FINANCIAL MANAGEMENT

ASSIGNMENT

CASE 6: ROYAL MAIL

PLC

Prepared By –

INDEX

Page | 1
 1. Case Background…………………………………………………………………….Page 3

2. Critical Financial Problems identified in the case………………………………Page 4

3. Analysis and Interpretations for solving the case……………………………….Page 6

4. Specific Recommendations and Implementation…………………………….Page 10

5. Conclusion……………………………………………………………………………..Page 10

Case Background

Page | 2
British postal service company Royal Mail Plc has recently seen a massive transition from 500
years as a Government owned enterprise to a for-profit company traded on the London Stock
Exchange. Since this privatization Royal Mail Plc was looking to achieve a more market based
orientation by shedding its government based decision making policies and adopting an investor
oriented cost of capital approach. At the same time the Company was under important review by
the Office of Communication as deregulation or private postal services was still at an
experimental stage then.
Royal Mail Plc, given its long history, had several aces in its history – ranging from being
pioneer in postal services, inventing postal stamp, introducing letter boxes, etc. However, in
2006, British Government had removed its monopoly status by allowing private companies to
compete in collecting and sorting mail. Further, Government’s decision to privatize Royal Mail
Plc was influenced by the fact that it was less efficient and disciplined than many other post
offices elsewhere in Europe. Whereas in fact since deregulation in 2006, Royal Mail’s operating
margin had improved considerably with cash flows increasing from negative GBP 504 million in
2009 to positive GBP 282 million in 2013.
When Royal Mail Plc was privatized in 2013, Br. Govt. sold 60% of its 1 billion shares to public
at 330 pence each -73% to institutional investors and 23% to individual investors. On the first
day of trading on LSE, its share price rose to 455 pence, to 600 pence in January 2014 and
reversed to reach 511 pence as on July 20, 2015. So, it may be said that there was still an
uncertainty regarding the value of shares. This was also because of competition and regulation.
In 2012, Dutch Postal co. TNT had entered UK and had launched its subsidiary business Whistl
that sought to use to Royal Mail’s infrastructure, but eventually suspended operations. There
were allegations on Royal Mail Plc regarding maintaining pricing power and engaging in anti-
competitive practices.
Also, they had lost a lot of market share in postal services on account of advent of electronic
communication services; however, their parcel business was offsetting declines in letter delivery
revenue.
So, now, as on 21st July 2015, Hillary Hart, the senior financial analyst for Royal Mail Plc
wanted to address the issue of cost of control as a measure of improving Company’s
effectiveness in improving returns to its investors. Here, her colleague, Kyle Brooks calculated
an estimate of cost of capital which worked out to be 3.828%.

Critical Financial Problems Identified in the Case

Page | 3
Five critical problems identified in the case –

1) Whether the capital structure weights considered by Kyle Brooks were up to

the mark?

Kyle Brook had considered the book values of sources of capital, i.e., debt and equity for
calculating the capital structure of weights. Whereas Brooks should actually have
considered the market values of debt (bonds) as well as equity for calculating cost of
capital because otherwise the book values may underestimate the equity and thus the cost
of capital. As on 20th July 2015, the share price stood at 511 pence and the market value
for firm’s equity should have been considered as GBP 5.11 billion.

No such data has been shared for debts. Current debts were rightly considered at their
book value; however, long term or non-current debts which also compose 12% of total
capital (in book value) should have been considered at their market value.

2) Whether the cost of debt calculated by Brooks was correct?

Brook has estimated Royal Mail’s cost of debt as 3.188% which is the weighted average
between 0.9% rates Royal Mail is paying on current debt and 4.375% it is paying on non-
current debt. This 4.375% rate is the annual coupon rate for a 10 year bond that Royal
Mail issued on July 29, 2014. This rate is from one year back and it simply tells us what
their cost of debt was back then and not what the cost of debt is today. It would have been
better if Brook had looked at the yield on debt in today’s marketplace. Since it is known
that the bond was rated as BBB by S&P who had recently also reaffirmed that rating, it
would have been better to consider the prevalent UK corporate benchmark bond yield for
10 year maturity in GBP as on July 14, 2015. Further, the total book value of bond is only
given and the maturity wise break up for the total bonds issued by the Company are not
mentioned. This also skews the calculation of WACC.

3) Whether the cost of equity calculated by Brooks by Dividend Yield model

approach was correct?

Brook estimated cost of equity using dividend yield model. In doing so he has not
considered that estimated growth rate for dividend. There is not much historical data in
this regard as the Company has been privatized only as recently as October 2013, nor
there is much data provided by analysts in view of the turbulent times the Company is
facing. Hence, the calculation by this model is wrong as it is does not encompass the
growth rate for dividend. Additionally the volatile security market risk is not adjusted for

Page | 4
 Royal PLC equities. Thereby, the method Adopted by Brook would provide wrong
analysis in estimating cost of capital.

