ACCA AFM Syllabus A. Role Of The Senior Financial Adviser - Ratios and Strategy - Past Papers ^{1 / 9}

High K Co is one of the three largest supermarket chains in the country of Townia. Its two principal competitors, Dely Co and Leminster Co, are of similar size to High K Co. In common with its competitors (but see below), High K Co operates three main types of store:

– Town centre stores – these sell food and drink and a range of small household items. High K Co’s initial growth was based on its town centre stores, but it has been shutting them over the last decade, although the rate of closure has slowed in the last couple of years.
– Convenience stores – these are smaller and sell food and drink and very few other items. Between 2003 and 2013, High K Co greatly expanded the number of convenience stores it operated. Their performance has varied, however, and since 2013, High K Co has not opened any new stores and closed a number of the worst-performing stores.
– Out-of-town stores – these sell food and drink and a full range of household items, including large electrical goods and furniture. The number of out-of-town stores which High K Co operated increased significantly until 2010, but has only increased slightly since.

The majority of town centre and out-of-town stores premises are owned by High K Co, but 85% of convenience stores premises are currently leased.

High K Co also sells most of its range of products online, either offering customers home delivery or ‘click and collect’ (where the customer orders the goods online and picks them up from a collection point in one of the stores).

High K Co’s year end is 31 December. When its 2016 results were published in April 2017, High K Co’s chief executive emphasised that the group was focusing on:

– Increasing total shareholder return by improvements in operating efficiency and enhancement of responsiveness to customer needs
– Ensuring competitive position by maintaining flexibility to respond to new strategic challenges
– Maintaining financial strength by using diverse sources of funding, including making use in future of revolving credit facilities

Since April 2017, Dely Co and Leminster Co have both announced that they will be making significant investments to boost online sales. Dely Co intends to fund its investments by closing all its town centre and convenience stores, although it also intends to open more out-of-town stores in popular locations.

The government of Townia was re-elected in May 2017. In the 18 months prior to the election, it eased fiscal policy and consumer spending significantly increased. However, it has tightened fiscal policy since the election to avoid the economy overheating. It has also announced an investigation into whether the country’s large retail chains treat their suppliers unfairly.

Extracts from High K Co’s 2016 financial statements and other information about it are given below:

High K Co statement of profit or loss extracts
Year ending 31 December (all amounts in $m)

High K Co statement of financial position extracts

Other information

Required:
(a) Evaluate High K Co’s financial performance. You should indicate in your discussion areas where further information about High K Co would be helpful. Provide relevant calculations for ratios and trends to support your evaluation.

Note: Up to 10 marks are available for calculations. (21 marks)

Cigno Co is a large pharmaceutical company, involved in the research and development (R&D) of medicines and other healthcare products. Over the past few years, Cigno Co has been finding it increasingly difficult to develop new medical products. In response to this, it has followed a strategy of acquiring smaller pharmaceutical companies which already have successful products in the market and/or have products in development which look very promising for the future. It has mainly done this without having to resort to major cost-cutting and has therefore avoided large-scale redundancies. This has meant that not only has Cigno Co performed reasonably well in the stock market, but it has
also maintained a high level of corporate reputation.

Anatra Co is involved in two business areas: the first area involves the R&D of medical products, and the second area involves the manufacture of medical and dental equipment. Until recently, Anatra Co’s financial performance was falling, but about three years ago a new chief executive officer (CEO) was appointed and she started to turn the company around. Recently, the company has developed and marketed a range of new medical products, and is in the process of developing a range of cancer-fighting medicines. This has resulted in a good performance in the stock market, but many analysts believe that its shares are still trading below their true value. Anatra Co’s CEO is of the opinion that the turnaround in the company’s fortunes makes it particularly vulnerable to a takeover threat, and she is thinking of defence strategies that the company could undertake to prevent such a threat. In particular, she was thinking of disposing some of the company’s assets and focussing on its core business.

Cigno Co is of the opinion that Anatra Co is being held back from achieving its true potential by its equipment manufacturing business and that by separating the two business areas, corporate value can be increased. As a result, it is considering the possibility of acquiring Anatra Co, unbundling the manufacturing business, and then absorbing Anatra Co’s R&D of medical products business. Cigno Co estimates that it would need to pay a premium of 35% to Anatra Co’s shareholders to buy the company.

Financial information: Anatra Co
Given below are extracts from Anatra Co’s latest statement of profit or loss and statement of financial position for the year ended 30 November 2015.

