Table of Contents
1.1 Free Cash flow
1.2 Hostile takeover:
1.3 Cash offer and mixed mode finance offer:
2.1 Exchange control
2.2 Investment decision
2.3 Foreign exchange risk
3.1 Credit risk exposure
3.2 Hedging options
3.3 Development in world financial market
2008 financial crisis
Dark pool trading system
Free movement of capital
Money laundering regulation
Proposed acquisition of Fly-up Airways, business expansion in Cambodia and company’s exposure to different risk and development in the world financial market.
Business expansion has grown dramatically over the last decade, bringing with it major changes in the organization and control of economic activity around the world. A company wants to expand its activity to achieve advantage of exposing the business to a wider audience and to exploit favorable financing opportunities.
The purpose of this report is to identify whether Stetson Group PLC should expand its planned business activities through acquisition and market development and how to finance its expansion and cope up with external issues.
This report provides information obtain through free cash flow methodology, Net present value calculation, sensitivity analysis and hedging option available to the company. All the relative calculation is in the three different appendices.
The aim of this report is to investigate Stetson’s expansion strategy in the UK and internationally and evaluation of the development in the world financial market. Different books, journals articles and newspapers have been looked for the purpose of preparing this report. Overall report include the value of Fly-up Airways and it indicate that the company will have positive net present value if it will go for the investment in Cambodia. The result also shown that, the company will have exposure to credit risk due to the borrowing requirement.
It is recommended that Stetson should finance its takeover in form of mixed financial offer which consists of both cash and share. The company need to manage its exposure to exchange risk effectively during international expansion and it should use future contract for the borrowing requirement of £20m
1.1 Free Cash flow
As the size of the acquisition is very significant so it is necessary to establish the potential group value on the assumption that shareholder value is not reduced in Fly-up Airways whereby this will give the maximum premium that should be paid.
Using the free cash flow valuation model (appendix 1) the value of FA is £980.6m which is wholly equity. Therefore, Stetson should pay maximum £980.6m or less then this to maximize its shareholder wealth.
This modeling method assumes that the free cash flow model represents the fair value of the business, that the company is a going concern; taxes are deducted in the same year and earning increase indefinitely like growing perpetuity. It is also assumed that company pay tax at the repayment date therefore they are entitled to tax savings in 2020 as well. Un-geared cost of capital has been used for the discounting purpose.
1.2 Hostile takeover:
Stetson Group wants to takeover Fly-up Airways (FA) to achieve trade advantages or synergy. As FA is successful trading company, they may not want to sell the company and may think this as a hostile bidding approach. FA could adopt the following defensive approaches to protect the company from hostile bidding of Stetson Group.
FA could follow staggered board approach where the directors of the company are divided into three classes. Only one class i.e. one third of the directors is elected each year. In essence, directors are granted three-year terms. Consequently, Stetson Group wishing to obtain control of the board of directors of the company will have to wait two years, even if they hold the majority of the company’s shares.
FA can make itself an unattractive company by giving the right to existing shareholder to buy the shares at a very low price. However, poison pills have many variants.
Non-Voting and Multiple Voting Shares:
FA could include provisions in the company’s articles of association whereby differential share structure are set up under which minority shareholders exercise disproportionate voting rights and thus enabling FA to frustrate this takeover bid.
FA can challenge the acquisition by inviting an investigation through the courts or by the regulatory authorities. FA may be able to sue for a temporary order to stop Stetson Group from buying any more of its share.
On facing a hostile bid FA can sell most valuable assets at its own initiative leaving the rest of the company intact and hence eliminate the motivation for which bid was offered. Instead of selling the assets, the FA may also lease them or mortgage them so that the attraction of free assets to Stetson Group is suppressed. By selling these jewels the company removes the incentive that may have caused the bid.
White Knights and white squires:
FA could invite a firm that would rescue the company from unwanted bidder. The firm would act as a friendly counter bidder which can acquire a majority stake in the company and is therefore called a white knight.
A different kind of the white knight strategy is the white squire. FA could invite a firm which will acquires a smaller portion rather than acquiring a majority stake in the company, but this is enough to hinder the hostile bidder.
Golden Parachutes: FA can arrange employment contracts between the management and key employees to increase their post employment compensation in the event of a hostile takeover. As a result of this FA will become less attractive to the Stetson Group because generous payments to departing management and employees could financially deplete the company.
