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Education Course Notes [Session 7 & 8] Chapter 11 Financial Reconstruction LEARNING OBJECTIVES 1. 2. 3. Assess an organizational situation and determine whether a financial reconstruction is the most appropriate strategy for dealing with the problem as presented. Assess the likely response of the capital market and/or individual suppliers of capital to any reconstruction scheme and the impact their response is likely to have upon the value of the organization. Recommend a reconstruction scheme from a given business situation, justifying the proposal in terms of its impact upon the reported, performance and financial position of the organization. Financial Reconstruction Reconstruction Schemes Financial Reconstructions Leveraged Buy-outs (LBOs) To Prevent Business Failure Leveraged Buy-outs Meaning of LBOs For Value Creation Leveraged Recapitalizations Procedures for Going Private Types of Reconstruction Debt-equity Swaps Advantages of LBOs Step-by-step Approach to Design Reconstructions Disadvantages of LBOs Different Stakeholders Requirements Prepared by Patrick Lui P. 248 Copyright @ Kaplan Financial 2015 Education Course Notes [Session 7 & 8] 1. Reconstruction Schemes 1.1 Reconstruction schemes to prevent business failure 1.1.1 A company might be on the brink of going into liquidation, but hold out good promise of profits in the future. In such a situation, the company might be able to attract fresh capital and to persuade its creditors to accept some securities in the company as 'payment', and achieve a capital reconstruction which allows the company to carry on in business. 1.2 Reconstruction schemes for value creation 1.2.1 Reconstruction schemes may also be undertaken by companies which are not in difficulties as part of a strategy to create value for the owners of the company. The management of a company can improve operations and increase the value of the company by 1.3 (a) reducing costs through the sale of a poorly performing division or subsidiary (b) increasing revenue or reducing costs through the acquisition of a company to exploit revenue or cost economies (c) improving the financial structure of the company Types of reconstruction 1.3.1 Depending on the actions that a company needs to take as part of its reconstruction plans, these schemes are usually classified in three categories (a) Financial reconstruction which involves changing the capital structure of the firm (b) Portfolio reconstruction, which involves making additions to or disposals from companies' businesses e.g. through acquisitions or spin-offs (c) Organisational restructuring, which involves changing the organisational structure of the firm Prepared by Patrick Lui P. 249 Copyright @ Kaplan Financial 2015 Education Course Notes 1.4 [Session 7 & 8] Step-by-step approach to designing reconstructions 1.4.1 You can use the following approach to designing reconstructions. Step 1: Estimate the position of each party if liquidation is to go ahead. This will represent the minimum acceptable payment for each group. Step 2: Assess additional sources of finance, for example selling assets, issuing shares, raising loans. The company will most likely need more finance to keep going. Step 3: Design the reconstruction. Often the question will give you details of how to do it. Step 4: Calculate and assess the new position, and also how each group has fared, and compare with Step 1 position. Check that the company is financially viable after the reconstruction. Step 5: 1.4.2 In addition, the following points should be remembered when designing the reconstruction: (a) Anyone providing extra finance for an ailing (生病的) company must be persuaded that the expected return from the extra finance is attractive. A profit forecast and a cash forecast will be needed to provide reassurance about the company’s future, to creditors and to any financial institution that is asked to put new capital into the company. (b) The reconstruction must indicate that the company has a good chance of being financially viable. The actual reconstruction might involve the creation of new share capital of a different nominal value than existing share capital, or the cancellation of existing share capital. It can also involve the conversion of equity to debt, debt to equity, and debt (c) of one type to debt of another. For a scheme of reconstruction to be acceptable it needs to treat all parties fairly, and it needs to offer creditors a better deal than if the company went into liquidation. If it did not, the creditors would press for a winding up of the company. Prepared by Patrick Lui P. 250 Copyright @ Kaplan Financial 2015 Education Course Notes 1.5 [Session 7 & 8] Different stakeholders requirements (Dec 15) 1.5.1 The interests of a number of different stakeholder groups must be taken into account in a reconstruction. A reconstruction will only be successful if it manages to balance the different objectives (risk and potential return) of: (a) ordinary