Answers
Part 3 Examination – Paper 3.7 Strategic Financial Management 1
June 2003 Answers
Report on the restructuring proposals of Evertalk plc. Any decision should be taken in the best interests of the shareholders of the company company,, with due regard paid to other stakeholders’ interests. The directors should not take decisions that are in their own best interests. (i)
Corporate restructuring For a restructuring to be successful it must treat all stakeholders fairly in accordance with their respective rights, and, if possible, offer each group a more favourable outcome than would occur if the company were to be liquidated. The company should also expect to be viable as a going concern as a result of the restructuring. Estimated liquidation value: Land and buildings Other fixed assets Stock Debtors Cash Less re redu dund ndan anccy and and clo closu sure re cos osts ts
Creditors Bank loan Bond Other creditors
£ million 140 (including the surplus £40m) 50 100 70 5 (10 100) 0) —— 265 40 300 209 —— 549
If the company were liquidated, on average creditors would receive approximately 48% of cash due to them. Ordinary shareholders would receive nothing. Examining each of the individual stakeholder’s positions: Bondholders: The bondholders are to be offered 95 million shares in exchange for existing bonds of £300 million, effectively pricing each share at 316 pence. They give up their rights to repayment of £300 million, of which about £145 million could be expected if the company is liquidated (equivalent to a value of 153 pence per share). On the other hand they have to subscribe an additional £100 million in order to allow rationalisation of the network division, and to improve the cash flow of the company. The bondholders would gain control of the company, but this is only of value if the company is expected to survive. The effect on the company is that interest of £300m × 12% would be saved, and the £40 million bank loan would be repaid from the disposal of surplus assets, saving a further £40m × 8% = £3·2 million interest. The Th e pro proje ject cted ed fr free ee ca cash sh fl flow ow of th the e com compa pany ny is is::
£m
Curren Curr entt in inco come me fr from om op oper erat atio ions ns (a (aft fter er in inte tere rest st)) Add Interest savings Rationalisation gains Add back depreciation Replacement investment
(60) (6 0)
Free cash flow
39 30 46 (100) —— (45)
(£300m (£
×
12% + £40m
×
8%)
(assumed to reduce pro-rata to the £40m disposal)
(Other items such as working capital are assumed to be constant) On this basis, even without discounting, the company as a whole is not likely to be financially viable after the proposed restructuring. In this situation the bondholders would be better not to accept the proposed reconstruction as they could potentially lose more of their investment if the company were subsequently forced into liquidation. However, if the bondholders accepted the offer and then closed the network division their position might be improved. The implications of closing the network division are discussed below. Existing shareholders If the company fails, existing shareholders would receive nothing. The proposal gives them at least some possibility of future value, and might be acceptable. Shareholders could of course currently sell their shares for 10 pence; however, if many of the shareholders were to sell the price would fall from this level. The convertible offer would then need to be judged against the revenue from the sale of shares. The initial conversion price of 200 pence per share does not look favourable; on current evidence the share price is unlikely to reach 200 pence during the next five years.
