Question 7.S-AQ.1: Ceres plc is a large conglomerate which, following a recent ...
Ceres plc is a large conglomerate which, following a recent strategic review, has decided to sell its agricultural foodstuffs division. The managers of this operating division believe that it could be run as a separate business and are considering a management buyout. The division has made an operating profit of £10 million for the year to 31 May Year 6 and the board of Ceres plc has indicated that it would be prepared to sell the division to the managers for a price based on a multiple of 12 times the operating profit for the most recent year.
The managers of the operating division have £5 million of the finance necessary to acquire the division and have approached Vesta Ltd, a private-equity firm, to see whether it would be prepared to assist in financing the proposed management buyout. The divisional managers have produced the following forecast of operating profits for the next four years:
| Year to 31 May | Year 7 | Year 8 | Year 9 | Year 10 |
| £m | £m | £m | £m | |
| Operating profit | 10.0 | 11.0 | 10.5 | 13.5 |
To achieve the profit forecasts shown above, the division will have to invest a further £1 million in working capital during the year to 31 May Year 8. The division has premises costing £40 million and plant and machinery costing £20 million. In calculating operating profit for the division, these assets are depreciated, using the straight-line method, at the rate of 2.5 per cent on cost and 15 per cent on cost, respectively.
Vesta Ltd has been asked to invest £45 million in return for 90 per cent of the ordinary shares in a new business specifically created to run the operating division. The divisional managers would receive the remaining 10 per cent of the ordinary shares in return for their £5 million investment. The managers believe that a bank would be prepared to provide a 10 per cent loan for any additional finance necessary to acquire the division. (The properties of the division are currently valued at £80 million and so there would be adequate security for a loan up to this amount.) All net cash flows generated by the new business during each financial year will be applied to reducing the balance of the loan and no dividends will be paid to shareholders until the loan is repaid. (There are no other cash flows apart from those mentioned above.) The loan agreement will be for a period of eight years.
However, if the business is sold during this period, the loan must be repaid in full by the shareholders.
Vesta Ltd intends to realise its investment after four years when the non-current assets and working capital (excluding the bank loan) of the business are expected to be sold to a rival at a price based on a multiple of 12 times the most recent annual operating profit.
Out of these proceeds, the bank loan will have to be repaid by existing shareholders before they receive their returns. Vesta Ltd has a cost of capital of 25 per cent and employs the internal rate of return method to evaluate investment proposals.
Ignore taxation.
Workings should be in £ millions and should be made to one decimal place.
Required:
(a) Calculate:
(i) The amount of the loan outstanding at 31 May Year 10 immediately prior to the sale of the business.
(ii) The approximate internal rate of return for Vesta Ltd of the investment proposal described above.
(b) State, with reasons, whether or not Vesta Ltd should invest in this proposal.
The answer to this question can be found at the back of the book on pp. 566.
Ceres plc
(a) (i) Preliminary calculations
Annual depreciation is £4 million [that is, property (£40m × 2½%) and plant (£20m × 15%)].
Cost of acquiring the business is £120 million (that is, £10m × 12).
Loan finance required is £70 million (that is, £120m – £50m).
| Loan outstanding at 31 May Year 10 | ||||
| Year to 31 May | Year 7 | Year 8 | Year 9 | Year 10 |
| £m | £m | £m | £m | |
| Operating profit | 10.0 | 11.0 | 10.5 | 13.5 |
| Add Annual depr’n | \underline{4.0} | \underline{4.0} | \underline{4.0} | \underline{4.0} |
| \underline{14.0} | \underline{15.0} | \underline{14.5} | \underline{17.5} | |
| Less Working capital | – | (1.0) | – | – |
| Loan interest | \underline{(7.0)} | \underline{(6.3)} | \underline{(5.5)} | \underline{(4.6)} |
| Cash to repay loan | \underline{7.0} | \underline{7.7} | \underline{9.0} | \underline{12.9} |
| Loan at start of year | 70.0 | 63.0 | 55.3 | 46.3 |
| Cash to repay loan | \underline{(7.0)} | \underline{(7.7)} | \underline{(9.0)} | \underline{(12.9)} |
| Loan at end of year | \underline{63.0} | \underline{55.3} | \underline{46.3} | \underline{33.4} |
(ii) Internal rate of return (IRR)
The net amount to be received in Year 10 by the private-equity firm is calculated as follows:
| £m | |
| Sale proceeds (12 × £13.5m) | 162.0 |
| Loan repayment | \underline{(33.4)} |
| Proceeds to shareholders | 128.6 |
| Less | |
| Amount to shareholder/managers (10%) | \underline{(12.9)} |
| For private-equity firm | \underline{115.7} |
Trial 1 – Discount rate 24%
NPV is:
(£115.7m × 0.42) – £45m = £3.6m
As it is positive, the IRR is higher.
Trial 2 – Discount rate 28%
NPV is:
(£115.7m × 0.37) – £45m = (2.2m)
As it is negative, the IRR is lower.
A 4 per cent change in the discount rate leads to a £5.8m (£3.6m + £2.2m) change in the NPV. Thus, a 1 per cent change in the discount rate results in a £1.45m change in NPV. The IRR is:
24\%+\left\lgroup\frac{£3.6m}{1.45} \right\rgroup\% = 26.5\%
(b) The IRR exceeds the cost of capital and so the investment should go ahead. However, the calculations are likely to be sensitive to forecast inaccuracies. The forecast inputs should be re-examined, particularly the anticipated profit in the year of sale. It is much higher than in previous years and forms the basis for calculating the sale price.