Chapter 11: Corporate failure and reconstruction
Chapter learning Objectives
Upon completion of this chapter you will be able to:
- describe the main indicators of financial distress
- discuss the limitations of corporate failure prediction models and explain other factors which need to be considered
- assess a company situation and assess the risk of corporate failure within the short to medium term using a range of appropriate financial evaluation methods, such as ratios, trends, EVA (TM) and MVA
- list and explain the factors which would suggest a financial reconstruction is the most appropriate strategy for dealing with the problem as presented
- assess a company situation and determine whether a financial reconstruction is the most appropriate strategy for dealing with the problem as presented
- explain the likely response of the capital market and/or individual suppliers of capital to any reconstruction scheme and the impact their response could have upon the value of a firm
- recommend a reconstruction scheme from a given business situation, justifying the proposal in terms of its impact upon the reported performance and financial position of the firm
- list, explain and evaluate the various strategies for unbundling (demerging) parts of a quoted company
- explain how the benefits of the concentration of growth and the maximisation of shareholder value may result from the unbundling of parts of a quoted company
- explain how benefits of the reduction of complexity and increased managerial efficiency may result from the unbundling of parts of a quoted company
- explain how the benefit of the release of financial resources for new investment may result from the unbundling of parts of a quoted company
- define and explain the reasons for a management buyout
- explain the issues to consider when evaluating a management buyout proposal
- explain the sources of finance available for a management buyout
- evaluate and advise on a management buyout proposal in a scenario question.
1 Financial distress and corporate failure
What is corporate failure?
Corporate failure occurs when a company cannot achieve asatisfactory return on capital over the longer term. If unchecked, thesituation is likely to lead to an inability of the company to pay itsobligations as they become due.
If a company is in financial distress, corporate failure willfollow unless the company's problems can be identified and corrected.
Therefore, it is important that we can recognise the main causes of financial distress.
2 The five core causes of financial distress
The five core causes of financial distress in a business are:
- Revenue failure, caused by either internal or external factors. Revenue failure may be through a loss of orders (market failure) or through the acceptance of business which does not contribute to the growth of shareholder value.
- Cost failure, caused by weak cost control, changes in technology, inappropriate accounting policies, inadvertent or exceptional cost burdens, poor financial management or failure of effective governance.
- Failure in asset management, through failure to invest in appropriate technology, poor working capital management, inappropriate write off and reinvestment or poor organisation of the available assets.
- Failure in liability management, through failure to manage the companyâ€™s relationship with the money markets, weak control of interest rate risk and currency risk or unsustainable credit policies.
- Failure of capital management, through either over or under-capitalisation or poor management of the companyâ€™s relationship with the capital markets and in particular the companyâ€™s debt portfolio and the optimisation of its cost of capital.
In practice problems rarely occur in isolation. A business is aninternal and external network of relationships of assets andindividuals, so problems in one area invariably have consequenceselsewhere.
Research into the causes of corporate failure
A major study (Grinyer, Mayes et al., 1988) examined reasons whyfirms experience decline. Chief among the reasons found (in order offrequency) in the study were:
- adverse changes in total market demand
- intensification of competition
- high cost structure
- poor financial controls
- weak management
- failure of a large project
- poor marketing effort
- poor acquisitions
- poor quality.
Clearly, some of these are not, in themselves, strategic issues.Much can be done, by strong management accounting, to reduce costs,improve financial information and controls, improve project managementand quality control systems, without changing strategy. It is alwaysworth repeating the adage that strategic management builds on goodoperations management. No strategy can compensate for operationalinefficiency in the long run.
However, many of the items listed involve changes in the marketplace, and the way that competition is carried out. Strategy is chieflyabout adapting the firm to such changes, and strategic failure resultswhen the organisation does not change as quickly as the market.
An illustration of financial distress
Norman English was a mechanical engineer, who founded his owncompany in the early 1970s, producing automotive parts. His earlysuccesses enabled him to diversify into a wide range of componentmanufacturing, and eventually into assembly of unbranded products. Manyhouseholds are entirely unaware that the product they identify by anexpensive, foreign brand was actually made locally.
In the mid 1980s, the company was floated and attracted favourableCity opinion. New investment was used to launch into several newprojects, and exporting. The latter was particularly well received and,with his forthright views, made Norman English a minor spokesperson forindustry. Public speaking and committee work took a great part of histime. During the 1980s, company size increased by more than five times.
By 1998, Norman was ageing, unwell, and thinking about retirement.For several years, his involvement as CEO had been somewhat peripheral,and he was aware that his middle managers spent some time fighting eachother. In the past, he had seen off such problems with his forcefulpersonality and understanding of the business. The geographical spreadof the company, and the proliferation of information made it extremelyhard for him to keep the issues clear in his mind.
Further, the companyâ€™s financial performance was not good anddividends were low. Manufacturing plant was old, and needed replacement.Product design was also looking dated; the firm had been slow toincorporate microchip technology into its products and was increasinglyforced into producing budget models with little margin.
A widely-circulated report suggested that the export initiative hadnever been profitable, but had consumed a great deal of capital.Nonetheless, investors and lenders wanted to feel that Norman Englishwas still in control.
Is this corporate failure? Give reasons for your answer. How has this arisen?
Although the company has not yet failed, it would seem to be only aquestion of time. When we look back at the purpose of a strategy, wesee that the company is under-performing in most respects. The firm hasfailed to adapt to the environment â€“ it is no longer producing goodsthat top firms wish to be associated with. It has failed to develop itsresource base, both in terms of plant and learning about thecapabilities of recent technologies. It no longer has a sense of purposeabout the future, rather it seems that middle and senior managerscannot even agree on how to manage the business in its present state.Finally, it has confused a strategy â€“ exporting â€“ with the purposeof the strategy, to produce a return on investment.
The problem may have arisen in several ways, but it is likely that aformerly dramatic leader has lost his touch, leaving an absence ofstrategic thinking and energy. There is the added problem that theobvious solution, succession planning, leading to replacement of theCEO, would not be well received by the City. Consequently, thissituation has been allowed to continue for longer than usual.
Identifying financial distress
It is possible to identify a business in financial distress by analysing its financial statements.
- Trends in ratios (such as return on capital employed and receivables collection period) can be used to identify the first signs of distress.
- Declining levels of cash. or reducing Economic Value Added (EVAÂ®) can be a sign of distress.
- Free cash flow analysis can also give an indication of likely problems.
3 Ratio analysis
A comprehensive analysis of performance will cover the followingfour areas: profitability, liquidity, gearing and stock market ratios.
Key ratios are listed under each of these headings below:
Return on capital employed (ROCE), which can be measured aseither net operating profit before tax or net operating profit after tax(NOPAT) as a percentage of capital employed.
EVAÂ® return is the difference between return on capitalemployed (based on NOPAT) and the weighted average cost of capital forthe business.
Asset turnover is the ratio of turnover to capital employed.
Operating profit margin is operating profit expressed as a percentage of turnover.
The most basic measure of liquidity is the current ratio(current assets / current liabilities). However, this ratio is sosimplistic that it is difficult to use it for any meaningful analysis.Instead, it is better to focus on the individual elements of workingcapital separately.
Debtor days (receivables collection period) = (Receivables / Turnover) Ã— 365
Creditor days (payables payment period) = (Payables / Purchases) Ã— 365
Inventory holding period = (Inventory / Cost of sales) Ã— 365
The firm's cash operating cycle is calculated as
Debtor days + Inventory holding period - Creditor days
Generally, a reduction in the overall length of the cycle indicates an improvement in the entityâ€™s liquidity position.
