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The Examiner's Answers – F3 - Financial Strategy Some of the answers that follow are fuller and more comprehensive than would be expected from a well-prepared candidate. They have been written in this way to aid teaching, study and revision for tutors and candidates alike.

SECTION A Answer to Question One – starts on page 2

Financial Strategy

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May 2010


(a) APPENDIX TO REPORT

Project 1 - Factory refit in Country C

2011 US$m

2012 US$m 160.0 3.628

2013 US$m 160.0 3.455

2014 US$m 160.0 3.291

2015 US$m 160.0 3.134

C$m 44.1

C$m 46.3

C$m 48.6

C$m 51.1

(30.0)

(30.0)

(30.0)

(30.0)

Cash inflows on new product line Exchange rate

3.810

C$ equivalent of US$ cash inflows Loss of income on current products Cash outflows on new product line

C$m 0.0 (4.0) -

Net operating cash flow Tax at 25% Post tax operating cash flows Cost of factory refit Tax relief on factory refit Net incremental project cash flows Discount rate at 8% NPV Total NPV

(4.0) 1.0 (3.0) (35.0) 4.4 (33.6) 0.926 (31.1) 13.9

14.1 (3.5) 10.6 1.1 11.7 0.857 10.0

16.3 (4.1) 12.2 0.8 13.0 0.794 10.3

18.6 (4.6) 14.0 0.6 14.6 0.735 10.7

21.1 (5.3) 15.8 4.0 0.8 20.6 0.681 14.0

2010 US$m (20.0) -

2011 US$m (60.0)

2012 US$m 50.0 15.0 65.0 (19.5) 45.5 (60.0)

2013 US$m 50.0 15.0 65.0 (19.5) 45.5 -

2014 US$m 50.0 15.0 65.0 (19.5) 45.5 -

(20.0)

18.0 (42.0)

18.0 3.5

45.5

45.5

2015 US$m 50.0 50.0 (15.0) 35.0 40.0 (6.0) 69.0

4.000 C$m (5.0) 1.000 (5.0) 17.6

3.810 C$m (11.0) 0.901 (9.9)

3.628 C$m 1.0 0.812 0.8

3.455 C$m 13.2 0.731 9.6

3.291 C$m 13.8 0.659 9.1

3.134 C$m 22.0 0.593 13.0

Project 2 - New factory in the USA Net operating cash inflows pre grant Grant Total net cash inflows Tax at 30% Post tax operating cash flows Cost of land Cost of development Residual value Tax relief on development Net incremental project cash flows Exchange rate Convert back to C$ Discount rate at 11% NPV Total NPV

Note: All cash flows are at 31 December of the relevant year

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Financial Strategy


Workings Tax depreciation allowances for Project 1 – Factory refit in Country C Tax Tax allowance relief C$m C$m C$m 2011 cost 35.0 FYA @50% (17.5) 17.5 4.4 2012

WDA @25%

2013

WDA @25%

2014

WDA @25%

2015

Residual value Balancing allowance

17.5 (4.4) 13.1 (3.3) 9.8 (2.5) 7.3 (4.0) 3.3

4.4

1.1

3.3

0.8

2.5

0.6

3.3

0.8

Exchange rate calculations end of 2010 end of 2011 end of 2012 end of 2013 end of 2014 end of 2015

C$/US$ 4.000 3.810 3.628 3.455 3.291 3.134

Assumptions • Fee of US$200,000 paid for the option of purchasing the full ownership rights of the land is treated as a sunk cost and not included in the NPV analysis. • Costs and revenue are as predicted, including underlying inflation assumptions. • Exchange rates move as predicted or can be covered forward at the forecast future rates. • Costs of consultants that have been excluded are not material or affect the result. • Supervisory costs in C$ for local management to support the USA development are not material or affect the result. • Real options are reflected in the residual value.

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(b) REPORT To: The Board of Directors of Aybe From: Mr X, external consultant Date: My 2010 Evaluation of proposed projects Purpose The purpose of this report is to present the findings of a recent study that was undertaken to review the financial and strategic implications of the two development projects under review and to recommend which project to adopt. Investment appraisal A full investment appraisal exercise has been carried out. The results are attached at Appendix A to this report. Summary of results The net present value analysis indicates a better financial result for Project 2 (new factory in the USA) than for Project 1 (factory refit in Country C). Project 2 has a NPV of C$17.6million, whereas Project 1 has a NPV of C$13.9million. Planning horizon The five year planning period seems to be unreasonably short and only includes four years of production. Questions that need to be addressed include: • •

How long is the life cycle of the new products? (Does four years reflect the expected life cycle?) What possible uses are there for the new production line and other facilities at the end of the life of the new product?

