Pack F - Mock Q's Flashcards
(20%) + (20%)
Hi,
The board has been doing some analysis on our import sales and analysing the countries where most of our sea cargo arrives from. It was noted that a large share of our cargo leaves ports located in
nearby Eastland. The Board of Directors has therefore decided that it would be a good time for Daistruk to invest in
building a new superwarehouse facility in Eastland. This would mean goods could be stored there until a ship load is ready, then we could charter a full ship load of goods, load it ourselves, ensure the
goods are well protected and loaded in such a way it’s easier to unload this end on allow onward travel to be much simpler. We could also charge local businesses in Eastland for storage and
warehouse management, not only for goods to be shipped by us but for other goods they may wish to keep there. It would be easier for them to pay us in their local currency, the E$. Considerable investment will be needed. Initial estimates are that around R$40 million (at today’s exchange rate) will be needed to build and set up the Warehouse within Eastland and make it operational. The superwarehouse will be much larger than any of our exiting warehouses. The
investment is expected to be loss-making for the first two years of operations but after that is expected to start generating profits. Given that this is the direct investment into a different country the Board of Directors are concerned
about potential currency risk.
- Firstly, could you explain the main types of currency risk that the company faces in
relation to the proposed investment in setting up the factory in Eastland?
[sub-task (a) = 20%] - Secondly, I know that the E$ (the currency of Eastland) has strengthened significantly against the R$ over the last 12 months. Please evaluate the impact on Daistruk if the E$ continues to strengthen against the R$ in the future after the investment has taken place?
[sub-task (b) = 20%]
Hi Rasim,
There are three types of currency risk: transation, economic and translation risk. All three types of risk will arise following our expansion into Eastland. The impact of each risk is dependent on whether the E$ strengthens or weakens against the R$.
Transaction risk is the gain or loss arising from the physical conversion of cash from one currency to another. Cash will need to be converted, most likely over a period of time, to fund the building work for the new warehouse - a total of R$40M. If the exchange rates move adversely before conversion this will increase the cost in R$. There is an expectation Daistruk will generate profits in E$ after 2 years, resulting in a cash surplus. Daistruk will presumably convert the cash surplus back to $R and remit the cash back to Roundland as this is where the head office and central accounting are based. If the exchange rate between E$ and R$ changes between now and the date the cash is converted, this is an example of transaction risk.
Translation risk is the gain/loss in the financial statements arising when translating the recording values of assets, liabilities, income and expenditure from E$ into R$ at the end of each accounting year. Any PPE, goodwill and trade receviables/payables will need to be translated from E$ into $R at year-end to produce Daistruk’s consolidated financial statements. This translation risk may result in theoretical gains or losses in the retained earnings as a result of exchange rate changes.
Economic risk is the long-term impact of exchange rate changes on the value of Daistruk. If the value of E$ changes significantly against R$ over time, this will adversely or favorably affect Daistruk as the changes will affect the value of income/expenditure, assets/liabilities in Eastland. If the long-term exchange rate is adverse (reducing value of E$ income and assets) Daistruk may need to increase price of its warehouse facility to compensate. This may be difficult because the key reason for investing is to be able to lower overall cost to the customer and make a smoother experience.
A strengthening of E$ against the R$ means each E$ will be convertible into a greater number of $R. E.g. if the exchange rate today is E$1=R$1 and in a years time it’s E$1=R$1.20 the E$ has strengthened as it is now worth R$0.2 more than it previously was. Vice versa, this would mean the R$ has weakened against the E$.
The impact of a strengthening E$ will mean each value of revenue will increase when it’s converted back to R$ and any assets (e.g. the warehouse and fittings) will also be of greater value in terms of $R. However, the strengthening will also lead to an increase in the value of costs (e.g. labour costs for warehouse staff) and liabilities in terms of R$.
For the first two years, the investment is expected to be loss making and we will also need to convert R$40M into E$ to undertake the investment. Therefore we will be adversely impacted in terms of translation, transaction and economic risk.
In 2 years’ time however (and presumably beyond that) the strenghtening of the E$ will be a favourable movement as we will get an increased value in terms of R$ for profit. If this continues to strengthen, any profits remitted back to Roundland will increase on conversion.
To conclude, if the E$ is strengthening, there will be an adverse effect as we will end up paying more than originally planned, and even more so if the E$ continues to strengthen throughout the investment timeline and first two years of operations. The value of any loss will increase when the E$ amounts are converted back into R$. Vice versa, after the first two years following a profit, we will be favorably impacted.
(30%) + (30%)
Hi,
As you know, at present, we operate solely within Roundland. The domestic market is very competitive, and it is difficult to grow our revenue substantially. We are a very ambitious board of
directors, and we are always looking for expansions into different countries to extend our logistics network and to diversify our risk, especially countries that are rapidly developing and are in need of
infrastructure improvements. Our aim would be to have a global network with subsidiary’s in as many different countries as possible – this will increase our global image and allow us to reach a wider pool
of customers.
Revenue will be generated in many different currencies. Future revenue and profits from overseas trading will be remitted to us in Roundland directly from the foreign countries at the end of each accounting period which will be submitted in their local currency. There will be an initial investment required to set up logistics networks in these new countries.
Daistruk has a central treasury management team who report directly to me. The treasury team manage cash flow within Daistruk and will use risk management techniques to reduce both currency and interest rate risk.
I am unhappy with the performance of the treasury management team; I believe they could do more. For example, especially with the planned overseas expansion. I need some guidance from you in relation to some of the areas that the treasury team will be focussing on. In particular, I need to consider currency risk management within the Daistruk group
assuming the expansion goes ahead, particularly if we are moving to countries outside of our geographical area, which we have less information about that those closer to home.
- Firstly, I would like you to prepare a briefing paper which discusses the types of currency risk Daistruk will face if the planned overseas expansions were to go ahead.
[sub-task (a) = 30%]
- Secondly, provide advice on how multilateral netting works and analyse the benefits to Daistruk of using this technique.
[sub-task (b) = 30%]
There are three types of currency risk: long-term economic risk, translation risk and transaction risk. Long-term economic risk is the impact of exchange rate changes on the present value of the cash flows of the company. Translation risk is the gain/loss arising in the financial statements when the results of overseas assets/liabilities are translated at the financial year-end. Transaction risk on the other hand is the short-term cash flow risk that arises when there is a timing delay between the transaction date and the subsequent settlement date of a physical settlement. All three types of currency risk will arise as we expand overseas, especially to countries where we are less familiar with the economic climate.
Long-term economic risk
As a result of expanding overseas, Daistruk will likely generate sales revenues and incur costs in many different currencies. Daistruk will remit the profit generated in each of these currencies back into R$ at the end of each accounting period. This means exchange rate movements will impact the long-term profitability of the company. A strengthening of the $R will likely reduce long-term profitability of the Daistruk group as this will reduce the value of profits generated by Daistruk group in other currencies. Vice versa, if the R$ was to weaken against another currency, e.g. D$, then the costs to Daistruk of operating and paying suppliers in D$ would increase. The long-term economic risk has upside potential when the $R weakens as this will increase the value of profits generated by the Daistruk group in other currencies.
Transaction risk
This is the short-term risk that the physical settlement of a receivable or payable from one currency to another is different than the value expected due to changes in the exchange rate. E.g. If Daistruk receives an invoice from a foreign company for the rental of warehousing this will be recorded in the ledger and converted into R$ using the transaction date’s spot rate. The exchange rate however will move between the recorded transaction date and date of payment (usually at the end of the payment period). If the $R was to weaken in this time period, Daistruk will now pay more than anticipated to settle the invoice.
Translation risk
As a result of expanding overseas, Daistruk will own many assets and liabilities in different countries. Daistruk will prepare financial statements to present the performance of Daistruk group as a whole in the reporting currency of R$. This means fluctuations in the exchange rate year on year will impact the value of assets/liabilities in the financial statements. For example, if the R$ was to weaken against another currency, D$, any assets/liabilities in the D$ currency will be of higher value and vice versa if the R$ was to strengthen.
b) Multilateral netting
Multilateral netting is an internal currency risk management ‘hedging’ technique. If the expansion goes ahead, Daistruk will have many more foreign currency transaction arising from the group during each accounting period. For example, a Daistruk subsidiary in country A could owe a large amount to Daistruk in Roundland, who in turn need to make a payment to a subsidiary in country B, all for recharges of transport services used intra-group. Multilateral netting can be used to settle these transactions whilst carrying out the minimal physical transactions required.
