Northumbria University Newcastle | Newcastle Business School

Table of Contents

INTRODUCTION

Whitbread Plc is the largest UK’s service provider in hospitality businesses, it has the most successful brands in hotels and restaurants. (Whitbread, 2020). Established in 1742, with the partnership of Samuel Whitbread, Godfrey and Thomas Shewell, Whitbread Plc has been conducting its businesses over the years through successful acquisitions, mergers, and franchising (Whitbread, 2020). Whitbread Plc was readmitted back to FTSE 100 stock index on 18th December 2006 to replace British Energy who fell off the index (BBC, 2006).

This report is divided into three parts. Part A discussed the financial performance of Whitbread Plc, with focus on the review of its income statement, the working capital management and dividend policies, as well as the historical performance of its share price through analysis of its average returns. Part B attempted to estimate the future share price of the company using the Dividend Discount Model otherwise referred to as the Gordon’s Growth Model (GGM) (Foerster & Sapp, 2005), and the calculation of the required rate of return based on Capital Asset Pricing Model (CAPM). Part C appraised Whitbread PLC capital structure with an in-depth analysis of how Modigliani and Miller’s theories impact the total equity and long-term debt in the balance sheet. The conclusion was drawn based on the outcome of these reviews of the financial statements over five years from 2016-2020.

PART A (Question 1)

Financial Performance Review (2016-2020)

Income statements

The financial statement is a useful effective decision tool, as its preparation reveals how close a business is to its objectives. Its information could be relied on to assess the financial health of a firm, as it shows how its resources are being utilised and earnings made from such activities. Several key performance indicators (KPI) are available in a financial statement which includes revenue, profit and many more. For this report, income statement KPIs in table 1 are used in discussing the activity performance of Whitbread Plc for the reviewed period.

Table 1: Shows selected KPIs from the income statements of Whitbread Plc. Data sourced from Yahoo Finance (2021), Whitbread Plc financial statements 2016 to 2020, Lansdown (2020) summary of Whitbread Plc financial performance and own calculations.

 

Whitbread had its best revenue performance of £3.29bn for the period reviewed in 2018 which was 123% of the average revenue generated from 2016 to 2020. The operating cost was kept at an average margin of 82% of revenue over the period. Net profit margin averaged 11.24%, as 2017 presented the highest net profit margin of 13.39% from normal business activities, it remained an average of 10% for 2018, 2019 and 2020 which is good considering the size of the business (CorporateFinanceInstitute, 2020). However, in 2019 an exceptional profit of £3.55bn was generated from the sales of discontinued Costa business sold to Coca-Cola (Whitbread, 2019), (Appendix 1).

Though reported profits after tax in 2019 and 2020 were not high, they maintained a higher average EBITDA margin slightly above 10% over 2017 and 2018, respectively. 2018 dividend payment of 101.15pence was the highest while 2020 dividend payment was pegged at 32.65pence to retain more earnings for the business growth due to the impact of Covid- 19 pandemic on the hospitality businesses globally.

Working Capital Management Policy

Like income statements, working capital management policies are also reflected in the financial statement. Ding, Guariglia and Knight (2013) referred to working capital as a determinant of liquidity, which is calculated as the difference between current assets and current liabilities. The ability of a business to withstand a cash flow shock depends on the size and years of its existence, as smaller businesses tend to be able to adjust working capital requirements better than bigger businesses (Ding et al., 2013). Whitbread working capital objective is to guarantee continuity in its operation by having adequate funds at its disposal to invest in new businesses and give good returns to the shareholders. Whitbread aims to maintain a ratio of debt to equity that balances risks and returns and complies with lending covenants. Table 2 shows the working capital calculation using the current assets and liabilities approach.

Table 2: Show the working capital requirement calculation. Data sourced from Lansdown (2020) summary of Whitbread financial statement for 2016-2020 and own calculations.

