201506 Q3

201506 Q3
In order to raise funds for future projects, the management
of Bento Co, a large manufacturing company, is
considering disposing of one of its subsidiary companies,
Okazu Co, which is involved in manufacturing rubber
tubing. They are considering undertaking the disposal
through a management buy-out (MBO) or a management
buy-in (MBI). Bento Co wants $60 million from the sale of
Okazu Co.
Given below are extracts from the most recent financial
statements for Okazu Co:
 201506 Q3
Year ending 30 April (all amounts in $000)
2015
Total non-current assets 40,800
Total current assets 12,300
Total assets 53,100
Equity 24,600
Non-current liabilities 16,600
Current liabilities
Trade and other payables 7,900
Bank overdraft 4,000
Total current liabilities 11,900
Total equity and liabilities 53,100
 201506 Q3

Year ending 30 April (all amounts in $000)

2015
Sales revenue 54,900
Operating profit 12,200
Finance costs 1,600
Profit before tax 10,600
Taxation 2,120
Profit for the year 8,480
 201506 Q3
Notes relating to the financial statements above:
I. Current assets, non-current assets and the trade and other
payables will be transferred to the new company when Okazu
Co is sold. The bank overdraft will be repaid by Bento Co prior
to the sale of Okazu Co.
II. With the exception of the bank overdraft, Bento Co has
provided all the financing to Okazu Co. No liabilities, except
the trade and other payables specified above, will be
transferred to the new company when Okazu Co is sold.
III. It is estimated that the market value of the non-current assets is
30% higher than the book value and the market value of the
current assets is equivalent to the book value.
IV. The group finance costs and taxation are allocated by Bento Co
to all its subsidiaries in pre-agreed proportions.
 201506 Q3
Okazu Co’s senior management team has approached Dofu Co, a
venture capital company, about the proposed MBO. Dofu Co has
agreed to provide leveraged finance for a 50% equity stake in the
new company on the following basis:
I. $30 million loan in the form of an 8% bond on which interest
is payable annually, based on the loan amount outstanding at
the start of each year. The bond will be repaid on the basis of
fixed equal annual payments (constituting of interest and
principal) over the next four years;
II. $20 million loan in the form of a 6% convertible bond on
which interest is payable annually. Conversion may be
undertaken on the basis of 50 equity shares for every $100
from the beginning of year five onwards;
III. 5,000,000 $1 equity shares for $5,000,000.
 201506 Q3
Okazu Co’s senior management will contribute $5,000,000 for
5,000,000 $1 equity shares and own the remaining 50% of the
equity stake.
As a condition for providing the finance, Dofu Co will impose
a restrictive covenant that the new company’s gearing ratio
will be no higher than 75% at the end of its first year of
operations, and then fall to no higher than 60%, 50% and 40%
at the end of year two to year four respectively. The gearing
ratio is determined by the book value of debt divided by the
combined book values of debt and equity.
 201506 Q3
After the MBO, it is expected that earnings before interest
and tax will increase by 11% per year and annual dividends of
25% on the available earnings will be paid for the next four
years. It is expected that the annual growth rate of dividends
will reduce by 60% from year five onwards following the
MBO. The new company will pay tax at a rate of 20% per
year. The new company’s cost of equity has been estimated at
12%.
 201506 Q3
Required:
a) Distinguish between a management buy-out (MBO) and a
management buy-in (MBI). Discuss the relative benefits
and drawbacks to Okazu Co if it is disposed through a
MBO instead of a MBI. (5 marks)
b) Estimate, showing all relevant calculations, whether the
restrictive covenant imposed by Dofu Co is likely to be
met. (12 marks)
c) Discuss, with supporting calculations, whether or not an
MBO would be beneficial for Dofu Co and Okazu Co’s
senior management team. (8 marks)
(25 marks)
 201506 Q3 - Answer
(b) Annuity (8%, 4 years) = 3·312
Annuity payable per year on loan = $30,000,000/3·312 = $9,057,971
Interest payable on convertible loan, per year = $20,000,000 × 6% = $1,200,000

