Hutchinson Whampoa Binding Bonds

7/27/2019 Hutchinson Whampoa Binding Bonds

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The Hutchinson Whampoa Case CLASS 18, BINDING BONDS

MARCO PATTI

In the past years Hutchinson Whampoa has seen a staggering growth of its activities all over the

world, and even today it shows no signs of slowing down. This massive growth has been financed

through retained earnings and with short-to-medium term bank financing, but now the firm wants to

shift to longer term borrowing at a more favourable rate. This report shows an overview of the other

ways in which Hutchinson Whampoa could raise money through the channels of share and bond

issues. The analysis is conducted assuming a US$ 1 billion 1 financing need for 1996.

As of today, the capital structure of the firm relies heavily on short/medium term debt and equity

funds. An in-depth breakdown is presented in the Appendix 1. To calculate the WACC of the

company we need to find the cost of equity and the cost of debt of the company, as well as the

proportions of debt and equity financing the company. We can obtain the cost of equity using the

Discounted Cash Flow model, as the sum of the expected growth rate and the expected dividend

yield, but there are several ways to calculate the cost of debt.

The company is able to borrow from banks at the HIBOR variable rate (assumed to be 5.32%) plus

a 70 basis points spread, which translates into a 6.02% interest rate. The corrispondent return on a

3-month US T-bill is 5.17%. However, since these loan s are very susceptible to changes in the

financing environment, we explore also the option of a fixed rate debt issue.

The return for a Treasury Bond with the desired 10 years maturity is 6.8%. If we assume that the 85

bps spread between the variable rate and the T-bills will carry to the longer term bonds, we obtain a

7.65% cost of debt for Hutchinson Whampoa, which will be used for the rest of the case. With the

existing capital structure, and assuming that the company will remain profitable in the future and

therefore able to use the tax-shields 2 from interest expenses, we obtain a WACC value of 10.1%.

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1 The Hong Kong dollar was pegged to the U.S. dollar at an exchange rate of US$1 = HK$7.80

2 We assume a marginal tax rate of 17.5%, which was the prevailing Hong Kong rate in 1996.


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There are many ways in which Hutchinson Whampoa can raise funds on the debt market. Each

option has its costs and advantages and not all of them are compatible with the company priorities,

as summarized in Appendix 2. All in all, the best option available seems to be the issue of

Eurobonds. This market has several advantages over Yankee bonds, resulting in a simpler and

speedier issue. There is no need for the company to comply with SEC regulation and to disclose

sensible informations, the market is large, deep and actively looking for investment opportunities in

the Hong Ko ng area.

The effects of a 1 Billion $ bond issue are presented in Appendix 3. The borrowing rate of 7.65% is

well under the companys cost of capital, so even after paying the interest expenses the shareholders

will see the value of their investment increase.

In the current situation, Hutchinson Whampoa will probably obtain an A rating from the S&P

evaluation. The parameters of a sample of comparable companies are very similar to those of our

firm, and both Swire Pacific Ltd. and Wharf Holdings Ltd. have debt issues with an A rating. The

analysis is based on the Long Term Debt / Capital ratio, since it seems to be a good predictor of the

effective rating. As this ratio goes up, the company will fall into a lower rating class, according to

Appendix 4, and new borrowers will demand an higher interest to the firm. Appendix 5 shows the

increase of the spread over the risk free rate as the rating worsens, as observable in the yields shown

in Exhibit 15 3. The cost of debt will therefore increase as new debt is issued, until it reaches a point

where further borrowing will become prohibitively costly. Common shareholders will also become

more concerned about default on the loans (and, in bankruptcy, losing all of their investment) and

will insist on receiving a higher rate of return to compensate them for the higher risk. Since both the

cost of debt and equity increases, the average cost of capital will also increase.

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3 We lack the data necessary to know the shape of the cost of debt curve, its increase at the higher ratios ofD/E and the S&P rating method to assign rating lower than B. Therefore, is not possible to obtain the optimalvalue of the D/E ratio, and we must limit ourselves to a qualitative analysis.


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The second option is an equity issue, which would require very little costs in promotion and

reorganization of the company financial statements. At the current share price of HK$ 48.8 the

company needs to issue 159836066 shares to reach its objective, as shown in Appedix 1. The

resultant diluition of control of existing shares would be of only about 4.4%, so there is little to

worry for the majority stakeholder about possible takeovers. Equity financing is not a bad option,

but the cost of a debt issue would be lower. Appendix 6 shows the changes in the after-tax WACC

derived from the issue of 7.8 Million HK$ via debt and equity.

A look to the immediate future shows us that Hutchinson Whampoa has authorized investments for

HK$ 42 billion over the next years, and new profitable investments probably lie ahead. The

forecasted perpetual growth rate is 9%, as shown in Appendix 1. If the existing dividend payout

policy 4 is mantained, the internal generated funds will not suffice to cover this massive financial

need. The money can be raised, as always, via debt or equity, and a breakdown of the two extreme

approaches is shown in Appendix 7.

Our o b jective is to minimize the WACC of the company, and consequently increase its total value

for the shareholders. It would be advisable for Hutchinson Whampoa to borrow money at the

relatively lower after-tax interest rate and to buy back some of the more expensive equity, shifting

the capital structure toward debt. The firm must however pay attention to avoid being perceived as

too risky, mantaining its financing leverage under reasonable terms.

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4 About 40% of Net Prots are returned each year to the shareholders, which would probably frown upon areduction in this payout ratio.


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Appendix 1, Capital Structure.

Appendix 2, Debt financing options

Appendix 3, Debt and Equity Issue.

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Appendix 4, Rating of companies financial ratios.

Appendix 5, Spread over risk free rate.

Appendix 6, WACC changes.

Appendix 7, Future financing needs.

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