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Corporate Financial Policy: HDC Inc.


HDC Inc.

Kyle Smith, CEO of HDC Inc. (HDC), sat in his office reflecting on a meeting he had with an investment banker earlier in the week. The banker, whom Kyle had known for years, asked for the meeting after a group of private equity investors made discreet inquiries about a possible acquisition of HDC. Although HDC was a public company, a majority of its shares were controlled by family members descended from the firm’s founders together with various family trusts. Kyle knew the family had no current interest in selling – on the contrary, HDC was interested in acquiring other companies in the same industry – so this overture, like a few others before it, would be politely rebuffed.

Nevertheless, Kyle was struck by the banker’s assertion that a private equity buyer could “unlock” value inherent in HDC’s strong operations and balance sheet. Using cash on HDC’s balance sheet and new borrowings, a private equity firm could purchase all of HDC ’s outstanding shares at a price higher than $114.33 per share, its current stock price. It would then repay the debt over time using the company’s future earnings. The banker pointed out that HDC itself could do the same thing

 – borrow money to buy back its own shares. In the days since the meeting, Kyle’s thoughts kept returning to a share repurchase.

HDC’s Business

HDC was a large producer of branded appliances primarily used in residential households. For the period 2012-2017 the industry posted modest annual unit sales growth of 1.8% despite positive market conditions including a strong housing market and product innovations. Competition from inexpensive imports and aggressive pricing by mass merchandisers limited industry dollar volume growth to just 2.5% annually over that same period. Under Kyle Smith’s leadership, HDC operated much as it always had, with three notable exceptions. First, the company completed an IPO in 2011.

This provided a measure of liquidity for founders’ descendants who, collectively, owned 62% of the outstanding shares following the IPO. Second, beginning in the 2010s, HDC gradually moved its production abroad. Finally, HDC had undertaken a strategy focused on rounding out and complementing its product offerings by acquiring small independent manufacturers or the kitchen appliance product lines of large diversified manufacturers. Thus far, all acquisitions had been for cash or HDC stock.

HDC’s Performance

During the year ended December 31, 2017, HDC earned net income of $6.35 billion on revenue of $83.18 billion. Exhibits 1 and 2 present the company’s recent financial statements. The company’s 2017 EBIT margin of nearly 13.0% was average within the peer group. During 2012-2017, compounded annual returns for HDC shareholders, including dividends and stock price appreciation, were approximately 11% per year. This was higher than the ASX S&P200, which returned approximately 6% per year. However, it was well below the 16% annual compounded return earned by shareholders of HDC’s peer group during the same period.

HDC’s Financial Policies

HDC’s financial posture was conservative and very much in keeping with HDC’s long-standing practice and, indeed, with its management style generally. In recent years the company’s largest uses of cash had been common dividends and cash consideration paid in various acquisitions. Dividends per share had risen only modestly during 2012-2016. However, as the company issued new shares in connection with some of its acquisitions, the number of shares outstanding climbed up to approximately 1.2 billion by the end of 2017.

            
 


 

 
 


 

 
 

31/12/2017

 
 


 

 
 

Net income (000s)

 
 

6,345,000

 
 


 

 
 

Average number of shares outstanding (000s)

 
 

1,267,881

 
 


 

 
 

Effective tax rate (corporate)

 
 

36.397%

 
 

QUESTIONS
Capital structure
1.  With the help of the Excel spread sheet provided, compute the market debt to equity (D/E) ratio for HDC. Then use it to compute the current cost of equity (rE) and the pretax-WACC for HDC. Assuming the cost of unlevered equity (rU) is 12%. (Hint: the market value of debt equals its book value; it is the sum of Long-Term Debt and Short-Term Debt.)
At present Kyle is considering the following share repurchase proposal from the firm’s CFO: the company could raise $5 billion new debt (on permanent basis) at a competitive rate of 0.58% to repurchase shares.
2. Compute the market D/E ratio, rE and pretax-WACC in this scenario.
3. Compare your results in Questions 1 and 2. Explain the relationship between capital structure and the cost of capital with no taxes (as if in perfect markets). How would the weight average cost of capital (WACC) differ if the effect of taxes is incorporated? Justify.

Assume that Kyle was impressed by your discussion in Question 3. He now understands that interest is tax deductable and the firm could potentially benefit from issuing more debt. Kyle decides to issue $5 billion of debt (on permanent basis) and use the proceeds to repurchase shares.

4. What is the present value of interest tax shield (ITS) of the new debt?

5. At the announcement of the repurchase, what is the new market value of the equity and the share price (assume no arbitraging)?