Table 2 revealed that Whitbread Plc adopted an aggressive working capital management policy. Weinraub and Visscher (1998) described aggressive working capital management policy as a situation where fewer current assets capital are employed to finance long-term investments of a business with the anticipation of greater profitability but higher liquidity risk. 2016 to 2018 showed that Whitbread had deficit working capital but posting good and reasonable profits, which is a feature of an aggressive working capital management policy. Likewise, its EBITDA also buttresses the fact that it used more of its earnings in servicing the interest elements on short-term borrowings employed in financing the business.

Aggressive working capital management policy though tends to bring about higher profitability, it could be unhealthy for a business to toll this path for a longer period (Weinraub & Visscher, 1998). Considering the assumption of acid test which favours a ratio 2:1 of current assets less inventories over current liabilities, a business could end up not being able to fulfil its short-term payment obligation to its creditors, resulting in stock out or service gap failure with an aggressive working capital policy (Van Horne & Wachowicz 2005). However, the cash flow from the sale of the discontinued costa coffee business sold to Coca-Cola in 2018 ended the era of aggressive working capital, thereby pointing Whitbread in the moderate/conservative working capital management policy direction.

Dividend Policy

To maximise shareholders wealth, managers consider dividend policy as important in growing the market value of a company (Baker, 2009). Though Miller and Modigliani (1961) opinion centred on payment of dividend after all investment’s opportunities had been undertaken to boost the market value of the business, Dong, Robinson, and Veld (2005) believed that there are several other reasons why shareholders will prefer regular dividend pay-out rather than being reinvested in the company.

Table 3 shows that Whitbread Plc believes in the dividend relevance theory, as it continues to increase the percentage of its earnings paid out as dividend and dividend growth between 2016 and 2018 (Lansdown, 2020). The reverse in 2020 was a result of the global impact of Covid-19 pandemic on businesses as the company declared it will be stopping the payment of final dividend to increase equity through retained earnings. Some underlying assumptions are responsible for dividend relevance theory such as signalling, bird-in-the-hand, clientele effect, agency theories and more. First, continuous dividend pay-out signals to the outside shareholders that the company is viable and therefore impacts its market value positively (Bhattacharya, 1979; Miller & Rock, 1985). Likewise, some shareholders believe taking the reward of their investments on regular basis is better than waiting for a future value (Walter, 1963). Therefore, as a company that listens and care for its shareholders, Whitbread continues to pay dividends yearly.

Table 3: Show the earnings and dividend per share of Whitbread Plc. Also, a calculation of the percentage of the earnings paid out as dividend in the review period. Data sourced from Lansdown (2020) summary of Whitbread financial statement for 2016-2020 and own calculation.

Historical Share Price Performance

Financial statements likewise show the history of share prices. Whitbread Plc share prices had not recorded any growth within the period under review as the shares had an average negative return of -0.16 for the 5 years (Appendix 3). This simply means investor had lost value for shares bought in 2016 by 2020. Figure 1 shows a graphical representation of the dip in the share prices over the period.

Figure 1: Graph of Whitbread 5 years historical share prices with calculated logarithm returns. Data sourced from Yahoo finance (2021) and own calculations.

Part B (Question 2)

This section discussed the estimation of the Whitbread share price using the Dividend Discount Model (DDM) also referred to as the Gordon Growth Model (GGM). Likewise, Cost of Equity (Ke), also known as the rate of return was determined by applying the Capital Asset Pricing Model (CAPM).

Dividend Discount Model (DDM)

Dividends are paid to shareholders of publicly quoted companies as returns on their investments. It is a portion of the company’s cashflow given back to shareholders as a reward for their investments (Agrawal & Jayaraman, 1994). Foerster and Sapp (2005) believe that dividends can be used to estimate the future value of a company, as the value of company stock is worth the discounted amount of its future dividends. William (1938 as cited in Foerster & Sapp, 2005) buttressed this assumption of DDM saying “…[A] stock is worth the present value of all the dividends ever to be paid upon it, no more, no less…Present earnings, outlook, financial condition, and capitalization should bear upon the price of a stock only as they assist buyers and sellers in estimating future dividends.” (p. 56). Therefore, DDM can be a very useful instrument for valuing equity.

