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