013 2014 2015 2016 2017 2018
Gross Profit Margin 34% 33% 33% 30% 28% 29%
Operating Profit Margin 10% 7% 7% 7% 5% 6%
Net Profit Margin 7% 3% 0% 2% 1% 1%
Coverage Ratio 5.37 1.46 1.03 1.31 1.15 1.52
Current Ratio 2.27 1.41 1.29 0.92 1.33 1.41
Debt to Equity 2.40 3.42 4.52 3.89 5.75 5.31

 

Financial Highlights – Good Energy:

Figure 1

 

Good Energy has performed well in increasing its revenue in last six years. The total revenue of GE has grown at a CAGR of 23.68% during the tenure from 2013 to 2018. However, GE has significantly struggled in controlling its cost of sales and maintaining its net income. Cost of sales since 2013 to 2018, grew at a much higher CAGR than that of revenue; that is at a CAGR of 25.49% which shows that the business has been facing tough challenges on cost side. Moreover, the GE has not been able to transfer the increment in the revenue over the period to the net income. The net income during the tenure faced a decline at CAGR of -21.37%.(Good Energy Group PLC, 2018)

Figure 2

Good Energy has shown a keen approach towards constantly increasing its asset base. Since 2013, Good Energy has grown its assets by average yearly rate of 17%. This trend shows the positive intend of the company. However, in order to fund this growth, Good Energy has relied on raising new debts, on a yearly basis, Good Energy’s long term debt has increased by an average rate of 22% since 2013 till 2018. Constant increment in debt has played its negative role in shrinking the overall net income as with increasing debt comes higher finance costs.

Good Energy’s non-current assets mainly include lease hold lands, electricity generation assets and other equipment. (Good Energy Group PLC, 2018)

 

 Critical Analysis:

Figure 3

 

 Being an electricity generating and supplying company, it is really crucial that you keep updating and expanding your electricity generating assets in order to keep yourself in the competition. Good Energy has not only been successful in maintaining its electricity generating assets base but also it has reinvested and expanded its asset base. Last considerable investment in electricity generation assets has been witnessed in 2015, where Good Energy increased the electricity generating assets from £35 million to £65 million. During the period from 2013 to 2015, Good Energy increased its electricity generating assets at CAGR of 135.82%. (Good Energy Group PLC, 2018)

 

 

Figure 4

 With time, the trade and bill receivables of Good Energy has increased at a drastic rate, which can be quiet devastating for the effective management of liquidity of the company. Moreover, further intensifying the situation, the provisions against the trade and bill receivables, haven’t kept the pace with the rapidly increasing receivables.(Good Energy Group PLC, 2018)

Figure 5

Receivables as a percent of total revenue also has increased from being 13% in 2013 to 27% in 2018 which represents the problem that Good Energy has either supplying more electricity on receivable basis or is not effectively collecting its receivables. In any scenario, this might presents issues to Good Company like liquidity crunches which is quiet important to manage well in electricity generating and supplying businesses. (Good Energy Group PLC, 2018)

Figure 6

On the other hand, the company’s management has been reluctant in increasing the provisions against the increasing trade and bill receivables.

Figure 7

On a positive side, Good Energy is a good stock to keep for investors who wants constant and stable dividends. Good Energy has been paying a constant amount of dividends every year since 2013 irrespective of its profitability as in 2015, even when GE didn’t make any profit, it still paid dividends quiet similar to that of previous years. In 2013, the dividend payout ratio of Good Energy was 14%, however in 2018, this metric was 28%, almost doubled.

Ratio Analysis – Peer Group:

To analyze the performance of Good Energy over the period from 2013 to 2018, we will dig deep into its financials and compare its ratios with those of its comparable peers.

Profitability Ratios:

  • Gross Profit Margin Ratio:
Figure 8

While industry average of Gross Profit Margin has witnessed ups and downs since 2013, Good Energy’s GPM ratio has been more or less constant which shows that GE has somewhat control of its input costs. In 2013, the industrial average of GPM was above that of GE, however, with passing years, GE maintained its margin quiet effectively whereas the margin of industry deteriorated with increasing fluctuations in raw material costs. Fluctuations in the gross profit margin in attributed to variations in commodity prices. (Good Energy Group PLC, 2018)(YU Group PLC, 2018)(AMP PLC, 2018)(OPG , 2018)(Green and Smart Energy, 2018)

 

  • Operating Profit Margin:
Figure 9

 Operating Profit Margin shows how effectively the company has managed its operating expenses with respect to its operating profits. Higher the margin, higher the effectiveness. Whereas, the industrial average witnessed a massive decline in the OPM, Good Energy has very effectively managed and maintained its OPM which shows that GE has kept costs like administrative expenses in control. (Good Energy Group PLC, 2018)(YU Group PLC, 2018)(AMP PLC, 2018)(OPG , 2018)(Green and Smart Energy, 2018)

  • Net Profit Margin:

 

Figure 10

 

The Net Profit Margin comparison has also followed the same trend as of GPM and OPM. Industrial average deteriorated with time but GE has at least been successful in maintaining its profit margins. (Good Energy Group PLC, 2018)(YU Group PLC, 2018)(AMP PLC, 2018)(OPG , 2018)(Green and Smart Energy, 2018)

Liquidity Ratios:

  • Current Ratio:
Figure 11

 Current Ratio tells us about how effectively a company manages its current assets and current liabilities. A company should have enough current assets to cover up its current liabilities at any given time of the year. Usually, anything below than 1 in CR is not acceptable. Current ratio of Good Energy has been on a decline since 2013 with going below than 1 in 2016. However, it recovered slightly from being 0.9 in 2016 to 1.40 in 2018. (Good Energy Group PLC, 2018)(YU Group PLC, 2018)(AMP PLC, 2018)(OPG , 2018)(Green and Smart Energy, 2018)

 

  • Debt to Equity Ratio:
Figure 12

 Good Energy’s balance sheet has more debt than the industry average. The debt level of GE has significantly increased since 2013, the debt to equity ratio increased from 2.3 in 2013 to 5.3 in 2018. Higher debt level has contributed to increase the financial cost which has shrunk the net profit. The finance cost of Good Energy has increased at CAGR of 43.41% during the tenure from 2013 to 2018.(Good Energy Group PLC, 2018)(YU Group PLC, 2018)(AMP PLC, 2018)(OPG , 2018)(Green and Smart Energy, 2018)

  • Interest Coverage Ratio:
Figure 13

 

Interest coverage ratio tells us about the company’s ability to cover and fulfill its interest payment liabilities. Anything below 1 is a sign of severe distress; however, ideally the number should be above 5. Interest coverage ratio of Good Energy also has declined since 2013, showing that the either the EBIT has declined drastically or the finance cost has increased. Good Energy has invested heavily in its electricity generating assets in 2013 and 2014 after taking new debts which resulted in higher D/E ratio and lower interest coverage metric. We expect that this ratio will improve in coming years as expansionary projects will start generating electricity which will help increasing the EBIT and with time, the finance cost will also decrease. (Good Energy Group PLC, 2018)(YU Group PLC, 2018)(AMP PLC, 2018)(OPG , 2018)(Green and Smart Energy, 2018)

Other Important Ratios:

Table 4

  Green Energy (As per 2019) Industry Average
P/E Ratio TTM 14.08 19.81
Price to Sales TTM 0.29 1.8
Price to Cash Flow MRQ 2.61 89
Price to Free Cash Flow TTM 2.05 89.04
Price to Book MRQ 1.69 2.68
Price to Tangible Book MRQ 2.14 4.37
Return on Equity TTM 12% 15.98%
Return on Equity 5YA 7.12% 16.31%
Return on Assets TTM 1.94% 3.76%
Return on Assets 5YA 1.34% 3.72%
Return on Investment TTM 2.96% 4.63%
Return on Investment 5YA 1.99% 4.6%

(Anon., 2019)

 

Non-Financial Ratios:

 

Table 5

  2017 2018
Customer Meter Growth 4.3% 0.2%
Business Customer Volume Growth 46% 23.2%
NPS 46< 46<

 

Good energy has continued the good work of enlarging its customer base of both, domestic and business customers. However, the growth has slowed down in 2018 as compared to that in 2017. Customer meter growth shows the growth in meters supplied to domestic customers whereas business customer volume growth presents the number for meters sold to business customers. NPS is a measurement of how likely is that a customer of Good energy would recommend the services to someone else. (Good Energy Group PLC, 2018)

Corporate Governance:

Corporate governance means keeping in mind the interests of all stakeholders while making crucial decisions. A corporation has several stakeholders and their interests may vary from one another; the goal of a corporation is to effectively manage the relationships among all the stakeholders and make the best possible choices for the long term betterment of each stakeholder.