How it works
Instead of each subsidiary or region settling transactions with all other subsidiaries, all transactions between them within the Daistruk group are recorded through inter-country accounts on our ledger, reducing the number of physical transactions. Periodically, the net amount owing by, or to, each country is settled by a signal payment to or from Daistruk’s central treasury department. E.g. suppose Daistruk is organising the shipment of goods between different countries and there’s a need for the goods to travel through a number of countries where each Daistruk subsidiary takes care of the transport within that country. This would mean multiple transactions are created by the Daistruk subsidiary responsible for the shipment. If this happens with multiple journeys there would be a substanial number of transactions, so by using multilateral netting both sides of the transactions will be recorded in each of the subsidiary’s inter-company account. At the end of the accounting period, the inter-company transactions are netted off and the relevant subsidiary will pay the central treasury team any net-payable or receive settlement for any net-receivable, reducing the number of transactions.
The benefits of this is reduced transaction costs as less commission is paid on converting currency due to less transactions happening and only the singular transaction happening at the end of the accounting period. Another benefit is reduction of currency risk, Daistruk can choose when to settle net amounts owed to or by its subsidiaries. Therefore, Daistruk can take advantage of exchange rate movements and only convert from one currency to another when exchange rates are favourable. The only issue here is if exchange rates are not favourable it can delay conversion. However, these delays should not be an issue so long as it does not create cashflow issues for the individual subsidiaries.
(50%)
Hi,
As you know, we recently upgraded both of our ports to be fully automated. This automation has led to a need for greater rail capacity as we can now load rail waggons much quicker than we did before. For this reason, we are looking to purchase a new locomotive. The board believes this would be an ideal opportunity to also cut our carbon emissions as a company. We have identified locomotive manufacturing company based in a country called Loland. This company is of particular interest to us it recently started manufacturing locomotives that are powered by electric rather than traditional diesel power. The company also uses more sustainable materials in
the manufacturing of their locomotives and apparently, they are aiming to be carbon neutral in the next 5 years. The main issue is Loland is based much further afield that we would usually trade with and as such is somewhat unknow to us. We expect to have to spend a significant amount to acquire this new “greener” locomotive. The cost will be denominated in L$ - the currency of Loland. We will have to make payment for the locomotive in their local currency. The exchange rate between the Roundland dollar and the Loland dollar (L$, the currency of Loland) is, however, very volatile, and we are concerned about the additional currency transaction risk that will arise because of the potential exchange rate movement before cash is converted from the Roundland dollar to the Loland dollar to make the payment. I need your advice:
- Firstly, can you respond by email, evaluating the main external techniques that can be used to manage our exposure to the additional currency transaction risk that may arise?
Forward contract
The simplest way to manage transaction risk is a forward contract. This is a binding agreement to convert an amount from one currency into another on a certain future date and at a rate agreed today. The contract fixes the rate at which the amount in one currency (R$) is converted into L$. The forward contract transfers currency transaction risk as it protects Daistruk from any exchange rate movements.
Forward contract - benefits and drawbacks
Forward contracts are easy to set up as they can be purchased from most banks and have low transaction costs. The forward contract requested can be tailored in terms of the value required and the date of conversion. A contract could be set up to convert a specific amount to L$ from R$ at an agreed time in the future, depending on our payment terms with the new supplier. Whilst the contract protects from exchange rate movements, the only downside is Daistruk could not take advantage of any favourable movements.
Money market hedge
A money market hedge involves borrowing money in one currency and depositing money in another. For example, a loan could be taken out today in R$ and the cash converted into $L and transferred to a Loland bank account, the exchange rate known as today’s date. This money is kept on deposit, accruing interest until the payment is required to be made. The R$ loan will also have been accruing interest, this is then repaid at the time of making the payment to the supplier.
Money market hedge - benefits and drawbacks
The aim of this technique is to allow money to be converted immediately instead of in the future. As a result, the money is converted at a known exchange rate and hence currency risk is avoided. Like a forward contract, the result of the hedge is to fix the rate at which one currency is converted into another. Therefore, the benefits/drawbacks are very much the same as a forward contract and Daistruk cannot benefit from favourable movements in the exchange rate. However, money market hedges have the additional drawback of being more complex to organise. On the other hand, greater flexibility is granted to money market hedges as there is no agreed specific date for the transaction, so this can be shortened or lengthened.
Futures
Currency futures are similar to forward contracts in the sense they allow us to buy a required amount of foreign currency at a given future date using an agreed forward rate. The major difference being currency futures are standardised market-traded contracts for fixed amounts of money on a limited range of future settlement dates which removes the tailor-made aspect of forward contracts. Futures contracts can be used at any time up to a formal settlement date whereas forwards can only be used on one particular date. Futures are derivative contracts which allows them to be traded on future exchanges. The futures contract which guarantees the rate is separated from the transaction itself, allowing the contracts to be easily traded.
Futures - benefits and drawbacks
As our initial margin (deposit paid to exchange) is returned when the position is closed out, there are no transaction costs with currency futures, making them very cheap and simple yet effective in protecting from exchange risk. The drawback being we cannot tailor the future to meet our needs and can only purchase the fixed amounts available to be settled in specific quarterly cycles. This means we will be unlikely to protect the whole purchase value from currency exchange risk.
Options
A currency option gives the holder the right to convert from one currency to another at an agreed forward rate but without any obligation to do so. Currency options offer flexibility in terms of strike price, periods, premiums etc. At the end of the contract period we can either carry out the exchange at the agreed forward rate or let the option lapse if the rate is no longer beneficial to Daistruk. This means we can protect ourselves from adverse movements but at the same time benefit from favourable movements.
Currency options - benefits and drawbacks
The biggest advantage is protection from downside risk whilst maintaining potential upside risk as we are not obliged to proceed with the purchase should we decide it is not favourable to do so. The major drawback of this however is these are more expensive than forward contracts, money market hedges or future contracts. This is due to high up-front premiums to help cover the market’s risk as Daistruk will only exercise the option to protect against worst-case scenario adverse movements. The premium is payable in advance and must be paid irrespective of whether the option is utilised.
(40%)
Hi,
As you are aware, Daistruk has debt finance - some R$280 million per the latest accounts. We have, in the recent past taken further debt, (R$260 up to R$280). We’ve chosen just to make the interest payments on the debt, as we wanted to ensure we had short-term liquidity in the business. Daistruk pays a variable rate of interest on debt finance. Interest rates have been consistently low in the recent past and Daistruk has taken advantage of this by increasing its borrowing. Although they have started to rise a little lately. I am concerned about the impact that a rise in interest rates would have on our profitability, as well as
our interest cover. This has been heightened by reading a copy of the financial section in today’s Roundland Telegraph, I have attached the article to substantiate my concerns. We must consider how we could hedge this potential rise in interest rates. One possible way of hedging would be to enter into an interest rate swap. Our bank has indicated that they would be prepared to offer us a floating to fixed rate swap and they would charge an annual rate of 0.2% of the swap value for this arrangement.
- Can you advise of the benefits of entering into an interest rate swap with the bank and evaluate any risks of entering into such an agreement.
Roundland Telegraph:
The recent past has been good to borrowers - interest rates have been low and so, the low cost of borrowing has been enjoyed by businesses and individuals alike. But at what cost? Cheap borrowing means it is easier to spend
cash on those things you may not be able to afford in more austerity driven times - the exotic holidays, flash cars and careless
spending. As we can see from the illustrations, this cheap borrowing has been forcing prices up. We must face up to it and say hello to our old friend inflation once again! What will the Roundland government do about this steady increase in the price level? If
Roundland’s usual monetary policy is anything to go by, interest rates will no doubt be reviewed and will therefore start to increase again. In the past the increases have been small, but with inflation looking even more bullish, don’t
rule out a big rise in interest rates in late 2023 and beyond - good news at least for the savers out there! Every cloud does have a silver lining after all!
Benefits of entering into an interest rate swap
An interest rate swap with the bank will involve the bank paying a floating rate of interest to Daistruk and Daistruk paying a fixed rate of interest to the bank. This will allow Daistruk to convert our current floating rate of interest into a fixed rate of interest. By converting Daistruk’s debt from a floating rate to a fixed rate, this will avoid Daistruk being exposed to rising interest rates. If the interest rates rise, Daistruk can generate higher profit margins than competitors who are paying a floating rate of interest if the fixed rate is lower than the floating rate.
