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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

(b)

The AIM issue is expected to be successful with a gearing of less than 40%, which requires the exercise of the warrants, increasing the expected value of equity to £5·272 million. The book value of equity divided by the number of shares provides an estimate of the minimum price per share, which is 3m£5·272mshares = 176 pence

Unless the listing places a value of at least this much on equity, the existing shareholders would be unlikely to undertake the listing. The actual share price at listing is likely to be much higher than this, and to reflect future cash flow expectations rather than book values.

Answer 35 REFLATOR PLC

(a)The advantages of a buy-out may be viewed from the perspectives of each of the parties involved.

The selling company may regard a buy-out as preferable to the liquidation of a loss making division. A buy-out might result in a higher disposal price, and has the social effect of protecting jobs. Selling part of the organisation might allow the company to focus on its core competence.

The current managers, with their existing expertise of the markets, relationships with clients etc may have a better chance of successfully operating the company. They are also likely to be highly motivated through their significant equity holdings, and by the potential for large capital gains if the company succeeds.

A venture capitalist or other type of investor normally takes a high risk, in the hope of high returns mainly through capital gains. Most investors would seek some form of exit route for their investment after several years, possible through a listing on the AIM or other relevant market. In some countries investing in buy-outs may offer tax advantages.

(b)

The increase in the value of equity may be estimated from the expected retained earnings over the four year period. The maximum 15% dividend payment is assumed.

Growth in the book value of equity from 800,000 to 1,397,888 over four years is a compound growth rate of 14·97%. This is considerably less than the 20% growth rate claimed by the managers.

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

It should be noted that this is a book value of equity. The market value of equity is much more relevant to a potential investor, and is likely to be very different from this book value.

Note

1Interest on the 9% loan

The equal annual payment comprising interest and capital that is necessary to pay off a £300,000 loan over six years is:

300,0004·486 = £66,875 (4·486 is the PV annuity factor for six years at 9%)

(c)

At the start of the buy-out, the equity holding would be 1,000,000 shares by the managers, and 600,000 by the venture capital organisation. The initial warrant proposal would allow the venture capital organisation to purchase 300,000 new shares after four years, a total of 900,000. The revised suggestion would allow 450,000 new shares to be purchased which would give majority ownership and control of the company to the venture capital organisation. This is likely to be unacceptable to the managers, unless they also will have further opportunities to increase their share ownership, for example through other forms of option.

Answer 36 EVERTALK PLC

Report on the restructuring proposals of Evertalk plc.

Any decision should be taken in the best interests of the shareholders of the company, with due regard paid to other stakeholders’ interests. The directors should not take decisions that are in their own best interests.

(i)Corporate restructuring

For a restructuring to be successful it must treat all stakeholders fairly in accordance with their respective rights, and, if possible, offer each group a more favourable outcome than would occur if the company were to be liquidated. The company should also expect to be viable as a going concern as a result of the restructuring.

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Existing shareholders

If the company fails, existing shareholders would receive nothing. The proposal gives them at least some possibility of future value, and might be acceptable. Shareholders could of course currently sell their shares for 10 pence; however, if many of the shareholders were to sell the price would fall from this level. The convertible offer would then need to be judged against the revenue from the sale of shares. The initial conversion price of 200 pence per share does not look favourable; on current evidence the share price is unlikely to reach 200 pence during the next five years.

Participants in the share option schemes

It is likely that currently the share options have little or no value as the current share price is so low. This offer appears to be generous to this group who are existing managers/directors of the company, and probably unfair to other stakeholders.

Other liabilities

The scheme does not offer any change in legal status to such liabilities. It could, however, slightly improve the future financial viability of the company, or, as the amount of loans outstanding is reduced, probably improve the proportion of funds repaid in the event of liquidation. If, however, the new loans are secured, this could have an adverse effect on other liabilities.

The proposed restructuring does not offer a viable financial solution to the company’s current problems.

