With increasing need for acquisition and mergers in companies to expand profit margins, it is becoming increasingly necessary for companies to study their potentials for expansion and thus avoid falling into the problem of lost profitability.
As a renowned Australian company, TNA intends to expand through the acquisition of a Vietnamese company at a total of $AUS 10,000,000. The company can source funds through debt or equity but a combination of the two is recommended. An analysis of the present value of the company yields results that show that the business will be unprofitable at $ 10,000,000 while an investment of $ 7,000,000 would be more attractive.
Expanding a company into a foreign country requires intensive work to be done on determining the potential profitability of the company in the intended location. As the company desires to expand, the key factors that come into consideration include the capital cost of expansion and the potential profitability, judged from the expected cash flow and present values at different times in the life of the new investment. Consequently, a company such as TNA which intends to diversify its operations into a new country should consider how it is going to source funds for the expansion based on capital cost estimations. Since the company already knows the capital cost for the intended investment, it is now necessary to select the most suitable sources of finances for the expansion. Sources can be defined as either Equity of debt sources. While debt sourcing involves borrowing money to be repaid within a stipulated time frame and with a pre-determined interest, Equity funding involves selling company shares to fund expansion. While these two are most probable sources of finance for TNA presently, other sources such as retained earnings can be used later when the new plant is up and running. The present report provides an analysis of the available funding options for TNA as well as an evaluation of the viability of the expansion based on financial reports.
Q1. The management of TNA are undecided about their best option for sourcing the $A10 million required for the transaction. Discuss their options for sourcing these funds.
To fund their expansion, TNA can consider the following options for obtaining funds through Equity and Debt.
Table 1: Funding sources: Alternatives for TNA
|Equity Capital Sources||Debt Capital Sources|
|1- From parent and/ or friends||1- From parent and/ friends|
|2- Joint venture partners in the parent country and joint venture partners in the host country can provide funds through shares.||2- Funds could be obtained through bond issue or bank loans in the host country as well as in the parent country.|
|3- From a third party country shares such as sale of stocks in the Euro market||3- From a third party country bond issue of loan such as through Eurobond or through World Bank loans.|
Equity funding provides a viable alternative for TNA to apply in the present situation. This type of financing can be achieved through trading of company shares, where the trade specifically targets the company owners (Calopa and others 19). The trade is in this case referred to as ordinary shares and is most appropriate and practical where the targeted ownershave the financial capability of paying for the sold shares. If this is not the case, the company may subject its owners to strain and uncertainty. In case the owners have been confirmed to be capable of paying for more shares, each of the owners is required to buy several additional shares in the company. The additional shares bought by the company owners give them a right to participate in the organizational decision making, through a voting right and claim to future organizational profits. In case there is need for additional capital, the company may have to rely on deferred shares. Starting operations in January 2017 makes this source of funding all the more practical.
In case TNA decides to rely on Equity as a source of funding, it will be essential to offer the company’s shares not only to the company owners but also for public purchase as the viable alternative to fund raising for its intended investment (Calopa and others 20). The shareholders in the company will increase through the purchase of shares. While this may be easy to say, the potential for acquiring new shareholders depends on the company’s ability to raise its reputation and be considered as a popular medium sized company and strong brand in Australia. Equity obtained through sale of shares to the public is referred to as preference shares and has a fixed value of dividend. Moreover, this type of shares is paid in advance in usual circumstances and may be applicable to a starting company such as the intended expansion. The greatest advantage that TNA could gain from such an arrangement is that it will not have to pay any dividends in case it does not make enough profits in the initial years like many expanding middle-sized companies fail to do.
Another alternative source of funds for TNAs expansion is through debt. When it comes to debt, the company could obtain funding by borrowing from a bank through bonds or loans (Calopa and others 19). Since the company is globally renowned and recognized for the provision of food packaging and processing, the company has relatively high debt capacity in case it has no standing debts (Mills and McCarthy 16). This availability of high credit could make it possible for the company to obtain the entire $ AUS10,000,000. However, before issuing any debts, the approached bank will have to consider the inherent risks in providing the debt in either form as well as the potential profitability of the business and the available security for the debt. The location of the intended expansion influences all these factors immensely and the source of debt funding therefore has to take this into consideration. It is only because of the intended project location that the company may fail to obtain the entire funding amount from the bank unless there is sufficient security for the same.
While debt sourcing may comprise a large percentage of the capital costs, banks will need to see the available funding or proof thereof and only top up where there is limitation. It is thus essential for the company to obtain sufficient equity funding to back up the debt potential (Moon 10). This need is made even more imperative due to the intention to invest in a foreign country. The combination of equity and debt sources of funds will help the company to reduce the risks associated with debt while managing the interest payable on the debt funding. This can effectively be achieved through a financing structure where TNA sources 60 percent of the total capital investment through equity and then obtains a debt of the remaining 40 percent. By using this financing structure, the company ensures that the debt is less compared to the equity funding hence increasing investor appeal.
