Calculate ABC's expected EPS, with 4 decimal places, for year 2016, if the company bought back all its preference shares on 01/01/2016 at a value of $95 by raising the same amount of new bank overdraft (Question 14)

For me, EPS(2016) = [($69M + 0.7*($10 * 200,000 - 8.5%*200,000*95)) / (580,000,000 - 200,000 * 100)]

In this calculus, I am confused because the face value and the current price at the time of the buy-back differs.

CFTP Case Study 2016 Spring session 1. ABC Limited was a manufacturer and supplier of yeasts, whitegoods, and household detergents. A review of the firm's businesses was conducted in early 2013. Following this review the Board made a substantial write-down in the carrying value of the whitegoods business. This write-down led to the firm being in breach of certain borrowing covenants relating to the firm's net assets. In conjunction with its financiers, the firm developed and implemented a restructuring plan which included the sale of non-core assets, a $300 million recapitalisation plan and a refinancing of the debt with its major financiers. 2. To the end of 2015, approximately $830 million of debt had been repaid from the proceeds of asset sales, improved cash management, and proceeds of the share placement. All significant asset sales that were required to be made under the restructuring plan had been completed. Significant cost reductions had been achieved in corporate overheads. In addition, all of the main operations had been subjected to cost reviews and savings had been achieved. ABC also raised new bank loans and issued new bonds. With the completion of its financial restructuring, ABC was in the position where it was able to pursue opportunities for enhancing returns to shareholders. 3. An external candidate, John Singleton, was appointed to be the chief executive officer in January 2016. The first major problem Singleton noticed was the way capital investment decisions were reached. ABC used NPV as the selection technique and used a notional cost of capital of 10% in all investment decisions. No explicit allowance was made for the differential risk as the average project in the Yeasts Division was substantially less risky than an average project in the Whitegoods Division. As a result, substantially more capital had been invested in the Whitegoods Division than otherwise might be prudent. Singleton suspected that the misspecification of project cost of capital was the cause for the asset write-down. Singleton decided to put the issue of the cost of capital to the board. 4. At the end of 2015, Harrison family controlled about 48 percent of the equity through its holding of ordinary and preference shares. Institutional investors had about 32 percent of equity interest with retail investors making up the rest. There were five directors at the board. Two long-serving non-executive directors were nominees of the institutional investors. The Harrison family had two representatives, including the chairmanship held by Wolf Harrison. The chief executive officer was the only executive director. 5. Board meetings were generally held monthly. Senior executives regularly attended and presented to board meetings on particular issues. The following agenda items were discussed at the first board meeting of 2016: i. What would be ABC's company after-tax WACC based on its capital structure as at 31/12/15? ii. Should a different cost of capital be established for each business division? How should each divisional cost of capital be measured? iii. Further, how should the risk of each project within a division be measured and incorporated into project evaluation? iv. A discussion of the financing and dividend policy. v. Should the new detergent product proposal be approved and how to finance it? 6. ABC reported an after-tax net profit of $65.9 million for 2015 and did not declare a dividend. ABC had not paid a dividend since the massive write-down in 2013. The net profit after-tax for the financial year 2016 was forecast to be $69 million for ordinary shareholders and a zero dividend payout was planned. 1 7. ABC's Balance Sheet as at 31 December 2015 showed the following data: ($million) ($million) Payables 153 Cash 51 Deferred income taxes 9 Receivables 186 Bank overdrafts 10 Inventories 105 Bonds 575 Investments 90 Bank loans 570 Property, plant and equipment 600 Provisions 68 Intangibles 337 Preference shares 20 Other 50 Share capital 580 Reserves (16) Accumulated losses (550) Total claims 1419 Total assets 1419 8. The after-tax WACC for the company would be calculated annually using the market value of the gross interest-bearing debt and equity securities outstanding at the balance date. The risk-free rate was assumed to be 2.5%. ABC used a market risk premium of 7% in all cost of equity estimates. The company tax rate was 30%. 