Indeed, the planning horizon is critical to the choice of project. It can be seen that the ‘steady state’ net cash flows (ignoring tax depreciation allowances as these are given in different years) are in the order of: Project 1: C$15.8million (post tax operating cash flow in 2015) Project 2: C$11.2million (US$35.0million / 3.134) Extending the time period over which the project is assessed can therefore be expected to have a major impact on the result, with cash flows from Project 1 exceeding those from Project 2 by C$4.6million a year and therefore quickly eliminating the original C$3.7million difference in net present values. The difference will be accentuated by the use of a higher discount rate in the US. DCF analysis of the cash flows in perpetuity can also be used to be used to show the potential extent of the benefit of Project 2 over Project 1 over the longer term. Credit was given for such calculations, which would also support the opinion that Project 1 appears to be more attractive financially than Project 2 over the longer term time horizon. The conclusion is the same, whichever approach is taken in comparing the future ‘steady state’ cash flows. That is, that the arbitrary planning horizon of five years does seem to have produced a misleading result if the useful life of the US factory and the Country C factory refit extends well beyond 2015.

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Disruption to production (Project 1) • •

The disruption to production under Project 1 is assumed to be C$4million as stated in the question with no permanent loss of business to competitors. This may not be a realistic assumption as it could prove difficult to recover lost business in the future.

Cost of specialist consultants • • •

The cost of specialist consultants has been ignored in the calculations due to lack of further details. Clearly this needs to be investigated and estimated costs included in the calculation. The question should also be asked as to why consultant costs are only being considered for the factory refit in Country C and not in the new build situation in the USA. Additional consultancy costs may also arise in the USA.

Residual values •

The residual value of the factory has a significant impact on the NPV calculation and it is therefore important to review the basis used to estimate residual value in order to assess its reasonableness. Changes in the residual value assumption could have a significant impact on the NPV results. Indeed, the analysis above with regard to planning horizon would indicate that the residual values do not take into account the full value of potential future earnings from these projects. The sensitivity of the NPV result to the residual value can be illustrated by considering the impact of an increase of 100% in residual values used in the calculation.

Project 1: If the residual value is increased to C$8million, an increase of 100% on the original figure of C$4million, the NPV of the cash flow in 2015 would increase to: Item C$million Residual value 8.0 Balancing charge (0.175) (= (7.3 –8.0) x 0.25) Net value 7.825 Which is a difference of 3.025 (= 7.825 – (4 + 0.8)) Discounting for 5 years at 8% gives an increase in NPV for Project 1 of C$2million (= 3.025 x 0.681).

Project 2: If the residual value is increased to C$80million (including C$40million for land), an increase of 100% on the original figure of C$40million, the NPV of the cash flow in 2015 would increase to: Item US$million Residual value 80.0 Tax relief (12.0) (= 40.0 x 0.30) Net value 68.0 Which is a difference of 34.0 (= 68 – (40 – 6)) Discounting for 5 years at 11% gives an increase in NPV for Project 2 of approximately C$6million (= 34 x 0.593/3.134).

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Exchange rates There is clearly a risk that the C$/US$ exchange rate does not move as expected. However, it is not the costs in isolation that are important here, but the overall US$ cash flows of SC and of Aybe. The US$ cash outflows may provide a natural hedge for US$ cash inflows and therefore actually reduce the company’s exchange exposure. In the short term, any residual exchange exposure can be hedged using instruments such as forward contracts. Examiner’s note: Ccandidates who model the sensitivity of the NPV result to changes in the exchange rate and include calculations would be awarded marks accordingly. Choice of discount rates The NPV result is also highly sensitive to the choice of discount rates. It is not clear from the question how the discount rate of 8% for Project 1 or the risk-adjusted rate of 11% for Project 2 have been arrived at. The underlying assumptions need to be researched and evaluated and compared with a result obtained using CAPM based on a proxy company. It may also be appropriate to calculate the sensitivity of the NPV results to the choice of discount rate and also compare the result with alternative approaches to adjusting for risk such as the use of certainty equivalents or probability distributions. Political risk The government grant may have conditions attached that need to be considered in the evaluation exercise. For example, these could include job creation conditions. In addition, there is a risk of changes to the grant or to tax rates if there is a change of government. Impact on gearing The Board of Aybe has decided not to issue any further equity shares over the next five years, so debt financing is the only option here. Aybe is also subject to a loan covenant that specifies that debt:equity should not increase above 75% The impact of debt financing for the Projects on the gearing levels of Aybe can be estimated as follows. Current Project 1 Project 2