If gearing is too high, the entity might be unable to service its debts. There are two ways of looking at gearing:
Balance sheet (statement of financial position) gearing
Debt value / Equity value, or
Debt value / (Value of equity + debt)
Note that equity value in the accounts is the share capital AND the reserves.
Income statement gearing
The key measure is interest cover = Profit before interest and tax / Interest (Finance charges)
It is usually easier to identify potential problems from the incomestatement figure, since a low figure close to unity gives an immediateand obvious cause for concern. Balance sheet gearing ratios need to becompared (to industry averages and / or prior years) before they can beproperly interpreted.
Stock market ratios
Note that if the entity being analysed is not listed, no calculations will be possible in this area.
However, if the entity is listed, this is arguably the mostimportant area, since the ratios in this area will show whether the restof the market perceives the entity positively or not.
Price-earnings (P/E) ratio = Share price / Earnings per share
Dividend cover = Earnings per share / Dividend per share
Dividend yield = Dividend per share / Share price
4 Economic Value Added (EVAÂ®)
Economic value added (EVAÂ®) is a performance measure developed byStern Stewart & Co that attempts to measure the true economic profitproduced by a company.
It is frequently also referred to as "economic profit", andprovides a measurement of a company's economic success (or failure) overa period of time. Such a metric is useful for investors who wish todetermine how well a company has produced value for its investors, andit can be compared against the company's peers for a quick analysis ofhow well the company is operating in its industry.
Trends in EVAÂ® can be helpful to analyse the performance of a firm - a declining trend may indicate financial distress.
EVAÂ® follows the same principles as residual income by deductingfrom profits a charge for the opportunity cost of the capital invested.
EVAÂ® is defined as:
NOPAT â€“ rC
NOPAT = Net operating profit after tax
r = WACC
C = firmâ€™s invested capital
Market Value Added (MVA)
If EVAÂ® is forecast for each future year and the figures arediscounted to present value, the total discounted EVAÂ® is known as theMarket Value Added (MVA).
Illustration 1: EVA and MVA
Cannon Trading Company (CTC), has 20X5 net after-tax operatingprofits of $200,000 and invested capital of $2 million. Its weightedaverage cost of capital is 8.5%.
(a) Calculate the 20X5 EVAÂ® for CTC.
(b) Calculate the MVA for CTC, assuming that the 20X5 profit is expected to stay constant into perpetuity.
(a) EVAÂ® = Net operating profit after tax - (WACC Ã— invested capital)
=$200,000 - (8.5% Ã— $2 million) = $30,000
(b) MVA = sum of discounted EVAÂ® figures
= (assuming EVAÂ® of $30,000 continues into perpetuity) $30,000 / 0.085
(NB: The value of CTC could then be estimated as
$2m (invested capital) + $352,941 (MVA) = $2, 352,941)
Test your understanding 1: Performance analysis
The following shows the balance sheet (statement of financialposition) and income statement for Zed Manufacturing for the years ended31 December 20X7 and 31 December 20X8.:
Summarised income statement ($m)
Summarised statement of financial position (balance sheet) ($m)
The current share price is $0.80 (it was $1.60 at the end of 20X7), and the firm's WACC is 10%.
Summarise the performance of Zed Manufacturing in20X8 compared with 20X7 based on EVA for each year and using two otherratios you consider appropriate.
5 Assessing the risk of corporate failure â€“ other considerations
Limitations of corporate failure prediction models
There are a number of limitations of ratio analysis as a predictor of corporate failure:
- Ratios are a snapshot â€“ they give an indication of the situation at a given point in time but do not determine whether the situation is improving or deteriorating.
- Further analysis is needed to fully understand the situation, for example a comparison with industry average ratio figures
- Ratios are only good indicators of performance in the short term.
Other corporate failure prediction methods
The development of corporate failure prediction methods
A large amount of research has been carried out into corporatefailure with the aim of developing an accurate model, using a range ofstatistical and modelling techniques. These have taken a number ofdifferent approaches and considered a range of possible variables:
- Some have attempted to estimate the probability of companies of entering a number of possible states, rather than the actual state at a point in time.
- Models have incorporated trend analysis.
- Research has also attempted to take account of variations by industry.
- Other models have included a range of different variables, such as:
- macroeconomic variables
- the quality of management of the company
- the growth phase of the firm
- the quality of the companyâ€™s assets.
Altman's Z score
Altman studied bankrupt manufacturing companies in the USA in 1968and concluded that the bankrupt firms shared common characteristics,which he incorporated in his Z score model. The Z score used ratioanalysis to highlight firms which were likely to fail. It onlyincorporated 5 key ratios and was criticised for being too simplistic.Calculation of the Z score is beyond the syllabus.
The development of the ZETAÂ® score
In order to address the limitations of the Z score, Altman andothers carried out further research and developed the ZETAÂ® score. Thisis a proprietary method and only available to subscribers to thecompany which owns the model â€“ therefore it is not possible to givedetails of the formula here. The approach taken is similar to the Zscore, but the ZETAÂ® score is based on seven variables, with theaddition of an assessment of the stability of the companyâ€™s earningsover a period of five to ten years, and the size of the company based onits total assets.
Argentiâ€™s failure model
From historical data on a wide range of actual cases, Argentideveloped a model, which is intended to predict the likelihood ofcompany failure. The model is based on calculating scores for a companybased on:
- defects of the company e.g. autocratic chief executive, passive board and lack of budgetary control.
- management mistakes e.g. overtrading (expanding faster than cash funding), gearing â€“ high bank overdrafts/loans, failure of large project jeopardises the company.
- the symptoms of failure â€“ deteriorating ratios, creative accounting â€“ signs of windowdressing, declining morale and declining quality.
Beaverâ€™s work in 1966 demonstrated the predictive ability of theoperating cash flow to total debt ratio. Beaver's key indicator of afirm's short term survival was its ability to meet its immediateinterest payments.
Practical indicators of financial distress
You should not think that ratio analysis of published accounts andfree cash flow / EVA analysis are the only ways of spotting that acompany might be running into financial distress. There are otherpossible indicators too. Some of this information might be given to youin an exam case study.
- Information in the published accounts, for example:
- a worsening cash and cash equivalents position shown by the cash flow statement
- very large contingent liabilities
- important post balance sheet events.
- Information in the chairmanâ€™s report and the directorsâ€™ report (including warnings, evasions, changes in the composition of the board since last year).
- Information in the press (about the industry and the company or its competitors).
- Information about environmental or external matter. You should have a good idea as to the type of environmental or competitive factors that affect firms.
Student Accountant article
Read Michael Pogue's July 2008 article "Business Failure" in theStudent Accountant magazine for more details on predicting corporatefailure.
More practical indicators
Going concern evaluation
A useful source of guidance on the troubled company is theInternational Standard on Auditing (ISA) 570. Of particular practicalassistance is paragraph 8, which identifies possible symptoms of goingconcern problems. Examples are outlined below. Again, if you come acrossany of these features in a case study the warning bells should start tosound.
- Net liability or net current liability position.
- Necessary borrowing facilities have not been agreed.
- Fixed-term borrowings approaching maturity without realistic prospects of renewal or repayment; or excessive reliance on short-term borrowings to finance long-term assets.
