Star Investments Limited Background Star Investments Limited is an investment company, specializing in Investing in small private equity companies. The objective of the firm is to maximize the return to its investments (ie to its shareholding in the companies into which it invests by maximizing its Earnings Per Share - EPS). Star Investments Limited usually undertakes to invest in companies which face financial and liquidity problems. Its strategy is to take over such companies (le to buy their share capital or its majority), to restructure their capital and by"Injecting the required long term capital to turn them into profitable entities. What it tries to do is to maintain a "profitable leverage (gearing) in their long term capital. Thus the objective is to invest in a balanced way in their share capital so that by obtaining a suitable long term loan (usually in the form of fixed interest long term debt) to create a long term capital structure to maximize its earnings per share. An Investment Opportunity Currently Star Investments Limited is examining an investment opportunity. A sea-side restaurant in Limassol, the second largest coastal city of Cyprus is running into difficulties. The restaurant is owned by LSS Restaurants Limited. The only activity of LSS Restaurants Limited is to own and run this restaurant, which Star Investments Limited is considering to take over. It is estimated that with a 600,000 investment in the long run capital of the company (LSS Restaurants Limited) Star Investments Limited will take over the operation and will turn it into a profitable business by introducing major changes which are expected to change its character and its management structure. Proposed Financial Plan The proposed financial plan has two options on which the directors of Star Investments Limited are expected to decide on the basis of their strategy objective which is to maximize the company's return on its investments, measured on the basis of the EPS it can achieve. The two options discussed are the following: Option 1: To invest 600,000 into the share capital of LSS Restaurants Limited, which represent the entire total long term capital of the company. This will involve the issue of 600,000 ordinary shares of 1.00 each of LSS Restaurants Limited to Star Investments Limited, Option 2: To invest 200,000 into the share capital of LSS Restaurants Limited, which represent 2/3 of the entire long term capital of the company. This will involve the issue of 400,000 ordinary shares of 1.00 each of LSS Restaurants Limited to Star Investments Limited. The rest of the long term capital requirement of 200,000 will be financed through the issue a 5% 15 year corporate bond. 5 Thus the proposed long term capital structures of the two options proposed for LSS Restaurants Limited will be summarized as follows: LSS Restaurants Limited Proposed Capital Structures Option 1 () 600,000 Ordinary Shares of 1.00 each 5% 15 year Corporate Bond Total Long Term Capital Option 2 (CO 400,000 200,000 600,000 600,000 Profitability The directors of Star Investments Limited have looked at the operational plan of LSS Restaurants Limited and they anticipate that the company's (LSS Restaurants Limited) expected annual profitability will be at least 30,000 (pessimistic scenario) before interest and tax (currently the corporate tax rate in Cyprus is 10%). The expected annual profitability level is 50,000 before interest and tax while an optimistic scenario suggests that the annual profitability can reach the level of 70,000. 1 The 5% 15 year Corporate Bond is expected to be an unsecured Corporate Bond issued directly by LSS Restaurants limited. It has already been agreed with the banks that co-operate with the expected to be Holding Company) Star Investments Limited, that should the company invest 400,000 in the share capital of LSS Restaurants Limited then they will be willing to invest in the Corporate Bond without asking for the provision of any further securities, Prepared in May 2010. Revised in November 2020 End of Case 3 Questions for Case 3 Question 1 Analyse the expected earnings per share of LSS Restaurants Limited for each one of the two proposed options on the basis of the three profitability scenarios Question 2 Discuss the advantages and disadvantages of the two options for Star Investments Limited and suggest to its directors which option they should adopt