1. Harvard Case Study -
Hutchison Whampoa Limited: The Capital Structure Decision
Term Paper
Laini Tsang
Golden Gate University
MS Finance, FI 312
Summer 2013
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Table of Content
Case Background
Capital Structure and What Hutchinson was Facing?
Debt Financing & Considerations
Equity Financing & Considerations
Interest Rates and Think Outside the Box
Recommendations
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Case Background
Similar to the U.S. Fortune 100 companies, Hutchinson Whampoa is one of the “blue chips” companies
in Hong Kong with market shares of approximately US$26 billion. Founded in 1977, the company
underwent a series of critical mergers where half of the company’s shares are owned by Cheung Kong
Holdings Limited of Li Ka Shing, the richest tycoon in Hong Kong according to Forbe. Hutchison invests in
five core businesses – the following chart details the corporate structure of Hutchinson in relation to its
mother company Cheung Kong Holdings as well as its subsidiary companies.
Source: Cheung Kong (Holdings) Limited’s corporate website
For decades, Hutchinson Whampoa leads Hong Kong’s commerce with footprints all over
telecommunications, energy, retail, real estate development, and logistic infrastructure and services.
Competitors of Hutchinson include Swire Pacific, Wharf Holdings and Jardine Matheson.
Outlined in this case, Hutchison would require US$ 5 billion in the next five years to maintain the
present growth rate of the company. Given various options in debts and equity financing, the company’s
finance team was in a position to configure an optimal capital structure for the company so that the
most conservative growth trajectory would be on track.
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Capital Structure and What Hutchinson was facing?
Capital structure is comprised of debts and equity financing in a combination that best facilitates the
growth of a company under minimal risks. It is the operational capital that a company needs in order to
generate cash flows through engaging in capital projects such as building a new facility or implementing
new enterprise software in addition to various merger and acquisition activities to generate future cash
flows for the company.
Source: Cengage Learning
From the above chart, we understand the relationships for cost of capital is determined by the
proportion of debts and equity mix; this combination is strategic as it is highly correlated to many
factors such as the market landscape, the industry, the financing market, the global economy, the
regulatory environment at the time and the company itself.
From class, we learned that Modigliani and Miller’s model with tax in proposition I (1963) suggested that
leveraged firm is equal to unleveraged firm plus tax shield. The tax shield component provides great
benefits for companies that need capitals. However, ultimate decision should be based on balancing the
company’s liquidity situation and realistic capability to take on business risks that exist or might exist in
the long term.
Like many Asian companies, Hutchinson emphasizes agility and does not want to be restricted by heavy
loads of debts. Although the company’s short term capital needs were financed through local Hong Kong
banks; the most preferable long term capital source tends to rely on the company’s reserve. For
decades, Hutchinson has built a vast network of relationships of business partners; the company’s
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reputation is essential and maintaining it is the key as Hong Kong investors are sensitive to news such as
company’s borrowing; they might perceive that the company had big trouble by borrowing large
amount of debts. Therefore, Hutchinson has been reluctant to issue long term bonds locally in Hong
Kong.
In 1995, the company accumulated a significant amount of short term liabilities and loan payments
totaling HK$26 billion (exhibit 5 and exhibit 9). With a vast amount of committed and authorized
projects in the pipeline such as container terminal projects, joint ventures of power plants, cellular and
pager networks, adding eighty new Watsons (Hong Kong retail outlets), the company is in need of rising
US$5 billion capitals for the next five years.
Debt Financing Considerations
Debt financing is the most preferred method amongst other financing options. The reason being is
explained by Modigliani and Miller’s model’s tax-shield factor. Moreover, loans restrict borrowers from
share dilution: borrowers are only required to return principals and interest payments while lenders are
not entitled to receive any future gains resulted from the loans or taking stakes from the company.
With the world’s economy becoming more interconnected, besides straight borrowing from banks,
numerous options in financing are available. There are also Yankee bonds in the U.S. and Euro bonds in
numerous foreign bond markets (exhibit 14). It is critical for companies to know what to choose and
how much money to be raised through these choices. More importantly, how much debts it can take on
in order not to jeopardize the company’s liquidity. If the firm decided to attract foreign investments, will
the additional debts affect its financial metrics and consequently its bond rating which means higher
costs in borrowing? Below are estimates of Hutchison’s ratings based on the company’s 1995 financial
metrics and S&P Bond rating criteria:
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Equity Financing Considerations
In 1995, the stock market in Hong Kong was bullish. With lowering interest rates, equity financing was
very attractive. However, a major disadvantage of equity financing is dilution of company’s ownership
equity. According to a survey conducted by Duke University (Graham and Harvey), most companies
regards EPS dilution as their primary concern in deciding equity offering. The secondary concern is
undervaluation or overvaluation, which means when companies offer new shares it is difficult to
determine the right offer price. When new shares are offered, investors may not perceive the company
be adding values with new capital investments but most will perceive the company is in fact offering
over-valuated stocks to investors, which causes drop in stock price and further increase the cost of
financing.
