CFTP Case Study 2017 Autumn Semester
- BPT Corporation was a provider of accommodation solutions and recreation vehicles, parts and accessories. BPT had two operating divisions: Manufactured Accommodation (MA) and Recreational Vehicles (RV). The MA division provided portable accommodation to the construction and resource industries. The division also provided park home and transportable housing to the retirement, recreation and education sectors. The smaller RV division was involved in the manufacture and sale of caravans, and campervan hire.
- Following several years of profit growth underpinned by strong demand from the resources sector, the focus of BPT’s management in 2016 was on restructuring the company’s operations to reduce costs and improve production efficiencies. The trading conditions in the company’s key markets were weak throughout 2016 and net profit after tax fell 70%.
- BPT’s financial performance over the last five years was set out below:
For the year ending 31 December 2016* 2015 2014 2013 2012
Revenue ($ millions) 343 394 476 289 361
Operating profit after tax ($ millions) 16.6 55.2 51.2 37.8 36.5
Cash flow from operations ($ millions) 25.3 76.3 52.8 53.8 53.0
Debt ($ millions) 44.8 0.9 21.0 – 9.0
Assets ($ millions) 312.6 289.8 307.5 210.5 197.2
Shareholders funds ($ millions) 214.1 231.2 206.2 156.9 141.7
Number of shares issued (million) 60.0 59.2 57.8 54.0 52.6
Earnings per share (cents) 27.6 93.8 90.0 72.6 68.7
Dividends per share (cents) 30.0** 76.0 73.0 68.0 66.0
Share price at end of year ($) 3.42 11.74 11.33 9.19 5.90
* Based on preliminary final results.
** The final dividend was yet to be determined.
- The Board was comprised of four non-executive directors and the chief executive officer, Greg Harper. Meetings were generally held monthly. The following agenda items were discussed at the Board meeting in January 2017:
- What would be BPT’s after-tax WACC based on its capital structure as at 31/12/16?
- Should a different cost of capital be established for the two business divisions?
- Further, how should the risk of each project within a division be measured and incorporated into project evaluation?
- Should the RV division be sold to Adventure Group or be retained and even expanded?
- Should BPT renew the remuneration package of Greg Harper?
- An update on BPT’s capital structure.
- A decision on the amount of the final dividend.
- Should BPT increase the discount on its dividend reinvestment plan?
- The after-tax WACC for the company would be calculated annually using the market value of the gross interest-bearing debt and equity securities outstanding at the balance date. The risk-free rate was assumed to be 2.7%. ABC used a market risk premium of 6% in all cost of equity estimates. The company tax rate was 30%. Harper suggested that the company WACC was about 7%.
- The Board decided that a separate cost of capital should be established for its business divisions. The divisional WACC would be estimated using the company debt-equity mix and the company borrowing rates as all debt and equity were issued by the company rather than by the divisions. The only difference from the company WACC was that the divisional equity beta would be used to determine the divisional cost of equity. Harper estimated that RV divisional equity beta was 2.1 and RV divisional WACC was about 12%-14%.
- The General Manager of RV division, Julia Humbo, requested to use industry capital structure to establish the weights in estimating the divisional WACC. Humbo argued that her competitors in the caravan industry had a higher average ratio of debt to equity of 30%. Harper was asked to estimate this alternative WACC based on the higher industry average debt-equity mix.
- On the question of incorporating risk into project evaluation, the Board decided that new projects would be classified into three categories: high risk, average risk and low risk. High risk projects would be evaluated at the yet-to-be-determined divisional WACC plus 1.5%; average projects at the divisional WACC; and low risk projects at the divisional WACC minus 1%.
- A proposal by a private equity firm Adventure Group to acquire the RV division for $51 million was presented at the meeting. The offer price was higher than the carrying book value of the division. However, with the divisional cost of capital yet to be determined, BPT was unable to ascertain the present value of the division business as a going concern. Harper suggested that the value of the division might improve if an expansion of its facilities scheduled at the beginning of 2018 was successful.
- The Board discussed a recommendation from its Remuneration Committee to renew Harper’ remuneration package for another three years. The design of the package was to strike a balance between fixed and variable (at risk) remuneration. The variable remuneration included short-term incentives in the form of cash payments and long-term incentives in the form of share options.
- The Short Term Incentive Plan (STIP) used a combination of individual and company performance targets. The weighting was 50% non-financial and 50% financial. Individual performance targets were derived from period specific objectives which were in turn aligned with key business strategies identified annually during the business planning process. Financial performance targets were derived equally from budgeted EBIT and return on capital, which measured the efficiency and profitability of invested capital. The maximum cash bonus Harper could earn through the STIP was capped at 50% of his annual fixed remuneration of $590,000. The Remuneration Committee was of the opinion that the STIP appropriately aligned executive remuneration and shareholder wealth generation.