15
Participants in the share option schemes It is likely that currently the share options have little or no value as the current share price is so low. This offer appears to be generous to this group who are existing managers/directors of the company, and probably unfair to other stakeholders. Other creditors The scheme does not offer any change in legal status to such creditors. It could, however however,, slightly improve the future financial viability of the company, or, as the amount of loans outstanding is reduced, probably improve the proportion of funds repaid in the event of liquidation. If, however, the new loans are secured, this could have an adverse effect on other creditors. The proposed restructuring does not offer a viable financial solution to the company’s current problems. Other possible strategies: Closure of the network division Given that the manufacturing division is performing much better than the network division, consideration should be given to closing the network division. The subscriber base of the network division could possibly be sold. Future activities, and any restructuring, could then be focussed on the manufacturing division that is currently profitable. (ii)
Sale of the company to Globtalk Globtalk would probably close the network division as it is loss making and a direct competitor to its own network. If the network division is closed the receipts are expected to be: £ million Land and buildings Other fixed assets Stock Debtors Cash
50 25 10 35 2·5
(£100m × 0·5. The other £40m is assumed to be used to repay the bank loan) (£50m × 0·5 ) (£100m × 0·1) (£70m × 0·5)
Less:
Creditors Bonds Closure costs Net liabilities
(104·5) (300) (50) ––––– (332 )
(£209m
×
0·5)
(£100m
×
0·5)
If the £300 million remaining bond liability is excluded from the closure, the outcome is an expected deficit on disposal of only £32 million. The projected free cash flow of the manufacturing division is: Curren Curr entt inc incom ome e fro from m op oper erat atio ions ns (af aftter in inte tere resst) Add back interest if bank loan is repaid
Tax (30%) Add Ad d de depr prec ecia iati tion on
Less replacement investment Free cash flow
£ million 90 3 —– 93 (28 ) 12
(tax would be payable in future) (ass (a ssum umed ed to be re rela lati ting ng to 20 20% % of cu curr rren entt an annu nual al depreciation as the manufacturing division only undertakes 20% of replacement expenditure)
(20) —— 57
If the network division is closed and none of the lost sales (25%) are replaced, then free cash flow would reduce to approximately £41 million. This is not an exact estimate, and in reality sales could increase rather than decrease, as Globtalk would be likely to use the division as a supplier of phones to its own network customers. Without any sales reduction the present value of the free cash flow to infinity at a 10% discount rate (see appendix below) is £570 million. If a shorter and more conservative time horizon of 10 years is used the present value of a free cash flow of £57m per year for 10 years is: £57m × 6·145 = £350 million. With a sales reduction the values are £410 million and £252 million. Both of these estimates are well in excess of the £50 million price offered. If Globtalk acquires Evertalk, there is potential also to access Evertalk’s Evertalk’s existing network subscribers (or at least part of them), and there could be vertical synergies with the manufacturing division. Even if Globtalk were to take full responsibility for existing loans, at a total cost of £382 million (£332m net liabilities plus £50m purchase cost), its offer could still be below the expected value of Evertalk with the network division closed. Given the above data it is recommended that an y acquisition by Globtalk should be conditional upon the company accepting liability for Evertalk’s existing loans.
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(iii) Closure of the company Closure of the entire company is not recommended. Given the poor performance of the network division it is recommended that this division is closed. The manufacturing division is viable, and could either continue to be operated by Evertalk, or sold to Globtalk. Closure of the network division would lead to a deficit of approximately £332 million (see above), which could not easily be paid by the manufacturing division. Conclusion: Unless an alternative restructuring scheme can be agreed, which would reduce the burden of the closure of the network division to the company, sale to Globtalk might be the best alternative, conditional upon Globtalk accepting the liability for all existing loans. Appendix: WACC for the manufacturing division: Cost of equity for the manufacturing division: Rf + (Rm - Rf) beta, or 5% + (14% – 5%) 5%) 0·9 = 13·1% The cost of debt may be estimated by using the current bank loan rate of 8%, or from the current bond price, by trial and error. 12 12 £121 = ———– + ——–—— + . . . 1 + Kd (1 + Kd)2 At 8%
12 100
× ×
12 100 ——–—— + ——–—— . (1 + Kd)7 (1 + Kd)7
£ 5·206 = 62·47 0·583 = 58·30 ——— 120·77
The cost of debt (before tax) is approximately 8%. The weighted average cost of capital for the manufacturing division, using target gearing of 60% equity, 40% debt is: 13·1% (0·6) + 8% (1 – 0·3) (0·4) = 10·1% 10% will be used as the discount rate. N.B. The after tax cost of debt is used as the manufacturing division is expected to pay tax in the future. 2