- Major debt repayment falling due where refinancing is necessary to the entityâ€™s continued existence.
Major restructuring of debt.
- Indications of withdrawal of financial support by debtors and other creditors.
- Negative operating cash flows indicated by historical or prospective financial statements.
- Adverse key financial ratios.
- Substantial operating losses or significant deterioration in the value of assets used to generate cash flows.
- Arrears or discontinuance of dividends.
- Inability to pay creditors on due dates.
- Inability to comply with the terms of loan agreements.
- Change from credit to cash-on-delivery transactions with suppliers.
- Inability to obtain financing for essential new product development or other essential investments.
- Loss of key management without replacement.
- Loss of key staff without replacement.
- Loss of a major market, franchise, licence, or principal supplier.
- Labour difficulties or shortages of important supplies.
- Fundamental changes in the market or technology to which the entity is unable to adapt adequately.
- Excessive dependence on a few product lines where the market is depressed.
- Technical developments which render a key product obsolete.
- Non-compliance with capital or other statutory requirements.
- Pending legal or regulatory proceedings against the entity that may, if successful, result in claims that are unlikely to be satisfied.
- Changes in legislation or government policy expected to adversely affect the entity.
Test your understanding 2
You have been asked to determine whether a company is failing. What areas would your analysis cover?
6 Corporate reconstruction
Corporate reconstruction of a failing company
Companies in financial distress often undergo corporatereconstructions to enable them to remain in business rather than go intoliquidation. Corporate reconstruction in a failing company ofteninvolves raising some new capital and persuading creditors / lenders toaccept some alternative to the repayment of their debts. This willensure that the business continues in the short term.
Longer term, the management need to consider whether thereconstruction will help the company develop a sustainable competitiveadvantage, and provide opportunities for raising further finance.
Options open to failing companies
Options open to failing companies not wishing to go intoliquidation, and which allow space for the development of recoveryplans, usually include:
- a Company Voluntary Arrangement (CVA)
- an administration order.
Reconstruction of failing companies
(1) A Company Voluntary Arrangement (CVA)
This is a legally binding arrangement between a company and itscreditors. It may involve writing off debit balances on the profit andloss account against shareholdersâ€™ capital and creditorsâ€™ capitaland therefore affects creditorsâ€™ rights. However it is designed toensure that the return to creditors is maximised. It is useful incompanies under pressure from cash flow problems.
The procedure is as follows:
- An application is made to the court, asking it to call a meeting between the company and its creditors or a class of creditor, e.g. debenture holders.
- The scheme of reconstruction is put to the meeting and a vote taken.
- If there is 75% in value and including proxies vote in favour the court will be asked to sanction it.
- If the court sanctions it, the scheme is then binding on all the creditors.
(2) Administration orders
Administration orders were introduced to allow space for arecovery plan to be put in place. The company, its Directors or one ofthe creditors can apply for an order. The company continues to tradewhilst plans are put in place to rescue the company or achieve a betterreturn for the creditors than if the company were liquidatedimmediately.
The use of an administration order
Consider the case of a manufacturing company which has becomeinsolvent. There are also indications of poor credit control, andproduction problems including long lead times, high defect rates andhigh levels of stock. However there is a growing market for thecompanyâ€™s products which are well-designed.
The company was put into administration to allow for a recoveryplan to be developed. Its debts were written down and creditors and thebank given equity in the business. New management was brought in whichimproved the production and financial management and turned round thecompany which is now profitable.
Test your understanding 3
Why might the decision be made to liquidate a failing company rather than attempt to carry out a reconstruction?
Corporate reconstruction of a solvent company
Corporate reconstructions can also be undertaken by successfulcompanies. The specific objectives of the reorganisation /reconstruction maybe one or more of the following:
- To reduce net of tax cost of borrowing.
- To repay borrowing sooner or later.
- To improve security of finance.
- To make security in the company more attractive.
- To improve the image of the company to third parties.
- To tidy up the balance sheet.
Options for solvent companies
There are four main types of reorganisation used by solvent companies, depending on the individual situation. These are:
- conversion of debt to equity
- conversion of equity to debt
- conversion of equity from one form to another
- conversion of debt from one form to another.
Reconstruction of solvent companies
1 Conversion of debt to equity
The most likely reasons for converting debt to equity are:
- Automatically by holders of convertible debentures exercising their rights.
- In order to improve the equity base of a company. This situation is particularly likely to arise when a company has financed expansion by short-term borrowings. Sooner or later, it will run into working capital problems, and if long-term loan funds are not available (because, for example, they would make the gearing excessively high) the only solution is to issue new shares, possibly by way of a rights issue.
2 Conversion of equity to debt
Conversion of equity to debt usually involves the conversion ofpreference shares to some form of debenture. Although through the eyesof both companies and investors there is little to choose betweendebentures or preference shares bearing a fixed rate of return, in theeyes of both tax and company law they are very different:
- From the tax point of view, payments to preference shareholders are dividends, and are not, therefore, an allowable charge in computing taxable profits.
- From the legal point of view, conversion of preference shares into debentures constitutes a reduction of capital. Company law provisions relating to redemption of shares must therefore be followed. In accounting terms the broad effect of these provisions is to reduce distributable profits by the nominal value of the preference shares redeemed (by transferring amounts from distributable profit to capital redemption reserve).
3 Conversion of equity from one form to another
- Simplifying the capital structure. It was once common to have a variety of types of share capital, designed to appeal to a variety of investors. This has now become less favoured, and the tendency is to have only one, or at most two, classes of share capital. Conversion of shares from one type to another can only be carried out in accordance with the procedures in the articles, normally approved by a prescribed majority of the class affected, subject to rights of appeal to the court.
- Making shares more attractive to investors, for example by sub-division into smaller units, or conversion into stock.
- Eliminating reserves by issuing fully paid bonus shares. This is very much a tidying up operation, and may be especially useful to remove share premium accounts and capital redemption reserves. Additionally, in a period of inflation, it may be recognising the fact that a substantial part of the revenue reserves could never be paid out as dividends.
4 Conversion of debt from one form to another
This procedure might be undertaken to improve security, flexibility or cost of borrowing. For example:
- Security â€“ Consider the example of a company financing itself out of creditors and overdraft facilities, neither of which give any security. Rather than a rights issue, converting the creditors to long-term loans, e.g. debentures, would be equally satisfactory in that it would give security as to the source of funds.
- Flexibility â€“ Again, a company financing itself out of short-term borrowings has little room to manoeuvre. Flexibility could be improved by arranging more permanent financing. Alternatively, a company already borrowing to the limits of its ability could reduce its borrowings and improve flexibility by using other sources of finance â€“ leasing for example.
- Cost â€“ Some loan finance is cheaper than others for example secured loans compared with unsecured loans. An opportunity may arise to shift from a relatively high cost to a relatively low cost source of funds.
The legal aspects of corporate reconstruction
Reconstruction schemes may be undertaken in companies which are healthy or those in financial difficulties.
The boundary line between these two types of scheme is not clearcut. Some provisions of company law can be used by both types ofcompany.
For example the capital reduction provisions of S135 in the UKCompanies Act 1985 can be used by a company to tidy up its balance sheetreserves or to write off debit balances arising from trading losses sothat further finance can be obtained.
7 Devising a corporate reconstruction scheme
General principles in devising a scheme
In most cases the company is ailing:
- Losses have been incurred with the result that capital and long-term liabilities are out of line with the current value of the companyâ€™s assets and their earning potential.