We could repay our existing debt which carries a floating rate of interest and raise new funds with a fixed rate of interest to replace these borrowings. However, converting our interest from floating to fixed by means of an interest rate swap is a cheaper and easier method than repaying our existing debt and raising funds with a fixed rate of interest. This way, we will avoid any significant early repayment penalties. We will also avoid the issue costs associated with raising new debt finance, e.g. underwriting fees to pay to a bank, by entering into an interest rate swap.
By swapping to a fixed rate of interest, Daistruk will be able to better predict cash flows as there’s greater certainty and predictability of cash payments. This may allow Daistruk to operate at lower average cash balances and optimise working capital, as buffer cash won’t be needed to cover potential rises in interest rates. Despite cash balance of Daistruk being relatively healthy currently, this could reduce very quickly if we don’t keep up with competitors and begin to lose market share.
Risks of entering into an interest rate swap
The bank charges additional interest for the swap arrangement (0.2%). There is a risk it may be cheaper for Daistruk to borrow directly at a floating rate compared to the interest payable if it enters an interest rate swap. We should carry out what-if analysis to predict what will be the most cost effective solution to lower interest payable. Whilst we can’t tell the future, this analysis should give us strong indication for the pathway of interest rates and therefore the best decision for Daistruk.
The swap is a derivative instrument and needs to be accounted for in accordance with the IFRS standards for financial instruments. Hedge accounting rules may apply. There is a risk that the financial statements do not correctly show the true financial position after entering into the interest rate swap. We should therefore ensure we are well acquainted with the accounting treatment and seek clarity from a third-party if necessary to ensure we account for the interest rate swap correctly in the financial statements.
Conclusion
The biggest drawback of the interest rate swap is that interest rates may not rise in the future and Daistruk are worse off from entering the agreement due to the 0.2% higher interest rates paid. If the interest rates were to fall, Daistruk would still not be able to take advantage of this as the swap will be a binding financial instrument. Whilst there can be significant benefits, we must be thorough with analysis and deduce that it’s most probable the interest rates will rise and remain above the fixed rate of interest we could swap to for the duration of the agreement. Otherwise, the interest rate swap would not be cost effective.
(50%)
Hello,
As you know we are always on the lookout for investment opportunities, not least in order to keep up with our competitors and gain any advantage we can over them in this competitive marketplace and
investments that allow us to expand the quality of our offering to the client to keep us ahead of the competition. Please see the attached article from the Roundland Telegraph which has caught our eye. We are always keen to improve and add services to our portfolio and until now the “last mile” delivery sector has also been tricky for us to crack. We have found it difficult to be able to provide an economic and effective service and so have tended to stay away from this area of logistics. Not only does Motolivery specialise in this area, it has done so by also being very green in the use of e-vehicles. This will help us hit our net zero target in the coming years. We can foresee a situation where we can combine Motolivery with our exiting hubs and be able to roll out to the whole country very quickly. We need to act fast, and the board has decided that the best course of action would be to put in a bid to acquire Motolivery. We need to be aware that other companies will also be looking at Motolivery, not least Carree Group. We believe that if a satisfactory price is reached Mr Harris would be willing to sell his majority stake in
Motolivery, granting us control of the company.
- Recommend, with reasons, the approach that we should take when valuing Motolivery
The Motolivery founder Jimmy Harris has found himself in hot water over a series of fraud allegations. The allegations date back to early 2019 where the founder is understood to have lost a significant
amount of his wealth when some deals on cryptocurrency went sour. Since then, it is rumored that he has been using the company to support his lifestyle by trying to conceal a number of personal
transactions and pass them off as business related expenses. Motolivery was founded by Mr Harris in 2001 and has been a very successful company, particularly in providing effective and efficient “last mile” delivery solutions. They have a fleet of specially developed
e-vehicles that are not only environmentally friendly, but also incorporate sophisticated route planers
that instantly update routes for efficiency and speed to suit traffic and weather conditions. They currently operate mainly in the major southern cities of Roundland. There were expanding further north
in the country, but this seems to have slowed down in the past 2 years. It is rumored that Mr Harris is looking to offload his majority shareholding in Motolivery to fund the repayment of debts and also to pre-empt his likely director disqualification. Any company looking to acquire the trading assets and intellectual property of Motolivery will be getting a well-recognised brand, that, despite a recent slowdown, is still very well thought of in the market and has led the way in short-distance delivery in the south for the past 5 years. Motolivery still continue to employ some of the most talented innovators, who are always developing the vehicles and mapping technology, but it appears that they have not been given the necessary resources and creative freedoms to carry on that development in the past 2 years. The future of Motolivery, and that of Mr Harris, remain very uncertain, but one thing is for sure, with the recent drive for more environmentally friendly solutions and increased reliability, Motolivery may
well be worth a punt by one of the large courier or logistics companies.
A good start would be valuing Motolivery’s assets. Asset valuations generally undervalue companies, however it is useful to know roughly how much the assets are worth. Mr Harris will not accept an offer less than the asset valuation, as he could break up the company for more. The key assets will be any land/buildings of their head office/manufacturing plant, any motor vehicles, any capitalised development costs, any intellectual property rights relating to existing products such as the e-vehicles and mapping software and brand values.
A significant proportion of the assets of Motolivery will be intangible assets. A difficulty with this is that they are difficult to value and some intangible assets, such as the brand, will not be on the balance sheet of Motolivery as they don’t meet the recognition criteria. It would be advisable to carry out some due diligence on the identifiable assets prior to purchase in order to check the carrying amount is a true representation of their actual value and they have not been impaired too much due to poor performance over the past 2 years. Any detriment in value should be factored into any offer price.
We are likely to be able to generate a higher return on the assets than they are currently achieving, as they have been less innovative over the past 2 years and the return is likely to have dropped. On the other hand we have been performing very well over the same period. Therefore, the book value of the assets will not give a realistic view of the value of the company from either side. Especially considering we will be able to instantly expand the business to cover the whole country, not just the southern cities.
Current earnings based valuation
It is possible to value a company by multiplying the current earnings by a suitable price/earnings (P/E) ratio. For this method to provide a meaningful valuation it is necessary to use the P/E ratio of a similar quoted company to the company being valued, and we need to assume that the current earnings are normal, maintainable earnings or we need to adjust the current earnings. This may prove difficult given Motolivery appears to be a ‘unique’ company specialising in e-vehicles providing last mile deliver solutions and therefore there may not be a similar quoted company. In addition, because of the 2 years of underperformance the company may be loss-making and, if so, there will not be a current earnings figure to apply a P/E ratio to.
Future free cashflow
An alternative approach would be to forecast the future free cashflows expected to be generated by Motolivery and discount using a suitable cost of capital or cost of equity (if free cash flow) or cost of equity (if free cash flow to equity). The cashflow forecasts could be based on the business plan of Motolivery, but we could also use specialists to forecast the likely growth in demand for e-vehicles that incorporate sophisticated route planners. The cost of equity used to discount could be based on the existing beta of 1.27 of Daistruk if we assume that the systematic risk of Motolivery will be similar to Daistruk.
We have an advantage over other possible acquirers, as we already have country wide coverage and 35 warehouses all over Roundland which will be able to act as local delivery hubs and thus increase the network over which Motolivery can operate. Using this to aid predictions of sales volumes, we should be able to place a reliable value on Motolivery.
The value of Motolivery could also be determined by looking at the value added to our organisation. By acquiring Motolivery we will have first access to innovative e-vehicles and mapping software and perhaps be able to reinvigorate staff and allow them to continue their innovation to further improve the performance of vehicles and maps. Bringing the delivery service in line with our brand name and image will further enhance their value as we are a well-respected company in Roundland. We could look at potentially doing an NPV calculation of the benefit and basing a value on that.
Negotiation
We may well come to a valuation we are happy with, but ultimately the price will be determined by negotiation and there is no correct answer. Mr Harris is likely to pressure us into paying more than market value of Motolivery’s earnings. We therefore should consider this possibility and have an upper limit that reflects the total perceived value that Motolivery will bring to Roundland before entering into any negotiation.
