ACCA AFM Syllabus A. Role Of The Senior Financial Adviser - Gearing considerations - Past Papers ^{3 / 9}

Three proposals were put forward for further consideration after a meeting of the executive directors of Ennea Co to discuss the future investment and financing strategy of the business. Ennea Co is a listed company operating in the haulage and shipping industry.

Proposal 1
To increase the company’s level of debt by borrowing a further $20 million and use the funds raised to buy back share capital. 

Proposal 2
To increase the company’s level of debt by borrowing a further $20 million and use these funds to invest in additional non-current assets in the haulage strategic business unit. 

Proposal 3
To sell excess non-current haulage assets with a net book value of $25 million for $27 million and focus on offering more services to the shipping strategic business unit. This business unit will require no additional investment in non-current assets. All the funds raised from the sale of the non-current assets will be used to reduce the company’s debt.

Ennea Co’s forecast after tax profit for the coming year is expected to be $26 million and its current share price is$3•20 per share. The non-current liabilities consist solely of a 6% medium term loan redeemable within seven years.

The terms of the loan contract stipulates that an increase in borrowing will result in an increase in the coupon payable of 25 basis points on the total amount borrowed, while a reduction in borrowing will lower the coupon payable by  15 basis points on the total amount borrowed.

Ennea Co’s effective tax rate is 20%. The company’s estimated after tax rate of return on investment is expected to be 15% on any new investment. It is expected that any reduction in investment would suffer the same rate of return.

Required:

Estimate and discuss the impact of each of the three proposals on the forecast statement of financial position, the earnings and earnings per share, and gearing of Ennea Co. (20 marks)

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:

Shown below is an extract of the latest annual income statement for Tyche Co:

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:

Calculate whether the debt-equity covenant imposed by Palaemon Bank on Tyche Co will be breached over the five-year period. (9 marks)

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:

Shown below is an extract of the latest annual income statement for Tyche Co:

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)