Solution on Corporate Financial Management EasyJet Airline

Question: Part 1 An understanding and explanation of dividend theories and policy. The ability to extract and analyse data from a variety of sources. The quality of the analysis and proper use of relevant literature. The ability to research and write persuasively. Evidence of understanding as well as proper implementation and application of relevant ideas and theories. Coherent and logical conclusion. Part 2 Clear description of the firms business and financial risks. Analysis of the firms financial performance. Assessment of the firms debt capacity and sources of capital available to the firm. Recommendation of an optimal capital mix for the firm. Coherent and logical conclusion. Clarity and professionalism of presentation . Answer: Introduction An indispensible part of any business is the requirement of capital and there are five types of capital in the business. They are Human Capital, Social Capital, Natural Capital, Manufactured capital and finance capital. The Finance capital can be further classified as debt capital and equity capital. The debt capital refers to the funds obtained from external sources like bank, debenture holders etc. On the other hand, Equity capital refers to the funds obtained from share holders or owners. The primary responsibility of the management is to create value for the owners and shareholders of the organization. It is widely believed by many experts that the value of the firm is reflected in the share price of the company. It is further argued that the share price of the company is dependent on the dividend payment so logically it can be said that the value of the firm and dividend payment is interrelated. The dividend payment represents that part of the profit of the company that is distr ibuted among shareholders. The dividend payment policy is significant because it affects the capital structure of the company. In this essay, an attempt is made to understand the dividend policy by evaluating the existing theories on dividend policies and their empirical findings. In this paper, an analysis of the statement that the analysts often value the firm depending on its dividend policy is conducted after considering the dividend irrelevance Theory of the Miller and Modigliani. Dividend Policy The Dividend Policy is referred to as the guidelines or set of rules that the company uses to decide the amount of profit it will distribute as dividend to its shareholders (Murto and Tervi 2014). It is the board of director, who declares the quantum of dividend and once it is decided then it becomes the debt of the company and it cannot be easily revoked. The Dividend Policy of the company depends upon various factors like availability of investment opportunity, expectation of future earning, legal obligations, liquidity position of the firm and various other factors. The Dividend Policy of the company can be classified into three categories depending upon the amount of dividend paid and the frequency of such payments. They are Stable Dividend Policy, Constant Dividend Policy and Residual Dividend Policy (Mori and Ikeda 2015). The company following stable dividend policy pays steady dividend every year. It is the most popular dividend policy because it offers shareholders least possible uncertainty about the future dividend level. In Constant Dividend Policy, a fixed percentage of earning is declared as dividend every year. In this system dividend, payment is very volatile because it is directly linked with earning of the company. This dividend policy is not very popular among the companies and shareholders. Lastly, under residual dividend policy the company pays dividend from fund that is left after utilizing them for profitable projects. This dividend policy is helpful for management in taking up various Investment projects but under this policy dividend payment is highly volatile so it may affect the valuation of the firm. Therefore, it is important for management to note that unexpected change in dividend payment may affect the investors perspective of the companys performance hence adversely affecting the value of the firm. Dividend Policy Theories The study of Theories on Dividend Policy is primarily classified into two categories depending upon the relationship between dividend and the value of the firm. According to one school of thought dividend does not affect the value of the firm this view is represented in Miller and Modigliani Dividend irrelevance Theory. The opposite school of thought suggests that the Dividend payment affects the value of the firm, which is supported by dividend relevance Theory of Walter and Gordon (Muneer and Butt 2013). As per Walter model, dividend affects the share price of the company and the formula for calculating it is given below: P = D/k + {r*(E-D)/k}/k P is Market price per share; D is dividend per share; E is earning per share; K is cost of capital; This could be explained with the help of an example, Market rate of discount applicable to the company (K) = 12.5%; EPS of the company = 15.00; Internal Rate of Return (r) = 10%; Dividend paid by the company= Rs. 5.00; Market Price Per share (P) = 5/.125 + {.10 * (15-5)/.125} /.125 = 104 The Model suggested by Gordon also shows that the dividend affects the share price of the company. The formula is given below: P = {EPS * (1-b)} / (k-g) P is Market price per share; EPS is earning per share; b is the retention ratio of the firm; (1-b) is the payout ratio of the firm; K is the cost of capital of the firm; g is the growth rate of the firm; This can be explained