6. After the repurchase, how many shares are outstanding? How has this deal affected the total value of the firm?

Payout Policy

7.  If HDC adopts a 100% dividend payout policy, what is the after-tax dividend income of a shareholder whose personal tax rate is 36%, in 1) a classic tax system; and 2) the imputation tax system? Which tax system would he/she favour? Why?8. Are there any downside to this deal? Justify.

Other

8. Are there any downside to this deal? Justify.

                                                                                                                                                                                                                                     APPENDIX I

                                                                                                                                                                                                      APPENDIX II 
                                                                                                                          HDC’s Financial Statements
                                                                                                                                                                                                 Case Exhibit 1: HDS’s Balance Sheet (in 000s)
                                                                                                                                                                                                                                   Balance Sheet
           
 

Period Ending:

 
 

31/12/2017

 
 

Current Assets

 
 


 

 
 


 

 
 

Cash and Cash Equivalents

 
 

1,723,000

 
 

Net Receivables

 
 

1,484,000

 
 

Inventory

 
 

11,079,000

 
 

Other Current Assets

 
 

1,016,000

 
 


 
                                                                                
 


 

 
 

Total Current Assets

 
 

15,302,000

 
 


 

 
 


 

 
 

Long Term Assets

 
 


 

 
 


 

 
 


 

 
 


 

 
 


 

 
 

Fixed Assets

 
 

22,720,000

 
 


 

 
 


 

 
 

Intangible assets

 
 

1,353,000

 
 


 

 
 


 

 
 

Other Assets

 
 

571,000

 
 


 

 
 


 

 
 

Total Assets

 
 

39,946,000

 
 


 

 
 


 

 
 

Liabilities & stock holders' Equity:

 
 


 

 
 


 

 
 


 

 
 


 

 
 

Accounts Payable

 
 


 

 
 

9,473,000

 
 


 

 
 


 

 
 

Short Term Debt/Current Portion of Long Term Debt

 
 

328,000

 
 


 

 
 


 

 
 

Other Current Liabilities

 
 

1,468,000

 
 


 

 
 


 

 
 

Total Current Liabilities

 
 

11,269,000

 
 


 

 
 


 

 
 

Long Term Debt

 
 

 16,869,000

 
 


 

 
 


 

 
 

Other Liabilities

 
 

1,844,000

 
 


 

 
 


 

 
 

Deferred Liability Charges

 
 

642,000

 
 


 

 
 


 

 
 

Total Liabilities

 
 

30,624,000

 
 


 

 
 


 

 
 

Stock Holders’ Equity

 
 


 

 
 

9,322,000

 
 


 

 
 


 

 
 

Total Liabilities & Shareholders' Equity

 
 

39,946,000

 
 


 

 
 


 

 
 


 

 
 


 

 
 


 

 
 


 

 
 


 

 
 


 

 
 
Case Exhibit 2: HDC’s Income Statement (in 000s)
Income Statement (000s)


 
 

 
 
Period Ending:
 
 
31/12/2017
 


 
 

 
 
Total Revenue
 
 
83,176,000
 
 

 
 

 
 
Cost of Revenue
 
 
54,222,000
 
 

 
 

 
 
Gross Profit
 
 
28,954,000
 
 

 
 

 
 
Operating Expenses
 
 

 
 

 
 

 
 
Sales, General and Admin.
 
 
16,834,000
 
 

 
 

 
 
Other Operating Items
 
 
1,651,000
 
 

 
 

 
 
Operating Income
 
 
10,469,000
 
 

 
 

 
 
Add'l income/expense items
 
 
337,000
 
 

 
 

 
 
EBIT
 
 
10,806,000
 
 

 
 

 
 
Interest Expense
 
 
830,000
 
 

 
 

 
 
Earnings Before Tax
 
 
9,976,000
 
 

 
 

 
 
Income Tax
 
 
3,631,000
 
 

 
 

 
 
Net Income-Cont. Operations
 
 
6,345,000
 
 

 
 

 
 
Dividends
 
 
6,345,000
 
 

 

  Corporate 
 

Answer

Corporate Financial Policy

Answer 1

Debt Value = Short term + Long term borrowing = 17,197,000

Equity Value = Share price * Shares Outstanding = $114.33 * 1,267,881 = 144,956,834.73

Total Value = 162,153,835

Debt/Equity Ratio = Debt/Equity = 0.12

Cost of Equity (ke) = ru+ [(ru – rd) * (1-t) * Debt/Equity]

ke = 12% + [(12%-0.58%) * (1-36.4%) * 0.12]

Cost of Equity (ke) = 12.86%

Pretax WACC = ke* (Equity Value/Total Value) + kd* (Debt Value/Total Value) 