Good Energy has taken several steps which portrays its effective management of “Corporate Governance”

GE sources all of its electricity from certified and proved renewables sources of energy like solar power, wind power, hydroelectric power and biofuels. All of the Good Energy’s suppliers are based in United Kingdom and Green Energy pledges that it will always deal with UK suppliers only. Gas used by GE is carbon neutral where 6% of the total gas comes from bio-methane and the rest through the Green Gas Certification program. The projects of GE delivers wider benefits to the local communities, including helping out local poverty and empowering local women.

Furthermore, GE shares all the important information to its shareholders in a timely manner. GE’s board of directors include professionals who look after key decision makings and manage enterprise risk.  (Good Energy Group PLC, 2018)

Aligning to the goals of effective corporate governance has become so essential in this era of social media where any mishap can damage the reputation of the organization in the longer run.

Strategies to become a FTSE 100 Company:

 

Following are few strategies, the management of Good Energy can adapt to become a FTSE 100 company.

  • Invest in research and development. The energy sector is very rapidly evolving and to become competitive and remain relevant, GE should increase its investments in R&D to find better, cheaper, and cleaner ways of generating electricity.
  • Envisage future. Good Energy should start planning for future beforehand. In future data will empower homesand businesses to control and store electricity, GE should prepare itself for future to take a competitive edge.
  • Invest in human resource. Great companies are made and run by great people. In order to be a FTSE 100 Company, GE should bring industry best practitioners and experts in to its top management team.
  • Build better and sustainable partnerships. In an era full of uncertainties and variations, to grow and thrive, GE should build better relationships with its suppliers and distributors.
  • Good energy should be well prepared to any changes in regulations and compliance of government or regulatory organizations. As the electricity and power sector is very exposed and vulnerable to such changes, any drastic change in the policies can harm the operations and profits of Good Energy. Hence the management should be well prepared for such changes.

Caveats and Methodology:

  • In order to make the numbers comparable, financial results of 2018 of all companies have been used in the analysis presented in this report as complete results of 2019 have been not published for few of the peer companies.
  • Peer group includes OPG Power Ventures, Aggregated Micro Power Holdings PLC, YU Group PLC, and GREEN & SMART HOLDINGS plc
  • In order to normalize the results from all peers, certain elements have been neglected like impairment provisions, other income, non-recurring items, gain on sale of assets Etc.
  • Few of the peer companies were in losses in few years.
  • Peers companies might vary slightly with the subject company in terms of operational size, geography and operations.

Annexes:

Table 6

  Net Asset
2013 11733
2014 35239
2015 65247
2016 64732
2017 62051
2018 62081

 

Table 7

Interest Coverage Ratio
Good Energy
2013 5.366
2014 1.464
2015 1.025
2016 1.312
2017 1.151
2018 1.525

 

Table 8

D/E Ratio
Good Energy Peer Group Average
2013 2.400 0.699
2014 3.421 1.170
2015 4.522 2.007
2016 3.891 2.496
2017 5.751 1.714
2018 5.310 1.481

Table 9

Current Ratio
Good Energy Peer Group Average
2013 2.27 2.06
2014 1.41 4.52
2015 1.29 1.69
2016 0.92 1.62
2017 1.33 1.47
2018 1.41 1.14

 

Table 10

NPM
  Good Energy Peer Group Average
2013 6.61% 14%
2014 3.14% 14%
2015 -0.30% 5%
2016 1.53% 7%
2017 1.24% 4%
2018 1.41% -4%

 

Table 11

OPM
  Good Energy Peer Group Average
2013 10% 24.69%
2014 7% 26.82%
2015 7% 7.79%
2016 7% 13.20%
2017 5% 7.22%
2018 6% -1.52%

 

 

 

Table 12

GPM
  Good Energy Peer Group Average
2013 34% 38%
2014 33% 46%
2015 33% 27%
2016 30% 38%
2017 28% 30%
2018 29% 19%

 

Table 13

Dividends Paid
2013 377
2014 472
2015 451
2016 491
2017 459
2018 462

 

Table 14

Total Receivables to Net Revenue
2013 15%
2014 18%
2015 18%
2016 19%
2017 32%
2018 27%

 

Table 15

Dividends Paid
2013 14%
2014 26%
2016 36%
2017 35%
2018 28%

 

Bibliography

AMP PLC, 2018. Annual Report, s.l.: s.n.

Anon., 2019. Investing.com. [Online]
Available at: https://www.investing.com/equities/good-energy-group
[Accessed 31 december 2019].

Good Energy Group PLC, 2018. Annual Report, s.l.: s.n.

Green and Smart Energy, 2018. Annual Report, s.l.: s.n.

OPG , 2018. Annual Report, s.l.: s.n.

YU Group PLC, 2018. Annual Report, s.l.: s.n.

 

 

 

 

 

 

Financial Statement Analysis of Micro Focus International plc

Pages:20

Group Analysis

Micro Focus International plc is a United Kingdom-based global software company. The Company is engaged in delivering and supporting software solutions. The Company enables customers to utilize new technology solutions while maximizing the value of their investments in information technology (IT) infrastructure and business applications.

Formed in 1976 Micro Focus has grown through several acquisitions and mergers. Micro Focus typically buys outdated software developers with minimum to no growth for reduced prices. They then cut the marketing, research, development and service.

This results in an immediate increase in profitability created by current cashflows and increases initial shareholder returns. This has been a successful model for the organisation since the turn of the millennium and is recognised as the firm’s growth strategy.

The organisation serves the most industries where IT plays a role in businesses. With over 40,000 customers globally it is considered one of the largest pure software organisations in existence with annual revenues of approximately $4 Billion.

Financial Statement Analysis

For the Financial analysis based on the Annual report of 2018 which consists of audited numbers for the 18-month period ending in October 31, 2018 compared to the previous period which was a 12-month period ending in April 30, 2017.

The financial analysis has been evaluated on parameters like Liquidity, Safety, Profitability, Efficiency, and Leverage. I have outlined the importance of each ratio.

Profitability

(Refer to Appendix for Tables)

According to industry analysts Micro Focus profits for the current year, which will be reported in February 2020 are expected to fall by between 6 per cent and 8 per cent for the financial year ending October 2019.

The following analysis of four specific ratios has been carried out for the previous year 2018. The objective is to measure the company’s ability to generate a return on its resources and thus calculate the profitability of Micro Focus.

Gross Profit Margin – Indicates how well the company can generate a return at the gross profit level. It addresses three areas: inventory control, pricing, and production efficiency.(Hamid Moridipour1*, Zahra Mousavi2, n.d.)

Given the company is in the application software space, Gross profit margins are expected to be high, however the last 18-month period has shown a drop which is cause of concern. It could be a possibility of the merged entities reporting along with the mixture of product.

 

Another possibility is the industry transition to Software as a Service (SaaS). This model allows organisation to subscribe and consume as required. It supports organisations business models and allows for operational spend to be leveraged as opposed to capital expenditure.

 

Net Profit Margin – Shows how much net profit is derived from every dollar of total sales. It indicates how well the business has managed its operating expenses. It also can indicate whether the business is generating enough sales volume to cover its overheads and still leave an acceptable profit.

 

Looking at the net profit margin can give insights on whether the product is priced adequately to cover overhead expenses. If the product is priced too low, then sales revenues may not be enough to cover all of the other operating expenses.

 

Reducing margins at 8% are a call for concern.

 

However, It could be an outcome of the acquisition related costs or change in revenue models.

 

Return on Assets (ROA)–Support us in effectively evaluating the way in which a company employs its assets to generate a return. It measures efficiency.

 

ROA reported is rather low @ 4%. This emphasizes the need for renewed focus on improving profit margins and product margin mix and keeping a check on overheads.

 

Return on Equity (ROE) – ROE can be considered as profitability ratio from shareholder’s point of view. This provides how much returns on generated from shareholder’s investments, not from the overall company investments in assets.

 

ROE reported is reasonable @9%, however it depends on the expectations of the board and management.

 

An improvement of the previous cycle is a positive. Profitability of the company is the main stay here.

Liquidity

(Refer to Appendix for Tables)

We have done some analysis on Liquidity- ultimately this means the organisations ability to pay its debts as they arise.

We have leveraged four ratios to ensure accuracy as this is a key area to investigate. We have excluded Quick Ratio because inventory does not play a key role for Micro Focus. Being a software vendor where the key value is Intellectual Property, stock is not relevant.

 

Current Ratio – It gauges the ability a business is to pay current liabilities by using their current assets only.(Craig G. Johnson, 1970)

A general rule of thumb for the current ratio is 2 to 1 within the software space is considered healthy.

The current ratio maintained of 1.25x at the end of the 18-month period October 2018, indicates the company is covered paying its current liabilities. There is scope to improve this ration by primarily increasing sales and ensuring credit worthy customers.

Cash Ratio – This ratio measures a company’s ability to pay off short-term liabilities with cash and cash equivalents. Cash ratio is useful for a company who is undergoing financial trouble. If the ratio is high, then it reflects underutilization of resources and if the ratio is low then it can lead to a problem in repayment of bills.

 

The cash ratio of 0.25x maintained is a relatively comfortable level.