Other possible strategies: Closure of the network division

Given that the manufacturing division is performing much better than the network division, consideration should be given to closing the network division. The subscriber base of the network division could possibly be sold. Future activities, and any restructuring, could then be focussed on the manufacturing division that is currently profitable.

(ii)Sale of the company to Globtalk

Globtalk would probably close the network division as it is loss making and a direct competitor to its own network. If the network division is closed the receipts are expected to be:

If the £300 million remaining bond liability is excluded from the closure, the outcome is an expected deficit on disposal of only £32 million.

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

The projected free cash flow of the manufacturing division is:

If the network division is closed and none of the lost sales (25%) are replaced, then free cash flow would reduce to approximately £41 million. This is not an exact estimate, and in reality sales could increase rather than decrease, as Globtalk would be likely to use the division as a supplier of phones to its own network customers. Without any sales reduction the present value of the free cash flow to infinity at a 10% discount rate (see appendix below) is £570 million. If a shorter and more conservative time horizon of 10 years is used the present value of a free cash flow of £57m per year for 10 years is: £57m × 6·145 = £350 million.

With a sales reduction the values are £410 million and £252 million.

Both of these estimates are well in excess of the £50 million price offered.

If Globtalk acquires Evertalk, there is potential also to access Evertalk’s existing network subscribers (or at least part of them), and there could be vertical synergies with the manufacturing division. Even if Globtalk were to take full responsibility for existing loans, at a total cost of £382 million (£332m net liabilities plus £50m purchase cost), its offer could still be below the expected value of Evertalk with the network division closed.

Given the above data it is recommended that any acquisition by Globtalk should be conditional upon the company accepting liability for Evertalk’s existing loans.

(iii)Closure of the company

Closure of the entire company is not recommended. Given the poor performance of the network division it is recommended that this division is closed. The manufacturing division is viable, and could either continue to be operated by Evertalk, or sold to Globtalk. Closure of the network division would lead to a deficit of approximately £332 million (see above), which could not easily be paid by the manufacturing division.

Conclusion:

Unless an alternative restructuring scheme can be agreed, which would reduce the burden of the closure of the network division to the company, sale to Globtalk might be the best alternative, conditional upon Globtalk accepting the liability for all existing loans.

Appendix: WACC for the manufacturing division:

Cost of equity for the manufacturing division:

Rf + (Rm – Rf) beta, or 5% + (14% – 5%) 0·9 = 13·1%

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

The cost of debt may be estimated by using the current bank loan rate of 8%, or from the current bond price, by trial and error.

The cost of debt (before tax) is approximately 8%.

The weighted average cost of capital for the manufacturing division, using target gearing of 60% equity, 40% debt is:

13·1% (0·6) + 8% (1 – 0·3) (0·4) = 10·1%

10% will be used as the discount rate.

N.B. The after tax cost of debt is used as the manufacturing division is expected to pay tax in the future.

Answer 37 SNOWWELL PLC

Briefing document for Snowwell plc.

(a) The current SO score may be estimated as follows:

Total SO score = 1·041

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Notes:

1Market value of equity is 232 pence × 150 million shares = £348m Market value of debt is 150 × 1·155 = £173·25m + £94m = £267·3m

Given a current redemption yield of 8% the market price of 14% £100 par loan stock with three years to maturity is estimated to be:

2Operating free cash flow may be estimated by:

Snowwell’s weighted average cost of capital is:

N.B other definitions of free cash flow are possible, including adjustments for the change in loans and disposal of assets.

(b)

The SO model suggests that a score of 1·04 is just above the level of probable failure, and at the low end of the remedial action range. However, this model is unlikely to be useful in predicting the probability of failure of Snowwell plc because:

The model was produced in 2001 and might not still be relevant in 2003.

Models predicting corporate failure are usually tailored to specific industries and specific size of companies. This general model might not be applicable to Snowwell.

There is no evidence about the predictive ability of the model.

