ACCA AFM Syllabus D. Corporate Reconstruction And Re- Organisation - Sell-offs - Past Papers ^{4 / 7}

Staple Group is one of Barland’s biggest media groups. It consists of four divisions, organised as follows:

– Staple National – the national newspaper, the Daily Staple. This division’s revenues and operating profits have decreased for the last two years.

– Staple Local – a portfolio of 18 local and regional newspapers. This division’s operating profits have fallen for the last five years and operating profits and cash flows are forecast to be negative in the next financial year. Other newspaper groups with local titles have also reported significant falls in profitability recently.

– Staple View – a package of digital channels showing sporting events and programmes for a family audience. Staple Group’s board has been pleased with this division’s recent performance, but it believes that the division will only be able to sustain a growth rate of 4% in operating profits and cash flows unless it can buy the rights to show more major sporting events. Over the last year, Staple View’s biggest competitor in this sector has acquired two smaller digital broadcasters.

– Staple Investor – established from a business which was acquired three years ago, this division offers services for investors including research, publications, training events and conferences. The division gained a number of new clients over the last year and has thus shown good growth in revenues and operating profits.

Some of Staple Group’s institutional investors have expressed concern about the fall in profitability of the two newspaper divisions.

The following summarised data relates to the group’s last accounting year. The % changes in pre-tax profits and revenues are changes in the most recent figures compared with the previous year.

Staple Group’s board regards the Daily Staple as a central element of the group’s future. The directors are currently considering a number of investment plans, including the development of digital platforms for the Daily Staple.

The finance director has costed the investment programme at $150 million. The board would prefer to fund the investment programme by disposing parts or all of one of the other divisions. The following information is available to help assess the value of each division:

– One of Staple Group’s competitors, Postway Co, has contacted Staple Group’s directors asking if they would be interested in selling 15 of the local and regional newspapers for $60 million. Staple Group’s finance director believes this offer is low and wishes to use the net assets valuation method to evaluate a minimum price for the Staple Local division.

– Staple Group’s finance director believes that a valuation using free cash flows would provide a fair estimate of the value of the Staple View division.

Over the last year, investment in additional non-current assets for the Staple View division has been $12·5 million and the incremental working capital investment has been $6·2 million.

These investment levels will have to increase at 4% annually in order to support the expected sustainable increases in operating profit and cash flow.

– Staple Group’s finance director believes that the valuation of the Staple Investor division needs to reflect the potential it derives from the expertise and experience of its staff.

The finance director has calculated a value of $118·5 million for this division, based on the earnings made last year but also allowing for the additional earnings which he believes that the expert staff in the division will be able to generate in future years.

Assume a risk-adjusted, all-equity financed, cost of capital of 12% and a tax rate of 30%. Goodwill should be ignored in any calculations.

Staple Group’s finance and human resources directors are looking at the staffing of the two newspaper divisions. The finance director proposes dismissing most staff who have worked for the group for less than two years, two years’ employment being when staff would be entitled to enhanced statutory employment protection.

The finance director also proposes a redundancy programme for longer-serving staff, selecting for redundancy employees who have complained particularly strongly about recent changes in working conditions.

There is a commitment in Staple Group’s annual report to treat employees fairly, communicate with them regularly and enhance employees’ performance by structured development.

Required:
(a) Evaluate the options for disposing of parts of Staple Group, using the financial information to assess possible disposal prices. The evaluation should include a discussion of the benefits and drawbacks to Staple Group from disposing of parts of the Staple Group. (19 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:
(a) Distinguish between a divestment through a sell-off and a management buy-in as forms of unbundling. (4 marks)