Corporate Finance: Theory and Practice

Case Study
1. TRUST Corporationwas a provider of accommodation solutions and recreation vehicles, parts and accessories. TRUSThad twooperating divisions: Manufactured Accommodation(MA) and Recreational Vehicles (RV). The MA division provided portable accommodation to the construction and resource industries. The division also providedpark home and transportable housing to the retirement, recreation and education sectors. The smaller RVdivision was involved in the manufacture and sale of caravans, and campervan hire.

2. Following several years of profit growth underpinned by strong demand from the resources sector, the focus of TRUST’s management in 2013 was onrestructuring the company’s operations to reduce costs and improve production efficiencies to minimise the effect of subdued demand caused by the significant drop in commodity prices since the second half of 2012. The trading conditions in the company’s key markets were weak throughout 2013 and net profit after tax fell 70%.

3. TRUST’s financial performance over the last five years was set out below:
For the year ending 31December 2013* 2012 2011 2010 2009
Revenue ($ millions) 334 383 467 291 355
Operating profit after tax ($ millions) 16.6 55.2 51.3 38.7 35.6
Cash flow from operations ($ millions) 25.4 77.3 51.8 54.8 54.0
Debt ($ millions) 45.2 0.9 21.0 – 9.0
Assets ($ millions) 312.6 289.8 307.5 210.5 197.2
Shareholders funds ($ millions) 214.1 231.2 206.2 156.9 141.7
Number of shares issued (million) 60.0 59.2 57.8 54.0 52.6
Earnings per share (cents) 27.6 93.8 90.0 72.6 68.7
Dividends per share (cents) 30.0** 76.0 73.0 68.0 66.0
Share price at end of year ($) 3.43 11.74 11.33 9.19 5.90
* Based on preliminary results.
**The final dividend was yet to be determined.

4. The Board was comprised of four Non-Executive Directors. Meetings were generally held monthly with ad hoc meeting called to consider specific or urgent matters. Senior executives such as the chief executive officer,BradStephens,regularly attended and presented to board meetings on particular issues.

5. The following agenda items were listed for the Board meeting in January 2014:
i. Should TRUST establish a formal WACC and stop using a notional 10% benchmark?
ii. What would beTRUST’s after-tax WACC based on its capital structure as at 31/12/13?
iii. Should a different cost of capital be established for the two business divisions?
iv. Further, how should the risk of each project within a division be measured and incorporatedintoproject evaluation?
v. Should the RV division be sold to Outbound Group or be retained and even expanded?
vi. Should TRUSTrenew the remuneration package of Brad Stephens?
vii. An update on TRUST’s capital structure.
viii. A decision on the amount of the final dividend.
ix. Should TRUSTincrease the discount on its dividend reinvestment plan?

6. The Board agreed to stop using a notional discount rate of 10% in evaluating projects and to establish the WACC formally. All new investment proposals were to be decided on their net present values. Stephens was asked to present an estimate of the company WACC at the next Board meeting. The after-tax WACC would be based on the market value of the gross interest-bearing debt and equity securities outstanding at the balance date 31 December 2013.

7. The Board also decided that a separate cost of capital should be established for its two business divisions. Stephens was again directed to report an estimate for each divisional WACC and would be applied to new projects immediately.

8. The General Manager of RV division, Julia Dumbo, requested to use industry capital structure to establish the weights in estimating the divisional WACC. Dumbo argued that her competitorsin the caravan industry had a higher average ratio of debt to equity of 30%. Stephens was asked to estimate this alternative WACC based on the higher industry average debt-equity mix.

9. On the question of incorporating risk into project evaluation, the Board accepted that any system to account for individual project risk would necessarily be somewhat arbitrary and involve subjective judgment. Adjusting cash flows and estimating project betas were deemed to be impractical. The Board decided that new projects would be classified into three categories: high risk, average risk and low risk. High risk projects would be evaluated at the yet-to-be-determined divisional WACC plus 1.5%; average projects at the divisional WACC; and low risk projects at the divisional WACC minus 1%.

10. A proposal by a private equity firmOutbound Group to acquire the RV division for $38 million was presented at the meeting. The offer price was higher than the carrying book value of the division. However, with the divisional cost of capital yet to be determined, Trust was unable to ascertain the present value of the division business as a going concern. Stephens suggested that the value of the division might improve if an expansion of its facilities scheduled at the beginning of 2015was successful.

11. The Board discussed a recommendation from its Remuneration Committee to renew Stephens’ remuneration package for another three years. The design of the package was to strike a balance between fixed and variable (at risk) remuneration. The variable remuneration included short-term incentives in the form of cash payments and long-term incentives in the form of share options.