(a)
It is useful to estimate the return and risk of the two diversification alternatives before examining in detail the views of the directors. The portfolio return is simply the weighted average of the expected returns of the two elements of the portfolio. The portfolio risk may be estimated using the two-asset portfolio theory equation, based upon the expected risk and return of each alternative. Europe Low growth Average growth Rapid growth
Probability 0·3 0·5 0·2
Return (%) 17 12 21
E (R) 2·1 6·0 4·2 —— 12·3
Probability 0·3 0·5 0·2
Return (%) 12 30 15
E (R) 10·6 15·0 13·0 —— 18·6
Probability 0·3 0·5 0·2
Return (%) 16 13 17
E (R) 1·8 6·5 3·4 —— 11·7
East Asia Low growth Average growth Rapid growth
UK Low growth Average growth Rapid growth
Expected return UK/Europe (0·7) (11·7) + (0·3) (12·3) = 11·88% Expected return UK/East Asia (0·7) (11·7) + (0·3) (18·6) = 13·77% The two-asset portfolio equation measures the total risk of the portfolio. This will include some specific or unsystematic risk: Portfolio risk UK/Europe 1 [(4·03)2 (0·7)2 + (4·86)2 (0·3)2 + 2(0·7) (0·3) (17·89)] / 2 σ = 4·20 p
17
1
Portfolio risk UK/East Asia [(4·03) 2 (0·7)2 + (12·26)2 (0·3)2 + 2(0·7) (0·3) (31·98)] / 2 σ = 5·91 p Summar y UK alone UK/Europe UK/East Asia
Portfolio return 11·70 11·88 13·77
Portfolio risk 4·03 4·20 5·91
Coefficient of variation 0·344 0·354 0·429
It is not obvious from these results which investment is best. As risk increases, so does the expected return. The coefficient of variation, which shows the amount of risk per pound of expected return, would suggest that continuing only in the UK is best. However, the risk/return preferences of Hasder plc would need to be considered before a decision was made, as would strategic and other issues discussed below. below. Director A Director A’s view has merit in that the company would be sticking to its core market and core competence. However, overseas investments are not always too risky. Some overseas investments are less risky than UK investments. If total risk is considered then international diversification can produce risk/return combinations that are not available from investing only in the UK. The benefits of international portfolio diversification might reduce overall risk below that available in the UK, and provide better combinations of risk and return for Hasder. This is the view of Director B who correctly states that international diversification will open up new opportunities. Director C produces no evidence that overseas investments are more expensive than UK investments. In many multinational companies lower labour and materials costs have been key motives for overseas investments, hence such investments have been cheaper than similar UK based investments. If the company is investing overseas purely to achieve diversification it is fair to say that in most cases shareholders, by investing in international unit trusts (mutual funds) or similar, could easily, and more cheaply, diversify for themselves. However, some countries do not permit such portfolio investments, and their markets are largely segmented from major Western markets. Segmented markets might include the developing markets in East Asia. Hasder might be able to offer risk/return combinations that are valued by its shareholders if it invests in countries that they could n ot easily invest in themselves as part of their share por tfolios. Investing in segmented markets might also mean that the systematic risk of investments available to Hasder can be reduced, especially if the segmented markets have a low or negative covariance with returns in the UK market. International diversification might also result in less variability of the cash flows of Hasder, as the markets are not perfectly correlated. This reduction in risk, if recognised by providers of finance, might result in lower financing costs, and a lower cost of capital. Director D The summary table shows that investment in East Asia offers a higher potential return than in Europe, but at significantly higher risk. If the coefficient of variation is considered then it is the least favoured alternative. Director E suggests a much higher proportion of investment in East Asia. If 50% – 70% was invested in Asia, and assuming market values reflected these proportions: 50% – Expected return UK/East Asia (0·5) (11·7) + (0·5) (18·6) = 15·15% 70% – Expected return UK/East Asia (0·3) (11·7) + (0·7) (18·6) = 16·53% Portfolio risk UK/East Asia If 50%: 1 [(4·03)2 (0·5)2 + (12·26)2 (0·5)2 + 2(0·5) (0·5) (31·98)] / 2 σ
p
= 7·59
If 70%; 1 [(4·03)2 (0·3)2 + (12·26)2 (0·7)2 + 2(0·3) (0·7) (31·98)] / 2 σ
p
= 9·41
The potential returns increase significantly, as does risk. Unless Hasder is seeking very high returns and is prepared to take the extra risk, there is no evidence to support the view that a higher proportion should be invested in East Asia. Such a move would probably mean closing some UK operations with the resultant problems of redundancy, and would be a major strategic change from the company’s current position. The risk and return evidence should only be part of the decision process. The data itself is likely to be subjective and inaccurate. It is impossible to know with any degree of accuracy what future returns will be, and the assignment of probabilities to different economic states is at best speculative.
