QUESTION

In Assignments on Unit 3 of the syllabus there are four companies, two each in “Reports and Accounts – Group A” and “Reports and Accounts – Group B”. You have already analysed two of those companies for the midterm. For the final you should pick one of the other two (i.e. either of the companies which you did not review in the midterm).

For that new company you are now required to take the current (and past if wished) annual reports of the company (you can find past 10-K reports under the SEC filings section in investor relations of the company website) and use that information to estimate:
1. A critical analysis of the company’s recent history (25% of the grade)
2. The company’s equity cost of capital and WACC (15%)
3. A revenue and earnings forecast for the next five years (20%)
4. Its likely dividend policy and growth over (a) next five years and (b) thereafter (10%)
5. An estimate of its equity value based on discounting future cash flows (and other methods if you think appropriate) (20%).

Your projections and estimates should be accompanied by a critical appraisal of the
methods, models and limitations employed. Your analysis should not simply rely on reproducing information from Morningstar or similar sites, but should be based on a primary analysis of the annual reports.

Your report should demonstrate skills of critical reflection, effective communication and balanced judgement. 10% of the available marks for this assessment are given to presentation, and the final assessment will account for 70% of your overall final grade. Submission is by the end of Wednesday April 11th (Swiss time), despite any other dates that may be shown on the Syllabus.

Do not exceed 3,500 words; scripts that are excessively long (i.e. exceeding the limit by more than 10%) will not be read beyond the point of the word limit. The word limit applies to the main report only, and excludes exhibits. There is no minimum word limit.

The overall structure should be as follows:

1. Cover Page (1 page)
2. Table of Contents/List of Exhibits (1 page)
3. Main Report (within range of words, see above)
4. Exhibits (if any)
5. References/Bibliography

The data in your answer should be clearly laid out in tabular format so that your approach and answer are both plainly evident.

Submissions can either be in MS-Word (.doc format only) or PDF formats, but not Excel or Powerpoint. Submit only one file and include any Excel analysis as images, not embedded files.

Finally, and most importantly, this work must be your own, and should not be based directly on input from others, either given verbally or in written form. RKC submits all assessment papers to electronic databases to identify plagiarised submissions, and will take severe action against any candidates who are subsequently found to have plagiarised work. Please note carefully that if you copy text from external sources (including Annual Reports or other published information) you must correctly reference the source, and to clearly identify copied text by means of italics or inverted commas.

SOLUTION

1. Introduction

Aceto Corporation founded in 1947 has emerged as a global leader in pharmaceutical products over the years. The organization is the pioneer in providing regulatory support in distribution of pharmaceuticals crop protecting chemicals and other speciality chemicals. With operations globally in over 10 countries the corporation largely distributes chemical and raw materials to produce pharmaceutical products like ink, colour etc. The Aceto corporation operates in countries like Unites States, Spain , Netherlands, France , India , China ,Germany as well as Singapore. The company largely purchases its products from developing countries like India and china with more than 57 % of the purchases concentrated in the region from over 500 companies in china and 200 in India.

(www.aceto.com – accessed on 29/03/2012)

Aceto’s business can largely be organised in three segments Health sciences which contributed to about 59% of revenues ,speciality chemicals contributed 36% of the revenues in 2009 and Crop protection contributed only 6% of the revenues in 2009. The health sciences sector is the highest contributor of revenues in Aceto therefore is also accounted with heavy investment. The firm invests highest proportion their capital in developing the health sciences sector to improve existing as well as create an efficient product for the future. The health sciences sector is also subject to large scale expenditure in research and development.

Figure 1: Revenue Contribution from different departments of Aceto (2009)

(Source: Aceto.com accessed on 29/3/2012)

Being global corporation Aceto employees a large diversity of human resources from many countries. The chairman also attributes the success to the company to the efficient management skills of human resource globally. With the acquisition of Rising Pharmaceutical Inc. in 2010 Aceto has emerged as the developer and marketer of the its own brand generic pharmaceutical The acquisition is likely to enhance the existing brand value of the corporation thereby increasing the scale of operations as well capturing new segments of the market.

