Kappa Pro-Plc the Managerial Team

¶ … Kappa Pro-Plc

The managerial team at Kappa Pro-Plc is currently faced with the challenging decision of selecting the best course of action to sustain the future development of the organization. In this scenario, we are presented with two viable alternatives. The first sees that we expand our company internally, and, if we decide in this direction, we must consider the sources of the necessary financial resource as coming from either debt, either equity. The second alternative is that of growing externally, through the takeover of Militin Bros SA. In order to make the most adequate decision, it is necessary to conduct a gradual analysis of several technical features of the available alternatives. At the end of this analysis, the final recommendation will take shape.

a) Raising funds through debt -- impact on shareholders

First of all, the company will have to pay back the value of the investment, increased by the interest rate, totaling as such to £490 x 1.15 = £789.1 million. Then, the company currently pays £40 million in dividends; if we select financing through debt, with an annual interest rate of 10%, this translates into the fact that dividend payments to our shareholders will be reduced by the value of the principal and the annual interest rate.

Value of the investment = £490 million

Annual principal = £490 / 5 years = £98 million

Annual interest rate = £98 x 10% = £9.8 million

Total annual cost with notes (debt) = £98 million + £9.8 million = £107.8

Dividend payments after investment with debt = £40 million -- £107.8 = -- £ 67.8 million

Nevertheless, this finding should not impact severely with the financing decision as dividend payments are also expected to increase due to the increases in revenues pegged to the expansion, either internal or external. Otherwise put, the annual cost of capital represents 10%, whereas the annual increase in sales represents 31%, meaning that the shareholders will in fact register financial benefits.

Burleigh Evatt argues that debt can impact shareholder value in several means, such as changes in the nominal interest rates which materialize in modifications upon the present value of operating cash flows, outstanding debt, the market cost of capital or product demand. Yet, he does not state the direction these modifications will follow. Another specification that has to be made refers to the priority of paying the debt, in the meaning that the notes must be paid first, whereas the dividends do not constitute for obligations (Blurt it, 2009). This will additionally generate shareholder dissatisfactions.

b) Debt's impact on key profitability ratios

EBITD (earnings before interest, tax and depreciation) = revenues -- expenses

EBITD = £450 x 1.32 (the increase from the investment) -- £75 (selling and administrative expenses) -- £107.8 (costs of the investment) = £411.2 million; comparative to the £300 EBITD (EBIT plus depreciation), this profitability ratio registers a net increase

ROA (return on assets) = net income / total assets = £490 x 1.32 / £2,000 = 0.3234, this is higher comparative to the current ROA of only 0.245 (490 / 2000), meaning that the investment will increase KP's profitability relative to its assets (Investopedia, 2009)

ROI (return on investment) = (gain from investment -- cost of investment) / cost of investment = (490 x 0.32 -- 107.8) / 107.8 = 0.4545 -- this profitability ratio before the investment equals 0, meaning then that it evolves in a positive direction; furthermore, since the ROI on the investment is positive, it should be undertaken; still, it should be compared to the ROIs of other investment projects and one should select the alternative with the highest ROI (Investopedia).

c) Debt to equity and weighted average cost of capital

The return of the assets can be estimated with the aid of the CAPM, or the Capital Asset Pricing Model, according to which: the return on the asset = risk free rate + beta x (expected return on the market -- risk free rate) = 3.8 + 1.2 x (13 -- 3.8) = 14.84

The weighted average cost of capital represents the total cost of capital for a firm, with the specification that each cost is proportionately included.

Generally, the formula for WACC is: WACC = proportion of debt x cost of debt (1 -- corporate tax rate) + proportion of equity x cost of internal equity

The cost of internal equity = dividends per share / market value of share + growth rate of dividends (Investopedia) = 0.8 / 30 + 0.8 / 0.5 = 0.026 + 1.6 = 1.626

WACC 1, with 20% debt and 80% equity = 0.2 x 0.1 x (1 -- 0.39) + 0.8 x 1.62 = 0.012 + 1.296 = 1.308

WACC 2, with 50% debt and 50% equity = 0.5 x 0.1 x (1 -- 0.39) + 0.5 x 1.62 = 0.0305 + 0.81 = 0.8405

WACC 3, with 80% debt and 20% equity = 0.8 x 0.1 x (1 -- 0.39) + 0.2 x 1.62 = 0.0488 + 0.324= 0.3728

The conclusion is then that the most optimal capital structure is given by more debt and less equity. The higher value of the WACC, revealed by the higher levels of equity, impacts the organization in the meaning of increasing the risks to which it becomes exposed, as well as lowering its organizational value.

d) Modigliani and Miller's Propositions

Nobel Prize laureates, Franco Modigliani and Merton Miller are two of the most notable contributors to the fields of finance and their crucial contribution has been brought by the introduction of two new propositions relative to capital structure. The first proposition states that, in the case where the firm does not pay taxes, its cash flows are independent from leverage. In the words of the economists, "assuming that there are no taxes paid, the value of a firm is independent of its capital structure" (Ramesh, 2000, p.76). The diagram below reveals this proposition:

Figure 1: MM Proposition I -- the value of the firm is not affected buy its capital structure

Source: Ramesh

Figure 2: MM Proposition II -- Taxes increase the value of the firm

Source: Ramesh

The second of Modigliani and Miller's propositions sees that, when a company pays taxes, it is desirable for it to increase its debt and as such increase the value of its organization. "If taxes are taken into consideration, then a firm's capital structure with 100% debt is optimal" (Ramesh). Relative to the situation at Kappa Pro-Plc, under the first proposition, the company is to pay no taxes and its capital structure would be based on both equity and debt, in the proportion desired and established by internal features. If on the other hand, as it is in fact the case, the company pays taxes, it is desirable for us to finance our project through debt, rather than equity, as this would create the most value.

e) Affordable dividend per share under a residual dividend policy

The residual dividend policy is used in cases when, just like us, the company's investment projects and outcomes are relatively unstable. Under this policy, we would only pay the dividends from the residual income, that is, the money left after other obligations have been honored (Shim and Siegel, 2007, p.339).