9. At the balance date, there were 2,000 million ordinary shares and 200,000 preference shares outstanding. ABC could issue new ordinary shares to the public at current market price of 30 cents per share and receive net 29 cents per share after flotation costs. The cumulative perpetual preference shares, issued for $100 each in year 2000, were currently traded at $95 and paid a single $10 annual dividend at year end. The outstanding $575 million bonds had two years to maturity with a coupon rate of 9.0%. The bank loans outstanding had seven years to maturity and interest was charged at the rate of 9.5% on a reducing balance basis. The interest rates on new 2-year bonds and 7-year bank loans were 9.0% and 10.0% respectively. The current interest rate on ABC's outstanding bank overdrafts was 8.5%. In addition, ABC still had access to an undrawn bank loan and overdrafts of $183 million. 10. ABC's chief financial officer, Ydiot Bowen, provided the following estimates to the Board: Division Proportion of corporate assets Divisional equity beta Product Yeasts 0.60 0.90 0.54 Whitegoods 0.30 2.10 0.63 Detergents 0.10 1.20 0.12 1.29 The weighted average of the divisional equity betas was the same as ABC company equity beta of 1.29. Bowen pointed out that his estimates of divisional equity beta were about 20% higher than the industry averages for the three businesses. 11. The Board decided that a separate cost of capital should be established for its business divisions. The divisional WACC would be estimated using the company debt-equity mix and the company borrowing rates as all debt and equity were issued by the company rather than by the divisions. The only difference from the company WACC was that the divisional equity beta would be used to determine the divisional cost of equity. New projects evaluated by each division would be classified into three categories: high risk, average risk and low risk. High risk projects would be evaluated at the divisional WACC plus 2%; average projects at the divisional WACC; and low risk projects at the divisional WACC minus 1%. 12. The general manager of Detergents Division, Simon Cream, had reservations about the use of company capital structure to estimate the division WACC. His competitors in the detergent 2 industry had similar products and asset risk but they employed much lower debt ratios to run their business. Cream would prefer to use the capital structure of the detergent industry to determine the divisional cost of capital. 13. ABC's objective was to maximise shareholders' returns. Debt had historically been used to fund new projects to take advantage of the interest tax shield. A director, John Howard, pointed out that high gearing levels in the past had been a negative factor on the share price. But with the successful restructuring completed, the firm had gradually paid down its debt and was likely to achieve an investment-grade credit rating soon. ABC was currently assigned a BBrating by Standard and Poors. Howard suggested the board to consider paying dividends again to shareholders. 14. The chairman, Wolf Harrison, was not in favour of the payout. Harrison pointed out that shareholders, such as his family members, who had large holdings of ABC shares would have to pay personal income tax on the dividends received. If the company continued to retain all of its earnings, this would be reflected favourably in the share price as the price would not have to fall on each ex-dividend date. These shareholders could then be taxed on the deferred capital gains rather than on dividends each year. Further, a zero payout would benefit long-term investors, including Harrison family, who brought ABC shares before the introduction of the capital gains tax in 1985 or investors who could apply the discount capital gains tax treatment introduced in September 1999. 15. Another director, Shane Lee, however reminded the board that retail shareholders had an overwhelming preference for a policy of high dividend payouts as revealed by the questionnaire sent out with the 2012 dividend notice. ABC paid out 50% of its profits to ordinary shareholders in 2012. 16. Harrison conceded that the interest of other shareholders could not be ignored. If ABC were to start paying dividends again, the firm would make a public announcement well before the implementation of the new policy to allow disgruntled shareholders to switch to other stocks. Singleton then presented his analysis of the existing corporate capital structure. He suggested that the ratio of interest-bearing debt to total assets be reduced to avoid potential financial distress. The ratio of total liabilities to total assets, measured by book values, had been above the average ratio of 0.35 for the manufacturing industry. A further reduction in debt or a new share issue might be good capital management. 