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Other factors that might influence the decision include: (i) (ii) (iii) (iv) (v) (vi) (vii) (viii) (ix)
How do the investments fit with Hasder’s strategic strategic plans? Has a full competitor/market analysis been undertaken? Has the company company any strategic strategic reason for favouring Europe or East Asia? Has political risk risk been considered, and its its possible effects effects built into the the cash flows? Has foreign exchange risk been included? Are there there other other investment investment alternatives? What future options could arise from the investments? investments? What are the non-financial implications of the investments? Is total risk the best measure of risk? risk? Should systematic risk be used instead? instead?
(b)
The correlation coefficient may be estimated by: Covariance ———————————————————. Standard deviation A × Standard deviation B 17·89 ——–——— = 0· 0·91 4·03 × 4·86
(i)
UK/Europe
(ii) (i i)
31·98 UK/ K/Ea Easst As Asia ——–— –—–— –—— — = 0·6 0·65 5 4·03 × 12·26
Although the returns between the UK and Europe and the UK and East Asia are both positively correlated, the degree of correlation is much higher for the UK and Europe at 0·91. This means that relatively little risk reduction will take place because of the strong relationship between the UK and Europe. This is evidenced evidenced by the portfolio standard deviation of 4·20, which is little different from the individual standard deviations. The lower correlation coefficient of 0·65 between the UK and East Asia allows much more risk reduction from international diversification, with the standard deviation of East Asia alone (12·26) reducing to a much safer 5·91 as part of a portfolio with the UK. (c)
Using CAPM Required return = Risk free rate + (Market return – Risk free rate) beta Europe: required return is 5% + (13% – 5%) 0·85 = 11.8% The expected return is 12·3%. The European investment is expected to provide an abnormally good return for its systematic risk, and on that basis would be recommended. East Asia: required return return is 8% + (18% – 8%) 1·32 = 21·2% The expected return is 18·6%. The investment is not providing sufficient return for its systematic risk and would not be recommended. However, strategic and non-financial factors should also play a major role in the decision process.
3
(a)
Interest rate caps and collars are available on the over the counter (OTC) market or may be devised using market based interest rate options. They may be used to hedge current or expected interest receipts or payments. An interest cap places an upper limit on the interest rate to be paid, and is useful to a potential borrower of funds at a future date. The borrower by purchasing a cap, will limit the interest paid to the agreed cap strike price (less any premium paid). OTC caps are available for periods of up to 10 years and can thus protect against long-term interest rate movements. As with all options, if interest rates were to move in a favourable direction the buyer of the cap could let the option lapse and take advantage of the more favourable rates in the spot market. The main disadvantage of options is the premium cost. A collar option reduces the premium cost by limiting the possible benefits of favourable movements. It involves the simultaneous purchase and sale of options, or, in the case of OTC collars the equivalent net premium to this. The premium paid for the purchase of the options would be partly or wholly offset by the premium received from the sale of options. Where it is wholly offset a zero cost collar exists.