Operating cash flow ratio – This measure of the number of times a company can pay off current liabilities with the cash generated in each period.

The company has maintained a cash ratio of 0.58x which is a relatively comfortable level, Efforts should be made to improve this over time with higher sales and improved gross margins.

Net Working Capital – A positive working capital is when the net working capital is a positive figure. This is a desirable situation for a company, specifically software and innovation driven organisations. Along with ensuring Micro Focus could stay competitive when required to innovate with cash when requires, it also ensuresit avoids bankruptcy.

If a company is in called negative working capital, the company may face liquidity issues and eventually lead to bankruptcy.

Micro Focus has maintained a positive working capital. Increase in Revenues while improving the margins and keeping a check on the receivables cycle would help keep the working capital in check.

Summary

For an investor this is a healthy liquidity to see. It is also expected within software organisations of this nature. Due to the nature of their organisations historic growth, acquisitions are key to their strategy; having a good liquidity ensures that they can continue to pursue this where required.(Mike Ashworth, n.d.)

Efficiency

(Refer to Appendix for Tables)

Evaluates how well the company manages its assets. Besides determining the value of the company’s assets, it also analyzes how effectively the company employs its assets.

Asset turnover ratio: This ratio is the relationship between the net sales of a company and total average assets a company holds over a period of time; this helps in deciding whether the company is creating enough revenues to make sure it is worth holding a heavy amount of assets under the company’s balance sheet.

As they are in the intellectual property business this ratio gives us good insight.

It indicates the relative efficiency with which managers have used the firm’s assets to generate output.

Here again, what is acceptable or appropriate varies. Usually, however, a higher ratio is better.

An Asset Turnover ratio of 28% is reasonable;

However it can be improved further with a focus on increasing sales volumes, as compared with other companies in the industry. The company needs to focus on improving its revenue generation or its revenue per employee, thereby utilizing the assets better.

Accounts Receivable Turnover – Shows the number of times accounts receivable are paid and re-established during the accounting period.

The higher the turnover, the faster the business is collecting its receivables and the more cash the company generally has on hand.

The company has maintained a Receivables Turnover of 3.74 which needs improvement, by focusing on faster payment from customers. Similar companies are having a higher Accounts Receivables to Turnover, which indicates that the credit policies need revamp or execution must be made more stringent while being more aggressive in ensuring receivables are realized faster.

Accounts Receivable Collection Period – Reveals how many days it takes to collect all accounts receivable.

The average collection period is a measure of both liquidity and performance. As a measure of liquidity, it tells how long it takes to convert accounts receivable into cash.

As a measure of performance, it indicates how well the company is managing the credit extended to customers.

The average collection period is over 95 days, which has a lot of scope for improvement..

The average receivables collection period across similar companies is nearly half that of the Micro Focus. Management and Sales team should implement strategies incentivizes customers to make quicker payments.

Accounts Payable Turnover – Shows how many times in one accounting period the companyrepays its accountsto creditors. A higher number may indicate either the business has decided to hold on to its money longer, or that it is having greater difficulty paying creditors.

 

Payables turnover ratio is rather low, indicating delayed payments resulting in interest implications. This has a cascading effect on delayed receipts from customers.

 

17 Payable Period – Shows how many days it takes to pay accounts payable. The business may be losing valuable creditor discounts by not paying promptly.

 

The Payables period is almost 300 days, which has declined further from the previous period. Cash inflows are lower resulting in delayed payments to vendors.

 

This may be a result of the adoption of the SaaS subscription models being offered to their customers.

 

Sales to Total Assets – Indicates how efficiently the company generates sales on each dollar of assets. A volume indicator, this ratio measures the ability of the company’s assets to generate sales.

 

The ratio is reasonable for a company of this nature. Improving the topline will improve this ratio further.

Leverage Financial Ratios

(Refer to Appendix for Tables)

Leverage financial ratios are used to evaluate a company’s debt levels.

Micro Focus’s most recent balance sheet shows liabilities of $3.93b due within the year, with liabilities of $6.23b which are due soon after that. Aside from these, the cash balance $2.67b. There is also receivables due which equate to $864.5m. These are due within 12 months.(Micro Focus, 2018)

So its liabilities outweigh the sum of its cash and (near-term) receivables by $6.63b.

Given the deficit is somewhat higher than the company’s market capitalization of $4.56b, We believe there is reason for concern from the shareholders and thus they should monitor the international debt of the company.

 

Common leverage ratios include the following:

 

Debt ratio: This measures the relative amount of a company’s assets that are provided from debt. (Lee Remmers, Arthur Stonehill, Richard Wright and Theo Beekhuisen, 1974)

                                                          

The company has maintained a debt ratio of 0.54x, which is better than industry standards.(Micro Focus, 2018)

 

Debt to Equity ratio: The debt to equity ratio calculates the weight of total debt and financial liabilities against shareholders’ equity. This is important as ultimately your investment is equity.

 

The company has maintained a debt ratio of 1.15x which leaves substantial scope to leverage the equity.

 

Interest Coverage Ratio: The interest coverage ratio determines how easily a company can pay its interest expenses.

 

The company has barely managed to service the interest.

 

Debt Service Coverage Ratio: The debt service coverage ratio determines how easily a company can pay its debt obligations.

 

The company is not able to service its debt obligations. Company needs to work towards increasing revenues, margins and ensuring sustainable profits to be able to cater to its financial obligations to lenders.

 

 

There are limitations in the above ratios and in order for this to be more comprehensive a Debt to Asset ratio would need to be considered. This would show the strength of the organisation when looking to raise capital from loans.

 

Investor Ratios

 

(Refer to Appendix for Tables)

 

 

These ratios ultimately will show the returns previous years have brought. Investor ratios are used to measure the ability of a business to earn an adequate return for the owners of the business. The owners have money tied up in the business and need a return commensurate with the risk involved.

 

Earnings per Share Ratio (EPS): EPS ratio formula denotes how much market price you as an investor are paying for a portion of the earnings of the company.

 

The EPS is reasonable. It sits within the standard for organisations of this size in the technology sector.

 

Price-to-Book Ratio (P/B): Companies use the price-to-book ratio to compare an organisations market to book value by dividing the price per share by book value per share. (Frank E. Block, 2018)

 

A lower P/B ratio could mean the stock is undervalued. However, it could also mean something is fundamentally wrong with the company.(Frank E. Block, 2018)

 

Price-to-Earnings Ratio (P/E): PE ratio formula denotes how much market price an investor is paying for a portion of the earnings of the company.

 

Here the price has been considered as of the last day of the respective financial period. The PE ratio has dropped considerably from the previous period

 

Dividend Yield ratio: Dividend yields are the ratio of dividend paid out by the company to the current market price of the share of the company; this is one of the most important metrics in deciding whether an investment into the share will result in the expected returns.

 

The company has maintained a DYR in the region of 10% All the above Investor ratios indicate that the company needs to leverage its position to boosts revenues.

Risk Analysis

political risk

Due to the nature of Brexit and the potential impact this might have on Micro Focus being an British Headquartered organisation, precautions are being made to ensure operations are not affected. However, as the potential impact is still relatively unknown, Micro Focus have operating offices across Europe. This supports the organisation with flexibility on where revenue’s declared.

Software Market Economic Impact

According to Gartner the global software market spends, specifically on Enterprise software will increase by 9% in 2019 from 2018. This economically is positive for an organisation like Micro Focus.(Gartner, Inc. , 2019)

 

However, it is not all opportunity for Micro Focus, with legacy on premise software set to come to end of life as the adoption of cloud continues to be a focus for organisations.

 

The adoption of cloud technology has been both an opportunity and a risk for Micro Focus. The transition from a Capital Expenditure Model (CAPEX) to a more Operating Cost Model (OPEX).(Thomas Martin Knoll, 2014), (Armbrust, Michael, 2009)

 

This has meant the organisation has had to change the way in which they forecast and report on their financials. It also reduces the operating profit as cloud based subscriptions accrue more operating costs due to the management of the infrastructure and hosting services.

 

The benefit for the organisation implementing a subscription model for hosted services in theory means they can forecast ore effectively with a clearer view on predictable revenues. However this means there is more competition to retain customers and requires a more effective sales and operating model to ensure limited churn of customers.

 

The adoption of cloud has opened up many opportunities for smaller software providers in niche lines of business to challenge the larger organisations. Global communities of software practitioners can now collaborate effectively to bring products to market that challenge the larger organisations market share.

 

Due to this open source movement, we are seeing an increase in competition on legacy Micro Focus offerings along with an increase in the development of in house applications.

Leadership

there are several questions to be asked about the leadership of Micro Focus. Executive Chairman Kevin Loosemore, a veteran in the software space has made some questionable decision over the last 24 months;

 

Most recent is his decision to sell of more than half of his shares for £11.6 million must be taken into consideration and is being deemed by analysts as a concern for investors.