Motives of Daistruk
For Daistruk, bringing this innovation will enhance our brand, increase our revenue (both from direct deliveries straight to the customer and also by bringing in more retailers and widening our customer base). We could pitch for business now that focus more on quick home delivery, say fashion, this will open us up to a whole new sector of the market. This will create a premium of its own, as well as expanding the customer base, that we should consider when deciding the maximum value of Motolivery to Daistruk.
Motives of Mr Harris
On the other hand, Mr Harris has motive for a quick and easy sale. He knows the net is closing in and may need to cash-in while he still can. However, he will know that there will be much interest in the company from many different parties and may try to play these parties against one another to achieve a higher price. For this reason, we must be firm with the maximum we are willing to pay and not be lured into a bidding war in which we overpay for the company.
(35%)
Hello,
I have recently commissioned an analyst to produce a report looking into specialising solely into supermarket clients. As you know Muddocks supermarkets is one of our largest clients in terms of revenue and I am of the option if we were to just specialise in logistics for supermarkets we could become more efficient in our operations and thus be able to generate higher margins and profits on our services. By creating this specialism, we could adopt our warehouses and delivery network to
offer much improved services to the supermarket sector and become the 3PL supplier of choice to all the supermarkets in Roundland. The main summary from the report, which looked at similar companies who have focused on a
speciality, are listed below:
- Specialism creates a more efficient offering as we can adopt our network to suit individual needs of supermarkets -
this will generally create an economy of scale, bringing down costs and thus increasing profits. - Companies are more exposed to systematic risk when they expose themselves heavily to a single industry or segment of the market. We estimate that Daistruk’s beta would rise by 10-20%.
- Firstly, I need you to draft a response that explains the relevance to the board of the findings above - namely that this specialism will increase profits and beta.
Increasing Profits
Increasing profits will increase future net operating cash flows. Those profits will be generated from being able to reduce our cost base, but also by increasing our market share potentially with Muddocks and other major supermarkets in Roundland. The analyst seems to be implying we can use economies of scale to reduce costs, by specialising solely on supermarkets we get to know the needs and wants of those clients and can develop a system to suit these, in so doing reduce our overall cost base. There may be a short-term cost increase as systems are changed and realigned, but once in place the saving would outweigh that. To be able to guarantee more profit is made, we need to ensure a higher margin is generated on these sales than is currently being made.
Increased cashflow
Increased cashflows will make it possible to pay more dividends. Shareholders also evaluate the performance of the board in terms of profitability, this will create upward pressure on the share price when the decision to move into this more profitable sector becomes known.
Potential issues
The above assumes the analysts’ predictions are correct. We may need to do further analysis to assess the opportunity cost of lost revenue and profits from our other sectors that we currently serve. It is possible that we can generate much better margins of some of the other work we do, for example movement of specialised loads is something that we currently offer and may generate a much better return, although volume may be lower. The findings of this analysis will determine if in fact this is the best way to grow our profits.
Increased beta
The increased beta implies that our volatility with respect to the stock market will increase. The beta is currently 1.27 which means the stock is more volatile than the market average and considered a riskier part of an investment portfolio. An increase in beta will make this even riskier and will lead to downward pressure on our share price.
Investors have come to invest in us for the perceived level of risk at 1.27. Increasing the risk factor will drive some investors away, hence a sell in shares and drop in the share price. New investors are unlikely to be attracted straight away, as most will take a ‘wait and see’ approach to assess if specialism will prove fruitful.
The increased beta will increase the cost of equity, as shareholders will now demand a higher return to compensate for the higher risk they are taking on. A higher cost of equity may discourage the board from seeking additional equity for expansion. The additional risk may not be a problem at all, as the enhanced future cash flows and the increased beta will be pushing the share price in opposite directions (enhanced cash flows increasing share price and increased beta decreasing share price).
(60%)
Hello,
In the past we have relied on a mixture of debt and equity finance to fund our business. Borrowings are currently R$280 million which gives us a debt/equity above the industry average. Despite this, the
Board of Directors are not overly concerned by this borrowing level and state that interest cover has never been an issue for us. They therefore believe that there is scope for us to raise further debt finance should we choose to do so.
I’m aware that there are certain risks relating to raising debt finance, with our creditworthiness as a company being one of those. I’m also aware that our creditworthiness has an impact on the credit rating we are given by the major credit rating agencies, and that the credit rating will have an impact of the interest rate that we would need to pay on any new borrowings. I would therefore like to understand more about creditworthiness and the factors that credit rating agencies and investors take into account when they assess the creditworthiness of prospective borrowers. If we had to pay a high rate of interest on new borrowings this may significantly affect future profit margins.
- Advise on what factors are important to lenders when they assess the creditworthiness of prospective borrowers of new finance such as ourselves?
Business Plan
To apply for new debt finance, such as borrowings from a bank, Daistruk would usually have to put together a business plan. This will contain important information such as how much we’d like to borrow and for what duration. Daistruk will need to detail their intended use of the funds borrowed e.g. to upgrade the transport fleet. We will need to provide detailed future profit and cash flow forecasts, showing likely cash flows, whether a future cash flow surplus or deficit is expected and if repayment of the loan is possible. The quality of this business plan will be considered by lenders.
Realistic assumptions within the business plan
A lender would perform due diligence on the business plan. The lender would review assumptions the forecasts are based upon and assess whether these are realistic. E.g. if a business plan is presented by Daistruk and an assumption was revenue increasing by 25% each year the lender would consider this unrealistic given we ony had 9.9% growth in the past year and we operate in a competitive market.
Future business strategy and plans
Any planned investments/strategies should be included in the plan, e.g. if we plan to target growth overseas then the full implications on assets, liabilities, revenues and costs would need to be included. There would also need to be prudent prediction on exchange rate movements including within the forecast. The lenders would assess the suitability, feasibility and acceptability of these plans when assessing creditworthiness. E,g, if the plans included significant diversification away from Daistruk’s core competencies then this may adversely affect creditworthiness.
Financial analysis using ratios
The lender will perform a detailed analysis of Daistruk’s past financial statements. A key objective of the lender will be to assess our liquidity and financial risk: whether our cash flows will be sufficient to make the interest and repayments. The interest cover ratio will be important since it gives an idea of the likelihood we will continue to meet our interest payments even if profits fall. Our interest cover is currently 9.9 times (however our rival Carree has an interest cover of 18.3 times), which indicates Daistruk should be able to comfortably meet interest obligations.
Cash generation
A lender will also assess our ability to generate cash. Daistruk has a bank balance of R$32 million which is similar to the previous year and it has been able to pay a dividend of R$92 million. This indicates Daistruk is generating a good amount of cash each year from operations.
Current gearing
Daistruk’s current debt/(debt + equity) ratio is 39.5%, which appears to be around industry average given the Carree group ratio is 41%. This means if Daistruk were to raise new finance, for example R$100 million, its gearing level would increase beyond that of Carree. The gearing level must be kept in check at a level all stakeholders are comfortable with.
Quality of management
Lenders also consider skills, quality and experience of the senior management team. A strong, experienced and diverse board with a track record of success would increase creditworthiness. Most of Daistruk’s board are fairly recent appointments, and although they have a wide variety of skills and experience, there is not a great deal of logistics industry experience. This could be reason for concern as they may not have confidence that the financial side of the company is in good hands given a lack of commercial experience. This could be overcome by pointing to the recent success of the business.
Reducing risk
Daistruk may be considered high risk given the move to net zero and need for innovation to survive. If this is a concern, a lender can reduce risk thorugh a variety of methods. E.g. Debt covenants against the borrowing which could include the borrower not allowed to seek additional finance elsewhere, or keep gearing below a certain percentage. Securing lending on assets would also reduce risk and so the lender may look at Daistruk’s statement of financial position to assess whether our assets could provide security for lending. In terms of tangible assets, we have R$530 million of PPE vs borrowing of R$280 million, so there would be scope for security on future lending.
Conclusion
Daistruk has recent record of financial success, a good interest cover ratio and a good reputation. However, the only concern is the current gearing level, but it should be possible to convince lenders Daistruk is a creditworthy business based on past performance. Lenders are generally more concerned about the future than the past so we’ll need a detailed plan showing the continued expected success if we incorporate the new investments and strategies.