12. The Short Term Incentive Plan (STIP) used a combination of individual and company performance targets. The weighting was 50% non-financial and 50% financial. Individual performance targets were derived from period specific objectives which were in turn aligned with key business strategies identified annually during the business planning process. Financial performance targets were derived equally from budgetedEBIT and return on capital, which measured the efficiency and profitability of invested capital. The maximum cash bonus Stephens could earn through the STIP was capped at 50% of his annual fixed remuneration of $590,000. The Remuneration Committee was of the opinion that the STIP appropriately aligned executive remuneration and shareholder wealth generation.

13. Long-term incentives in the form of options were used to align executives’ long term interests with those of shareholders. Under the plan, the number of options granted was determined with reference to Stephens’ individual performance over the immediately preceding financial year. No amounts were payable for the options. All of the issued options would vest on the third anniversary of the grant date, and the exercise price of options issued was calculated using the volume weighted average price of the shares over the five days prior to the issue date. The options were only exercisable if the company’s total shareholder return (share price appreciation plus dividends) was at least 15% per annum compounded from 1999 and was equal to or greater than the ASX 300 All Industrials Accumulation Index.The options would expire 5 years from the date of issue.

14. In regard to Stephens’ performance in 2013, a $75,000 short-term bonus payment and 40,000 options would be issuedfor his variable remuneration. For financial year 2012, a $150,000 short-term bonus was paid to Stephens and 110,000 options were issued.

15. TRUST did not have a target gearing ratio. Operating cash flows were used to maintain and expand operating assets, make payments of tax and dividends and to repay maturing debt. In 2013, operating cash flowsfell sharply and the level of debt increased to $45.2 million ($44 million of bank loans and $1.2 million of short-term hire purchase commitments). The ratio of debt to shareholders funds increased to 21% in 2013 from 0% in 2012.The interest cover was about 19 times.TRUST had increased the limit of its bank loan facility in June 2013 to $50 million, with $44 million of the facility being utilised by the year end. Bank loans beared interest at the floating bank bill swap bid rate plus a margin. The effective annual interest rate at the end of 2013 was 3.48% for bank loans and 6.18% for hire purchase creditors.

16. In the period of 2005-2012, TRUST had increased its dividend payouts from 60 cents per share to 76 cents per share.The payout ratio and dividend yield had been above peers for years. TRUST did not have a formal dividend policy but its simple objective was to increase dividends each year with the growth of sustainable earnings. An interim dividend for 2013 of 30 cents had been declared and paid. In view of the earnings performance in the second half of 2013 and the capital expenditure requirements for some existing projects, the Board believed that TRUST would have to cut the final dividend. However the directors were divided on the level of the cut.

17. TRUST had a dividend reinvestment plan with a 2.5% discount feature. TRUST had attracted around 20 percent participation rate from its shareholders. Stephens suggested that the discount on the DRP would need to increase in order to attract a higher reinvestment rate.

18. After the Boardmeeting, Stephens looked at the Balance Sheet as at 31/12/13 to estimate TRUST’s after-tax WACC:
($’000) ($’000)
Payables 45167 Cash and cash equivalents 12665
Current tax liabilities 1147 Receivables 54065
Interest bearing debt 45200 Inventories 55795
Provisions 6995 Property, plant and equipment 114471
Share capital 193001 Intangibles 67463
Reserves (578) Other 8141
Retained earnings 21668
Total claims 312600 Total assets 312600

19. The equity beta of TRUST’s 60 million outstanding shares was estimated to be 0.81.The internal forecast for earnings per share in fiscal 2014 was expected to be 26 cents.

20. On the question of the divisional cost of capital, Stephens decided to simply adjust the pre-tax divisional cost of capital for the tax deduction of interest payments on debt to obtain an after-tax divisional WACC. The pre-tax cost of capital for RV division was estimated to be14.42%, usingTRUST’s company-wide debt-equity mixand an equity beta of 2.1. The pre-tax divisional cost of capital was currently used to assess the recoverable amount of the goodwill in the division.

21. To establish an alternative WACC using RV’s industry’s debt-equity ratio,Stephens used athree-step procedure. First, the pre-tax WACC of RV was taken to be opportunity cost of capital. Second, assuming an overall cost of debt of 3.5%, the new cost of equity was estimated at the industry debt-equity ratio of 30%. Third, the new cost of debt and cost of equity were combined into the alternative divisional WACC.

