Cadburys beta and the weighted average cost capital wacc

Sample Financial Analysis Report

3210AFE Advanced Corporate Finance

Cadbury is a profitable business which several options for shareholder value increase available to it. Cadbury’s beta is 0.81 and the weighted average cost of capital (WACC) is 10.56%. A lease/buy opportunity for a packaging machine currently under examination by Cadbury executives has been analysed and the highest value lies in the outright purchase of the machines on offer. Using real option analysis we also recommend postponing the purchase of 10 new packing machines by six months. We recommend the acquisition of Mars Barz Pty Ltd at 15% premium to current share price which will represent significant vale accretive activity in the order of $1.57 per share. Applying some simple risk management tools for hedging FX and cocoa exposures would improve the volatility of EBIT. We recommend implementing an FX and cocoa hedge policy for the full book to reduce EBIT volatility by around 3-4%. We recommend a stable dividend policy be made public in the form of imputed cash dividends as opposed to rights issues would also assist in shareholder perception and align with general market conditions. The firm’s financial ratios are stable and healthy indicating that its raw beta is reasonably accurate. Cadbury’s WACC remains under pressure while debt levels rise and it may be prudent to issue equity in the next round of financing to improve the debt ratio of the firm. Cadbury’s corporate governance and executive compensation model is aligned with the general market however some unwanted risk remains on the balance sheet.

We believe the above recommendations would improve the financial position of Cadbury and position the corporation for further growth.

FIRM STRUCTURE AND CORPORATE GOVERNANCE

On 27 February 2009 the confectionery and beverages businesses of Cadbury Schweppes Pty Ltd in Australia were formally separated and the beverages business began operating as Schweppes Australia Pty Ltd. In April 2009, Schweppes Australia was acquired by Asahi Breweries.

the majority of the Non-Executive Directors are independent

one-third of the Board (other than the Group Managing Director) is required to retire at each AGM and may stand for re-election

The six basic tools of compensation or remuneration are used at Cadbury to compensate executives. The six tools are:

base salary

compensation protection

The CEO and other main executives are paid salary plus short-term incentives or bonuses referred to as Total Cash Compensation (TCC). Short-term incentives are formula-driven and have some performance criteria attached. For example, the Marketing Director's performance related bonus is based on incremental revenue growth turnover and the CEO's is based on incremental profitability and revenue growth. The main executives are also compensated with a mixture of cash and shares of the company which are subject to vesting restrictions (a long-term incentive of 3-5 years). The vesting term refers to the period of time before the recipient has the right to transfer shares and realize value. Depending on the executive vesting can occur in two ways: Cliff vesting and Graded Vesting. In case of Cliff Vesting, everything that is due to vest vests at an instant in time. For graded vesting, partial vesting occurs at different times in the future. This is further sub-classified into two types: Uniform graded vesting (equal proportions vest each year for 5 years) and non-uniform graded vesting (different proportions vest each year for the next 5 years). Other components of an the standard executive compensation package include a generous retirement plan, health insurance and interest free loans for the purchase of housing. Some Executives are also compensated with restricted stock, which is stock given to an executive that cannot be sold until certain conditions are met and has the same value as the market price of the stock at the time of grant.

Financing activities over the past 2 years included debt borrowings and repayments, payments of dividends, the exercise of stock options, incentive plan transactions, and the repurchase of Common Stock. During the past three years, short-term borrowings in the form of commercial paper or bank borrowings were used to purchase Nabisco's mint and gum business, fund seasonal working capital requirements, and finance share repurchase programs. In our view this purchase could have been funded using retained earnings and cash reserves before deploying debt. This would maintain a debt-equity ratio at pre-takeover levels (42 percent) rather than push the level to 47 percent. This may heighten the risk of cost of capital increases.

During the past three years, a total of 4,261,484 shares of Common Stock have been repurchased for $224.4 million. Cash used for incentive plan transactions of $274.7 million during the past three years was partially offset by cash received from the exercise of stock options of $141.1 million. The dividend policy of Cadbury does not appear to be aligned with its corporate objectives. Research into dividend policy has shown that a stable dividend policy and shareholder preference for imputation credits (see Brearly and Myers (2008)). Cadbury’s shareholder base would value a stable dividend policy higher than one based on issuing dividends in the form of cash or rights.

Table 1: Selection of monthly returns for market index and Cadbury 1998.

Table 3: Regression of returns for Cadbury to compute beta.

Cadbury’s beta is less than unity indicating it is best suited for portfolios seeking defensive stocks. Compared to other retail companies a beta that is less than unity is rare. Cadbury’s main competitors include ZZZZ Corp which has a beta of 1.21, QQQQ Corp which has a beta of 1.07 and BBBB Corp which has a beta of 1.11. Fund managers looking to include a retail stock in a diversified portfolio should consider Cadbury and senior management and the board of directors should advertise the benefit of Cadbury stocks to a portfolio manager. For instance, an existing Australian

equities portfolio tracking a broad index of Australian firms generally has a beta in excess of 1.07, so adding Cadbury stock to comprise around 12 percent of the portfolio can reduce the portfolio beta to near 1. This would be of strategic importance over the business cycle.

