Sell a part of own business: 201212Q1(a)

Coeden Co is a listed company operating in the hospitality and leisure industry. Coeden Co’s board of directors met recently to discuss a new strategy for the business. The proposal put forward was to sell all the hotel properties that Coeden Co owns and rent them back on a long-term rental agreement. Coeden Co would then focus solely on the provision of hotel services at these properties under its popular brand name. The proposal stated that the funds raised from the sale of the hotel properties would be used to pay off 70% of the outstanding non-current liabilities and the remaining funds would be retained for future investments.

The board of directors are of the opinion that reducing the level of debt in Coeden Co will reduce the company’s risk and therefore its cost of capital. If the proposal is undertaken and Coeden Co focuses exclusively on the provision of hotel services, it can be assumed that the current market value of equity will remain unchanged after implementing the proposal.

Coeden Co Financial Information Extract from the most recent Statement of Financial Position

Coeden Co’s latest free cash flow to equity of $2,600,000 was estimated after taking into account taxation, interest and reinvestment in assets to continue with the current level of business. It can be assumed that the annual reinvestment in assets required to continue with the current level of business is equivalent to the annual amount of depreciation. Over the past few years, Coeden Co has consistently used 40% of its free cash flow to equity on new investments while distributing the remaining 60%. The market value of equity calculated on the basis of the free cash flow to equity model provides a reasonable estimate of the current market value of Coeden Co.

Sell a part of own business: 201212Q1(a)

The bonds are redeemable at par in three years and pay the coupon on an annual basis. Although the bonds are not traded, it is estimated that Coeden Co’s current debt credit rating is BBB but would improve to A+ if the non-current liabilities are reduced by 70%.

Other Information

Coeden Co’s current equity beta is 1·1 and it can be assumed that debt beta is 0. The risk free rate is estimated to be 4% and the market risk premium is estimated to be 6%. There is no beta available for companies offering just hotel services, since most companies own their own buildings. The average asset beta for property companies has been estimated at 0.4. It has been estimated that the hotel services business accounts for approximately 60% of the current value of Coeden Co and the property company business accounts for the remaining 40%.

Coeden Co’s corporation tax rate is 20%. The three-year borrowing credit spread on A+ rated bonds is 60 basis points and 90 basis points on BBB rated bonds, over the risk free rate of interest.

Required:

(a) Calculate, and comment on, Coeden Co’s cost of equity and weighted average cost of capital before and after implementing the proposal. Briefly explain any assumptions made. (20 marks)

Answer to Sell a part of own business: 201212Q1(a)

Before implementing the proposal

Cost of Equity and Debt:

Cost of equity = 4% + 1.1 × 6% = 10.6%

Cost of debt = 4% + 0.9% = 4.9%

Market value of debt (MVd):

Per $100: $5.2 × 1.049–1 + $5.2 ×1.049–2 + $105.2 ×1.049–3 = $100.82

Total value = $42,000,000 × $100.82/$100 = $42,344,400

Market value of equity (MVe):

Assumption 1: Estimate growth rate using the rb model. The assumption here is that free cash flows to equity which are retained will be invested to yield at least at the rate of return required by the company's shareholders. This is the estimate of how much the free cash flows to equity will grow by each year.

r = 10.6% and b = 0.4, therefore g is estimated at 10.6% x 0.4 = 4.24%

MVe = 2,600 x 1.0424/(0.106 – 0.0424) approximately = $42,614,000

The proportion of MVe to MVd is approximately 50:50

Therefore, cost of capital:

10.6% ×0.5 + 4.9% × 0.5 × 0.8 = 7.3%

After implementing the proposal：

Coeden Co, asset beta estimate

1.1 × 0.5 / (0.5 + 0.5 × 0.8) = 0.61

Asset beta, hotel services only

Assumption 2: Assume that Coeden Co’s asset beta is a weighted average of the property companies' average beta and hotel services beta.

Asset beta of hotel services only:

0.61 = Asset beta (hotel services) × 60% + 0.4 × 40%

Asset beta (hotel services only) approximately = 0.75

Coeden Co, hotel services only, estimate of equity beta:

MVe = $42,614,000 (Based on the assumption stated in the question)

MVd = Per $100: $5.2 × 1.046–1 + $5.2 × 1.046–2 + $105.2 × 1.046–3 = $101.65

Total value = $12,600,000 × $101.65/$100 = $12,807,900 say $12,808,000

0.75 = equity beta × 42,614/(42,614 + 12,808 x 0.8)

0.75 = equity beta × 0.806

Equity beta = 0.93

Coeden Co, hotel services only, weighted average cost of capital

Cost of equity = 4% + 0.93 × 6% = 9.6%

Cost of capital = 9.6% × 0.769 + 4.6% × 0.231 × 0.8 = 8.2%

Comment:

Implementing the proposal would increase the asset beta of Coeden Co because the hotel services industry on its own has a higher business risk than a business which owns its own hotels as well.

However, the equity beta and cost of equity both decrease because of the fall in the level of debt and the consequent reduction in the company’s financial risk.

The company’s cost of capital increases because the lower debt level reduces the extent to which the weighted average cost of capital can be reduced due to the lower cost of debt.