Conservation, Flora and Transformative Power (CFTP)

    1. CFTP Corporation was a provider of conservation initiatives and Transformative power panels and accessories. CFTP had two operating divisions: Conservation and Flora (CF) and Transformative Power (TP). The CF division provided conservation solutions to the home owners and property developers. The division also provided conservation and plant advice to councils, home owners and property developers. The smaller TP division was involved in the manufacture and sale of solar panels and accessories. 2. Following several years of profit growth underpinned by strong demand from the property development sector, the focus of CFTP’s management in 2017 was on restructuring the company’s operations to reduce costs and improve production efficiencies. The trading conditions in the company’s key markets weakened throughout 2016 due to less demand for green space in the developments and net profit after tax fell 40%. 3. CFTP’s financial performance over the last five years was set out below: For the year ending 30 June 2017 2016 2015 2014 2013Revenue ($ millions) 372 414 500 303 379Operating profit after tax ($ millions) 34.78 57.96 53.76 39.69 38.33Cash flow from operations ($ millions) 48.10 80.12 55.44 56.49 55.65Debt ($ millions) 23.75 0.95 22.05 0.00 9.45Assets ($ millions) 315.73 304.29 322.88 221.03 207.06Shareholder’s funds ($ millions) 238.27 242.76 216.51 164.75 148.79Number of shares issued (million) 30 29.2 27.8 24 22.6Earnings per share (cents) 116 198 193 165 170Dividends per share (cents) 35* 80 77 71 69Share price at end of year ($) 7.27 12.33 11.90 9.65 6.20* The final dividend was yet to be determined 4. The Board was comprised of four non-executive directors and the chief executive officer, Josh Botanica. Meetings were generally held monthly. The following agenda items were discussed at the Board meeting in August 2017:i. What would be CFTP's after-tax WACC based on its capital structure as at 30/06/17?ii. Should a different cost of capital be established for the two business divisions?iii. Further, how should the risk of each project within a division be measured and incorporated into project evaluation?iv. Should the TP division be sold to Earthly Energy or be retained and even expanded?v. Should CFTP renew the remuneration package of Josh Botanica?vi. An update on CFTP’s capital structure.vii. A decision on the amount of the final dividend. viii. Should CFTP increase the discount on its dividend reinvestment plan? 5. 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 2.62% based on the five year Australian Government Bond Rate. CFTP used a market risk premium of 7% in all cost of equity estimates. The company tax rate was 30%. Botanica suggested that the company WACC was about 8%. 6. 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. Botanica estimated that TP divisional equity beta was 1.9 and TP divisional WACC was about 11%-13%. 7. The General Manager of TP division, Clair Green, requested to use industry capital structure to establish the weights in estimating the divisional WACC. Green argued that her competitors in the solar power sector had a higher average ratio of debt to equity of 40%. Botanica was asked to estimate this alternative WACC based on the higher industry average debt-equity mix. 8. 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%. 9. A proposal by a private equity firm Earthly Energy to acquire the TP division for $60 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, CFTP was unable to ascertain the present value of the division business as a going concern. Botanica suggested that the value of the division might improve if an expansion of its facilities scheduled at the beginning of 2018 was successful. 10. The Board discussed a recommendation from its Remuneration Committee to renew Botanica’ 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. 11. The Short Term Incentive Plan (STIP) used a combination of individual and company performance targets. The weighting was 40% non-financial and 60% 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 Botanica could earn through the STIP was capped at 40% of his annual fixed remuneration of $465,000. The Remuneration Committee was of the opinion that the STIP appropriately aligned executive remuneration and shareholder wealth generation. 12. 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 Botanica’ 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 10% per annum compounded from 2003 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. 13. In regard to Botanica’ performance in 2017, a $50,000 short-term bonus payment and 20,000 options would be issued for his variable remuneration. For financial year 2016, a $130,000 short-term bonus was paid to Botanica and 80,000 options were issued. 14. CFTP 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 2017, operating cash flows fell sharply and the level of debt increased to $23.75 million ($21.5 million of bank loans and $2.25 million of short-term hire purchase commitments). The ratio of debt to shareholders funds increased to 10% in 2017 from 0% in 2016.The interest cover was about 46 times. CFTP had increased the limit of its bank loan facility in June 2017 to $30 million, with $22.5 million of the facility being utilised by the year end. Bank loans beared interest at the floating bank bill swap bid rate plus a margin. The effective annual interest rate at the end of 2017 financial year was 4.2% for bank loans and 6.7% for hire purchase creditors. 