Vodafone Optimal Capital Structure

Running Head: Vodafone Group‟s Optimal Capital Structure

Vodafone Group’s Optimal Capital Structure for the year ended March 31, 2011

Toru Sekiguchi

June 27th, 2010

i

Table of Contents

Title Page…………………………………………………………………………………............ i

Table of Contents…………………………………………………………………….................. ii

Abstract…………………………………………………………………………….................... iii

I. Introduction…………………………………………………………………………………. 1

II. Current Financial Performance and Capital Structure …………………………………. 3

III. Optimal Capital Structure for fiscal year 2011 …………………………………………... 8

IV. Conclusions……………………………………………………………………………….... 12

V. Bibliography………………………………………………………………………….......... 13

ii

Abstract

Firms generally have an optimal capital structure, that is defined as the proper mix of debt

and equity, which maximizes their stock price. It is inevitably essential to Vodafone Group to

determine and manage the optimal capital structure as sources of assets which enable the Group

to continuously maintain its international expansion strategy through its subsidiaries, joint-

ventures, and strategic alliances rather than maintaining the lower growth domestic and

European market. According to Vodafone Group‟s guidance to 2011 financial year released in

May 2010, “Adjusted operating profit is expected to be in the range of £11.2 billion to £12.0

billion” (Vodafone, 2011). To achieve the target level for the year ended March 31, 2011, the

optimal capital structure is analyzed by using the WACC that makes it easy to predict the cost of

each capital component as a source of the optimal capital structure and to use a definite

correlation between WACC and its stock price that the optimal capital structure that maximizes

the stock price also minimizes the WACC.

In conclusion, if Vodafone Group maintains current level of its capital structure, it can

achieve the optimal capital structure that can minimize the WACC and thus maximize its stock

price but the total debt to total capital ratio is below that of the expected a low single A credit

rating. Debt is a key source of capital growth for Vodafone Group to maintain its capital

intensive growth strategy and downgrading its credit rating thus has a great impact on its

efficient debt financing and low cost of debt, and its growth strategy. While maintaining current

level of capital structure, Vodafone must inevitably make efforts on maintaining current a low

single A credit rating.

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I. Introduction

Vodafone Group is the world‟s leading mobile operator with a significant presence in

Europe, Asia Pacific, United States, and the Middle East through its subsidiaries, joint-ventures,

and strategic alliances. Vodafone has a truly international customer base with “341.1 million

proportionate mobile customers across the world” (Vodafone, 2010). Despite the volatile

economic conditions, Vodafone‟s financial results for the year ended March 31, 2010 exceeded

its guidance released in May 2009, increased its commercial focus, achieved its £1 billion cost

reduction target ahead of its original schedule, and took advantage of its strong cash generation

to accelerate investment in fixed and mobile broadband networks and in value-added services.

According to Vodafone Group‟s guidance to 2011 financial year released in May 2010,

“EBITA margins are expected to decline but a significantly lower rate than that experienced in

the previous year. Adjusted operating profit is expected to be in the range of £11.2 billion to

£12.0 billion” (Vodafone, 2010). This represents that adjusted operating profit during fiscal year

2011 will increase by up to 4.4% or decrease by up to -2.38%. Although Vodafone Group has

relied on around 70% of revenues and 60% of adjusted operating profit in the European market,

its revenues increased only by 0.8% and adjusted operating profit decreased by 2.9% in the

market. The European market has achieved 130% mobile penetration rate and had lower growth

potential while revenues contributions from emerging markets have increased and the market

growth prospects remain highly positive.

To achieve the target profit level for the year ended March 31, 2011, Vodafone Group

“intends to maintain capital expenditure at a similar level to last year, adjusted foreign exchange,

ensuring that we continue to invest in high speed data network, enhancing our customer‟s

experience and increasing the attractiveness of the Group‟s data products” (Vodafone, 2010).

1

The objective of this research is to analyze the optimal capital structure to ensure that

Vodafone Group achieves the financial objective for the year ended March 31, 2011 in line with

its capital and growth strategy to maximize its shareholder value.