Source: How do CFOs Make Capital Budgeting and capital Structure Decisions, Graham & Harvey
Since Cheung Kong Holdings is assuming half of the position of Hutchinson, issuing more securities
would mean the company’s stake would be further diluted; this was something that Hutchinson’s
Finance team did not prefer; therefore, equity offer did not seem to be a good option, and debt
financing should be considered.
If it was not for liquidity concerns and bond rating constraints, the company should raise the entire
amount in debt financing. But how much does it hurt if assuming 100% of capitals (US$ 5 billion) was to
be financed through debts? Let’s add US$5 billion into the existing long term debts and divide it by the
total capitalization plus this US$5 billion; the ratio is about 50%, which is still within S&P’s BBB
investment grade rating (exhibit 8). The difference between BBB and BB is important: having a BB grade
means not only the company has to pay for additional interests in borrowing, but also other opportunity
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costs to be considered due to the rating gap. With this in mind, we proceed focusing on pure debt
financing and narrowing our decisions down to select the best vehicles in debt financing.
Interest Rates and Think Outside the Box
In mid-90s, lending interest rates in Hong Kong for short term and medium term were on the rise – they
were in mid-9% to 10% range. In order to secure cheaper rates for long term needs, Hutchinson needed
to think outside the box.
In 1995, interest rates in Japan were relatively low (from low to mid 2.0% range) because of Japan’s
asset price bubble at that time; interest rates of the country had dropped in half since 1989. However,
the country was still a well-capitalized financial center with robust financial management , regulations,
and infrastructure. Its bond markets are comparable to European’s and the United States’. More so,
Hutchinson has presence in Japan with vast relationships already established for years. Issuing euro
bonds in Japan should be considered easier than issuing elsewhere such as the United States.
Furthermore, as mentioned in appendix I in the case, simplicity and speed are two main advantages to
select euro bonds. Since Hutchinson has presence in Japan, attracting investors would not be a problem
in the country, and additional costs to promote the company through marketing activities would not be
much needed. Moreover, issuing euro bonds in Japan did not require converting the company’s
accounting standard into expensive GAAP’s standard, which will be a pricy investment for the company
given short timeframe.
Despite the attractiveness financing in Japan, since Hutchinson was projected to grow with the most
conservative rate, the company may be growing at a much higher rate than predicted. This means the
needs of capitals could be underestimated. Therefore, Hutchinson should consider the U.S. capital
market as it has the largest capitalization in the world. The company should thinking of paving path to
raise funds in the U.S capital market, starting from a small amount and using Yankee bonds to tap into
the U.S. capital market. Further on, if Hutchinson decided to finance more by getting themselves listed
in one of the U.S. stock exchanges, the company will have established tracking records in the U.S.’s
capital market, which means Hutchinson Whampoa is no stranger to the U.S. investors. Since issuing
Yankee bonds is exempt from the SEC’s registration requirements, it is presumably easier for the
company to tap into this bond market in the U.S. territory filled with sophisticated investors and
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capitals. Once the company has established visibility in the U.S. bond markets, it will definitely be pivotal
for its future growth down the road.
Recommendations
With the above analyses, my proposed recommendation for Hutchinson to raise US$5 billion dollars is
100% debt financing with the following debt structure to be considered:
1. Issue US$4 billion Eurobond in Japan, various from 15 to 20 years maturity terms at a fixed rate,
giving enough time for capital projects to generate cash flows. And,
2. Issue US$1 billion Yankee bonds for the period of 10 to 15 years in the U.S. through 144A
exemption.
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References
Graham and Harvey. How do CFOs Make Capital Budgeting and Capital Structure Decision. Journal of
Applied Corporate Finance. Duke University.
Hong King’s 50 Richest. Forbe. January, 19, 2013
Hutchinson Whampoa Ltd. Annual Reports. Hutchinson Whampoa. 1999-2000
Hutchinson Whampoa Wins $130 million contract to upgrade Omani Port. Reuters. January 19, 2013
IVEY. Hutchinson Whapoa Limited: The Capital Structure Decision. Ivey Management Services. 1999
Shane, Scott. Why Equity Financing Eludes Startups. Bloomberg BusinessWeek. July 2010
Villamil, Anne P.. The Modigliani-Miller Theorem. The New Palgrave Dictionary of Economics.
