The European Sovereign Debt crisis

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Question 1b

Nahara Co and Fugae Co
Nahara Co is a private holding company owned by the government of a wealthy oil-rich country to invest its sovereign funds. Nahara Co has followed a strategy of risk diversification for a number of years by acquiring companies from around the world in many different sectors.

One of Nahara Co’s acquisition strategies is to identify and purchase undervalued companies in the airline industry in Europe. A recent acquisition was Fugae Co, a company based in a country which is part of the European Union (EU). Fugae Co repairs and maintains aircraft engines.

A few weeks ago, Nahara Co stated its intention to pursue the acquisition of an airline company based in the same country as Fugae Co. The EU, concerned about this, asked Nahara Co to sell Fugae Co before pursuing any further acquisitions in the airline industry.

Avem Co’s acquisition interest in Fugae Co
Avem Co, a UK-based company specialising in producing and servicing business jets, has approached Nahara Co with a proposal to acquire Fugae Co for $1,200 million. Nahara Co expects to receive a premium of at least 30% on the estimated equity value of Fugae Co, if it is sold.

Given below are extracts from the most recent statements of financial position of both Avem Co and Fugae Co.

Avem Co $ million Fugae Co
Share capital (50c/share) 800 100
Reserves 3,550 160
Non-current liabilities 2,200 380
Current liabilities 130 30
Total capital and liabilities
6,680

670

Each Avem Co share is currently trading at $7·50, which is a multiple of 7·2 of its free cash flow to equity. Avem Co expects that the total free cash flows to equity of the combined company will increase by $40 million due to synergy benefits. After adding the synergy benefits of $40 million, Avem Co then expects the multiple of the total free cash flow of the combined company to increase to 7·5.

Fugae Co’s free cash flow to equity is currently estimated at $76·5 million and it is expected to generate a return on equity of 11%. Over the past few years, Fugae Co has returned 77·3% of its annual free cash flow to equity back to Nahara Co, while retaining the balance for new investments.

Fugae Co’s non-current liabilities consist entirely of $100 nominal value bonds which are redeemable in four years at the nominal value, on which the company pays a coupon of 5·4%. The debt is rated at B+ and the credit spread on B+ rated debt is 80 basis points above the risk-free rate of return.

Proposed luxury transport investment project by Fugae Co
In recent years, the country in which Fugae Co is based has been expanding its tourism industry and hopes that this industry will grow significantly in the near future. At present tourists normally travel using public transport and taxis, but there is a growing market for luxury travel. If the tourist industry does expand, then the demand for luxury travel is expected to grow rapidly. Fugae Co is considering entering this market through a four-year project. The project will cease after four years because of increasing competition.

The initial cost of the project is expected to be $42,000,000 and it is expected to generate the following after-tax cash flows over its four-year life:

Year 1 2 3 4
Cash flows ($000s) 3,277.6 16,134.3 36,504.7 35,683.6

The above figures are based on the tourism industry expanding as expected. However, it is estimated that there is a 25% probability that the tourism industry will not grow as expected in the first year. If this happens, then the present value of the project’s cash flows will be 50% of the original estimates over its four-year life.

It is also estimated that if the tourism industry grows as expected in the first year, there is still a 20% probability that the expected growth will slow down in the second and subsequent years, and the present value of the project’s cash flows would then be 40% of the original estimates in each of these years.

Lumi Co, a leisure travel company, has offered $50 million to buy the project from Fugae Co at the start of the second year. Fugae Co is considering whether having this choice would add to the value of the project.

If Fugae Co is bought by Avem Co after the project has begun, it is thought that the project will not result in any additional synergy benefits and will not generate any additional value for the combined company, above any value the project has already generated for Fugae Co.

Although there is no beta for companies offering luxury forms of travel in the tourist industry, Reka Co, a listed company, offers passenger transportation services on coaches, trains and luxury vehicles. About 15% of its business is in the luxury transport market and Reka Co’s equity beta is 1·6. It is estimated that the asset beta of the non-luxury transport industry is 0·80. Reka Co’s shares are currently trading at $4·50 per share and its debt is currently trading at $105 per $100. It has 80 million shares in issue and the book value of its debt is $340 million. The debt beta is estimated to be zero.

General information
The corporation tax rate applicable to all companies is 20%. The risk-free rate is estimated to be 4% and the market risk premium is estimated to be 6%.

Required:
(b) Discuss why the European Union (EU) may be concerned about Nahara Co’s stated intention and how selling Fugae Co could reduce this concern. (4 marks)

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Question 3a

Riviere Co is a small company based in the European Union (EU). It produces high quality frozen food which it exports to a small number of supermarket chains located within the EU as well. The EU is a free trade area for trade between its member countries.

Riviere Co finds it difficult to obtain bank finance and relies on a long-term strategy of using internally generated funds for new investment projects. This constraint means that it cannot accept every profitable project and often has to choose between them.

Riviere Co is currently considering investment in one of two mutually exclusive food production projects: Privi and Drugi. Privi will produce and sell a new range of frozen desserts exclusively within the EU. Drugi will produce and sell a new range of frozen desserts and savoury foods to supermarket chains based in countries outside the EU. Each project will last for five years and the following financial information refers to both projects.

Project Drugi, annual after-tax cash flows expected at the end of each year (€000s)

Year Current 1 2 3 4 5
Cash flows (€000s) (11,840) 1,230 1,680 4,350 10,240 2,200
Privi Drugi
Net present value €2,054,000 €2,293,000
Internal rate of return 17·6% Not provided
Modified internal rate of return 13·4% Not provided
Value at risk (over the project’s life)
95% confidence level €1,103,500 Not provided
90% confidence level €860,000 Not provided

Both projects’ net present value has been calculated based on Riviere Co’s nominal cost of capital of 10%. It can be assumed that both projects’ cash flow returns are normally distributed and the annual standard deviation of project Drugi’s present value of after-tax cash flows is estimated to be €400,000. It can also be assumed that all sales are made in € (Euro) and therefore the company is not exposed to any foreign exchange exposure.

Notwithstanding how profitable project Drugi may appear to be, Riviere Co’s board of directors is concerned about the possible legal risks if it invests in the project because they have never dealt with companies outside the EU before.

Required:
(a) Discuss the aims of a free trade area, such as the European Union (EU), and the possible benefits to Riviere Co of operating within the EU. (5 marks)

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