Corporate Financial Policy: HDC Inc.

pages Pages: 4word Words: 890

Question :

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.










Net income (000s)






Average number of shares outstanding (000s)






Effective tax rate (corporate)




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.


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:




Current Assets






Cash and Cash Equivalents




Net Receivables








Other Current Assets







Total Current Assets








Long Term Assets












Fixed Assets








Intangible assets








Other Assets








Total Assets








Liabilities & stock holders' Equity:










Accounts Payable










Short Term Debt/Current Portion of Long Term Debt








Other Current Liabilities








Total Current Liabilities








Long Term Debt








Other Liabilities








Deferred Liability Charges








Total Liabilities








Stock Holders’ Equity










Total Liabilities & Shareholders' Equity



















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


Period Ending:


Total Revenue


Cost of Revenue


Gross Profit


Operating Expenses



Sales, General and Admin.


Other Operating Items


Operating Income


Add'l income/expense items




Interest Expense


Earnings Before Tax


Income Tax


Net Income-Cont. Operations




Show More

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:







Additional $5bn debt














Pre-tax WACC






After tax WACC






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:







Additional $5bn debt


Debt value






Equity value






Total value






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.