with the help of an example, EPS= 15 b=70% k=12% g=10% Then Market price per share as per Gordon model is P= {15 * (1-.70)} / (.12-.10) = 15*.30 / .02 = 225 Differences between Dividend Relevant and Irrelevant Theory The Dividend Relevance Theory argues that dividend policy affects the value of the firm whereas Dividend Irrelevance theory suggests that dividend does not affect the value of the firm. The dividend irrelevance theory puts forth the argument that any increase in the value of the firm because of dividend payment will be set off due to payment made for external financing and hence total wealth of share holder will remain the same. As per the dividend relevance theory forwarded by the Gordon, it argues that investors value current dividend more than future capital appreciation therefore payment of dividend will increase value of the firm. If it is assumed that a company A plans to pay dividend of 10 per share then according to Dividend irrelevance theory the dividend paid will not affect the value of the firm. It is because as the company distributes fund as dividend it has to obtain additional funds from external sources for financing the project therefore there will be increase in int erest payment. On considering the same example for Dividend Relevance the share holder of the company will value more that the dividend is paid hence the value of the firm will appreciate. Dividend Irrelevance Theory of Miller and Modigliani In 1961 Francos Modigliani and Merton Miller they argued that the value of the firm is not affected by the dividend policy developed The Dividend Irrelevance Theory. Prior to this theory was developed it was widely believed that the value of the firm increase with the increase in dividend. This theory challenged the popular opinion and suggests that the value of the firm is not dependent on dividend. It depends on firms ability to earn money and take risks (Miller and Modigliani 1961). The Dividend Irrelevance Theory is based on certain assumptions. Firstly, it is assumed that the Capital Market is perfect. Secondly, it is assumed that there are no taxes. Thirdly, it is assumed that there are no transaction or floatation costs. Fourthly, it is assumed that the company has a fixed investment policy. This theory states that if the company retains earning instead of distributing it as dividend then the shareholders will enjoy capital appreciation equal to the retained earnings. On the other hand, if the company distributes earning as dividend then the shareholders will enjoy dividend equal to the capital appreciation foregone. Hence, this theory concludes that the division of earning between dividend and retained earning does not affect the value of the firm (Rees and Valentincic 2013). Empirical Evidence of the Dividend irrelevant Theory Empirical evidence is the knowledge acquired through observation and experiments. In this section, the empirical evidence relevant to Dividend Irrelevant theory is discussed. Firstly, The Dividend Irrelevant Theory is based on the assumption of perfect capital market but in actual world, the capital market is not perfect. Further, the assumption that the company is not required to pay tax is also unrealistic. This unrealistic assumption makes the theory look unrealistic in the actual work but rejecting the theory outright would be a mistake (Ang et al. 2009). In order to verify the Dividend Irrelevant Theory a study was conducted in 1974 by Black and Scholes to see whether the dividend policy has effect on the value of the firm. To conduct the study 25 companies was chosen from New York Stock Exchange for identifying the relationship between dividend yield and stock return. After the study it was concluded that the dividend yield does not have any effect on stock returns (Lee et al. 2015). So it can be concluded that the result of the study was consistent with the dividend irrelevance theory which states that firms dividend policy does not affect the share price. Conclusion In this essay after going through the Dividend irrelevant Theory and empirical evidences it can be concluded that the theory is not completely correct but the fundamental argument of the theory that share price is not related to dividend policy is valid (Baker and Weigand 2015). Therefore based on the theory and its empirical evidences it can be concluded that the valuation should not be based on dividend policy. Therefore, the statement that Analysts often uses dividend policy to value the firm is correct but it is advised to the analysts that in the light of dividend irrelevance theory this practice should be avoided. Part 2 To: The Directors From: Date: Subject: Analysis of overall business and financial performance of Easy Jet Executive Summary In this report, the annual report of 2015 is analyzed to assess the capital structure of the company. The financial performance of the company is discussed along with the cash flow statement so that the competitive advantage of the company could be ascertained. At last, the SWOT Analysis of the company is conducted in the report so that correct conclusion could be drawn. Introduction Easy Jet is a leading low cost European Airline. It operates in more than 800 routes covering 30 countries across Europe. It started its journey in 1995 and for more than 20 years it has provided high quality flying experience to its customers. The easy Jet has a clear cut competitive advantage because of its network design connecting important cities, its ability to maximize the utilization of assets, advantage on cost and its financial strength (Cattaneo et al. 