Agenda

Case – Royal Mail plc.

1. Introduction to Royal Mail 3

2. Our approach to the case study 8

3. Revaluating the cost of equity 14

4. Revaluating the cost of debt 19

5. Recalculating WACC and conclusion 22

6. A modern perspective on the case 25

2
Overview of Royal Mail's History
Company history

First public Post activity Royal Mail loses

postal services reaches peak post monopoly
The post opens to Post officers join UK government
the public, the first the British Armed abolished Royal
ever postal mark Forces in WWI - Mail’s monopoly
was introduced, Sent mail reaches power - Price-
and English, peak levels of 12 setting ability was
Welsch and million letters and transferred from
Scottish posts 1 million parcels government to
were unified per week Royal Mail

1516 1635-1711 1784-1839 1918 -1919 1968 2006 2013

Founding UK New Royal Mail Separation of Privatization of
postal service expands abroad Royal Mail Royal Mail
Late King Henry The postal system The General Post Royal Mail was
VIII initiates a on the British Office controlling privatised and
national English islands is named Royal Mail and listed in London
postal network to “Royal Mail - Telecom in Britain due to its
transport Ships and trains is shut down and comparative
government are used to send postal services inefficiency to
documentation mail through the are separated other postal
and information Commonwealth from telecom service suppliers

4
Successful initial public offering of Royal Mail
Key facts and performance review

Cumulative total weekly returns of Royal Mail and FTSE100

between Oct 2013 and Jul 20151
0.30
600 million shares issued
0.25 The British government sold 60% of its one billion shares in
Royal Mail at a price of 330 pence per share, raising two billion
Royal Mail pounds.
0.20
FTSE 100
0.15
σ RM Majority of buyers were institutional investors
0.10 0.104 73% of the initial shares were sold to institutional investors, with the
remainder going to 690,000 retail investors. The high institutional
0.05 shareholding indicates a long-term investment horizon.
σ FTSE
0.027
0.00
Solid performance with increased volatility
-0.05
On the first day of trading, the share price rose by 38 percent to 455
pence per share. However, the share price experienced
-0.10 2013 2014 2015 increased volatility in the following years.

Royal Mail's share price experienced volatility, with a significant increase in share price from October 2013 to April 2014, then a decline until December
2014. Since 2015, Royal Mail has been on an upward trend. The stock's deviation from the broader FTSE100 suggests that company-specific factors
may be disproportionately influencing its price.
1) Yahoo Finance

5
New regulations influencing the competition in the postal service market
Market developments

Regulations Competition

1 Change in market structure 1 Increased competition

In 2006, the British government ended Royal Mail's Increased market activity has forced Royal Mail to
existing monopoly status, allowing international change its approach in order to compete effectively. As
competitors to enter the market. a result, postage rates need to be set independently to
be competitive.

2 Postal service act 2 Pros and cons

The Postal Services Act came into force in 2011, The act gave the postal market substantially more
removing the responsibilities of the Postal Services commercial freedom. However, Royal Mail was also
Commission and transferring regulation of the postal required to operate six days a week and to apply
market to Ofcom. universal prices as part of this.

3 Privatization of the Royal Mail 3 Benefits of privatization

The privatization of Royal Mail was based on the fact The goal of the privatization was to gain greater
that Royal Mail was operating significantly less commercial confidence, capital and business
efficiently than its direct competitors. experience as quickly as possible in order to become
more efficient and thus sustainable in the market.

6
The expansion of the parcel market offset a decline in the letter market to a certain extent
Royal Mail unit volume history

Royal Mail letter volume (in M units) Royal Mail parcel volume (in M units)

CAGR: - 3.9% CAGR: 2.7%

18,224 1,101
17,127 16,485 1,064 1,068
16,166 1,016

15'147 13'869 13'342 13'009 991 1'015

950 994

3'077 3'258 3'143 3'157

66 70 77 86
2012 2013 2014 2015 2012 2013 2014 2015
Unaddressed letters Addressed letters Parcelforce worldwide Royal Mail core network

There has been a significant decline in letter volume. The

Parcel volumes are growing at a CAGR of 2.7%. The international
compound annual growth rate (CAGR) over the last 4 years is
parcel market in particular is experiencing strong growth.
-3.9%.