2

II. Current Financial Performance and Capital Structure

Telecommunications industry is very capital-intensive and it needs a huge amount of capital

to acquire and maintain its network infrastructure and technologies, and launch new services. In

addition, Vodafone Group has maintained its international expansion strategy while establishing

its entities through the mergers and acquisitions, joint-ventures, and strategic alliances around the

globe. Therefore, goodwill, which is associated with its operations and joint-ventures around the

globe, has accounted for the largest portion of total assets, 33% and 35.3% of total assets in fiscal

year 2010 and 2009 respectively and the asset turnover ratios thus has been relatively lower than

the industry average cited from Thomson One, as shown in the Table 1. As a result, setting the

optimal capital structure as sources of assets is inevitably essential to Vodafone Group to

effectively manage a balance between risk and return associated with debt and equity financing

in order to achieve the ultimate objective of maximizing its stock price.

Table 1 Vodafone Group annual key financials and financial ratios

Thomson One
31 March 2010 31 March 2009 31 March 2008
Industry Average
Revenues £44,472m £41,017m £35,478m £45,800m
Total Assets £156,985m £152,699m £127,270m £93,469m
Goodwill £51,838m £53,958m £51,336m N/A

Goodwill to Total Assets 33.0% 35.3% 40.3% N/A
Total Assets Turnover 0.28x. 0.27x. 0.28x. 0.49x.

Firms generally have an optimal capital structure, that is defined as the proper mix of debt

and equity, which maximizes their stock price. Setting the optimal capital structure inevitably

involves a trade-off between risk and return; “using more debt will raise the risk borne by

3

stockholders” and “using more debt generally increase the expected return on equity” (Brigham

and Houston, 2009, p. 402). Although capital markets perceive a default risk on highly leveraged

firms, debt is perceived as a key source of capital to maintain its growth strategy by Vodafone

Group. According to Vodafone (2010), “Our key sources of liquidity in the foreseeable future are

likely to be cash generated from operations and borrowings through long-term and short-term

issuances in the capital markets”. The Table 2 indicates that while Vodafone Group increased its

assets, that are associated with its international expansion strategy, by 20% and 2.8% for the year

ended March 31, 2009 and 2010 respectively, it has maintained the range of the proportion of its

capital structure with roughly 40% of debt and 60% of equity. The debt ratio measures the

percentage of capital provided by creditors and is calculated by dividing total debt by total assets.

The debt ratios have been less than 50%, which means that shareholders have supplied more than

half of its total capital.

Table 2 Vodafone Group balance sheets and debt ratio

Assets
Current Assets £14,219m £13,029m £8,724m
Noncurrent Assets £142,766m £139,670m £118,546m
Total Assets £156,985m £152,699m £127,270m

Liabilities and Equity
Current Liabilities £28,616m £27,947m £21,973m
Noncurrent Liabilities £37,559m £39,975m £28,826m
Equity £90,810m £84,777m £76,471m
Total Liabilities and Equity £156,985m £152,699m £127,270m

Debt Ratio 42.1% 44.5% 39.5%

4

Debt, preferred stock, and common stock are called capital components and the cost of

the component is called its component cost. The costs of debt, preferred stock, and common

stock are used to form a weighted average cost of capital (WACC) that is used to make the

capital structure decisions because “the capital structure that maximizes the stock price also

minimizes the WACC; and at times, it is easier to predict how a capital structure change will

affect the WACC than the stock price” (Brigham and Houston, 2009, p. 430). WACC is formed

“by the firm‟s capital structure (the firm‟s relative amounts of debt and equity), interest rates, the

firm‟s risk, and the market‟s attitude toward risk” (Brigham and Ehrhardt, 2009, p. 30) and it

thus generally changes over time. Vodafone Group has not issued preferred stock and therefore

debt and common stock have been perceived as its capital components. Vodafone Group‟s

WACC is calculated as below.

WACC = (% of debt)(after-tax cost of debt) + (% of common equity)(cost of common equity)

The range of Vodafone Group‟s WACC has been very stable form 6.1% to 6.5% for the most

recent three fiscal years, as shown in the Table 3.