40/115 = (40 + 35)/(115 + 13.9) = (40 + 140/4)/(115 + 17.6) =

35% 58% 57%

Where: • 115 = market value of equity based on the share price on 31 December 2009, that is, 64cents x 180million shares and • assuming that there has been no increase in the share price since 31 December 2009 except for an increase in value of equity to reflect the estimated NPV of each project) Examiner’s note: other reasonable assumptions were acceptable.

These results show that the impact on gearing is similar for both projects, with both projects being expected to increase gearing to approximately 58% and so gearing is not an important factor when choosing between the two projects.

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Advice on how to proceed Sensitivity analysis is particularly important in this case as a result of the large number of uncertainties surrounding the project cash flows. A ‘most likely’ band of outcomes and also a ‘worst case’ scenario would be helpful when deciding how best to proceed. If the life of the new products is genuinely only four years, and purely on the evidence presented so far, my advice would be to proceed with the USA project. The main reasons for this are: • It has the highest return based on present values, due largely to the generous government grant available • Specialist consultants are located in the USA and should be able to provide a more rapid response to any problems arising than if they had to travel long distances to visit the factory in Country C. • The USA is an important market for the product and so the location provides easier access to customers and lower transport costs. • This also reduces Aybe’s long term exchange risk as the company now has US$ costs to set against its US$ income streams. • This eliminates the disruption to production of current products at the factory in Country C and therefore also removes the risk that customers do not return to Aybe after being forced to source products elsewhere during this time. However, if an investigation of the planning horizon proves that the new products can be successfully produced and sold for at least six years (rather than the current estimate of four years), this conclusion needs to be reviewed as Project 1 (factory refit in Country C) becomes more attractive than Project 2 (new factory in the USA) purely on financial terms.

(c) The main choice here is between C$ and US$ denominated borrowings. It should be possible to raise either C$ or US$ borrowings in Country C, so ease of raising the funds should not affect the decision on which currency to use. C$ borrowings have the advantage of being simple to service from local C$ income. They are also more straight forward to value and account for and do not create any new foreign exchange issues. On the other hand, the company is already creating foreign exchange exposure in developing in the USA and so US$ borrowings may actually reduce translation exposure overall as they provide a natural hedge of the US$ denominated investment. However, US$ borrowings also need to be serviced and it is possible that US$ cash inflows for SC may not be sufficient to cover its US$ costs (including financing costs). However, Aybe also has US$ income from other divisions and so, taking the group as a whole, it is likely that it will have sufficient US$ income to cover the US$ financing costs. Shareholder expectations should also be taken into account. To what extent do shareholders expect Aybe’s results to be affected by movements in the US$ exchange rate? If the group is largely protected from exchange rate movements, shareholders would not benefit from any favourable exchange rate movements. Would this be likely to cause a problem or would shareholders prefer to have lower risk by using US$ borrowings? Conclusion: Overall, the reduced foreign exchange risk as a result of matching the currency of borrowings with that of the investment is likely to outweigh the potential disadvantages of using US$ borrowings. The best advice is therefore likely to be to use US$ denominated borrowings.

