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The Capital Structure DecisionCase Study Solution Essay

1.Assume Hutchison Whampoa will require US$1 billion of financing in 1996. Assumethat equity can be raised at $48.80 a share and that a long-term debt issue will carry aninterest rate of HIBOR plus 70 basis points. How would an equity or debt issue impactHutchison’s financial position and performance?

Hutchison Whampoa Limited (HWL) had multiple major long-term projects that would requiresubstantial 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 werelong-term, the previous way of funding these projects would not be feasible. HWL would have toguarantee that their spending would not dry up and halt the project.

The amount that was estimatedto be used by investment analysts was as high as $5 billion. So HWL was not able to use the samemethods 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 financedtheir US$1 billion spending need with long-term debt. In order to analyze these two scenarios, Iforecasted the financial statements to 1996.

Scenario 1 – Equity Offer
The first analysis was the impact of the US$1 billion equity offer on HWL’s financial position and performance. Based on appendix A, the average exchange rate for US$1 to HK$ in 1996 was7.73485. US$1 billion would be HK$7.8 billion.

When new shares are created and then sold by thecompany, 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 dilutionis only to the percent of the company that the shareholder’s own, not to the value of the companythey own. That is because this equity offering is increasing the value of the company because nowthey have the long-term capital needed to undertake all the projects they have planned andapproved. The projects that will now occur have created additional value for the company.1

First, immediately following the equity offering, the impact on the balance sheet will increase theshareholder’s equity by the HK$7.735 billion, which will be offset by current assets. This is enoughfunding 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 flowfrom 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 Lossstatement (P&L). I took exhibit one, and forecasted it out to 1996 to analyze the impact of theequity 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 HWL’s financial position and performance. HWL had numerous different options for raising capital thru debt. They includeissuing bonds in Hong Kong, issuing bonds abroad, Eurobonds or Yankee bonds. Same with theequity 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 itstax shield.

The interest that HWL will pay on its taxes will be tax deductible. Hence, the value of aleveraged 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.

Thefinancial risk in this situation would be if HWL was to go bankrupt, the debt issuers would havefirst claim to the assets, leaving the equity holders with little to nothing. I would argue taking onthis 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 balancesheet will increase the long-term liabilities by the HK$7.735 billion, which will be offset by currentassets.

Just like with the equity offering, this is enough funding to cover the short-fall they facedwith funding the projects in exhibit 10. With the other outstanding loans they had that are not duefor 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.

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 Whampoa’s current capital structure considering its future financialneeds. To assess the current capital structure of HWL, you have to analyze the composition of itsliabilities. For the most recent year (1995), the balance sheet in exhibit 2 shows that HWL hasHK$26,174 million in long-term liabilities and HK$5,329m of current liabilities.

The cash flowstatement in exhibit 3 shows that interest paid on financing was HK$2,808m. Spreadsheet appendixC shows that the average interest rate for HWL in 1995 was 9.7%, which comes from 17% of theliabilities being current, and the remaining 83% in long-term. However, this does not take intoaccount the 7% convertible bonds based on HK$2,125.8m. If none of the bonds are converted, theamount 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 thecapital 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 projectsin exhibit 10, the net positive cash flows are HK$8.532 in 1995.

Based on the liabilities and cashflows of HWL, the current capital structure (prior to the debt or equity offer of US$1 billion) is notsufficient for the planned growth. All of the projects in exhibit 10 will have a negative cash flow inyear 1, and the majority will have a negative cash flow in year 2, it is not likely that the cash flowsfrom these projects can help pay for additional capital expenditures until year

3. So enough fundingis needed before year 3.HWL, like other large firms in Hong Kong, relied heavily on internally generated funds to fuelgrowth. This capital structure was appropriate when projects funded were not long in duration, andthe internal funds were forecasted to cover it. But HWL now wants guaranteed funding for long-term 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 countrycurrency you are obtaining the capital in. There are several different ways to obtain the capital thrudebt. However, some have greater currency risk exposure than others. For example a Yankee bondwould denominated in US currency.

There is a certain amount of exchange rate risk that HWL willtake on by raising the capital in US$. Whenever a company has assets or business operations acrossnational borders, they face currency risk if their positions are not hedged.

A consideration thatHWL might want to make is to hedge its currency risk to reduce its exposure to the US$. If this risk was too much for HWL to take on, they could raise the capital using straight debt. Straight bondsare issued in Hong Kong and denominated in Hong Kong dollars. Or if HWL wanted to obtainfunding in neither US$ or HK$, they could obtain a Eurobond, which is an international bond that isdenominated in a currency not native to the country where it is issued. It can be categorizedaccording to the currency in which it is issued.

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