Annual interest on 8% bond

(All amounts in $ 000s)
Year end 1 2 3 4
Opening loan balance 30,000 23,342 16,151 8,385
Interest at 8% 2,400 1,867 1,292 671
Annuity (9,058) (9,058) (9,058) (9,058)
Closing loan balance 23,342 16,151 8,385 (2)*

*The loan outstanding in year 4 should be zero. The small negative figure is due
to rounding.
 201506 Q3 - Answer
Estimate of profit and retained earnings after MBO
(All amounts in $ 000s)
Year end 1 2 3 4
Operating profit 13,542 15,032 16,686 18,521
Finance costs 3,600 3,067 2,492 1,871
––––––– ––––––– ––––––– –––––––
Profit before tax 9,942 11,965 14,194 16,650
Taxation 1,988 2,393 2,839 3,330
––––––– ––––––– ––––––– –––––––
Profit for the year 7,954 9,572 11,355 13,320
Dividends 1,989 2,393 2,839 3,330
––––––– ––––––– ––––––– –––––––
Retained earnings 5,965 7,179 8,516 9,990
 201506 Q3 - Answer
Estimate of gearing
(All amounts in $ 000s)
Year end 1 2 3 4
Book value of equity 15,965 * 23,144 31,660 41,650
Book value of debt 43,342 36,151 28,385 20,000
Gearing 73% 61% 47% 32%
Covenant 75% 60% 50% 40%
Covenant breached? No Yes No No
 201506 Q3 - Answer
*The book value of equity consists of the sum of the
5,000,000 equity shares which Dofu Co and Okazu Co’s
senior management will each invest in the new company
(total 10,000,000), issued at their nominal value of $1 each,
and the retained earnings from year 1. In subsequent years the
book value of equity is increased by the retained earnings
from that year.
The gearing covenant is forecast to be breached in the second
year only, and by a marginal amount. It is forecast to be met
in all the other years. It is unlikely that Dofu Co will be too
concerned about the covenant breach.
 201506 Q3 - Answer
(c) Net asset valuation
Based on the net asset valuation method, the value of the new company
is approximately:
1·3 × $40,800,000 + $12,300,000 – $7,900,000 approx. = $57,440,000

Dividend valuation model

Year Dividend DF (12%) PV
($000s) ($000s)
1 1,989 0·893 1,776
2 2,393 0·797 1,907
3 2,839 0·712 2,021
4 3,330 0·636 2,118
–––––––
Total 7,822
–––––––
 201506 Q3 - Answer
Annual dividend growth rate, years 1 to 4 = (3,330/1,989)1/3 – 1 =
18·7%
Annual dividend growth rate after year 4 = 7·5% [40% x 18·7%]
Value of dividends after year 4 = ($3,330,000 × 1·075)/(0·12 –
0·075) × 0·636 = $50,594,000 approximately

Based on the dividend valuation model, the value of new company

is approximately:
$7,822,000 + $50,594,000 = $58,416,000
 201506 Q3 - Answer
The $60 million asked for by Bento Co is higher than the
current value of the new company’s net assets and the
value of the company based on the present value of future
dividends based on the dividend valuation model.
Although the future potential of the company represented
by the dividend valuation model, rather than the current
value of the assets, is probably a better estimate of the
potential of the company, the price of $60 million seems
excessive.
Nevertheless, both the management team and Dofu Co are
expected to receive substantial dividends during the first
four years and Dofu Co’s 8% bond loan will be repaid
within four years.
 201506 Q3 - Answer
Furthermore, the dividend valuation model can produce a
large variation in results if the model’s variables are changed
by even a small amount.
Therefore, the basis for estimating the variables should be
examined carefully to judge their reasonableness, and
sensitivity analysis applied to the model to demonstrate the
impact of the changes in the variables.
The value of the future potential of the new company should
also be estimated using alternative valuation methods
including free cash flows and price-earnings methods.
 201506 Q3 - Answer
It is therefore recommended that the MBO should not be
rejected at the outset but should be considered further. It is
also recommended that the management team and Dofu Co
try to negotiate the sale price with Bento Co.
(Note: Credit will be given for alternative, relevant
discussion for parts (a) and (c))
 You’re a Champion!
Thanks for staying with us. You have finished this task.