shareholders (b) preference shareholders (c) creditors, including trade payables, bankers and debenture holders 1.5.2 In a failing company, the reconstruction should be organized so that the main burden of any loss falls on the ordinary shareholders. Stakeholder Solvent companies Requirements It often enter reconstruction schemes to improve their ability to raise finance in the future by making security in the company more attractive or to improve the image of the company to third parties. Ordinary shareholders The main burden of losses should be borne primarily by the ordinary shareholders, as they are last in line in repayment of capital on a winding up. In many cases, the capital loss is so great that they would receive nothing upon a liquidation of the company. Preference shares They must, however, be left with some remaining stake in the company if further finance is required from them. Their loss should be less than that borne by ordinary shareholders. They may agree to forgo arrears of dividends in anticipation that the scheme will lead to a resumption of their dividends. Creditors Including debenture and loan stock holders may agree to a reduction in their claims against the company if they anticipate that full repayment would not be received on liquidation. An incentive may be given in the form of an equity stake. In addition, trade creditor may also agree to a reduction if they wish to protect a company which will continue to be a customer to them. Prepared by Patrick Lui P. 251 Copyright @ Kaplan Financial 2015 Education Course Notes 2. [Session 7 & 8] Financial Reconstructions (Dec 10, Dec 15) 2.1 Introduction 2.1.1 A financial reconstruction scheme is a scheme whereby a company reorganises its capital structure, including leveraged buyouts, leveraged recapitalisations and debt for equity swaps. 2.1.2 There are many possible reasons why management would wish to restructure a company's finances. A reconstruction scheme might be agreed when a company is in danger of being put into liquidation, owing debts that it cannot repay, and so the creditors of the company agree to accept securities in the company, perhaps including equity shares, in settlement of their debts. 2.1.3 On the other hand a company may be willing to undergo some financial restructuring to better position itself for long term success. 2.2 Leveraged buy-outs 2.2.1 A leveraged buy out is a transaction in which a group of private investors uses debt financing to purchase a company or part of a company. 2.2.2 In a leveraged buy out, like a leveraged capitalisation, the company increases its level of leverage, but unlike the case of leveraged capitalisations, the company does not have access to equity markets any more. This is covered in more detail in Section 3 of this chapter. 2.3 Leveraged recapitalizations 2.3.1 In leveraged recapitalisation a firm replaces the majority of its equity with a package of debt securities consisting of both senior and subordinated debt. 2.3.2 Leveraged capitalisations are employed by firms as defence mechanisms to protect them from takeovers. The high level of debt in the company discourages corporate raiders who will not be able to borrow against the assets of the target firm in order to finance the acquisition. 2.3.3 In order to avoid the possible financial distress arising from the high level of debt, companies that engage in leveraged recapitalisation should be relatively debt free, they should have stable cash flows and they should not require substantial ongoing capital expenditure in order to retain their competitive position. Prepared by Patrick Lui P. 252 Copyright @ Kaplan Financial 2015 Education Course Notes 2.4 [Session 7 & 8] Debt-equity swaps (Jun 13) 2.4.1 A second way of changing its capital is to issue a debt/equity or an equity/debt swap. 2.4.2 In the case of an equity/debt swap, all specified shareholders are given the right to exchange their stock for a predetermined amount of debt (ie bonds) in the same company. 2.4.3 A debt/equity swap works the opposite way: debt is exchanged for a predetermined amount of equity (or stock). 2.4.4 The value of the swap is determined usually at current market rates, but management may offer higher exchange values to entice share and debt holders to participate in the swap. After the swap takes place, the preceding asset class is cancelled for the newly acquired asset class. 2.4.5 One possible reason that the company may engage in debt-equity swaps is because the company must meet certain contractual obligations, such as maintaining debt/equity ratio below a certain number. 2.4.6 Also a company may issue equity to avoid making coupon and face value payments because they feel they will be unable to do so in the future. 2.4.7 The contractual obligations mentioned can be a result of financing requirements imposed by a lending institution, such as a bank, or may be self-imposed by the company, as detailed in the company's prospectus. A company may self-impose certain valuation requirements to entice investors to purchase its stock. 