Corporate Finance Assignment
Full Time MBA 2009
Anonymous Marking Code: Z0910803
1- Analyse the Key motivation for corporate restructuring and the potential benefits and drawbacks of an MBO.
2- Critically evaluate any corporate governance issues that might arise.
3- Compute and analyse the risk faced by the company and calculate the cost of capital.
4- Using appropriate valuation techniques calculate the company’s value.
5- Analyse the alternatives available for financing the MBO.
6- Present your conclusions and recommendations to the management team in the light of current economic conditions.
Executive Summary
Grainger plc is the UK’s largest specialist residential property owner and manager traded on the London Stock Exchange. We have approximately £2.1 billion of property assets and £2.8 billion of assets under management. We are property managers for approximately 24,650 properties in the UK and Germany. We intend to maintain this market leading position. (Grainger plc Annual report, Page 2, 2009)
The purpose of this report is to cover the key aspect of the potential corporate restructuring (Management buyout) of Grainger plc. This analysis is not only based on the financial statements but also a comparison to competitors and the market situation taken into consideration.
The main objective for management buyout is: More access to capital & aggressive business plan and to grow the business
Key Motivations for Management:
- 1- Management’s own venture
2- Don’t have to share profit, Don’t have to give dividend
As per Agency Theory, Managers have different interests and motivations than shareholders. For Shareholders, The major concern is depicted as being share prices, whereas managers care about their power, security, and status, and organization size as well as their wealth. Dividend Payments to shareholders reduce the size of the assets under managers’ control and the discretionary power and security of the managers. In the publicly held corporation, managers are supposed to be the agents of shareholders.
But after MBO, management owns a substantial part of the firm, the separation between ownership and control has been reduced. The larger the managers’ ownership position, the more control they have and the more they tend to identify their interests with the interests of the owners. By having a large stake in the firm, the managers become significantly less diversified in their own personal wealth and human capital. Managers become motivated to operate the firm efficiently. They take on greater risk in exchange for greater rewards. Once the debt holders are paid off, the remaining profit belongs to them. (The Causes and Consequences of Leveraged Management Buyouts, 1992, Isaac Fox and Alfred Marcus).
Peter Magowan (1989: 13-14), the CEO of Safeway, wrote after that particular LBO: “The transformation … from being managers to being co-owners may have been the most powerful stimulus of all…. It was now, after all, our money too.” Personal risk and added potential reward puts pressure on managers to operate the firm efficiently. The fear of bankruptcy is a powerful motivator for managers who are now also the firm’s owners because of the damage it could have to their personal wealth, security, and career opportunities.
Advantage
- Management buyout ensures the smooth continuation of the business, because of the transfer of ownership to the people who have a good understanding of the company and its potential, and they are often well-known by clients, suppliers, and financial partners.
- Another advantage is the ability to take tough decision that would be off limits for a public company, such as extensive lay-offs that can plunge it temporarily into the red.
- Management motivated by a potentially big payoff and put under pressure by a heavy debt burden, will manage the company in the most efficient manner possible, increasing cash flows and hence the values of the company. (Corporate Finance Second Edition, Page 928, PIERRE VERNIMMEN)
- It greatly reduces agency problems and in so doing, creates value.
- By changing their corporate structure (including modifying and replacing management staff, unnecessary company sectors, and excessive expenditures), a company can revitalize itself and earn substantial returns.
Disadvantage
- Corporate restructuring from Management buyouts can greatly impact employees. Sometimes companies may have to downsize their operations and reduce the number of paid staff, which results in unemployment for those who will be laid off.
- In addition, unemployment after leveraged acquisition of a company can result in negative effects of the overall community, hindering its economic prosperity and development. Some leveraged buyouts may not be friendly and can lead to rather hostile takeovers, which goes against the wishes of the acquired firms’ managers.
- Not every MBO turns out to be successful as planned. Management buyouts can generate substantial conflicts of interest among employees and managers alike. Management and executive teams can easily be lured to propose a short-term buyout for personal profit. In addition, they can also corruptly mismanage a company, leading to an enterprise’s depreciated stock.
- Often times, the restructuring can lead a company to downsize and can even result in hostile takeovers. The high interest rates from the high debt-to-equity amounts can result in a corporation’s bankruptcy, especially if the company is not generating substantial returns after acquisition.
Corporate Governance Issues
The management of Grainger will be committed to maintaining high standards of corporate governance after the MBO, which it see as fundamental to effective management of the business.