(b)
For the company to earn interest of £6,750,000 it would need to earn an annualised annuali sed intere interest st rate, rate, after after premium premium cost costss of
£6,750,000 —————–— —————–— £400,000,000
19
×
12 –— = 4·0 ·05% 5% 5
The collar needs to produce a minimum of more than 4·05% including premium costs. As Troder plc is investing, a lending collar will be required whereby the company will simultaneously buy a floor and sell a cap. Buying a call option that will increase in value if interest rates fall will set the floor, or minimum interest rate. The cap, achieved by selling put options, will set the maximum interest, with the company foregoing any higher interest rate than the put option exercise price, but paying a lower overall premium. The overall cost of the collar will be the call option premium paid less the put option premium received. In order to achieve a return of more than 4·05% (£6,750,000) a collar needs to be arranged with the call strike price higher than the put strike price (in order to set the maximum interest that can be received). Alternatives are: Call strike price 95750 95750 95500
Interest rate 4·25% 4·25% 4·50%
Less call cost 0·165% 0·165% 0·280%
Plus put receipt 0·170% (95500) 0·085% (95250) 0·085% (95250)
Less 0·25% 0·25% 0·25% 0·25%
Total 4·005% 3·92% 0 4·055%
Only the purchase of a call at 95500 and sale of a put at 95250 will result in a minimum return of £6,750,000. The actual minimum return (ignoring any possible remaining time value that might increase the return) is: £400,000,000
×
5 — 12
×
4·055% = £6,758,333
N.B If a collar is set with the same put and call price the return will be Strike price 95250 95500 95750
Interest rate 4·75% 4·50% 4·25%
Less call cost 0·445% 0·280% 0·165%
Plus put receipt 0·085% 0·170% 0·305%
Less 0·25% 0·25% 0·25% 0·25%
Total 4·14% 4·14% 4·14%
This would achieve the required 4·05%, but would not allow Troder Troder to take advantage of any favourable movement in interest rates. (ii)
The maximum maximum return would would occur if market interest interest rates rates are at least 4·75% 4·75% and the call option option were allowed allowed to lapse. The put option would be exercised by its buyer and the maximum overall return would be: Strike price 95500
Interest rate (call not exercised) 4·75%
Less call cost
Plus put receipt
Less 0·25%
Total
0·280%
0·085%
0·25%
4·305%
This would yield: £400,000,000
4
(i)
×
5 — 12
×
4·305% = £7,175,000
The use of trade insurance limits the effect of possible payment/default, although Discos would still have to bear some of the risk. The spot equivalent of 55 million pesos is: 55 ——— = £1,672, ——— £1,672,241 241 32·89 55 The three three month month forward rate rate is: is: ——— = £1,591,896 £1,591,896 34·55 This is much less favourable than the spot rate, but has the advantage of fixing the expected cash flow from the export deal. If payment is received in three months: Receipts from payment Interest cost Insurance cost
£ 1,591,896 (27,174 ) (20,903 ) ————– 1,543,819
(1,672,241 (1,672,241
× ×
20
6·5% × 3 / 12) 1·25%)
If payment is not made in three months the forward contract will have to be fulfilled, or rolled over at an unknown cost. The late payment/default is assumed not to be the result of government action. If exchange rates don’t change during the months 4–6 (which is very unlikely): In six months receive: £ 55 × 0·9 ———— 35·90 Interest cost (six months) Insurance cost
1,378,830 (54,348 ) (20,903 ) ————– 1,303,579
If the estimated 5% risk of late payment or default is accurate, the expected return is (£1,543,819 (ii)
×
0·95) + (1,303,579
×
0·05) = £1,531,807
The use of an export factor eliminates foreign exchange risk as payment will be made in sterling. As the factor is non-recourse, the factor bears the risk if the customer pays late/defaults, except for the reduced sterling payment in six months that would be made to Discos. The factor will also take responsibility for the debt collection process. If the customer pays in three months: Receipts from payment Factor interest cost Other interest cost Factor fee
£ 1,590,000 (20,034 ) (6,504 ) (39,750 ) ————– 1,523,712
(1,590,000 × 0·8 × 6·3% × 3 / 12 12 ) [(1,590,000 × 0·2 + 82241) × 6·5% (1,590,000 × 2·5%)
×
3
(1,590,000 × 0·8 × 6·3% × 6 / 12 12 ) (1,590,000 × 0·2 + 82241) × 6·5% [ (1,590,000 × 2·5%)
×
6
/ 12 12 ]
If the customer pays late/defaults: Receipts from payment Factor interest cost Other interest cost Factor fee
£ 1,530,000 (40,068 ) (13,008 ) (39,750 ) ————– 1,437,174
Expected return is (£1,523,712
×
/ 12 12 ]
0·95) + (1,437,174 x 0·05) = £1,519,385
Other issues: (1) Will the the factor be prepare prepared d to undertake a ‘one off’ off’ deal, or will further busines businesss be required? required? (2)
Will the use of the factor improve the the chance of payment? Most factors are subsidiaries subsidiaries of major banks, and might have more market power to achieve payment.