(60%)
Hello,
At yesterday’s board meeting we had an extensive discussion about raising finance for future investments. It was agreed that in order for Daistruk to continue driving our business forward, we need to invest in more projects and innovations. These projects may require a significant initial
investment. An opportunity has arisen for us to purchase our first cargo ship. In recent years it has become apparent that many of our customers are importing from the same country, Farland. As you know we work closely with shipping companies to organise cargo for our clients, but with the increased number
of imports coming from Farland we have long considered the idea of purchasing our own cargo ship. I have asked members of our treasury team to produce a NPV calculation to determine if purchasing our own cargo ship would be a worthwhile investment. After considering many factors including the
purchase price, the running costs and the potential fallout with our current cargo ship companies, the NPV returned a positive value. Based on this investment appraisal we believe the acquisition of our
own cargo ship would enhance shareholder wealth.
To proceed with this opportunity there is a need to raise a substantial amount of new finance. It was decided that we should look to raise R$75 million. This will be used to acquire the ship and fit it out
with the relevant fixtures to enable its use, particularly to make it compliant with our new fully automated container terminal. Various financing options were suggested at the board meeting where we discussed how we could raise the finance required. There was a lot of talk around the boardroom table with people speaking over one another, but in the end the board were torn between using cash held in the bank, a rights issue to our existing shareholders or an issue of 11% 10-year bonds. I need your advice:
- Please consider how should we raise the new finance? Please ensure you include an evaluation of the three alternatives suggested, an explanation of some of the factors to consider when raising new finance and a sound recommendation I can go back to the board with.
Rights issue - equity
A rights issue would give our current shareholders the right to purchase new shares in Daistruk in proportion with their existing shareholding, usually at a discount to the market value. This would increase our equity base by R$75M. It would also reduce our company gearing (debt/debt+equity) from 39.5% to 35.8%.
Share price used in the issue
When carrying out a rights issue, Daistruk need to consider what share price to issue to ensure there is a full take up. Once the share price is determined Daistruk can determine the terms of the issue such as the proportion of new shares allotted to shareholders. As well as short-term cost of rights issues, Daistruk must consider the long-term implication of serving the increased equity with dividends to ensure sustainable growth in shareholder wealth.
Deciding the appropriate price
The price will need to be less than the market price at the issue date otherwise shareholders have no incentive to take up their rights. Too small a discount will increase the risk of adverse movement in the share price that may cause the issue to fail. Too large a discount could discourage shareholders because of the psychological impact of the dilution to the share price even though the dilution should not affect shareholder wealth. Unfortunately our share price has fallen significantly in the last few months.
Issue of bonds - debt
This issue of bonds will increase Daistruk’s long-term debt by R$75M, increasing our gearing ratio from 39.5% to 45.3% potentially causing concern to current shareholders/lenders as there will be an increase in the perceived risk. This will also put Daistruk at a higher gearing ratio compared to rivals Carree, who have a ratio of 41%.
Cost of servicing bonds
The cost of servicing the bonds would be R$8.25M (75M*11%) of interest per year for the next 10 years, plus the need to repay the capital at the end of the period. This would drop our interest cover from 9.9 to 6.2 times. This is a move in the wrong direction and would reinforce the earlier point of shareholder concerns due to perceived risk. The advantage of debt finance over equity is that the cost of debt is tax deductible so the cost to the company would be 8.25M net of tax, whereas dividends are paid after tax.
Recent funding strategy
Daistruk should consider the recent funding strategy applied. The debt value has only just increased by R$20M in 2022 against 2021. Shareholders will be aware of this and may not want to accept further borrowing. The large dividend payout should also be taken into account as this used significant cash funds. A change in financing strategy will need to be carefully monitored from the shareholders point of view. An increase in debt may mean they start demanding a higher rate of return given a higher perceived risk.
Shareholder reaction to increased debt
Shareholders may have assumed the current level of debt is what we’re going to operate at, and may feel uncomfortable with any increased in, baring in mind the increased from prior year. An additional R$75M of debt finance would be an increase of 26.8% from 2022 borrowings. Some shareholders may be concerned the Daistruk’s board plan is to increase borrowings by this amount each year if new bonds were issued to finance this investment.
Use of cash held
Given we had R$32M at year end means we cannot fund this entirely from cash reserves but potentially partially. However, we need to ensure sufficient liquidity is kept to pay current liabilities. We have been maintaining a current ratio of 1.3 to 1.4 times and any depletion in cash reserves will adversely affect this ratio. Cash is also needed to fund day-to-day operations, so we would need a cashflow analysis to ensure we can still meet expected expenditure, including our investment to the new solution to not leave us in a cash deficit position. Other investments in the pipeline should also be considered as these may be more business critical or prioritised due to profitability.
Factors to consider - Cost of finance
The cost of equity issue arises as shareholders will expect dividends for their investment whilst lenders will require interest on their debt issue. The length we require finance for should also be considered as equity is only usually used when a long-term investment is required.
Factors to consider - Covenants
Daistruk may need to consider any existing covenants in place in relation to our current borrowing of R$280M. It’s possible we have agreed to restrict our gearing ratio, to say 50%, and this borrowing (increasing ratio to 45.3%) may want to be avoided as it reduces flexibility for borrowing in the future. It could also mean any losses leading to a reduction in equity may lead to a breach in covenant. If Daistruk is close to its borrowing limit, it would be necessary to seek equity to raise this finance.
Factors to consider - Cashflows
We must also consider any cash inflows from owning the cargo ship. These cash flows will be in the form of cost savings and potential revenue generation if the ships are used to import/export other goods that we don’t get involved in the Roundland logistics market with. This is likely to take some time before the cargo ship reaches capacity and can be fully utilised. For this reason, we must consider the timings of these cash inflows and the impact on our ability to repay.
Factors to consider - share price volatility
We must also consider how the company share price has shown a rapid rise since January 2021, despite now stabilising and falling off a little. The recent fall in share price will need to be considered when thinking about the shareholders attitude to further investment. The shareholders may be reluctant, however they have been rewarded with healthy dividends.
Recommendation
Assuming the interest on our existing borrowings and overdrafts is cheaper than the cost of raising new equity, I think the best approach would be to first review cashflow and assess the level of funds the business must hold to maintain liquidity. This will help us understand any surplus funds available to partially fund the investment as this will be the cheapest and quickest option.
If there are not surplus funds, or its cheaper to raise external finance, I recommend we raise the funding by increasing our debt borrowings. Although this will raise gearing and lower interest cover in the short-term, the expected inflows from cost savings and newfound autonomy to control our shipping, will have much greater future benefits to the company. The image of the company will also benefit from being seen as more global company willing to invest in large purchases of capital equipment.
(60%)
Hello,
I have just been having a chat with Professor Hongyu Liu, and something cropped up regarding Daistruk’s debt finance. Hongyu has been looking at our accounts and asked me about Daistruk’s gearing level. As you know, they have some experience of finance from their years in academia and in management science which included some financial modules (they loved CAPM – who doesn’t!), albeit a few years ago. They were questioning why our total amount of debt is not increasing at a more rapid rate. Hongyu’s Financial Strategy teachings always used to tell them that theoretically companies should increase gearing as much as possible. It doesn’t appear that the teachings considered the real-world problems of running a company!
- Please evaluate the main theoretical and practical advantages and disadvantages of using debt finance compared to equity finance.
Advantages of using debt finance
M&M assumptions and traditional view
This theory is based on some assumptions, such as perfect markets and no bankruptcy costs, which aren’t very likely to be replicated in the real world, even though Roundland has a very well-developed capital market. An analysis of real-world businesses (traditional view of gearing) still shows Daistruk could reduce its cost of capital by raising debt finance when it has low or moderate levels of gearing. The current gearing level of 39.5% seems broadly in line with the overall market, given the Carree group has 41% gearing. It could be possible to reach an optimal level of gearing where more debt finance could lower the cost of capital, but this would depend on whether the benefits of lower cost of debt outweigh the impact of higher cost of equity.
Low cost of servicing the debt
The required return of a lender (e.g. an investor in bonds or a bank providing borrowings) tends to be lower than the required return of a shareholder because the lender faces less risk than an equity shareholder. The lender’s returns are an obligation that can’t be avoided, reducing the lender’s risk which in return reduces the lender’s required rate of return. For Daistruk, this would be R$14M interest payable in 2022. This means the cost of servicing the debt finance is cheaper than the cost of equity as equity shareholders take on more risk and require more compensation. Given this, the dividend payable to shareholders can vary significantly year on year.