7
The cost of capital is central to the privatization and deregulation of Royal Mail
Case study

Problem statement
Kyle Brooks, a senior financial analyst at Royal Mail plc, needs to evaluate the company's cost of capital for a meeting with several senior executives.

Why had the cost of captial of Royal Mail become an issue?

1 Privatization of Royal Mail

Since its privatization, Royal Mail has progressively abandoned the previous government-driven decision-making in favor of a more market-
oriented perspective. The cost of capital, as a market-based indicator, is determined by investors rather than managers.

2 Deregulation of postal service industry

Royal Mail and Ofcom, the regulatory government body of Royal Mail, were shifting to private ownership after 500 years of state control. Additionally,
the UK's ongoing privatization of postal services was being reassessed by Ofcom due to recent competition. In this context, the cost of capital served
as a key factor in evaluating Royal Mail‘s profitability and sustainability.

The case study requires an evaluation of the cost of capital calculations to be performed. Improvements need to be identified and implemented. The
whole case should be considered from the perspective of the year 2015.

9
We divided the case into two phases to find the optimal solution
Our perspective when analysing the case
1 2 Review individual components and calculate alternatives
Recalculate all the components of the
Analysis and recalculation
WACC and estimates in the case to
of the base assumptions
understand their derivation and
identify potential errors early in 1) Weightings
Using market cap for
using an Excel model. equity rather than book
values
2) Tax rate
Using the effective tax
rate instead of the
industry average
Analysis and recalculation
of cost of equity
1) CAPM
Recalculation of beta
• Levered/unlevered
• Historic vs. FTSE
2) DDM
Using historic UK growth
rates
3) Historic return on
equity
Taking last 2 share prices
Analysis and recalculation
of cost of debt
1) Yield-to-maturity
Find the YTM using the
current Royal Mail bond
price
2) Credit rating
Use Royal Mail‘s credit
rating to find an implied
company spread
3) Interest rate
according to P&L
Interest paid according to
financial statements
10
WACC is a weighted average of the costs, which combines equity and post-tax debt costs
Introducing the WACC for Royal Mail

Equity ratio Debt ratio Cost of debt

• Amount of equity held by a • Amount of debt held by a • Interest expense on debt, takes
company as a proportion of all company as a proportion of all interest payed on current and
liabiliites and equity held liabiliites and equity held non-current debt into account

E D
WACC = × rE + × (1-!C) × rD
E+D E+D
Cost of equity Tax shield
• Payments made to equity holders by a • Savings made through holding debt
company • Interest payments on debt, unlike
• Similarly to cost of debt, payments dividends on equity, reduce the
need to be done to revieve equity taxable income

11
Kyle Brooks calculated the cost of capital using the following numbers and assumptions
WACC calculation according to Kyle Brooks

Cost of equity Other options Kyle considered

• Weighted mix of current
and non-current debt
Cost of equity - CAPM 5.32%
Cost of debt
• Dividend payout ratio Risk-free rate
Weights • 5 year yield average last 18 months 1.55%
• Book value of debt
• Book value of equity β
• Equity research firm publication
0.65

Market risk premium

• Academic survey of investor 5.8%

Why not: Dividend yield more conservative!

Cost of debt 3.78%

Tax rate Bond rating

• S&P BBB rating 3.78%
• Based on marginal
tax rate of other
companies

12
Kyle Brooks analysis with updated weightings of debt and equity
WACC calculation according to Kyle Brook

Other options Kyle considered

Cost of equity - CAPM 5.32%

Risk-free rate
Weights • 5 year yield average last 18 months 1.55%
• Book value of debt
• Market value of β
• Equity research firm publication
0.65
equity

Market risk premium

• Academic survey of investor 5.8%

Why not: Dividend yield more conservative!

Cost of debt 3.78%

Tax rate Bond rating

• S&P BBB rating 3.78%
• Average effective
tax rate of Royal
Mail

13
The CAPM beta was derived from historical, levered, and broker-suggested data
Capital Asset Pricing Model (CAPM)

Given β in the case study: 0.65 E(ri) = rF + βi [E(rM) - rF]

Seems low! Adjusted β: (1.00)*0.33 + 0.67*1.79 = 1.52

The postal industry is exposed to index movements as economic Our calculated beta is similar to the Damodaran average for the
growth helps drive industries such as e-commerce, which is related to Transportation sector (1.41) as well as for the Packaging and
the parcel business. Containers sector (1.26).