(3)
Will Discos Discos save administrative/labour costs if the factoring company undertakes the debt collection collection process? If so such savings would need to be included in any financial assessment.
(iii) The use of a documentar y letter of credit should ensure that Discos receives the due payment. The letter of credit is confirmed and irrevocable, which means that as long as Discos correctly presents all the agreed documents to the importer’s bank (normally via the exporter’s bank), both banks guarantee to make payment to the exporter (or to the third party holding the discounted bill of exchange). Thus in the case of late payment/default the guaranteeing banks will bear the risk. Letters of credit are very useful for high value exports, and when dealing with customers whose creditworthiness is uncertain, as is the case here. £ 55m × (1 – (0·25 × 3 / 12 12 )) Discount nte ed rec receipts fro from pay payment 1,5 ,56 67,726 ——————————— 32·89 Arrangement cost (30,000 ) ————— 1,537,726 The banks guaranteeing the bill will be liable for payment on the bill. Discos plc will immediately discount the bill in Xeridia and convert the net proceeds into sterling at the spot rate, in order to raise the necessary finance. Discos will face no further foreign exchange risk or commercial risk. Recommendation: Unless Discos could make substantial administrative savings from option (ii), option (iii), the use of a confirmed letter of credit results in the highest expected receipts and is the recommended alternative.
21
5
(a)
A yield curve may be upward sloping because of: (i)
Future expectations. If future short-term interest rates are expected to increase then the yield curve will be upward sloping.
(ii)
Liquidity preference. It is argued that investors seek extra return for giving up a degree of liquidity with longer-term investments. Other things being equal, the longer the maturity of the investment, the higher the required return, leading to an upward sloping yield curve.
(iii) Preferred habitat/market segmentation. Different investors are more active in different segments of the yield curve. For example banks would tend to focus on the short-term end of the curve, whilst pension funds are likely to be more concerned with medium and long term segments. An upward sloping curve could in part be the result of a fall in demand in the longer term segment of the yield curve leading to lower bond prices and higher yields. (b)
(i)
The current market prices of the two bonds may be estimated to be: £100 Zero Ze ro co coup upon on ——–— ——–—– – = £41 £41·7 ·73 3 (1·06)15 12% gilt with a semi-annual coupon 1 – (1·03)–30 Present Pre sent value value of an annuity annuity for 30 30 periods periods at 3% 3% is ——––––—– ——––––—– = 19·6004 19·6004 0·03 Present value of interest payments 1 Pre rese sent nt val value ue of of rede redemp mpti tion on usi using ng —— ——–— –——— —— (1 + 0·03)30
£6
×
£100 £1 00
£ 19·6004 = 117·6 19·6004 117·60 0 ×
0·4120 0·4 120 = 41· 41·20 20 ——— 158·80
If interest rates increase by 1% £100 Zero Zer o coupon coupon —––—– —––—– = £36·25 £36·25,, a decreas decrease e of £5·48 £5·48 or 13·1% 13·1% (1·07)15 12% gilt 1 – (1·035)–30 Present Pre sent value of an annuity annuity for 30 peri periods ods at 3·5% is —–—— —–——––—– ––—– = 18·3 18·3920 920 0·035 Present value of interest payments
£6
×
1 Pre rese sent nt val value ue of of rede redemp mpti tion on usi using ng ——–— ——–——— —— £1 £100 00 (1 + 0·035)30
£ 18·3920 18·39 20 = 110·35 110·35 ×
0·3563 0·3 563 = 35·63 35·63 ——— 145·98
