CASE STUDY: GRACE TELECOM LIMITED
Introduction
Grace Telecom Ltd. is a well-established company which is providing telecommunications services both nationally and internationally. Its business has been concerned with telephone calls, the provision of telephone lines and equipment, and private telecommunication networks. Grace Telecom Ltd. has supplemented these services recently by offering mobile phone, which is an expanding market worldwide
The company maintains a diverse customer base, including residential users, multi-national companies, government agencies and public sector organisations. The company handles approximately 100,000 million calls each working day, and employs nearly 140 personnel.
Strategic development
The Chairman of Grace Telecom Ltd stated within its latest Annual Report that there were three main areas in which the company aimed to develop in order to remain a world leader in the telecommunications market. He believes that the three main growth areas reflect the evolving nature of the telecommunications market and will provide the scope for development.
The areas in which development is planned are:
- expansion of the telecommunications business in the national and overseas markets, both by the company acting on its own and through partnership arrangements with other suppliers
- diversification into television and multi-media services, providing the hardware to permit telephone shopping from home and broadcasting services
- extension of the joint ventures and strategic alliances which have already been established with companies in West Africa.
The Chairman explained that the company is intent on becoming a world leader in communications. This will be achieved through maintaining its focus on long-term development by improving its services to customers, developing high quality up-to-date products and being innovative, flexible and market-driven. His aim is to deliver a world-class service at competitive cost.
Financial information
The following comparative statistics show extracts from the company’s financial performance in its national telecommunications market over the last two years:
The company estimates its cost of capital to be approximately 18%.
The Chairman expressed satisfaction with the increase in turnover and stated that cost efficiencies were now being generated following the completion of a staff reduction programme. This would assist the company in achieving a target return on capital employed (ROCE) of 20% in this market over the next three years.
Business opportunities
The Chief Executive of Grace Telecom Ltd. has stated that the major opportunities for the company lie in the following areas:
- encouraging greater use of the telephone
- provision of advanced services, and research and development into new technology, including the internet and systems integration.
the increasing freedom from government control of worldwide telecommunication services.
An extensive television and poster advertising campaign has been used by the company. This was in order to penetrate further the residential market segment by encouraging greater use of the telephone with various charging incentives being offered to residential customers.
To further the objective of increasing long-term shareholder value, the company is actively considering an investment of GHS200 million in each of the next three years in new technology and quality improvements in its national market. Because of its specialist technical nature, the investment is not expected to have any residual value at the end of the three-year period.
Following the investment, the directors of Grace Telecom Ltd. believe that its rate of profit before interest and tax to turnover in its national telecommunications market will remain constant. This rate will be at the same level as last year for each of the three years of the investment.
Markets and competition
The company is currently experiencing an erosion of its market share and faces increasingly strong competition in the mobile phone market. While Grace Telecom Ltd. is the leader in its national market, with an 85% share of the telecommunications business, it has experienced a reduced demand for the supply of residential lines in the last five years as competition has increased.
The market for the supply of equipment in the national telecommunications market is perceived to be static. The investment of GHS200 million in each of the next three years is estimated to increase Grace Telecom Ltd.’s share of this market to a level of 95%. The full improvement of 10% is expected to be received by Grace Telecom Ltd. next year, and its market share will then remain at this level for the full three-year period. It is anticipated that unless further investment is made after the three-year period, Grace Telecom Ltd.’s market share will revert to its current level as a consequence of the expected competitive response.
Industry regulation
The government has established an industry regulatory organisation to promote competition and deter anti-competitive behaviour.
As a result of the activities of the regulator and aggressive pricing strategies, it is anticipated that charges to customers will remain constant for the full three-year period of the new investment.
All cash flows can be assumed to occur at the end of the year to which they relate. The cash flows and discount rate are in real terms.
Future outlook
The business still remains under family control, but the board is considering an expansion programme for which and that the family would need to raise GH¢200 million in equity or debt finance. One of the possible risks of expansion lies in the fact that the market for fixed telephone lines is falling. New income is being generated by expanding the product range to include mobile money transfer. The key to profit growth for Grace Telecom is the ability to generate sales growth, but the company recognizes that it faces stiff competition from large telecom companies in respect of the prices charged.
In planning its future, Grace Telecom is advised to look carefully at a number of external factors which may affect the business including government economic policy. In recent months the following information has been published in respect of key economic data.
i) Bank base rate has been reduced from 22% to 20%, and the forecast is for a further 0.5% reduction within six months.
ii) The annual rate of inflation is now 12%, down from 14% in the previous quarter, and 16% 12 months ago. No further falls in the rate are expected over the medium term.
iii) Personal and corporate tax rates are expected to remain unchanged for at least twelve months.
Required:
Explain the relevance of each of the items of economic data listed in the case to Grace Telecom Ltd. [6 marks]
View Solution
i) Reduction in bank base rate
1) Change in costs of borrowing
This may occur directly through the change in the cost of borrowing and therefore the cost of capital. A fall in interest rates will make borrowing cheaper, and therefore reduce the cost of raising the finance for the proposed expansion. This is likely to apply to any means of financing the company, since corporate borrowing rates are generally set at a certain premium above base rate. If Grace Telecom Ltd. applies DCF techniques in evaluating the expansion, the reduction in the cost of capital will lead to an increase in the level of the NPV for the proposals.
2) Level of demand
Level of demand within the economy could be indirectly affected through the effect of interest rates. Keynesian theory contends that a fall in the level of interest rates will increase the demand for money, and hence the overall level of demand within the economy. Monetarists, on the other hand, believe that the level of consumer demand is unaffected by changes in interest rates. Grace Telecom Ltd is trading in low value basic products for which the level of demand is relatively inelastic. Even if a fall in interest rates affects overall demand in the way that Keynesians predict, this is unlikely to have any significant effect on the level of demand for Grace Telecom Ltd.’s products.
3) Economic confidence
The reduction in the interest rate will increase general economic confidence and encourage expansion. Again though it is likely that the level of confidence will not have much impact on the type of product the company is dealing in.
4) Summary
To summarize, the reduction in the bank’s base rate is likely to reduce the cost of the expansion plans, but will probably have little effect on the level of sales.
ii) Effect of present and forecast rates of inflation
1) Interest rates
Interest rates are unlikely to rise if inflation remains so low
2) Costs of purchases
The cost of the products that Grace Telecom purchase should remain stable. Wage rates may be less affect, there may be pressures other than inflation rates that cause wage increases.
3) Price increases
In conditions of low inflation, it is hard to make any price increase without losing business. Grace Telecom, as already noted is offering low value products and services and thus are unlikely to increase prices up to a certain extent, thereby reducing its ability to compete favourably based on price.
Low inflation is therefore likely to present more of a threat than an opportunity to Grace Publishing
iii) Effects of stable tax rates
1) Consumer demand
Changes in personal tax rates can affect consumer demand, but as was discussed above, demand for Grace Telecom products and services are inelastic, and therefore the stability or otherwise of tax rates is unlikely to have much effect on sales.
2) Tax relief
When planning the expansion, it is easier to plan with confidence since the levels for tax relief available to both the company and individual equity investors are known.
Stable personal and corporate tax rates will therefore help in developing the expansion plans.