Question 11.Qfr.5: It is currently 1 January 2007 and Lissom plc is looking to ...
It is currently 1 January 2007 and Lissom plc is looking to divest itself of one of its subsidiaries in order to focus on its core business activities. Financial information relevant to the divestment is given below. Lissom plc has been negotiating the disposal with the subsidiary’s current management team.
Turnover and profit after tax of the subsidiary over the last five years:
| Year ending December: | 2003 | 2004 | 2005 | 2006 |
| Turnover (£m) | 40.0 | 41.6 | 42.8 | 43.7 |
| Profit after tax (£m) | 6.0 | 6.2 | 6.3 | 6.3 |
Other financial information:
| Current liquidation value of subsidiary: | £42m |
| Cost of capital of Lissom plc: | 14% |
| Long-term debt of subsidiary: | £10m of 13% debenture repayable in 2009 |
(a) Using the information provided, determine a purchase price for the subsidiary that could be acceptable to both Lissom plc and the management buyout team.
All relevant supporting calculations must be shown.
(b) Discuss any financial aspects of the proposed buyout that you feel should be brought to the attention of the management buyout team.
(c) Discuss the stages that will theoretically be followed by the management buyout of the subsidiary of Lissom plc.
(d) Critically discuss the financing of management buyouts.
(a) From the information given the value of the subsidiary can be found by considering the present value of expected earnings:
Equivalent annual earnings growth = \left(6.3/ 6.0\right)^{0.33}- 1 = 0.0164 or 1.64%
Present value of expected earnings = (6.3 × 1.0164)/(0.14 − 0.0164) = £51.81m
However, it may be that no earnings growth is expected.
Now the present value of expected earnings = 6.3/0.14 = £45m
This is higher than the liquidation value of £42m.
We are unable to determine the value of the subsidiary to its buyout team since we do not know its cost of capital and the liquidation value would be reduced by additional long-term debt. It seems that a purchase price of between £45m and £52m would be acceptable to Lissom plc.
(b) The growth in turnover has declined each year over the three-year period. It was 4 per cent in 2000, 3 per cent in 2001 and 2 per cent in 2002. A question that needs to be asked is: will the buyout team be able to improve turnover?
Growth in profit after tax has declined from 3.3 per cent in 2000 to 1.6 per cent in 2001, with no growth at all in 2002. When compared with turnover growth, it is clear that costs have been increasing over the period. Can the buyout team arrest the decline in profit after tax?
The repayment of the £10m debenture in two years will cause significant strains on cash flow. This factor must be considered in the business plan prepared by the buyout team.
(c) The following stages should be discussed:
- divestment decision is made;
- management buyout decision is made;
- financial analysis of the division;
- purchase price determined;
- extent of management investment determined;
- debt investors are assembled;
- additional equity investment is determined;
- cash flow analysis is carried out;
- financing package is agreed.
(d) The answer to this part of the question can be found in Section 11.7.3.