2.4.8 Debt/equity swaps may also be carried out to rebalance a firm's WACC. Question 1 ABC Computer Global is a company that manufactures a range of personal computers that are sold to retailers, and also directly to individuals and businesses through online sales. Due to a number of technical problems the company’s sales have fallen significantly over the last year resulting in an operating loss of $160,000. The company has, as a result, built up losses on its retained earnings and there is a significant risk of insolvency. To avoid this, the company’s financial advisers have proposed a scheme of reconstruction. Prepared by Patrick Lui P. 253 Copyright @ Kaplan Financial 2015 Education Course Notes [Session 7 & 8] Statement of financial position as at 31 December 2014 $000 $000 Assets 1,100 Non-current assets Current assets Inventory Receivables Cash 410 220 25 655 1,755 Total assets Equity and liabilities Share capital ($1 per share) Retained earnings 200 (50) 150 1,200 Total equity Non-current liabilities – bank loan Current liabilities Payables Overdraft 205 200 405 1,755 Total equity and liabilities Notes: 1. If the company was liquidated all of the assets could be sold for their book values except for inventory. Following a review it was discovered that $220,000 of the inventory is obsolete but the remainder could sold for book value. In addition $90,000 of the receivables is irrecoverable. 2. To be successful a scheme of reconstruction would need to raise $195,000 of cash to invest in new manufacturing processes. 3. Given the risk attached to the company any providers of new equity capital will require a return of at least 18%. 4. The current interest rates are 8% on the bank loan and 6% on the overdraft. The bank loan is secured. The following scheme of reconstruction is proposed: 1. 2. 3. The nominal value of each existing share will be reduced to 50c. Goodwin bank (who provide both the overdraft and loan) will convert half of the overdraft and 1/3 of the loan into a total of 200,000 new shares. New finance of $400,000 will be raised from a venture capital company, PC ventures, who will buy new shares for $1.25 per share. In addition to investing in the new Prepared by Patrick Lui P. 254 Copyright @ Kaplan Financial 2015 Education Course Notes [Session 7 & 8] manufacturing process the finance will also be used to repay the payables. 4. Following the reconstruction it is expected that the company will generate $320,000 of profit before interest and tax per annum. Tax is payable at 28%. Assume no tax losses. Required: (a) (b) (c) (d) Determine how much each of the original investors likely to get in the event of a liquidation. Following the reconstruction, calculate the expected EPS, and the return on equity to the venture capital company, and advise as whether the venture capital company is likely to invest in ABC Computer Global. From the post reconstruction EPS calculation above, calculate the effective return that the bank is likely to receive on the capital converted into equity. Determine whether the existing ordinary shareholders, and the bank, are likely to accept the scheme. 3. Leveraged buy-outs (LBOs) 3.1 Meaning of LBOs 3.1.1 A leveraged buyout (LBO) is a transaction when a company is purchased with a combination of equity and significant amounts of borrowed money, structured in such a way that the target's cash flows or assets are used as the collateral (or "leverage") to secure and repay the money borrowed to purchase the target. 3.2 Procedures for going private 3.2.1 A public company 'goes private' when a small group of individuals, possibly including existing shareholders and/or managers and with or without support from a financial institution, buys all of the company's shares. This form of restructuring is relatively common in the USA and may involve the shares in the company ceasing to be listed on a stock exchange. Prepared by Patrick Lui P. 255 Copyright @ Kaplan Financial 2015 Education Course Notes 3.3 [Session 7 & 8] Advantages of LBOs 3.3.1 Advantages: (a) The costs of meeting listing requirements can be saved. (b) The company is protected from volatility in share prices which financial problems may create. (c) The company will be less vulnerable to hostile takeover bids. (d) Management can concentrate on long-term needs of the business rather than the short-term expectations of shareholders. (e) Shareholders are likely to be closer to management in a private company, reducing costs arising from the separation of ownership and control (the agency problem). 3.4 Disadvantages of LBOs 3.4.1 The main disadvantages with LBOs is that the company loses its ability to have its shares publicly traded. If a share cannot be traded it may lose some of its value. 3.4.2 However, one reason for seeking private company status is that the company has had difficulties as a quoted company, and the prices of its shares may be low anyway. Prepared by Patrick Lui P. 256 Copyright @ Kaplan Financial 2015