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Question 3a

Newimber Co is a listed company which has always manufactured formal clothing for adults and children. It obtained a listing ten years ago after years of steady growth. 70% of shares in the company are owned by its directors or their relatives, with the remaining 30% owned by external investors, including institutional investors.

Sportswear division
Eight years ago it set up a division to manufacture sportswear. This investment has been very successful and the sportswear division now accounts for 40% of total group revenue, having grown much quicker than the original formal clothing division.

Newimber Co’s board has given divisional management at the sportswear division more authority over time, although the board has continued to make major policy and investment decisions relating to the division.

Initially, relations between Newimber Co’s board and management of the sportswear division were good, but there have been problems over the last couple of years. The sportswear division’s management has been frustrated by the board’s refusal to approve their recent investment plans on the grounds that they were too risky.

In order to achieve operational efficiencies, the sportswear division’s management would also like to pursue stricter policies for managing operational staff and suppliers than Newimber Co’s board has so far allowed.

In addition, Newimber Co started to prepare an integrated report three years ago, but Newimber Co’s board has had difficulties in obtaining all the information it requires for the report from the sportswear division.

A few months ago, the management of the sportswear division approached Newimber Co’s board with a proposal for a management buyout of the sportswear division.

However, the price the sportswear division’s management was able to offer was insufficient to persuade Newimber Co’s board to sell the sportswear division to them.

Newimber Co’s board has, subsequently, decided that the sportswear division should be demerged into a new company, Poynins Co. The shareholders and proportion of shares held would be the same for Poynins Co as currently for Newimber Co.

The sportswear division’s senior management team would become the board of Poynins Co and Poynins Co would seek an immediate listing on the same stock exchange as Newimber Co.

Financial information
The market capitalisation of Newimber Co’s share capital is currently $585 million. Newimber Co also currently has $200 million 5·9% loan notes.

The loan notes are redeemable in five years’ time at a premium of 5%. Newimber Co’s equity beta is currently estimated at 1·4. Newimber Co’s current cost of equity is 11·8% and its current before-tax cost of debt is 4·5%.

The asset beta of the formal clothing division is estimated to be 1·21. The weighting in estimating Newimber Co’s overall asset beta is 60% for the formal clothing division to 40% for the sportswear division. The debt beta can be assumed to be zero.

In return for 40% of the issued share capital of Newimber Co, its current shareholders will receive 100% of the issued share capital of Poynins Co, corresponding to the assets and liabilities being transferred.

The shares in Newimber Co which shareholders have given up will be cancelled. After the demerger, Newimber Co’s new market capitalisation can be assumed to be $351 million. Poynins Co will have no long-term debt, the liability for the $200 million loan notes remaining with Newimber Co.

The current risk-free rate of return is estimated to be 3·4%. The market risk premium is estimated to be 6%. A tax rate of 28% is applicable to all companies.

The sportswear division currently has $36 million operating cash flows. Its managers believe that operating cash flows can increase by the following rates once Poynins Co has been listed:

Year %
1 25
2 20
3 15
4 onwards 2

The sportswear division’s managers believe that Poynins Co will require a $20 million investment of additional assets in Year 1, rising to $22 million in each of Years 2 and 3, and to $25 million annually from Year 4 onwards.

(a) Discuss the advantages and disadvantages of demerging the sportswear division into a new company. (5 marks)