 

CEO Stephen Murdoch has had questions asked around the levels of compensation he has received. His return to the helm of the organisation in 2017 saw an increase of salary of 66% which meant a £850,000 Salary. This is not uncommon and would be on the median side of salaries at the level,  when you consider Oracle CEO SafraCatz earned $950,000 in 2018.(Ben Woods, 2019), ( DAVID LIEBERMAN and BRENT LANG, 2018)

 

With the actions of Kevin Loosemore over the past 12 months showing signs of potential profit losses, will be interesting to see what transpires over the next 12 months.

Rumours circulated by some analyst speak of sales of non-key software assets by the organisation which could see a large shift in executive leadership.

Recommendations and conclusions

Looking at the organisations current debt to cash reserves and the outlined factors in the above report, we would advise to tread carefully when investing in Micro Focus for both the short to long run.

The recent sale of the SuSe business has been a success in one sense that the organisation has been able to remove an asset that does not support the overall product stack, however we believe this is a sign of things to come.

The sale of future assets looks imminent and the shifts in leadership confidence does not bode well for the short term.

With net debt outweighing the cash reserves within the organisation there is reason for concern.

We would suggest limiting the percentage of your investment portfolio in this organisation. There are still potential returns to be had as we have outlined in the investment returns section of this report as historically shareholder value in a high priority for the organisation,. However the risks for us outweigh the opportunity.

Please feel free to reach out to us directly if you would require any more support and trading guidance.

Part2

Evaluation for Projects under consideration

EXECUTIVE SUMMARY

With alignment on the request of management, to determine which project options would be the best opportunity for the business, I have compiled a report with my findings on the cost benefits of each of the three options.

We have gone through a process of Capital Budgeting by which management determine the value of a potential investment project.

We have used the three most common approaches to project selection which are- payback period (PB), internal rate of return (IRR) and net present value (NPV).

The Payback Period determines how long it would take Outdoors PLC to recover the original investment.

The Internal Rate Of Return is the expected return on a project. If the rate is higher than the cost of capital, it’s a good project. If not, then it’s not.

The Net Present Value shows how profitable a project will be versus alternatives and is perhaps the most effective of the three methods.

The Financial evaluation of the project options has given a split decision, with three of the parameters favouring Option A and one of the parameters favouring Option C.

The management ideally should take a suitable decision depending on the availability of funds and the duration of availability.

Here in this case, assuming the funds are available or can be financed, the company should invest to produce Greenhouse and Conservatories.

BACKGROUND

Outdoors Plc, is a company which produces a variety of high-quality garden furniture and associated items.

The management is evaluating opportunities to grow the company.

They are considering whether to invest in the potential to expand the business, the directors identifying three main options.

For successful implementation, each of the projects requires an upfront investment.

Assumptions made for financial evaluation:

CASH FLOW GENERATION

The estimated Cashflow to be generated from the each of the projects is provided in the respective tables below along with the projected investments which need to be made in Year 1. The following tables show the Net Cashflow positions for each option considered.

CAPITAL BUDGETING

According to Priya, C 2019 – Capital budgeting is the method of determining and estimating the potential of long-term investment options involving enormous capital expenditure. It is all about the company’s strategic decision making, which acts as a milestone in the business. (Priya,C,2019)

When a firm is presented with a capital budgeting decision, one of its first tasks is to determine whether the project will prove to be profitable.(Karim Bennouna, Geoffrey G. Meredith, Teresa Marchant, 2010)

The payback period (PB), internal rate of return (IRR) and net present value (NPV) methods are the most common approaches to project selection.

Payback Period

The payback period calculates the length of time required to recoup the original investment. A short PB period is preferred as it indicates that the project would “pay for itself” within a smaller time frame.(H. Martin Weingartner, 1969)

Payback periods are typically used when liquidity presents a major concern. As Outdoor PLC  has a limited amount of funds, we might be able to only undertake one major project at a time. Therefore, management will heavily focus on recovering their initial investment in order to undertake subsequent projects. This is what we have scored as important due to the nature of the business.

Another major advantage of using the PB is that it is easy to calculate once the cash flow forecasts have been established. We can run this quite easily considering our expansion projects fall within our current operations.

There are drawbacks to using the PB metric to determine capital budgeting decisions. Firstly, the payback period does not account for the time value of money (TVM). Simply calculating the PB provides a metric which places the same emphasis on payments received in year one and year two. Such an error violates one of the fundamental principles of finance.

Internal Rate of Return

The internal rate of return (or expected return on a project) is the discount rate that would result in a net present value of zero. Since the NPV of a project is inversely correlated with the discount rate – if the discount rate increases then future cash flows become more uncertain and thus become worthless in value – the benchmark for IRR calculations is the actual rate used by the firm to discount after-tax cash flows. An IRR which is higher than the weighted average cost of capital suggests that the capital project is a profitable endeavor and vice versa.(Joseph Hartman, 2014)

The IRR rule is as follows:

IRR > cost of capital = accept project

IRR < cost of capital = reject project

 

The best primary advantage of implementing the internal rate of return for decision-making is that it provides a benchmark figure for every project that can be assessed in reference to a company’s capital structure.

The IRR should consistently produce the same types or similar decisions as net present value models which in turn allows firms to compare projects based on returns on the invested capital.

Traditionally IRR is an easier model to use in finaincail calculators and in software solutions for financial management.

The downfall of using this metric is- the PB method, the IRR does not give a true sense of the value that a project will add to a firm – it simply provides a benchmark figure for what projects should be accepted based on the firm’s cost of capital.

The internal rate of return doesn’t allow for an effective appropriate comparison of mutually exclusive projects. Thus management might be able to determine that project A and project B are both beneficial to the firm, but they would not be able to decide which one is better if only one may be accepted.

The IRR is a useful valuation measure when analyzing individual capital budgeting projects, not those which are mutually exclusive. It provides a better valuation alternative to the PB method yet falls short on several key requirements.(Joseph Hartman, 2014)

Net Present Value

The net present value approach is the most intuitive and accurate valuation approach to capital budgeting problems.

Discounting the after-tax cash flows by the weighted average cost of capital allowed us to determine whether the projects will be profitable or not. And unlike the IRR method, NPVs reveal exactly how profitable a project will be in comparison to alternatives.

The NPV rule states that all projects which have a positive net present value should be accepted while those that are negative should be rejected. If funds are limited and all positive NPV projects cannot be initiated, those with the high discounted value should be accepted.(Stephen A. Ross, 1995)

Some of the major advantages of the NPV approach include its overall usefulness and that the NPV provides a direct measure of added profitability. It allows one to compare multiple mutually exclusive projects simultaneously, and even though the discount rate is subject to change, a sensitivity analysis of the NPV can typically signal any overwhelming potential future concerns. Although the NPV approach is subject to fair criticisms that the value-added figure does not factor in the overall magnitude of the project, the profitability index (PI), a metric derived from discounted cash flow calculations can easily fix this concern.

The profitability index is calculated by dividing the present value of future cash flows by the initial investment. A PI greater than 1 indicates that the NPV is positive while a PI of less than 1 indicates a negative NPV.

Although an ideal capital budgeting solution is such that all three metrics will indicate the same decision, these approaches will often produce contradictory results. Depending on management’s preferences and selection criteria, more emphasis will be put on one approach over another. Nonetheless, there are common advantages and disadvantage associated with these widely used valuation methods.

The Bottom Line

Different businesses will use different valuation methods to either accept or reject capital budgeting projects. Although the NPV method is considered the favorable one among analysts, the IRR and PB methods are often used as well under certain circumstances. Managers can have the most confidence in their analysis when all three approaches indicate the same course of action.(Stephen A. Ross, 1995), (Joseph Hartman, 2014), (H. Martin Weingartner, 1969)

 FINANCIAL EVALUATION

To the Initial cashflow (EBITDA) projected, in the Cashflow generation section, for each project, we factor in the Capital Allowances at 25% on a straight-line basis, over the 4-year evaluation period, to give us the Earning Before Tax (EBT).

The Corporate Tax of 12.5% is then applied to this which results in the Earnings After Tax (EAT), which here refers the Free Cashflow’s for the company.

The Free Cashflows generated over the 4-year evaluation period, discounted at the Cost of Capital (8%) gives us the Net Present value (NPV) of these futuristic cashflows.

The Free Cashflows generated over the 4-year evaluation period, discounted at the Cost of Capital (8%) gives us the Net Present value (NPV) of these futuristic cashflows.

Calculating the IRR, Profitability Index, and Payback Periods,

Outcome of the Financial Evaluation

  • All the options have a Positive Net Present Value (NPV)
  • All the options under evaluation provide higher return (IRR) than the cost of capital.
  • All the options have a Positive Profitability Index
  • All have payback ranging from 2 to 3 years.

Best Options

  • Option C has the best NPV of €37 million
  • However, Option A provides the best IRR of 43.4%, and the highest Profitability Index of 1.93 with the lowest Payback Period of 2 years.