- Long-term incentives in the form of options were used to align executives’ long term interests with those of shareholders. Under the plan, the number of options granted was determined with reference to Harper’ individual performance over the immediately preceding financial year. No amounts were payable for the options. All of the issued options would vest on the third anniversary of the grant date, and the exercise price of options issued was calculated using the volume weighted average price of the shares over the five days prior to the issue date. The options were only exercisable if the company’s total shareholder return (share price appreciation plus dividends) was at least 15% per annum compounded from 2002 and was equal to or greater than the ASX 300 All Industrials Accumulation Index. The options would expire 5 years from the date of issue.
- In regard to Harper’ performance in 2016, a $75,000 short-term bonus payment and 40,000 options would be issued for his variable remuneration. For financial year 2015, a $150,000 short-term bonus was paid to Harper and 110,000 options were issued.
- BPT did not have a target gearing ratio. Operating cash flows were used to maintain and expand operating assets, make payments of tax and dividends and to repay maturing debt. In 2016, operating cash flows fell sharply and the level of debt increased to $44.8 million ($44 million of bank loans and $0.8 million of short-term hire purchase commitments). The ratio of debt to shareholders funds increased to 21% in 2016 from 0% in 2015.The interest cover was about 19 times. BPT had increased the limit of its bank loan facility in June 2016 to $50 million, with $44 million of the facility being utilised by the year end. Bank loans beared interest at the floating bank bill swap bid rate plus a margin. The effective annual interest rate at the end of 2016 was 3.8% for bank loans and 6.2% for hire purchase creditors.
- In the period of 2008-2015, BPT had increased its dividend payouts from 60 cents per share to 76 cents per share. The payout ratio and dividend yield had been above peers for years. BPT did not have a formal dividend policy but its simple objective was to increase dividends each year with the growth of sustainable earnings. An interim dividend for 2016 of 30 cents had been declared and paid. In view of the earnings performance in the second half of 2016 and the capital expenditure requirements for some existing projects, the Board believed that BPT would have to cut the final dividend. However the directors were divided on the level of the cut.
- BPT had a dividend reinvestment plan with a 2.5% discount feature. BPT had attracted around 20 percent participation rate from its shareholders. Harper suggested that the discount on the DRP would need to increase in order to attract a higher reinvestment rate.
- After the Board meeting, Harper looked at the Balance Sheet as at 31/12/16 to estimate BPT’s after-tax WACC:
Payables 45467 Cash and cash equivalents 12665
Current tax liabilities 1247 Receivables 54065
Interest bearing debt 44800 Inventories 55795
Provisions 6995 Property, plant and equipment 114471
Share capital 192001 Intangibles 67463
Reserves (1078) Other 8141
Retained earnings 23168
Total claims 312600 Total assets 312600
- The equity beta of BPT’s 60 million outstanding shares was estimated to be 0.95. The earnings per share in fiscal 2017 were forecasted to be 26 cents.
- To establish an alternative WACC using RV’s industry’s debt-equity ratio, Harper used a three-step procedure. First, the pre-tax WACC of RV of 13.25% was taken to be opportunity cost of capital. Second, assuming an overall cost of debt of 3.5%, the new cost of equity was estimated at the industry debt-equity ratio of 30%. Third, the cost of debt and the cost of equity were combined into the alternative divisional WACC.
- To find out the present value of the RV division, Harper used the internal divisional budget 2017 to form year one cash flows in Table 1. Various assumptions were then applied to forecast subsequent cash flows. BPT used a 5-year valuation horizon and a 2% long-run growth rate in estimating the terminal value. The recovery of working capital was implicitly included in the terminal value and was not separately accounted for.
- Harper further re-examined the $2.5 million expansion project of RV division that was scheduled to begin in a year’s time. The “extra” after-tax cash flows from the expansion, generated over and above the cash flows expected in Table 1, were projected in Table 2. The extra cash flow of year 5 in Table 2 was the sum of year 5 cash flow plus the year-5 value of all subsequent cash flows. All the extra cash flows in Table 2 were considered to be low-risk.
|Forecast Free Cash Flow for RV without expansion ($’000)|
|Operating cash flow||5830|
|Investment in fixed assets||1200|
|Investment in working capital||115||121|
|Free cash flow||4515|
Sales growth rate starting in year 2 and 3
|5.5% per year|
Sales growth rate starting in year 4 and 5
|3.5% per year|
Sales growth rate starting in year 6 and beyond
|2% per year|
Variable cost as a percentage of sales in year 1 to year 6
|Fixed cost growth rate in year 2 and beyond||3% per year|
|Increase in depreciation in year 2 and beyond||$100,000 increase per year|
|Investment in fixed assets in years 1-6||$1.2 million per year|
|Investment in working capital in years 2 – 6 is equal to 10% of the expected change in sales from the previous year.|
All figures are rounded to the nearest thousand dollars.