This is a counter bid which is an aggressive rather than defensive tactics. FA can attempt to take-over Stetson Group. However, FA needs to be willing to leverage itself by raising funds through the issue of junk bonds.
Real life examples:
Attempted Hostile takeover of Yahoo by Microsoft: (2008)
Microsoft had raised its initial bid by about US$5 billion, but that didn't convince Yahoo to accept the revised offer. Microsoft failed to takeover yahoo because of their defensive tactics. (Schofield, 2008)
Forman approached to Lenox:
Forman (manufacturer of Jack Daniels) approached Lenox for a hostile bid at a 60% premium over the market price. Lenox hired Lipton to help with the defense. During rejecting the offer from Brown Forman (BF) the board of Lenox issued a 'Special Cumulative Dividend' to the shareholders of Lenox. This forced Brown Forman to increase its offer and enter into a new negotiated agreement to acquire Lenox. (Sunder, 2013)
Lundin Mining Corporation Equinox Minerals Ltd: (2011)
On 28 of February 2011 Lundin mining Corporation received a hostile takeover bid from Equinox for the whole company of C$4.8 billion in cash and share. However, Lundin’s board of directors adopted a limited duration shareholder right plan to reject the bid and successfully defend the company from hostile takeover. (Anon, 2011)
1.3 Cash offer and mixed mode finance offer:
Stetson can pay in form of share exchange, cash or convertible loan stock. The choice will depend on levels of gearing, availability of cash, shareholders’ taxation position and changes in control.
Cash payment: Stetson may divest some of its own asset to accumulate cash to finance the takeover of FA. They may also generate cash by the proceeds of debt issues and a loan facility from bank.
Mixed mode: this method of payment involves both cash and share payment. Stetson can give its own share to finance takeover of FA.
Advantages and disadvantages:
Acquisition by cash may create tax liabilities to the selling firm’s stakeholder and the use of stock to finance a merger may create agency problem which is, trying to exploit the information advantage the acquirer has over the target firm’s shareholder. Both Stetson and FA companies’ shareholders may have the following advantages and disadvantages as a result of both types of payment.
From Stetson perspective:
1. Reduced earnings per share: If Stetson wants to purchase by equity shares it will be the cause of falling in earning per share attributable to its existing shareholder.
2. Increased cost: if Stetson uses loan stock to back cash offer this will have lower cost than equity and attract tax relief on the interest. Ordinary share will have higher coupon rate than Convertible loan stock.
3. Changing in control: if Stetson issues a large number of shares to purchase FA it may result of changing in control significantly.
4. Authorization: authorization will be needed if payment is in form of shares which will involve arranging a general meeting to press the important exploration.
From FA perspective:
1. Tax on capital gain: if FA receives payment in form of cash, many investors of the company will be subject to tax liability on capital gain.
2. Income: if payment is not cash, alignment has to mean that current income is maintained or be recompensed by reasonable growth expectation and suitable capital gain.
3. Future investment: many shareholders of FA will prefer payment in form of share who want to retain share in target business and want to be sure that the share retain their values.
2.1 Exchange control:
Exchange controls limit the flow of foreign exchange into and out of a country due to defend the local currency and to protect reserves of foreign currencies. Exchange controls are normally very restrictive in developing countries like Cambodia and less in developed countries like UK although some still exist in developed countries. (Tamirisa, 1998)
The following exchange control issues may be faced by Stetson due to make investment in Cambodia
Rationing the supply of foreign exchange:
If Stetson want to make payment for the expansion in Cambodia in a foreign currency, will be restricted by the limited supply and this will stop them from investing as much as they want in Cambodia. (Anon, 2014)
Restricting the types of transaction
Restricting the types of transaction for which Stetson is allowed to make payment in Cambodia, for example by banning or suspending the payment of dividends to Cambodian branches. These types of restriction will create the problem of blocked funds for Stetson. (Anon, 2014)
Reducing trade of the company:
Exchange controls may raise transaction and other trade-related costs and thus reducing trade of the company. Costs and uncertainty associated with international transactions will increase because exchange controls tend to constipate the efficient foreign exchange markets and modern payment instruments. Moreover, exchange control may encourage evasion and rent-seeking, which impose unproductive costs on the company. (Zhang, 2007)
Stetson is considering a potential project to be implemented in Cambodia where government restrictions may require that a percentage of Cambodian earnings remain in Cambodia. Since Stetson may never have access to these funds therefore the project may not be attractive to Stetson although it may be attractive to the Cambodian branches. (Anon, 2012)
One possible solution is to let the Cambodian branches to obtain partial financing for the project within the Cambodia. In this case, the portion of funds which is not allowed to be sent to Stetson can be used to cover the financing cost over tome.