- New capital is normally desperately required to regenerate the business, but this will not be forthcoming without a restructuring of the existing capital and liabilities.
The general procedure to follow would be:
(1) Write off fictitious assetsand the debit balance on profit and loss account. Revalue assets todetermine their current value to the business.
(2) Determine whether thecompany can continue to trade without further finance or, if furtherfinance is required, determine the amount required, in what form(shares, loan stock) and from which persons it is obtainable (typicallyexisting shareholders and financial institutions).
(3) Given the size of thewrite-off required and the amount of further finance required, determinea reasonable manner in spreading the write off (the capital loss)between the various parties that have financed the company (shareholdersand creditors).
(4) Agree the scheme with the various parties involved.
The impact on stakeholders
The interests of a number of different stakeholder groups must betaken into account in a reconstruction. A reconstruction will only besuccessful if it manages to balance the different objectives (risk andpotential return) of:
- ordinary shareholders
- preference shareholders
- creditors, including trade payables, bankers and debenture holders
In a failing company, the reconstruction should be organised sothat the main burden of any loss falls on the ordinary shareholders.
Test your understanding 4
Why is it important to consider the interests of shareholders in developing a reconstruction scheme?
Different stakeholder requirements
- Solvent companies often enter reconstruction schemes to improve their ability to raise finance in the future by making security in the company more attractive or to improve the image of the company to third parties. The view taken of the scheme by banks and investors is therefore vital in ensuring that this aim is achieved.
- Banks have been criticised in the past for being too quick to close down failing companies in order to protect their investment at the expense of others â€“ it is important that they are initially supportive and allow time for decisions about the companyâ€™s future to be made with the full co-operation of all stakeholders.
- The design of a reconstruction scheme for a failing company needs to take into account the interests of:
- ordinary shareholders
- preference shareholders
- In a failing company the main burden of the losses should be borne primarily by the ordinary shareholders, as they are last in line in repayment of capital on a winding up. In many cases, the capital loss is so great that they would receive nothing upon a liquidation of the company. They must, however, be left with some remaining stake in the company if further finance is required from them.
- Preference shares normally give holders a preferential right to repayment of capital on a winding up. Their loss should be less than that borne by ordinary shareholders. They may agree to forgo arrears of dividends in anticipation that the scheme will lead to a resumption of their dividends.
- If preference shareholders are expected to suffer some reduction in the nominal value of their capital, they may require an increase in the rate of their dividend or a share in the equity, which will give them a stake in any future profits.
- Creditors, including debenture and loan stock-holders may agree to a reduction in their claims against the company if they anticipate that full repayment would not be received on liquidation. Like preference shareholders, an incentive may be given in the form of an equity stake.
- In addition trade creditors may also agree to a reduction if they wish to protect a company which will continue to be a customer to them.
Test your understandingion 5: Wire Construction Case Study Part 1
Case study â€“ Wire Construction plc
Wire Construction plc has suffered from losses in the last threeyears. Its statement of financial position (balance sheet) as at 31December 20X1 shows:
Sales have been particularly difficult to achieve in the currentyear and inventory levels are very high. Interest has not been paid fortwo years. The debenture holders have demanded a scheme ofreconstruction or the liquidation of the company.
Show the likely position of the key stakeholders (ordinaryshareholders, preference shareholders and debenture holders) if the firmgoes into liquidation. Assume that
(1) The investment is to be sold at the current market price of $60,000.
(2) 10% of the receivables are to be written off.
(3) The remaining assets were professionally valued as follows:
Illustration 2: Wire Construction Part 2
Continuing with the information on Wire Construction from the previous Test Your Understanding:
During a meeting of shareholders and directors, it was decided tocarry out a scheme of internal reconstruction. The following scheme hasbeen proposed:
(1) Each ordinary share is to be re-designated as a share of 25c.
(2) The existing 70,000preference shares are to be exchanged for a new issue of 35,000 8%cumulative preference shares of $1 each and 140,000 ordinary shares of25c each.
(3) The ordinary shareholdersare to accept a reduction in the nominal value of their shares from $1to 25c, and subscribe for a new issue on the basis of 1 for 1 at a priceof 30c per share.
(4) The debenture holders are toaccept 20,000 ordinary shares of 25c each in lieu of the interestpayable. It is agreed that the value of the interest liability isequivalent to the nominal value of the shares issued. The interest rateis to be increased to 9Â½% and the repayment date deferred for threeyears. A further $9,000 of this 9Â½% debenture is to be issued and takenup by the existing holders at $90 per $100.
(5) The profit and loss account balance is to be written off.
(6) The bank overdraft is to be repaid.
(7) It is expected that, due tothe refinancing, operating profits will be earned at the rate of $50,000pa. after depreciation but before interest and tax.
(8) Corporation tax is 21%.
Prepare the statement of financial position (balancesheet) of the company, assuming that the proposed reconstruction hasjust been undertaken.
Tutorial note: in a question like this, do not waste timeproducing a statement of financial position unless it is specificallyasked for by the examiner.
Statement of financial position at 1 January 20X2 (after reconstruction)
Tutorial note: as $12,800 of debenture interest is to becancelled for $5,000 nominal of ordinary shares the excess is sharepremium (i.e. the consideration for the shares is deemed to be theliability removed.
Test your understanding 6: Wire Construction Part 3
Advise the shareholders and debenture-holders as to whether they should support the Wire Construction plc reconstruction.
More detail on the Wire Construction Case Study
Reconstruction account, relating to the second part of the case study
Note: The capital reconstruction account can be proved as follows:
Detailed advice to shareholders and debenture holders, relating to the third part of the case study
It follows that the scheme must be favourable to thedebenture-holders if it is to have success. The holders are beingoffered an increased rate of interest but an extended repayment date.
The expected interest cover is reasonable:
In financial terms it is a matter of comparing the prospective rateof interest with interest rates currently available elsewhere.
The preference shareholders are having half of their investmentturned into equity. This is very reasonable as about half their capitalwould be lost on a liquidation. They will have 140,000/560,000 Ã— 100 =25% of the ordinary share capital. In addition they will have anincreased dividend rate and are not required to contribute any furthercapital.
The ordinary shareholders retain part of their stake in the companyif they participate 200,000/560,000 = 36% without any further cashinvestment. The further cash investment required of $50,000 leaves themwith the majority holding.
The expected available earnings will be:
However, as the shareholders would receive nothing on aliquidation, the additional expected return to them is twice 5.4c pershare i.e.:
On old shareholding
200,000 Ã— 5.4c
On new shareholding
200,000 Ã— 5.4c
This therefore seems a reasonable proposition to the ordinary shareholders.
Test your understanding 7: Another reconstruction example
BDJR Computers Global is a company that manufactures a range ofpersonal computers that are sold to retailers, and also directly toindividuals and businesses through online sales.
Due to a number of technical problems the companyâ€™s sales havefallen significantly over the last year resulting in an operating lossof $160,000. The company has, as a result, built up losses on itsretained earnings and there is a significant risk of insolvency.
To avoid this, the companyâ€™s financial advisers have proposed a scheme of reconstruction.
Balance Sheet at 31/12/20X9 (statement of financial position)
(1) If the company was liquidatedall of the assets could be sold for their book values except forinventory. Following a review it was discovered that $220k of theinventory is obsolete but the remainder could be sold for book value. Inaddition $90k of the receivables is irrecoverable.
