Hutchison Whampoa Limited

The Capital Structure Decision Case Study Solution

Hutchison Whampoa Limited: The Capital Structure Decision

1. Assume Hutchison Whampoa will require US$1 billion of financing in 1996. Assume that equity can be raised at $48.80 a share and that a long-term debt issue will carry an interest rate of HIBOR plus 70 basis points. How would an equity or debt issue impact Hutchisons financial position and performance? Hutchison Whampoa Limited (HWL) had multiple major long-term projects that would require substantial funding in the future. Previously, HWL would finance these projects with cash on hand, internal cash generation and short to medium term bank financing. Because these projects were long-term, the previous way of funding these projects would not be feasible. HWL would have to guarantee that their spending would not dry up and halt the project. The amount that was estimated to be used by investment analysts was as high as $5 billion. So HWL was not able to use the same methods of financing projects as they have done in the past, this was going to be a much bigger undertaking. I analyzed the financials to determine the impact of raising US$1 billion in two different scenarios. The first scenario is if they issued US$1 billion in stock. The second scenario is if they financed their US$1 billion spending need with long-term debt. In order to analyze these two scenarios, I forecasted the financial statements to 1996. Scenario 1 - Equity Offer The first analysis was the impact of the US$1 billion equity offer on HWLs financial position and performance. Based on appendix A, the average exchange rate for US$1 to HK$ in 1996 was 7.73485. US$1 billion would be HK$7.8 billion. When new shares are created and then sold by the company, the number of shares outstanding increases and this causes dilution of earnings on a per share basis. Usually the gain of cash inflow from the sale is strategic and is considered positive for the longer term goals of the company and its shareholders. By issuing the US$1 billion in equity at $48.80 a share, HWL is issuing 20,491,803 shares. The pre-equity quantity of shares outstanding was 155,881,137. The percent of dilution to the shares (not the value of the company) is 11.7% (from appendix B). It is important to note that this dilution is only to the percent of the company that the shareholders own, not to the value of the company they own. That is because this equity offering is increasing the value of the company because now they have the long-term capital needed to undertake all the projects they have planned and approved. The projects that will now occur have created additional value for the company. 1|Page

Hutchison Whampoa Limited

The Capital Structure Decision Case Study Solution First, immediately following the equity offering, the impact on the balance sheet will increase the shareholders equity by the HK$7.735 billion, which will be offset by current assets. This is enough funding to cover the short-fall they faced with funding the projects in exhibit 10. With the other outstanding loans they had that are not due for over 5 years, plus the eventual net positive cash flow from these projects, this will put them in position to guarantee the long-term funding for the projects. Next you have to move to the look at the impact of the equity offering on the Profit and Loss statement (P&L). I took exhibit one, and forecasted it out to 1996 to analyze the impact of the equity offer on the P&L. See analysis below appendix D for details. Scenario 2 - Debt Offer The second analysis was the impact of the US$1 billion debt issue on HWLs financial position and performance. HWL had numerous different options for raising capital thru debt. They include issuing bonds in Hong Kong, issuing bonds abroad, Eurobonds or Yankee bonds. Same with the equity offering, if HWL is raising US$1 billion that would convert to HK$7.8 billion. One aspect that HWL has to address when analyzing the debt offer is the impact this will have on its tax shield. The interest that HWL will pay on its taxes will be tax deductible. Hence, the value of a leveraged company is more than the value of an all equity firm by the value of its tax shield. However, it would not be wise to take on more debt that can be impacted by the tax shield. A downside for shareholders if HWL goes with debt financing is the added financial risk. The financial risk in this situation would be if HWL was to go bankrupt, the debt issuers would have first claim to the assets, leaving the equity holders with little to nothing. I would argue taking on this financial risk outweighs the dilution in their value of shareholder equity by issuing more stock. The first impact of the debt issue is immediately following the debt issue the impact on the balance sheet will increase the long-term liabilities by the HK$7.735 billion, which will be offset by current assets. Just like with the equity offering, this is enough funding to cover the short-fall they faced with funding the projects in exhibit 10. With the other outstanding loans they had that are not due for over 5 years, plus the eventual net positive cash flow from these projects, this will put them in position to guarantee the long-term funding for the projects. See analysis below appendix D for details. Analysis Appendix D shows the impact of the 2 scenarios on the P&L. The debt offering yields a higher amount for the profit after taxation. The equity offering will have to issue great dividends (assuming no change in the dividend structure), which will then yield a lower profit for the year for equity. Financially the company is in a better position with the debt offering. 2. Assess Hutchison Whampoas current capital structure considering its future financial needs. 2|Page

