CFTP Case Study 2012 Autumn Semester
1. BBC Limited was a diversified industrial company with four main divisions – Construction, Decorative Products, Doors, and Water Products. BBC supplied branded products to industrial trade customers in the new housing, renovations, commercial buildings and infrastructure markets. These businesses had evolved through a series of divestments and acquisitions since 2001. BBC aimed to achieve high returns on investment, strong cash flows and steady growth through strategic bolt-on acquisitions and disciplined application of operational improvement programs to their existing brands.
2. 2010 was an extremely challenging year for BBC. The company’s financial performance was unsatisfactory. Revenues from continuing operations were down to $773 million. The company recognised a significant non-cash impairment charge against the Water Products division of $133 million, reflecting the continued decline in the performance of this division since it was acquired in 2005. Net profits after tax (before significant items) decreased from $29 million to $12.4 million. Taking significant items into account, BBC recorded a net loss after tax of $124.3 million. Despite the decline in earnings, BBC’s businesses continued to generate strong operating cash flows of $60 million. The company’s net debt at the end of financial year was $128.9 million with gearing (net debt/net debt plus book equity) at 23%. No final dividend was declared though an interim dividend of 7 cents was paid.
3. BBC’s recent financial performance was summarised in the following table:
Financial year ending 31 December 2010 2009 2008 2007 2006
Revenue ($ millions)* 773 1001 1061 748 602
EBITA ($ millions)** 46.8 85.7 123.6 87.8 75.6
Significant items (net of tax) -136.5 -42 -7.8 -4.0 0.8
Amortisation of intangibles -11.0 -15.5 -6.5 -4.9 -4.5
Reported net profit after tax ($ millions) -124.3 -12.8 57.8 43.4 42.6
Net debt ($ millions) 129 160 319 294 155
Shareholders’ equity ($ millions) 428 551 594 344 333
Earnings per share (cents)** 24.8 48.2 83.7 74.5 66.1
Dividends per share (cents) 7 7 67 63 55
Interest cover (times)** 4.2 4.1 5.4 6.4 6.9
* From continuing operations
** Before amortisation and significant items
4. The Board was comprised of six non-executive directors and the Managing Director, John Singleton. Meetings were held monthly. Senior executives regularly attended and presented to board meetings on particular issues.
5. The following agenda items were discussed at the Board meeting in January 2011:
i. What would be BBC`s after-tax WACC based on its capital structure as at 31/12/10?
ii. Should a different cost of capital be established for the four business divisions?
iii. Further, how should the risk of each project within a division be measured and incorporated into project evaluation?
iv. An update on the executive remuneration review.
v. Should BBC sell its Water Products division and for much?
vi. How should the proceeds of the sale be applied?
6. BBC had established a capital allocation policy that required NPV to be used in all investment decisions. The after-tax WACC for the company was calculated annually using the market value of the interest–bearing debt and equity securities outstanding at the balance date. Singleton reported that the company WACC was about 11 percent at the end of 2010.
7. The Board decided that a separate cost of capital should be established for all its business divisions. Singleton was requested to present an estimate for each divisional WACC in the next meeting.
8. On the question of incorporating risk into project evaluation, the Board accepted that any system to account for individual project risk would necessarily be somewhat arbitrary and involve subjective judgment. Adjusting cash flows and estimating project betas were deemed to be impractical. The Board decided that new projects would be classified into three categories: high risk, average risk and low risk. High risk projects would be evaluated at the yet-to-be-determined divisional WACC plus 1.5%; average projects at the divisional WACC; and low risk projects at the divisional WACC minus 1%.
9. The General Manager of the Water Products division, Kelvin Mud, requested before the meeting to use the industry’s capital structure to establish the divisional cost of capital. Mud argued that his competitors in the water products industry had a higher ratio of net debt to net debt plus equity to run their business. Singleton was asked to report on the merits of establishing a cost of capital based on the industry average debt-equity mix.