17. Harrison explained that ABC was the leader in each of its market segment and had consistently achieved a profit margin higher than its competitors. Due to strong and stable operating profitability and cash flow, the existing high level of debt would not cause any distress unless the firm suffered a huge slump in its earnings before interest and taxes. The recovery of the share price from the low level of 4 cents in 2013 to its current level of 30 cents indicated the confidence of the investors. Historically long-term debts were used to fund longlife projects while bank overdrafts were used for working capital purposes. In addition, ABC had not chosen any specific target debt ratio. The current high debt ratio was simply the result of the write-down in 2013 and of the historical need for external capital. The interest coverage was currently similar to the industry average although the ratio of net interest-bearing debt to equity, based on market values, was higher than the industry average. 18. Singleton noted that ABC was the only company in the industry to have issued preference shares. Singleton suggested the company redeem its outstanding preference shares and issue debt instead to take advantage of the interest tax shield. Harrison explained that the preference 3 shares were issued in 2000 to his family members as a defence mechanism against potential takeover bids. 19. A proposal to develop a new concentrated detergent was presented by Cream. The project life was estimated to be 6 years. A $1 million feasibility study completed in December 2015 indicated that the company could pursue the project with two potential strategies. The first strategy, labelled as 'Big', required ABC to build a $20 million production facility that could meet potential demand in all six years. The second strategy, 'Small' required a $9 million plant to be built first and a $5 million expansion of the production capacity would be considered at the end of year 1. Cream expected a 60% probability that the expansion would be warranted. 20. Howard was concerned with the proposed debt financing arrangement for the project. Cream suggested the use of the bank overdrafts because of the lower interest cost. Howard argued that long-life projects should be funded by long-term finance and equity could be used to rebalance the debt/equity mix. The board asked Singleton to re-examine the detergent project and make a recommendation on the strategy as well as the funding method. If the project was considered viable, it would begin immediately. 21. Table 1 showed the after-tax cash flow projections for the 'Big' strategy. Table 2 showed the \"additional\" after-tax cash flows that would be earned over and above the cash flows from the 'Small\" strategy when expansion went ahead. Table 3 showed an incomplete construction of the after-tax cash flows for the 'Small' strategy without expansion. The before-tax salvage value of the 'Small\" strategy without expansion was expected to be $1 million in year 6. The 'Big' strategy was considered high-risk, the expansion option low-risk and the 'Small' strategy without expansion average risk. Table 1 After-tax cash flow projections for 'Big' ($'000) Year Cash flow Discounted value @10% t=0 -20000 -20000 t=1 4000 3636 t=2 5000 4132 t=3 6500 4884 t=4 5000 3415 t=5 4500 2794 t=6 4000 2258 NPVt=0 = 1119 Table 2 After-tax cash flow projections for 'Expansion' option ($'000) Year Additional cash flow Discounted value @10% t=0 0 0 t=1 -5,000 -5,000 t=2 1500 1364 t=3 1500 1240 t=4 1500 1127 t=5 1000 683 t=6 1000 621 NPVt=1 = 34 4 Table 3 Construction of the after-tax cash flows for 'Small' without expansion ($'000) t=0 t=1 t=2 ... t=5 -9000 t=6 Plant Tax Investment in working capital -400 -16 Capital cash flow -9400 -16 Revenue 4000 4160 Variable cost 1600 1664 Fixed cost 200 Depreciation 1500 Profit before tax 700 Tax (30%) 210 Profit after tax 490 Depreciation 1500 Operating cash flow 1990 Total after-tax cash flow -9400 1974 All figures are rounded to the nearest thousand dollars. Assumptions: Maximum revenue capacity without expansion $4.5 million Tax rate 30% Revenue growth rate in year 2 and 3 4% Revenue growth rate from year 4 onwards 2% maximum Variable cost as a percentage of sales in years 1-6 40% Fixed cost growth rate 5% per year Depreciation straight-line over 6 years $1.5 million a year Initial investment in working capital is equal to 10% of estimated first-year revenue. Investment in working capital in years 1-5 is equal to 10% of the expected change in revenue from the subsequent year. 5 Instructions: Attempt the following problems to help Singleton make the decisions. All cash flows and present values must be rounded to the nearest thousand dollars. Show all workings and/or explanation. