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STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Value of the bids

7September – BZO bids 7 1 0 × 2/3 = 473 pence per share

2October – Nadion bids 170 pence plus effectively £4 per share (£100 debenture at par for £6.25 nominal value or 25 ordinary shares), total 570 pence per share plus the conversion opportunity.

This is only 14.9% above the current share price of Nadion (335 pence), and the opportunity for substantial capital gains on conversion exists as there are up to five years before the final conversion date. A rise in stock market price could mean that Nadion issues new shares on conversion at well under market price to Demast’s old shareholders.

19 October – BZO cash offer of 600 pence per share.

Commentary

Although all offers are significantly above the estimated asset valuation, the final successful bid is only 16 pence above the dividend valuation model figure. If this is accurate, the bid would seem to be financially prudent. However, BZO’s strategy is to acquire undervalued companies. Unless BZO has knowledge of how to significantly increase the value of Demast e.g. by disposing of part of the operations, or land, the acquisition of Demast does not appear to be in line with this strategy. Additionally financing the 600 pence cash offer with a £24 million term loan increases the book value of BZO’s gearing (measured by loans and overdraft to shareholders’ funds) from its already high level of 3069+35 = 94%.

If the stock market is efficient the significant fails in BZO’s share price on the occasions of both of the company’s bids illustrate that the acquisition is not regarded as financially beneficial by the company’s shareholders.

(c)

Knowledge is required of the nature of corporate governance, and discussion of possible conflicts between the objectives of directors and shareholders of both the acquiring and acquired company using specific information on an acquisition.

Corporate governance is the system by which companies are run. The board of directors should act on behalf of the shareholders of the company, taking note of other interest groups such as the government, creditors, customers and employees.

In an acquisition situation the actions of directors are constrained by the City Code on Takeovers and Mergers, a set of self-regulatory rules administered and enforced by the Panel on Takeovers and Mergers. The directors of both the bidding and bid for companies should disregard their own personal interests when advising shareholders.

It is questionable whether BZO’s directors’ actions are in the best interests of the company’s shareholders, given the market reaction to the bid and the likely adverse effects on the company’s gearing and interest cover. The company appears short of liquidity (current ratio 0.79:1), and may be trying to maintain its high growth in turnover through acquisitions.

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

The directors of Demast advised shareholders to reject the bid of Nadion worth 570 pence plus a likely capital gain on conversion, and accept the bid from BZO of 600 pence, which also offered them seats on subsidiary boards within BZO. It could be argued that the directors were acting in their own interests to retain well-paid employment, and not in the interests of the owners of the 75% of the shares not controlled by the directors and their families, although the value of the conversion option is difficult to quantify. Acceptance of the bid by BZO might also affect the operations and employment levels of Demast, if part of the operation were to be sold, or the patents sold. Continuit,, of current operations would be more likely under the ownership of Nadion, a company in the same industry, although some cost-saving rationalisation might occur, with loss of employment.

Answer 20 DRICOM PLC

Report for the board of directors of Dricom plc on the proposed reconstruction. The scheme of reconstruction is likely to be successful if:

It leaves all providers of finance in at least as good a position as they would have been had the reconstruction not taken place.

It treats all parties fairly.

Adequate finance is provided for the company’s needs.

As a result of the reconstruction the company is expected to be financially viable.

If the reconstruction does not take place it is possible that the company will be forced into receivership during the next year or soon afterwards as losses are likely to continue without the new investment. Even if the company survives 1998, the £1 million repayment of the convertible debenture in 1999 is likely to pose a major cash flow problem.

The following analysis assumes 30 September 1997 values, but the situation could have deteriorated since that time.

If the company was to go into receivership, the expected realisable value of assets would be:

2,060

_____

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

In order to secure the agreement of the convertible debenture holders Dricom may have to offer them redemption of the debentures, with the associated impact on financing requirements.

The venture capital organisation

The venture capital provider would bear a major risk, as it would hold only equity. The price of 143 pence per share might be regarded as too high by a venture capital provider. Under the proposed reconstruction a total of 1.8 million new 25 pence par value shares would be issued, of which the venture capital organisation would own 700,000 or almost 39% (directors and employees 28%, convertible debenture holders 33%), probably giving it effective control of the company. Almost certainly a venture capital company would require significant board representation. It might also require fixed price options on future share issues or other ‘sweeteners’ which would provide potential capital gains. Many venture capital organisations would not be willing to take such a high equity stake in a company.

Other creditors

Other creditors are in a similar position to the unsecured loan stock holders, and would stand a much better chance of full repayment of their loan after the reconstruction. Other creditors are likely to agree to the reconstruction.

Directors and employees

Although the company’s directors have presumably agreed to participate in the purchase of the shares the attitude of the company’s employees is unknown. They may not wish to, or be able to, subscribe to the amount of shares on offer. The success of the proposed reconstruction will partly depend upon finance being agreed by the company’s employees.

