A REPORT ON INVESTMENT VALUE OF BUILDING AN OFFICE BLOCK AT THE UNIVERSITY OF READING

Introduction

The current capital structure of Helical Bar is 42.25% equity and 57.75% debt. 34% of debt capital is secured while the group’s share of property at fair value is £1,021 million which is an increase from £802m in March 2014. For the year ended in March 2015, the Helical Bar an average interest of 4.5% on the fixed rate borrowings. The highest type of borrowing that the company uses is other fixed rate borrowings that account for is £400 million accounting for 70% of the total debt. The company also has a retail bond and a convertible bond in its debt portfolio. The retail and convertible have maturities of March 2019 and March 2020 respectively. After completing paying the two bonds the company expect the interest rates to go down to 3.6%.

The ratio of secured loan to the value of property portfolio has remained constant and stable for the last fifteen years indicating that the company has been making prudent investment decisions (Chand, 2014). However, since 2013 when the company acquired unsecured debt the ratio of total debt to the value of property has notably increased. On the other hand the acquisition of unsecured debt has helped the company increase the value of property portfolio to above £1000 million. The table below shows loan expiry in parent and subsidiaries as at March 31 2015.

Table 1: Loan Expiry in parents and subsidiaries as at 31 March 2015

Expiry Period Amount of the Loan (£)
Less than 1 year 45.4m
1-2 years 136.1m
2-3 years 3.6m
3-4 years 83.6m
4-5 years 175.2m
5-6 years 80.1m
6-7 years 1.1m
7-8 years 1.1m
8-9 years 1.1m
9-10 years 71.0m

The average maturity period is 4.4 years while average cost of debt is 4%. Out of the entire debt, there is £100 million 5 year convertible bond. From the above table, the company requires to repay £443.9 million in less than five years.

The table below show the loan maturity time in joint ventures as at 31 March 2015

Expiry Period Amount of the Loan (£)
Less than 1 year
1-2 years 22.8
2-3 years 25.6
3-4 years 21.6
4+ years

In two years the non recourse is £44.4m of which £21.6m has interest guarantees. The debt in joint venture has an average maturity of 3 years and average cost of debt of 4.5%. There is also £165m of a 5 year development facility. Overall, the group had unutilized bank facilities of £93m and cash deposits of £136m.It also has uncharged property of £131m fair value.

Use of high proportion of debt financing reduces the overall cost of capital because it has lower required rate of return as compared with equity financing (CFA Institute, 2013). There are several alternatives available for Helical Bar to reduce its overall cost of capital. The first approach is to secure more loans at the prevailing interest rates. The company can use the uncharged properties of £131m top secure the loans. The second option is to use the unutilized bank facilities for the development and investment acquisition. Thirdly, the company can renegotiate the terms of some of the debts that have less than 3 years maturity.

Determination of Discount Rate

Before delving into calculation of discount rate, it is critical to understand what it is. The discount rate is the rate of return applied in discounted cash flow analysis to get the present value of future cash flows (Schmidt, 2013). The formulae for calculation of net present value are shown here:

Whereas

C is sum of all future cash flows

N is the holding period

R is the rate of return or the discount rate (Stein, 2003).

Hence, we can use the above formulae in the case of Helical Bar to calculate the discount rate. Assuming that the company will get a loan of £16m for the project and with a repayment period of 5 years at £5m per year. Then the discount rate is calculated as follows:

NPV=£16m

N = 5 Years

C = £4.5m

Helical Bar
Net Present Value Model
Time (annual intervals) 0 1 2 3 4 5
£’000 £’000 £’000 £’000 £’000 £’000
Cash Flows     (16,000.00) 5,000 5,000 5,000 5,000 5,000
Net cash flow     (16,000.00) 5,000 5,000 5,000 5,000 5,000
Discount Rate 7.74%

The calculation of discount rate is different for corporates because it requires use of Weighted Average Cost of Capital (WACC) (McClure, 2014). Companies have debt or equity as the source of their finances and they can also user retained earnings that remain after distribution of dividends to the shareholders. WACC is basically the weighted average of all these sources and profitable business should earn return that is more than cost of capital (DeMarzo & Yuliy, 2006). Below is the calculation of WACC for Helical Bar.