Historic raw β (Oct 13 – Jun 15) Historic β without outliers (Oct 13 - Jun 15)

Raw Beta: 1.79 Beta without outliers: 1.18

30% 15%

10%
20%

5%
10%
0%
0% -8% -6% -4% -2% 0% 2% 4% 6% 8%
-10% -5% 0% 5% 10% -5%

-10%
-10%

-20% -15%

15
The CAPM β was derived from historical, levered, and broker-suggested data
Capital Asset Pricing Model (CAPM)

Used project β approach using the publicly traded comparable companies according to Kyle Brook (in M GBP)

National Severn United

Company Tesco Vodafone Companies are not comparable
Grid Trent Utilities 1
Market cap 31,892 5,234 16,192 6,138 60,812
Big differences in market capitalization
Book debt 25,950 4,622 11,213 6,042 25,362 • For example, Seven Trent (5,234 M GBP) and
Vodafone (60,812 M GBP)
Avg. tax rate 20% 20% 20% 20% 20%

β 0.6 0.79 0.87 0.67 0.86

Companies operate in significantly different
Unlevered beta 0.42 0.53 0.64 0.43 0.74 2 industries
Royal Mail data to relever beta Vodafone (telecommunication), National Grid
Debt/Equity Ratio Debt + Equity Tax rate (Energy) and Tesco (Retail)

17% 5,959 M GBP 25%

Very different risks and exposure to

Relevered β 0.37 0.48 0.57 0.39 0.66 3 macroeconomic effects
Example includes exposure of national grid to
Average: 0.55 energy prices globally

16
Using a new risk-free rate the CAPM model produces a higher cost of equity
Capital Asset Pricing Model (CAPM)

Higher WACC
• The higher cost of equity
caused WACC to rise
Capital Asset Pricing Model
RF = risk-free
rate
E(ri) = rF + βi [(E(rM) - rF)] ßi = beta
E(rM) = equity
return (exp.)

Assumptions

Risk-free rate
• 10 Year government bond
2.03%

β
• Chambers & Thompson Research 0.65

10Y government bond Equity risk premium

Equity research report • Most recent yield on 10 • Academic UK investor survery 5.80%
year government bond
• Equity research report
Academic survey • Assume UK government
• Historic beta only had time
window of less than 2 bond to be risk-free Cost of equity 5.80%
• Use investor sentiment on
what should be expected years
return on equity

17
Using the Dividend Discount Model to recalculate the cost of equity and the WACC
Dividend Discount Model (Gordon Growth Model)

Higher WACC
• Adding sustainable growth
lets WACC rise
Dividend Discount Model Formula
• Rising dividends induce more
costs/returns D = dividend
D1 D0 x g P = share
rE = +g= +g price
P0 P0 g = sust.
growth

Assumptions

Dividend
• Royal Mail plc.
21p.

Stock price
• Royal Mail plc. 511p.

Sustainable growth (1949-2015)

• UK GDP growth rate 2.46%

Growth D1 D0 x g
rE = +g= +g 6.67%
• Adding sustainable growth P0 P0
• Incorporates changes in
dividends over-time

18
Using the dividend discount model to recalculate the cost of equity and the WACC
Yield-to-Maturity Model

Lower WACC
• Lower non-current debt Yield-To-Maturity Model Formula
costs cause WACC to sink
• This induces a lower return $%#
VC VF + VC
VP = share
price
VP = ! + . VC = coupon

!"# (1+YTM)t (1+YTM)T VF = face

value

Assumptions (in GBP)

Face Value
• Based on Royal Mail plc. bonds
100

Present Value
• Royal Mail plc. 106

Coupon
• 4.375 4.375

Yield-to-maturity $%#
VC VF + VC
• Calculating the overall
VP = ! + . 3.65%
!"# (1+YTM)t (1+YTM)T
return gained if long-term
bond held till maturity

20
Credit rating yields surpasses excluded implied interest rates due to limitations
Credit Rating & Implied Interest Rate Model

rD

Lower WACC
• Lower non-current debt Credit Risk Rating
costs cause WACC to sink
• This induces a lower return
BBB rating provided by S&P 3.78%