After-tax cash flow projections for ‘Expansion’ next year ($’000)
Year Expansion Discounted value @ notional 10%
t=1 -2500 -2500
t=2 500 455
t=3 1000 826
t=4 1500 1127
t=5 4000 2732
NPVt=1 = 2640
Attempt the following problems. All cash flows and present values are rounded to the nearest thousand dollars. All explanations are limited to a 50-word limit. Show all workings and/or explanation.
- Calculate BPT’s company after-tax WACC, rounded to four decimal places.
- Calculate RV Division WACC using the method in paragraph 6.
- Was the business risk of RV Division higher than, lower than or equal to its industry competitors if industry equity beta and RV divisional equity beta were the same as 2.10? Explain.
- Complete Table 1 fully, in accordance with the given assumptions, to show how the free cash flow in year 1 to year 6 is derived.
- Calculate the terminal value as of year 5 using the constant-growth discounted cash flow formula.
- Use an appropriate cost of capital, calculate the present value of the RV Division without expansion.
- Calculate the NPVt=1 of the expansion in Table 2 with the appropriate cost of capital.
- Calculate the value of the option for RV Division to expand as of year 0.
- Calculate the value of the abandonment option at t=0 if RV Division could be sold to another company for $51 million, without any expansion undertaken, at the beginning of year 2.
- Calculate the economic depreciation in year 1 based on the completed free cash flow in Table 1.
- From the shareholders’ viewpoint, what would be the major criticism on the STIP for 2016? Explain.
- From the viewpoint of Harper, what would be the worst feature of the long-term incentives? Explain.
- Calculate the alternative divisional WACC using the 3-step procedures in paragraph 19.
- Name only one specific source of finance from the balance sheet BPT would use for the expansion project scheduled for next year? Assume BPT’s financial position next year would be the same as of 31/12/16. [General answer such as debt or equity will not be acceptable]
- What should be the amount of the final dividend to be declared for financial year 2016?
- Use the cost of equity in Q1 and the dividend growth formula Price=DPS1/(re – growth rate) to work out the implied total dividend for year 2017. Assume a constant growth rate of 3.4%. Is this implied dividend amount for 2017 achievable? Explain.
- Should BPT increase the discount on the DRP for its 2017 dividends in order to attract a higher reinvestment rate? Explain.
Group limit: Students can form a group of 4 people or less to attempt the assignment. [UTSOnline Discussion Board may help students find partners.] If a student is unable or unwilling to find anyone else to form a group, he/she has to attempt the case study individually.
Presentation: The assignment is to be typed, doubled spaced with a font size of 12 (no smaller than this font size). The length of the submitted work should not exceed 7 A4 pages including the cover page and any spreadsheet.
Answer each question in correct sequence. Do not separate any table/spreadsheet from the body of the answers. No appendices should be used.
In non-calculation questions 3, 11, 12, 14, 15, 16 and 17, do not use more than 50 words for the explanation/answer. No mark will be awarded if exceeding the word limit.
Due Date: The assignment is to be submitted to the assignment box “FINANCE 1” at Building 8 Level 5 before Thursday 1 June 11am. The assignment is worth 20 marks. Each question is worth one mark except questions 1, 4 and 16.
Late submission, with whatever reasons, will result in loss of 5 marks per 24 hours or thereof. It is assumed that students would have completed Questions 1-13, that are related to Topics 1-6, by mid-May.
Members of a group will receive the same mark for the assignment. Get started early to avoid problems such as team members getting sick or leaving the group unexpectedly. As in real life, students have to deal with the “free-rider” problem themselves and be actively involved to avoid being kicked out of a group.
Assessment: Most issues involved in the case would have been covered in classes. Team discussion of all questions helps achieve a better result (half of the individual work submission received a fail grade in spring session 2016).
The following will be considered in assessing the submitted work:
– the correctness of the calculations and reasoning; no partial credit is given in any 1-mark question
– the 50-word limit on explanation
– no mark is awarded if working is not shown
– the quality of the written expression (grammar, spelling etc…)
– plagiarism will result in zero marks for the assignment (all assignments are marked by the subject coordinator himself)
- No plastic cover. Just staple the 7 pages together.
- Use the cover sheet provided at UTSOnline and list alphabetically the name of the students with student number included.