Focus plc has several wholly owned subsidiaries engaged in activities that are outside the business’s core business. A decision has recently been taken to concentrate exclusively on the core business and to divest the other activities.

One of the non-core subsidiaries is Kane Ltd, which operates in an activity that the board of Focus believes to be fast declining. It seems likely that it will be difficult to find a buyer for Kane as a going concern. Also, its break-up value is considered to be small.

In view of these points it has been decided to retain Kane, allowing it to run down gradually over the next three years as its product demand wanes.

Estimates of the various factors relating to Kane, assuming that it continues to be a subsidiary of Focus, have been made. These estimates are shown in notes 1 to 8 below.

All of the cash flows are expressed in terms of current (that is, beginning of Year 1) prices.

The years referred to are the accounting years of Focus (and Kane).

1 Sales revenue for Year 1 is estimated at either £6 million (60 per cent probable) or

£5 million (40 per cent probable). If sales revenue in Year 1 is at the higher level, Year 2 sales revenue is estimated at either £4 million (80 per cent probable) or £3 million

(20 per cent probable). If Year 1 sales revenue is at the lower level, Year 2 sales revenue is estimated at either £3 million (20 per cent probable) or £2 million (80 per cent probable). If Year 2 sales revenue is at the £4 million level, Year 3 sales revenue is estimated at either £3 million (50 per cent probable) or £2 million (50 per cent probable).

At any other level of Year 2 sales revenue, Year 3 sales revenue is estimated at

£2 million (100 per cent probable).

2 Variable costs are expected to be 25 per cent of the sales revenue.
3 Avoidable fixed costs are estimated at £1 million p.a. This does not include depreciation.
4 It is expected that Kane will operate throughout the relevant period with zero working capital.
5 When the closedown occurs at the end of Year 3, there will be closedown costs (including redundancy payments to certain staff) estimated at £0.5 million, payable immediately on closure. The premises will be put on the market immediately. The premises can be sold during Year 4 for an estimated £2 million with the cash being received at the end of Year 4. This is not expected to give rise to any tax effect. The plant is old and would not be expected to yield any significant amount. The tax effects of the plant disposal are expected to be negligible.
6 The corporation tax rate for Focus is expected to be 30 per cent over the relevant period. It may be assumed that tax will be payable at the end of the accounting year to which it relates.
7 Focus’s cost of capital is estimated for the next few years at 14 per cent p.a., in ‘money’ terms.
8 The rate of inflation is expected to average about 5 per cent p.a. during the relevant period. All of Kane’s cash flows are expected to increase in line with this average rate.
Senior managers at Kane disagreed with the Focus directors’ pessimistic view of Kane’s potential. Shortly after the announcement of Focus’s intentions for Kane, the Focus board was approached by some of Kane’s managers with a view to looking at the possibility of an immediate management buy-out, to be achieved by the managers buying the entire share capital of Kane from Focus. The managers had taken steps to find possible financial backers and believed that they could find the necessary support and produce cash at relatively short notice. The board of Focus was asked to suggest a price for Kane as a going concern.
The Focus board was sympathetic to the Kane managers’ proposal and decided to set the offer price for the buy-out at the economic value of Kane to Focus, as if Kane remained a group member until its proposed closedown in three years’ time. The economic value would be based on the expected present value of Kane’s projected cash flows, Focus’s tax position and Focus’s cost of capital. Put another way, Focus was prepared to sell the Kane shares at a price that would leave the Focus shareholders as well off as a result of the management buy-out as they would be were Kane to wind down over the next three years as outlined above.

(a) How much will the Kane managers be asked to pay for the shares? (Work in ‘money’
terms.)

(b) Assuming that the estimates are correct, does this seem a logical price from Focus’s point of view? Why?

(c) What factors may cause the managers of Kane to place a different value on the business? Why? What direction (higher or lower) is the difference likely to be?
(Assume that all cash flows occur at year-ends.)