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Question 2a

Eview Cinemas Co is a long-established chain of cinemas in the country of Taria. Twenty years ago Eview Cinemas Co’s board decided to convert some of its cinemas into sports gyms, known as the EV clubs. The number of EV clubs has expanded since then. Eview Cinemas Co’s board brought in outside managers to run the EV clubs, but over the years there have been disagreements between the clubs’ managers and the board. The managers have felt that the board has wrongly prioritised investment in, and refurbishment of, the cinemas at the expense of the EV clubs.

Five years ago, Eview Cinemas Co undertook a major refurbishment of its cinemas, financing this work with various types of debt, including loan notes at a high coupon rate of 10%. Shortly after the work was undertaken, Taria entered into a recession which adversely affected profitability. The finance cost burden was high and Eview Cinemas Co was not able to pay a dividend for two years.

The recession is now over and Eview Cinemas Co has emerged in a good financial position, as two of its competitors went into insolvency during the recession. Eview Cinemas Co’s board wishes to expand its chain of cinemas and open new, multiscreen cinemas in locations which are available because businesses were closed down during the recession.

In two years’ time Taria is due to host a major sports festival. This has encouraged interest in sport and exercise in the country. As a result, some gym chains are looking to expand and have contacted Eview Cinemas Co’s board to ask if it would be interested in selling the EV clubs. Most of the directors regard the cinemas as the main business and so are receptive to selling the EV clubs.

The finance director has recommended that the sales price of the EV clubs be based on predicted free cash flows as follows:

1. The predicted free cash flow figures in $millions for EV clubs are as follows:

Year 1 2 3 4
390 419 455 490

2. After Year 4, free cash flows should be assumed to increase at 5·2% per annum.
3. The discount rate to be used should be the current weighted average cost of capital, which is 12%.
4. The finance director believes that the result of the free cash flow valuation will represent a fair value of the EV clubs’ business, but Eview Cinemas Co is looking to obtain a 25% premium on the fair value as the expected sales price.

Other information supplied by the finance director is as follows:
1. The predicted after-tax profits of the EV clubs are $454 million in Year 1. This can be assumed to be 40% of total after-tax profits of EV Cinemas Co.
2. The expected proceeds which Eview Cinemas Co receives from selling the EV clubs will be used firstly to pay off the 10% loan notes. Part of the remaining amount from the sales proceeds will then be used to enhance liquidity by being held as part of current assets, so that the current ratio increases to 1·5. The rest of the remaining amount will be invested in property, plant and equipment. The current net book value of the non-current assets of the EV clubs to be sold can be assumed to be $3,790 million. The profit on the sale of the EV clubs should be taken directly to reserves.
3. Eview Cinemas Co’s asset beta for the cinemas can be assumed to be 0·952.
4. Eview Cinemas Co currently has 1,000 million $1 shares in issue. These are currently trading at $15·75 per share. The finance director expects the share price to rise by 10% once the sale has been completed, as he thinks that the stock market will perceive it to be a good deal.
5. Tradeable debt is currently quoted at $96 per $100 for the 10% loan notes and $93 per $100 for the other loan notes. The value of the other loan notes is not expected to change once the sale has been completed. The overall pre-tax cost of debt is currently 9% and can be assumed to fall to 8% when the 10% loan notes are redeemed.
6. The current tax rate on profits is 20%.
7. Additional investment in current assets is expected to earn a 7% pre-tax return and additional investment in property, plant and equipment is expected to earn a 12% pre-tax return.
8. The current risk-free rate is 4% and the return on the market portfolio is 10%.

Eview Cinemas Co’s current summarised statement of financial position is shown below. The CEO wants to know the impact the sale of the EV clubs would have immediately on the statement of financial position, the impact on the Year 1 forecast earnings per share and on the weighted average cost of capital.

$m
Assets 390
Non-current assets 15,621
Current assets 2,347
Total assets
17,968
Equity and liabilities
Called-up share capital 1,000
Retained earnings 7,917
Total equity
8,917
Non-current liabilities
10% loan notes 3,200
Other loan notes 2,700
Bank loans 985
Total non-current liabilities
6,885
Current liabilities 2,166
Total equity and liabilities
17,968

Required:

(a) Calculate the expected sales price of the EV clubs and demonstrate its impact on Eview Cinemas Co’s statement of financial position, forecast earnings per share and weighted average cost of capital. (17 marks)