22. To find out the present value of the RV division, Stephens used the internal divisional budget 2014 to form year one cash flows in Table 1. Various assumptions were then applied to forecast subsequent cash flows. TRUST used a 5-year valuation horizon and a 2% terminal long-run growth rate in estimating the horizon value. The recovery of working capital was implicitly included in the horizon value and was not separately accounted for.

23. Stephens further re-examined theexpansion project of RV division scheduled to beginin a year’s time. The extra after-tax cash flows from the expansion, generated over and above the cash flows expected from Table 1, were projected in Table 2. The extra cash flow in year 5 in Table 2 had incorporated the discounted value of all subsequent cash flows beyond year 5. All these extra cash flows in Table 2 were considered to be low-risk.
Table 1Forecast Free Cash Flow for RV ($’000)
t=1 t=2 ….. t=5 t=6
Sales 22000 26231
Variable cost 13200
Fixed cost 2000
Depreciation 1000
Operating income 5800
Tax (30%) 1740
Net income 4060
Depreciation 1000
Operating cash flow 5060
Investment in fixed assets 1200
Investment in working capital 115
Free cash flow 3745

Assumptions:
Tax rate 30%
Sales growth rate starting in year 2 and 3 5.5% per year
Sales growth rate starting in year 4 and 5 3.5% per year
Sales growth rate starting in year 6 and beyond 2% per year
Variable cost as a percentage of sales in year 1 to year 6 60%
Fixed cost growth rate in year 2 and beyond 3% per year
Depreciation growth rate in year 2 and beyond $100,000 increase per year
Investment in fixed assets $1.2 million per year
Investment in working capital in years 2 – 6 is equal to 10% of the expected change in sales from the previous year.
All figures are rounded to the nearest thousand dollars.
Table 2
After-tax cash flow projections for ‘Expansion’ next year ($’000)
Year Expansion Discounted value @10%
t=1 -2500 -2500
t=2 500 455
t=3 1000 826
t=4 1500 1127
t=5 4000 2732
NPVt=1 = 2640
Instructions:
You are asked to answer the following problems. Show all workings and/or explanation.
1. Calculate TRUST’s company after-tax WACC. The risk-free rate was 4.21%, the market risk premium was 6% and the company tax rate was 30%. The WACC should be rounded to four decimal places.
2. Calculate the RV Division WACC using Stephens’s method in paragraph 20.
3. What could be deduced about the relative business risk of the RVDivision compared to its industry competitors if the industry equity beta was 2.10?
4. Complete Table 1, in accordance with the given assumptions, to show thederivation of free cash flow inyear 1 to year 6.
5. Calculate the horizon value as of year 5 using the constant-growth discounted cash flow formula.
6. Use an appropriate cost of capital and a presentationtable similar to Table 2, show the discounted value of RV’s free cash flow in year 1 to year 5plus that of the horizon value. What would be the present value of the RV Division on its own without expansion, rounded to the nearest thousand dollars?
7. Reconstruct Table 2 again with the appropriate cost of capital to show the correct discounted value of the expansion cash flows in year 1 to year 5. Must show the appropriate NPVt=1 as well.
8. Calculate the value of the option for RV Division to expand as of year 0.
9. If RV Division could still be sold for $38 million, without any expansion undertaken, at the end of year 1, calculate the value of the abandonment option at t=1. Assume TRUST would have already received the free cash flow of year 1.
10. Calculate the economic depreciation and thenthe EVA in year 1, rounded to the nearest thousand dollars, based on the free cash flow in Table 1.
11. From the shareholders’ viewpoint, what would be the major criticism on the STIP? Explain.
12. From the viewpoint of Stephens, what would be the worst feature of the long-term incentives? Explain.
13. What specific sourceof funding would TRUST choose to use for the expansion project scheduled for next year? Assume TRUST’s financial position next year would be the same as of 31/12/13.
14. What should be the amount of the final dividend to be declared for financial year 2013? Explain.
15. Calculate the alternative divisional WACC using the 3-step procedures in paragraph 21.
16. Use the cost of equity in Q1 and the dividend growth formula Price=DPS1/(re – growth rate) to work out the implied total dividend for next year. Assume a constant growth rate of 3.4%. Is this implied dividend amount for 2014 reasonable/achievable? Explain.
17. Should TRUST increase the discount on the DRP for its 2014 dividends in order to attract a higher reinvestment rate? Explain.
Presentation: The assignment is to be typed, single-spaced with a font size of 12 (no smaller than this font size). The length of the submitted work must not exceed 6 A4 pages including any spreadsheet.