The main aim of the organization has been to provide high profitability to its investors by manufacturing world class products and emerging as the market leader in the pharmaceutical industry. This can be clearly analysed by examining the financial performance of the enterprise.

2.  Company’s Recent Financial Performance

2.1 Revenue

Over 20 years the business has consolidated its position considerably in the market. The firm over the last five years have experienced a steady growth in revenues. The growth in revenue however may not be express but it would certainly translate into consolidating the position of the firm in the long-term.

Figure 2: Revenue Growth 2007-2011

(Source: Aceto Annual Reports – Aceto.com accessed 29/3/2012)

The company has experienced phenomenal increase in the sales largely attributed to the increase in the sales from the domestic health sciences sector. Over the period from 2010 – 2011 the sales have increased by over 17 % annually. But however the last quarter of 2011 has experienced a growth of more than 40% from the health sciences sector. The growth in sales has been largely attributed to the company’s performance in the global markets like Singapore, India and China. Though the company has experienced a near satisfactory growth performance but has experienced a decline in sales in the agricultural sector. Also large scale changes in the management may be responsible for the decline in the revenues of the business.

Figure 3: Growth of Sales % 2007-2011

(Source: Annual Report Aceto – Aceto.com and Morningstar.com accessed on 29/03/2012)

It is clearly evident from the above chart that in the fiscal 2008-2009 the company has experienced some crisis and has been unable to generate a positive revenue growth. The company has been affected by the financial crisis in 2008-2009 effecting both domestic and global operations. But the firm has made speedy recovery by investing in growth markets like India and china thus maintaining profitability for its investors.

(Aceto.com accessed on 29/03/2012)

However with a new functional management the business hopes to revise its business strategy and create a high performance in the future. The business has now pledged to focus on the daily business activities of the enterprise as well as take steps to consolidate an efficient management structure.

2.2 Profitability and Financial Health

2.2.1 Profits

With the consistent increase in the revenue over the years the business has consolidated its position and emerged as a profit generator for all stakeholder parties. The management of the business has effectively achieved the targets set. An efficient management along with an efficient human resources and investment in growth countries like China, Singapore and India have been the cause of success of the operations of Aceto. Largely labour intensive these economies offer highly cost effective output. Thus the business benefits from the economies of scale.

Economies of scale are experienced by a business when there is large scale production which permits specialization. Each worker is concentrated to a specific task and the production is mechanised leading to cost effectives (Mankiw ,2011).

Figure 4: Gross Profits 2007-2011

(Source: Annual Report Aceto – Aceto.com and Morningstar.com accessed on 29/03/2012)

With experiencing large scale economies of scale the organizations operating profits and operating profit margins have been consistently been increasing. However the same cannot be said for the net income and the income available to shareholders that has been subject decline. This is because of the firm is still recovering from the strain of the economic crisis of 2008-2009. The decline in the net income has been largely due to the fact to increased debt costs and high operating expenses.

Figure 5: Net Income 2007-2011

(Source: Annual Report Aceto – Aceto.com and Morningstar.com accessed on 29/03/2012)

2.2.2 Cash-flows

The main problem with the finances of the company over the past five years has been inconsistent cash flows. The company has experienced large scale fluctuations in both operating as well as the free cash flows. This inconsistency has been largely due to high operating expenses and the clear lack of appropriate planning of the cash flows. The company has been burdened by the financial crisis which has adversely affected the cash flows in the years 2009 and 2011. Therefore though the business has recovered to some extent but however still has a long way to go to show positive investor performance.

Figure 6: Operating Cash flows 2007-2011

(Source – Aceto.com Annual Reports- accessed on 29/3/2012)

The fluctuation in the operating cash flows and the lack of free operating cash flows has been the main reason affecting the growth of the corporation. Lack of free cash impedes the business from undertaking capital as well as research and development expenditure. The lack of investment in the business impedes business growth. The operating cash flows have been adversely affected by the financial crisis but the firm has improved its operating cash flows in 2010 owning to the growth in revenues from global operations in business.