(2) To be successful a scheme of reconstruction would need to raise $195k of cash to invest in new manufacturing processes.
(3) Given the risk attached to the company any providers of new equity capital will require a return of at least 18%.
(4) The current interest rates are 8% on the bank loan and 6% on the overdraft. The bank loan is secured.
The following scheme of reconstruction is proposed:
(1) The nominal value of each existing share will be reduced to 50c.
(2) Goodwin bank (who provide boththe overdraft and loan) will convert half of the overdraft and 1/3 ofthe loan into a total of 200,000 new shares.
(3) New finance of Â£400k will beraised from a venture capital company, PC ventures, who will buy newshares for $1.25 per share. In addition to investing in the newmanufacturing process the finance will also be used to repay thepayables.
(4) Following the reconstructionit is expected that the company will generate $320K of profit beforeinterest and tax per annum. Tax is payable at 28%. Assume no tax losses.
(a) Determine how much each of the original investors in likely to get in the event of a liquidation.
(b) Following the reconstructioncalculate the expected EPS, and the return on equity to the venturecapital company, and advise as the whether the venture capital companyis likely to invest in BDJR computers.
(c) From the post reconstructionEPS calculation above calculate the effective return that the bank islikely to receive on the capital converted into equity.
(d) Determine whether the existing ordinary shareholders, and the bank, are likely to accept the scheme.
8 Business reorganisation methods
Unbundling is the process of selling off incidental non-corebusinesses to release funds, reduce gearing and allow management toconcentrate on their chosen core businesses. The main aim is to improveshareholder wealth. Unbundling can take a number of forms:
- Spin-offs, or demergers, in which the ownership of the business does not change, but a new company is formed with shares in the new company owned by the shareholders of the original business. This results in two or more companies instead of the original one.
- Sell-offs, which involves the sale of part of the original company to a third party, usually in return for cash.
- Management buyouts, in which the management of the business acquires a substantial stake in and control of the business which they managed.
- Liquidation, when the entire business is closed down, the assets sold and the proceeds distributed to shareholders. This is done when the owners of the business no longer want it or the business is not seen as viable.
The rest of this chapter explains these unbundling options in detail.
Test your understanding 8
Why might shareholders support the unbundling of a diversified organisation?
Spin-offs or demergers
The aim of a demerger is to create separate businesses whichtogether have a higher value than the original company. Following ademerger:
- shareholders own the same proportion of shares in the new business or businesses as they did in the previous one
- each company owns a share of the assets of the original company
- the new company or companies generally have new management who can take the individual companies in diverging directions; and each company could eventually be sold separately
- the original company may no longer exist, with all its assets distributed to the new business.
A company may sell-off parts of the business for a number of reasons, such as:
- to raise cash
- to prevent a loss-making part of the business from lowering the overall performance business
- to concentrate on the core areas of the business
- to dispose of a desirable part of the business to protect the rest from the threat of a takeover.
What is a management buy-out?
Overall the distinguishing feature of an MBO is that a group ofmanagers acquires effective control and substantial ownership and formsan independent business. Several variants of an MBO may be identifiedand are explained below:
- Management buy-out â€“ where the executive managers of a business join with financing institutions to buy the business from the entity which currently owns it. The managers may put up the bulk of the finance required for the purchase.
- Leveraged buyout â€“ where the purchase price is beyond the financial resources of the managers and the bulk of the acquisition is financed by loan capital provided by other investors.
- Employee buyout â€“ which is similar to the above categories but all employees are offered a stake in the new business.
- Management buy-in â€“ where a group of managers from outside the business make the acquisition.
- Spin-out â€“ this is similar to a buyout but the parent company maintains a stake in the business.
Example of a MBO (Springfield ReManufacturing Corporation)
One of the most well-known examples of a management buy-out is theSpringfield ReManufacturing Corporation (SRC) in 1982. Prior to thebuy-out the company was the Springfield, Missouri unit of InternationalHarvester, a manufacturer of agricultural and construction equipment inthe USA. The unit remanufactured components for the companyâ€™sconstruction division.
In 1981 although the unit was profitable, International Harvesterwas in significant difficulties and decided it no longer needed theSpringfield unit. However a group of managers led by Jack Stack, now CEOof SRC Holdings Corporation, kept the plant running and eventuallybought the unit.
SRC Holdings now owns more companies, all extremely successful.
Reasons for a management buy-out
Opportunities for MBOs may arise for several reasons:
- The existing parent company of the â€˜victimâ€™ firm may be in financial difficulties and therefore require cash.
- The subsidiary might not â€˜fitâ€™ with the parentâ€™s overall strategy, or might be too small to warrant the current management time being devoted to it.
- In the case of a loss-making part of the business, selling the subsidiary to its managers may be a cheaper alternative than putting it into liquidation, particularly when redundancy and other wind-up costs are considered.
- The victim company could be an independent firm whose private shareholders wish to sell out. This could be due to liquidity and tax factors or the lack of a family successor to fill the owner-manager role.
Advantages of buy-outs to the disposing company
There are a number of advantages to the parent company:
- If the subsidiary is loss-making, sale to the management will often be better financially than liquidation and closure costs.
- There is a known buyer.
- Better publicity can be earned by preserving employeeâ€™s jobs rather than closing the business down.
- It is better for the existing management to acquire the company rather than it possibly falling into the hands of competitors.
Advantages to the acquiring management
The advantages to the acquiring management are that:
- it preserves their jobs
- it offers them the prospect of significant equity participation in their company
- it is quicker than starting a similar business from scratch
- they can carry out their own strategies, no longer having to seek approval from head office.
Issues to be addressed when preparing a buy-out proposal
MBOs are not dissimilar to other acquisitions and many of the factors to be considered will be the same:
- Do the current owners wish to sell? The whole process will be much easier (and cheaper) if the current owners wish to sell. However, some buy-outs have been concluded despite initial resistance from the current owners, or in situations of bids for the victim from other would-be purchasers.
- Will the new business be profitable? Research shows that MBOs are less likely to fail than other types of new ventures, but several have collapsed. As the new owners the management team must ensure that the business will be a long-run profit generator. This will involve analysing the performance of the business and drawing up a business plan for future operations.
- If loss-making, can the new managers return it to profitability? Many loss-making firms have been returned to profitability via management buyouts. Managers of a subsidiary are in a unique position to appreciate the potential of a business and to know where cost savings can be made by cutting out â€˜slackâ€™.
- What will be the impact of loss of head office support? On becoming an independent firm many of the support services may be lost. Provision will have to be made for support in areas such as finance, computing, and research and development. Although head office fees might be saved after the buyout these support services can involve considerable expense when purchased in the outside market.
- What is the quality of the management team? The success of any MBO will be greatly influenced by the quality of the management team. It is important to ensure that all functional areas are represented and that all managers are prepared to take the required risks. A united approach is important in all negotiations and a clear responsibility structure should be established within the team.
- What is the price? The price paid will be crucial in determining the long-term success of the acquisition. Care must be taken to ensure that all relevant aspects of the business are included in the package. For example, trademarks and patents may be as important as the physical assets of the firm. In a similar way responsibilities for costs such as redundancy costs must be clearly defined.
- Is the deal in the best interests of shareholders? Managers known to the existing owners may be able to secure the buyout at a favourable price, and the final price paid will be a matter for negotiation. However, the current directors of the firm have a responsibility to shareholders to obtain the best deal possible, which may mean a full â€˜commercialâ€™ price being paid for the victim company.