It is important to have detailed discussions with equity partner about governance issues before sign the deal. Grainger management needs to deal with these tough issues right at the outset or later under circumstances where you no longer have any leverage. The contract should describe the governance structure for the new company and address some of the key issues you may face going forward. The equity partner usually wants a few members on the board to be actively involved in the firm’s progress. The agreement should specify how many people are on the board, who will serve as chair, and the respective responsibilities of the board and the CEO.
Following key governance issues that might arise and need to be take care:
1. CEO termination: – If you are the CEO, on what basis can you be fired? The equity firm usually controls the majority of the company and can make these decisions. Though it is unlikely, it is possible the buyout firm can turn around and fire you the day after closing. Because they control the board and most decision making, you need to define the bases upon which they would have those kinds of conversations. Usually they only consider firing you if you are meaningfully off plan, but you need to negotiate all severance arrangements up-front to make sure you are fully protected.
2. Severance: – Negotiate your severance deal to make sure if they fire you, you have one full year of salary for the CEO orCFO. If they fire you early on, without cause, a small portion of your equity should vest upon that termination.
3. Board: – You need to have clear conversations about how the management team is going to interact with the board, and which investment professionals at the firm will be your daily contact. Who will be on the board? How often is the board going to meet? Typically, in the first six months, the board meets monthly and moves to quarterly meetings after the critical post-closing period.
4. Scope of Control: – You need to specify what issues the board will control and which ones management will control. For example, you might negotiate specificclipping levels
on expenditures. The CEO may be able to approve expenditures under $250,000. Anything above that goes to the board. These levels depend very much on the size of the company and the nature of its business. Can the CEO unilaterally hire and fire key executives and enter into supplier or customer agreements? Who is responsible for approving acquisitions, divestitures, and sales of stock and issuances of debt? (Hint: Almost always, it’s the board.) Make sure all governance issues are clear to avoid setting up flash points for later conflicts.
5. Points of Contact: – Discuss with investors how their points of contact are going to work. Can they call your direct reports without your knowing? Typically, the investor would call the CEO and CFO directly, who would route calls through to directors. Most investors feel they can call anyone in the company anytime they want to. This is an issue that needs to be clarified.
6. Board Composition: – Who is going to represent you on the board? For example, a seven-person board may have two members from management and five from the investor team. The CEO and CFO often sit on the board. The investor may bring in three people from within the firm and two outsiders with specific industry experience. You also need to determine whether these investors and directors are going to have compensation. Will they receive options or draw board fees? Any compensation going to the board is coming out of the company, which means it is taken from your hide. Typically, representatives from the investment firm do not receive compensation. The outside directors get some stock in the company, which is dilutive to managers. Directors may receive $50,000 in stock that vests over three years if they serve on the board. Members who leave the board forego a portion of the stock due to thesevesting provisions.
Analyse risk faced by company- Beta
The major risks to Grainger’s business are macroeconomic.
Housing market
– further severe and rapid downturn in UK house prices
– Stagnation in the market including through lack of mortgage finance and/or finance to acquire properties financing
– Significant increases in borrowing costs
– Lack of or reduction in finance available to Grainger
(Grainger Annual Report 2009, Page 9)
“We also recognise a number of potential risks, such as tightening regulations, increasing costs of meeting required planning and development standards, and changing customer and investor expectations.” (Grainger Annual Report 2009, Page)
Companies beta is a bit greater than one imposing a higher risk and bigger than the industries beta. Competitors such as Audi has better beta but Daimler’s beta is much higher than BMW.
Calculate cost of capital
The cost of capital is used as the minimum rate of revenue capital investments. The cost of capital originally has two forms: Return on equity ROE and WACC (Weighted Average Cost of Capital).
ROE is the cost of equity to a business. It evaluates the equity in a business and afterwards the cost of this equity. This cost is the rate of return that could be earned elsewhere and the risk to the business that is being considered. WACC – the Weighted Average Cost of Capital is literally debt and equity in a business. To analyze the calculation of WACC we need:common stock, preferred stock,bonds(debt) and retainedearnings.
