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Question 1a

Morada Co is involved in offering bespoke travel services and maintenance services. In addition to owning a few hotels, it has built strong relationships with companies in the hospitality industry all over the world. It has a good reputation of offering unique, high quality holiday packages at reasonable costs for its clients. The strong relationships have also enabled it to offer repair and maintenance services to a number of hotel chains and cruise ship companies.

Following a long discussion at a meeting of the board of directors (BoD) about the future strategic direction which Morada Co should follow, three directors continued to discuss one particular issue over dinner. In the meeting, the BoD had expressed concern that Morada Co was exposed to excessive risk and therefore its cost of capital was too high. The BoD feared that several good projects had been rejected over the previous two years, because they did not meet Morada Co’s high cost of capital threshold. Each director put forward a proposal, which they then discussed in turn. At the conclusion of the dinner, the directors decided to ask for a written report on the proposals put forward by the first director and the second director, before taking all three proposals to the BoD for further discussion.

First director’s proposal
The first director is of the opinion that Morada Co should reduce its debt in order to mitigate its risk and therefore reduce its cost of capital. He proposes that the company should sell its repair and maintenance services business unit and focus just on offering bespoke travel services and hotel accommodation. In the sale, the book value of non-current assets will reduce by 30% and the book value of current liabilities will reduce by 10%. It is thought that the non-current assets can be sold for an after-tax profit of 15%.

The first director suggests that the funds arising from the sale of the repair and maintenance services business unit and cash resources should be used to pay off 80% of the long-term debt. It is estimated that as a result of this, Morada Co’s credit rating will improve from Baa2 to A2.

Second director’s proposal
The second director is of the opinion that risk diversification is the best way to reduce Morada Co’s risk and therefore reduce its cost of capital. He proposes that the company raise additional funds using debt finance and then create a new strategic business unit. This business unit will focus on construction of new commercial properties.

The second director suggests that $70 million should be borrowed and used to invest in purchasing non-current assets for the construction business unit. The new debt will be issued in the form of four-year redeemable bonds paying an annual coupon of 6·2%. It is estimated that if this amount of debt is raised, then Morada Co’s credit rating will worsen to Ca3 from Baa2. Current liabilities are estimated to increase to $28 million.

Third director’s proposal
The third director is of the opinion that Morada Co does not need to undertake the proposals suggested by the first director and the second director just to reduce the company’s risk profile. She feels that the above proposals require a fundamental change in corporate strategy and should be considered in terms of more than just tools to manage risk. Instead, she proposes that a risk management system should be set up to appraise Morada Co’s current risk profile, considering each type of business risk and financial risk within the company, and taking appropriate action to manage the risk where it is deemed necessary.

Morada Co, extracts from the forecast financial position for the coming year

$000
Non-current assets 280,000
Current assets 48,000
Total assets
328,000
Equity and liabilities
Share capital (40c/share) 50,000
Retained earnings 137,000
Total equity
187,000
Non-current liabilities (6·2% redeemable bonds) 120,000
Current liabilities 21,000
Total liabilities
141,000
Total liabilities and equity capital
328,000

Other financial information
Morada Co’s forecast after-tax earnings for the coming year are expected to be $28 million. It is estimated that the company will make a 9% return after-tax on any new investment in non-current assets, and will suffer a 9% decrease in after-tax earnings on any reduction in investment in non-current assets.

Morada Co’s current share price is $2·88 per share. According to the company’s finance division, it is very difficult to predict how the share price will react to either the proposal made by the first director or the proposal made by the second director. Therefore it has been assumed that the share price will not change following either proposal.

The finance division has further assumed that the proportion of the book value of non-current assets invested in each business unit gives a fair representation of the size of each business unit within Morada Co.

Morada Co’s equity beta is estimated at 1·2, while the asset beta of the repairs and maintenance services business unit is estimated to be 0·65. The relevant equity beta for the new, larger company including the construction unit relevant to the second director’s proposals has been estimated as 1·21.

The bonds are redeemable in four years’ time at face value. For the purposes of estimating the cost of capital, it can be assumed that debt beta is zero. However, the four-year credit spread over the risk free rate of return is 60 basis points for A2 rated bonds, 90 basis points for Baa2 rated bonds and 240 basis points for Ca3 rated bonds.

A tax rate of 20% is applicable to all companies. The current risk free rate of return is estimated to be 3·8% and the market risk premium is estimated to be 7%.

Required:
(a) Explain how business risk and financial risk are related; and how risk mitigation and risk diversification can form part of a company’s risk management strategy. (6 marks)