The cash flows fluctuations have been caused by the high degree of financial leverage by the firm. The gradual increase in the financial leverage from a steady rate of 1.5 % in 2008-2010 to about 2 % is a clear indicator of increasing debt load on the corporation. The debt load to some extent has effectively deterred the growth of the corporation over the years. But the acquisition of Rising Pharma in 2010 has largely attributed to the lack of availability of free cash flows in 2010.The acquisition had adversely strained the cash position of the company but with their strong fundamentals in place the firm has consolidated in the market in 2011; with Rising Pharmaceuticals contributing to its enhanced brand value.

Thus analysing the 5 year financial performance of Aceto it is evident that the financial crisis in 2008-2009 have adversely affected the corporation. Aceto is still trying to recover from the impact of the crisis by investing in growth economies like India and China. Though the firms operations are small scale in these countries but the firm intends consolidate in these markets to increase its profitability of the business.

3. Weighted Average Cost of Capital

The capital structure of the firm is a mix of debt, common equity, preferred equity such that maximization of stock price can take place. The goal of each firm is to create an optimal capital structure by mixing the various instruments of debt and equity. An optimal capital structure is part of financial policy decision of the firm  these include dividend policy as well as WACC.

3.1 Advantages of an optimal Capital Structure

• An optimal structure enables to enhance the valuation of the business and enable the business to undertake expansion activities and adopt strategies to maximise earnings for its shareholders.
• An optimal capital structure is the determinant of the financial flexibility of an organization. It provides the business the opportunity to undertake financing from various sources of finance depending upon their cost effectiveness.
• An optimal capital structure enables the organization to absorb alterations in the business plan caused by the changes in the external environment of the business.

(burleighevatt.com – accessed on 30/03/2012)

The optimal capital structure of the firm can be determined using the Weighted Average cost of capital technique (WACC). WACC is the average cost of financing using either debt or equity as the source of financing (Beasly et al,2009).

Aceto also aims to create an optimal capital structure to maximise its value and finance the global operations of the business.  The WACC can therefore be obtained mathematically by inserting the WACC inputs into the WACC equation.

Thus Mathematically the WACC equation reads as follows

3.2 WACC Equation

Where       Wd is the propotion of financing taken by debt

Kd is the Cost of financing using the debt instruments

Wpfd is the proportion of financing taken by preferred stock options

Kpfd is the cost of financing using preferred stock option

We is the proportion of financing using equity

Ke is the cost of financing using equities , comprising of the market β and the risk free rate of return in the market.

(Beasly et al,2009)

3.3  WACC Inputs

• Risk Free Rate     4.5%
• Cost of Debt     6.7% ,
• Equity Risk Prem 5.0%

WACC of Industry

• Beta (unlevered)  1.03
• Industry D/E      19.2
• Tax Rate (5 yrs)  26.6%

Thus inserting the given data in the WACC equation we obtain the WACC.

WACC debt

• Cost of Debt (after-tax) 4.9%
• Debt / Capital       16.1%

WAC (debt)   0.8%

Cost of Equity (CAPM) 10.4%

Equity / Capital        83.9%

WACC (equity)         8.7%

WACC is 9.5 or 10 % approximately.

(Data source- Annual Reports Aceto.com, Google finance.com- accessed on 30/3/2012)

Therefore it can be concluded from the above calculation that Aceto largely relies on equities to finance its optima capital structure. From the above analysis it is clear Aceto is aligned with industrial average of the WACC this implies that Aceto’s performance is close to the industry performance. Therefore it is clear that Aceto will return to the industry in the long run. Though the determination of the optimal capital structure is subjective to each firm however it is also important to consider the costs of financing as well industrial average while determining the optimal capital structure.

4. Equity Valuation Using Discounted Cash flows

The discounted cash flow method (DCF) is one of the ways to determine the valuation of a firm. It involves the determination of the present to determine the expected future cash flows. This method draws its basis from the net present value analysis. The cash flows vary from asset to asset and are dependent upon several factors like – dividend, interest rates, taxation rates. The discounted cash flows are also a estimation of the future risk and an effective risk and return analysis.