Management Decision:

Taking a very objective look at the results, Option C would be better option, if the company has the investment amount (i.e. €2 million) freely available for 3 years.

However, if the funds available are limited (i.e. less than €2 million) or available for a shorter duration (less than 3 year), then the company could also look at Option A, with an investment of €0.75 million with a payback period of 2 years.

OPTIMAL INVESTMENT POLICY

Assumption:

  1. Funds are limited to €2,500,000
  2. Projects are divisible, (i.e. it is possible to undertake a fraction of a total project).

Here we have assumed that a project can be divisible into 25% parts

We can create 10 scenarios with varying degrees of project implementation (increments of 25%) capped within the €2.5 million budget.

Evaluating the NPV, IRR, Payback period and the Profitability Index, we arrive at the conclusion that Option 4 is Optimal Investment, from all parameters under evaluation.

Option 4, is combination of

100% of Option A – Expand Retail Outlets;

100% of Option B – Develop Internet Sales; and

25% of Option C – Produce Greenhouse & Conservatories.

The total project outlay is €2.45 million, which will generate an IRR of 37.4% with a payback in Year 3. The net present value of the future cashflows comes to €4.47 million with a profitability index of 1.82

SOURCES OF FINANCE

Sources of finance for business are equity, debt, debentures, retained earnings, term loans, working capital loans, letter of credit, euro issue, venture funding etc. These sources of funds are used in different situations. They are classified based on time period, ownership and control, and their source of generation. It is ideal to evaluate each source of capital before opting for it.(Maja Lalić, Marina Klačmer Čalopa, Jelena Horvat, n.d.)

  • Based on a time period, sources are classified as long-term, medium term, and short term.
  • Ownership and control classify sources of finance into owned and borrowed capital.
  • Internal sources and external sources are the two sources of generation of capital.

Given the payback period of the project options under consideration, we are looking for a medium-term financing, which could be:

  • Preference Capital or Preference Shares
  • Debenture / Bonds
  • Medium Term Loans from
  • Financial Institutes
  • Government, and
  • Commercial Banks
  • Lease Finance
  • Hire Purchase Finance

Owned Capital

Owned capital also refers to equity. It is sourced from promoters of the company or from the general public by issuing new equity shares. Promoters start the business by bringing in the required money for a startup. Following are the sources of Owned Capital:

 

  • Equity
  • Preference
  • Retained Earnings
  • Convertible Debentures
  • Venture Fund or Private Equity

 

Further, when the business grows and internal accruals like profits of the company are not enough to satisfy financing requirements, the promoters have a choice of selecting ownership capital or non-ownership capital.

Certain advantages of equity capital are as follows:

  • It is a long-term capital which means it stays permanently with the business.
  • There is no burden of paying interest or instalments like borrowed capital. So, the risk of bankruptcy also reduces.
  • Businesses in infancy stages prefer equity for this reason.

 

Borrowed Capital

Borrowed or debt capital is the finance arranged from outside sources. These sources of debt financing include the following:(Maja Lalić, Marina Klačmer Čalopa, Jelena Horvat, n.d.)

 

  • Financial institutions,
  • Commercial banks or
  • The general public in case of debentures

 

In this type of capital, the borrower has a charge on the assets of the business which means the company will pay the borrower by selling the assets in case of liquidation. Another feature of the borrowed fund is a regular payment of fixed interest and repayment of capital.(Maja Lalić, Marina Klačmer Čalopa, Jelena Horvat, n.d.)

Certain advantages of borrowing are as follows:

  • There is no dilution in ownership and control of the business.
  • The cost of borrowed funds is low since it is a deductible expense for taxation purpose which ends up saving on taxes for the company.
  • It gives the business the benefit of leverage.

References

 

Capital Budgeting, Priya C, March 2019,  https://theinvestorsbook.com/capital-budgeting.html

Capital Budgeting Methods, https://www.wallstreetmojo.com/capital-budgeting-methods/

An Introduction to Capital Budgeting, By ARTHUR PINKASOVITCH, June 2019.https://www.investopedia.com/articles/financial-theory/11/corporate-project-valuation-methods.asp

DAVID LIEBERMAN and BRENT LANG, 2018. What the Media’s Most Powerful Executives Were Paid in 2018. Vareity.

Armbrust, Michael, 2009. Above the Clouds: A Berkeley View of Cloud Computing.

Ben Woods, 2019. Micro Focus boss Stephen Murdoch faces revolt over pay. The Sunday Times.

Craig G. Johnson, 1970. Ratio Analysis and the Prediction of Firm Failure. The Journal of Finance.

Frank E. Block, 2018. A Study of the Price to Book Relationship. Financial Analysts Journal .

Gartner, Inc. , 2019. Gartner Says Global IT Spending to Grow 0.6% in 2019. Gartner, Inc. .

  1. Martin Weingartner, 1969. Some New Views on the Payback Period and Capital Budgeting Decisions. Management Science.

Hamid Moridipour1*, Zahra Mousavi2, n.d. Relationship between inventory turnover with gross profit margin and sales shocks. International Research Journal of Applied and Basic Sciences.

Joseph Hartman, 2014. THE RELEVANT INTERNAL RATE OF RETURN. A Journal Devoted to the Problems of Capital Investment.

Karim Bennouna, Geoffrey G. Meredith, Teresa Marchant, 2010. Improved capital budgeting decision making: evidence from Canada. Emeral Insight.

Lee Remmers, Arthur Stonehill, Richard Wright and Theo Beekhuisen, 1974. Industry and Size as Debt Ratio Determinants in Manufacturing Internationally. Financial Management Association International.

Maja Lalić, Marina Klačmer Čalopa, Jelena Horvat, n.d. Analysis of financing sources for start-up companies. Management – Journal of Contemporary Management Issues.

Micro Focus, 2018. Annual Report 2018, s.l.: s.n.

Mike Ashworth, n.d. Working capital management. ACCA – Think Global.

Stephen A. Ross, 1995. Uses, Abuses, and Alternatives to the Net-Present-Value Rule. Financial Management.

Thomas Martin Knoll, 2014. A combined CAPEX and OPEX cost model for LTE networks. IEEE.

[Merger & acquisition Essay] Acquisition of XYZ Company

 

 

Importance of Regulatory Compliance and Transparency at a Global Level

Pages:6

With increasing impacts of globalization and growing interdependence among financial markets of the world, the importance of complying with the regulations and being transparent with your dealings has reached the highest levels. Whether it is exploiting accounting loopholes to show inflated profits like energy giant “Enron” or mismanaging investment funds like private equity mammoth “Abraaj,” the end of such wrongdoings is always disastrous.

Being the Chief Compliance Officer of W&W Inc., the apparent situation is very alarming. While enjoying a high growth rate for the last 15 years in emerging countries where corporate bribes and loopholes in the regulatory environment are not uncommon, the sudden and mysterious exit of the former COO within a year raises red flags. Furthermore, obtaining store permits faster than in Europe, hiring of shady Third Party Intermediaries (TPIs) without carrying out proper due diligence and paying them higher commissions, and overlooking of controls which were supposed to stop improper payments to TPIs and government officers demonstrate that there must be something going on which is not righteous.

Such allegations can probe regulatory compliance institutions, which can result in the proper investigation against W&W Inc. And a case of a finding of any significant proof, our organization can face risks of hefty fines, loss of reputation, and even rescinding of working license.

As a new COO of W&W. Inc, this situation will give me tough challenges. To cater to the issues systematically and adequately, I will go with the following strategy.

My Strategy:

  • Know the reality:

Being a new COO, my priority would be to know what has been happening with the organization internally. How accurate such allegations are and what are their backings. To understand such things, I would curate a committee mostly consist of outside individuals whose task would be to carry out a detailed and comprehensive audit check of the organization for the past years. That committee would go through the allegations and see what their realities are. The committee won’t be including officials from the organization as this will increase the risk of biases as it has been mentioned in the allegations that even the top leadership of our subsidiaries have been involved in such malpractices.

The committee would also be interviewing the former COO so that we can know why she left and if she knew more than us.

  • Take action:

After the audit and review committee has done its work, it will generate a comprehensive report regarding their findings. If the report points out any wrongdoing, deceit, fraud, or misalignment from the code of conduct, proper action against the notified personally would be taken.

  • Precautionary measure:

Taking action after the misconduct and punishing the culprit is not the end and accurate solution for such issues. To prevent such cases from happening again, I would take proper precautionary measures, which can help in preventing such incidents from happening again, which can significantly damage the reputation of W&W Inc.

Such precautionary measures may include forming a board of governance that would look after the compliance with regulations, ethical conduct, and transparency of deals and transactions. The committee would consist of external directors to make it hard to influence that board. After setting up a board, we will curate a properly documented set of policies and procedures which would tell what and how to do organizational affairs and deals. A proper check and balance procedure would be introduced, which will focus on the review and segregation of duties. This will help in preventing individual level frauds and also in catching up innocent mistakes. Furthermore, a particular focus will be put on communicating the drafted policies and conducts; without proper communication, the desired results of such drastic steps might not be fruitful.

