CIMA F3 Exam Surgery

Past Paper Answer Q79

Q79 XK


Marking scheme

Marks

(a) Up to 3 marks per group of stakeholders discussed Max 7
(b) Up to 3 marks per economic or market factor discussed Max 7
(c) Calculations Max 5
Advantages and disadvantages 1 mark per valid point Max 4
Recommendations Max 2
Max 11
Total 25

(a) Interests of the various stakeholder groups
Shareholders in XK
The removal of Company Ys earnings which account for 6% of group earnings may have an effect on
the risk of the group and thus on the required return for investors. In response to these changes the
market value of XK might be adversely affected, thus impacting on shareholders wealth.
XKs directors and employees
If directors have share options, the value of these may be affected if share price falls. Also any profit-
related earnings may be adversely affected if the divestment of Y causes group earnings to fall. If
directors have neither of these benefits the effects of the divestment are likely to be minimal.
Employees should feel few effects unless their jobs were in some way related to Company Y (for
example, head office services). A few redundancies may occur if this is the case.
Company Ys directors and employees
The executive directors of Company Y are funding part of the MBO and as a result are taking on
significantly more risk than they had been exposed to. However with the increase in risk comes the
increase in control.
Non-director employees may be at risk of redundancy or revised terms and conditions if the MBO
results in a restructuring of Company Y or a review of costs. In the long-term the MBO should result in
increased employment if the executive directors ambitions to respond to market challenges are
successful.
Customers
Company Ys customers may be subjected to revised terms and conditions and may lose some
benefits of their supplier being part of a large group (for example, after sales service). However any loss
of earnings as a result of customers going elsewhere will have a greater effect on Company Ys
shareholders and staff than on the customers themselves.
Suppliers and providers of debt finance
In a similar way to customers, Company Ys suppliers may experience revised terms and conditions,
particularly if purchasing policy is currently controlled by Group Head Office. Any major changes to
terms of trade could result in suppliers withdrawing their services or being less generous with credit
terms and discounts.
The removal of Company Y from the group statement of financial position should not cause XKs bank
any great concern. The bonds are secured on non-current assets and even the removal of Company
Ys US$220m non-current assets will not affect the bonds security (US$1,000m secured on the
remaining US$2,030m of non-current assets).
XK should be careful with its current assets : current liabilities ratio. It is required to maintain a ratio of
at least 1.5 : 1. At the moment the ratio stands at 1.65 : 1 (700/425) but this may be affected by the
removal of Company Ys figures from the statement of financial position.
Other stakeholders
Local government and national government may be affected by the divestment although lack of
information precludes us from predicting the extent of the effect. Local government will be anxious to
maintain employment levels in their community whilst national government may focus on the effect of
the divestment on corporation tax receipts.
The group that is most likely to be affected is the executive directors involved in the buyout. XKs
employees may suffer redundancies whilst suppliers may experience changes in terms and conditions.
(b) Economic and market factors
Recession
The current recession could have a significant impact on the negotiations. It may have been a factor in
encouraging the divestment in the first place. XKs bargaining position may be weakened by the
possibility that it is just wanting to remove Company Y from the group, resulting in a lower price being
obtained for the sell-off.
Inflation
As inflation starts to rise, this will erode the real value of the company and also make it more difficult to
estimate future cash flows (and thus NPV). Such uncertainty may reduce the price the financing
syndicate is prepared to pay for Company Y. This will have an obvious negative impact on XKs cash
flow in the event of a sell-off.
Interest rates
Should interest rates increase consumers will be less inclined to spend money on items deemed non-
necessity. Company Ys cash flows are likely to suffer as a result which could have an impact on
perceived risk and cost of capital. An increase in the cost of capital will reduce the NPV of Company Y
and thus the amount that the financing syndicate will be willing to pay.
Alternative investment opportunities
Before XK makes a final decision on whether to divest Company Y, it should consider what it might do
with the cash (currently estimated to be US$325m). There is no point just having this substantial sum
sitting in the bank there should be some potential ideas of how the money might be invested. XK
could consider paying off some of its debt (although the debt situation gives no cause for concern) or
perhaps returning some money to its shareholders in the form of a special dividend or share buyback. If
there are no feasible or attractive options available XK should ask whether it should be divesting itself of
the profitable Company Y.
Stock market sentiment
It is unclear how XKs perceived risk will be affected by the divestment of Company Y. If the divested
subsidiary has a greater perceived risk than that of XK then XKs risk should fall. However without
further information on risk profiles no predictions can be made.
The fact that XKs share price has risen by 5% in the last three months (against a general stock market
decline of 3%) suggests that the stock market has some inside knowledge of the potential divestment.
Shareholders have not been informed nor their views sought therefore their reaction to the proposed
divestment is not yet known.
The share price is likely to increase further when details of the divestment are revealed. XK will be
divesting 6% of group earnings for a price that equates with approximately 10% of total market value
[325/(375 x 8.75)].