Models which are based upon accounting ratios suffer the same weaknesses as the accounting systems on which they are based.

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

No matter what such models predict, managers may be able to take remedial action that will prevent corporate failure.

(c)Other ways by which corporate financial distress or failure might be predicted include:

Alternative models predicting failure such as those of Argenti, Marais and Beaver, or use of “probit and logit analysis.”

Financial ratios, especially those focusing on liquidity, cash flows, gearing and market values.

Accounting information including levels of debt, liquidity, payment periods, contingent liabilities, and events after the reporting date.

Macro events affecting the company, including inflation and foreign exchange rates.

Market information, especially the potential growth of the jewellery sector.

Actions of competitors.

Comment by company directors (e.g. profit warnings), analysts and newspapers

Audit reports – if accurate!

Credit ratings produced by specialist agencies and banks.

(d)

Snowwell is not recommended to take any action based upon the SO model. Any recommendation would be assisted by additional financial analysis, especially of growth trends and ratios.

Selected ratios and growth trends:

Gearing (market value of M & LT debt/ market value of equity) 267/348 or 77%

Interest cover 43/20 or 2·15 times

Current and quick ratios are low, but probably not unusually low for a retailer. Gearing at 77% is significantly higher than the industry average and might be a cause for concern, and interest cover at 2·15 is quite low. The immediate problem is that inventory has increased much more than turnover, leading to a similar increase in liabilities. Snowwell’s managers should urgently review the company’s inventory levels. Reducing inventory would release cash flow and might allow gearing to be reduced. Consideration might also be given to reducing the level of dividends paid, unless profits are expected to increase in 2004.

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

(e)

The organisation providing the forecast is considered to be reputable and is likely to have tailored the forecast to Snowwell using analysis which has been specifically related to Snowwell’s size and industry. If Snowwell could not easily replicate the analysis itself, and if the forecasting company has a good track record of predicting failure it might be worth purchasing the forecast. However, if the market in which Snowwell operates is considered to be efficient, then market analysts will already be aware of the publicly available information used in the model, and this should already have been incorporated in the share price of 232 pence. A price of this level does not suggest that investors feel that the company is likely to fail in the near future.

If the market is not considered to be efficient, and/or the forecasting technique is believed to be superior, and to convey significant new information, then Snowwell might have a reason to purchase. In such circumstances a purchase might be conditional upon the information not being released to any third parties, although if relevant information was then to be withheld by Snowwell’s managers this might not be considered to be ethical, and acting in the best interests of all stakeholders.

N.B. The SO model used in the question is a fictitious model

Answer 38 HGT

Under the current scheme:

Total taxes and tariffs 214 + 16 + 352 + 157 + 71 = 810

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

If goods are sold at cost by the Glinland subsidiary:

Total taxes and tariffs 486 + 104 + 97 = 687

The proposed change would result in an overall saving of £123,000 per year.

The proposal might not be acceptable to:

The tax authorities in Glinland, where £230,000 in taxation would be lost. The tax authorities might insist on an arms length price for transfers between Glinland and Rytora.

The subsidiary in Glinland, which would no longer make a profit, or have retentions available for future investment in Glinland. Depending upon how performance in Glinland was evaluated, this might adversely affect rewards and motivation in Glinland.

Answer 39 TOUPLUT PLC

(a)Economic Value Added is estimated by:

Net operating profit after tax (NOPAT) – (capital employed × cost of capital)

NOPAT is normally measured in cash flow terms after numerous adjustments to accounting profit. However, economic depreciation is deducted when estimating NOPAT, as it is considered to be a measure of the economic use of assets during a year. It is assumed that NOPAT can be estimated from the data provided by adding back to after tax profit non-cash expenses (excluding economic depreciation), and net of tax interest. (Adding back net of tax interest results in earnings that would have been reported had all of the company’s capital requirements been financed with ordinary shares. Interest and the tax effect of actual gearing are incorporated in the weighted average cost of capital.)

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