Mathematically the Discounted cash flow can be determined as

Where CF is the future cash flows in the time period t , r is the rate of interest of growth and t is the time period to determine the value.

(Damodaran, 2012)

Thus using the above mathematical equation to determine the valuation of Aceto . The Aceto Corporation has had an earnings growth rate of 5.7% over the past 10 years.

Thus by using the discounted cash flow method for a period of 5 years the valuation of the firm over the 5 year period is determined at $ 5 million (Approx.)  Thus the valuation of Aceto is likely to improve in the future . The valuation is an indicator of the positive cash flows of the corporation over the next fiver year. This clearly indicates that they firm may recover from the impact of the financial crisis from 2008. It is also an indicator that the firm has increased its market capitalization and therefore has been able to achieve a high earnings growth rate in the future. Thus the discounted cash flow can be used a measure to estimate risk faced by the corporation in the future. Thereby the management can take appropriate steps to overcome the risk as well as minimize the risk to some extent by adopting hedging techniques or cost effectiveness measures.

5. Revenue and Earnings Forecast

5.1 Revenues

Based upon the past performance of the firm has witnessed in-consistent growth in sales. In the past years the growth in sales has been phenomenal, whereas in some years the sales growth has been negative. The primary aim of the management should be to identify the cause of inconsistency in the sales growth. Therefore adopt strategies to overcome this inconsistency. As inconsistency in performance often demotivates investors as investment  in the firm becomes a high risk proposition.

Figure 7: Growth of Sales % 2007-2011

The above figure represents the sales growth over the five year period from 2007 -2011 the inconsistency is evident from the financial performance.

Taking a 5 year average growth rates of sales the average rate of growth of revenues have been 7.2 % approx.

Thus based on the performance of the past 5 years and the expansion of the firms operations to cost effective countries like India and China the sales are likely to grow at a confirmed rate of 7.2 %. The expansion of operations in developing countries like India and China is likely to increase the cost efficiency of the organization. With the annual report of the firm clearly indicating further penetration in these markets it is almost certain to realise gains. It should also not be ignored despite the financial crisis in 2008 India and China continues to grow at an average rate of 7% (Worldbank.com – accessed on 30/3/2012) which is much higher than US which is the home country Aceto. Therefore the gain is likely to come by spreading the risk globally and gain from efficient fast growing economies.

5.2 Earnings

The net income of Aceto has been on constant rise since 2007.Despite facing a crisis like situation from 2009-2010 and negative sales growth rate and facing shortage of cash flows. The corporation has maintained profitability and positive net income growth rate over the years.

Figure 6 : Net Margin % 2007-2011

(Source- Aceto.com Annual Reports)

Thus from the above figure it is clear that Aceto has tried to maintain an average profit margin of nearly 2% consistently from 2009-2011. This is a clear indicator that the business has consolidated its position firmly in the market and has strong fundamentals to emerge out a crisis like situation speedily. Taking a 5 year average from 2007-2011growth rate of profit the margin is 2.7%.

The firm has already experienced a 40% increase in sales in the last quarter of 2011; this is likely to also have an impact on the earnings capacity of the business. With no major debt burdens on the business and effective globalization strategies in place the profit margins are likely to improve. Thus assuming even a 2% projection and hedging against exchange rate risks and inflationary conditions the Net income of the business is likely to increase. However the organization should take steps to accelerate the growth of net profits consistently over the nest 10 year period to emerge as a market leader.

6. Dividend Policy

Aceto has maintained steady dividend policy throughout their operations. The main aim of an efficient dividend policy is to ensure investor confidence in the organization there by ensuring the growth of the organization. Aceto has effectively maintained a consistent dividend policy therefore despite a drop in the net income from $8.6 million in 2008 to nearly $5.6 million in 2009; Aceto did not change their dividend policy. In fact in the year 2009 Aceto paid a nearly $1 million higher dividend in comparison to 2009.There has been a consistent increase in dividends thereafter as well (Aceto.com – Annual Reports – accessed on 30/03/2012).A critical acquisition by Aceto in 2010 contributed severely to reducing the cash flows and net income subsequently. But however the dividend policy of the firm remained unaffected with the firm maintaining its previous dividend pay-out ratio. The management did not consider a reduction in the dividend pay-out rather increased the total amount of dividend distributed to ensure shareholder confidence in the business.