Pretax WACC = 11.56%

After Tax WACC = ke* (Equity Value/Total Value) + kd* (Debt Value/Total Value) * (1-t)

After Tax WACC = 11.54%

Answer 2

Debt Value = Short term + Long term borrowing = 22,197,000

Equity Value = Share price * Shares Outstanding = $114.33 * 1,267,881 = 144,956,834.73

Total Value = 167,153,835

Debt/Equity Ratio = Debt/Equity = 0.15

Cost of Equity (ke) = ru+ [(ru – rd) * (1-t) * Debt/Equity]

ke = 12% + [(12%-0.58%) * (1-36.4%) * 0.15]

Cost of Equity (ke) = 13.11%

Pretax WACC = ke* (Equity Value/Total Value) + kd* (Debt Value/Total Value) 

Pretax WACC = 11.45%

After Tax WACC = ke* (Equity Value/Total Value) + kd* (Debt Value/Total Value) * (1-t)

After Tax WACC = 11.42%

Answer 3

As seen above, we can summarize results in two scenarios as follows:

              

 


 

 
 

Initial

 
 

Additional $5bn debt

 
 

D/E

 
 

0.12

 
 

0.15

 
 

Ke

 
 

12.86%

 
 

13.11%

 
 

Pre-tax WACC

 
 

11.56%

 
 

11.45%

 
 

After tax WACC

 
 

11.54%

 
 

11.42%

 

Clearly, as more debt was assumed in the capital structure, debt/equity ratio increased to reflect the same. 

The cost of equity also increased as now the company has become relatively riskier due to more fixed obligations in the capital structure. The firm will have to meet more fixed obligations in form of debt interest expense before it can reward its equity shareholders.

Both pre-tax and after tax WACC have reduced which is due to high gearing in capital structure that has been acquired at lower rates. Additionally, the after tax WACC reduces more in second case. This is because tax benefit is available on a higher debt base now, leading to more reduction in after tax WACC.

Answer 4

Assuming entire $5bn debt is used to repurchase stock at $114.33/share, total number of shares to be repurchased (‘000) is 43,733.05.

Tax shield on debt (‘000) = 5,000,000*0.58%*(1-36.4%) = 18,572.08  

Discount rate for PV = after tax WACC in repurchase scenario = 11.42%

PV of tax shield = 18,572.08/(1+11.42%) = $9,538.61

Answer 5

At the time of announcement, the debt increases by $5bn and shares outstanding reduce as follows (in ‘000): 

Initial EPS = Earnings / Initial #shares = 6,345,000/1,267,881 = $5.00

Earning yield = Share price / EPS = 114.33/5 = 22.85

Now, after repurchase,

After tax cost of fund = Amount used for repurchase * Kd * (1-t) = 5,000,000*0.58%*(1-36.4%) = 18,572.08

EPS = Earnings-After Tax cost of fund/ New#shares = (6,345,000-18,572.08) / (1,267,881-43,733.05) = $5.17

Assuming same earning yield of 22.85, new share price = 22.85*$5.17 = $118.07

Market cap (‘000) = New # shares * share price = 1,224,147.95 * 118.07 = $144,532,540.11

Share price = $118.07

Market cap (‘000) = $144,532,540.11

Answer 6

As seen above, the number of shares outstanding (‘000) has reduced from 1,267,881 to 1,224,147.95. The values of firm can be summarized as follows:

           

 


 

 
 

Initial

 
 

Additional $5bn debt

 
 

Debt value

 
 

17,197,000

 
 

22,197,000

 
 

Equity value

 
 

144,956,834.73

 
 

144,532,540.11

 
 

Total value

 
 

162,153,835

 
 

166,729,540

 

Despite reduction in number of shares outstanding, equity value has reduced only marginally. This is due to increased share price. The total value of the firm has increased after the repurchase with borrowed funds.

Answer 7

The shareholder will definitely prefer imputation system as it avoids double taxation. Due to tax credit, the funds in hand of shareholder increase. For example, in this case, corporate tax rate is 36.4% while personal rate is 36.0% only. Hence, shareholders will get a credit for tax difference.

Answer 8

The buyback of shares through borrowed money helps to increase share price as well as company value. It may also lead to more disciplined operations due to high gearing in capital structure. It also helps the company to resist hostile takeovers. Additionally, it is good for shareholders as their per share value increases.

However, a company may deceptively use this method to only increase EPS without any significant improvement in performance. This inflated EPS may also deflect attention from other financial metrics that may be signalling otherwise. In such cases, the increased interest expense may actually become a liability and lead to increased pressure on business.





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