This project is base on the corporate financial analysis of Dee Valley Group PLC at the end of the financial year which ends on the 13th June 2007. Dee valley group is a water company established in 1994 as a holding company for Wrexham water plc (formally Wrexham and East Denbighshire Water Company). In 1997, Chester waterworks was acquired by Dee valley group and the two companies combined to form Dee Valley water plc with head office established at Wrexham. The company supply potable and non-potable water to 106,000 households and 8,250 commercial, industrial and business customers within North east Wales and Cheshire. Following disposal of non – water operation in 2002, the group now comprises of Dee Valley group plc and its wholly subsidiary, Dee valley plc. Dee valley is an independent public company and is fully listed on the London stock exchange.
At Dee valley group, there is separation between the management and the ownership of the company, with the evidence of the existence of 5 Board of Directors which comprises of the Graham Scott (Chairman) and 2 other non executive directors namely Andrew bird and David Weir .The executive directors are Bryn Bellis (Managing Director) and David Guest (Finance Director and Secretary). The Board is committed to high standard of corporate governance; the board is responsible for the overall management of the group and determining long term objectives and strategy. Though, the executive directors take active part in the running of the company, but the power resides on the stockholders, with the facts that the directors interest is about 0.53% of the total stock and the existence of a larger institutional stockholder, also the non executive directors are more than the executive directors. The management of the group business is delegated to the executive directors subject to formal schedule of matter specifically reserve to the board.
The board attaches high importance to communicating with all shareholders by encouraging shareholders participation in annual general meetings. The policy of the board is to be available for meetings with institutional shareholders in order to explain the group’s results, policies and future strategy. The meetings are normally attended by all directors where they make themselves available to answer question either formally or informally in respect of their responsibilities as a board member. Also shareholders receive the full annual and interim report of the company.
Dee valley group provides estimates of company’s earnings per share and future growth, with the substantial amount of information provided about its earnings report, though there were no clear analyst reports to show that the company is a well followed firm, so there is no information from external sources about the company’s earnings report, expert that it is listed in the FTSE 100 index. This fact could lead us to bias in the information that is available about the firm.
During the year the group contributed £1,895 to water Aid in the economy in which it operate and have the intention of doing more in the coming years. And the company aim is also to reduce, as far as possible, the negative effects of its operations on the environment. Water abstraction is kept to a minimum by ensuring that leakage levels are maintained at the lowest economic level and that water efficiency activities are proportionate to the supply position.
Dee valley group as at the end of last year, has different stockholders, out of which are basically are mutual funds, other investors (pension funds), individual investors and very small insider interest. The analysis of the stockholders is presented in the bar chart and tables below.
The substantial institutional holder is AXA Managers UK ltd. The framework of the shareholders holding is presented in a table format below.
AXA INVESTMENT MANAGERS UK LTD
GARTMORE INVESTMENTS LTD
RATHBONE INVESTMENT MANAGEMENT LTD
CHELVERTON ASSETS MANAGEMENT
EL ORO EXPLORATION CO. LTD (INVESTMENT MANAGEMENT)
DEE VALLEY DIRECTORS INTEREST
Most of these are domestic investment management companies, though diversified into other markets. The highest institutional investor is an Axa investment manager UK LTD which owns about 35.1% of the total stock and other investors as presented above.
The average institutional investor at Dee valley group is a domestic institutional investor which is an investment management firm, and also the company is the marginal investor as it owns the majority stock of the company.
Analyzing the risk profile of the Dee valley water, I plot the monthly stock prices of the valley group between 2002 and 2007, which is a five year period. The stock prices show an upward trend over the last 5 years, though there is a considerable volatility in the prices.
To analyze how much of this volatility can be attributed to market forces; we have to run a regression of Dee valley stock prices against the FTSE 100 index:
In our regression result, I found out that
Slope of the regression = 0.2184. This is the beta for Dee valley group, based on the monthly return from 2002 – 2007.
Intercept of the regression = 0.0065%. This measures the performance of Dee valley group between these periods, when it is compared with RF (1-AZA²). Since the regression result are based on monthly returns between the periods, which averaged 0.31%  . This will result in rate of performance for Dee valley group estimated below.
RF (1-AZA²) = 0.31% (1-0.22) = 0.2418 %
Intercept – RF (1-AZA²) =0.0065% – (0.2418%) = -0.2353%
This analysis suggests that Dee valley group performance for this time period between 2002 and 2007 is performed -0.2353% worst than expected based on the CAPM. This result in an annualized excess loss of approximately -0.96 %
Annualized excess return = (1 + monthly excess return) 12 -1
Since we have a negative return, it shows the company has a negative excess return for the year 2002 – 2007. We now have to calculate the Annualized excess return for Dee valley Group.