Gordon (1962) came up with a dividend discount model now known as Gordon’s Growth Model (GGM) in determining the stock price of a company, stating that:

Where:

– Share price.

– Annual nominal dividend in the year

– Cost of Equity/Capital

– Dividend growth rate.

To determine the Dividend growth rate, we apply the valuation of dividend formula as

Where:

– Dividend in year “n”

– Current value of dividend

– Dividend growth rate.

n- Time value

Table 4: Show the dividends paid to Whitbread shareholders in the 5-year period reviewed. Data sourced from Lansdown (2020) summary of Whitbread financial statement for 2016-2020.

From table 4 above, to calculate for the growth rate applying the formula above,

where:

n= 5.

= 32.65,

= 90.35

= -0.18419, translating to a negative dividend growth rate for Whitbread Plc for the period reviewed.

Coming back to Whitbread future share price estimation adopting the GGM where:

and getting the data from table 4

= 32.65

= -0.18419

= 10.1% (Finbox.com, 2021)

= 93.39

Table 5: Show the share prices estimation based on GGM growth and cost of equity estimations. Highlighted value in orange shows the value nearest to the calculated market value, while those in green shows the nearest value to the FTSE 100 index for Whitbread Plc on 7^th January 2021.

 

Based on the above parameters and estimations in table 5, Whitbread share price was calculated using excel and was estimated to be 9339 pence which is 300% of its current share price of 3048 pence on the FTSE 100 index as of 7^th January 2021 (Yahoo finance, 2021). The result showed that the share price of Whitbread Plc is either been undervalued in the market, or there could be some flaws in the calculation of the GGM. Flaws in the growth rate or equity cost determination will translate into having different values for the share price calculated for the same period, as they both have an inverse effect on each other (Table 5). Likewise, investors undervaluing of equity during inflationary periods through the adoption of an inappropriate discount rate could affect GGM calculation (Modigliani & Cohn, 1979). Also, GGM does not take other economic factors such as market volatility and value of intangible assets e.g., goodwill into consideration. These identified flaws could affect the result of the GGM calculation of share prices

.

Capital Asset Pricing Model (CAPM)

The CAPM was employed to check the correctness of the rate of return otherwise known as the cost of equity (Ke) used in the GGM calculation which was 10.1%. CAPM was developed on the assumption that lending and borrowing in the security market will have a rate which is risk-free (Rf), and that investors have same expectations of return from the market (Rm) (Markowitz, 1959; Sharpe, 1964; Lintner, 1975; Elbannan, 2015). Thus, the cost of equity can be calculated as

Where:

= Cost of Equity or Rate of Return

= Risk free rate of Govt bond, 5 years bond rate is 0.38% (Macrotrends, 2021)

= Slope of the Curve (1.2501) Figure 2

= Average return of FTSE 100 Index market is 7.07% (Finbox.com, 2021)

= 8.74%

Figure 2: Equation of monthly returns for the FTSE 100 Index and Whitbread Plc share prices. Data sourced from Yahoofinance (2021) and main data body used for own calculation and graph can be found in Appendix 4.

Based on the above parameters using spreadsheet calculation, Cost of equity- Ke is 8.74%. However, this contrasts the declared cost of equity of 10.1% for Whitbread Plc (Finbox.com, 2021). Though Financial times Market predicts a negative trend of 5.03% in the share price of the company over the next 12 months (FinancialtimesMarket, 2021), this does not justify the disparity between the calculated and market cost of equity.