4) Whether the cost of equity calculated by Brooks by CAPM estimate was

correct?

For calculating cost of equity by this method Brook has used risk free rate as per the
average yield on 5 year government bond in the last 18 months. He should have used to
figure for 10 year bonds considering the long term nature of debt and equity both.
Additionally during the period Royal PLC has gone through privatization due to which
variable beta has been estimated so, short period will not give unbiased and holistic
overview of the company to estimate accurate discounting rate.

5) What are the other issues being faced by Royal Mail Plc?

1. Reduction in its share price which rose to as high as 600 pence in January 2014,
which now closed at 511 pence as on July 20, 2014.
2. Allegations of maintaining pricing power and engaging in competitive pricing by
other players.
3. Increased competition from private players in the industry.
4. Change of orientation from Government controlled behemoth to increasing returns for
investors for survival in the market.
5. Reduction in share of revenues from delivery of letter.
6. Office of Communication’s regulatory policies and impeding review of policies and
practices of Royal Mail by them.

Analysis and Interpretations for Solving the Case

Page | 5
Here, in order to calculate the WACC, for the cost of debt we used prevailing yield of the bonds,
in terms of Bond ratings, with comparison with the bond yields of the other competitor of the
same industry.
In order to calculate the cost of capital, we have estimated the value, using Security Markey Line
(SLM) method.
Cost of Capital (Ke):
Risk free rate (Rf): 2.00%
Return on equity of Royal Mail (Rm): 9.1 % (From the historical average of cumulative Weekly
Stock return from Oct-13 to Jul-15).
Beta (B): 0.65 (As per the estimation made by the equity research Thompson)
Cost of Equity (Ke) = Rf + B*(Rm - Rf)
= 2% + .65(9.1% - 2%)
=6.615%
Cost of Dept (Kd):
Bond rating: BBB (It has been recently reaffirmed by S&P for Noncurrent debt)
Yield of BBB dept: 3.76%
Interest on current debts: 0.9%
Rate Weights Cost of Debt
0.9 290 2.96
3.76 599  

In order to calculate the cost of debt, we took weighted average of debt –rate from both current
and non-current source of funding.
Thus, Kd = 2.96 %

Weighted Average Cost of Capital of Royal PlC

Details of funding for Royal PLC.

Page | 6
Source of Capital Value Capital Structure Weights
Debts(Book Value) 849 0.14
Equity (Market Value) 5110 0.86

Tax Rate = 20%

WACC= (E/E+D)*Ke + (D/E+D)*Kd*(1-T)

Where;
E - Part of funding from equity
D - Part of funding from debts
WACC = 0.86*6.615 +.14*2.96*(1-0.2)
= 6.02 %
As per our estimation, taking in accounts factors from fluctuating security market and the
adjustment of the risk, usage of market value for calculating source of capital, to varying growth
rate of the dividends. It would be advisable to rectify the wrong method Kyle Brook, we propose
WACC value of 6.02%. Should be used by Royal PLC.
Based on SML method and it we prudent to apply this model cause, a large no. of data are
provided so estimation of market risk premium and volatility or risk can precisely approximated.
Moreover, the market trend of FTSE-100 doesn’t depict major fluctuation as an effect of any
vital economic change, and within the period Royal PLC equity exhibits one cyclic movement,
which is also a reflection of privatization of Royal PLC in the period of consideration. Since both
the caveat to SML model is not present in the Royal PLC case. Thus it would be appropriate to
use Security Market Line model here in estimation of WACC.

Specific Recommendations and Implementation

Page | 7
We have calculated the Weighted Average Cost of Capital for Royal Mail Plc which works out
to be 6.02%. This we have down considering the following –
 We calculated the capital structure weights considering the market value of equity which
is GBP 5.11 billion. The market value for debt was not available and therefore we have
considered the book value itself.
 We calculated total cost of debt using weighted average for current debt at the rate of
interest being paid over it (0.9%) and the non-current debt at current UK corporate
benchmark bond yields for 10 year maturity as on 14.07.2014 for BBB rates bonds
(3.776%). The cost of debt works out to be 2.96%.
 We calculated total cost of equity using security market line approach where we have
considered risk free rate at 2.03% for 10 year bonds as per prevailing one month
interbank lending rate and government bond yields and the method we adopted is
Security Market Line (SML) cause it will adjust for the risk in the security market as well
as fluctuating dividend growth rate of Royal PLC. This works out to be 6.615%.

So, Ms. Hart was interested in capturing the ideal weighted average cost of capital for Royal
Mail Plc, she should consider the above figure 6.02%.
The Company has introduced 30 new projects. They must be reviewed and it should be ensured
that the NPV for them is not negative in consideration of this WACC.
Further, the Company should ensure that the investors get returns at least to the tune of 6.02% or
more.

Conclusion:
The weighted average cost of capital as calculated for Royal Mail Plc is
6.02%.

Page | 8