Post-acquisition benefits from acquiring Anatra Co
Cigno Co estimates that following the acquisition and unbundling of the manufacturing business, Anatra Co’s future sales revenue and profitability of the medical R&D business will be boosted. The annual sales growth rate is expected to be 5% and the profit margin before interest and tax is expected to be 17·25% of sales revenue, for the next four years. It can be assumed that the current tax allowable depreciation will remain equivalent to the amount of investment needed to maintain the current level of operations, but that the company will require an additional investment in assets of 40c for every $1 increase in sales revenue.

After the four years, the annual growth rate of the company’s free cash flows is expected to be 3% for the foreseeable future.

Anatra Co’s unbundled equipment manufacturing business is expected to be divested through a sell-off, although other options such as a management buy-in were also considered. The value of the sell-off will be based on the medical and dental equipment manufacturing industry. Cigno Co has estimated that Anatra Co’s manufacturing business should be valued at a factor of 1·2 times higher than the industry’s average price-to-earnings ratio. Currently the industry’s average earnings-per-share is 30c and the average share price is $2·40.

Possible additional post-acquisition benefits
Cigno Co estimates that it could achieve further cash flow benefits following the acquisition of Anatra Co, if it undertakes a limited business re-organisation. There is some duplication of the R&D work conducted by Cigno Co and Anatra Co, and the costs related to this duplication could be saved if Cigno Co closes some of its own operations. However, it would mean that many redundancies would have to be made including employees who have worked in Cigno Co for many years. Anatra Co’s employees are considered to be better qualified and more able in these areas of duplication, and would therefore not be made redundant.

Cigno Co could also move its headquarters to the country where Anatra Co is based and thereby potentially save a significant amount of tax, other than corporation tax. However, this would mean a loss of revenue for the government
where Cigno Co is based.

The company is concerned about how the government and the people of the country where it is based might react to these issues. It has had a long and beneficial relationship with the country and with the country’s people.

Cigno Co has estimated that it would save $1,600 million after-tax free cash flows to the firm at the end of the first year as a result of these post-acquisition benefits. These cash flows would increase by 4% every year for the next three years.

Estimating the combined company’s weighted average cost of capital
Cigno Co is of the opinion that as a result of acquiring Anatra Co, the cost of capital will be based on the equity beta and the cost of debt of the combined company. The asset beta of the combined company is the individual companies’ asset betas weighted in proportion of the individual companies’ market value of equity. Cigno Co has a market debt to equity ratio of 40:60 and an equity beta of 1·10.

It can be assumed that the proportion of market value of debt to market value of equity will be maintained after the two companies combine.

Currently, Cigno Co’s total firm value (market values of debt and equity combined) is $60,000 million and Anatra Co’s asset beta is 0·68.

Additional information
– The estimate of the risk free rate of return is 4·3% and of the market risk premium is 7%.
– The corporation tax rate applicable to all companies is 22%.
– Anatra Co’s current share price is $3 per share, and it can be assumed that the book value and the market value of its debt are equivalent.
– The pre-tax cost of debt of the combined company is expected to be 6.0%.

Important note
Cigno Co’s board of directors (BoD) does not require any discussion or computations of currency movements or exposure in this report. All calculations are to be presented in $ millions. Currency movements and their management will be considered in a separate report. The BoD also does not expect any discussion or computations relating to the financing of acquisition in this report, other than the information provided above on the estimation of the cost of capital.

Required:
(c) Discuss whether the defence strategy suggested by Anatra Co’s CEO of disposing assets is feasible. (6 marks)

Kamala Co, a listed company, manufactures parts and machinery for the construction industry. About five years ago, Kamala Co started to manufacture parts and machinery for hospitals and companies engaged in biomedical research using largely the same manufacturing and processing systems it already had in place. In 2011, a young and ambitious chief executive officer (CEO) took over the running of the company.

With the publication of the latest financial statements for the year to 30 November 2014, the CEO made a brief statement and it includes the following two points:

– The CEO was very pleased with growth in the financial ratios provided and sales revenue from 2012 to 2014.
More pleasing was growth in the share price, which increased even faster than the growth in the market index, suggesting that Kamala Co has been a successful company.
– The CEO expressed a desire to make Kamala Co the leading manufacturer of parts and machinery for the construction industry by acquiring a major rival manufacturer in 2015, and financing the acquisition through an issue of a new bond and a small rights issue.

An analyst, after examining the recent financial statements and the two points above, was less positive about Kamala Co’s future prospects.

Given below are extracts from the recent financial statements, some ratios, and other financial information for Kamala Co.

Required:
(c) Evaluate Kamala Co’s performance and conclude whether the analyst’s opinion or the chief executive officer’s opinion has the greater validity. Include any additional ratio and activity trends, and share price analysis, which are deemed to be relevant to the evaluation. (14 marks)