CAPITAL STRUCTURE ASSUMPTIONS
    Target New Diff.
Cost of Equity 8.0% 12.9% 4.9%
Cost of Debt 3.7% 3.7% 0.0%
Target Leverage 35.0% 35.0% 0.0%
Cost of Assets 6.9% 10.6% 3.7%
Spread 3.7%
WACC (target) 6.0% 9.2% 3.2%
Corporate Taxes 36%
Levered Unlevered Adj Unlev Relevered
Rf 1.32%
Rm – Rf 6.01%
Beta 0.92 0.68 1.29 1.74
CAPM 6.8% 5.4% 9.1% 11.8%
Cost of Equity Amount of Equity
Risk free rate 6.03% Shares 118183806
Beta 0.68 Price 0.01
Market return 8% Value 1181838.06
Cost of Equity 7.38%
Cost of Debt Amount of Debt
Rate 5.36% Book value 61.7
Taxrate 36% Adjustment 1
Cost of Debt 3.70% Value 61.7
Total Capital 1181899.76
WACC 7.38%

Cost of Debt

A. 100% SECURED – 3.7
After-tax cost of debt = R(1-tc)
Note: Rd represents the cost to issue new debt, not the cost of the firm\’s existing debt.
3.7%(1-0.36) = 2.37%
B. 100% SECURED – 3%
3%(1-0.36) = 1.92%
C. 100% UNSECURED 6%
6%(1-0.36) = 3.84%
D. Mix of 70% secured of debt and 30% unsecured 3 and 3.7
[3%(1-0.36)X70% ]+ [3.7%(1-0.36) X30% = 2.06%

 

Capital Structure of the Company

The current capital structure of Helical Bar is 42.25% equity and 57.75% debt. The capital structure of a company determines the level of risks exposed to the company. Use of much debt increases the risk of default in repayment of the principal and interest. It also determines the cost of capital of the company. Helical Bar has increased the proportion of debt financing from 51.53 percent in 2010 to the current proportion of 57.75 percent. The table below shows the trend of the ration of debt to equity in the company.

Year 2015 2014 2013 2012 2011 2010
Debt Amount    552,713.00      347,811.00    389,758.00    346,588.00      344,658.00    341,985.00
Equity Capital    404,363.00      340,527.00    338,625.00    325,689.00      324,897.00    321,644.00
Total capital    957,076.00      688,338.00    728,383.00    672,277.00      669,555.00    663,629.00
2015 2014 2013 2012 2011 2010
Debt %age 57.75% 50.53% 53.51% 51.55% 51.48% 51.53%
Equity % age 42.25% 49.47% 46.49% 48.45% 48.52% 48.47%

The debt financing has been increasing at higher rate than equity financing exposing the company to risks of default (Myers, 2000). However, increase in debt reduces cost of capital as the fixed interest rates and short repayment periods make it cheaper than equity (Morellec, 2004).

Here is a graph that shows how the capital structure of Helical Bar has changed in the last ten years.

Graph 1: Ten year capital structure changes

 

Assumptions about the capital structure include:

  1. The company has only two types of capital: equity and debt (Harris, Milton& Raviv, 2001).
  2. The total assets of the company are available and the ratio can be changed by selling debt and purchase shares as well as sell shares to retire debt.
  3. The company pays 100 percent dividends (Strebulaev, 2007).
  4. The earnings per share are not going to grow (Allen & Roni, 2003).
  5. The business risk is constant and does not depend on the financial risk or capital structure (Lawler, 2012)..
  6. There are no corporate taxes (Graham & John, 2003).

Sensitivity Analysis

Sensitivity analysis is an estimation of how business decisions will be affected if some assumptions do not hold. It incorporates changing those assumptions and related estimations and understanding how they impact the implementation of the project. The analysis helps businesses to further evaluate the viability of the project (Markham & Palocsay, 2006). Below is comparison the cost of capital for the targeted capital structure and the new capital structure.

