Topic: Financial strategy formulation

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ABC Ltd is a listed company that operates in the Information Technology industry. The company has been experiencing losses for several years now, and its reserves are fast depleting. Its earnings per share have been negative for the past three years. A team of the company’s largest shareholders and some managers are considering acquiring the company in a leveraged buy-out (LBO).

Required:
Discuss THREE advantages and THREE disadvantages of ABC Ltd being acquired in an LBO.

Advantages of LBO for ABC Ltd:

  1. Cost Savings from Delisting: Once ABC Ltd is converted to a private company, the costs associated with maintaining its listed status, such as meeting regulatory listing requirements, can be eliminated.
  2. Reduced Volatility in Share Value: Delisting will make the company less vulnerable to stock market fluctuations and inefficiencies, reducing the volatility of its share value.
  3. Increased Managerial Focus: As a private company, the management can focus on long-term business goals rather than short-term profitability targets to satisfy shareholders. This could lead to better strategic decisions.

Disadvantages of LBO for ABC Ltd:

  1. Reduced Marketability of Stock: Delisting from the stock exchange will decrease the liquidity and marketability of ABC Ltd’s shares, which might negatively affect its share value.
  2. Higher Financial Risk: An LBO involves significant debt financing, increasing the financial obligations of ABC Ltd. If the company fails to generate enough cash flow to meet these obligations, it could face bankruptcy.
  3. Potential for Poor Corporate Governance: Without the regulatory oversight associated with being a publicly listed company, ABC Ltd may be perceived to have weaker corporate governance practices, potentially lowering its credit rating and investor confidence.

When determining the financial objectives of a company, it is necessary to take three types of policy decisions into account: investment policy, financing policy, and dividend policy.

Required:
Discuss the nature of these three types of decisions, commenting on how they are interrelated and how they might affect the value of the firm (i.e., the present value of projected cash flows).

The investment decision considers the benefits of investing cash either in projects, working capital, or high-yield deposit accounts. It is crucial for shareholders, as it affects cash flow generation, dividends, and share price. Shareholders compare the risk versus return, knowing that higher-risk investments require higher returns.

The financing decision involves selecting the sources of finance, typically a mix of equity and long-term debt. Debt is cheaper but increases risk for shareholders due to interest obligations, potentially affecting company stability.

The dividend decision determines how much profit is distributed to shareholders versus retained for future investment. Predictable dividends tend to reduce perceived risk and increase firm value.

These three decisions are interrelated as funding investments may come from internal retained earnings or external financing. The cost of capital from the financing decision affects investment viability, which impacts dividends. Ultimately, these decisions together influence the present value of future cash flows, thus affecting the firm’s value.