Case Coopers & Co is a private equity firm managing a series of equity funds on behalf of their equity providers. The firm specialises in the acquisition of underperforming publicly quoted companies, aggressively restructuring operations and returning to the stock market at a premium to produce high returns for Coopers & Co's equity providers. Management are seeking to raise a new fund as they have identified Harvey's plc as a potential investment opportunity. Harvey's plc is a chain of supermarkets operating in the UK and Coopers & Co believe that the chain is failing to realise its earnings potential. Harvey's supermarkets have premium town and city centre locations however with the changing behaviour of consumers switching to on-line grocery shopping, coupled with the gentrification of such local hubs, the chain is losing its long established customer loyalty. Coopers & Co believe that re-branding the chain for the 'metro customer and convenience shopper, is the right direction to take the chain. Coopers & Co is prepared to offer a premium over the current share price to persuade Harvey's plc's shareholders to accept the takeover bid. The plan is to re- float the company on the London Stock Exchange in 4 years' time after rigorous stream-lining and restructuring. The senior management of Coopers & Co are confident that their 4-year investment strategy will generate a resale value equivalent to 4 times the forecasted 2024 net after-tax cash flow. As part of the finance team, you have been tasked to evaluate the financial position and performance of the chain of supermarkets as a suitable takeover target and prepare a relevant cash flow appraisal of the 4-year investment. Extracts of Harvey's ple's Summarised Financial Statements for the last 5 years and relevant information on the proposed takeover and projected future cash flows of the investment (notes 1 to 10) have been supplied. 2 Additional Financial Information Shareholder Value Data, FTSE Index Values and Competitor Share Prices 2016-2020 No of shares (10p ordinary shares) Book Value per share (pence) Share price (pence) FTSE 100 Index Samsoms plc share price (pence) Turners plc share price (pence) 2016 2017 2018 2019 2020 2,335, 200,000 2,335,600,000 2,355,900,000 2,368,300,000 2,405,000,000 160.84 173.96 180.40 182.62 188.81 199.00 242.60 224.90 230.10 171.25 6274 7143 7688 6728 7542 254.40 259.00 267.60 265.00 272.50 180.40 189.10 210.80 229.10 228.50 Investment Information 1. Acquisition of Harvey's plc The senior management of Coopers & Co forecast that the chain will be sold at a value equivalent to 4 times the forecasted 2024 net after-tax cash flow. Coopers & Co is therefore prepared to offer a premium of 30% over the current 2020 share price to secure the entire issued share capital, as recorded in Harvey's plc's 2020 accounts. 2. Disposal of Assets Some of Harvey's portfolio of supermarkets have been trading at a loss for some years, making closures and sell-offs necessary in order to improve the company's longer-term profit potential. Coopers & Co estimates that asset disposals will generate 300 million in 2021 and 500 million in 2022. The assets will be sold at a loss compared to their book values. The 2021 asset disposals are expected to reduce the 2020 book value of non-current assets' by 400 million, with the 2022 disposals producing a further reduction in book value of 750 million. Although the losses on these disposals are substantial they will however reduce the company's corporate tax liabilities. 3. Operating Revenues The closures and sell-offs will reduce Harvey's sales revenues in the short term. The sales estimate for 2021 and 2022 is 15000 million and 18000 million respectively. These figures already include the effects of the forecast for price inflation. Thereafter with re-branding and advertising, sales are expected to grow by 10% per cent per annum in real terms over the subsequent 2 years. 4. Cost of Goods Sold New supplier contracts negotiated and an overhaul of inventory management will result in cash flows associated with the cost of goods sold averaging 90% of sales revenues for the 4 trading years from 2021-2024. 