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. Calculate ABC's company after-tax WACC, rounded to four decimal places. Calculate the Detergent Division cost of capital, rounded to four decimal places. Provide a valid reason to support Bowen for his estimate of the Detergent Division's equity beta. Explain whether the estimate of the divisional WACC would be higher or lower if Cream used detergent industry capital structure to determine the divisional WACC. Calculate the NPVt=0 of the 'Big' strategy using the appropriate discount rate. Using the appropriate discount rate, calculate the NPVt=1 of the expansion option. Complete Table 3 fully, in accordance with the given assumptions, to show how the total after-tax cash flows in year 0 to year 6 are derived. Calculate the NPVt=0 of the 'Small' strategy without expansion. Calculate the NPVt=0 of the 'Small' strategy with expansion included. Based on the total after-tax cash flows in Table 3, calculate the economic depreciation in year 1 for the 'Small' strategy without expansion. Calculate the value of the abandonment option at t=0 if the 'Small' strategy without expansion could be sold to another company for $9.5 million at the beginning of year 2. Calculate algebraically the break-even annual sales revenue for the \"Small\" strategy without expansion. Assume the project cost of capital to be 10% and a zero growth rate for both sales and fixed costs in all years. Other factors and assumptions remain unchanged. Based on ABC's financial position at 31/12/2015, how would ABC finance the detergent project? Name only one specific source of finance from the balance sheet and the amount required. [General answer such as debt or equity will not be acceptable] Calculate ABC's expected EPS, with four decimal places, for year 2016 if the company bought back all its preference shares on 01/01/2016 at a value of $95 by raising the same amount of new bank overdrafts. Calculate ABC's expected EPS, with four decimal places, for year 2016 if the company issued sufficient new ordinary shares to redeem all outstanding bonds at face value on 01/01/2016. Apart from the impact on EPS, suggest two valid reasons for ABC not to issue new ordinary shares to replace its long-term debt. Explain whether ABC should restart its dividend payout in 2016 and the reason. 6 Group limit: Students can form a group of 4 people or less to attempt the assignment. [UTSOnline Discussion Board may help students find partners.] If a student is unable or unwilling to find anyone else to form a group, he/she has to attempt the case study individually. Presentation: The assignment is to be typed, doubled spaced with a font size of 12 (no smaller than this font size). The length of the submitted work should not exceed 7 A4 pages including the cover page and any spreadsheet. Answer each question in correct sequence. Do not separate any table/spreadsheet from the body of the answers. No appendices should be used. Do not use more than 50 words to explain the answer in any question. No mark will be awarded if exceeding the word limit. Due Date: The assignment is to be submitted to the assignment box \"FINANCE 3\" at Building 8 Level 5 before Monday 17 October 11am. The assignment is worth 20 marks. Each question is worth one mark except questions 1, 7 and 16. Late submission, with whatever excuses, will result in loss of 5 marks per 24 hours or thereof. Students are expected to have completed Questions 1-12 by late September. Members of a group will receive the same mark for the assignment. Get started early to avoid problems such as team members getting sick or leaving the group unexpectedly. As in real life, students have to deal with the \"free-rider\" problem themselves and be actively involved to avoid being kicked out of a group. Assessment: Most issues involved in the case would have been covered in classes. Team discussion of all questions helps achieve a better result (half of the individual work submission received a fail grade in autumn session 2016). The following will be considered in assessing the submitted work: - the correctness of the calculations and reasoning; no partial credit is given in any 1-mark question - the 50-word limit on explanation - no mark is awarded if working is not shown - the quality of the written expression (grammar, spelling etc...) - plagiarism will result in zero marks for the assignment (all assignments are marked by the subject coordinator himself) Note: 1. 2. No plastic cover. Just staple the 7 pages together. Use the cover sheet provided at UTSOnline and list alphabetically the name of the students with student number included. 7