A case study on timbertops, Financial Accounting

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Q. A case study on TIMBERTOPS?

Cost of capital

Use Ke = Do (1 + g)/ Po + g

where g = br

Retention rate b = 245 ÷ 442

= 55%

Return on capital r = 442 ÷ (1,932 - 245)

= 26%

Therefore         g = 0.55 * 0.26

   = 0.143

Do       = 197 ÷ 1,000 * 19.7c

Po        = 275c

Ke           =19.7 (1.143)/275 + 0.143

= 0.225

= 22.5%

Explanations, assumptions and justification

- The dividend valuation model has been utilize to calculate the cost of capital. This supposes that none of the current liabilities has an element of "permanent" nature (example a core overdraft) and that the long term financing is therefore "all equity".

- The dividend growth rate has been computed using Gordon's growth model which is based on one year's worth of data. This is acceptable by the comment that both profits and dividend cover are consistent with previous year and therefore can reasonably be assumed to continue into the future.

- The expansion even though large is into related activities. Therefore is seems appropriate to assume that the project will not significantly change the business risk of Timbertops and that the current cost of capital can be used to appraise the project.

(b) Sources of finance

Bank loan

- Timbertops presently has no long-term debt and so no gearing problems. Thus it seems reasonable that some or all of the finance could be raised from a bank loan without exposing the company to extreme gearing levels.

- The fixed asset base ($1.9m) is double that of the required finance. It appears probable therefore that ample security will be available for the debt finance as long as the asset base is tangible (which appears probable given the nature of the business).

- Timbertops' current liquidity position and the current ratio just above one that would suggest that there is little spare cash available. The banks would require convincing via a detailed business plan, that Timbertops was capable of meeting the interest repayments.

- The nature of Timbertops' business would as well appear to be extremely seasonal. Cash flows in the winter months are probable to be very low. The stiffness of the debt interest payments may well be a problem in this period.

Rights issue

- A rights issue of equity tenders shares to existing shareholders in proportion to their current holding. As long as it is completely taken up it would not so change the balance of control. This is probable to be an important consideration for the Jenkins family who will wish to retain control.

- A further advantage will be the flexible nature of the dividend payments which will help Timbertops given the likely seasonal nature of its cash flows.

- It appears unlikely nevertheless that the family members presumably with limited resources available could provide the full $1m.

- If this were the case then additional shareholders would need to be found. This could be a matter for the following reasons.

- Shareholders would require to be found who would be willing to support the family's views on expansion. Hostile shareholders could source significant business problems.

- Given the fact that Timbertops isn't quoted and therefore doesn't have a readymade market for its share it may be difficult to find shareholders who are willing to take on an investment that isn't particularly marketable.

Other options

Other financing options that must be considered include the following.

- Grant income South Wales may possibly well be an area where money is available via Regional Enterprise Grants or European funding. Timbertops must seek specialist help in this area.

- Access to additional equity could be obtained and marketability could be improved via a listing on AIM. Timbertops must be aware nevertheless that this will involve onerous listing and reporting commitments and is likely to dilute control and be costly.

Theoretical issues

The effect of increasing the new finance via debt or equity on the cost of capital needs to be considered. As-per to Modigliani and Miller (M&M) 1958 the cost of capital isn't influenced by the debt/equity mix. But this only applies to non-tax paying companies which Timbertops is not. M&M's 1963 theory proposes that a tax-paying company should gear up as far as possible as the cost of capital decreases as gearing increases. In contrast the usual theory of gearing suggests judicious use of debt can achieve a minimum cost of capital for a tax-paying company.

Conclusion

The new finance must be obtained via a combination of rights funding and a bank loan. The level of the family's funds should be ascertained and equity rose at a level with which they feel comfortable. This will enable manage not to be diluted.

The balance must be raised via a loan. The commitment given by the family must help persuade the banks to provide funds. Security must be used to bring down the cost. Because the bank isn't supplying all the funds the interest payments should be more manageable.


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