Conclusion

The reconstruction as currently proposed is unlikely to succeed. The company should consider altering the proposed terms that are to be offered, especially to the existing ordinary shareholders, the convertible debenture holders and to the venture capital provider. The price at which new ordinary shares are to be offered should be reviewed and a lower price may be necessary.

Answer 21 EQUITY AND DEBT ISSUES

(a)

A company is required by law to offer an issue of new equity finance on a pro-rata basis to its existing shareholders. This ensures that the existing pattern of ownership and control will not be affected if all shareholders take up the new shares offered. Because the right to be offered new equity is a legal one, such an issue is called a rights issue.

If an unlisted company decides that it needs to raise a large amount of equity finance and provided existing shareholders have agreed, it can offer ordinary shares to new investors (the public at large) via an offer for sale. Such an offer is usually part of the process of seeking a stock exchange listing, as it leads to the wider spread of ownership that is needed to meet stock exchange listing regulations. An offer for sale may be either at fixed price, where the offer price is set in advance by the issuing company, or by tender, where investors are invited to submit bids for shares. An offer for sale will result in a significant change to the shareholder structure of the company, for example by bringing in institutional investors. In order to ensure that the required amount of finance is raised, offers for sale are underwritten by institutional investors who guarantee to buy any unwanted shares.

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STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

A placing is cheaper than an offer for sale. In a placing, large blocks of shares are placed with institutional investors, so that the spread of new ownership is not as wide as with an offer for sale. While a placing may be part of seeking a listing on a stock exchange (for example, it is very popular with companies wanting to float on markets for smaller companies such as the Alternative Investment Market in the UK), it can also provide equity finance for a company that wishes to remain unlisted.

New shares can also be sold by an unlisted company to individual investors by private negotiation. While the amount of equity finance raised by this method is small, it has been supported in recent years by government initiatives such as the Enterprise Investment Scheme and Venture Capital Trusts in the UK.

(b)

The factors that should be considered by a company when choosing between an issue of debt and issue of equity finance could include the following:

Risk and Return

Raising debt finance will increase the gearing and the financial risk of the company, while raising equity finance will lower gearing and financial risk.

Financial risk arises since raising debt brings a commitment to meet regular interest payments, whether fixed or variable. Failure to meet these interest payments gives debt holders the right to appoint a receiver to recover their investment. In contrast, there is no right to receive dividends on ordinary shares, only a right to participate in any dividend (share of profit) declared by the directors of a company. If profits are low, then dividends can be passed, but interest must be paid regardless of the level of profits. Furthermore, increasing the level of interest payments will increase the volatility of returns to shareholders, since only returns in excess of the cost of debt accrue to shareholders.

Cost

Debt is cheaper than equity because debt is less risky from an investor point of view. This is because it is often secured by either a fixed or floating charge on company assets and ranks above equity on liquidation, and because of the statutory requirement to pay interest. Debt is also cheaper than equity because interest is an allowable deduction in calculating taxable profit. This is referred to as the tax efficiency of debt.

Ownership and Control

Issuing equity can have ownership implications for a company, particularly if the finance is raised by a placing or offer for sale. Shareholders also have the right to appoint directors and auditors, and the right to attend general meetings of the company. While issuing debt has no such ownership implications, an issue of debt can place restrictions on the activities of a company by means of restrictive covenants included in issue documents such as debenture trust deeds. For example, a restrictive covenant may specify a maximum level of gearing or a minimum level of interest cover, or may forbid the securing of further debt on particular assets.

Redemption

Equity finance is permanent capital that does not need to be redeemed, while debt finance will need to be redeemed at some future date. Redeeming a large amount of debt can place a severe strain on the cash flow of a company, although this can be addressed by refinancing or by using convertible debt.

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Flexibility

Debt finance is more flexible than equity, in that various amounts can be borrowed, at a fixed or floating interest rate and for a range of maturities, to suit the financing need of a company. If debt finance is no longer required, it can more easily be repaid (depending on the issue terms).

Availability

A new issue of equity finance may not be readily available to a listed company or may be available on terms that are unacceptable with regards to issue price or issue quantity, if the stock market is depressed (a bear market). Current shareholders may be unwilling to subscribe to a rights issue, for example if they have made other investment plans or if they have urgent calls on their existing finances. A new issue of debt finance may not be available to a listed company, or available at a cost considered to be unacceptable, if it has a poor credit rating, or if it faces trading difficulties.

Answer 22 GOVERNMENT ASSISTANCE

(a)Government assistance with financial requirements

Governments assist corporate financing in many ways including:

The availability of writing-down allowances on fixed assets.

Tax deductibility of many other expenses.

Influence through government policies on the level of interest rates in the economy. This can be beneficial or detrimental.

Grants and subsidies. These may be specific to particular regions or industries. They may support, in particular, companies in areas of high unemployment, or the development of high technology industries.

