Topic: Business reorganisation

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  • 10 Marks

AFM – May 2017 – L3 – Q4b – Financial reconstruction, Business reorganisation

Distinguishing between leveraged buy-out and recapitalization, identifying types of reconstruction, and describing steps in financial reconstruction.

There are many possible reasons why management would wish to restructure a company’s finances. A reconstruction scheme might be agreed upon when a company is in danger of being put into liquidation.

Required:
i) Distinguish between a leveraged buy-out and leveraged recapitalisation. (4 marks)
ii) What are the THREE main types of reconstruction? Describe them briefly. (3 marks)
iii) Describe the procedures that should be followed when designing a financial reconstruction scheme. (3 marks)

i) Difference Between Leveraged Buy-out and Leveraged Recapitalisation:

  1. Leveraged Buy-out (LBO):
    A leveraged buy-out occurs when a group of investors uses a significant amount of borrowed money (leverage) to acquire a company. The assets of the company being acquired, along with the acquiring company’s assets, are often used as collateral for the loans. LBOs are typically used to take over large companies without having to commit significant capital upfront.
  2. Leveraged Recapitalisation:
    Leveraged recapitalisation is a strategy used by a company to increase its debt levels in order to pay a large dividend to shareholders or buy back shares. Unlike an LBO, a leveraged recapitalisation does not involve the acquisition of another company but is rather focused on altering the company’s capital structure to return value to its existing shareholders.

(4 marks)

ii) The Three Main Types of Reconstruction:

  1. Financial Reconstruction:
    This type of reconstruction involves altering the company’s capital structure, which may include issuing new shares, renegotiating debt, or converting debt into equity.
  2. Portfolio Reconstruction:
    This involves changing the company’s assets by either acquiring new businesses or divesting existing ones, such as through acquisitions or spin-offs.
  3. Organizational Reconstruction:
    This entails restructuring the company’s management or operational structure, which could involve layoffs, merging departments, or a complete overhaul of the company’s leadership or divisions.

(3 points for 3 marks)

iii) Procedures for Designing a Financial Reconstruction Scheme:

  1. Estimate the Position of Each Party:
    The first step is to evaluate the financial position of all stakeholders (creditors, shareholders, etc.) if liquidation were to occur. This establishes the minimum acceptable outcome for each group.
  2. Assess Additional Sources of Finance:
    The next step is to explore other funding options, such as selling off non-core assets, issuing new shares, or raising additional loans. This can provide the necessary capital to keep the company afloat.
  3. Design a Capital Restructure Scheme:
    A new capital structure must be devised that satisfies all parties involved. This may involve renegotiating debt terms, issuing new equity, or adjusting the ownership structure.
  4. Evaluate the Post-Reconstruction Position:
    The company’s financial viability must be assessed after reconstruction, ensuring that it can operate sustainably with the new structure.

(3 marks)

  • 14 Marks

AFM – Nov 2016 – L3 – Q1b – Business reorganisation | Valuation of acquisitions and mergers

Calculate and analyze the effects of a proposed spin-off on shareholder wealth and discuss reasons and disadvantages of a spin-off.

Last Chance Limited operates various manufacturing and retail operations throughout Ghana and has 400 million GH¢0.25 ordinary shares in issue. For the year that has just ended, the directors reported total after-tax profits of GH¢300 million and the P/E ratio of the company is 11.4 times.

The company has developed sophisticated computer software over the years and now considers ‘spinning-off’ its subsidiary, Ananse Systems Limited. Ananse Systems Limited has contributed GH¢40 million of the total after-tax profits of Last Chance Limited. After the spin-off, Last Chance Limited’s P/E ratio is expected to reduce to 11.0 times, while Ananse Systems Limited is expected to attract a P/E ratio of either 17 or 18 times.

Required:
i) Suggest THREE reasons why Last Chance Limited may wish to ‘spin-off’ part of its operations. (3 marks)
ii) Discuss THREE possible disadvantages of a ‘spin-off’ for the shareholders of Last Chance Limited. (3 marks)
iii) Calculate the likely effect of the proposed ‘spin-off’ on the wealth of a shareholder holding 10,000 ordinary shares in Last Chance, assuming that Ananse Systems Limited trades at a P/E ratio of 17 times and 18 times. (8 marks)
(Ignore taxation)

i) Three reasons for ‘spin-off’:

  • Market sentiment: Investors may feel more confident in separate, specialized companies rather than a conglomerate, increasing shareholder value.
  • Market valuations: The market may undervalue a particular operation. A spin-off can help unlock the value of that operation.
  • Strategic objectives: Directors may wish to focus on the core business, spinning off non-core operations for better strategic alignment.
    (3 marks)

ii) Three disadvantages of ‘spin-off’:

  • Increased vulnerability to takeover: After the spin-off, Last Chance may become a smaller, more attractive acquisition target.
  • Reduced ability to raise finance: A smaller company post-spin-off may struggle to raise finance through debt or equity.
  • Loss of economies of scale: With reduced size, Last Chance may lose advantages like bulk purchasing and shared administrative costs.
    (3 marks)

iii) Effect of spin-off on shareholder wealth:

  • Before spin-off:
    Value of one share in Last Chance Ltd = GH¢300 million × 11.4 / 400 million = GH¢8.55
    Value of 10,000 shares = 10,000 × GH¢8.55 = GH¢85,500
  • After spin-off:
    Earnings available to Last Chance Ltd after spin-off = GH¢300 million – GH¢40 million = GH¢260 million
    Value of one share in Last Chance Ltd after spin-off = GH¢260 million × 11.0 / 400 million = GH¢7.15
    Value of 10,000 shares = 10,000 × GH¢7.15 = GH¢71,500

Ananse Systems Ltd (P/E ratio of 17 times):
Value of one share in Ananse Systems = GH¢40 million × 17 / 64 million = GH¢10.625
Value of 10,000 shares = (1/8 × 10,000) × GH¢10.625 = GH¢13,281
Total wealth of the shareholder = GH¢71,500 + GH¢13,281 = GH¢84,781

Ananse Systems Ltd (P/E ratio of 18 times):
Value of one share in Ananse Systems = GH¢40 million × 18 / 64 million = GH¢11.25
Value of 10,000 shares = (1/8 × 10,000) × GH¢11.25 = GH¢14,062
Total wealth of the shareholder = GH¢71,500 + GH¢14,062 = GH¢85,562

Comment on findings:
The shareholder’s wealth after the spin-off is nearly equal to or slightly higher than before the spin-off, indicating a marginal benefit at best. There is a risk that shareholder wealth could be reduced, depending on the P/E ratio achieved by Ananse Systems.

 

  • 20 Marks

AFM – May 2016 – L3 – Q5 – Corporate Reconstruction and Reorganisation, Business reorganization

Calculate the maximum possible loss of the company and allocate it between preference and ordinary shareholders.

Additional Information:

  • The realizable values of the assets are as follows:
    • Furniture & Fittings: GH¢27.0m
    • Motor Vehicle: GH¢67.5m
    • Land & Building: GH¢26.25m
    • Stocks: GH¢10.95m
    • Debtors: GH¢7.5m
  • The stated capital of the company is made up as follows:
    • 2,000,000 ordinary shares of no par value: GH¢67.5m
    • 500,000 15% cumulative preference shares of no par value: GH¢30.0m
  • The cost of winding up is estimated at GH¢21.3m.
  • The bank overdraft and 18% debentures are secured by a floating charge on the company’s assets.
  • The preference dividends and interest on debentures are two years in arrears. However, no provision has been made for these in the financial statement.
  • The ordinary shareholders have decided to inject GH¢60.0m in consideration for a new issue of equity shares if the capital reconstruction scheme is accepted.
  • Although it is the company’s policy to amortize intangible assets over five years, the Board of Directors has decided to maintain the Goodwill indefinitely in the books due to the persistent losses, in contravention of the company’s policy. Goodwill has been outstanding since 2009. The current financial state of the company negates the value and existence of the goodwill.
  • The preference shareholders have indicated their willingness to bear any deficit resulting from the reconstruction in proportion to their interest in the stated capital. In return, their stake would be converted into equity, and they would be permitted to make nominations to key management positions, including chairing the board for the first five years. If these proposals are accepted, the preference shareholders will contribute further equity of GH¢60.0m. They have also agreed to waive 50% of the arrears of dividend and convert the rest into equity.
  • Any arrears of preference dividends are to form a first charge upon any surplus on winding up.
  • The original ordinary shareholders have decided to waive any dividend due to them during the first two years in order to put the company on sound financial ground.
  • The company is expected to improve its cash flow position and commence dividend payments if the additional capital of GH¢120.0m is introduced.

Required:
a) Calculate the amount available if Crave Cottage Industry Limited is liquidated and its distribution.

(7 marks)
b) Calculate the maximum possible loss of Crave Cottage Industry Limited and its allocation to Preference Share Capital and Ordinary Share Capital. (6 marks)
c) Calculate the Bank/Cash balance of Crave Cottage Industry Limited after the reorganization. (2 marks)
d) Calculate the new stated capital for the company after the reorganization. (2 marks)
e) Prepare a Statement of Financial Position of Crave Cottage Industry Limited showing the position immediately after the scheme has been put in place.

(3 marks)

5a) Liquidation Amount and Distribution

5b) Loss Allocation to Preference and Ordinary Shareholders

Therefore, the maximum possible loss is GH¢75,600 million, of which GH¢23,262 million is allocated to preference shareholders and GH¢52,338 million is allocated to ordinary shareholders.
(2 marks)

  • 10 Marks

AFM – May 2018 – L3 – Q4b – Business reorganisation

Estimating equity growth for a management buyout and determining if the growth target is viable.

UTFM Ltd is experiencing financial difficulties, and management is prepared to undertake a buyout. UTFM Ltd is considering selling the business for GH¢50 million. After an analysis, management concluded that the company requires a capital injection of GH¢30 million. A Venture Capitalist has agreed to raise the required funds, providing GH¢8 million at 10% interest and GH¢7 million in equity. Management will provide the remaining funding as equity.

Forecasted Earnings Before Interest and Tax (EBIT) for the next 5 years are as follows:

Corporation tax is charged at 25%, and dividends are expected to be no more than 10% of profits for the first five years. Management forecasts that the value of equity capital is likely to increase by approximately 15% per annum for the next 5 years.

Required:
On the basis of the above forecasts, determine whether management’s estimate that the value of equity will increase by 15% per annum is a viable one.

Conclusion:

The actual growth rate of equity is 14.60% per annum, which is slightly below the management’s target of 15%. Therefore, while the growth is close, the estimate of 15% per annum growth is not fully viable based on the given forecast.

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