Table 3 Vodafone Group’s WACC

Actual capital structure
Debt 42.1% 44.5% 39.5%
Equity 57.9% 55.5% 61.5%

Expected rates of return
Debt 5.1% 5.7% 4.4%

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Equity 8.5% 8.4% 8.0%

Corporate Tax Rate 26.5% 24.9% 26.3%

WACC 6.5% 6.5% 6.1%

According to Vodafone Group‟s guidance to 2011 financial year released in May 2010,

“EBITA margins are expected to decline but a significantly lower rate than that experienced in

the previous year. Adjusted operating profit is expected to be in the range of £11.2 billion to

£12.0 billion” (Vodafone, 2010). EBITDA and adjusted operating profit for the most recent three

fiscal years are shown in the Table 4.

EBITDA is earnings before interest, taxes, depreciation, and amortization, and one of the

popular performance yardsticks to analyze whether the core business is profitable in capital-

intensive industries. “Companies that have spent heavily infrastructure will generally report large

losses in their earnings statements. EBITDA helps determine whether that new multimillion

dollar fiber-optic network, for instance, is making money each month, or losing even more”

(Investopedia, 2010). Group‟s EBITDA margin has declined in line with its expectations, “as a

result of lower revenue in Europe and the greater weight of lower margin operations in emerging

economies” (Vodafone, 2010). EBITDA margin is calculated by dividing EBITDA by Revenues.

Adjusted operating profit excludes non-operating income of associates, impairment losses

and other income and expense. Although both EBITDA and adjusted operating profit are non-

GAAP measures that should not be viewed as an alternative to the equivalent GAAP measure,

they are regularly reviewed by Vodafone Group‟s management and useful to analyze internal

performance.

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Table 4 Vodafone Group EBITDA margin and adjusted operating profit

Revenues £44,472m £41,017m £35,478m
EBITDA £14,735m £14,490m £13,178m
EBITDA margin 33.1% 35.3% 37.1%
Adjusted operating profit £11,466m £11,757m £10,075m

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III. Optimal Capital Structure for fiscal year 2011

WACC is used to analyze the optimal capital structure to achieve the expected adjusted

operating profit in the range of £11.2 billion to £12 billion stated in the guideline for the year

ended March 31, 2011 because when the WACC is minimized, the firm can maximize its stock

price. Although the firm‟s ultimate objective is to maximize shareholder values, it is difficult to

predict and manage the stock price itself. Meanwhile, it is easier to predict how a capital

structure will affect the WACC than the stock price. Consequently, WACC is useful to make the

decision on the future optimal capital structure. Return on Common Equity (ROE) is the most

important bottom-line accounting ratio while net income is an accrual-based accounting measure

of profits during the accounting period and may fundamentally differ from the actual return

earned by stockholders. While it is difficult to calculate expected stock price, ROE is relatively

more easily calculated to calculate and there is “a significantly positive correlation between

return on equity (ROE) and the stock price of a company” (Schlinchting, 2009, p. 23).

Consequently, the optimal capital structure would enable Vodafone Group to minimize the

WACC while achieving the expected adjusted operating profit in the range of £11.2 billion to

£12 billion and exceeding the expected ROE as shown in the Table 5.

Table 5 Vodafone Group’s expected financial performance for fiscal year 2011

High Low Sources
Adjusted operating profit £12,000m £11,200m Vodafone Group
ROE 11.1% 8.7% Thomson One

For now, assume that two financial performances are being considered to analyze the optimal

capital structure; (1) Case 1, £12 billion adjusted operating profit while exceeding 8.7% ROE as

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shown in the Table 6, and (2) Case 2, £11.2 billion adjusted operating profits while exceeding

8.7% ROE as shown in the Table 7. Here are key assumptions to develop both cases.

 Total assets are calculated by using the average adjusted operating profits to total assets ratio

for the most recent three fiscal years. Total assets are £156,985m, £152,699m, and

£127,270m, and adjusted operating profits are £11,466m, £11,757m, and £10,075m for the

year ended March 31, 2010, 2009, and 2008 respectively. The average adjusted operating

profits to total assets ratio are calculated as below.