Sources of finance for buy-outs
For small buy-outs the MBO, the price may be within thecapabilities of the management team, but the acquiring group usuallylack the financial resources to fund the acquisition. Severalinstitutions specialise in providing funds for MBOs. These include:
- the clearing banks
- pension funds and insurance companies
- merchant banks
- specialist institutions such as the 3i group and Equity Capital for Industry
- government agencies and local authorities, for example regional development agencies.
Different types of finance
The types of finance and the conditions attached vary between the institutions. Points to be considered include:
- The form of finance â€“ Some institutions will provide equity funds. However, more commonly loan finance will be advanced. Equity funds will dilute the management teamâ€™s ownership but on the other hand high gearing could put substantial strain on the firmâ€™s cash flow. Leveraged buyouts, with gearing levels up to 20:1, have been known.
- Duration of finance â€“ Some investors will require early redemption of loans and will provide funds in the form of redeemable loan stock or preference shares. Others may accept longer-term involvement and look to an eventual public flotation as an exit from the business.
- The involvement of the institution â€“ Some institutions may require board representation as a condition of providing funds.
- Ongoing support â€“ The management team should also consider the institutionâ€™s willingness to provide funds for later expansion plans. Some investors also offer other services such as management consultancy to their clients.
- Syndication â€“ In large buyouts it is possible that a syndicate of institutions may be required to provide the necessary funds.
- The need for financial input from the management team â€“ All institutions will look for a â€˜significantâ€™ input of finance from the management team relative to their personal wealth as a demonstration of their commitment. Managers can expect to have to plough in their redundancy payments, take second mortgages on their homes and often provide personal guarantees on loans.
- The need for a business plan â€“ Institutional investors will also expect to see a well-prepared business plan and usually an investigating accountant and a technical advisor will be employed to investigate the proposal.
- Other sources of finance â€“ The management team can also look for other sources of finance to assist in the MBO. Hire purchase or leasing of specific assets may ease initial cash flow problems. Government grants might be available for certain firms, and the managersâ€™ and employeesâ€™ pension scheme may be available to provide some of the required finance.
The management buy-out industry has developed a range of colourful jargon terms over its period of existence, such as:
- BIMBO - A deal involving both a buy-in by outside managers and a buy-out by current managers has been coined a bimbo by Investors in Industry (the 3i group) and unfortunately the name has stuck. Around 50% of recent deals take this form.
- Caps, floors and collars are limits to which the interest rate charged in a leveraged buy-out can respectively rise, fall and range between.
- Junk bonds are trade-able high yielding unsecured debt certificates issued by companies in US leveraged buy-outs. Their equivalent in the UK is mezzanine finance, though this is less easily traded than junk bonds since it is not usually issued in certificate form.
- Lemons are deals that go wrong.
- Plums are successful deals.
- The living dead are companies which just earn enough cash to pay the interest on their borrowings, but no more. They can continue indefinitely, but are never expected to flourish.
- A ratchet arrangement permits managers to be allocated a larger share of the companyâ€™s equity if the venture performs well. It is intended as an incentive arrangement to encourage managers to be committed to the success of the company.
Assessing the viability of buy-outs
Both the management buy-out team and the financial backers willwish to be convinced that their proposed MBO will succeed. It isimportant to ask the following questions:
- Why do the current owners wish to sell? If the owners are trying to rid themselves of a loss-making subsidiary, are the new management being over-confident in believing that they can turn it round into profitability?
- Does the proposed management team cover all key functions? If not, new appointments should be made as soon as possible.
- Has a reliable business plan been drawn up, including cash flow projections, and examined by an investigating accountant?
- Is the proposed purchase price too high?
- Is the financing method viable? The trend is now away from highly geared buy-outs.
Test your understanding 9
Identify some advantages and disadvantages of management buy-outs.
Numerical example of a management buy-out
Example question â€“ Management buy-out
(a) The following information relates to the proposed financing scheme for a management buy-out of a manufacturing company.
Loans are repayable over the next five years in equalinstalments. They are secured on various specific assets, includingproperties. Interest is 12% pa.
The manufacturing company to be acquired is at present part of amuch larger organisation, which considers this segment to be no longercompatible with its main line of business. This is despite the fact thatthe company in question has been experiencing a turnover growth inexcess of 10% pa.
The assets to be acquired have a book value of â‚¬2,250,000, but the agreed price was â‚¬2,500,000.
You are required to write a report to the buy-out team, appraising the financing scheme.
(b) What problems are likely tobe encountered in assembling a financing package in a management buy-outof a service company as opposed to a manufacturing company?
To: Buy-out team
From: Consulting accountant
Subject: MBO Financing Scheme
The financing scheme involves the purchase of assets with a netbook value of â‚¬2,250,000 for an agreed price of â‚¬2,500,000. Thefinance that will be raised will provide funds of â‚¬2,850,000 in theform of:
Of the funds raised only â‚¬350,000 will be available to thebusiness after the purchase price has been paid. This will be in theform of unused overdraft facilities.
As is common to MBOs the gearing level will be very high. Thereis only â‚¬250,000 of equity compared to â‚¬2,250,000 of debt finance(including the preference shares and excluding the unused element of theoverdraft). The gearing level will mean that the returns to equity willbe risky, but the buyout team own 40% of a â‚¬2.5 million company foran investment of only â‚¬100,000. The rewards are potentially very high.
One consequence of the level of gearing is that it will bedifficult to raise any additional finance. There are unlikely to be anyassets that are not secured, and in any case the level of interest andloan repayments would probably prohibit further borrowing.
The annual cash commitments from the financing structure are summarised below:
Annual payments will have to be made in the repayment of capital and interest on the â‚¬700,000 loan. The annual amount will be:
Â£700,000/3.605* = â‚¬194,175
- The cumulative discount factor for 5 years at 12%.
(ii) Redeemable preference shares
The redeemable preference shares will be either cumulativeor non-cumulative. Assuming that they are cumulative â‚¬120,000 will, onaverage, have to be paid every year. There is a little flexibility inthat if the dividend cannot be met it can be postponed (but notavoided).
The redeemable preference shares will have to be repaidafter 10 years. This can either be provided for over the 10 years, or analternative source of finance found to replace the funds. Assuming thatthey will be required to be provided for according to the terms of thefinancing package this will require a commitment of â‚¬120,000 pa.
The element of the overdraft used to finance the purchaseprice is effectively a source of long term finance. The rate of interestis not known but if we make the (unrealistic) assumption that it isalso at 12%, then the â‚¬350,000 drawn down will cost â‚¬42,000 pa. Intotal there will be a commitment to pay approximately â‚¬476,000 pa.
This will be the first priority of the new company. Themanagement team will need to generate sufficient funds from the onlyavailable source, operations, in order to meet this commitment.
Other cash requirements
Apart from the need to generate cash to satisfy therequirements of the financing scheme the company will also need togenerate funds to invest in working capital and fixed assets asrequired. At the moment these capital requirements are unknown. In thecontext of 10% annual growth in turnover, however, they might exceed theunused element of the overdraft facility.
By virtue of their stake in the company of 60% of the equitythe financial institutions hold the controlling stake. This will beenhanced by their position as the providers of the remainder of thefinance. Consequently the institutions will able to determine manyaspects of the companyâ€™s management, including the appointment ofdirectors. The institutions are likely to have two overridingobjectives:
(i)The security of loan andinterest repayments. Any breach of the loan arrangements might triggerthe appointment of administrators or receivers, and the institutionsâ€™investment would almost certainly be lost.