The average 5 year dividend yield has been 2.9%, and thus based on previous calculations and the existing dividend policy the dividend yield is likely to grow over the next 5 years. The firm has consistently maintained a dividend pay-out ratio of 36%. This is a healthy ratio as it effectively maintains a balance between dividend pay-outs and reinvestment in the business. Re investment is vital for the business as can be clearly seen in the case of Aceto. Despite facing a decline in the net income in 2009 but has adequate reserves and investments the firm was able to pay a higher dividend to its shareholders. Therefore investments in business ensure shareholder interests and generate value for all stakeholders of the business (Yahoofinance.com, accessed on 30/3/2012)

7. Conclusion

Aceto’s financial performance has been consistent over the past 5 years. The credit of the sound financial performance can be attributed to the management of the corporation. The management has effectively identified the growth opportunities and has formulated growth strategies to seize the opportunities. This is evident with the management diversifying their cost effective and labour intensive economies like India and China. Operations in India and China have provided the firm cost effectiveness as well contributed to increasing in the profit margins. Investment in such economies has somewhat insulated Aceto from the impact of the global financial crisis in 2008 as India and China continue to post high growth rates despite poor performance by world economies.

The aim of the management has been to ensure investor confidence in the fundamentals of the organization. The business has largely financed its operations with equity a clear indicator of the high shareholder confidence the firm enjoys.

Therefore, high growth rates and high valuation for the company is expected in the next 5 years. The projections are largely based upon the past financial performance of the firm as well as their future plans and strategies. To achieve a high rate of growth it is important for Aceto to overcome inconsistency particularly in cash flow. The cash flow inconsistency could prove to be detrimental for the organization in the future especially faced with a strained economic environment. A greater availably of free cash flows would enable the firm to incur expenditure on research and development vital for a pharmaceutical firm well as undertake capital expenditure to modernize plant and equipment to ensure efficient production.

Therefore, Aceto needs to carefully analyse the global business environment and formulate an efficient business strategy to maximise productivity and profitability with minimum risk exposure.

8. References

• “ACETO – Company Profile.” ACETO – Company Profile. N.p., n.d. Web. 30 Mar. 2012. <http://investor.aceto.com/index.cfm>.
• “Income Statement for Aceto Corporation (ACET) from Morningstar.com.” Welcome to financials.morningstar.com. N.p., n.d. Web. 30 Mar. 2012. <http://financials.morningstar.com/income-statement/is.html?t=ACET®ion=USA&culture=en-us>
• Mankiw, N. Gregory. Principles of economics. 1998. Reprint. Fort Worth, TX: Dryden Press, 2011. Print.
• Burleighe Vatt. “Adopt an optimal capital structure to improve shareholder value.” burleighevatt holdings 1 (2011): 1-5. Print.
• Besley, Scott, and Eugene F. Brigham. Principles of finance. Fort Worth: Dryden Press, 1999. Print.
• “Aceto Corporation: NASDAQ:ACET quotes & news – Google Finance.” Google. N.p., n.d. Web. 30 Mar. 2012. <http://www.google.com/finance?cid=2096>.
• Damodaran, Aswath. Investment valuation: tools and techniques for determining the value of any asset. 8 ed. New York: Wiley, 2012. Print
• Country. “GDP growth (annual %) | Data | Table.” Data | The World Bank. N.p., n.d. Web. 30 Mar. 2012. <http://data.worldbank.org/indicator/NY.
• “ACET Key Statistics | Aceto Corporation Stock – Yahoo! Finance.” Yahoo! Finance – Business Finance, Stock Market, Quotes, News. N.p., n.d. Web. 30 Mar. 2012. <http://finance.yahoo.com/q/ks?s=ACET>.

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