Moreover, based on the ratio of the equity to debt financing, the banks from which the debt is to be obtained is more likely to be agreeable where the risks associated with the debt is less such as where the amount of debt required is lower than the total capital investment. The comparison of other potential risks however has to take precedence over the agreeability factor since the ability to pay debt is dependent on factors beyond financial conditions of the company. While the debt funding may help the company to invest in its intended acquisition, it is also possible for investment in a foreign country to affect the cash flow of the parent company.This is because as operations go on, it becomes mandatory for the company to pay the lenders through the cash flow returns. This makes it necessary to calculate the expected cash flow from the company to determine its profitability through the discounted cash flow rate. Besides factors of debt repayment, the company should also prepare for other factors such as taxation. This implies that while expanding to Vietnam, TNA has to choose between local and host banks as potential sources of funds.In Vietnam, the taxation on the profit would be 21 percent while in Australia; the taxation would be 30 percent. While tax in Australia seems higher, TNA may gain advantage through the subtraction of the debt interest from the tax returns which lowers investment costs.
While each of the available funding options seems viable for the company, each of these options also has limitations and relative strengths. A combination of the two is thus the most essential decision that the company could make. The following provides a comparison of the key strengths and limitations of the funding sources.
- Debt funding exempts the company from following up on the owners’ interests in company ownership, as done where equity is used.
- Theonly requirementsfrom the company while using debts are the ability to pay the debt with interest.
- Subtraction of the debt interest from the tax returns would reduce the debt cost especially when the debt is taken from an Australian bank
- Debt capital is easier to raise since there are no state and federal laws on security as compared to equity financing
- Investors do not have to make frequent meetings due to project finances; similarly, the shareholders do not have to have periodic meetings.
- Debts have to be repaid at some time/ within the limits of the provided time frame, interests and taxes.
- High risk levels due to the cost of interest accumulating (Kunigis par. 2 – academic).
- Debt instruments pose limitations of future financing which may hinder the company from getting alternative sources of funds from other places.
Q2. Carry out a capital budget evaluation of the proposed takeover assuming a 5-year timeframe and an estimated residual value of A$ 200,000 for the capital equipment at the end of the 5 years. Assume that TNA use a weighted average cost of capital of 10% in their financial evaluations. Does the takeover represent a good investment for TNA based on your evaluation? What would be the situation if the investment required was only A$ 7 million?
To determine how viable the project is based on financial reports, an evaluation of the capital budget for the investment is carried out founded on the assumption that the project time frame will be five years. It is assumed that while budgeting for its operations, TNA will allocate funds beginning 1stJuly in its new acquisition. The Net Present Value will be used to provide the required view into the business. The baseline exchange rate for the project will be taken to be the exchange rate as at 18th May 2016; 16237.8 5 Vietnamese Dong is equivalent to $ AUS 1.
Table 2: Vietnamese market: Annual Sales Growth Rate
|Description||Year 0||Year 1||Year 2||Year 3||Year 4||Year 5|
|Financial year||July2016 June2017||July2017 June2018||July2018 June2019||July2019 June2020||July2020 June2021|
|Annual sales growth rate||0%||20%||30%||30%||20%||10%|
Evaluation of the capital budget to be proposed for five years is carried out through definite steps as shown below. First, the revenue collected from the operations will be calculated based on the monthly revenue of $AUS 200,000. This amount is translated into yearly revenue through multiplication by 12 months as shown.
+ Food processing and packaging revenue
Food processing and packaging revenue results from the new equipment to be installed by TNA. This will be considered as the annual sales growth rate using the percentages fromtable 2 above. The revenue will be in terms of Vietnamese Dong since the project is to be located in Vietnam. The calculation ensuing from the inclusion of the food processing and packaging revenue is as follows. Additional growth in sales is included in the revenue at the end of each year for the next five years.
During the second financial year, the revenue will be:
This process is followed for all the five years. The results are as shown in the table below.
Table 3: Revenues collected annually by TNA
|Description||Financial year||Annual growth rate in sales||Revenue [VD$]|
|Year 1||July 2016 – June 2017||20%||$46,765,008,000|
|Year 2||July 2017 – June 2018||30%||$60,794,510,400|
|Year 3||July 2018 – June 2019||30%||$79,032,863,520|
|Year 4||July 2019 – June 2020||20%||$94,839,436,224|
|Year 5||July 2020 – June 2021||10%||$104,323,379,846|
The cost is then calculated using the revenue as the basis through multiplication with the cost percentage factor. In this case, the cost is 60 percent of the revenue in the first year and 50 percent thereafter. The cost is always a negative amount since it is deducted from the revenue
Cost = cost percentage (Revenue)*(-1)
i.e. Cost for year 1 = $46,765,008,000 *60% * (-1) =-AUS$28,059,004,800
After calculation of the costs for the five years, the residual value is added to the final year as a positive value since it represents the value of the equipment after five years of use.The table below shows the results for the project costs for all the five years.