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(d) Examiner’s note: Bullet points are provided below. However, in an examination, candidates would be expected to develop each point in more detail. For both projects, general principles of good management and control of the implementation process apply, including: • Prepare plan for implementation; o appoint competent project manager; the project manager should be located in the USA for the duration of Project 2; o set up a steering committee to oversee the project; o put together a suitable team(s) – may include contractors; o ensure sufficient resources are available and commitment of top management; o focus on key goals and targets – for example, minimising disruption to production and servicing current customers during the closure of the factory for Project 1; o break down plan into manageable tasks; o consider impact of changes to product line and what training or other preparation may need to be built into the implementation plan; o review post completion audit reports from earlier projects to see if there are useful points, such as previous experience of capital budget overspends (as mentioned in the pre-seen material), to take into consideration here; o carry out feasibility study (including test of quality and market acceptability of products) if not already carried out; include additional work to assess the feasibility of project timings and costs in the light of history of capital budget overspends; o build relationships with third parties such as sub contractors and relevant government departments. •

Carry out implementation according to plan; o requires coordination between teams and management; o test running of new production line; o select and manage sub-contractors; o monitor quality of work, including work outsourced to sub-contractors.

Monitor events by collecting regular statistics; o monitor costs/revenues/timings against plan – noting that this is of particular importance in view of Aybe’s poor record in respect of capital budget overspends – and report to steering committee on a regular basis; o adjust plans as necessary; o consider real options throughout the project, including the possibility of terminating a project in extreme circumstances.

Carry out a post-completion appraisal and publicise the fact that this will be carried out in order to provide additional motivation to the project team in effective and efficient implementation of the project according to the agreed plans.

For Project 1 (factory refit in Country C), additional considerations include: •

The disruption to current production – this is of critical importance to the success of the project and requires detailed and careful planning to minimise any disruption; it may even be possible to bring forward production to increase inventory levels to reduce or avoid a break in supply during the refitting period.

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For Project 2 (new factory in the USA), additional considerations include: •

• • •

Management of a project in a foreign country at a significant distance away creates travel and control issues for SC division. It is also important to understand the different legal and operational environment in the USA. However, this may not be a major problem for SC since Aybe already operates in the USA. Manage environment issues such as those arising from the land clearance operation. Ensure adherence to conditions specified under the revenue grant. Focus on obtaining the planning permission required for the project.

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SECTION B

Answer to Question Two (a) Calculations (i) Total working capital requirements are calculated as follows: minimum (1.64 - 14.79 + 17.26) = A$ 4.11m maximum (3.29 – 7.40 +29.59) = A$ 25.48m Thus the fluctuating element of net current assets is A$21.37m (25.48 – 4.11) and the permanent proportion A$4.11m. Short and long-term financing requirements would therefore be: Aggressive Conservative (A$ million) (A$ million) Short-term, 22.19 17.10 financing = (20% x4.11) + 21.37 = (80% x 21.37) (e.g. overdraft) Long-term, 3.29 8.38 financing = (80% x 4.11) = (20% x 21.37) + 4.11 (permanent) Total 25.48 25.48

(ii) The issue price of the proposed bond on a “Yield to Maturity” basis can be demonstrated using a unit of A$100. The proposed bond will pay A$100, its face value, at the end of 5 years. The formula is: Annual interest x (annuity factor for t = 5, r = 9%) + A$100 x (discount factor for t = 5, r = 9%) = (A$8 x 3.89) + (A$100 x 0.650) = 31.12 + 65.00 = 96.12

The issue price of the bond would therefore be A$96.12 per A$100 nominal. (iii) Current WACC is calculated as follows: Type of security

Market Value A$m

Rate of return %

Proportion of total %

Weighted return %

Equity

350.00

10.0

74.5

7.45

6.5 (= 8.125%x0.8) 5.6 (= 7%x0.8)

21.3 4.2 100%

1.38 0.24 9.07

Long term debt 100.00 20.00 Overdraft Total 470.00

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The WACC at present is 9.07% assuming the full amount of short term financing is used continuously as suggested by the scenario in the question. If PIC switched to additional long term financing instead of overdraft the cost of equity and the cost of its remaining overdraft might change. However, the overall effect would be minimal. PIC is re-financing a very small proportion of its total capital structure and the difference in the cost of the two methods being considered is very small. Also, how entities finance net current assets does not attract significant market interest unless it is a very large component of its total capital.

(b) (i)

Evaluation of proposed change in policy

The advantages of PIC’s current, aggressive policy are: •

• •

It would generally provide the highest expected return. Short-term financing is (generally) cheaper than long term financing due to the compensation required by long-term lenders for loss of liquidity and greater credit risk of longer term finance. Even if net current assets fall below expected “permanent” levels, PIC would not be over-financed. PIC faces potentially large fluctuations in net current asset levels so it would benefit from the flexibility that an aggressive financing policy provides.