15. In the period of 2010-2016, CFTP had increased its dividend payouts from 60 cents per share to 80 cents per share. The payout ratio and dividend yield had been above peers for years. CFTP did not have a formal dividend policy but its simple objective was to increase dividends each year with the growth of sustainable earnings. An interim dividend for 2016 – 2017 financial year of 35 cents had been declared and paid. In view of the earnings performance in the second half of the 2016 – 2017 financial year and the capital expenditure requirements for some existing projects, the Board believed that CFTP would have to cut the final dividend. However the directors were divided on the level of the cut. 16. CFTP had a dividend reinvestment plan with a 3% discount feature. CFTP had attracted around 20 percent participation rate from its shareholders. Botanica suggested that the discount on the DRP would need to increase in order to attract a higher reinvestment rate. 17. After the Board meeting, Botanica looked at the Balance Sheet as at 30/06/17 to estimate CFTP’s after-tax WACC: ($’000) ($’000)Payables 45467 Cash and cash equivalents 12665Current tax liabilities 1247 Receivables 57195Interest bearing debt 23750 Inventories 55795Provisions 6995 Property, plant and equipment 114471Share capital 216181 Intangibles 67463Reserves -1078 Other 8141Retained earnings 23168         Total Liabilities and Owners Equity 315730 Total assets 315730 18. The equity beta of CFTP’s 30 million outstanding shares was estimated to be 1.05. The earnings per share in fiscal 2017 were forecasted to be 116 cents. 19. To establish an alternative WACC using TP’s industry’s debt-equity ratio, Botanica used a three-step procedure. First, the pre-tax WACC of TP of 11.25% was taken to be opportunity cost of capital. Second, assuming an overall cost of debt of 4.45%, the new cost of equity was estimated at the industry debt-equity ratio of 40%. Third, the cost of debt and the cost of equity were combined into the alternative divisional WACC. 20. To find out the present value of the TP division, Botanica 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. CFTP 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. 21. Botanica further re-examined the $4 million expansion project of TP division that was scheduled to begin in a year’s time. The “extra” after-tax cash flows from the expansion, generated over and above the cash flows expected in Table 1, were projected in Table 2. The extra cash flow of year 5 in Table 2 was the sum of year 5 cash flow plus the year-5 value of all subsequent cash flows. All the extra cash flows in Table 2 were considered to be low-risk. Table 1Forecast Free Cash Flow for SP without expansion ($’000)Year 1 2 3 4 5 6Sales 45000 51636 Variable cost -20250 Fixed cost -4050 Depreciation -2000 Operating income 18700 Tax (30%) -5610 Net income 13090 Depreciation 2000 Operating cash flow 15090 Investment in fixed assets -1400 Investment in working capital -180 -187 Free cash flow 13510  Assumptions:Tax rate 30%Sales growth rate starting in year 2 and 3 4% per yearSales growth rate starting in year 4 and 5 3% per yearSales growth rate starting in year 6 and beyond 2% per yearVariable cost as a percentage of sales in year 1 to year 6 45%Fixed cost growth rate in year 2 and beyond 2% per yearIncrease in depreciation in year 2 and beyond $50,000 increase per yearInvestment in fixed assets in years 1-6 $1.4 million per yearInvestment in working capital in years 2 – 6 is equal to 10% of the expected change in sales from the previous year. All figures are rounded to the nearest thousand dollars.       Table 2 After-tax cash flow projections for ‘Expansion’ next year ($’000)Year        Expansion Discounted value @ notional 10%t=1 -4000 -4000t=2 1000 909.091t=3 2000 1652.89t=4 3000 2253.94t=5 6000 4098.08         NPVt=1 $4,914.01 Instructions: 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. 1. Calculate CFTP’s company after-tax WACC, rounded to four decimal places. 2. Calculate TP Division WACC using the method in paragraph 6.3. Was the business risk of TP Division higher than, lower than or equal to its industry competitors if industry equity beta and TP divisional equity beta were the same at 1.9? Explain.4. 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.5. Calculate the terminal value as of year 5 using the constant-growth discounted cash flow formula.6. Use an appropriate cost of capital, calculate the present value of the TP Division without expansion.7. Calculate the NPVt=1 of the expansion in Table 2 with the appropriate cost of capital.8. Calculate the value of the option for TP Division to expand as of year 0.9. Calculate the value of the abandonment option at t=0 if TP Division could be sold to another company for $120 million, without any expansion undertaken, at the beginning of year 2.10. Calculate the economic depreciation in year 1 based on the completed free cash flow in Table 1.11. From the shareholders’ viewpoint, what would be the major criticism on the STIP for 2017? Explain. 12. From the viewpoint of Botanica, what would be the worst feature of the long-term incentives? Explain.13. Calculate the alternative divisional WACC using the 3-step procedures in paragraph 19.14. Name only one specific source of finance from the balance sheet CFTP would use for the expansion project scheduled for next year? Assume CFTP’s financial position next year would be the same as of 30/06/17 [General answer such as debt or equity will not be acceptable] 15. What should be the amount of the final dividend to be declared for financial year 2017?  Explain.16. 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 2.5%. Is this implied dividend amount for 2017 achievable? Explain.17. Should CFTP increase the discount on the DRP for its 2017 dividends in order to attract a higher reinvestment rate? Explain.