Detailed Strategies:

Setting up a board of governance:

To improve processes according to compliances, among other aims and objectives, align with ethical practices, honesty, and transparency in our business, W&W Inc. should focus on adhering to external and internal laws, methods, and regulations. To enforce the implementation of such a plan which aims to enhance and improve the current compliance environment, compliance and government board should be created (if not already in existence), which should include constituents executives from the government department and executivesfrom the compliance department. If such a board already exists, I would try to remake it through shuffling and adding more executives who have relevant working experiences related to executing ethical practices, making effective external and internal control systems, and transparency mechanisms.

The first task of this board of governance would be to examine and audit the past track records and available data to know the reality about the rumors regarding the violations of regulations.

Documented processes:

Even though there are generally available systematic manuals regarding ethical conduct and regulatory compliances for offices to pursue and follow, an organization ought to build up its very own comprehensive and intensive code of conduct for its internal usage and transactions related procedures. Having a complete set of policies and procedures would serve different capacities, such as communicating openly to all employees of the organization the ethical and regulatory policies of the organization so that the employees know what the organization is expecting from them. Properly drafted a set of policies guides the employees regarding how to deal with business transactions and what to do when they observe something happening, which is not harmonious with the values and policies of the organization.

Without such a drafted set of policies, there would be an element of ambiguity, and the employees may get a chance of pursuing an act which is against the values of the company and not harmonious with the regulatory compliances.

Review of transactions:

At the point when an operation is performed inside an organization, there should be another degree of audit and endorsement performed by an individual that is not involved in that particular transaction. The reviewer ought to have the relevant experience and knowledge to recognize blunders and oversights. The endorsement should be recorded to confirm that a review or audit has been finished. Such analysis and audit help in lessening errors mistakes happening in the proper recording of the transactional data, and even might catch frauds and deceits.

Segregation of Duties:

Separation of duties is an essential and vital internalcontrol and one of the most challenging tasks to accomplish. At the most fundamental level, it implies that no single individual ought to have command over more than at least two phases of any business or financial transaction. It is used to guarantee that mistakes or anomalies are counteracted and identified conveniently by the leadership in the daily routine of business. Separation of duties gives advantages like it makes committing conscious deceit more troublesome as now it would take at least two persons to commit fraud or misrepresentation.

Amendments to HR Policies:

It has been mentioned that “top management is aggressively setting goals for the frontline company officials to achieve stiff targets, which is taken into account for performance evaluation and setting annual bonuses.” Policies like this force top management to set high and sometimes pragmatically unachievable goals for the frontline managers to avail of high bonuses. To fulfill the expectations and achieve those high targets, managers can be negatively influenced to take unethical steps which can violate compliance and transparency standards. To fix this policy, I would align with the human recourse department to make the relevant amendments in the annual bonuses policy.

Communication:

Communication is the key to the effective implementation of any policy. After drafting up the compliance, ethics, and transparency guidelines and procedures, I would communicate them to the employees of the organization.

Moreover, Iwill curate a specific draft on compliance issuesand it would be available to every employee featuring the main plans carried out, the ethics guidelines, other internal and external procedures, the laws, and other vital documents, like the code of conducts, code of ethics and morality, and code of transparency.

 

Training:

I will primarily focus on the continuous provision of instructions to employees to deepen their knowledge of compliance guidelines, fundamentals, and legislative responsibilities. I would also conduct training which helps employees in identifying, stopping, and communicating situations of misconduct, threats, or risks with signals of deceit and corruption in business transactions.

I would also implement specialized training and workshops for executives who hold positions that are at higher stakes and risks so that they can know the importance and exposure of their roles and the precautions they must take while doing their duties.

Time Frame:

Indeed, implementing such drastic changes will take time. When dealing with issues like misconducts and allegations regarding fraud, bribes, and deceits, we often face hurdles and challenges, which can take a little amount of time to sort out.

However, my priority would be to form the audit committee, which will be completed within the time frame of a month. To review the allegations and audit the records or transactions, the review committee will be provided for two months. After the report of the audit committee, we won’t take much time to make the relevant and recommended actions. However, the “preventing” part of the strategy may take time as it implementing new policies, communicating them to the employees, and providing them with the relevant training would be a timely process.

Expected Outcome:

The expected outcome would be positive. With all the steps mentioned above, I hope W&W. Inc would be able to deal with the regulatory issues in a better way in the future.

 

Analysis of General Motors

Pages:2

“General motors” is an automobile manufacturing company, based in USA, which manufactures and sells luxury brands of car like Chevrolet, GMC and Cadillac.

Profitability Ratios:

General Motors had maintained stable profit margins ratios from 2014 to 2017 with slight improvement from 2014 onwards. However, due to increase in cost of goods and doing business, profit margins shrank slightly in 2018. Gross profit margin increased from 8.8 in 2014 to around 12 and remained almost constant for the next three years before dropping to 9.5 in 2018. Same scenario occurred with operating profit margin and EBIT margin. However, net income margin showed a rather inconsistent behavior throughout the tenure due to varying amount payable in taxes.

Return on assets and return on equity followed the pattern of previous profitability ratios. Increasing slightly from 2014 levels, remaining stable for the next three years and then falling down slightly in 2018.

Fall in profitability ratios in 2018 can be attributable to increasing costs of raw material like steel, warming up trade tensions with China, tough competition from eco-friendly car manufacturers like Tesla, and overall slowing down of global economy.

Efficiency Ratios:

During the tenure of 2014 to 2018, General Motors has drastically improved its inventory turnover ratio which shows that the company has managed its inventory pretty efficiently. The ratio increased from 10.4 in 2014 to 13.5 in 2018.

On the other side, account receivables, another measure of company’s efficiency, has remained on the decreasing side, which demonstrate that the company has facing delays in collecting its receivables. The ratio decreased during the tenure from being at 6 in 2014 to 4.4 in 2018. This may also have caused liquidity problems and shrinkage in current ratio of the company.

Liquidity Ratios:

Current ratio of General Motors has been under 1 during the tenure with the only exception in 2014, which may indicate liquidity management problem. However, keeping in mind the long cycle of account payables in automobile industry and the reputation of General Motors, this doesn’t demonstrate any serious threat to the operations of GM. Moreover, GM has been maintaining a good operating cash flow per share which shows the availability of enough cash to keep the operations continue without any hassle.

In last two years, General Motors has increased its debt which is visible by its increasing debt to equity ratio; debt to equity ratio increased to 2.6 in 2017 from being at 1.7 in 2016.

Stock Portfolio Strategy Paper

Pages:11

Investment Strategy: 

After carefully assessing the client and keeping in mind her constraints, risk appetite, time horizon, return demand, and personal interests we have formulated our investment strategy for her. As per our strategy, we will invest all the available fund of $100,000 in stocks; whereas, allocating 20% of the fund for short term liquid stocks. In order to diversify the unsystematic risk and hedge the uncertainties of geopolitical world, our proposed investment portfolio would consist of a mixture of tech, consumer discretionary, financial services, healthcare, and material processing sector.

Our investment strategy is both tailored to the current events affecting the global economy and the personal preferences of the client to suit the client’s stated and implicit needs.

 

Technical Analysis

We applied technical analysis to all the stocks and compared the 20 day moving averages to that of 200 day. Unless the technical analysis hinted an explicit decline in stocks in the future, we considered it safe.  

If a company’s 200 day moving average were higher than the 20 day moving average, we concluded that the company has a higher potential to prosper in future. When the difference between the 200 day moving average and that of 20 day of a company was really critical, we marked the company as a potential short term investment. 

For screening, we used the website Screener.in where the website showed PE ratio of the company from the year it was created to the present. 

 

 

Fundamental Analysis — Projections of the US-China Trade War

As many may know, the United States and China are currently undergoing a trade war and in order to win this war, there is a currency war going on alongside. To accomplish this, they are lowering the intrinsic value of their currency to gain advantage over the other nation, a practice seen in many countries. However, a major difference is that, for this trade war, the countries participating in it are the two biggest countries in the world, in terms of gross GDP, with US and China having gross GDPs of $21.41 trillion and $15.54 trillion respectively. (World Population Review, 2019) With this, because the two countries are dropping their dollar ($) price and RMB (¥) price, an economic recession seems inevitable.

So then, why does a trade war necessarily lead to an economic recession? First, we have to know why devaluing the national currency necessarily serves as an advantage. There are three main advantages of currency devaluation: boost of domestic demand, improvement in currency deficit, and economic growth. These seem to be what the current Trump administration is striving to achieve with the devaluation of currency, which is why devaluation will keep on happening.

