Analysis of A2 Milk Company's Capital Structure and Dividend Policy

This report analyses A2 Milk Company's capital structure and dividend policy, computes the weighted average cost of capital, and provides recommendations for investment. The report includes analysis of the company's stability, ratios, and implications, as well as the computation of WACC.

CORPORATE FINANCE
A2 MILK COMPANY
STUDENT ID:
[Pick the date]

Introduction
The objective of the given report is to analyse the given company (i.e. A2 Milk Company)
and compute the weighted average cost of capital. In this regards, the capital structure of the
company as in FY2018 has been considered. Additionally, the stability of the capital structure
of the company is analysed using the debt ratio as a proxy. Besides, the dividend policy of the
company would also be analysed with reference to the precise reason of the company
preferring such a policy. Based on this analysis and also reference to ratio analysis,
recommendation would be provided to the client with regards to whether investment should
be made in the given company or not.
Analysis of company
The analysis of the company has been carried out with regards to dividend policy, ratios and
implications coupled with the computation of WACC.
6i) The beta of the company as per Reuters is 0.90 as shown in the Appendix.
ii) The required rate of return on equity for a company can be estimated using the CAPM
model whose equation is shown below (Damodaran, 2015).
Required rate of return = Risk free rate + Beta * Market Premium
Based on the given inputs, risk free rate = 4%, market risk premium = 6% and beta = 0.90
Hence, expected return on equity = 4 + 0.9*6 = 9.4% p.a.
iii) Yes, the company selected would be considered as a “conservative” investment since the
underlying beta of the stock is lower than 1 which implies that the relative movement in
either direction would be lesser than the market index (Parrino and Kidwell, 2014).
7i) Based on the above computation, the objective is to compute the WACC for the company.
Cost of equity (computed above) = 9.4% p.a.
Based on the FY2018 annual report, it is apparent that the company does not have any debt
on the books of account. As a result, the capital structure of the company comprises of only
equity. Since the capital structure comprises of only equity, hence the WACC should be same
as cost of equity or 9.4% p.a (Petty et. al., 2015).

ii) Any increase in the WACC would tend to adversely impact the viability of the various
investments. This is because the hurdle rate would tend to increase which would make less
investments feasible. It is also possible that owing to higher WACC, some of the projects that
are currently feasible may be rendered infeasible after the WACC increases. Also, the NPV
of the projects tends to be extremely sensitive to the changes in the WACC and the same
would need to be considered while taking decisions of capital budgeting. This may also bring
about a phase where the capital investment of the company may reduce owing to inability of
the projects to meet the hurdle requirements. As a result, the company may pay higher
amount as dividends (Damodaran, 2015).
8i) The debt ratio is defined as the ratio of total liabilities to total assets. The computation of
this ratio for the company for FY2017 and FY2018 is indicated below (A2Milk, 2018).
Total Assets (FY2017) = $ 343.93 million
Total Liabilities (FY2017) = $102.45 million
Total Assets (FY2018) = $ 722.578 million
Total Liabilities (FY2018) = $ 166.869 million
Debt ratio (FY2017) = (343.93/102.45) = 3.36
Debt ratio (FY2018) = (722.578/166.869) = 4.33
Based on the above, it is apparent that the capital structure of the company is not stable since
there seems to be a shift towards equity based financing which is leading to the rise in the
debt ratio whereby the assets are increasing and the liabilities are increasing are at a much
lower pace owing to compensation from rise in equity (Parrino and Kidwell, 2014).
ii) The company has been debt free for both FY2017 and FY2018 since there is no debt on
the books of the company. However, in both the years, the company has been aggressively
raising equity. This is apparent from the cash flow statement where the amount of equity
proceeds in FY2017 and FY2018 amount to $ 3.754 million and $ 7.264 million respectively.
The directors report does not outline any particular reasons as to why the company is
continuously raising equity and not going for debt based financing. (A2Milk, 2018).
9) The objective is to highlight the dividend policy of the company. The company dividend
policy is aligned with the basic objective of creating long term value for the shareholders. As

a result, the company tends to favour providing regular dividends to shareholders on the basis
of surplus cashflows after meeting any need for future or present capital funding requirement.
Further, the company also uses dividend policy as a means to alter the capital structure. This
is done specially through the issuance of the stock dividends where the issued share capital
tends to arise (A2Milk, 2018).
The strong relation of the dividends based on the operational profitability is established from
the recent announcement by the company when it is considering providing a special dividend
to the shareholders owing to the stellar performance of the company. Hence, the company is
averse to the idea of holding significant amount of cash on the books unless the same is
required for any particular investment which can potentially fund expansion to newer markets
and hence ensure that the reach of the company further enhances. This policy is labelled as
residual policy where the company pays the residual amount as dividends to the shareholders
(Petty et. al., 2015).
The above policy makes sense for the company considering the fact that the company is
currently performing very well and is expanding to new markets (Sprague, 2017). This
performance would not continue in the future and eventually the company would slow down.
A constant dividend policy and stable dividend policy are more suitable for firms that are in
their maturity phase. But the given company is in the growth phase where the profits
generated are not stable and tend to be quite fluctuating owing to which it is best that the
dividends be recommended after considering the residual amount from the profits generated
(Damodarab, 2015).
Conclusion & Recommendation
10) Based on the given performance by the company in the recent times, it would be correct
to assume that the stock is a good choice for investment and expected to generate superior
returns. The ratios of the company are quite healthy and there is an incremental increase in
not only the revenues but also the profit margins. Also, the company is debt free which
implies low financial risk and potential to grow in the future using debt funding as the
underlying mechanism. Also, the company under the current phase is offering significant
amount of discounts owing to the commitment of the company to create value for
shareholders. The dividend yield for the company is attractive which also makes a strong
case for investment. Also, the company is witnessing significant growth in sales and profits
which is reflected in the share price rise. This is particularly true with regards to the instant

formula which has global demand which is on the rise (NBR, 2017). As a result, despite the
current run up in stock price, this provides a good opportunity to the client for making
investment.

References
A2Milk (2018) Annual Report FY2018, [online] Available at
https://thea2milkcompany.com/wp-content/uploads/A2M-Annual-Report-FY18.pdf
[Assessed October 20, 2018]
Damodaran, A. (2015). Applied corporate finance: A user’s manual 3rd ed. New York:
Wiley, John & Sons.
NBR (2017) A2 Milk triples annual profit and mulls special dividend, [online] Available at
https://www.nbr.co.nz/article/a2-milk-triples-annual-profit-and-mulls-special-dividend-b-
206810 [Assessed October 20, 2018]
Parrino, R. & Kidwell, D. (2014) Fundamentals of Corporate Finance, 3rd ed. London:
Wiley Publications
Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M., & Nguyen, H. (2015).
Financial Management, Principles and Applications, 6th ed.. NSW: Pearson Education, French
Forest Australia
Sprague, J. (2017) The a2 Milk Company considers dividends as profit surges, [online]
Available at https://www.afr.com/business/retail/fmcg/a2-milk-company-considers-
dividends-as-profit-surges-20171121-gzpjf6 [Assessed October 20, 2018]

Appendix