Calculate cost of capital
The cost of issuing common stock:
No of Shares Issued = 416.33m
Last Five year dividend given by Grainger: (Source: Grainger Annual report 2009)
| Year | Dividend | Growth (g) |
| 2004 | 4.65 | |
| 2005 | 5.11 | 0.09892 |
| 2006 | 5.62 | 0.0998 |
| 2007 | 6.18 | 0.0996 |
| 2008 | 6.18 | 0 |
Average Growth= 0.07458
Company Beta = 2.43 (Reuters)
Company Beta = .74 (source- Digital look)
Average Beta = (2.43 + 0.74)/2 = 1.585
Risk free rate = 2.75 (5 year UK government bond rate)
Expected market return = 10.46 % (last 5 year 2003-2009)
CAPM
Cost of equity capital (K)
Required Rate of Return= Risk free rate + Beta (Expected market return – Risk free rate)
= 4.02 + 1.58 (10.46 – 4.02) = 14.764
Dividend growth model:
Security pricing:
Price P = D (1+g)/ (K – g)
= .0618 (1+0.07458)/ (.14764-0.07458)
= £ 0.9089 pound
Cost of actual stock = No of shares * Price p
= 416.33m * 0.9089
= £ 378.402 m
Total Value of Equity = £ 378.402 m
Cost of debt:
The £112m 3.625% convertible bond due 2014 was issued in May 2007. Interest is payable semi-annually.
The discount rate used for this was based on a rate of 7.5% compounded semi-annually.
Total value of issued bond = £112m
Nominal bond value = 100
Total no of bonds = £112m /100 = 1.12 m
Discount rate (YTM) = 5%
Bond valuation:-
P = C1/ (1+YTM) + C2/ (1+YTM)2 + ………+ C7/ (1+YTM)7 + M/ (1+YTM)7
P = C (PVDFA (7, YTM)) + M (PVDF (7, YTM))
= 3.625 (PVDFA (7, 5)) + 100 (PVDF (7, 5))
= 3.625*5.786 + 100 *0.7107
= 20.97 + 71.07
= 92.04
Value of Debt = Total no of bond * bond price
= 1.12 * 92.04
= 103.08 m
Total value V = Value of Equity + Value of Debt
= £ 378.402 m + 103.08 m = 481.49 m
The main purpose of the calculation of the cost of capital is to estimate how much interest the company has to pay for every dollar it borrows. After the percent cost of each component is evaluated, comes the turn of calculating the percent of capital structure of each component. The percent summery of the capital components makes the cost of the capital of a firm. Or you the cost of capital can be calculated by another formula. It is different, but the main concept it the same.
WACC=E/V*Re+D/V*Rd*(1-Tc)
Re = cost of equity
Rd = cost of debt
E = the market value of the firm’s equity
D = the market value of the firm’s debt
V = E + D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = the corporate tax rate
E/V = 378.402 / 481.49 = 0.78589
Re = 14.764
D/V = 103.08 / 481.49 = 0.21408
Rd = YTM = 5
Tc = 0.28
WACC = 0.78589 * 14.764 + 0.21408 * 5 * (1- 0.28)
= 11.6028 + 0.77068
= 12.3734
So the cost of capital will always depend on the kind of company and on any additional components, which cannot be foreseen by one universal formula. The cost of capital defines the cutoff point for capital budgeting and the real growth prospects for the firm.
Valuation
Discounted cash flow method
Free cash flows measure the cash-producing capacity of the company
The value of the firm is the sum of the present value of after-tax cash flows over the explicit forecast period and the terminal value at the end of the explicit forecast period.
EV = ? FCFFt/ (1+k) exp (t)
Free Cash flows are estimated as follows:
Free cash flow to firm = Operating income (EBIT) – Normalized tax on operating income + Depreciation and amortization – capital expenditure – change in working capital
Financial Projections
The mean value of yearly revenue growth is approximately 16% till 2007. In 2008, because of global recession and market downturn revenue is decreased. But we have already seen that market is getting better and Conditions in the general residential market have improved over the last few months. Thus growth of revenue looks positive in future. For 2010, assumption is based on previous year’s performance, and total sales drop projection. If market conditions are getting better in a same manner then in 2011, BMW’s revenue growth can be increase with positive EBIT in 2011. As per improving market conditions and past sales growth, we can expect average revenue growth of 10% in next 3 years. But we have projected a conservative increase of 8% for next year 2010. However, cost to revenue is also increasing steadily in last 5 years. It is increasing around 8.2% every year till 2007, and decreased in 2008 and 2009 both. BMW is already implementing their cost cutting strategies, but with that they are also increasing there production as per expected sales growth.