Exchange control may reduce the NPV of the project and the project may not be financially viable as a result of exchange control.
2.2 Investment decision: (Calculation in appendix: 2)
During making decision whether investment in Cambodia is financially viable or not, the following assumptions have been considered.
1. Market research cost is not incremental to the project therefore this is irrelevant in net present value calculation.
2. Fixed cost is associated with the investment therefore this is incremental.
3. Since Stetson needs to buy sell therefore, they will get lower rate which is 1.645.
The acceptability of proposed investment:
The net present value is positive +£78.81 (from appendix 2) so the proposed investment is financially acceptable.
This refers to how sensitive the present value of the project with the variables such as sales, variable cost, fixed cost, taxation and so on.
From appendix 1 sale is 28% sensitive to the present value of the project. Therefore, if Stetson’s sale reduces to 28% then NPV= 0. However, if sales reduce more than 28% there will be negative present value in the project.
Fixed cost is 353% sensitive to the net present value of the project. Therefore, fixed cost can increase by as much as 353% and at this point NPV = 0. However, if fixed costs increase above 353% there will be negative present value.
However, the following issues need to be considered when conducting sensitivity analysis.
1. The method requires that changes in each variable are isolated. However, management is more interested in the combination of the effect of changes in two or more variable.
2. This analysis does not take into account the probability that any particular variation in revenues or costs may occur
2.3 Foreign exchange risk:
if Stetson make investment in Cambodia, they will be potentially exposed to foreign exchange risk - i.e. their wealth will be affected by movements in exchange rates. Different types of foreign exchange risks that Stetson may face and how they can manage these risks are given bellow.
The exchange rate may change between the transaction date and the subsequent settlement date and this may result of gain or loss arising on transformation. This risk will primarily be correlated with imports and exports of Stetson If the company exports goods on credit then it has a figure for borrowers in its accounts and the amount it will finally receive depends on the foreign exchange movement from the transaction date to the settlement date.
Transaction risk will have a potential impact on the cash flows of the company and the degree of exposure will be dependent on the size of the transaction and the hedge period which is the time period before the expected cash flows occurs. As the Stetson transaction is material therefore the company may have significant exposure to transaction risk.
Manage Transaction risk:
1. Invoice in home currency ( £): one easy way that Stetson may insist foreign customer to pay by UK currency “£” and the company will pay all imports by UK currency. However, potential customers may not accept this strategy and potentially they may look for another supplier.
2. Leading: Stetson can try to reduce credit term and this could be done by factoring of negotiation with customer. Company can offer discount to the customer who will pay faster.
3. Lagging: Stetson may delay conversion Cambodian currency to the UK currency to get better of favorable rate at future.
4. Matching: When Stetson will have receipts and payments in the Cambodian currency due at the same time, company can simply match them against each other
Stetson may make exchange losses when the accounting results of its Cambodian branches will be translated in to UK currency. The company will expose to translation risk because the value of these accounts must finally be stated in UK currency for reporting purpose in the Stetson’s financial statement. If exchange rates change, the UK currency value of Cambodian branch’s assets and liability will change, and these movements will be the result of translation losses or gains.
Manage translation risk:
If the company wants to minimize its exposure to translation risk, they can follow two methods to deal with translation risk. These are
1. Balance sheet hedge: The most possible translation exposures to Stetson are balance sheet items, such as foreign denominated receivables, payables, cash or other short-term assets or obligations. Company can hedge these with forward contracts that match the underlying asset or liability in amount, currency and time frame. Stetson may eliminate the mismatch between net asset and net liabilities denominated in the same currency. However, this may create transaction exposure.
2. Derivatives hedge: Stetson may use forward contracts with a maturity of the reporting period to attempt to manage the accounting numbers. Using this technique to manage translation exposure implies speculation regarding foreign exchange rate changes.