Financial statement Implied Interest Rate

Implied interest cost 2014 8.36%

Implied interest cost 2015 3.35%

Limitations of implied interest rate due to:

- Large fluctuations in debt costs

Credit-risk rating
- Numbers are from March which means it
• S&P provided a risk rating does not fully reflect current debt rates
of BBB

21
Our WACC is similar to comparable firm
Final WACC calculation

Our WACC Comparables Evaluation of our results

CAPM Strengths Weaknesses

Risk free rate
National Grid 3.84%
2.03% • Used more up-to-date and • We would have preferred to use a
Beta 0.65 company relevant numbers: longer historical period
Market risk premium 5.8% • Using 10-year bond • Specifically, the last 10 years
• Using optimized cost of debt • Utilize weekly data rather
Cost of equity 5.8% Severn Trent 4.02% than monthly
Non-current debt • Same applies for beta
Debt cost based on YTM 3.65% • Closer to companies with more
logistics and competitor • Beta of 0.65 does not represent
Weight 65.84%
Tesco 5.04% components such as Tesco and an accurate version of Royal Mail's
Current debt Vodafone (which are not volatility when assessing historical
Cost of non-current debt 0.9% monopsonies) beta
Weight 34.16%
Tax rate 25.25% • Used market cap and more • Very high WACC is, however,
United Utilities 3.52%
Post-tax cost of debt 2.03% company specific tax rate to justified by the elevated beta
ensure that the WACC was more
Weights focused on Royal mail
Market cap 85.8%
Vodafone 5.27%
Book debt 14.2% What could have been useful: An expanded dataset with a broader
scope, alternative peer companies more closely aligned with our
own, and historical stock return data from the FTSE100 for
Royal Mail’s WACC: 5.26%
comparison with Kyle's equity risk premium.

23
Which issues did we identify in Kyle Brooks calculation?
Brooks’ shortcomings

Weighted Cost of Equity Weighted Cost of Debt

• Cost of Equity, based on one year dividend assumes no growth • Current debt is based on current interest expenses from the
and constant payout balance sheet

• Equity valuation is based on book values • Using a one-year-old bond for evaluation of non-current debt

• Data is from different time periods which is not consistent

Why is it relevant for the WACC?

CoE based on one Influence on the Interest expenses for Using outdated
Valuation Methods
year dividend WACC estimation of CD Bonds for NCD
Assumes no growth Using book values, Due to these different Does not consider Using a one-year-old
and constant payout, if accounting figures, for assumptions and uses present market bound might not give
the payout changes in equity instead of of measures, the conditions; ignoring the an adequate picture of
the future, it could lead market values does not WACC in our forward-looking nature future interest rates.
to a misconception in capture the current calculation is higher of the WACC
CoE value of the equity than the one from Kyle
appropriately. Brooks

24
The case would be viewed differently today, highlighting cost of capital calculation limitations
Back to the future – A modern perspective

Interest rates Brexit Higher market return

• 2015 à QE kept interest rates • New legislation: Higher VAT and customs • Market returns have been very attractive
• 2023 à Constant rate hikes have charges over the past couple of years
increased the cost of debt significantly • Less international postal traffic • The implied market return is up by ~2.5%

5.0% Implied Market Return

4.45%
Implied Market Risk Premium
4.0%
Risk-free-rate
3.0%
9.2%
2.0% 6.7%
4.7% 5.1%
4.1%
1.0% 1.49% 2.0%
0.0%
Jan Sep Jul-15 May-23
2015 2023

Higher cost of debt à Higher WACC WACC Higher return on equity à Higher WACC
• Royal mail has the advantage that their capital structure consists • Using CAPM, higher risk-free rate means higher RoE
Implications
primarily of equity

25
WACC Calculations (I/VII)
Calculations according to Kyle Brooks (book-value weights)

27
WACC Calculations (II/VII)
Calculations according to Kyle Brooks (market-cap weights)

28
WACC Calculations (III/VII)
Calculations using CAPM for non-current debt

29
WACC Calculations (IV/VII)
Calculations using Credit Rating for equity

30
WACC Calculations (V/VII)
Calculations using Yield-To-Maturity for non-current debt

31
WACC Calculations (VI/VII)
Calculations using Dividend-Discount Model for equity

32
WACC Calculations (VII/VII)
Calculations using Credit Rating for equity

33