Tax relief on interest
Interest paid to lenders is paid out of pre-tax profits, whereas dividends paid to equity shareholders are paid out of post-tax profits. This means Daistruk receives tax relief on debt interest, making the servicing of debt even cheaper. Given Daistruk’s significant operating profits, Daistruk will be able to gain tax relief even if we were to raise a significant amount of additional debt finance in addition to our current position.
Impact on overall cost of capital
As a consequence of the two factors above, more debt finance is likely to reduce the overall cost of capital and increase shareholder wealth. According to Modigliani and Millers’ Gearing Theory, companies should raise large amounts of debt finance to reduce the cost of capital.
Flexible terms
Debt finance can be negotiated to tailor the finance based on Daistruk’s circumstances. The debt could be short or long-term and repaid all at once or in stages during the borrowing. The flexibility ensures Daistruk are only paying the cost of debt for their specific requirements.
Cheap and simple to arrange
Admittedly, for listed companies such as ourselves, it can be expensive to raise debt finance through the issuing of bonds. However, it can be cheaper by raising borrowings from banks, this would be reflected in the statement of financial position. The current position is that most debt is likely to be bank borrowings or similar, probably due to the fact bank borrowings are easy to arrange and have low arrangement fees. Equity finance can be complex and cumbersome due to the processes and restrictions likely to be imposed by Roundland’s stock exchange, making new equity issues potentially expensive and complicated.
Disadvantages of debt finance compared to equity finance
Interest is an unavoidable obligation
When agreements with debt finance are made, the binding contract requires lenders to pay interest and make capital repayments on specific dates. However, for equity finance, dividend payments are made at the discretion of the directors, so the biggest risk of using debt finance is a failure to meet the obligations which in turn may cause Daistruk to be liquidated. For this reason, if a project is likely to have volatile returns, equity may be a preferable source.
Redeemable debt
Companies rarely agree to repurchase shares when equity finance is issued, but debt finance usually has to be repaid. This can put pressure on the cash position and make it difficult to forecast future cash flows. A defaulting payment may affect Daistruk’s credit rating and their ability to borrow further funding down the line. However, Daistruk has a relatively good cash position with R$32M at year-end however it can sometimes be impossible to ensure sufficient liquidity will be available to repay any debt finance.
Covenants/security
Lenders often insist covenants and/or security when lending which can significantly restrict a company’s activity. The lender effectively becomes a more powerful stakeholder with greater influence over the director’s decisions due to the covenants in place. It would be useful to know if Daistruk has any covenants in place due to current borrowings. Some lenders also request a form of security, acting as a deposit on the borrowing. For example, a lender could request Daistruk secure any borrowing against one of our non-current assets, e.g. a warehouse or fleet of vehicles. If we were to default, the lender would gain the warehouse/fleet of vehicles to cover their loss. There are no such covenants/security attached to equity finance.
Conclusion
The key issue is debt finance is cheaper than equity finance, but the potential restrictive obligations may limit Daistruk’s activity. It’s generally accepted a company has both equity and debt finance in its capital structure to take advantage of the low cost of debt finance but not have too much so that capital repayments become overwhelmingly onerous.
(50%)
Hello,
It was noted at a recent board meeting that cash reserves need to be carefully monitored. There are, however, some interesting projects on the horizon that may be of interest to us. One of the projects involves a mini revamp of the trailer fleet. There have been some technology advancements in the production of curtain side trailers. A new material has been developed that’s
means the curtains are now stronger but also lighter, this also means that some of these trailers can have curtain sides but also curtain tops- which make them extremely useful for all types of loads.
Henrik was asked about this material in a recent interview given to Roundland TV News and he said that it was an ‘exciting development in the industry’. Investing in these new trailers means we can increase our capacity on the network and become more efficient by making less journeys and each journey costing less- as the curtains are lighter, less power is required to pull the trailers. Some preliminary work has revealed that this project has a large
positive NPV, due to the added benefits it will give to customers and the reduction in running costs. For this reason, we’d like to go ahead with the investment, but we need to finance it somehow. I presented this information to the board last week. The subject of raising finance was brought up by Max Foster, Max suggested, to everyone’s surprise, that we could raise finance by adjusting our dividend policy. As you can imagine this was met with a very mixed response, with the main concern being the reaction of the shareholders, especially considering how competitive the market is currently, and the slight downturn in our recent share price. I need your advice:
- Could you please advise how finance could be raised by adjusting our dividend policy, along with your thoughts on the impact that this change may have on our shareholders? If you back up your arguments with some generally accepted theories on the subject that would help to
give the argument more weight when I meet with the board.
Last year we paid out R$92M of dividends, which was 82% of our earnings. In 2023 we could decrease the dividend or not pay at all, meaning the cash would be retained instead of being distributed to shareholders, this would then provide finance to the new curtain side trailers.
Why dividends have been at this level in the past
It’s always preferable to distribute cash to the members over retaining funds if there is no clear reason for doing so. Large cash balances create the impression of weak and ineffective management because it leaves the company with unproductive assets not being put to good use. In 2022, Daistruk paid out 84% of earnings and Carree group paid out 85%, so it may be the case investors have come to expect high dividend pay-outs from our type of companies. Both companies may feel it necessary to pay dividends out to keep shareholders happy but without knowledge of Carree’s share price we don’t know the other side of shareholder value they have.
M&M irrelevance theory
This theory suggests investors/shareholders should be indifferent to receiving dividends and having cash reinvested internally into projects with an NPV of 0. Given positive NPV project/s are available, these should be invested in to increase shareholders’ wealth, and given they are positive this should increase shareholders’ wealth more than that of a dividend payment today.
Clientele effect
Daistruk’s investors have likely built an expectation of the exact return they are expecting, either in terms of dividend payment or capital growth. Given Daistruk issued 84% of earnings as dividend, it’s likely Daistruk’s shareholders expect a high return as dividends as well as some capital growth. Therefore, a change in the dividend policy would upset current shareholders and may prompt them to sell shares, this is known as the Clientele effect.
Signalling effect
When a company announces a dividend, it signals to the market about the financial state of the company. A reduction in dividends may send out a negative signal that Daistruk is struggling. Although this is almost the complete opposite scenario, the signalling effect may cause unrest in the market and lead to shareholders selling their shares and a potential fall in the share price.
Communication
A way to counteract these effects would be to have strong communication with the shareholders and let them know reasoning behind the reduced dividends. Explaining the long-term benefits to Daistruk and their investment may alleviate any fears shareholder may have and improve our relationship if we seem more transparent.
Market expectations
It should be remembered the capital market is believed to be efficient, so following the interview with Henrik the market will be aware of the likelihood of significant expenditure on new curtain side trailers. This may have already been accounted for in predicting future dividends and reflected in the share price, hence the announcement wouldn’t make an impact on the current price. The board should take care to not overreact to possible disappointing dividend payments because it could confuse the market into believing there is more bad news on the way.
Market expectations - dissapointment
The response should take into account the extent of any dissapointment. If the dividend is only expected to be slightly less than expected, the impact on share price will be minimal and the simplest and most effective response would be to wait until the normal announcement date and explain the circumstances when the figures are announced. The market will have the figure, probably the annual report, and be able to decide on the overall impact on the company’s future. If the disappointment is likely to be severe, then it may make sense to brief key analysts on the extent of the expenditure, if the analysis knows they have been briefed about the worst possible outcome the market will not panic. This should reduce any undue volatility in the share price.
Scrip dividends
As an alternative to paying dividends, we can offer a scrip dividend in its place. This is where shareholders are awareded bonus shares free of charge as an alternative to a cash dividend. This will enable Daistruk to retain cash in the business. They may be beneficial to some shareholders who wish to reinvest their dividends in the business but avoid breakage costs of buying the shares. There may also be tax advantages of receiving shares rather than cash in some jurisdictions. A script dividend has the effect of capitalising reserves, so reserves are reduced and share capital increases. A disadvantage is there will be reduced reserves for future distributions.
Conclusion
Cutting dividends will always be a risky strategy that may upset shareholders, so if we were to employ this strategy then communication to shareholders and key analysts with justification for the change in dividend policy would be crucial.