(£11,466m / £156,985m + £11,757m / £152,699m + £10,075m / £127,270m) / 3 = 7.6%

Total assets for the year March 31, 2011 is calculated for each case as below.

 Case 1 Total Assets = £12,000m / 7.6% = £157,071m

 Case 2 Total Assets = £11,200m / 7.6% = £146,600m

 Interest rates are calculated by using the average amounts of interest payment to total debt

ratio for the most recent three fiscal years. Total amounts of the interest payment are

£1,601m, £1,470m, and £1,545m, and total debt are £66,175m, £67,922m, and £50,799m for

the year ended March 31, 2010, 2009 and 2008 respectively. The average amounts of interest

payment to total debt ratio are calculated as below.

(£1,601m / £66,175m + £1,470m / £67,922m + £1,545m / £50,799m) / 3 = 2.54%

 Tax payment is calculated by using the average corporate tax rates for the most recent three

fiscal years. The corporate tax rates are 26.5%, 24.9%, and 26.3% for the year ended March

31, 2010, 2009 and 2008 respectively. The average corporate tax rates are calculated as

below.

(26.5% + 24.9% + 26.3%) / 3 = 25.9%

9

 WACC is calculated by using Vodafone Group‟s principal actuarial assumptions. Expected

rates of return on equity are 8.5% and on bonds are 5.1% for the year ended March 31, 2010.

 There is “a strong correlation between bond ratings and many of the ratios” (Brigham and

Houston, 2009, p. 217), and lower debt ratios generally have higher bond ratings. Standard &

Poor‟s has assigned credit ratings of A- to Vodafone and the target total debt to total capital

of „A‟ and „BBB‟ in Standard & Poor‟s bond rating criteria is 37.5% and 42.5% respectively

(Brigham and Houston, 2009, p. 217). While a low single A credit rating enables Vodafone

Group to have access to a wide range of debt finance to maintain its international expansion

strategy through the mergers and acquisitions, joint-ventures, and strategic alliances around

the globe, “adverse change in credit markets or our credit ratings could increase the cost of

borrowing and banks may be unwilling to renew facilities on existing terms” (Vodafone,

2010). Consequently, assume that Vodafone is not willing to exceed more than 50% of

debt/assets that can cause rating downgrade.

Table 6 Case 1: Vodafone Group Optimal Capital Structure (£12 billion adjusted operating

profit while exceeding 8.7% ROE)

Interest Tax
Debt/ Pretax Net
Total Debt Total Equity Payment Payment ROE WACC
Assets Income Income
(2.54%) (25.9%)
0% £0m £157,071m £0m £12,000m £3,108m £8,892m 5.68% 8.50%
10% £15,707m £141,364m £399m £11,601m £3,005m £8,596m 6.08% 8.03%
20% £31,414m £125,657m £798m £11,202m £2,901m £8,301m 6.61% 7.56%
30% £47,121m £109,950m £1,197m £10,803m £2,798m £8,005m 7.28% 7.08%
40% £62,828m £94,243m £1,596m £10,404m £2,695m £7,709m 8.18% 6.61%
42.5% £66,755m £90,316m £1,696m £10,304m £2,669m £7,636m 8.45% 6.49%
44.6% £70,054m £87,107m £1,779m £10,221m £2,647m £7,575m 8.70% 6.39%
50% £78,535m £78,536m £1,995m £10,005m £2,591m £7,414m 9.44% 6.14%

10

Table 7 Case 2: Vodafone Group Optimal Capital Structure (£11.2 billion adjusted

operating profit while exceeding 8.7% ROE)