According to this dividend model, the amounts of money paid to shareholders are determined by subtracting the target equity ratio multiplied by the needed capital from the net income:

Dividend = Net Income -- Target Equity Ratio x Capital Needed (Lakehead University, 2005, p.16).

For a 10% equity ratio: Dividend KP = £450 x 1.32 -- 10% x £107.8 = £594 -- £10.78 = £583.22 million

Considering that £49 million must be raised through the issuing of stock, Kappa Pro-Plc will have to issue a total of 1,633,333.3 shares, meaning that the affordable dividend per share is of 583.22 / 1.63 = £357.803

For a 50% equity ratio: Dividend KP = £594 -- 0.5 x £107.8 = £540.1

Needed equity issued = £245 million / 30 (price per share) = 8,166,667

Dividend per share = 540.1 / 8.16 = £66.13

For an 80% equity ratio: Dividend KP = £594 -- 0.8 x £107.8 = £507.76 (million)

Needed equity issued = £392 million / £30 = 13,066,667

Dividend per share = 392 / 13.06 = £29.99

f) Stopping dividend payments

The specialized literature offers different points on the impacts of dividend cut upon the firm and its stakeholders. Yet, the answer lies within the organization and the projects assessed, meaning that the lesson send by theoreticians is that of understanding the situation and its needs and adapting the academic models to best suit our goals. Some of the most notable opinions are succinctly revealed below:

Might seem based on speculative information and could result in the company's ratings being downsized

On the other hand, the money could be used to finance new ventures which would increase the company's financial results (Calamos, 2003, p.238)

Dividend cuts force organizations to reassess their capital structure and may even prevent them from successfully completing new acquisitions (Van Frederikslust, Ang and Sudarsanam, 2007, p.593)

Pike and Neale (2006, p.454) peg the impact to the return shareholders require on their investments (ke) -- if ke is lower than the expected return on the new investment, the dividend cut has a positive impact on organizational value; if ke is higher than the ROI on the new investment project, the impact is that of decreasing the firm's value; finally, if the two ratios are similar, the impact is neutral.

g) Pros and Cons of Mitilin Bros Takeover

Arguments in favor:

Diversification of activities and incomes, which translates into lower levels of risk

Access to a wider customer market

Benefits derived from the extensive expertise of the managerial team at Mitilin Bros

Increases in income and the gaining of a stronger competitive position

From a theoretical standpoint, the acquisition of Mitilin would be beneficial due to its ability to "ensure management accountability, offer easy growth opportunities, create mobility of resources, avoid gestation periods and hurdles involved in new projects, offer a chance to sick units to survive and open up alternatives for selective divestment" (Kazmi, p.191)

Arguments against:

Mitilin sells its products to a further global region, meaning that it would be difficult to centralize the operations and decisions

The company operates in a different currency (the euro, as opposed to the Great British pound), meaning that difficulties in accounting and necessity for hedging against currency risks would arise

From a theoretical standpoint, the takeover would be undesirable as it could lead to personnel downsizing, the need to cope with the hidden liabilities of the target organization (Mitilin Bros), cultural / managerial conflicts or the possibility of price increases (Spiritus Temporis, 2005)

h) Relative P/E

Compared to the more commonly used price-earnings ratio which assesses the price of a share in terms of earnings per share, the relative P/E ratio compares this price against the prices of other organizational stocks within the market (Damodaran, 2002, p.487). The implementation of a relative P/E ratio would also be useful as it would allow an analysis of the company's evolution in time. Generally, a relative P/E assessed as time evolution indicates a strong relationship with the company in the meaning that relative P/E develops in the same direction as the relative growth and the relative risk. Furthermore, the ultimate advantage of relative P/E is that it is not influenced by other organizational ratios, but remains rather objective (New York University, Leonard N. Stern School of Business). The financial advantage of such an endeavor would rely in the registration of a combined net income of £195 million. Furthermore, due to the 1:4 conversion rate, KP would only have to assign 12.5 million shares in order to purchase the totality of Militin stocks.

i) Maximum offer price

Based on the principles of the free cash flow method of organizational valuation, the Kappa Pro-Plc would offer a maximum price of Militin Bros' net income, discounted by the cost of capital (Koller, Goedhart, Wessells and Copeland, 2005, p.166). Considering a 10% cost of capital (debt), the maximum offer would be of £60 x 0.9 = £54 million.

j) Cash vs. stock

The final decision on the payment mechanism depends on the internal features of each organization, but both alternatives present advantages and disadvantages. For once, issuing stock reduces the control of the owners, who will be forced to include the new investors in the decision making process. Then, payment in cash generally implies either debt, either a reduction in the firms' future development opportunities. On the other hand, cash payments reveal the advantage of maintained control and lower costs, with the specification that debt is tax deductible. The main benefit of stock is that the payment of dividends does not represent a priority in the face of creditors and other organizational obligations (Fabozzi and Peterson, 2003).

k) Bid's impact on share price

A final question that has to be asked refers to the impact on the share's price upon a bid made for the acquisition of Militin Bros. The question is a fairly complex one and the literary sources answering it are extremely scarce. Yet, it can be assumed that the price will increase. The explanation is a fairly simple one -- investors realize the growth and development opportunities created by Kappa Pro-Plc's prospective purchase of Militin and buy more shares in order to be included in the distribution of the larger profit; this increased demand leads to increases in the prices of the KP share.