We need to be aware other firms in the market, such as Carree, also pay out a large share of earnings as dividends so we would need to ensure this move to cut dividends wouldn’t push investors towards Carree. It would be interesting to see how their share price has moved over the past 5 years. The last thing we want is shareholders selling shares and a reduction in the share price, as this would undo all hard work and capital growth in previous years. We must therefore be very cautious when employing this strategy.
(50%)
Hi,
As you know we are always looking for ways to increase our revenue and market share, particularly in the competitive marketplace of 3PL. We have recently become aware of a smaller unlisted logistics company, whose owners, Barry and Paul, are nearing retirement and are looking to sell. The company, To-me-to-you logistics has been successfully trading for many years and has found a small niche in delivery to harder to reach areas of Roundland. They have exception knowledge of how to schedule such deliveries and the problems faced in that sector. We feel having their expertise and knowledge, as well as their fleet would be a great strategic advantage to us, as we’d be able to extend that offering to our customers and further widen our network. We have decided that we will offer to acquire 100% of To-me-to-you by means of a share-for-share exchange but we have not yet agreed on the number of Daistruk shares that we will offer as
consideration.
- Could you discuss the problems associated with agreeing the number of Daistruk shares that might be given in exchange for To-me-to-you’s equity and recommend an approach that the
board might use to determine the most that it should give.
The number of shares would be based on the value attributed to To-me-to-you, divided by Daistruk’s post-issue value per share. Deciding on the number of shares requires agreement on the value of Daistruk shares and of To-me-to-you as a company.
Market efficiency
Daistruk is a quoted company with an observable share price, which should reflect the value of the company. If we assume the stock market is efficient, the market price will reflect all available information. This same efficiency could cause problems around the uncertainty of the number of shares and how this could reduce the share price. The capital market might be concerned Daistruk will overpay by issuing too many shares and dilute the share price. While the directors of to-me-to-you are unlikely to accept this agreement, Daistruk’s shareholders may be concerned that the uncertainty is likely to cause a self-fulfilling prophecy in which the depressed share price leads to an overpayment.
Valuation of To-me-to-you
As the company is unquoted, there is no observable market price. Daistruk’s board must agree on a suitable valuation model that can be applied as this is likely to be challenged by the shareholders. The fact To-me-to-you has such a specialised line of business means it cannot be valued by referring to a quoted company in the same line of business. This would make it impossible to base a value on a comparable company’s price/earnings ratio or its beta coefficient and implied cost of equity.
Asset valuation
It may be possible to place a value on To-me-to-you’s assets. It may have tangible assets, namely its fleet, however the value of these assets is likely to undervalue the company as the true value will also reflect To-me-to-you’s knowledge, experience and skills of its staff. The reputation, brand, and history in the market will also need to be considered.
Premium on acquisition
As well as getting a standalone valuation of To-me-to-you, Daistruk will need to consider the added value their acquisition will create by being able to offer specialised servicing to the market alongside its current offering. For this reason, there may be a justifiable premium payable on top of any value placed on To-me-to-you.
Final price negotiation
Ultimately, the price of any unquoted company must be finalised through negotiation with, of course, the buyer wanting to pay the minimal amount and seller keen to receive the maximum amount. Daistruk could argue there is a limited market for this specialist service and if they were not to buy the company it may have to be wound down and its assets sold off individually, resulting in a much lower payout. To-me-to-you could argue Daistruk is unlikely to find such a company that could add this much to their overall customer experience and that it would take a significant amount of time and funds to start a similar venture themselves.
(30%)
Hi,
I’m sure that you have seen the major development in the market over the last couple of weeks. HDL, a large multinational logistics company from Eastland has had a bid accepted to purchase Carree. It’s been a few years since there was a major takeover like this within our industry. Subsequently this month, since the announcement, our share price has fallen, and the board are
concerned about the impact of this. Interestingly the predicted market capitalisation of the HDL/Carree Group is less than their combined pre-takeover individual market capitalisations.
- Explain how Daistruk’s board should interpret the decrease in our share price and also the decreased market capitalisation of HDL and Carree.
Decrease in share price
The decrease in share price has persisted since the announcement of HDL’s bid for Carree, indicating the capital markets regard the acquisition as bad news for Daistruk. It’s not surprising at the time of transaction there is a decrease in Daistruk’s share price, however the fact it still remains suggests the market has reviewed Daistruk’s position and believe it’s now worth less than before the rivals’ acquisition.
Real significance
Arguably, there is no real significance for Daistruk as there is no actual cost associated with the reduced share price, although it means there would be more shares issued in the event Daistruk need further equity and this would lead to a bigger dilution for shareholders. The fact the market believes the future cash flows will be depressed by the acquisition, does not mean the downturn will actually occur.
Lower combined value
HDL’s board would have hoped to see a higher market capitilisation than the two companies combined. The logic here being that acquiring Carree produces synergies enabling the overall value of the combined company to exceed the value of its individual parts. The fact that this is less indicates the market believes there will be inefficiencies that will more than offset any synergies created on acquisition.
Conclusion
Taken together, the market seems to believe the acquisition will harm both Daistruk and HDL/Carree. There could be concerns about the need to persuade large numbers of customers/retailers/supermarkets to switch companies that they have been using for many years and perhaps quality will fall with lack of competition, so all companies lose out. The overall implication is that HDL’s board has acted irresponsibly and has damaged Roundland’s logistics industry as a whole.
(50%)
Hi,
I’ve attached a news article which is of great interest to the Board. It is true that the Board has been considering acquiring ShipRod with a view to expand its operations into Sudland. There is also the opportunity to improve our current systems by using some of the technology that ShipRod has developed. It has been at the forefront of new innovation in the industry for the past 12-18 months.
ShipRod’s share price has been on a rising trend over the last few weeks but has also been volatile. This may be related to the rumours.
- Explain the significance of the movement in ShipRod’s share price that has already taken place, and which may take place in the future, in response to rumours about an acquisition by
Daistruk or Carree.
Attachment:
ShipRod – is this company a game changer? The heat is on for rivals such as Daistruk and Carree. ShipRod is a highly innovative listed company based in Sudland. The company was founded by the American entrepreneur Chill B Lane. What is so innovative about this company? ShipRod has recently been voted top of a poll of the most efficient 3PL services for businesses in Sudland. ShipRod gets the top spot for its innovative features for efficient inventory distribution, real-time order tracking, and in-depth data analysis. The web-based ShipRod platform also offers easy onboarding to ecommerce merchants through assistance from an implementation team and out-of-the-box integrations with all major ecommerce platforms and marketplaces. In this way,
business owners can quickly get started in organizing their order fulfillment activities, whether they own one or multiple stores.
ShipRod supports efficient inventory distribution through a network of coast-to-coast fulfillment centers in Sudland. The ShipRod platform offers a 2-day express shipping program, that
automatically verifies delivery addresses against the nearest fulfillment centers. The platform’sintuitive dashboard also provides a timeline of where orders are in the fulfillment process. They have a free analytics tool that tracks a wide variety of metrics, including shipping costs, storage cost per unit, and average cart value. Lastly, the ShipRod platform seamlessly integrates with all major ecommerce platforms and marketplaces. There are rumours that both Daistruk and Carree have been considering making an offer to buy ShipRod.
Market efficiency
If the stock market is efficient all relevant and available information about a company will be incorporated into the share price in an unbiased manner. Rumours of acquisition may constitute as information, even if there is no truth behind these rumours, and as a result in an efficient market the share price would be expected to change in response to this.
Premium to current share price
If Daistruk/Carree were to make an offer this would be made at a premium to the existing share price (normally 20/30% above the current share price). Rumours are likely to cause the shire price to rise towards the expected offer price.
Volatility
ShipRod’s share price has been volatile over the last few weeks. This is likely due to no confirmation of the truth behind the rumours of potential acquisition. The problem with rumours is that investors may become nervous if the price rises too much, especially if they personally believe that an offer is unlikely to be made and may decide to sell shares whilst the price is high with the belief the price will plummet if the offer fails to materialise.
Formal bid
If a formal bid is made this will confirm the expectation of acquisition and the share price may rise even further. If the rumour proves unfounded and both Daistruk/Carree confirm they are not interested in making an offer, the share price will likely fall back to its original level prior to the rumour circulation.
Who benefits?
Given ShipRod’s share price has been on the rise following acquisition, the market believes the acquisition is good news but does not necessarily imply that the successful bidder will benefit from acquiring the subsidiary. For the shareholders of Daistruk, the important metric for success is the share value of Daistruk, not ShipRod’s share price.