Helical Bar WACC Model
Cost of Equity Amount of Equity
Riskfree rate 5.43% 6.03% 6.63% Shares 118183806
Beta 0.62 0.68 0.75 Price 0.01
Market return 7.20% 8% 8.80% Value 1181838.06
Cost of Equity 6.64% 7.38% 8.12%
Cost of Debt Amount of Debt
Rate 4.82% 5.36% 5.90% Book value 61.7
Taxrate 32.40% 36% 39.60% Adjustment 1
Cost of Debt 3.33% 3.70% 4.07% Value 61.7
Total Capital    1,181,899.76
WACC 7.38%
WACC 6.64%
WACC 8.12%

Under the new capital structure, WACC will increase to 8.1 percent from 6.4 percent of the target structure. Cost of assets will also increase to 9.3 percent from 7.3 percent. The new capital will have 10.7 percent of levered CAPM, an increase from 8 percent of the target CAPM (Bragg, 2012). Thus the new capital structure increases the cost of capital and should the management of Helical Bar should review it to come up with another better structure.

Conclusion

The current capital structure of Helical Bar is 42.25% equity and 57.75% debt. The ratio of secured loan to the value of property portfolio has remained constant and stable for the last fifteen years indicating that the company has been making prudent investment decisions. Use of high proportion of debt financing reduces the overall cost of capital because it has lower required rate of return as compared with equity financing. There are several alternatives available for Helical Bar to reduce its overall cost of capital. The first approach is to secure more loans at the prevailing interest rates. The company can use the uncharged properties of £131m top secure the loans. The second option is to use the unutilized bank facilities for the development and investment acquisition. Thirdly, the company can renegotiate the terms of some of the debts that have less than 3 years maturity. The discount rate is the rate of return applied in discounted cash flow analysis to get the present value of future cash flows. The calculation of discount rate is different for corporate because it requires use of Weighted Average Cost of Capital (WACC). Use of much debt increases the risk of default in repayment of the principal and interest. It also determines the cost of capital of the company. Sensitivity analysis is an estimation of how business decisions will be affected if some assumptions do not hold.

References

Allen, F. & Roni, M. (2003). Payout Policy. Handbook of Economics

Bragg, S. (2012). Business Ratios and Formulas – A Comprehensive Guide. New Jersey: John Wiley & Sons

CFA Institute. (2013). Cost of Capital. Retrieved on 16th October 2015 from http://www.cfainstitute.org/learning/…/inv/…/corporate_finance_chapter3.pptx

Chand, S. (2014). Theories of Capital Structure. Retrieved on 16th October 2015 from http://www.yourarticlelibrary.com/financial-management/theories-of-capital-structure-explained-with-examples-financial-management/29398/

DeMarzo, M. & Yuliy, S. (2006). Optimal Security Design and Dynamic Capital Structure in a Continuous-Time Agency Model. Review of Financial Studies, 20(1), 2079-2128

Graham, P. & John, K. (2003). Taxes and Corporate Finance: A Review. Review of Financial Studies, 16(1), 1075-1129.

Harris, J., Milton, T & Raviv, A. (2001). The Theory of Capital Structure. Journal of Finance, 46(1), 297-355.

Lawler, E. (2012). Financial reporting systems. Berrett-Koehler, California

Markham, I. & Palocsay, W. (2006). Sensitivity Analysis in Spreadsheets with Excel’s Scenario Tool. INFORMS Transactions on Education, 6(2), 23-31.

McClure, B. (2014). DCF Analysis: Calculating the Discount Rate. . Retrieved on 16th October 2015 from http://www.investopedia.com/university/dcf/dcf3.asp

Morellec, E. (2004). Can Managerial Discretion Explain Observed Leverage Ratios? Review of Financial Studies, 17(1), 257-294.

Myers, C. (2000). Outside Equity. Journal of Finance, 55(1), 1005−1037.

Schmidt, R. (2013). What You Should Know About the Discount Rate. Retrieved on 16th October 2015 from http://www.propertymetrics.com/blog/2013/09/27/npv-discount-rate/

Strebulaev, A. (2007). Do Tests of Capital Structure Theory Mean What They Say? Journal of Finance, 62(1), 1747-1787.

Stein, J. (2003). Agency, Information and Corporate Investment. Handbook of the Economics of Finance.