The disadvantages are: • •

The policy carries a higher risk of illiquidity unless overdrafts are backed up by committed bank facilities. It involves greater management time to manage and renew short-term financing sources.

Other factors that should be considered are: PIC’s proposed conservative financing policy involves all non-current assets, the “permanent” proportion of net current assets and 20% of fluctuating net current assets being financed by medium to long-term funding. Short-term finance would continue to be used for part of the fluctuating net current assets. There would be a proportionately high cost involved in issuing a relatively small amount of new medium to long-term bonds. PIC is currently using supplier credit to finance much of its fluctuating working capital requirements; accounts receivable (credit given to customers) is an average of 15 days whereas accounts payable (credit taken from suppliers) is on average 60 days. This is the norm in retailing but this does not mean there is no cost involved; PIC might be foregoing early payment discounts. More information is needed on various factors before accurate advice can be provided on whether it should change its current policy. The main factors to consider are:    

The availability of increased overdraft – PIC currently has a facility of A$20 million but may breach that limit in the current year and needs up to A$22 million if the financing policy is not changed. The future cost of overdraft financing. The method and interest rate receivable from investing short term cash surpluses. More frequent patterns of net current assets levels should be analysed throughout the year. At a minimum these should be forecast monthly but weekly or even daily would be appropriate for a large retailing entity.

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(ii)

Alternative approaches to financing net current assets that PIC should consider

Moderate policy - somewhere in between the two extremes of aggressive and conservative. This policy matches the short-term finance to the fluctuating net current assets, and the medium to long-term finance to the permanent part of net current assets plus non-current assets. Financing methods that are only relevant to receivables: • Factoring should be considered – where a bank or other financial institution takes over the collection of accounts receivable and pays PIC a discounted value up-front. A bank could offer important additional services such as credit checking and approval of new customers wishing to make use of this credit facility. • Invoice discounting or other similar type of securitized short-term debt should also be considered. This has the advantage of maintaining a direct relationship between the company and the customer when collecting debts due. Note that other long term methods such as equity or complicated bonds (for example, debt with warrants) are not suitable here.

Answer to Question Three (a) The effect on stakeholders The main stakeholders to consider will be the shareholders of XK, the directors and employees of the subsidiary and the creditors of both entities. XK’s shareholders Shareholders will have bought shares in XK recognizing and understanding its policies in respect of risk and return. Approximately 6% of the earnings are provided by subsidiary Y and removing this might impact the risk profile and earning capacity and, hence, the value of XK. Directors and employees of XK This group of stakeholders is unlikely to be affected to any great extent, other than by the overall impact on the level of earnings, although some services provided to the subsidiary by head office will no longer be required. This might involve a small number of redundancies unless they can be transferred to the subsidiary on divestment. Directors and other employees of subsidiary Y The MBO provides the executive directors of Y with the opportunity to take control and expand the business. They also take on significant personal financial risk. Non-director employees might face redundancy or reduced pay or conditions if the divested subsidiary’s directors take the opportunity to review staff needs and/or the employment terms and conditions of current personnel. However, in the long-term, the new entity could provide increased employment if it adopts an aggressive growth strategy but in the short-term there could be redundancies.

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Creditors (suppliers) and bankers XK’s bankers are unlikely to be affected as the bonds are secured on XK’s non-current assets. The lenders would only be concerned if the sale of Company Y made it less likely that the bonds would be fully secured. The scenario says the subsidiary’s non-current assets are valued at US$220million in the accounts. Removing this amount from group non-current assets still leaves US$2,030 million which comfortably covers the secured debt of US$1,000 million. The current ratio of XK, at the last balance sheet date, is 1.65:1 (current assets/current liabilities = 700/425 = 1.65) so trade creditors seem well protected but this is getting close to the externally imposed overdraft condition of 1.5:1. Some suppliers could be affected if the purchasing policy for Company Y is currently controlled by the parent. This responsibility will pass to the newly independent company and it is possible there will be some changes to terms of trade. Customers The customers of Company Y, the divested subsidiary, might notice some changes to terms and conditions. As an independent company, Company Y might lose some customers as it will no longer benefit from joint marketing initiated by XK. This possible loss of earnings will affect other groups of stakeholders rather than the customers themselves. Other Other groups that could possibly be affected are government and local communities. It is hard to see from the information available how either group will be significantly affected one way or another. The national and local governments will of course have an interest in ensuring employment is maintained. In summary, the main winners are likely to be the executive directors in the buyout team. The main losers, possibly, will be some of XK’s current employees and, also possibly, XK’s suppliers.