2016). Key Financial Performance of Easy Jet In this section, the financial performance of the Easy Jet is discussed for the year 2015 based on the Annual Report. On analyzing the Financial Statement of the company it is found that the Revenue per seat of the company has decreased by 13% in 2015 but still it has managed to book profit because it has successfully reduced the cost (Demydyuk 2012). Profitability Ratio The Gross Profit and Net Profit percentage is the profitability indicator which is very useful in determining the operational efficiency of the company (Komala and Nugroho 2013). The Gross Profit of the company has increased by 18.1% in 2015 and the net profit has increased by 21.8% in 2015. The increase in both Gross Profit and Net profit percentage during the year indicates that the company is operating efficiently. Further, it is important to note that the increase in Net profit percentage is higher than the GP percentage that means that the company has significantly reduced its administrative and other costs. It signals to an improved cost management strategy of the company. A statement showing common size statement is prepared. On analyzing the statement it can be seen that the trend of last five years suggests that profitability of the company is reducing. Earnings per Share The earning per share represents that part of the profit that is available for per unit of equity share. The Earning per share is important because it reveals the financial health of the company and an increasing EPS is taken as a positive sign for any company (Brigham and Ehrhardt 2013). In the case of Easy Jet, the Earning per Share has increased by 139.1% in 2015 which is very encouraging. Return on Capital Employed The Return on Capital Employed is an important financial ratio that measures the performance of the company. It also indicates the efficiency with which the company has utilized the capital employed (Brigham and Houston 2012). The return on capital employed of Easy Jet has shown a marginal increase of 1.7% it was 20.5% in 2014 which came to 22.2% in 2015. The reason for such marginal increase in ROCE is due to increase in Capital Employed during the year. Leverage Ratio The financial leverage of a company is best measured by its Gearing ratio which measures the proportion of companys debt to its equity (Petty et al. 2015). In case of Easy Jet the gearing ratio has reduced from 17% in 2014 to 14% in 2015 which shows that in the capital structure the proportion of debt has reduced in 2015. It means that more of the companys assets are financed by owners capital, which is good for solvency but it should also be remembered that it increase the cost of financing. Analysis of Cash Flow Statement The analysis of the Cash Flow statement of the company shows that it has a positive operating cash flow in both 2014 and 2015. The operating cash flow has increased by 55% in 2015 that is a positive sign. The cash Flow from investing activity is negative because of heavy investment made in purchase of 20 aircrafts. It is a positive indicator because it shows that the company has increased its operational capacity. The Cash Flow from Financing Activity has increased and it is positive in 2015 because of decrease in money market deposit. The money market deposit represents the unearned revenue of ticket sold by the Easy Jet so the decrease in 2015 is a positive sign. Financial Risk faced by Easy Jet The financial performance of the Easy Jet is adversely affected because of the companys exposure to variety of risk. There are mainly three types of risk the company is exposed to Market Risk, Counter party risk and liquidity risk. Market Risk The Market Risk faced by the company is due to fluctuation in fuel price, exchange rate and interest rate. It is recommended that the company should appropriately hedge fund so that risk exposure of the company could be reduced. Counterparty Risk The counterparty risk arises due to non-fulfillment of contractual obligation by either party of the contract. The counterparty risk faced by the Easy Jet arises from non-performance of the deposited surplus funds. Liquidity Risk The liquidity risk arises from the inability of the company to meet its current obligations. It may happen due to inappropriate cash planning so it is recommended that cash budget should be prepared and followed. The company has adopted many stringent policies to mitigate the financial risk. The most important among them is that the company has formed a financial committee to monitor the financial activities of the company. Capital Structure The Capital Structure of the company represents the mix of different sources of fund that the company uses to finance its activity and growth (Vasigh et al. 2014). The Capital Structure of the Easy Jet Company includes Shareholders fund, long-term borrowing and money market deposits. The strategy used by the company in maintaining the capital structure is to maximize the return to share holders. As discussed in point 2.4 the company has low capital gearing ratio which implies that the company has low debt in its capital structure. SWOT Analysis The SWOT Analysis is a very useful tool for analyzing the companys strength, weakness, opportunities and threats (Dey 2016). The SWOT Analysis of Easy Jet shows the following: Strength It is a low cost carrier with price almost 50% less than other major carriers. The cost per unit is significantly low so it enjoys a cost advantage. It has a good brand reputation in the market. It provides offers that are reliable. It has successfully developed strong customer