Under the equivalent loan method the decision to buy the asset is clear, as per the analysis below.

From the above analysis it is clear that Cadbury management should look to purchase the machine outright using retained earnings in the balance sheet.

REAL OPTION ANALYSIS OF CAPITAL PURCHASE

The primary economic rationale for a possible take-over is that they it is a positive NPV investment. The value of Cadbury and the merged entity must be greater than the sum of its parts. Through combining operations we require V(AB) > V(A) + V(B) where V(AB) = the value of the combined firms A and B, V(A) = the pre-acquisition value of firm A and V(B) = the pre-acquisition value of firm B.

The process synergy (or operating synergy) is as follows:
Synergy = V(AB) - (V(A) + V(B))
A firm's intrinsic value is the sum of its future discounted cash flows. One or more of incremental cash flows, revenues, costs and taxes of the new entity must result from the takeover and increases cash flows and hence synergy, which would justify the takeover on economic grounds.

4.Mars Barz has a relatively weak balance sheet which limits its ability to fight a takeover offer. 5.Mars Barz has a similar working culture to Cadbury which would allow it to merge operations relatively easily.

There are some reasons against a possible takeover which include:

Table 9: Mars Barz takeover data assumptions.

Pro Forma for Cadbury

Table 11: Acquisition premium scenarios for Mars Barz takeover at various premiums.

Table 12 provides a detailed analysis of the main outcomes of the takeover analysis. As shown it funded through debt the takeover would not be value accretive however significant value can be derived if funded through current retained earnings. This would deplete Cadbury’s cash reserves however it still has capacity to raise funds in the short term debt market for working capital requirements.

RISK MANAGEMENT AND HEDGE POLICY ANALYSIS

Cadbury operates an Enterprise Risk Assessment process, facilitated by the Company’s Chief Risk Officer, to identify, manage and report on the Company’s material business risks. The ERA process comprises five sub-ERAs conducted annually, with a semi-annual review, under the stewardship of each executive manager and their particular area of responsibility (Corporate Affairs, Finance, Marketing, Operations and Strategy & Development). Upon completion of the five sub-ERAs, a consolidated, prioritised and summarised ERA is prepared and tabled at the Audit & Risk Committee. During the year, a new specialised risk-management software package from Canadian company Dyadem International Ltd was introduced. The Dyadem software is now at the heart of risk assessments across the Group. An important benefit of the new software is that it now interfaces into a Pulse Actions Required module to assist in managing the timely completion of Recommended Controls. (Pulse is the Group’s accounting and enterprise reporting system.) The ERA process is

The tripling of price and the increase in AUD against other major currencies is having a large affect on Cadbury’s EBIT. Simple sensitivity analysis suggests that a 1% change in cocoa prices translates into a 4% change in EBIT while a 1% change in AUD translates into a 2.7% change in EBIT. Hedging against both cocoa and FX would significantly reduce this risk.

Net interest expense for 2009 was $8.4 million below the prior year, primarily as a result of a decrease in short-term interest expense due to reduced average short-term borrowings. Net interest expense for 2008 was $6.9 million below 2007 reflecting a decrease in short-term interest expense due to a decrease in average short-term borrowing rates and reduced average short-term borrowings.

Net income increased $196.4 million from 2008 to 2009. Excluding the after-tax effect of the business realignment initiatives in 2009 and 2008, the after-tax effect of incremental expenses to explore the possible sale of the Corporation in 2009 and the after-tax gain on the sale of the YYY throat drops business in 2008, net income increased $44.5 million or 11%.

ANALYSIS OF RETURN

OPERATING RETURN AVERAGE STAOCKHOLDERS' EQUITY

The Corporation's financial condition remained strong over the period 2007-09. The capitalization ratio (total short-term and long-term debt as a percent of stockholders' equity, short-term and long-term debt) was 39% as of December 31, 2009, and 44% as of December 31, 2008. The ratio of current assets to current liabilities was 2.3:1 as of December 31, 2009, and 1.9:1 as of December 31, 2008. In June 2009, the Corporation completed the sale of certain confectionery brands to Farley's & Sather's for $12.0 million in cash as part of its business realignment initiatives. In July 2008, the Corporation's Brazilian subsidiary, Cadbury do Brazil, acquired the chocolate and confectionery business of Visagis for $17.1 million.

RATIO ANALYSIS

OUTLOOK

CONCLUSION

Cadbury is a profitable business which several options for shareholder value increase available to it. Along with the lease and real option analysis, the possible acquisition of Mars Barz Pty Ltd represents significant vale accretive activity in the order of $1.50-2.00 per share. Applying some simple risk management tools for hedging FX and cocoa exposures would improve the volatility of EBIT. A stable dividend policy in the form of imputed cash dividends as opposed to rights issues would also assist in shareholder perception and align with general market conditions. The firm’s financial ratios are stable and healthy indicating that its raw beta is reasonably accurate. Cadbury’s WACC remains under pressure while debt levels rise and it may be prudent to issue equity in the next round of financing to improve the debt ratio of the firm. Cadbury’s corporate governance and executive compensation model is aligned with the general market however some unwanted risk remains on the balance sheet, see Section 1.

Cadbury Annual Report 2010