Download Chapter 11 Financial Reconstruction

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