(c) Advantages and disadvantages of proposed buyout structure
Venture capitalists
The main advantage of having venture capitalists involved is that they are willing to take a substantial
amount of risk. However this risk-taker approach does not come without a price in this case, the
venture capitalists require all earnings to be retained in the business for five years and an average
return of 25% over that period. If all funds are retained in the business this will help to promote
capital growth. The required return is not unusual for venture capitalists.
However delivering a 25% return will not be easy. The following calculations illustrate the point.
(i) Net earnings per annum after interest
US$m
Previous years earnings (6% of US$510m) 30.6
Contribution to financing by investment bank = 90% of 220 = 198m
Interest on financing by investment bank = (6% of 198m) x (1 0.25) (8.91)
Net earnings for the year 21.69
(ii) Venture capitalists contribution to funding Company Y buyout
US$m
Total cost of buyout 325.0
Directors contribution (5.0)
Investment banks contribution (90% of US$220m) (198.0)
Venture capitalists contribution 122.0
(iii) Return on venture capitalists investment

US$m
Investment 122.00
Net earnings per annum 21.69
Return on investment (21.69/122) 17.8%
Given the figures above, venture capitalists are only likely to receive a maximum of 17.8% return
on their investment (assuming no returns are given to the directors), as opposed to the 25% they
require. The venture capitalists will only invest in Company B if they think the directors can
deliver on their goal of rapid growth.
Investment bank
The maximum investment from the investment bank will be US$198m, resulting in high interest
payments. However the main advantage of debt funding is that equity shareholders retain a
greater share of the business.
The high interest payments will reduce the earnings of Company Y which will in turn reduce the
value of the company and increase its risk. An increase in risk means higher cost of capital.
Interest cover can be calculated as follows.
US$m
Profit before interest and tax: 6% of [(510 x 100/75) + (7.5% x 1,150)] 45.98
Interest on Ys debt: 6% of US$198m 11.88
Interest cover: 45.98/11.88 3.87 times
Interest cover is not very high. If earnings cannot be sustained at the level above then Company
Y may struggle to cover interest payments.
A substantial amount of earnings is being consumed by interest payments, leaving little for
investment for growth. Given the difficulties in trying to meet the venture capitalists required
return (see above), the directors need as much investment as possible to grow the business
otherwise the venture capitalists will start asking questions.
A further issue that cannot be ignored is the matter of repaying the US$198m loan at the end of
five years. The directors will need to accumulate sufficient cash within the business to allow
them to do so. If a significant proportion of earnings is being taken up with interest payments
then this may not be possible.
Directors
The directors are the last to be considered when it comes to earning returns. The calculations of
venture capitalists returns (see above) were based on the assumption that the directors received
no returns which is not sustainable. However no returns will be possible until the other
investors requirements have been met and sufficient growth has taken place.
Alternative financing structures
There are several serious reservations with the current proposed financing structure. As has
been illustrated above, the venture capitalists will not receive the required 25% return on their
investment if current predictions regarding earnings and interest rates are correct. In addition,
there will be little or no opportunity for company growth to remedy this problem as interest
payments comprise a substantial proportion of predicted earnings.
It may be worth negotiating with the venture capitalists to see if they would be willing to take a
larger share of the company. This would reduce the debt finance required from the investment
bank and thus the interest payments, leaving more funds available to provide a return to the
venture capitalists.
Another possibility would be to source another debt provider, perhaps with a more favourable
rate of interest. If that is not possible, the current lender might be prepared to provide an
alternative to straight debt for example, convertible debt or warrants. However this may not be
acceptable given the resultant dilution of equity in the long-term.