Long term finance

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Question 3b

Amberle Co is a listed company with divisions which manufacture cars, motorbikes and cycles. Over the last few years, Amberle Co has used a mixture of equity and debt finance for its investments. However, it is about to make a new investment of $150 million in facilities to produce electric cars, which it proposes to finance solely by debt finance.

Project information
Amberle Co’s finance director has prepared estimates of the post-tax cash flows for the project, using a four-year time horizon, together with the realisable value at the end of four years:

Year 1 2 3 4
$m $m $m $m
Post-tax operating cash flows 28·50 36·70 44·40 50·90
Realisable value 45·00

Working capital of $6 million, not included in the estimates above and funded from retained earnings, will also be required immediately for the project, rising by the predicted rate of inflation for each year. Any remaining working capital will be released in full at the end of the project.

Predicted rates of inflation are as follows:

Year 1 2 3 4
8% 6% 5% 4%
The finance director has proposed the following finance package for the new investment:
$m
Bank loan, repayable in equal annual instalments over the project’s life, interest payable at 8% per year 70
Subsidised loan from a government loan scheme over the project’s life on which interest is payable at 3·1% per year 80

150

Issue costs of 3% of gross proceeds will be payable on the subsidised loan. No issue costs will be payable on the bank loan. Issue costs are not allowable for tax.

Financial information
Amberle Co pays tax at an annual rate of 30% on profits in the same year in which profits arise.
Amberle Co’s asset beta is currently estimated at 1·14. The current return on the market is estimated at 11%. The current risk-free rate is 4% per year.

Amberle Co’s chairman has noted that all of the company’s debt, including the new debt, will be repayable within three to five years. He is wondering whether Amberle Co needs to develop a longer term financing policy in broad terms and how flexible this policy should be.

Required:
(b) Discuss the factors which may determine the long-term finance policy which Amberle Co’s board may adopt and the factors which may cause the policy to change. (10 marks)

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Question 3b

In order to raise funds for future projects, the management of Bento Co, a large manufacturing company, is considering disposing of one of its subsidiary companies, Okazu Co, which is involved in manufacturing rubber tubing. They are considering undertaking the disposal through a management buy-out (MBO) or a management buy-in (MBI). Bento Co wants $60 million from the sale of Okazu Co.

Given below are extracts from the most recent financial statements for Okazu Co:

Year ending 30 April (all amounts in $000)

2015
Total non-current assets 40,800
Total current assets 12,300
Total assets
53,100
Equity 24,600
Non-current liabilities 16,600
Current liabilities
    Trade and other payables 7,900
    Bank overdraft 4,000
Total current liabilities
11,900
Total equity and liabilities
53,100
Year ending 30 April (all amounts in $000)
2015
Sales revenue 54,900
Operating profit 12,200
Finance costs 1,600
Profit before tax 10,600
Taxation 2,120
Profit for the year
8,480

Notes relating to the financial statements above:

(i) Current assets, non-current assets and the trade and other payables will be transferred to the new company when Okazu Co is sold. The bank overdraft will be repaid by Bento Co prior to the sale of Okazu Co.

(ii) With the exception of the bank overdraft, Bento Co has provided all the financing to Okazu Co. No liabilities, except the trade and other payables specified above, will be transferred to the new company when Okazu Co is sold.

(iii) It is estimated that the market value of the non-current assets is 30% higher than the book value and the market value of the current assets is equivalent to the book value.

(iv) The group finance costs and taxation are allocated by Bento Co to all its subsidiaries in pre-agreed proportions.

Okazu Co’s senior management team has approached Dofu Co, a venture capital company, about the proposed MBO. Dofu Co has agreed to provide leveraged finance for a 50% equity stake in the new company on the following basis:

(i) $30 million loan in the form of an 8% bond on which interest is payable annually, based on the loan amount outstanding at the start of each year. The bond will be repaid on the basis of fixed equal annual payments (constituting of interest and principal) over the next four years;

(ii) $20 million loan in the form of a 6% convertible bond on which interest is payable annually. Conversion may be undertaken on the basis of 50 equity shares for every $100 from the beginning of year five onwards;

(iii) 5,000,000 $1 equity shares for $5,000,000.
Okazu Co’s senior management will contribute $5,000,000 for 5,000,000 $1 equity shares and own the remaining 50% of the equity stake.

As a condition for providing the finance, Dofu Co will impose a restrictive covenant that the new company’s gearing ratio will be no higher than 75% at the end of its first year of operations, and then fall to no higher than 60%, 50% and 40% at the end of year two to year four respectively. The gearing ratio is determined by the book value of debt divided by the combined book values of debt and equity.

After the MBO, it is expected that earnings before interest and tax will increase by 11% per year and annual dividends of 25% on the available earnings will be paid for the next four years. It is expected that the annual growth rate of dividends will reduce by 60% from year five onwards following the MBO. The new company will pay tax at a rate of 20% per year. The new company’s cost of equity has been estimated at 12%.

Required:
(b) Estimate, showing all relevant calculations, whether the restrictive covenant imposed by Dofu Co is likely to be met. (12 marks)

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Question 5b

Kilenc Co, a large listed company based in the UK, produces pharmaceutical products which are exported around the world. It is reviewing a proposal to set up a subsidiary company to manufacture a range of body and facial creams in Lanosia. These products will be sold to local retailers and to retailers in nearby countries.

Lanosia has a small but growing manufacturing industry in pharmaceutical products, although it remains largely reliant on imports. The Lanosian government has been keen to promote the pharmaceutical manufacturing industry through purchasing local pharmaceutical products, providing government grants and reducing the industry’s corporate tax rate. It also imposes large duties on imported pharmaceutical products which compete with the ones produced locally.

Although politically stable, the recent worldwide financial crisis has had a significant negative impact on Lanosia. The country’s national debt has grown substantially following a bailout of its banks and it has had to introduce economic measures which are hampering the country’s ability to recover from a deep recession. Growth in real wages has been negative over the past three years, the economy has shrunk in the past year and inflation has remained higher than normal during this time.

On the other hand, corporate investment in capital assets, research and development, and education and training, has grown recently and interest rates remain low. This has led some economists to suggest that the economy should start to recover soon. Employment levels remain high in spite of low nominal wage growth.

Lanosian corporate governance regulations stipulate that at least 40% of equity share capital must be held by the local population. In addition at least 50% of members on the Board of Directors, including the Chairman, must be from Lanosia. Kilenc Co wants to finance the subsidiary company using a mixture of debt and equity.

It wants to raise additional equity and debt finance in Lanosia in order to minimise exchange rate exposure. The small size of the subsidiary will have minimal impact on Kilenc Co’s capital structure. Kilenc Co intends to raise the 40% equity through an initial public offering (IPO) in Lanosia and provide the remaining 60% of the equity funds from its own cash funds.

The directors of Kilenc Co have learnt that a sizeable number of equity trades in Lanosia are conducted using dark pool trading systems.

Required:

Explain what dark pool trading systems are and how Kilenc Co’s proposed Initial Public Offering (IPO) may be affected by these. (5 marks)

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