(ii) Realising their equityinvestment. The institutional investors will probably expect to realisetheir investment in a relatively short time frame. This is commonly setat between 5 and 7 years.
Apart from the requirement to generate cash as noted above thecompany must also generate steady profit growth. The institutionalinvestors will require a history of profit growth in order to enable thesale of their stake through either flotation or a trade sale.
The financing scheme will place a heavy cash burden on thecompany, particularly in the early years. The involvement of theinstitutions will perhaps prove unwelcome, but the MBO would beimpossible without accepting it.
(b) There are three main problems particular to arranging a finance package for a service company.
(i)The lack of tangible assets
Because MBOs normally have to be highly geared there is arequirement to provide security for the loans in a package. Servicecompanies commonly have a very low level of tangible assets. It willtherefore be difficult to attract much debt finance.
(ii) â€˜Peopleâ€™ businesses
The success of service companies depends on their staff.Institutions tend to view such success with suspicion because people,unlike plant and machinery, can resign. Unless the people in questionare tied into the company within the MBO financing package by, forexample, insisting on their investing in equity there is littleguarantee that they will stay with the company.
The nature of most service businesses is that they have unusuallyhigh working capital requirements. The main expense for a servicecompany is staff costs. It is almost impossible to take extended creditfrom staff without losing their services. The supplies of servicecompanies often involve a long period of work before customers can bebilled. Consequently, a finance package would have to provide for theworking capital, and working capital finance is particularly riskybecause it is difficult to secure and so may be equally difficult toraise.
Evaluating the benefits of reorganisations
Concentration of growth and maximisation of shareholder value
Following the unbundling of a company the resulting value of thenew businesses can exceed that of the original business. This suggeststhat the shares in the original business were selling for less thantheir potential value and can be for a number of reasons:
- The splitting-off of non-core activities from the rest of the business may increase the visibility of an under-valued asset which is then valued more highly by the market.
- Businesses may be valued more highly in the hands of the new managers than under the previous management.
- The sale of less profitable parts of the business may be viewed favourably by the market, result in an increased valuation for the remainder.
- The performance of the individual businesses may improve, also resulting in a higher valuation.
Reduction in complexity and improved managerial efficiency
Since the 1980s, increasing numbers of demergers and sell-offs havetaken place in order to reduce the complexity of the organisation:
- Diversified businesses are complex to manage. As the pace of change and uncertainty facing organisations has increased, the complexity of large businesses becomes more difficult to cope with and absorbs management time and energy which is diverted from the business itself.
- Smaller companies tend to be more flexible and respond more easily to change.
- Following a demerger, the new companies have a clearer, more focused management structure.
- Improved managerial effectiveness also results from the splitting off of non-core businesses as managers are free to concentrate on what they do best.
- Changes in the market can also mean that benefits of synergy no longer exist, and there is no longer any business reason for the organisation to retain unrelated businesses.
The release of financial resources for new investment
Unbundling parts of the company can also release financial resources:
- selling a loss-making part of the business which is absorbing funds can release cash to invest in the core businesses or new activities
- a reduction in the size and complexity of the organisation can reduce the central management costs, freeing up resources
- unbundling generates a lump sum in proceeds which can be invested in a specific project
In October 2006 GUS plc, a major UK retail and business servicesconglomerate, completed the process of demerger into three separatebusinesses. Burberry, a luxury brand, was demerged first, and theremaining company was demerged in October 2006 into Experian, a providerof analysis and information services, and Home Retail Group, a majorhome and general retailer.
This demerger was the culmination of a strategy to maximiseshareholder wealth by focusing on a small number of high-growthbusinesses. Other parts of the business were sold off to raise funds forreinvestment. Among the reasons given for the demerger were:
- the lack of synergy between the businesses
- separate opportunities for investment for shareholders
- allowing the independent businesses to pursue individual strategies and benefit from a better management focus.
9 Chapter summary
Test your understanding answers
Test your understanding 1: Performance analysis
Net operating profit after tax - (WACC Ã— Capital invested)
20X7: 100 Ã— (1-0.50) - (10% Ã— 473) = $2.7m
20X8: 57 Ã— (1-0.50) - (10% Ã— 542) = ($25.7m)
Tutorial note: It is often considered to be better tocalculate EVAÂ® based on the opening capital invested figure (at thestart of the year). However, when given so little information in aquestion, the closing capital figure is used each year so that acomparison between the two years can be made.
This is a worrying trend. In 20X7 Zed generated a positive EVAÂ®showing that shareholder value was increased in that year. However, the20X8 figure is negative, showing a reduction in shareholder value.
This has been caused by a drop in profitability, coupled with anincrease in the capital invested. Zed cannot afford to service itscurrent level of finance from the low level of profits generated in20X8.
If the level of profitability cannot be increased soon, the firmfaces the real possibility of corporate failure in the medium term.
Other appropriate ratios
Tutorial note: The question asked for two other ratios. More have been presented here for illustration purposes.
Return on Capital Employed (based on pre tax operating profit)
20X7: 100 / 473 = 21.1%
20X8: 57 / 542 = 10.5%
Return on Capital Employed (based on post tax operating profit)
20X7: 100 (1-0.50) / 473 = 10.6%
20X8: 57 (1-0.50) / 542 = 5.3%
= ROCE - WACC
20X7: 10.6% - 10% = 0.6%
20X8: 5.3% - 10% = (4.7%)
These three ratios all show a declining performance.
In 20X7, Zed had a much higher level of ROCE, indicating that thefirm was generating far more profit from its capital invested. However,as profitability fell in 20X8, the ROCE fell and now the EVAÂ® return isnegative, indicating that the percentage return being generated is notsufficient to meet the required returns of the investors.
= (Receivables / Turnover) Ã— 365
20X7: (105 / 840) Ã— 365 = 46 days
20X8: (132 / 830) Ã— 365 = 58 days
= (Payables / Cost of sales) Ã— 365
(Cost of sales used since purchases is not given)
20X7: (133 / 554) Ã— 365 = 88 days
20X8: (122 / 591) Ã— 365 = 75 days
Inventory holding period
= (Inventories / Cost of sales) Ã— 365
20X7: (237 / 554) Ã— 365 = 156 days
20X8: (265 / 591) Ã— 365 = 164 days
Cash operating cycle
= Debtor days + Inventory holding period - Creditor days
20X7: 46 + 156 - 88 = 114 days
20X8: 58 + 164 - 75 = 147 days
The liquidity position of Zed has worsened between 20X7 and 20X8.
Both inventory holding period and debtor days have increased,indicating perhaps a lack of control over working capital levels. At thesame time, the creditor days figure has fallen, indicating that Zed isbeing pushed by its creditors to pay sooner. This may indicate thatcreditors are becoming worried about the ability of Zed to meet itsobligations.
Balance sheet: Debt / Equity
20X7: 74 / 399 = 19%
20X8: 94 / 448 = 21%
Income statement: Interest cover = Profit before interest / Interest
20X7: 100 / 6 = 16.7 times
20X8: 57 / 8 = 7.1 times
Gearing is not a problem at the moment for Zed.
The gearing ratio is low and relatively stable, while the interestcover is high. Even with the drop in profitability in 20X8, Zed's profitis still large enough to cover the low level of debt interest payable.