Annualized excess return = (1 + monthly excess loss) 12 -1
= (1 + (-0.2353)) 12 – 1
= -0.96 % (negative annual excess return)
(C) R squared of the regression: In our regression result, we found out that the value of our R2 is 0.0229 at 95% confidence level, which means or suggest that 2.29% of the risk (variance) in Dee valley water comes from market sources (interest rate risk, inflation and others), and the remaining 97.71% of the risk is comes from firm-specific components. I believe this was as a result of the kind of industry the firm is that makes the risk from the market so low, because of the utility service the company (water) produced. The firm specific risk can be diversified, and therefore be rewarded in the CAPM.
Dee valley group is said to be very risky and has done worse than expected during the period of this study. It also has a very small portion of its risk coming from the market, which is not diversifiable.
Calculating Dee valley expected return:
We use the levered beta, estimated market value of equity and debt
Market value of equity = share price * No of shares, (10.05 * 1,454,407) = £14,616, 790
Using the share price for the company as at December 2007 = £10.05, no of shares = 1,454,407
Market value of debt: To get this we find
Book value of debt = £45.12million, interest expenses = £1.624million, and assuming 3yrs maturity
Cost of borrowings = risk free rate + default spread
Where risk free rate=3.75(10yrs uk treasury bond rate), default spread=1.80%,
Interest coverage ratio = EBIT/ interest expenses, where EBIT= (net income/1-t) + interest expenses
EBIT= (4.27/1-0.30) + £1.624= £7.724, interest coverage ratio = £7.724/£1.624 = £4.756 falls in the default spread of 1.80%
Therefore cost of borrowings (pre tax cost of debt) = 3.75 + 1.80% = 5.55%
Estimated value of debt = 1.624((1-1/ (1+0.0555)3))/0.0555) + 45.12m/ (1.0.055)3
Expected return = rf + beta (risk premium), = 3.75% + 0.22(4.50) = 4.75% (return that potential investors will require as a rate for investing in Dee valley stock and also the cost for Dee valley)
Where 4.75 is the UK risk premium gotten from the Damodaran A. website.
After tax cost of debt = (Riskfreerate + default spread)(1-t), = (3.75% + 1.80%)(1-0.30), = 3.885%
Dee weight for debt and equity, using the market value of debt and equity
Equity ratio= 14.62/72.05 = 20%
Debt ratio= 57.43/72.05 = 80%
Cost of equity = 4.75%
After tax cost of debt = 3.89%
Cost of capital = 4.75 %( 0.20) + 3.89(0.80), = 4.06%
Dee valley group is financed with both mixture of equity and debt, with the company cost of equity the expected rate of return, there were are evidence from the company’s report about the source of debt to include commercial papers, debentures and others. The firm uses banks overdraft of £7300, current borrowing under revolving credit facilities of £2500 and irredeemable debenture stock of £99(all in £000) and others totaling to £37772 as at March 2007. The company falls in the A rating and uses more of debt finance to equity finance. The earning of the company is volatile as they change from year to year. One would expect Dee valley to have a more tax benefit, though the company is finance more of debt finance.
Current cost of capital/financing mix
Using the market value of equity (£14.62million) and estimated market value of debt (£57.43million) calculated earlier on hurdle rate. Cost of equity (4.75%) and after tax cost of borrowings of (3.89%).
Cost of capital = 4.75 %( 0.20) + 3.89% (0.80), = 4.06%
Then we have to unlevered our beta. Bu = Bcurrent / (1+ b/s (1-t))
= 0.22 / (1+ 4(0.7), = 0.06
COST OF EQUITY
Based on the objectives of cost of capital minimization, the optimal debt ratio for Dee valley is 90% and the firm’s value at optimal in which Dee valley would have saved if the optimal cost of capital was used is at 3.89 than that of 4.06% used.
Firm value before the change= £14,617 + £57,434 =£72,051
WACCb = 4.06% Annual cost = £72,051 * 4.06% = £292,527
WACCa = 3.89% Annual cost = £72,051 * 3.89% = £280,278
Change in WACC = 0.17% change in Annual cost = £12,249
The below table shows the calculations of the after tax cost of debt at different levels, where the lowest depict the cost that will be inquired by Dee valley group if they take into consideration different financial mix.
Aftertax cost of debt
The table above shows that the optimal cost of debt in which Dee valley group should have used is that of 10% debt in the firm’s finance mix. I will recommend Dee valley group to increase its debt from the formal 20% debt to 80% equity to the 10% debt and 90% equity because by doing this the cost inquired reduces and this leads to cost saving and increase profit for Dee valley group.