loyalty. It has a very effective Corporate Social Responsibility program. The companys ability to generate income from its assets is continuously improving as suggested by Asset Turnover ratio of last 5 years. Return on Investment and Return on Capital employed both are in uptrend which is a positive sign. Weakness The industry is highly competitive. It does not offer free food in the airline. It is not expanding beyond Europe. The Gross profit and Net profit margin of last five years indicates that profitability of the company is in decreasing trend. The idle Current Ratio is 2 but the Current Ratio of the company is continuously decreasing for last 5 years as shown in the table provided in the Appendix. Opportunities It has got large market to expand. It could improve the framework for operation. It could enter into agreement with Airports. Threats The airport fess is increasing. The increase in competitors. The financial leverage indicates more than half of the asset is financed by funds from external sources. As a result there is a huge interest payment, the company has to bear as a result there is a threat of insolvency of the company. Cash and Cash equivalent is in decreasing trend as shown in common size statement it indicates a threat of liquidity of the company. Pestle Analysis: PESTEL Analysis is a framework that is used to analyze the external environment of the organization. PESTEL stands for Political, Economical, Social, Technological, Environmental, legal factors. It is important to assess the impact of these factors in order to ascertain the impact it has on business strategy and performance in future. The PESTEL analysis of easy jet is provided below. Political There are no proactive political will to increase airport capacity across Europe. The crisis of British exiting European Union (BREXIT) has affected the business and commerce across Europe, reducing the demand of easy Jet. Since 9/11, cancellations of flight due to terrorist threats have been a cause of major loss. The Euro zone crisis has made the entire economy vulnerable as a result affecting the airline industry. Economics The increase in fuel price affects the profitability of the airlines. It is estimated that approximately the fuel bill will decline by 140 million till the end of 30th September 2016. This estimate is based on current market price. The regional airports are the main operating ground for low cost carriers. The rapid growth of regional airports that was earlier seen has slowed down resulting in decrease in demand. The crisis has economically slowed down Europe affecting the business of Easy Jet. Social In spite of crisis and economic slowdown it is expected that business travelers will increase. Europe continues to be favorite tourist destination for international tourists. The flight network of easy jet connects all major cities therefore, it stands to gain from increase in tourism. Technological The technological environment of the industry is rapidly changing and easy jet has always maintained its pace with the change. The company has planned to acquire 36 aircrafts out of which 30 are next generation highly technologically advanced A320 aircrafts. Environmental The Governments are likely to increase regulations regarding carbon emission due to the ever increasing problem of Global warming. The company acknowledges that its major impact on environment is carbon emission therefore it has set a target to reduce carbon emission per passenger to 8% by 2020 and it has already achieved 3% Legal The open sky agreement provides more access to US to enter into European markets increasing the competition. There is little or no resistance to merger approvals among airlines. There is a limitation of foreign participants which is 49% it does not includes participants from US. Competition Analysis The primary competitor of Easy Jet is Ryan air because both are biggest budget airlines of Europe. In this section a competitive analysis is conducted to understand the position of easy jet as compared to its primary competitor. Table Showing Comparison between Easy Jet and Ryan Air Particulars Easy Jet Ryan Air Bases 26 70 Airports 135 186 Routes 755 1600 Flights per day 1205 1438 Passenger per year (million) 64.8 81.7 Load factor 89% 86% Aircrafts 230 312 Easy Jets 9649 9501 Current Ratio 0.72 1.72 Quick Ratio 0.66 1.45 Financial Leverage 2.15 3.02 Debt/Equity 0.14 1.01 In terms of operational outreach as represented by bases, airports and routes in which operations are conducted it is seen that easy jet is clearly in a competitively disadvantageous position over Ryan Air. The Ryan Air also operates more flight per day thus providing it another useful advantage over Easy Jet. The occupancy rate of Easy Jet is high that is a positive sign. The Easy Jet has less aircrafts and it operates in less routes but it has more staff thus indicating that cost per route of easy Jet is more than Ryan Air. As can be seen from the table above in terms of key ratios the position of Ryan Air is far better than Easy Jet. Conclusion In this report after analyzing all the factors in SWOT and PESTEL analysis it can be said that The Easy Jet enjoys a competitive advantage due to its capital structure. The company manages debt very cautiously because it uses more own capital in financing project than using debt capital which is evident by low capital gearing ratio. In conclusion it can be said that the overall financial condition of Easy Jet looks very bright and the future prospect of the company looks very promising. 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