5. Administrative expenses and advertising Coopers & Co would restructure and slim-line Harvey's administrative and distribution processes. The estimate for 2021 administrative expenses is 250 million, however this figure is expected to fall by 3% per year in nominal terms over the subsequent 3 years. The extensive rebranding and advertising campaign is estimated to be a fixed cost of 200 million per year subject to annual inflation from year one onwards. 6. Working Capital Improvements in Harvey's operational efficiency would release 50 million of working capital in the first year. 7. Tax and Capital Allowances The corporate tax rate is 20% and paid one year in arrears. Harvey's plc 2020 outstanding tax liability of 87 million is payable at the end of 2021. Assume that the calculation of capital allowances for tax purposes is based on the non-current assets whose opening value for 2021 is the same as the figure for 'Non- Current Assets' contained in the Statement of Financial Position in 2020. The non- current assets attract capital allowances averaging 5% p.a. on a reducing balance basis. These allowances are claimed on assets net of the effects of the disposal of assets outlined above. Capital allowance claims are on a current year basis. 8. Coopers & Co's Transaction Costs In 2020 Coopers & Co had already spent 150 million in research, legal and consultancy fees associated with its interest in launching a bid for Harvey's plc. A successful takeover would incur further legal, administrative and consultancy costs of 300 million, payable immediately. Legal and administrative costs associated with borrowing funds are estimated at 2% of the total amount borrowed and would be paid up-front rather than capitalized. 9. Inflation Inflation is expected to average 2.5% per annum over the next 4 years. 5 Assignment Requirements (100 marks) Task 1 - Ratio & Comparative Analysis - Required 1a. Undertake a ratio analysis of Harvey's plc based on the Financial Statements for the period 2016 to 2020. Highlight the trends in Harvey's plc's profitability and efficiency, solvency, liquidity and shareholder value. (16 marks) 1b. Undertake a comparative analysis of developments in Harvey's plc's share price over the period from 2016 to 2020 with reference to developments in the FTSE 100 index and the share prices of its two main rivals (Samsoms plc and Turners plc) over the same period. (4 marks) Task 2 - Financing & Cost of Capital - Required 2a. Calculate how much Coopers & Co is prepared to pay to acquire Harvey's plc i.e. the investments initial outlay. (2 marks) 2b. Based on the valuation of Harvey's plc (calculated in 2a) and referring to note 10, show how Coopers & Co plan to structure the finance required to fund the takeover, assuming that the entire reserve of available equity (3000 million) is deployed. i.e. how much of the bond finance is required. (2 marks) 2c. Calculate the after-tax weighted average cost of capital (WACC) of the financing used to fund the takeover. (7 marks) Task 3 - Investment Appraisal - Required 3a. Based on the information given (notes 1-10) prepare a 4-year cash flow analysis of Coopers & Co's investment in Harvey's plc. You should incorporate the estimated resale value for Harvey's (note 1), as a relevant after-tax cash flow for year 2024. (16 marks) 3b. Using the after-tax WACC (calculated in 2c) as the appropriate discount rate, calculate the expected net present value (NPV) of the 4-year investment. (2 marks) 3c. Calculate the investment's expected internal rate of return. (2 marks) 3d. Perform a sensitivity analysis based on your cash flow appraisal; re-calculate the NPV and IRR, assuming the chain will be sold at a value equivalent to 3 times the forecasted 2024 net after-tax cash flow. What is the margin of safety? (4 marks) 1 Extracts of Financial Statements for Harvey's plc Summarised Statements of Income 2016-2020 2016 2017 2018 2019 2020 Em Em m Em Em Revenue 16,122 16,317 17,262 17,735 17,536 Cost of sales 15,505 15,713 16,629 - 17,083 16,907 Gross Profit 617 604 633 652 629 Other operating income 169 108 97 88 160 Administrative expenses 472 244 308 - 268 Operating profit 314 468 458 432 521 Finance costs 97 143 78 - 129 86 Profit before taxation 217 325 380 303 435 Taxation 5 - 87 Net earnings 222 305 311 233 348 272 - 20 - 69 - 70 2020 m 9,598 660 353 309 1,322 10,920 Summarised Statements of Financial Position 2016-2020 2016 2017 2018 2019 Em m Em m Assets Non-current assets 7,991 8,070 9,183 9,287 Currents assets Inventory 616 614 686 713 Trade and other receivables 192 214 247 344 Cash and cash equivalents 508 348 346 322 1,316 1,176 1,279 1,379 Total assets 9,307 9,246 10,462 10,666 Current liabilities Trade and other payables 2,518 2,837 2,921 3,070 Other liabilities 237 27 159 279 2,755 2,864 3,080 3,349 Non-current liabilities 2,796 2,319 3,132 2,992 Total Liabilities 5,551 5,183 6,212 6,341 Equity Share capital 234 234 236 237 Other reserves 2,744 2,745 2,776 2,795 Retained earnings 778 1,084 1,238 1,293 3,756 4,063 4,250 4,325 9,307 9,246 10,462 10,666 3,051 345 3,396 2,983 6,379 240 2,809 1,492 4,541 10,920 3 10. Financing Coopers & Co has obtained firm commitments of equity capital from investors of 3000 million to finance corporate acquisitions and plans to borrow the additional funding required to acquire Harvey's plc. Given the financially leveraged character of acquisition strategy, the equity providers expect returns commensurate with exceptionally high levels of risk. Though Coopers & Co equity isn't publicly traded on a stock exchange, an analysis of its business and financial risks suggests that an appropriate equity beta for Coopers & Co is 4. The prevailing risk free rate is 1%, and the expected return on the market portfolio is 9.5%. Management have succeeded in negotiating a 4-year loan of 1500 million from a consortium of finance companies. The consortium, aware of the high level of financial leverage connected to the takeover, would charge an annual fixed rate of interest of 15%. The loan would be paid back as a single payment after 4 years. The remainder of the debt capital required to finance the acquisition would come from a fixed-rate, 4-year irredeemable bond issue. The bond issue is likely to be given a B rating by a credit-rating agency. The average yield on B-rated 4-year bonds is 13% above the annual yield on 4-year UK government securities, which is currently 2.9%. 6 Case Coopers & Co is a private equity firm managing a series of equity funds on behalf of their equity providers. The firm specialises in the acquisition of underperforming publicly quoted companies, aggressively restructuring operations and returning to the stock market at a premium to produce high returns for Coopers & Co's equity providers. Management are seeking to raise a new fund as they have identified Harvey's plc as a potential investment opportunity. Harvey's plc is a chain of supermarkets operating in the UK and Coopers & Co believe that the chain is failing to realise its earnings potential. Harvey's supermarkets have premium town and city centre locations however with the changing behaviour of consumers switching to on-line grocery shopping, coupled with the gentrification of such local hubs, the chain is losing its long established customer loyalty. Coopers & Co believe that re-branding the chain for the 'metro customer and convenience shopper, is the right direction to take the chain. Coopers & Co is prepared to offer a premium over the current share price to persuade Harvey's plc's shareholders to accept the takeover bid. The plan is to re- float the company on the London Stock Exchange in 4 years' time after rigorous stream-lining and restructuring. The senior management of Coopers & Co are confident that their 4-year investment strategy will generate a resale value equivalent to 4 times the forecasted 2024 net after-tax cash flow. As part of the finance team, you have been tasked to evaluate the financial position and performance of the chain of supermarkets as a suitable takeover target and prepare a relevant cash flow appraisal of the 4-year investment. Extracts of Harvey's ple's Summarised Financial Statements for the last 5 years and relevant information on the proposed takeover and projected future cash flows of the investment (notes 1 to 10) have been supplied. 