Boost of domestic demand is caused because exports become cheaper. When exports become cheaper, then domestic exports are more appealing to foreign buyers than that of other countries, and when that happens, there will be a boost for domestic demand because the items that could have been sold to the domestic market is now overseas. Therefore, in order to meet the demand, there can be more job creation to meet exports. As there are more exports, this would then in turn lead to an improvement in the nation’s deficits, something that is important especially for a country like the United States, which has a massive deficit due to multiple loans. Lastly, economic growth can be caused due to the two benefits listed above, as those benefits may in turn bolster the economy as more jobs are created and more products are created for consumption.

However, there is a caveat to this. Although the three advantages listed above may happen, there are also other factors that need to be accounted for: the state of business cycle, elasticity of demand, and competitiveness. Those three factors need to be adjusted for and must come in consonance, in order for currency devaluation to truly play a positive effect, something that the United States is missing. If those three factors do not harmonize then the disadvantages of devaluation will follow, such as inflation, reduction of purchasing power, reduction of international investors, and debt repayments.

Something to note is that the United States is a heavily import-dependent country, in which many of the items in daily use are imported from foreign countries such as China. If the United States were a country in which the majority of citizens bought from domestic selections, then it would be alright but since the United States citizens opts to choose from imports, more currency if flowing out of the country than before, one of the reasons causing an economic recession. Also, although imports are more expensive, the US cannot rely on domestic items because the US has been so import-dependent for such a long amount of time and because even if imports are more expensive, it’s still better and cheaper for the consumer than domestic items. Due to the inelasticity of demand for domestic items, we can see that economic growth does not happen, and jobs will not be created.

In response to the inevitable economic recession that is projected to happen, we decided to buy companies that deal in gold and precious metals. The purchasing power of gold, unlike currencies, stays relatively the same for a long time, while currencies, such as the US dollar, tend to fluctuate and are at risk of currency devaluation. Therefore, gold is frequently used as a hedge or a safe haven during trade wars as their value tends to remain stable and likely rise during deliberate currency drops, it is good to invest in companies that deal with gold, as their values will likely rise.

Fig. 1 Price fluctuation of gold during economic recessions in the past 35 years in comparison to S&P 500 price fluctuations

Fig. 2 Graph of Fig. 1 with trendline

            As seen in Fig. 2, gold prices tend to rise the more the economy falls (as seen in the trendline). With only one instance of gold falling during an economic recession, it is a safe bet to target companies that deal with gold.

Our selected Portfolio:

 

 

 

 

 

 

 

 

 

While strategizing for the investment strategy, we specially kept in mind the need and importance of a diversified portfolio. As mentioned above, the global economy is going through a tough period and as per our consideration, the situation may get little tougher with coming years. With such fear of sluggish economy and high probability of recession, keeping all the fund in one company or sector was not advisable.

8.75% of our total fund would be allocated to consumer discretionary. As per our analysis and research, this particular sector has always performed well as compared to other sectors during recessions as even in tough time, people won’t probably stop using the products and services of consumer discretionary sector. Our selected stock in this sector is “New oriental education & technology group INC” which is a online provider of education in China.

The largest pie of our fund would be invested in the financial services sector. After thorough analysis and researching the past trends, we came into conclusion that there are few types of the companies in financial sector which performs at par even in sluggish time. Such companies may include credit analysts, private equity and alternative investment firm. Moreover, as our client is a tech savy and in greatly inclined towards tech startups, we picked Fair Isaac Corporation, Experian PLC, and KKR & Co. Inc. from financial services sector.

Fair Isaac is a data analytics company, focused on credit scoring services. Its FICO score, a measure of consumer credit risk, has become a fixture of consumer lending in the United States. Experian PLC is aconsumer credit reporting company; it collects and aggregates information on over one billion people and businesses including 235 million individual U.S. consumers and more than 25 million U.S. The last but not least, KKR & Co. is an American global investment firm that manages multiple alternative asset classes, including private equity, energy, infrastructure, real estate, credit, and, through its strategic partners, hedge funds.

Our third sector was healthcare, from which we selected Myriad Genetics which is a leading molecular diagnostic company dedicated to saving and improving lives by discovering and delivering tests across major diseases. We believe that in future, the combination of tech, data and health will progress greatly. We allocated 12.5% of our fund in this stock.

To diversify our portfolio and to hedge even the systematic risk of the market, we decided to invest a big chunk of our fund, 23.12%, in material and processing sector. Whenever people are skeptical and fear that the recession is coming, they turn towards safe haven investments like material precisely gold, silver and other precious stones. Royal Gold is a precious metals company with royalty claims on gold, silver, copper, lead and zinc at mines in over 20 countries. SSR Mining Inc. is a Vancouver-based mining company focused on the operation, development, exploration and acquisition of precious metal projects.

24% of our fund would be invested in tech sector. The future belong to the companies which are acknowledging the importance of technology and aligning their operations and strategies with the evolving era. We carefully assessed the tech sector and picked three companies which we believe will perform very well in future. Hexaware Technologies Limited is an IT and business process outsourcing service provider company based in India, founded in 1990. Mindtree Limited is an Indian multinational IT and outsourcing company headquartered in Bangalore, India and New Jersey, USA.NIIT Technologies Limited is a leading global IT solutions organization with over 10,000 employees serving clients across Americas, Europe, Asia, and Australia. With selecting these companies, we also diversified our portfolio geographically as two out of three companies have their head offices in India.

Key Considerations:

Following are the key considerations which we kept in our mind while making out the strategy and picking up the stocks.

  • Diversification, as we envisage and fear sluggish economy or even a recession in future.
  • Client’s preferences such as 20% of the fund in short term liquid assets so that she can get some monthly or yearly income.
  • Long term perspective, as the client wants to fund the education of her kids and plan her retirement from this fund, we have specially picked growth stocks which may not be able to give great returns right now but would be very fruitful in future.

Analyzing the Client’s Needs

Furthermore, our client, Ms. ReshmaSohoni expressed that she’d like her portfolio to reflect her long-term investment goals: education, retirement, and larger contributions to society. She also indicated a deep interest in technology and business. Upon closer inspection, it was apparent that she revealed multiple times in her social media account, namely Twitter, that she’s also interested in financial technology and the environment. In accordance, we targeted these industries and executed fundamental and technical analyses to narrow down our candidates.

In particular, Ms. Sohoni seemed to have great interest for Financial Technology (Fintech), according to her Twitter account. 

Exhibits 1~4  (ordered chronologically from most recent), examples of client’s interest in Fintech

Also, because Ms. Sohoni seemed like she knew much about Fintech, we believed that it would be better to invest in, for high liquidity short term stocks, the Fintech sector. Therefore, we decided that to suit her interests, we would invest money into high liquidity stocks (to suit one of her stated needs) in the Fintech sector such as ICICI Bank and Mr. Cooper Group INC. 

As we expected, the two companies we decided to invest in as our short-term showed increase in value. For the short term stocks, we used technical analysis to predict whether they are highly liquid and whether they would bring profit. ICICI showed a 16.6 % return while Mr. Cooper Group INC showed a 5.60 % return. 

 

 

Decision Making:

(https://docs.google.com/spreadsheets/d/15K59l_F5wZMT9MnonmWouGqWk-2YzGgCNoPPTotpkgM/edit#gid=334093795)

Mention d specifics (itz on the sheet above)

            Team Dynamics:

One of the many challenges our team faced when working as a team was communication. Because some of our members were busy with SATs while some were busy with schoolwork, it was really hard to schedule a meeting where all the members were available.  We were able to overcome such challenge by maximizing the number of meetings with members that were available at that time and later on informing the members who couldn’t attend the meeting with what we went over during the meeting. Also when the majority of the members didn’t have enough time to meet physically, we communicated through skype. We divided the tasks into three sections : Portfolio manager, Stock managers and Client . There were two portfolio managers and they decided the overall strategy for our investment and decided the portion of money for each company to be invested on. The two stock managers researched the stocks and decided the stocks to invest in that met the portfolio managers’ requirements. They also managed the OTIS, looking at the progress and making changes when needed. The last section, Client, had one person connect the two sections to the client of the competition. We decided the roles by having those who have strength in fundamental analysis to be the portfolio managers, those who have strengths in technical analysis and research to be our stock managers and lastly to those who clearly know the client’s background to work on the client section. All 3 sections require advanced researching skills and stock analysis skills which all our members excelled in.  During the competition, we didn’t really have disagreements. We trusted each other sections to do their jobs properly and helped each other if others made a mistake or needed help with anything.

Industry Ethics

As we planned and carried out our strategy for our client Ms. Sohoni, we made sure that we operated by the CFA Institute’s Asset Manager Code. Our decisions were made entirely based on our client’s interests as well as our well-planned strategy based on detailed research and well-founded predictions of the market and economy. 

Our research was mainly based on current news, which we then researched deeper to find out the impacts it has on the economy. Through his process, we were able to develop a reasonable and adequate strategy. As for our client research, we mainly branched off of the case study. To further our knowledge about our client and her investment objectives, we took a look at her social media account (Twitter) to get an idea of what other values she holds.

            Our client expressed numerous times through both the case study as well as her personal social media account of what we should invest in. In her case study, she stated she’s interested in education, retirement, large contributions to society, business, and technology, while in her social media, she revealed her interests in financial technology and the environment. 