Relating Dee valley debt to the sector, Other firms in the water providing industries in the UK use more of debt in their finance mix, I think using more debt finance and little equity is common within the water producing industries in the country, but the debt /equity mix differs from one water firm to the other.
The market analysis will involve using all firms listed on the UK market, to yield a regression of debt ratio against the variance in the market prices. The result from this result will help us to analyze Dee valley debt in relative to the market, but we don’t have enough data to execute this.
Dee valley has made profit available for distribution and resolved to be distributed by the company in respect of the financial year are distributed amongst the holder of ordinary shares and non-voting shares(parri pasu as if they constitute one class of shares) ratably according to the amount paid up for such share. The company has returned cash to its owner through dividend paid to stockholder every end of the financial year. The table below shows the company’s dividend paid for the last 4 years
Dividend paid (£000)
Dividend per share(ordinary and non voting ordinary share)
Based on dee valley decision of paying dividend at the end of all financial year, they can bought back more stock from the stock holder, this l believe will increase the finance through equity to the firm and possibly leads to higher profit even if they have enough cash.
In analyzing the dividend policy of the company, we have take into consideration the amount of earnings, retained profit and the dividend paid over the 5 years under consideration. We examine the capacity of the company to pay and how much was actually paid.
The above table gives the earnings, dividend, retained earnings, capital expenditure and depreciation for Dee valley group, we used the formula below for calculating the FCFE to get the Dee valley capacity to pay dividend.
FCFE = Net income – (cap.ex – Deprc) (1-DR) – chg WC (1-DR)
Where change in non working capital= 1.33m, depreciation =2887, capital expenditure= 5.42m, and Net income of 3029 for the year 2007.
FCFE 2007 = 3029-(5.42-2887) (1-0.80)-1.33(1-0.80) = £3,606
The free cash flow for Dee valley group for the year 2007 is £3,606 and a dividend of £2186 was paid and the balance remains as reserves for the company. The FCFE was composing using the debt ratio of Dee valley group. Given the dividend policy of Dee valley, in which they pay some of the return in terms of dividend and some others bought as stock, I will advice Dee valley should more cash to the owner because Dee is a utility service provider firm and more of their capital comes from debt.
Here, we get the type of cash flow Dee valley would use to discount. Using the FCFF for Dee valley to discount the cash flow, we use the formula below.
FCFF 2007 = EBIT (1-t) – (cap.Exp. – Depr) – chgWC
Where EBIT = 7.724, t= 30%, capital expenditure = 5.420m, depreciation = 2.887, change in working = 1.33.
FCFF= 7.724 (1-.30) – (5.420 – 2.887) – 1.330 = 1.544
The free cash flow for Dee valley is 1.544m for the year 2007; we used the FCFF to discount for Dee because the leverage at Dee valley is expected to change.
Total reinvestment = Net capital exp. + change in working cap.
Where Net capital exp. = cap. Exp. – Depreciation, = 5.420 – 2.887= 2.533
and change in working cap. = 1.33
Total reinvestment =2.533 + 1.33, = 3.863
Reinvestment rate = Total reinvestment/EBIT (1-t), = 3.863/7.724 (0.70) = 45.86%
Calculating the Growth rate using the operating income
g = reinvestment rate * return on capital
g = (net cap exp + chg in WC/EBIT (1-t)) * (EBIT (1-t)/ BV of capital)
g = 458.86 * (7.724(0.70)/54.49), = 4.59%
To calculate the firm’s value = FCFF (1-g)/ cost of capital -g
Where the cost of capital is 4.06%, g = 4.59% and FCFF is 1.544
Firm value = 1.544(1-4.59)/ (4.06 – 4.59) = 10.452
The key variable driving the value of Dee valley group is the leverage, Dee valley group has a substantial fund gotten from the bank in terms of long term debt this shows in their capital structure and the finance mix for the firm. This fund has added value to the firm and remain a key competing firm in the water industries that operates in Wales.
If hired as to help enhance the value of the firm, I will implement an appropriate finance mix that will leads to a reduced cost of capital used in the investment. If more debt leads to increase in the firms profits compared to that of equity and enhance the value then debt finance will be considered more.
The essay gives an analytical report of Dee valley group, a water producing firm in Wales based on the data gotten from its annual report of 2007 in calcuting key corporate financial analysis of the company. The accuracy of this report may not be the actual figure as they are lack of data to give accurate report and assumptions were made too in the analysis of this report.
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