(b) The economic and market factors affecting the negotiations The decision to divest Company Y could have been influenced by the recession of the last two years as the household electrical goods sector was not immune to its effects. This might affect XK’s bargaining position. The main economic factors that might impact on negotiations are interest rates, stock market movement/sentiment, alternative investment opportunities, and regulatory controls. Interest rates and inflation •

A change in interest rates is likely to have a major impact on the divested subsidiary’s future cash flows and the cost of capital. An increase in interest rates can be expected to lead to a reduction in discretionary expenditure on household electrical goods. It will also increase the discount rates used in NPV calculations which will have the effect of decreasing the value of the subsidiary. Both of these factors could be used by the buyout team to argue that the buyout price should be reduced.

Increased inflation will undermine confidence in the economy, making it harder to assess future cash flows and again will cause the buyout team to claim a lower valuation for the subsidiary.

Stock market movement/sentiment

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• Shareholders have not yet been informed or consulted so their reaction is not known. However, it is very difficult for this type of negotiation to remain confidential and the market is almost certain to have obtained some “insider” information. The share price has risen 5% over the past 3 months which might imply the market is at least not opposed to the planned divestment. Subsequent movements in the share price will depend on what the market had been expecting. • Once details of the divestment are known, the share price can be expected to rise further since the company is disposing of only 6% of earnings at a price equivalent to 10% of the market value (= 325/3281). On the other hand, it does make a positive contribution to group earnings and this will be lost to current shareholders. • We have not been given any information about the risk profile of Y. Only if it is more risky than XK will the risk of XK reduce with the sale of Y. Alternative investment opportunities Assuming a sale is agreed at or near the valuation of US$325 million, XK will have a large cash balance to invest. It could pay off some of its debt. However, the group is not overly indebted – using the book value of debt as an approximation of market value, gearing is only 23% excluding overdraft (23% = 1000/(1000 + 3281)) and 26% including overdraft (26% = (1000 + 150)/(1000 + 150 + 3281)) - and this would not be a good use of funds. The group should evaluate alternatives before agreeing to divest what is a profitable subsidiary. Regulatory controls There are unlikely to be any issues that would concern the competition authorities.

(c) Advantages and disadvantages of the proposed buyout structure Venture capital The main advantage of a venture capital investor (VC) is that this investor shares in the risk – in fact takes most of the risk and only ranks ahead of the buyout team of executive directors. The VC may or may not require a dividend but will require substantial returns for the risk it is taking. In the scenario here the VC has stated it requires all earnings to be re-invested. The consequence of reinvesting all earnings is that capital growth is encouraged. The return required appears high but this is typical of this type of investor. If we assume the NPV of the subsidiary is its initial market capitalisation the implied P/E ratio is 10.6, (US$325m divided by US$30.6m earnings (where 30.6m = 6% x 510m)) which does not seem excessive. However, there would need to be significant growth in the business to enable the VC to realise 25% per annum return. With debt of US$198million, earnings would be reduced to approximately US$21.7million (see W1) which represents a return of less than 18% (see W3) to the VC, even before providing any return to the management buyout team of executive Directors. The VC would only be prepared to invest in the business if it believes in the new management’s ability to ‘transform’ the business and achieve rapid growth.

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Workings: W1: Previous year’s earnings less interest after tax relief of 6% x 198 x (1 – 0.25) Profit after tax and interest W2:

Venture capitalist contribution Price less Director’s contribution less Investment bank Balance from VC

W3:

US$million 30.6 (8.91) 21.69

325 (5) (198) 122

17.8% = 21.7/122

The main disadvantages of using venture capitalist finance is that, if the ultimate exit route is by Initial Public Offering (IPO), the majority of the returns will go to the venture capitalists. However, the buyout team has limited choice. Buyout team of executive directors The executive directors will be at the bottom of the pile in terms of returns on their investment. As we have calculated above, they need to realise substantial growth and ‘transform’ the business in order to satisfy the VC and therefore also provide themselves with some return on their investment. Investment bank Financing a proportion of the buyout from an investment bank allows equity investors to retain a greater share of the business but there is a high cost in terms of interest payments that will impact on earnings and affect the overall risk of the business. The value of the subsidiary is likely to be lower with the involvement of this type of finance because of the interest payments and the increased cost of equity. There are however some serious concerns about the amount of borrowing from this bank.