Appendix

  1. Weighted Average Cost Of Capital (WACC)
CAPITAL STRUCTURE ASSUMPTIONS
    Target New Diff.
Cost of Equity 8.0% 12.9% 4.9%
Cost of Debt 5.3% 5.3% 0.0%
Target Leverage 35.0% 35.0% 0.0%
Cost of Assets 7.3% 11.0% 3.7%
Spread 3.7%
WACC (target) 6.4% 9.6% 3.2%
Corporate Taxes 36%
Levered Unlevered Adj Unlev Relevered
Rf 1.83%
Rm – Rf 5.50%
Beta 1.13 0.84 1.51 2.02
CAPM 8.0% 6.5% 10.1% 13.0%
Cost of Equity Amount of Equity
Riskfree rate 6.39% Shares 118183806
Beta 0.84 Price 0.01
Market return 8% Value 1181838.06
Cost of Equity 7.74%
Cost of Debt Amount of Debt
Rate 5.36% Book value 61.7
Taxrate 36% Adjustment 1
Cost of Debt 5.30% Value 61.7
Total Capital 1181899.76
WACC 7.74%
  1. Historical Capital Structure for Helical Bar
Year 2015 2014 2013 2012 2011
Debt Amount    552,713.00      347,811.00    389,758.00    346,588.00      344,658.00
Equity Capital    404,363.00      340,527.00    338,625.00    325,689.00      324,897.00
Total capital    957,076.00      688,338.00    728,383.00    672,277.00      669,555.00
2015 2014 2013 2012 2011
Debt %age 57.75% 50.53% 53.51% 51.55% 51.48%
Equity % age 42.25% 49.47% 46.49% 48.45% 48.52%
2010 2009 2008 2007 2006
   341,985.00    339,644.00      339,142.00      338,544.00        327,459.00
   321,644.00    359,875.00      365,489.00      368,756.00        369,452.00
   663,629.00    699,519.00      704,631.00      707,300.00        696,911.00
2010 2009 2008 2007 2006
51.53% 48.55% 48.13% 47.86% 46.99%
48.47% 51.45% 51.87% 52.14% 53.01%

 

  1. Sensitivity Analysis
CAPITAL STRUCTURE ASSUMPTIONS
    Target New Diff.
Cost of Equity 8.0% 10.7% 2.7%
Cost of Debt 5.3% 5.3% 0.0%
Target Leverage 35.0% 35.0% 0.0%
Cost of Assets 7.3% 9.3% 2.0%
Spread 2.0%
WACC (target) 6.4% 8.1% 1.7%
Corporate Taxes 36%
Levered Unlevered Adj Unlev Relevered
Rf 1.83%
Rm – Rf 5.50%
Beta 1.13 0.84 1.20 1.62
CAPM 8.0% 6.5% 8.5% 10.7%
Helical Bar WACC Model
Cost of Equity Amount of Equity
Riskfree rate 5.75% 6.39% 7.03% Shares    118,183,806.00
Beta 0.76 0.84 0.92 Price                        0.01
Market return 7.20% 8% 8.80% Value        1,181,838.06
Cost of Equity 6.97% 7.74% 8.52%
Cost of Debt Amount of Debt
Rate 4.82% 5.36% 5.90% Book value 61.7
Taxrate 32.40% 36% 39.60% Adjustment 1
Cost of Debt 4.77% 5.30% 5.83% Value 61.7
Total Capital 1181899.76
WACC 7.74%
WACC 6.97%
WACC 8.52%
  1. Calcuation of Discount Rate (NPV Model)
Helical Bar  
Net Present Value Model  
Time (annual intervals) 0 1 2 3 4 5
£’000 £’000 £’000 £’000 £’000 £’000
Cash Flows        (16,000)          5,000          5,000          5,000          5,000          5,000
Net cash flow        (16,000)          5,000          5,000          5,000          5,000          5,000
Discount Rate                0
Time (annual intervals) 0                1                2                3                4                5 Total
£’000 £’000 £’000 £’000 £’000 £’000
Cash Flows        (16,000)          5,000          5,000          5,000          5,000          5,000
Net cash flow        (16,000)          5,000          5,000          5,000          5,000          5,000
Discount Factor                1                1                1                1                1                1
Present Value        (16,000)          4,401          3,875            3,411          3,002          2,643          1,332
Discount Rate 7.74%
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