Corporate Finance Theories - Assignment
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Added on 2020-02-14
Corporate Finance Theories - Assignment
Added on 2020-02-14
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15058285_P58836_assignment 3ACCOUNTING AND FINANCE RESEARCH PROJECTStudent number: 15058285Submission date: 30th September 2016EXECUTIVE SUMMARY1
15058285_P58836_assignment 3After globalisation, companies carry out operations at international level as they operate in different countries across globe.Thus, in order to sustain in the competitive age, they need huge amount of capital that is collected from debt and equity capital. Thecomposition of fixed and fluctuating capital that companies use is called capital structure. TUI Group is world’s leading tour companythat provides superior quality services to the global consumers to attain success. It is listed on London Stock Exchange (LSE) andconstutitents of FTSE index and regulated market of the Frankfurt Stock Exchange. This assignment report will lay emphasizes uponthe application of different corporate finance theories like capital structure theory in contxt to TUI Group. Moreover, shareholdersvalue analysis will be done in order to measures TUI Group’s worth to shareholders. Along with this, sensitivity analysis will be doneto assess the potential change in business performance with the market uncertainties. 1
15058285_P58836_assignment 3Table of ContentsINTRODUCTION........................................................................................................................................................................................31.TUI’s capital structure under the light of finance models.....................................................................................................................32. TUI’s market evaluation.....................................................................................................................................................................10A. Weighted Average Cost of Capital for TUI.......................................................................................................................................10B. Shareholder Value Analysis Model...................................................................................................................................................14C. Value Drivers.....................................................................................................................................................................................17D. Practically Application Difficulties of SVA......................................................................................................................................19E. Market Value of TUI..........................................................................................................................................................................223. Impacts of modifications of key assumptions of the model...............................................................................................................23CONCLUSION..........................................................................................................................................................................................26REFERENCES...........................................................................................................................................................................................27APPENDIX................................................................................................................................................................................................29Appendix 1. DCF model.........................................................................................................................................................................292
15058285_P58836_assignment 3INTRODUCTIONIn the volatile market era and tough competitive age, companies are require to make evaluation of their performance andmarket valuation as well. TUI Group is one of the top or leading tourism organization that has more than 1800 travel agencies, sixairlines, 130 aircraft, 300 hotels and 13 cruises around the globe.The present project report aims at developing an understanding of thedifferent capital structure theories in the light of finance models. Moreover, the report will also make market value analysis byestimating weighted average cost of capital of TUI Group. Apart from this, Shareholders value analysis (SVA) refers to the process ofanalysing that how operations of a firm affects the value of net present value (NPV) to the investors. In other words, it helps tomeasure the ability of organizations to generate excessive earnings than the cost of capital. The assignment report will apply the SVAmodel for TUI Group to analyse its earnings capability. Along with this, the report will also describe the difficulties associated with themodel in real corporate practice.This report will guide the management to take necessary steps and suitable and necessary decisions forthe better functioning, expansion and performance of the organization.1.TUI’s capital structure under the light of finance modelsFor understanding the capital structure of the company, first of all an understanding is needed to be established for the ways of selecting theircapital structure and its formation by any of the organizations. There is a relationship exists between capital structure of the company and thevalue of the firm (GmbH, 2016). The capital structure formations are different with respect to the nature of the organization and the region oflocation of the organization. This basic theory by Modigliani and Miller (1958) was proposed in a seminal research paper which is named as“The cost of capital, corporation finance, and the theory of investment”. This paper explained that the factors like taxation remedies on interestpayment and transaction cost are absent, credit of corporations and people takes place with similar rateand the value of the organization is3