Hutchison Whampoa Limited

The Capital Structure Decision Case Study Solution To assess the current capital structure of HWL, you have to analyze the composition of its liabilities. For the most recent year (1995), the balance sheet in exhibit 2 shows that HWL has HK$26,174 million in long-term liabilities and HK$5,329m of current liabilities. The cash flow statement in exhibit 3 shows that interest paid on financing was HK$2,808m. Spreadsheet appendix C shows that the average interest rate for HWL in 1995 was 9.7%, which comes from 17% of the liabilities being current, and the remaining 83% in long-term. However, this does not take into account the 7% convertible bonds based on HK$2,125.8m. If none of the bonds are converted, the amount of long-term debt not due to be repaid in the next five years is 51%, or HK$13,216m. After breaking-down the current capital structure of HWL, it needs to be analyzed against the capital commitments as of 1995. HK$6,468.9m has already been contracted, while another HK$23,736.2m has been authorized but not contracted. Not taking into consideration the projects in exhibit 10, the net positive cash flows are HK$8.532 in 1995. Based on the liabilities and cash flows of HWL, the current capital structure (prior to the debt or equity offer of US$1 billion) is not sufficient for the planned growth. All of the projects in exhibit 10 will have a negative cash flow in year 1, and the majority will have a negative cash flow in year 2, it is not likely that the cash flows from these projects can help pay for additional capital expenditures until year 3. So enough funding is needed before year 3. HWL, like other large firms in Hong Kong, relied heavily on internally generated funds to fuel growth. This capital structure was appropriate when projects funded were not long in duration, and the internal funds were forecasted to cover it. But HWL now wants guaranteed funding for longterm projects, and its current capital structure cannot support this growth.

3. What other considerations arise here? How important is the international aspect? The international aspect is very important. This is because a major factor in the case is the country currency you are obtaining the capital in. There are several different ways to obtain the capital thru debt. However, some have greater currency risk exposure than others. For example a Yankee bond would denominated in US currency. There is a certain amount of exchange rate risk that HWL will take on by raising the capital in US$. Whenever a company has assets or business operations across national borders, they face currency risk if their positions are not hedged. A consideration that HWL might want to make is to hedge its currency risk to reduce its exposure to the US$. If this risk was too much for HWL to take on, they could raise the capital using straight debt. Straight bonds are issued in Hong Kong and denominated in Hong Kong dollars. Or if HWL wanted to obtain funding in neither US$ or HK$, they could obtain a Eurobond, which is an international bond that is denominated in a currency not native to the country where it is issued. It can be categorized according to the currency in which it is issued. 3|Page

Hutchison Whampoa Limited

The Capital Structure Decision Case Study Solution Another consideration that arises with the data from exhibit 10 is the future effect on the corporations value. The future cash flows are not provided for the projects. Future cash flows are needed to calculate the net present value (NPV) of each project. To calculate the NPV, you need to calculate the weighted average cost of capital (WACC). The calculation of WACC is: WACC = wd (1-T) rd + we re wd = debt portion of value of corporation T = tax rate rd = cost of debt (rate) we = equity portion of value of corporation re = cost of internal equity (rate) The (1-T) portion of the formula is the tax shield. So without being able to calculate the NPV of the projects, we are missing what the advantages are of debt financing. The advantages of the tax shield only exist with debt financing since the interest is tax deductible. There is no tax shield for financing with equity.

4. What bond rating do you think Hutchison Whampoa will be able to obtain from Standard and Poors? Why? To understand what Hutchison Whampoas bond rating should be, you have to analyze some of their key ratios in comparison to the industrys key financial ratios. Below are the key industrial financial ratios and highlighted is the range that HWL best fits into. Based on this chart, it would appear that HWL would either have a bond rating of a BB or a BBB. But after comparing it to comparable HWL with comparable firms in Hong Kong, HWL has weaker ratios, and would probably have a BB rating from Standard and Poors. The difference between a BBB and BB bond rating is very large. This is the biggest discrepancy between bond ratings. BBB is an investment-grade bond rating, BB is a noninvestment-grade bond rating. Noninvestment-grade bonds are often referred to as high yield or junk debt. Some large investors, such as pension funds and charitable trusts, are barred from investing in noninvestmentgrade debt. The premium that HWL would have to pay on its debt if it drops by one rating is in the 1.6% to 1.7% range. To put this into perspective, HWL would only save 0.4% if its rating improved to an A bond rating.
Appendix 4 Key Industrial Financial Ratios Three-Year Medians (1994-1996) Hutchison

4|Page

Hutchison Whampoa Limited

The Capital Structure Decision Case Study Solution
Whampoa 1995 Range

AAA

1 2

AA

1 1

BBB

BB

4. 3.

