Question 4c
Proteus Co, a large listed company, has a number of subsidiaries in different industries but its main line of business is developing surveillance systems and intruder alarms. It has decided to sell a number of companies that it considers are peripheral to its core activities.
One of these subsidiary companies is Tyche Co, a company involved in managing the congestion monitoring and charging systems that have been developed by Proteus Co. Tyche Co is a profitable business and it is anticipated that its revenues and costs will continue to increase at their current rate of 8% per year for the foreseeable future.
Tyche Co’s managers and some employees want to buy the company through a leveraged management buy-out. An independent assessment estimates Tyche Co’s market value at $81 million if Proteus Co agrees to cancel its current loan to Tyche Co.
The managers and employees involved in the buy-out will invest $12 million for 75% of the equity in the company, with another $4 million coming from a venture capitalist for the remaining 25% equity.
Palaemon Bank has agreed to lend the balance of the required funds in the form of a 9% loan. The interest is payable at the end of the year, on the loan amount outstanding at the start of each year.
A covenant on the loan states that the following debt-equity ratios should not be exceeded at the end of each year for the next five years:
| Year | 1 | 2 | 3 | 4 | 5 |
|---|---|---|---|---|---|
| Debt / Equity (%) | 350% | 250% | 200% | 150% | 125% |
Shown below is an extract of the latest annual income statement for Tyche Co:
| $'000 | |
|---|---|
| Sales Revenue | 60000 |
| Materials and consumables | 12000 |
| Labour costs | 22000 |
| Other costs | 4000 |
| Allocated overhead charge payable to Proteus Co | 14000 |
| Interest paid | 2000 |
| Taxable Profit | 6000 |
| Taxation | 1500 |
| Retained Earnings | 4500 |
As part of the management buy-out agreement, it is expected that Proteus Co will provide management services costing $12 million for the first year of the management buy-out, increasing by 8% per year thereafter.
The current tax rate is 25% on profits and it is expected that 25% of the after-tax profits will be payable as dividends every year. The remaining profits will be allocated to reserves. It is expected that Tyche Co will repay $3 million of the outstanding loan at the end of each of the next five years from the cash flows generated from its business activity.
Required:
Discuss briefly the implications of the results obtained in part (b) and outline two possible actions Tyche Co may take if the covenant is in danger of being breached. (5 marks)