            We first put our client’s interests before our strategy. We selected stocks that would best fit her interests such as Hexaware Technologies Ltd and New Oriental Education & Technology Group Inc.

            As we moved onto stocks that would fit our strategy, we still kept the client’s interests in mind. During meetings, we discussed whether or not the stocks we chose would support her interests and be applied to our strategy at the same time.

            By complying with the Asset Manager Code, we were able to uphold our most important values: always putting our clients first and developing reasonable and effective strategies that best suit the clients. 

Takeaways

            From this competition, our team learned how the whole investment process works as well as learning new stocks and companies through researching what stocks to invest in. We also learned how to do fundamental analysis and technical analysis on stocks as these two were the main methods for our team to decide on what stocks to invest in. Obviously our team would have not invested in some stocks and invested in others in hindsight as we now know if they will increase or decrease. However, other than that, I think our team would have done the same thing when deciding our investment strategies because our investment strategy was both tailored to the current events affecting the global economy and the personal preferences of the client. The competition was more difficult than our team imagined because none of the members had experience with investing. We had to start from the very beginning, where we learned what fundamental and technical analysis were and watched a movie that had a content of investing to know more about investment. Our team enjoyed this competition as this competition was such a new experience for each of us. Also seeing the result of our investment and our stocks in OTIS go up and down really was really entertaining . The fact that OTIS was based on real life, as the increase and decrease of stocks were legit, it made the whole competition more realistic, making it more interesting.

 

 

COST OF CAPITAL – VOSSLOH

Pages:8

COST OF CAPITAL - VOSSLOH

 

 

  1. How can the business activity of the company be best described? Is the market risk implied by these business activities expected to be above or below average?

Business Activity:

Vossloh is a global firm which operates in around 20 countries and primarily deals with products and services pertaining to railway infrastructure. The products of Vossloh include track fastening systems, concrete ties, switch systems and the innovative services associated with the life cycle of rail tracks. With over 30 production sites, Vossloh segregates itself into four basic divisions.

  • Core Components: This division of Vossloh manufactures standard and common products for railway infrastructures on an industrial level. The products of this division include railway fasting, screw-fastened and maintenance-free elastic systems which are applicable and required for all kind of railway tracks ballasted and slab tracks, mainline and conventional lines, high-speed lines, heavy haul and local transport.
  • Customized Modules: This division manufactures products which are customized to different clientele needs. Products of this division includes turnouts and crossings, manganese frogs, switch blade, switch actuators and locking devices, signaling products and rail monitoring systems; such products are unique and different for every other project.
  • Lifecycle Management: This divisions incorporates providing railway track services in order to increase the life of the tracks and keep them well maintained. Services of this division includes welding and transportation of long rails, the corrective milling and the preventative care of tracks and switches and reconditioning and recycling of old rails.

 

 

Market risk of “Vossloh”:

Market risk is the uncertainty which arises from external factors and which impact the whole financial system as a whole, also known as “Systematic Risk”. Market risk includes events and incidents like recessions, political turmoil, changes in interest rates, natural disasters and terrorist attacks etc.

Vossloh’s market exposure and risk are above average as compared to firms operating in other sectors for the following reasons:

  • Companies operating in infrastructure industry highly depends on the performance of governments of countries where they operate. Government only invests in infrastructure projects when they have budget surplus or enough room from lending so to invest in projects like railways which are not considered as important as providing the basic necessities like food, education, and health. So a recession, regional or global, can really hamper the business and financial performance of Vossloh.
  • The other external factor which can impact negatively the financials of Vossloh is increment in the interest rate. Operating in construction and infrastructure industry, sometimes require accumulating huge debts, which can result in higher finance cost. Vossloh’s net interest expense increased from £12.5 million in 2017 to £13.4 million in 2018 which tells that Vossloh has a significant amount of debt in its balance sheet and any hike in interest rate can shrink the net profit. However, this risk can be mitigated as Vossloh enjoys a fine reputation in the industry which can result in negotiated, better and fixed markup rate.
  • As Vossloh operates in 20 different countries and has supplied its products to more than 65 countries, fluctuations in foreign exchange rates can also impact the final profits if not hedged properly.

Above mentioned aspects show that the market exposure of Vossloh is slightly higher than the average but as with higher risks come higher profits, Vossloh has been mitigating such risks pretty well since its inception and we expect the same to continue. (Vossloh , 2018)

  1. What is the cost of debt of the company? Describe the critical issues you are facingand propose a well-founded solution.

Cost of Debt of Vossloh:

Total Outstanding Debt:

Net Interest Paid:

Source: Vossloh Annual Report 2018

The cost of debt of Vossloh should be (14.9/267.9 = 0.055), 5.5%.

Issues in calculating cost of debt:

One issue we faced in calculating the cost of debt of Vossloh is that Vossloh hasn’t provided the breakdown of its “Other interest expense” so we can’t be so sure that this amount only includes interest paid for its debt as companies also tend to pay interest on its outstanding account payables and other trade debts. In order to deal with this issue, we will add a caveat regarding this. However, this issue is not severe as the probable amount of interest paid for trade debts are not usually so high.

So, the cost of debt of Vossloh is 5.5%.

 

  1. What is the cost of equity of the company? Please identify a Beta-factor based onyour own calculations. For that purpose collect the appropriate stock quotes (e.g. onariva.de) and explain your approach. Moreover, discuss the problems in identifyingthe risk-free rate and the market risk premium and explain your solution.

Cost of Equity:

In order to calculate the cost of equity, we will take a step by step approach, which is the following:

Step 1: Calculate the risk free rate:

We are taking the rate of USA Treasury Bill – 10 years as our risk free rate which is currently 2.21%. (Source: US Department of Treasury)

A risk free rate is one which guarantees a certain rate of return and doesn’t have any uncertainty. US Treasury Bill – 10 Year offers the qualities of risk free rate as it is free from all kinds of risks including default risk, liquidity risk, and time horizon risk.

Step 2: Calculate the Beta.
In order to calculate the beta, we need to extract the closing stock price of Vossloh and the closing index value of the stock market where Vossloh trades. The data should at least be of last 4 years as having data of a shorter span may not truly portray the risk of the stock as it might not be enough to take into account all the ups and downs the company has went through.

After collecting the data, we will use the following formula to calculate the beta.

With the above mentioned formula, the beta of Vossloh is calculated as 0.50. We took the data from December 2015 to December 2019.

Step 3: Calculate the market premium.

Market premium is the extra return Xetra has provided over the risk free rate.Xetra’s last 1 year return has been taken as taking a return of longer horizon, i.e. 10 years, may take into account financial crisis period of 2008/09 which may distort the return the market has provided recently. Also, as per industry practices, market premium should reflect the current scenario rather than historical years.

Step 4: Using the equation of CAPM to calculate cost of equity:

CAPM equation is, Cost of equity = risk free rate + (Beta*Market Premium)

CE of Vossloh = 2.21% + (0.50 * 22%) = 13.21%

So, the cost of equity of Vossloh as per the CAPM model is 13.21%.

 

  1. How do you determine the weight of equity and the weight of debt? Again, describethe problems you are facing and propose a solution.

Weightages:

In order to calculate the weight of equity and debt, we first need to determine the total amount of funding Vossloh has acquired in form of both, debt and equity. After calculating the amount, we will calculate the share and weightage of each, debt and equity, in that amount.

Total Funding:

Hence, the total amount of funding for Vossloh is 512.5+267.9 = £780.4 million

Weightage of debt:

= 267.9/780.4 = 0.343

Weightage of Equity:

= 512.5/780.4 = 0.656

  1. What is the WACC of the company? Discuss your result in terms of robustness andreliability.

WACC of Vossloh:

WACC = (13.21% * 0.656) + (5.5% * 0.343 * (1-0.15))

WACC = 10.26%

As per our calculations, the WACC of Vossloh is 10.26%. We believe this is accurate and reliable as we have extracted all the data from relevant sources and used methodologies which are used by professionals. 

Bibliography

Vossloh , 2018. Annual Report , s.l.: s.n.

 

    FEELING PANICKED ABOUT YOUR ASSIGNMENT?

    GET PROFESSIONAL HELP IN NO TIME

    GET YOUR PAPER NOW
    Our free essay samples can be used to generate ideas and to get aid in doing your reports. This service is for those students who are either busy or find difficulty writing reports.

    Menu Links

    USEFULL LINKS

    • Free Citation Generator
    • Free Online Plagiarism Checker
    • About Us
    • Privacy Policy
    • Acceptable Use Policy

    REACH US

    • +1 302 2022739
    • info@essaysupport.com
    • 23 Street, New York, NY 5500
    Facebook Twitter Instagram Youtube

    Copyright © Essay Support – All Rights Reserved 2020 — Designed by IT Daftar

    Crazy Offer!

    25% off

    on your first order

    ORDER NOW