This is a decrease of £12·82 or 8·1% If interest rates decrease by 1%: £100 Zero coupo coupon n —––—– —––—– = £48·10, £48·10, an increase increase of £6·37 £6·37 or 15·3% 15·3% (1·05)15 12% gilt with a semi-annual coupon 1 – (1·025)–30 Present Pre sent value value of an annuity annuity for 30 30 periods periods at 2·5% 2·5% is —––––––––—– —––––––––—– = 20·9303 20·9303 0·025 £ 20·9303 = 125·5 20·9303 125·58 8
Present value of interest payments
£6 × 1 Pre rese sent nt val value ue o off rede redemp mpti tion on usi using ng —— ——–— –——— —— £100 £100 × 0·4767 0·4767 = 47· 47·67 67 (1 + 0·025)30 ——— 173·25 This is an increase of £14·45 or 9·1%
22
(ii)
The price/yield relation is not linear; it has a convex shape. There is a bigger absolute movement in bond prices when interest rates fall than when they rise. The percentage movement is also higher for low coupon bonds than high coupon bonds. Other things being equal, a financial manager would prefer to hold high coupon bonds if interest rates are expected to increase, and low or zero coupon bonds when interest rates are expected to decrease.
(iii) If interest rates are expected to rise, and the gap between yields on short and long dated bonds to widen, the financial manager would not want to hold longer dated bonds as these would suffer a larger fall in price than short dated bonds. Short dated bonds, probably with high coupons, would be preferred. 6
(a)
Bondholders are concerned that payments of interest and repayments of principal are made on time and without problems. The willingness of bondholders to provide funds to companies depends upon the risks and returns that they face, including the companies’ expected cash cash flows, assets (including (including available security on assets), assets), and credit ratings. Shareholders, in theory, seek to maximise the value of their shares. This is not necessarily consistent with the interests of bondholders, or the incentive to maximise the total value of the company (the value of equity plus debt). Shareholders seeking to maximise their wealth might take actions that are detrimental to bondholders. For example, shareholders, normally through their agents, managers, might use the finance provide by bondholders to invest in very risky projects, which change the character of the risk that the bondholders face. If the risky projects are successful, then the rewards flow primarily to the shareholders. If the projects fail then much of the cost of failure will fall on the bondholders. If there are no constraints on shareholders, the shareholders might have a natural incentive to take such risks. Management, acting on behalf of shareholders, might also reduce the wealth, and/or increase the risk of bondholders by: (i)
Selling off assets of the company;
(ii)
Paying large dividends;
(iii) Borrowing additional funds that rank above existing bonds in terms of prior payment upon liquidation. The incentive for shareholders to take on risks at bondholders’ expense is especially strong when the company is in financial difficulties and in danger of failing. In such circumstances the shareholders may believe that they have little to lose by undertaking risky projects. In the case of corporate failure significant ‘bankruptcy costs’ normally exist. Direct costs of bankruptcy include receivers and lawyers’ fees, whilst indirect costs might include loss of cash flow prior to failure through loss of sales, worse credit terms etc. When corporate failure occurs most of the firm’s value will be transferred to its debt holders who ultimately bear most of the bankruptcy costs. (b)
Bond covenants might include: (i)
An asset covenan covenant. t. This would would govern the the company’s company’s acquisitio acquisition, n, use and disposal disposal of assets. assets. This This could be for specifi specified ed types of assets, or assets in general.
