In: Finance
WACC and Company Valuation Mini Case Study Brian Jones is a
30-year-old managing director of Full...
WACC and Company Valuation Mini Case Study Brian Jones is a
30-year-old managing director of Full Charge Corporation. Recently
promoted to the role upon the retirement of his father, he is the
third generation of his family to run the business. Historically
Full Charge Corporation had been a significant player in the market
for battery production for diesel and petrol fuelled vehicles. More
recently, the business has pivoted toward addressing demand for
batteries used in electric vehicles. Despite strong and steady
profitability in recent years, Full Charge’s share price had been
relatively stagnant at around $25 per share. Brian felt that this
was in part due to the financial policies followed by his father,
which he viewed as overly conservative. Full Charge Corporation
have historically been 100% equity financed with no debt in the
capital structure. Full Charge Corporation are active in the
production of a technology that will help reduce environmentally
harmful emissions and thus they benefit from a major tax break.
More specifically, they pay zero corporation tax. Noting that
unconventional monetary policies had supressed yields (and thus
lowered borrowing costs) in the aftermath of the financial crisis,
Brian proposed that Full Charge make a significant change to its
capital structure. He proposed that the company buy back $500m of
its outstanding shares using cash raised by issuing new debt. He
estimated that the cost of this debt would be around 4% based on
prevailing market yields on the debt of firms with similar levels
of credit quality. Brian was confident that this policy would make
shareholders (of which he was one) better off. In aggregate, those
who sold would receive $500m in cash, but Brian projected the share
price for the remaining shareholders would also rise as a result of
his actions. Historically Full Charge had a policy of returning all
company profits to shareholders in the form of a dividend, and
Brian was clear that this policy should continue. Whilst reducing
the share-count would mean that in aggregate less dividends would
be distributed, he was confident that the dividend paid per share
would increase. His accounting department prepared the following
basic set of pro forma financial statements for the coming year
(for the all equity-financed firm)… Full Charge Corp Pro- Forma
Financial Statement All figures (except per share) in $m Shares
Outstanding Measured in Millions Income Statement Revenue 1500
Operating Expenses 1375 Operating Profit 125 Net Income 125
Dividends 125 Shares Outstanding 62.5 Dividends Per Share 2.00
Balance Sheet Current Assets 450 Fixed Assets 550 Total Assets 1000
Total Debt 0 Total Equity 1000 Total Capital 1000 Inflation was
currently running at close to zero. Revenue and operating expenses
were thus projected to remain at the same amount per year
indefinitely. Brian observed that the company’s equity beta was
around 0.8 whilst the market risk premium was around 5%. He
estimated the current cost of equity of the no-debt firm as 8%. On
the basis of an estimated cost of debt of 4%, Brian argued that any
increase in debt would lead to a lowering of the company’s capital
cost. He thought “If we aggressively seek the best deals for raw
materials, why shouldn’t we extend the same philosophy to our
capital?” Brian’s colleague and MBA graduate, Amanda, expressed
some concerns about the restructuring. Firstly, she asserted that
the proposed action might boost EPS, however adding debt to the
capital structure would magnify the sensitivity of EPS to changes
in operating profit. Furthermore, she expressed doubt as to whether
or not the restructuring would have the share price impact Brian
predicted. Provide some financial analysis to help support Amanda’s
line of reasoning. (For ease of exposition, assume that there are
neither distress costs nor signalling value associated with capital
structure decisions). Given the growth in the market for electric
vehicles, the government is weighing up whether to drop the tax
exemption enjoyed by Full Charge Corporation. More specifically,
there is debate about the introduction of a 20% corporation tax
rate for companies in this market. What would this proposed tax
change mean for the post restructuring weighted average cost of
capital (WACC) and the share price of Full Charge? (For the
scenario where corporate taxes apply, assume that the
post-restructuring share count equals 39.4m). Again, assume there
are neither distress costs nor signalling implications associated
with capital structure decisions. Explain the underlying mechanisms
that lead to any changes in the WACC and share price.