Potential Synergies
An increase in the share price of ShipRod as a result of the takeover rumour implies the market believes there are potential synergies associated with a successful bid and the bidder has a chance to add value. For example, a potential synergy would be the ability of Daistruk to implement ShipRod’s innovative systems into its own. The belief does not necessarily mean synergies will arise, but is an encouraging indicator that the market supports the logic behind a bid.
Buying shares in ShipRod
If Daistruk is considering making an offer to acquire the whole of ShipRod then it should consider purchasing as many shares as it’s allowed prior to making a formal takeover bid. The number of shares purchased without needing to make a formal takeover bid depends on the takeover rules in Roundland but would typically be up to 30% of the shares. Buying shares in advance would mean Daistruk can avoid paying top price for all shares.
Market response to purchase of shares
If Daistruk/Carree purchase a significant number of shares the market is likely to respond to this, as it gives a clear signal to the market that a bid is underway and the share price will likely rise significantly as a result.
Competing bids
If the market believes both companies will engage in a bidding war for ShipRod, the share price will increase significantly and potentially to a level where it would be uneconomic for one, or both, companies to proceed. If Carree formally announces they will not bid for ShipRod then the share price may not rise as significantly as the market will know Daistruk will not offer more than a certain price for the shares of ShipRod.
(40%)
Hi,
Not sure if you’ve had chance to read the high level internal memo that came round this morning? In brief, last night, the head of IT security received an email threatening to encrypt all of the data we
hold on our servers unless we pay a rather large ransom. The attackers have given us 48 hours to make the payment.
My security manager is looking into the demands and trying to establish if the threat is credible or not, early indications suggest that this is a highly sophisticated attack that could have major consequences to our business.
Over the past 2 weeks there has been a steady decline in our share price. This was brought to the attention of some of the board members last week and no explanation or reason could be found as to why this was happening. However, it’s now been suggested that the falling share price could be a result of the person making the ransom demands short selling our shares.
- Evaluate the possibility that the steady decline in share price could be a result of short selling by the cyber attacker
Market Efficiency
This could be an example of a strong form of market efficiency, meaning all information is incorporated into the share price, regardless of whether it’s publicly available. One way in which a steady and persistent decrease in the share price could occur would be if someone was selling shares on the open market, despite the declining price.
This could be explained by someone in possession of inside information and who knows the price will soon fall much further, from which they will profit from the short selling. This involves selling shares that have been borrowed from a third party, hoping that the price fall occurs in time, and then buying the shares required to close out the position if and when the fall occurs. If the price fall is as large as expected, it would be possible to buy shares to replace those borrowed and still be left with a surplus from the sale.
Short selling
This could be consistent with the hacker who plans to attack Daistruk, selling shares in advance of the attack, given the adverse publicity from a successful attack would make the share price plummet and hence make the shares much cheaper on the open market. The hacker could be planning to use short sales in an additional way to benefit from the malware attack, perhaps in case we do not pay ransom.
Selling Daistruk short and triggering the threat will benefit the hackers over and above any ransom that the company pays, but only if the attack occurs before the short sales have to be closed out. If it is assumed the decreasing share price is linked to the threatened attack, the assumption is consistent with the threat being real.
Other reasons for price fall
There is no guarantee the attack is linked to the short selling, and there could be other insider information triggering the sales. The same behaviours could be caused by someone else knowledgeable of an emerging threat/problem. For example, an employee of a competitor could know the competitor is about to launch an exciting new service or product, but the information is being kept confidential until launch date.
Insider trading
Insider trading is a serious crime, and it may be difficult to profit from such a blatant short sale as this without getting caught. Authorities will be suspicious if Daistruk suffers a major cyber-attack and short-selling positions are closed out immediately afterwards.
Large investor actions
The declining share price may not be due to short selling and may not be a sign of stron-form efficiency. It may be attributable to a large shareholder wishing to liquidate their position. Announcing a large sale will always decrease the share price and the shareholder will not get the full market price for a large shareholding. Shareholders with large blocks generally do their best to sell them in small blocks in the hope that the market will not pay too much attention.
Conclusion
Whatever the reason for the fall, it might have nothing to do with sales. Share prices respond to new information reaching the market, and the market can adjust prices without waiting for purchases and sales to adjust through supply and demand. Whilst unlikely, there could have been a succession of news events that the market has perceived as negative over the past few weeks.
(40%)
Hello,
As you know, we employ over 22,000 people in Roundland and one thing we’re very conscious of is employee retention, especially in key roles. The board has been assessing our employees and how they are sourced and taking a wider view of the Roundland labour market. What they found was surprising to them, there has been a trend over the past decade of youth unemployment in Roundland. This is the number of 16–25-year-olds looking for a job but unable to find one. The board have decided to set-up the “Daistruk Foundation” as a separate charitable entity, with an aim to lower youth unemployment in Roundland by helping charities and school partners ensure that disadvantaged young people aged 14 to 25 years have access to the best possible education, develop essential life skills and can ultimately secure meaningful and sustainable employment.
One of the key strategies of the foundation is encouraging Daistruk employees to use their experience to inspire disadvantaged young people about their future careers and help them prepare to enter the workplace. They will do this by developing a variety of meaningful opportunities for colleagues to use their skills and knowledge to add value to the work of our school and charity partners. The Foundation could also be used to deliver training to existing Daistruk employees that are recognised as in need of additional support. I need your advice:
- Please consider the impact on the Social & Relationship and Human capital headings of our Integrated Report.
Human capital
Human capital includes the skills and know-how of an organisation’s employees, along with their commitment and motivation to the job, which affect their ability to fulfil their roles effectively. Human capital also considers the number of employees at Daistruk’s disposal to utilise their skills to create value for shareholders.
Opportunities for existing workforce
The Daistruk Foundation would need to be staffed by skilled and knowledgeable staff. This is likely to provide opportunities from within the existing workforce for staff members to get involved in training and supporting others and so could provide them with an opportunity to tap into new skills they otherwise may not have. There could be staff members within the existing workforce that would relish the challenge of setting up Daistruk Foundation.
New staff
Whilst we can tap into the existing staff pool, it’s likely we will need to recruit externally to staff the Daistruk Foundation or to replace staff that has moved from Daistruk to the Foundation. Either way, the proposal will require additional recruitment and staff numbers will increase.
Training offered to internal staff
One aspect of Human capital is the training and development opportunities being offered by the organisation. The fact Daistruk are going to put resources into the Foundation shows commitment to training. Whilst the primary objective of the Foundation is to clearly develop toung people in schools or just out of college, existing staff members will also be provided the training. Therefore, the number of training hours delivered by the Foundation to Daistruk could be reviewed and monitored.
Access to future talent
Daistruk will have access to the best future talent within Roundland by working alongside schools and colleges. Daistruk will have access to young people with an interest in technology/engineering which could lead to them developing knowledge, skills and experience to be the future talent within Daistruk.
Loyalty and motivation
One output of human capital is how loyal and motivated the workforce are, and it’s highly likely this proposal will be seen in a positive light by existing employees. Employees will be pleased to see Daistruk giving back to society and a company with good Corporate Social Responsibility initiatives often see good rates of employee retention and often attract high calibre staff.
Social and relationship capital
This refers to the relationships the company has with communities, groups of stakeholders and other networks, including the company’s common values and behaviours. It includes key stakeholder relationship, and the trust and willingness to engage that an organisation has developed and strives to build/protect with customers, suppliers, business partners and other external stakeholders.
Local communities in Roundland
These are another consideration relating to the Foundation, and the proposal should be seen as a favourable move. This creates goodwill and strengthens relationships between Daistruk and local communities within Roundland. Communities will be grateful Daistruk are actively seeking to train, upskill and enable to next generation.
Relationships with colleges/schools
Daistruk will need to invest time and resources to building good relationships with colleges/schools in Rounldand, particularly wherever the Foundation is built. Daistruk will need regular open days for colleges/schools to attend the Foundation and understand more about the Logistics industry and how the Foundation can help and support them in the future.
Daistruk’s clients
This initiative is likely to be seen as favourable by Daistruk’s clients. This will be published in the annual report alongside how the Foundation is creating jobs for young people and supporting the next generation. It would be good for clients to see information regarding training, showing clients that Daistruk are fully committed to on-going training and long-term prosperity.
