• 20 Marks

FM – Nov 2014 – L3 – SB – Q2 – Corporate Restructuring

Analyze divestment strategies for Chelsy Plc’s divisions, compute finance needs, and assess buyout and sale implications.

Chelsy Plc has two manufacturing divisions, Bolts and Nuts. The Bolts division is profitable whereas the Nuts division is not. The company’s share price has consequently declined to 50 kobo per share from a price of N2.83 per share three years ago.

The board of directors is considering two proposals:
i. To cease trading and close down the company.
ii. To close the Nuts division and continue the Bolts division through a leveraged management buyout. The new company will continue to manufacture bolts only but will require an additional investment of N275 million to grow the Bolts division’s after-tax cash flows by 3.5 percent in perpetuity. The proceeds from the sale of the Nuts division will be applied to pay the division’s outstanding liabilities. The finance raised from the management buyout will be applied in paying any remaining liabilities, fund additional investment, and purchase the current equity shares at a premium of 20 percent.

The Nuts division is twice the size of the Bolts division in terms of the assets attributable to it.

Extracts from the most recent financial statements of Chelsy Plc are as follows:

Statement of Financial Position as at 31 December 2013

N’000
Non-current assets 605,000
Current assets 1,210,000
Share capital (40 kobo per share) 220,000
Reserves 55,000
Liabilities (non-current and current) 1,540,000

Comprehensive Income Statement for the year ended 31 December 2013

Division Revenue Costs (prior to depreciation, interest, and tax)
Bolts division 935,000 (660,000)
Nuts division 1,870,000 (2,035,000)
Depreciation, interest, and tax (combined): (187,000)
Loss: (77,000)

If the company’s assets are sold, the estimated realizable values are as follows:

N’000
Non-current assets 550,000
Current assets 605,000

Additional Information:

  1. Redundancy and other costs will be approximately N297 million if the whole company is closed and pro rata for individual divisions that are closed. These costs have priority for payment before any other liabilities in case of closure. The taxation effects relating to this may be ignored.
  2. Company income tax on profits is 30%, and it can be assumed that tax is payable in the year it is liable.
  3. Annual depreciation on non-current assets is 10%, and this is the amount of investment needed to maintain the current level of activity.
  4. The new company’s cost of capital is expected to be 11%.

Required:

(a) Discuss, briefly, the possible benefits of divesting Bolts division through a management buyout. (4 Marks)
(b) Estimate the return the creditors and the shareholders will receive in the event that Chelsy Plc is closed and all its assets sold. (3 Marks)
(c) Estimate the additional amount of finance needed and the value of the new company if only the assets of Nuts division are sold and the Bolts division is divested through a management buyout. (8 Marks)
(d) Discuss the issues that should be taken into consideration in relation to:
i. Seeking potential buyers and negotiating the price
ii. Due diligence
(Assume that the Nuts division is to be sold as a going concern). (5 Marks)

(a) Possible Benefits of Divesting Bolts Division through a Management Buyout (4 Marks)

  1. Continuation of Business Operations: Allows the profitable Bolts division to continue operations under new management, preserving jobs and business relationships.
  2. Focused Strategy: The Bolts division can focus solely on its growth and profitability without being burdened by the losses of the Nuts division.
  3. Better Valuation: The leveraged buyout ensures the division is valued independently based on its profitability and growth potential.
  4. Efficient Capital Allocation: Funds raised from the buyout can be directed towards the company’s liabilities and additional investments for growth.
  5. Shareholder Value: The shareholders receive a premium on their shares as part of the buyout.

(b) Return to Creditors and Shareholders if Chelsy Plc is Closed (3 Marks)

Calculations:

  1. Realizable Asset Value:
    • Non-current assets: N550,000
    • Current assets: N605,000
    • Total: N1,155,000
  2. Liabilities and Redundancy Costs:
    • Total liabilities: N1,540,000
    • Redundancy costs: N297,000
  3. Net Realizable Value:
    • Total assets (N1,155,000) – Total liabilities and redundancy costs (N1,837,000) = Deficit of N682,000

Outcome:

  • Creditors: Would recover only part of their claims, with a shortfall of N682,000.
  • Shareholders: No returns, as liabilities exceed asset realizations.

(c) Additional Finance Needed and Value of the New Company (8 Marks)

Step 1: Sale of Nuts Division

  1. Nuts division asset proportion = 2/3 of total assets = (2/3) × N1,155,000 = N770,000.
  2. After liabilities and redundancy costs attributable to Nuts (2/3 of N1,837,000 = N1,224,667), net proceeds = N770,000 – N1,224,667 = Deficit of N454,667.

Step 2: Valuation of New Company (Bolts Division)

  1. Bolts division’s annual cash flow growth: After-tax cash flow = N(935,000 – 660,000) × (1 – 0.3) = N192,050.
  2. Growth rate of cash flows = 3.5%, Cost of capital = 11%.
  3. Perpetual valuation formula:
    Value=Cash flowCost of capital−Growth rate=192,0500.11−0.035=N2,560,667.         

Step 3: Additional Finance Needed

  1. Total required:
    • Additional investment for Bolts = N275,000.
    • Premium for equity purchase = N220,000 × 1.2 = N264,000.
    • Total finance needed = N275,000 + N264,000 = N539,000.
  2. Shortfall from Nuts sale = N454,667 deficit → Additional finance needed = N539,000 – (-N454,667) = N993,667.

(d) Issues in Potential Buyer Search and Due Diligence (5 Marks)

(i) Seeking Potential Buyers and Negotiating Price:

  1. Market Research: Identify strategic buyers who can benefit from synergy with the Nuts division.
  2. Valuation Agreement: Set a fair price based on going concern value and asset realizations.
  3. Terms of Sale: Negotiate terms favorable to both parties, including payment timelines and liabilities coverage.
  4. Stakeholder Communication: Ensure transparent discussions with employees, creditors, and shareholders.

(ii) Due Diligence:

  1. Financial Review: Verify the division’s financial health, including profit margins, assets, and liabilities.
  2. Legal Compliance: Confirm adherence to regulatory requirements and environmental standards.
  3. Operational Analysis: Assess operational efficiency and future profitability.
  4. Risk Assessment: Identify risks, including contingent liabilities and market competition.
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