= Share price / Earnings per share
N.B Zed has 100m / 0.50 = 200m shares
20X7: 1.60 / (49 / 200m) = 6.5
20X8: 0.80 / (26 / 200m) = 6.2
The share price has halved between 20X7 and 20X8, and the P/E ratiohas also fallen. This is a worrying trend. The market seems to belosing confidence in Zed.
Test your understanding 2
The analysis is likely to include:
- The calculation of score based on a corporate failure prediction model such as the Z score, with a trend over several years.
- An analysis of key ratios, including trends.
- Changes in the cash flow of the business.
- An analysis of the company report to identify any significant changes over the year.
- An assessment of the environment facing the company and any opportunities and threats.
- An assessment of the strengths and weaknesses of the company.
Test your understanding 3
Possible reasons include:
- The main reason for the companyâ€™s failure is that there is no longer a market for its products.
- The level of assets is so low that there is no chance of covering any of the companyâ€™s debts.
- The management of the company and the creditors are not prepared to co-operate with one another, making it impossible to agree a way forward.
Test your understanding 4
The shareholders are important for the future financing of thebusiness. If they are not happy with the scheme or donâ€™t retain astake in the business they will not invest in the company in the future.
However, the ordinary shareholders have the most to gain if thecompany performs well, so it is only fair that if the company isfailing, they should bear the greatest loss.
Balancing these two factors is key to the success of the reconstruction.
Test your understanding 5: Wire Construction Case Study Part 1
Position of interested parties in a liquidation (assuming assets can be sold at going concern value)
The above statement of assets reflects the position of the threeinterested parties with no reconstruction scheme. The debenture holderswould be sure of their capital repayment on a liquidation and mostprobably the arrears of interest. The preference shareholders would alsoreceive their repayment of $70,000. $51,863 would then be left for theordinary shareholders (unless there is a difference between goingconcern and break up values of the assets).
Test your understanding 6: Wire Construction Part 3
Before the reconstruction, the ordinary shareholders own 100% ofthe control and voting rights in the company. After the reconstruction,their control will be diluted to 71.4% (400,000 shares out of a total of560,000) assuming they take up their rights.
These shareholders may be unwilling to take up their rights giventhat the company is failing, but clearly if the company cannot raise anynew finance it will slide into liquidation and the shareholders willreceive little return (shown in the first part of this case).
This should be the key consideration of the ordinary shareholders:if they don't accept the reconstruction, they may well end up withnothing. Accepting the reconstruction will mean that they keep controlof the company and will benefit in the future if the company'sperformance improves.
On balance it appears that the scheme is acceptable to the shareholders.
Before the reconstruction, the preference shareholders areguaranteed a return of $3,500 per year (5% x 70,000 $1 shares). Initially they may well be unhappy about exchanging this income streamfor a new proposal of 8% on 35,000 $1 shares (i.e. $2,800), but thereare two other factors which make the scheme more appealing on furtherexamination:
- the preference shareholders will also own some ordinary shares, so that if the company's performance improves, they will receive more dividends (and capital growth) from these shares in the future.
- as mentioned above with the ordinary shareholders, the risk is that if the company goes into liquidation, the shareholders may receive a lower than hoped for return. (Admittedly the preference shareholders' position is less risky than the ordinary shareholders' position, but some risk remains).
Again, on balance, it seems that the scheme is acceptable to the preference shareholders.
The debenture holders' patience is wearing thin: no interest hasbeen paid for two years, so the debenture holders could apply to thecourts to liquidate the company, in which case (according to part one ofthis case study) they would receive a full settlement of all that isowed to them.. However, in a liquidation there is no guarantee that thedebenture holders would get back all that is owed to them (assets maynot be worth as much as was first thought), so a reconstruction may wellbe more appealing.
The terms of this reconstruction seem quite favourable to thedebenture holders. Despite having to forgo interest in the short term,the debenture holders are being offered:
- ordinary shares - i.e. the chance of capital growth and dividends in the longer term if the company's performance improves.
- higher longer term interest rates (9.5% per annum will be paid until 20X7 rather than 8% until 20X4 as at present)
- extra debentures offered at a discount, so redemption will bring a capital gain here.
Providing the debenture holders are not struggling for cash in theshort term, the scheme should be appealing to them in the long term. Ifthe debenture holders do have a preference for short term income, aliquidation may be a better option, since we have forecast that theywill receive all their money back.
Test your understanding 7: Another reconstruction example
Assuming that there are no liquidator's fees, in the event of liquidation the distribution will be as follows:
(1) Unsecured creditors will only receive 245/405 = 60% of the amount owing.
(2) Ordinary shareholders will receive nothing.
(b) Post reconstruction EPS
Number of shares post reconstruction
= 200,000 (existing s/h) + 200,000 (bank) + 320,000 (venture capitalist)
Post reconstruction forecast EPS
= 180/720 = 25c per share.
Return on equity to venture capital company = 25c/125c = 20%
This is above the target required return of 18% and is therefore acceptable to the venture capital company.
(c) Effective return to bank on converted capital
Capital foregone = (1/2 Ã— 200,000) + (1/3 Ã— 1,200,000) = $500,000
Number of shares in exchange = 200,000
Earnings generated = 200,000 Ã— 25c = $50,000
Therefore return = $50,000/$500,000 = 10%
(d) Acceptability of the scheme
Existing ordinary shareholders
If the company is liquidated then the existing ordinary shareholders will get nothing.
In a reconstruction the existing ordinary shareholders willlose control of the company (they will only own 200/720 = 28% of theequity) but they are likely to earn 25c per new ordinary share. Based onthe original nominal value of each share this represents a return of25c/$1 = 25%.
Given the return that the providers of new capital are likelyto receive the scheme seems very generous to the existing shareholders.It is likely that the bank and the venture capital providers would wantthe scheme to be amended so as to make it less generous to the existingshareholders.
If the company is liquidated the bank is likely to recover thefull amount of the secured loan but will only recover 60% of theoverdraft. Following the reconstruction the bank will only get a returnof 10% on the capital converted into equity but will continue to receiveinterest on the remaining loan and overdraft at the existing rate.
Given that 1/3 of the secured loan is converted into equity andthe forecast return on this is only 2% more than the current loaninterest, this is unlikely to be acceptable to the bank.
Test your understanding 8
- There is potential for improved performance leading to increased shareholder value.
- There may be an increase in the total value of the investment.
- Selling off unrelated or loss-making businesses may improve financial performance.
- There is an opportunity to choose how much to invest in particular parts of the business.
Test your understanding 9
- Although the risks are high so are the potential rewards. In the situation of leveraged buyouts, where the bulk of the equity is in the hands of the management team, the returns to shareholders once the loans have been covered can be very large.
- They are usually considered to be less risky than starting a new business from scratch.
- Firms that have been subject to MBOs tend to operate at a higher level of efficiency. The traditional divorce between ownership and control is effectively ended and managers (and shareholding employees) have great incentive to improve the efficiency of the firm.
- They are risky (approximately one in ten fail) and can involve managers losing their personal wealth as well as their jobs.
- Problems will be encountered when the new company becomes independent. For example, head office support services will be lost, and existing customers may go elsewhere if they see the new firm being too risky.
Created at 5/24/2012 3:56 PM by System Account
(GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London
Last modified at 5/25/2012 12:55 PM by System Account
(GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London
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