(ii)
Financing covenant. covenant. This covenant often defines the type and amount of additional debt that the company can issue, issue, and its ranking and potential claim on assets in case of future default.
(iii) Dividend covenant. A dividend covenant restricts restricts the amount of dividend that the company is able to pay. pay. Such covenants might also be extended to share repurchases. (iv) Financial ratio covenants, fixing the the limit of key ratios such as the gearing gearing level, interest cover, cover, net working capital, or a minimum ratio of tangible assets to total debt. (v)
Merger covenant, covenant, restricting restricting future merger activity activity of the company company..
(vi) Investment covenant, concerned with the company’s future investment policy policy. (vii) Sinking fund covenant whereby the company makes payments, payments, typically to the bond trustees, who might might gradually repurchase bonds in the open market, or build up a fund to redeem bonds. There will often also be a ‘bonding covenant’ that describes the mechanisms by which the above covenants are to be monitored and enforced. This often includes an independent audit and the appointment of a trustee representing the interests of the bondholders From the company’s perspective the major disadvantage of covenants is that they restrict the freedom of action of the managers, and could prevent viable investments, or mergers from occurring. They also necessitate monitoring and other costs. However,, covenants are also of value to companies. Without covenants the company might not be able to raise as much fun ds However in the form of debt, as lenders would not be prepared to take the risk. Even if lenders were to take the risk they would require a higher default premium (higher interest rates) in order to compensate for the risk. The existence of covenants therefore reduces the cost of borrowing for a company.
23
Part 3 Examination – Paper 3.7 Strategic Financial Management 1
June 2003 Marking Scheme
This question requires the analysis of which strategy, if any, a company in financial difficulties should adopt. It tests knowledge of the principles of corporate restructuring and the valuation of companies, and requires the ability to use financial information to suggest alternative strategies that a company might use. Marks 1 1
Repor t format Overall principle(s) that should influence the decision Corporate restructuring Fair treatment Financial viability estimates/comments Liquidation value Stakeholders’ positions: Bondholders Shareholders Option holders Other creditors
1 2–3 2 2–3 2 2 2 –— Max 15
Sale to Globtalk Cost of capital Valuation – preferably using free cash flow Conclusion
Max
5 6–7 1–2 —– Max 12
Closure of the company company.. Discussion/calcs
3–4
Alternative suggestions. Reward sensible suggestions, especially related to the viability of the manufacturing division. Allow for overlap
4–5
Total 35 2
This question requires understanding of the potential benefits of international diversification, and the ability to analyse risk and return data in order to assist investment decision-making. (a)
Estimates of risk and return UK and other returns Europe/UK risk and return East Asia/UK risk and return Views of directors A B C D E including additional calculations
2 3 3
Overall views of directors Marks may be credited for relevant overlap Other factors relevant to the decision 1 mark for each good point
2–3 2 2–3 1 3–4 —– max 10 max 7 ——— max 25
(b)
Estimates Discussion
3 3 — 6
(c)
Estimates of required return Discussion of implication for the diversification decision
2 2 — 4 Total
25
35
3
(a)
Advantages of caps Advantages of collars
(b)
Required interest yield Collar calculations
Marks 3 3 — 6 1 6 — 7
Give credit for technique (c)
Maximum yield if option is not exercised
2 Total 15
4
Insurance plus forward market Non-recourse factor Documentary letter of credit plus discounting Conclusion Reward technique.
5 5–6 4 1 Total 15
5
(a)
For full marks three reasons are necessary
4
(b)
(i)
Current market prices Increase 1% Decrease 1%
2 2 2
(ii)
Reward awareness of different size of movement and its implication
3
(iii) Full marks for correct interpretation
2 Total 15
6
( a ) Discussion of reasons 1–2 for each good point (b)
max
Examples of covenants. 1 mark for each sensible suggestion Advantages and disadvantages to companies (not investors!)
26
8
max
5 2–3
Total
15