Cost of equity can be affected by the dividend payment, time, share price, company growth, and many other factors. Fama and French (2004) criticised the validity of CAPM, as its adoption might not be excellently adequate in a real-life application. Also, the higher the borrowing the greater the interest rate and risk of default which limits the volume of capital that can be borrowed or lend; therefore, a risk-free market does not really exist (Reilly & Brown, 2003; Black, 1972). Furthermore, there are always transaction costs which may sometimes erode the anticipated gain from a security or stock transaction, thereby faulting the assumption of the same rate of market return to all investors (Reilly & Brown, 2003).

Part C (Question3)

Capital Structure

Companies globally need capital to run their activities which makes them look to various sources for cheaper funds, the outcome of the transactions with several providers of these finances forms the capital structure of the company (Luigi & Sorin, 2009). Barton and Gordon (1988) described capital structure as total assets less current liabilities, which is made up of owners equity and long-term liabilities. They believed this structure finances the company in a long-term, as current liabilities are subject to more fluctuations due to the short-term nature. Capital structure of a company determines the weighted average cost of capital (WAAC) and how much investments it will be able to take on with cheaper sources of funding. Whitbread Plc capital structure is made up of both equity and long- term liabilities as shown in figure 3 below and has an average WAAC of 8% (Withbread, 2020; Finbox.com, 2021).

Figure 3: Whitbread capital structure for 2016-2020. Data sourced from Lansdown (2021) summary of Whitbread financial statement for 2016-2020

A further review of Whitbread Plc capital structure revealed that the company is highly geared. Its long-term debt to equity ratio as at the 2020 financial year-end was 92%. Tables 6 and 7 gives a better insight into Whitbread equity and long-term debts composition.

Table 6: Shows Whitbread Plc equity composition. Retained earnings made up the bulk of the company’s equity as negative reserves lowered the equity value of the shareholder. Data sourced from Lansdown (2021) summary of Whitbread financial statement for 2016-2020.

Table 7: Shows Whitbread Plc Long-term debt composition. Borrowing which surged higher in 2019 is largely made of lease arrangements. Data sourced from Lansdown (2021) summary of Whitbread financial statement for 2016-2020.

Capital Structure Theorems

Many authors had come up with different theories about capital structure. Some of the theories identified are (1) the capital structure irrelevance theory of Modigliani and Miller (1958), (2) the trade-off theory, (3) the pecking order theory, and (4) the market timing theory (Luigi & Sorin, 2009). The discussion will be based on the M&M irrelevance theory and trade-off theory.

Capital Structure Irrelevance Theory of Modigliani and Miller

In the work of M&M 1958, they proposed that a company’s market value is independent of the structure of its capital (Breuer & Gϋrtler, 2008). The major argument of this theory was that irrespective of the financial decisions of a company to either add debt or not in changing its capital structure, it has no direct consequence on the company market value (Brigham & Ehrhardt, 2010). This proposition assumed that (i) there is the existence of an efficient and perfect capital market with no taxes, transaction, or bankruptcy costs, and (ii) all parties to a transaction have adequate information on the investment they want to undertake (Ahmeti & Prenaj, 2015). M&M believes that only profitability and risk decide a company’s value, not the capital structure (Ahmeti & Prenaj, 2015). Pan 2013 developed an equation based on this assumption as

=

Where and are the values of levered and unlevered companies respectively in the capital structure. This proposition assumes that there is no effectual relationship between the weighted average cost of capital (WACC) and capital structure (Ahmeti & Prenaj, 2015).

However, M&M in 1961, introduced the element of tax to their proposition which moved their earlier position towards considering the impact of taxes. They proposed that companies with debt will have a higher market value than companies without debt in their capital structure due to payment of interest on capital borrowed. Since interest payment is an allowable expense and reduces the amount of taxable profit, this tax shield directly affects the company’s market value (Alifani & Nugroho, 2013). Thereby, leading to the modification of the equation by Pan in 2013 to

= +

Where and D are the values of tax ratio and debt, respectively.