2 Additional Financial Information Shareholder Value Data, FTSE Index Values and Competitor Share Prices 2016-2020 No of shares (10p ordinary shares) Book Value per share (pence) Share price (pence) FTSE 100 Index Samsoms plc share price (pence) Turners plc share price (pence) 2016 2017 2018 2019 2020 2,335, 200,000 2,335,600,000 2,355,900,000 2,368,300,000 2,405,000,000 160.84 173.96 180.40 182.62 188.81 199.00 242.60 224.90 230.10 171.25 6274 7143 7688 6728 7542 254.40 259.00 267.60 265.00 272.50 180.40 189.10 210.80 229.10 228.50 Investment Information 1. Acquisition of Harvey's plc The senior management of Coopers & Co forecast that the chain will be sold at a value equivalent to 4 times the forecasted 2024 net after-tax cash flow. Coopers & Co is therefore prepared to offer a premium of 30% over the current 2020 share price to secure the entire issued share capital, as recorded in Harvey's plc's 2020 accounts. 2. Disposal of Assets Some of Harvey's portfolio of supermarkets have been trading at a loss for some years, making closures and sell-offs necessary in order to improve the company's longer-term profit potential. Coopers & Co estimates that asset disposals will generate 300 million in 2021 and 500 million in 2022. The assets will be sold at a loss compared to their book values. The 2021 asset disposals are expected to reduce the 2020 book value of non-current assets' by 400 million, with the 2022 disposals producing a further reduction in book value of 750 million. Although the losses on these disposals are substantial they will however reduce the company's corporate tax liabilities. 3. Operating Revenues The closures and sell-offs will reduce Harvey's sales revenues in the short term. The sales estimate for 2021 and 2022 is 15000 million and 18000 million respectively. These figures already include the effects of the forecast for price inflation. Thereafter with re-branding and advertising, sales are expected to grow by 10% per cent per annum in real terms over the subsequent 2 years. 4. Cost of Goods Sold New supplier contracts negotiated and an overhaul of inventory management will result in cash flows associated with the cost of goods sold averaging 90% of sales revenues for the 4 trading years from 2021-2024. 5. Administrative expenses and advertising Coopers & Co would restructure and slim-line Harvey's administrative and distribution processes. The estimate for 2021 administrative expenses is 250 million, however this figure is expected to fall by 3% per year in nominal terms over the subsequent 3 years. The extensive rebranding and advertising campaign is estimated to be a fixed cost of 200 million per year subject to annual inflation from year one onwards. 6. Working Capital Improvements in Harvey's operational efficiency would release 50 million of working capital in the first year. 7. Tax and Capital Allowances The corporate tax rate is 20% and paid one year in arrears. Harvey's plc 2020 outstanding tax liability of 87 million is payable at the end of 2021. Assume that the calculation of capital allowances for tax purposes is based on the non-current assets whose opening value for 2021 is the same as the figure for 'Non- Current Assets' contained in the Statement of Financial Position in 2020. The non- current assets attract capital allowances averaging 5% p.a. on a reducing balance basis. These allowances are claimed on assets net of the effects of the disposal of assets outlined above. Capital allowance claims are on a current year basis. 8. Coopers & Co's Transaction Costs In 2020 Coopers & Co had already spent 150 million in research, legal and consultancy fees associated with its interest in launching a bid for Harvey's plc. A successful takeover would incur further legal, administrative and consultancy costs of 300 million, payable immediately. Legal and administrative costs associated with borrowing funds are estimated at 2% of the total amount borrowed and would be paid up-front rather than capitalized. 9. Inflation Inflation is expected to average 2.5% per annum over the next 4 years. 