Aid to small and developing companies. This can include differential corporate tax rates.

In the UK the policy is now for selective assistance to be given rather than automatic grants to companies in specific regions.

It is still difficult in the United Kingdom for a company to raise long-term debt and equity in amounts less than £250,000. The government has introduced several schemes to facilitate the small companies.

The Enterprise Investment Scheme (EIS), which replaced the former Business Expansion Scheme (BES) which ceased at the end of 1993. Under the EIS, investors can gain income tax relief at 20% on investments of up to £100,000 in each tax year in qualifying companies (these are broadly unquoted trading companies).

The Loan Guarantee Scheme. This is intended to allow companies to obtain bank loans when the bank would otherwise be unwilling to lend funds to the company because it has inadequate security for the loan. Loans can be for up to £75,000, and the government guarantees 70% of the value of the loan. The borrower has to pay a premium on top of normal interest rates to obtain the loan.

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Development Agencies (e.g. Scottish and Welsh Development Agencies). These have been established to stimulate trade and industry within their regions, and can offer various types of assistance including free or low rent factories, subsidised loans, or direct equity or other investment in companies.

Regional development grants are available on a selective basis to small firms, which offer assistance towards the purchase of fixed assets, or product and process innovation (the Regional Enterprise Grant).

Under the Enterprise Initiative the government offers more generous tax allowances on research and development than normal capital investment, and grants for collaborative developments between industry and higher education.

The Enterprise Allowance Scheme gives a small allowance to unemployed people wishing to set up their own business.

From April 1995 individuals may invest in unquoted trading companies through a venture capital trust, a quoted company holding investments in unquoted companies. Income tax and CGT reliefs are available to the investor.

Many local government authorities also provide grants, loans or equity support to encourage businesses to establish in their areas.

(b)

Corporate planning influences the long-term future of an organisation. It is vital for a company to clearly establish its objectives prior to engaging in detailed planning. A corporate philosophy and mission statement will often be developed, and general details formulated of the desired product range and the geographical markets in which the company is to operate. Objectives should include the specific goals that management seeks to achieve, for example with respect to market share, return on capital and various non-financial objectives.

Objectives should be realistic. In order to assess whether they can be achieved an analysis of both the internal environment within the organisation, and the external environment will be necessary, involving forecasts of any important future changes in these environments (market growth, inflation, exchange rates, developments within the industry, labour shortages etc.).

Once such analysis is complete, alternative strategies may be formulated that could achieve the company’s objectives, and the best alternative selected. More detailed planning will normally follow, with:

Medium-term operating plans including financial projections, contingency plans, and monitoring and control mechanisms for the organisation. If possible, planning models should be used which allow for sensitivity analysis to be carried out on major variables.

Shorter-term plans to implement the selected strategy e.g. detailed sales and cost projections, and cash budgets.

From the early stages of the planning process individuals affected by the plan should be involved as much as possible in its formulation.

The selected strategy will be implemented within various parts of the organisation, probably with departmental or other targets being set.

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

The whole process will require monitoring, with corrective action taken, where possible, against significant deviations from the plan, and forecasts reviewed and plans re-assessed in the light of changing circumstances.

(c)National Sand

(i)Advantages of tender issue

A tender issue normally allows the issuing company to receive a higher price per share than would be achieved by an offer for sale or other fixed price issue. In a tender a minimum price will be set, and investors invited to bid for shares at or above that price. In a fixed price issue the price is often set at a discount to the company’s estimated market value, and the benefit from any rise in general share prices that occurs between the date the price is fixed and the date the issue comes to the market is lost to the issuing company. With a tender issue much of the effect of rising share prices should be reflected in higher tender offers, directly benefiting the issuing company.

Tenders are useful where there is uncertainty about the market value of a company. Rather than the company risk offering a large discount relative to the price of the shares when traded, a tender is effectively letting the market set the company’s value. This may be of particular benefit to National Sand which has not previously had an open market value.

(ii)Disadvantages of tender issue

They are said to be unpopular among small investors, who, it is argued, are not sophisticated enough to know at what price to tender or do not wish to go to the effort of deciding a tender price. (This is debatable, and in any case more than 70% of all UK shares are now held by financial institutions.)

An offer for sale or other fixed price issue is more certain for the issuing company in the amount of finance it will produce.

Tender issues are prone to inflated bids for large amounts of shares by speculators who believe that a substantial premium will exist when shares are first traded on the market.

(ii)Average shareholding

The striking price to dispose of 400 million shares is likely to be 130 pence, with all successful applicants paying this price even if they tendered a higher price.

If the company does not give priority to small investors (as was done in most UK privatisations), all bidders of 130 pence or more will receive some allocation. 655 million shares were tendered for, with only 400 million available. Assuming shares are allocated proportionate to applications, each successful applicant will receive:

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