Despite the twist in 1961 and 1963 M&M publications to their earlier assumptions, M&M proposition did not recognise the imperfection in the capital market as bankruptcy and transaction costs underlie cost of sourcing funds from providers of finances (Breuer & Gϋrtler, 2008). Likewise, Gifford 1998 stated that the perfect market envisioned by M&M differs from the market these propositions were actualised. Also, the reality in the recent world has given more evidence to show that changes in capital structure composition affect the market value of a company (Ahmeti & Prenaj, 2015).

Moreover, if Whitbread Plc does not have any form of debt in its books, this means its WACC will be based only on the cost of equity of 10.1%. This will be too expensive to undertake the value of investments (£2.54bn) undertaken and financed by leases having a cost of debt of 3.6%, which bring down its WAAC to 8% average (Whitbread, 2020; Finbox.com, 2021).

The Trade-off Theory

Trade-off theory, on the other hand, aims at finding an internal solution to financing plans, it seeks to find a balance between cost and benefits of different sources of capital, i.e., debt and equity (Luigi & Sorin, 2009). The WACC of a company tends to decrease with the introduction of debt and subsequently grows its market capitalisation, but at a certain leverage level bankruptcy risk emerge. Trade-off theory attempts to determine the optimal capital structure at which profit realised from taking advantage of tax shield using debt capital will be equal to the financial distress costs associated with sourcing such capital (Brusov, Filatova & Orekhova, 2014). Luigi and Sorin (2009) later expanded the theory into static and dynamic trade-off theories. With static always aiming to restore the capital structure of a company to a fixed optimal level, while dynamic attempts to adjust the capital structure of a company per time to generate a better financing margin.

Whitbread Plc seems to be operating a capital structure in-line with the dynamic trade-off theory as it shows to be optimising its leverage to have better financing margin per time.

Conclusion

Whitbread Plc revenue though declining in recent years has been enough to sustain a 10% net profit margin which resulted from the aggressive working capital management policy adopted for a larger part of this review. This may not be a healthy practise in the long run as it is always good for a company to balance its working capital management optimally to avoid service disruption. The suspension of dividend announced by Whitbread to use the internally generated fund to build up capital because of the disruption caused by Covid- 19 on global businesses is a welcome development, however, it could affect it share price as it had always maintained a dividend relevance policy and a shareholder with a “bird-in-hand” philosophy might not want to invest in such stock that had been posting a negative return since 2016.

In part B, Whitbread share price estimation was calculated using the GGM. The result revealed that the share price could have been undervalued on the FTSE 100 index market. However, some challenges with dividend growth and cost of equity (Ke) calculations which could be flaws of the GGM and the CAPM might have resulted in overvaluing the share price through my calculations. Further estimations made based on the assumption that dividend growth and cost of equity maintain an inverse relationship revealed several share price range.

The concluding part C reviewed Whitbread Plc capital structure. An in-depth analysis revealed that the company is highly geared with a debt-equity ratio of 92% (Whitbread, 2020). It further reviewed its total equity and long-term debt composition. The research revealed that debt had a positive impact on its WACC averaging it to 8% (Finbox.com, 2021). This is better than executing all investments at 10.1% cost of equity. In conclusion, a review of the capital structure theories was done with more emphasis on the trade-off theory and capital structure irrelevance theory by Modigliani and Miller. Whitbread Plc tends to be managing its capital structure in line with the dynamic trade-off theory as it shows to be optimising its leverage to have better financing margin per time.

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Appendices

Appendix 1

Appendix 1: Summary of 5 years Withbread Plc income statements. Data sourced from Lansdown (2020)

 

Appendix 2

Appendix 2: Summary of 5 years Withbread Plc balance sheet. Data sourced from Lansdown (2020)and own calculations.

Appendix 3

Appendix 3: Withbread 5 years historical share prices with calculated logarithm returns. Source: Yahoo finance.

Appendix 4

Appendix 4: 5 years historical share prices of Whitbread Plc and FTSE 100 Index with calculated logarithm returns. Source: Yahoo finance (2021)

 

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