W4:

1

The debt of US$198million is only just covered by the estimated value of the noncurrent assets. This leaves little spare debt capacity and explains the high interest rate relative to current market rates for secured borrowings.

2

If earnings are maintained at around US$30.6million in the first year of operations then the interest cover is just about adequate at 3.1 times (W4). However, the figures here are based on many assumptions that might not be accurate.

3

The earnings need to be adequate to allow an accumulation of cash to repay the US$198million secured loan (principal) at the end of the 5 years. Unless the new entity can grow its earnings substantially over the next 5 years this will not be possible. Profit before interest and tax attributable to Y is: 6% x (510/(1 – 0.25) + 7.5% x 1150) = 46.0million (assuming interest on overdraft is also 7.5%) Interest payable by Y is: 7.5% x 198million = 14.9million Interest cover = 3.1 times = 46.0/14.9

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Summary The key points to emerge are that: 1

The divestment appears to have few “losers” among the stakeholders and the market appears to be reacting favourably to “insider” information about the divestment. There are no major external threats that would seriously de-rail negotiations.

2

Alternative financing structures The most serious concerns are the methods of financing. The interest payments to the investment bank are very high and leave little or no room for accumulating cash from earnings to repay the principal of the debt and fund future growth. The venture capital entity will certainly not receive its required growth of 25% if 61% of the purchase consideration is via an investment bank. The recommendation is that the financing of the buyout is reconsidered. The buyout team could consider one or more of the following options:   

Negotiate a staged payment to XK – if XK has no immediate need of the funds this could be attractive to both parties. Discuss the venture capital entity taking a larger share of the business. Look for alternative providers of debt or re-negotiate with the investment bank to provide, say, debt with warrants rather than straight debt although this will dilute the equity in the longer term and might not be acceptable to the venture capital entity.

Answer to Question Four (a) Systematic and unsystematic risk Risk that cannot be diversified away is called systematic risk. This risk is due to economic factors which affect the economy as a whole (such as interest rates, recession etc.). Risk that can be reduced by diversifying the securities in a portfolio is unsystematic risk. This risk relates to factors which are unique to a company or of the industry in which it operates. Total risk is the combination of systematic and non-systematic risk. The total risk of a share can be measured by its standard deviation. Systematic risk of a share is measured by its equity beta. Beta is the measurement of systematic risk estimated by considering the volatility of an individual share price movement against the movement in the market as a whole. This is usually undertaken by plotting on a graph movements over time of the individual share price on the vertical axis against movements in the market over the same time period on the horizontal axis. Regression analysis is used to estimate the slope of the line, which is then referred to as beta. An entity with an equity beta greater than 1 would be expected to have systematic risk proportionately greater than the risk of the market. Conversely an equity beta which is less than 1 would suggest systematic risk for that company proportionately less than the risk of the market. However, to use betas it is necessary to assume that betas calculated on the basis of historic information are reliable indicators of current and future risks.

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The following diagram illustrates the difference between unsystematic and systematic risk, showing how unsystematic risk can be diversified away but systematic risk will remain even in a fully diversified portfolio.

(b) Calculations of beta and discount rates To calculate asset betas it is first necessary to “ungear” the proxy companies’ equity betas using the formula below

Bu =

  VE Bg x    VE +VD [1 - t ] 

 VD [1 - t ]  Bd x    VD [1 - t ] + VE 

+

COMPANY A

Bu =

Bu =

1.3 x

  3  3 + 1 [1 - 0 ⋅ 25]   

+

0.3 x

 1[1 - 0.25]  1[1 - 0.25] + 3   

1.04+0.06 = 1.10

COMPANY B

Bu =

0.9

Bu =

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+

0

0.8

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To calculate discount rates using the CAPM it is now necessary to “regear” the ungeared betas for the proposed investments using the formula below. As CIP’s debt is risk free the debt beta for CIP is zero. Bg =