EBIT Interest Coverage (x) EBITDA Interest coverage (x) Funds from operations/total debt (%) Free operating cash flow/total debt (%) Pretax return on permanent capital (%) Operating income/sales (%) Long-term debt/capital (%) Total debt/capitalization incl. short-term debt (%)
Source: Standard & Poor's, 1999.

6.10

1.10

6.30

4.10

2.30

1.20

90

BBB

0.30 4.90 8.50 6.00 3.60 2.30 70 BB 116.40 72.30 47.50 34.70 18.40 10.90 14.80 % % % % % % % BB 76.80 30.50 18.80 7.30 % % % 8.40% 2.40% 1.20% % BBB 31.50 23.60 19.50 15.10 11.90 12.40 % % % % % 9.10% % BB 24.00 19.20 16.10 15.40 15.10 12.60 17.80 % % % % % % % AA 13.40 21.90 32.70 43.40 53.90 65.90 28.90 % % % % % % % A 23.60 29.70 38.70 46.80 55.80 68.90 44.80 % % % % % % % BBB

5. Compare the debt financing options. Explain why you are for/against the Yankee bond option. The debt financing options included three different types of bonds; straight debt, Eurobonds and Yankee bonds. Straight debt would be bonds issued in Hong Kong and denominated in Hong Kong dollars. Eurobonds are issued in the international bond market (can be multiple counties) and can be issued in Hong Kong dollars. Yankee bonds for HWL are bonds that are issued by a firm in the United States and denominated in US dollars. I am not for HWL issuing a Yankee bond. This would be one of the more difficult bonds for HWL to issue, and because it is denominated in US$, it increases the currency risk that HWL will be taken on. The reason why it is the most difficult bond for HWL to issue is because if they are raising the capital through the public, they have to file a registration statement with the Securities and Exchange Commission (SEC), and disclose their financials in accordance to GAAP. Since they are not disclosing their financials in accordance with GAAP, this will take time and money to do. But if they wanted to raise the money from the Yankee bonds through institutional investors only, there 5|Page

Hutchison Whampoa Limited

The Capital Structure Decision Case Study Solution is a SEC rule that exempts them from the registration requirement; rule 144A. However, this decreases the amount of investors that can purchase this debt, and since HWL is not well known in the United States, it may not fully fund if it can not maximize the amount of potential investors. Eurobonds and straight debt do not require HWL are unregistered, and not require any additional financial statements that have not already been filed by HWL. The other reason I did not like Yankee bonds as an option for HWL is the currency risk that it does not need to take on. HWL can eliminate currency risk by getting issuing straight debt or a Eurobond. If they went with the Yankee bond and wanted to eliminate the risk, they would have to hedge against the risk, which again uses resources they would not need to use if they went with a bond with no currency risk. For HWL, the Eurobonds are the best option. The market is the largest, and since it is unregistered this would not use any additional resources from HWL.

6. What kind of capital structure would you propose to Hutchison Whampoa and why? HWL needs to analyze its financial flexibility. Flexibility is how much debt you can issue before you lose the investment-grade bond rating. With more debt, the lower the cost of capital because of the tax shield, but because of the situation HWL is in with its bond rating, a BB rating is a huge difference from BBB. The ideal situation for HWL would be to take-on the maximum amount of debt while keeping its BBB rating. This way it will not have to pay the 1.6% premium for having its rating drop to a noninvestment-grade bond rating. The remaining amount of capital it needs to obtain can be done thru the equity offer. The equity offer can still take place at $48.80 a share, but for fewer shares. The debt should be obtained through Eurobonds. Because of the size, and ease for HWL to raise capital, HWL should obtain its long term debt financing through Eurobonds. The cost of debt is cheaper, and has the added benefit of the tax shield. If it was not for the change in rating for issuing too much debt, the entire capital would be raised by debt. But the change in rating makes it necessary for HWL to raise the remaining amount through the equity issue.

6|Page