Interest Tax
Debt/ Pretax Net
Total Debt Total Equity Payment Payment ROE WACC
Assets Income Income
(2.54%) (25.9%)
0% £0m £146,600m £0m £11,200m £2,901m £8,299m 5.66% 8.50%
10% £14,660m £131,940m £372m £10,828m £2,804m £8,023m 6.08% 8.03%
20% £29,320m £117,280m £745m £10,455m £2,708m £7,747m 6.61% 7.56%
30% £43,980m £102,620m £1,117m £10,083m £2,611m £7,471m 7.28% 7.08%
40% £58,640m £87,960m £1,489m £9,711m £2,515m £7,196m 8.18% 6.61%
42.5% £62,305m £84,295m £1,583m £9,617m £2,491m £7,127m 8.45% 6.49%
44.6% £65,383m £81,216m £1,661m £9,539m £2,471m £7,069m 8.70% 6.39%
50% £73,300m £73,300m £1,862m £9,338m £2,419m £6,920m 9.44% 6.14%

The range of Vodafone Group‟s WACC has been very stable form 6.1% to 6.5% for the most

recent three fiscal years that are approximate equivalent to the WACC for the year ended March

31, 2011 to achieve the optimal capital structure when the range of debt to assets is from 42.5%

to 50%. However, it needs to exceed 8.7% ROE and therefore the range of debt to assets of its

optimal capital structure should be from 44.6% to 50% as far as it can maintain a low single A

credit rating.

11

IV. Conclusions

Firms generally have an optimal capital structure that would maximize their stock price. It is

essential to Vodafone Group to manage the optimal capital structure as sources of assets which

enable the company to continuously maintain its international expansion strategy through its

subsidiaries, joint-ventures, and strategic alliances rather than maintaining the lower growth

domestic and European market. WACC is used in this research to analyze the optimal capital

structure in line with shareholder‟s value because (1) it is relatively easy to predict the cost of

each capital component to form WACC as a source of the optimal capital structure while

predicting and managing its high stock price that is a primary source of its stockholder‟s value is

nearly impossible by its own efforts, and (2) there is a definite correlation between WACC and

its stock price that the optimal capital structure can maximize the stock price while minimizing

the WACC. Vodafone‟s expectation to efficient debt financing and low cost of debt while

maintaining a low single A credit rating is also considered in this research.

In conclusion, if Vodafone Group maintains current level of its capital structure, it can

achieve the optimal capital structure that can minimize the WACC and thus maximize its stock

price but the total debt to total capital ratio is below that of expected a low single A credit rating.

Debt is a key source of capital growth for Vodafone Group to maintain its capital intensive

growth strategy and downgrading its credit rating thus has a great impact on its efficient debt

financing and low cost of debt, and its growth strategy. While maintaining current level of

capital structure, Vodafone must inevitably make efforts on maintaining current a low single A

credit rating. However, its reliance on only numerical analysis would be imperfect to set the

optimal capital structure and using a combination of judgment and numerical analysis would be a

practical manner.

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V. Bibliography

Brigham, E. F., & Houston, J. F. (2009). Fundamentals of Finance Management, Concise Edition

(with Thomson One – Business School Edition). Florence, KY: South-Western College

Publishing.

Brigham, E. F., & Ehrhardt, M. C. (2009). Corporate Finance: A Focused Approach. Florence,

KY: Cengage Learning.

Cengage Learning. (2009). Thomson One Business School Edition: Financial Analyst Data and

Forecasts. Retrieved June-25, 2010 from

http://tobsefin.swlearning.com/

Investopedia. (2010). The industry handbook: the telecommunications industry. Retrieved June-

25, 2010 from

http://www.investopedia.com/features/industryhandbook/telecom.asp/

Schlichting, T. (2009). Fundamental Analysis, Behavioral Finance and Technical Analysis on the

Stock Market: Theoretical Concepts and Their Practical Synthesis Capabilities. Munich,

Germany: GRIN Verlag.

Vodafone. (2010). Vodafone Group Plc: Annual Report for the year ended 31 March 2010.

Retrieved June-25, 2010 from

http://www.vodafone.com/static/annual_report10/downloads/vf_ar2010.pdf

13

Vodafone. (2009). Vodafone Group Plc: Annual Report for the year ended 31 March 2009.

Retrieved June-25, 2010 from

http://www.vodafone.com/annual_report09/downloads/VF_Annual_Report_2009.pdf

14

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