5 Assignment Requirements (100 marks) Task 1 - Ratio & Comparative Analysis - Required 1a. Undertake a ratio analysis of Harvey's plc based on the Financial Statements for the period 2016 to 2020. Highlight the trends in Harvey's plc's profitability and efficiency, solvency, liquidity and shareholder value. (16 marks) 1b. Undertake a comparative analysis of developments in Harvey's plc's share price over the period from 2016 to 2020 with reference to developments in the FTSE 100 index and the share prices of its two main rivals (Samsoms plc and Turners plc) over the same period. (4 marks) Task 2 - Financing & Cost of Capital - Required 2a. Calculate how much Coopers & Co is prepared to pay to acquire Harvey's plc i.e. the investments initial outlay. (2 marks) 2b. Based on the valuation of Harvey's plc (calculated in 2a) and referring to note 10, show how Coopers & Co plan to structure the finance required to fund the takeover, assuming that the entire reserve of available equity (3000 million) is deployed. i.e. how much of the bond finance is required. (2 marks) 2c. Calculate the after-tax weighted average cost of capital (WACC) of the financing used to fund the takeover. (7 marks) Task 3 - Investment Appraisal - Required 3a. Based on the information given (notes 1-10) prepare a 4-year cash flow analysis of Coopers & Co's investment in Harvey's plc. You should incorporate the estimated resale value for Harvey's (note 1), as a relevant after-tax cash flow for year 2024. (16 marks) 3b. Using the after-tax WACC (calculated in 2c) as the appropriate discount rate, calculate the expected net present value (NPV) of the 4-year investment. (2 marks) 3c. Calculate the investment's expected internal rate of return. (2 marks) 3d. Perform a sensitivity analysis based on your cash flow appraisal; re-calculate the NPV and IRR, assuming the chain will be sold at a value equivalent to 3 times the forecasted 2024 net after-tax cash flow. What is the margin of safety? (4 marks) 1 Extracts of Financial Statements for Harvey's plc Summarised Statements of Income 2016-2020 2016 2017 2018 2019 2020 Em Em m Em Em Revenue 16,122 16,317 17,262 17,735 17,536 Cost of sales 15,505 15,713 16,629 - 17,083 16,907 Gross Profit 617 604 633 652 629 Other operating income 169 108 97 88 160 Administrative expenses 472 244 308 - 268 Operating profit 314 468 458 432 521 Finance costs 97 143 78 - 129 86 Profit before taxation 217 325 380 303 435 Taxation 5 - 87 Net earnings 222 305 311 233 348 272 - 20 - 69 - 70 2020 m 9,598 660 353 309 1,322 10,920 Summarised Statements of Financial Position 2016-2020 2016 2017 2018 2019 Em m Em m Assets Non-current assets 7,991 8,070 9,183 9,287 Currents assets Inventory 616 614 686 713 Trade and other receivables 192 214 247 344 Cash and cash equivalents 508 348 346 322 1,316 1,176 1,279 1,379 Total assets 9,307 9,246 10,462 10,666 Current liabilities Trade and other payables 2,518 2,837 2,921 3,070 Other liabilities 237 27 159 279 2,755 2,864 3,080 3,349 Non-current liabilities 2,796 2,319 3,132 2,992 Total Liabilities 5,551 5,183 6,212 6,341 Equity Share capital 234 234 236 237 Other reserves 2,744 2,745 2,776 2,795 Retained earnings 778 1,084 1,238 1,293 3,756 4,063 4,250 4,325 9,307 9,246 10,462 10,666 3,051 345 3,396 2,983 6,379 240 2,809 1,492 4,541 10,920 3 10. Financing Coopers & Co has obtained firm commitments of equity capital from investors of 3000 million to finance corporate acquisitions and plans to borrow the additional funding required to acquire Harvey's plc. Given the financially leveraged character of acquisition strategy, the equity providers expect returns commensurate with exceptionally high levels of risk. Though Coopers & Co equity isn't publicly traded on a stock exchange, an analysis of its business and financial risks suggests that an appropriate equity beta for Coopers & Co is 4. The prevailing risk free rate is 1%, and the expected return on the market portfolio is 9.5%. Management have succeeded in negotiating a 4-year loan of 1500 million from a consortium of finance companies. The consortium, aware of the high level of financial leverage connected to the takeover, would charge an annual fixed rate of interest of 15%. The loan would be paid back as a single payment after 4 years. The remainder of the debt capital required to finance the acquisition would come from a fixed-rate, 4-year irredeemable bond issue. The bond issue is likely to be given a B rating by a credit-rating agency. The average yield on B-rated 4-year bonds is 13% above the annual yield on 4-year UK government securities, which is currently 2.9%. 6