Projected after tax cash flow:
|
In £ m |
2008 |
2009 |
2010 |
2011 |
2012 |
2013 |
|
EBIT |
(112.10) |
(170.00) |
(3.65) |
11.14 |
||
|
– Corporate Income tax at 28% |
31.38 |
47.6 |
1.02 |
(3.119) |
+ Depreciation and amortization
-Capital Expenditure
– Change in working capital
= Free cash flow
Capital Expenditure = s
EV = ? FCFFt/ (1+k) exp (t)
Terminal value
Value of the company at the end of the explicit forecast period
= Normalized free cash flow / (k-g)
Enterprise value = EV + terminal value
Alternatives available for financing MBO:
- Debt Financing
- Private Equity Financing
- Venture capitalist Financing
- Own Funding
Debt Financing
Usually, Management of company doesn’t have financeavailable to buy the company. They would seek all the options to arrange finance. One of these options is to borrow from bank, provided that thebankwill be willing to accept therisk. Management buyouts are normally seen as too risky for a bank to finance the purchase through a loan.
Private Equity Financing
If management will not get loan from bank then they will look for private equity investors who can fund their buyout. Normally a big proportion of buyout finance will provided by equity investors.
Theprivate equity investorswill invest money in return for a proportion of thesharesin the company, though they may also grant aloanto the management. The exact financial structuring will depend on the backer’s desire to balance the risk with its return, withdebtbeing less risky but less profitable thancapitalinvestment.
Although the management may not have resources to buy the company, private equity houses will require that the managers each make as large an investment as they can afford in order to ensure that the management is locked in by an overwhelming vested interest in the success of the company. It is common for the management to re-mortgage their houses in order to acquire a small percentage of the company.
Private equitybackers are likely to have somewhat different goals to the management. They generally aim to maximise their return and make an exit after 3-5 years while minimisingriskto themselves, whereas the management rarely look beyond their careers at the company and will take a long-term view.
Venture capitalist Financing
Venture capitalists have strict investment criteria, and specialize in very specific high-growth industries.Venture capitalis a broad term that indicates investment funds, partnerships, and divisions of large corporations whose focus is on investing in emerging and promising young companies.
capitalists generally take preferred stock in a corporation in exchange for their investment, and expect to receive certain rights regarding their investment, including the right to elect one or more Directors to the corporation’s Board of Directors, the right to receive financial and other corporate reports and information, and priority over common shareholders. ReadThe Structure of a Venture Capital Investmentfor details.
Venture capitalists hope to cash out in three to five years, and rarely invest less than several million dollars at a time. Also in contrast with angel investors, venture capitalists often take an active role on the boards of companies in which they invest, which may result in loss of independence and control by the owners of those companies.
Stock Purchase Agreement
When a deal has been struck with venture capitalists, the terms of the venture capital investment are first memorialized in a Term Sheet, with full-blown legal documents subsequently embodied in a Stock Purchase Agreement. The Stock Purchase Agreement can be a fairly complicated document and is usually drafted by the venture capitalists’ attorneys. Sample Stock Purchase Agreements are available for review and purchase in AllBusiness.com’sForms & Agreementssection.
The Stock Purchase Agreement includes the following terms:
- The price of the stock to be sold and number of shares to be purchased
- Representations and warranties of the corporation
- Covenants of the corporation
- Conditions to closing the deal
- A requirement to reimburse the venture capitalists’ legal fees
- Exhibits and any related agreements
Seller Financing
In certain circumstances it may be possible for the management and the original owner of the company to agree a deal whereby the seller finances the buyout. The price paid at the time of sale will be nominal, with the real price being paid over the following years out of the profits of the company. The timescale for the payment is typically 3-7 years.
This represents a disadvantage for the selling party, which must wait to receive its money after it has lost control of the company. It is also dependent on the returned profits being increased significantly following the acquisition, in order for the deal to represent a gain to the seller in comparison to the situation pre-sale. This will usually only happen in very particular circumstances.
The advantage for the management is that they do not need to become involved with private equity or a bank and will be left in control of the company once the consideration has been paid.
Conclusion/Recommendations to the management team
Probable Issue
- If demand will less becoz of market down
- In case of economic downturn if company can’t make profit to pay interest and can’t pay tp Venture capitalist
- Not easy to get loan again if needed
- Will get loan on high interest
References:
* Grainger plc Annual report, Page 2, 2009
http://online.hemscottir.com/ir/gri/pdf/Grainger_AR_2009.pdf
* The Causes and Consequences of Leveraged Management Buyouts, Isaac Fox and Alfred Marcus, 1992
http://www.jstor.org/stable/258648?origin=JSTOR-pdf
http://www.thefreelibrary.com/Governance+’term+sheet’+for+a+buyout-a078640417