Table 4: Costs per year
|Description||Revenue [VD$]||Cost percentage||Total Cost [VD$]||Residual value Each year [V$]|
|Year 0||$0||Capital cost
The revenue is marked with a positive sign while the costs incurred are marked using a negative (-) sign. The calculations were as shown in the screen shot picture below.
Figure 1: Net Present Value Calculations
Microsoft Excel was used to perform calculations which were based on an initial capital investment of $AUS 10,000,000. From the results shown in the figure above, it can clearly be observed that each of the rows and columns have clear labelling. The calculations show the exchange rate, the revenue per month and per year, the costs incurred as well as other calculations. The base exchange rate used belonged to 18th May 2016 and can be used to estimate the exchange rates for the subsequent years through multiplication by 1* the inflation rate. The equation below gives the exchange rate for subsequent years.
|Year 0||Year 1||Year 2||Year 3||Year 4||Year 5|
|Exchange rate, [VD$/AUD$]||16237.85||16,725||17,227||17,744||18,276||18,824|
From the results obtained above, calculations for the Net Present Value of the investment can be calculated using the formula shown below (Gallo par. 10).
In the above formula:
From this formula, the Net Present Value factor can be found as shown in the table below for years 0 to 5.
|Year 0||Year 1||Year 2||Year 3|
|Net cash flow in AUS$]||-$10,000,000||$1,118,447||$1,764, 540||$2,227,089|
|PV factor||1/ (1+0.1) ^0 =1||1/ (1+0.1) ^1=0.909||1/ (1+0.1) ^2=0.826||0.751|
The remaining years can be seen in figure 1 above.
The present value is then calculated from the product of the obtained factor and the net annual cash flows per year. For example, year 1 can be calculated as PV = net cash flow for year 1 * the PV factor for year 1.
Similarly, the present values for all the years are calculated using the formula above. The results are as shown below.
|Net cash flow [AUD$]||-$10,000,000||$1,118,447||$1,764, 540||2,227,089|
|Present value factor for the year||1||0.909||0.826||0.751|
|Present value in [AUD$]||-$10,000,000||$1,006,993||$1,444,275||$1,673,245|
To obtain the net present value, the present values are summed up together through the following formula.
|Net present value in [AUD$]||-$2,251,799.04|
From the results obtained through the calculations for the Net present value, it can clearly be seen that the findings are negative. This implies that the Vietnamese investment is more of a cost incurred than a profitable business (Dunn and Harry 4). This means that if TNA was to purchase the company, it would not recover its initial investment and would end up undergoing a loss (Gallo par. 8). From this point of view therefore, it would not be advisable for TNA to invest in the acquisition with a capital investment of AUS $ 10,000,000 as this would not be profitable. For Vietnam investors, the project will still be less attractive hence TNA will find it very hard to get debt funding.
For an investment of $ AUS 7,000,000, the same formula and procedure is used. The results realized as shown in the figure below show a Net Present Value of $AUS 748,200.96. The results show a positive value, indicating that this is an attractive venture for TNA. Compared to $10M, the 7M would be more profitable if invested and is thus the more realistic option for the business.
Besides the analysis of the present value of the business, TNA needs a lot of other information such as factors that may influence the business operations. It would be necessary for the company to carry out due diligence, a study of internal and external organizational factors as well as strength and weakness analyses (Dunn and Harry 3). It is only through this that the company can be able to obtain additional information on company valuation and thus pay the most appropriate, attractive and profitable investment costs.
Following the availability of an investment opportunity which involves cross border acquisition, TNA intends to acquire a company in Vietnam. The total investment capital as calculated by TNA would be $ 10,000,000. The company thereforehas to look for funds for the investment through debt or equity sources. Both sources of funding have limitations and strengths, therefore, company is advised to seek for funding through 60 percent equity and 40 percent debt. While this may be possible, the company still faces a challenge in that from the present value analyses, the business proves to be potentially unprofitable based on the current capital investment cost of 10,000,000 AUS $, this can however be reversed if the cost is reduced to $ 7,000,000, which has been proven to be more attractive.
Calopa, Marina, Jelena Horvat and Maja Lalic. “Analysis of Financing Sources for Start up Companies.” Journal of Management 19, 2(2014): 19-44.
Dunn, Robert and Everett Harry. “Modeling and Discounting Future Damages.” Journal of Accountancy, 2001.
Gallo, Amy. “A Refresher on Net Present Value.” Harvard Business Review.[Web]. 2014.
Kunigis, Allan. Advantages Vs. Disadvantages of Debt Financing. Web. 2016.