 VE + VD [1 - t ]  Bu x   VE  

INVESTMENT 1 (Proxy company A)

Bg =

1.1 x

 (3 + 2 [1 - 0 ⋅ 25])    3

Bg =

1.65

INVESTMENT 2 (Proxy company B)

Bg =

0.8 x

Bg =

 3 + 2 (1 - 0 ⋅ 25)    3 1.20

The “re-geared” betas can now be used in the CAPM formula to calculate a discount rate. R f + Beta (R m – R f )

Discount rate = INVESTMENT 1

Discount rate = 3% + 1·65 (8% - 3%) =

11.25%

INVESTMENT 2 Discount rate =

3% + 1.2 (8% – 3%) =

9.0%

As the proportion of debt being used to finance the investment is given in the question an argument could be made to estimate the weighted average costs of capital. This will be an estimate as the interest rate on debt is not given and it is therefore necessary to assume the post-tax risk free rate of 3%. This might not be accurate but provides an approximation. INVESTMENT 1 Estimated WACC = (60% x 11.25%) + (40% x 3%) = 6.75% + 1.2% = 7.95% INVESTMENT 2 Estimated WACC = (60% x 9%) + (40% x 3%) = 5.4% + 1.2% = 6.6% Examiner’s note: Credit was given for other valid approaches.

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(c) Benefits and limitations of possible discount rates WACC Using an estimated WACC is a practical expedient for many companies and understood by many non-finance people. The argument against using the WACC would be (a) theory does not support using WACC for investment appraisal other than in very specific circumstances (equivalent risk to the company as a whole and financed in the same proportions), and (b) here it is estimated – how is not explained but unlikely to be based on a theoretically correct formula (for example CAPM). Adjusted WACC These are not theoretically acceptable and suffer from the same problems as the basic WACC. However, as with WACC, they are easily understood by non-finance people and provide a good rule of thumb and at least attempt to reflect in a rough and ready manner the risk of the specific investment against the average investment. CAPM-derived rates This is a theoretically acceptable method of determining a discount rate but it has major limitations in the circumstances here:   

CAPM is a single period model, which is being used to calculate a discount rate for, presumably, a number of years. The risk of the investments could well change over their lives. It is based on historical data and the variance surrounding beta is large; using the CAPM at all can only provide a rough estimate. It also assumes that past variability with the market will continue. CAPM assumes only systematic risk needs to be captured as unsystematic risk has been diversified away. This might not be true in a single, relatively small private company with few shareholders, whereas the proxies are listed companies with, presumably, a large number of unconnected shareholders. Comparisons with proxy companies are difficult as they assume close similarity of activities and business risk. No two companies are exactly alike and even if the activities seem similar their operations could be quite different in terms of business risk.

(d) Explanation of asset and equity betas, investment appraisal and objectives An equity beta is the beta that attaches to a company’s shares; it is this beta that is published. An asset beta reflects business risk assuming a company is ungeared. An asset beta is more useful than an equity beta in Proxy companies A and B because it incorporates the total business risk inherent in those companies, but stripping out the impact of the financing structures of the individual companies. Companies A and B have been selected as proxy companies primarily because they have the same business risk characteristics as Investments 1 and 2. However, the asset beta does not take into account the financing structure of the investments, Therefore, the asset beta needs to be adjusted. This is achieved by regearing the asset (that is, the ungeared) beta and inserting it in the CAPM formula to obtain a geared cost of equity which reflects both

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(a) The business risk of the investment (based on the business risk of the proxy company) and (b) The long-term financing structure.

Using CAPM-derived rates could help determine if CIP’s current use of 12% for all investments is appropriate. For example, the CAPM-derived rates calculated in part (b) suggest that for the investments under consideration lower rates would be more appropriate than 12%. CIP would have rejected investment opportunities that would have been profitable and therefore contributed to the achievement of its objective. On the other hand if the CAPM had suggested rates above 12% then CIP would not be fully compensating shareholders for the risks inherent in its investments, which in the long term might threaten the viability of its business and not just its dividends. However, the limitations of the CAPM described above should not be forgotten and a single company such as CIP might not have the opportunity or desire to diversify away unsystematic risk.

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F3 – financial strategy - the examiner's answers - May 2010