15058285_P58836_assignment 3termed as independent from its capital structure.This proposed prototype is ideal for the organizations which exist in the environment of perfectcompetition and product markets.Apart from this basic model of capital structure, other three models for the structuring the base for theoreticalconsiderations for the organization are discussed subsequently (Hammes y.n.d).Miller and Modigliani(1958), developed two prepositions to describe the capital structure one is in the absence of capital structure and anotheris with the absence of taxation liabilities that are enumerated underneath:Preposition: 1. In the absence of taxation In this preposition, it has been believed that changes in capital structure do not influence net value and weighted average cost of capital ofthe firm. In other words, change in leverage and mix of debt and equity will not have any effect on firm’s value and cost of capital, thus, capitalstructure is irrelevant. As per the theory, TUI can gathered funds either from the use of debt or equity capital each has different benefits andshortcoming as well and each of the investors in the market have a same access to buy or sell their holdings. Preposition: 2. With the presence of taxation (Trade-off theory)The earlier preposition believe that there are no taxes, however, in the real corporate world, companies are require to pay taxes on theirearnings. This theory is termed as trade-off theory, in which, it has been discovered that debt is a cheaper financial source relatively to the costof equity. The reason behind this is interest paid on borrowed money is tax deductible, therefore, it provides tax benefits to the TUI Group.However, such kind of benefits will not be available on equity financing as dividend on equity capital will not give tax advantage to the4
15058285_P58836_assignment 3company. Thus, on the basis of this theory, TUI Group must make use of debt capital to a threshold point in their capital structure so as toreduce the overall cost of capital and rise firm’s value. However, beyond a threshold point, if debt are increase then it gives rises to the equitycapital risk, which in turn, result in higher cost. Therefore, in accordance with the theory, TUI Group must makes use of debt capital to aspecified point in order to reduce WACC and maximize value.The mode of debt financing is not a straight forward process but annexed with a lot of costs along with the benefits.The firm needs to make afine balance between costs and benefits by equalizing both the debt and capital sources through the application of trade off method. Somethingis forgone to achieve other thing but the thing that is permitted to forgo should not be in higher value than the benefits so the marginaldifference is the profit that is enjoyed by the company. Hence for the purpose of effective capital structure through the suitable mix of debt andequity financing, a cost and benefit analysis is also required to maintain for trading off the costs for the benefits and to determine the level ofcredit that is manageable by the firm for maximizing the value. If factors like rate of corporate tax, rate of personal tax on equity earning, ifmark-up rates on debt are under level, positive sentiments of market towards debt financing, knowledge from signs of quality of firm, signsfrom aggressive competition, accessibility to capital markets at fair value, expense of excess financing, costs of transaction, rights of thefinancers, the control mechanism and better skills of negotiations are signals of the benefits of the debt and these factors take the debt to higherbest possible stage. There are other factors which work in opposite direction like personal rate of tax on net revenue, direct financial distresscost and otherwise, the high rate of mark up on debt, negative sentiments of market toward debt financing, flexibility in knowledge,accessibility to capital markets at fair price, costs of underfinancing, transaction costs, rights of creditor and competitiveness of the market.5
15058285_P58836_assignment 3These factors show themselves as the cost of debt and they are contributing factor in declining the best possible stage (Serveas and Tofano2006)Pecking Order TheoryAccording to this theory, the organization does not set any particular amount of debt in conscious but relies solely on the outcome ofprofitability of the organization. This theory suggests that companies can raise money from three sources, that are retained profit, equityfinancing and debt financing (Serveas and Tofano 2006). It is one of the most influential theory of corporate leverage that demonstrates thatavailability of asymmetric information to the managers affects the selection of internal and external financing. It believes that retained earningsis the most effective source of finance because it is available at nil financial cost and have no adverse impact. While, if they need to raise moneythrough external finance, then debt gains preference over equity because share capital is more riskier and costlier because of higher premium.The reason behind this is debt interest is fixed and also give tax benefits, whereas, external investors need higher return in return for the riskundertaken. Thus, it can be said that firms often prefer internal financing, if require more funds, then debt will be issued first and then rest of thefunds will be collected by equity capital (Serveas and Tofano 2006).Agency costsAgency costs theories of finance takes their origination from basic principle of partnership and agent-principal relation. Principal under thisscenario is shareholder and members of management work as agents of the principal to function in the favour of shareholder and organization6
15058285_P58836_assignment 3by conduct of best practices. However, due to occurrence of asymmetric and imperfect level of comprehension and medium of transfer thatknowledge, the control of outcome and resultant factors are beyond the capacity of the management sometimes same is the case with decisionswhich are taken by the management. As per agency cost theory, shareholders do not necessarily desire a high level of variation and hence theyraise the debt level of the company. Therefore, they reduce the FCFF (Free cash flow for the firm) which is available to managers who are self-motivatedfor fund provision in variation programs which are not profitable(Jstor.org, 2016).This theory says that agency costs arises when managers of the firm owns a proportion of total share capital. As a result, they can work inthe interest of stakeholders. This theory proposes that indebtedness can be considered as a way to resolve conflicts between both the managersand shareholders. The theory indicates that indebtedness gives rises to three type of costs that are control and justification, higher risk andbankruptcy as well. Thus optimal capital structure gives huge assistance to the firm to minimize agency cost and to appeal for external funds tomeet out long-term capital requirement.TUI’s Structure of CapitalThe capital structure of TUI is dependent on several factors namely size of the firm, CVA, earnings volatility, profitability, growthopportunities, energy extremity, framework of ownership, rated vs. non-rated, less cost against service and leasing characteristics. With respectto size of the firm, TUI is considered as one of the greatest because of the widespread huge size and number of employees as well as area ofmanagement. The greater the size, theless capacities and abilities ofearnings due to meeting up the mass administrative and operational cost. Asper Wessel and Titman (1988) the size of the company stimulates the revenue capacity of that company. TUI Group follows trade-off theory, in7
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