10. During 2010 an assessment on the company’s remuneration practices was conducted at the direction of the Board, with the assistance of an external independent remuneration consultant. The review focused on how the remuneration structure could be best aligned with the objective of sustained shareholder value creation over time. A new performance rights plan was proposed. In order for executives to receive shares, a performance hurdle needed to be met over a three-year period. An earnings per share (EPS) hurdle based on earnings after significant items and amortisation would be used, as distinct from the previous plan which was before significant items and amortisation. The EPS hurdle for the 2011 plan was proposed to be 19.0 cents per share and this target was to be increased by 10% a year on a compounding basis.
11. The Board received an offer from a private equity group for the acquisition of the Water Products division for $20 million. Despite expecting a turnaround for the water products industry in 2012 and implementing measures to cut fixed operating costs, the Board was quite keen to divest the loss-making division. Singleton noted that if a planned program of store upgrades and rebranding was successfully undertaken in a year’s time, the division could be worth more. This upgrade project was considered low risk. The Board directed Singleton to investigate the best course of action for the division and make a recommendation at the next meeting.
12. The Board was divided on how to apply the proceeds of the Water Products division, if the sale was approved. Singleton wanted to resume paying regular interim and final dividends to shareholders. BBC’s dividend policy was to have an annual full year dividend payout ratio of 60-80% of net profit after tax. Due to losses suffered in 2009 and 2010, BBC dramatically cut down its dividend from 67 cents to 7 cents. BBC did not pay an interim dividend for 2009 and no final dividend for 2010.
13. Some Board members were worried about the financing arrangement of the company and wanted to use the sale proceeds to reduce the gearing level. BBC was scheduled to repay $120 million in January 2012 and the company was in the process of negotiating with the banks to extend its bank loans facility.
14. After the January meeting, Singleton looked at the Balance Sheet as at 31/12/10 to estimate BBC’s after-tax WACC:
Bank overdraft 3880 Receivables 117427
Payables 96319 Inventories 120614
Bank loans 125000 Property, plant and equipment 55158
Provisions 39182 Intangibles 371412
Share capital 520407 Other 27310
Retained earnings (103601)
Total claims 691921 Total assets 691921
15. BBC had arranged a bank overdraft facility with a $4 million limit. The interest rate for the overdrafts as at the balance date was 7.5%. BBC also had a variable-interest bank loans facility of $240 million, with $125 million already utilised at the balance date. The interest rate for bank loans was 8.1% at 31 December 2010. BBC complied with all financial covenants during 2010. BBC had 94.2 million ordinary shares outstanding at year-end 2010, with the equity beta estimated to be 2.0. Except with about 1 million shares issued under the employee share plan, BBC had not issued any new shares since 2006.
16. Assuming no further writedown of assets, earnings per share was forecasted to be 14.4 cents per share. A total annual dividend of 8.5 cents per share was planned for 2011. If the Water Products division was sold before April 2011, EPS would be about the same.
17. To establish a cost of capital for the Water Products division, Singleton decided to first estimate the divisional cost of equity using a beta of 2.30, which was the average equity beta of the division’s competitors. Combining it with BBC’s cost of debt and market-value debt-equity mix, Singleton worked out the divisional WACC.
18. To find out the present value of the Water Products division, Singleton took the divisional results of 2010 as the base year (t=0) and made various projections to prepare a spreadsheet “Table 1”. Singleton expected sales revenue to fall further in 2011 before returning to a steady state of growth. Singleton used a valuation horizon of 4 years and estimated the horizon value by using the constant-growth discounted cash flow formula with a long-run growth rate of 3% per year. The recovery of working capital was implicitly included in the horizon value and was not separately accounted for. Singleton applied the divisional WACC to discount the cash flows.
19. Singleton further examined if a $2 million upgrade project of Water Products division should begin in a year’s time (at the end of 2011). The extra after-tax cash flows from the upgrade, generated over and above the cash flows expected from Table 1, were projected in Table 2. The extra cash flow in year 4 in Table 2 had already incorporated the discounted value of all subsequent cash flows beyond year 4. All these extra cash flows from the upgrade in Table 2 were considered to be low-risk.
Forecast Year-end Free Cash Flow Spreadsheet for Water Products division ($’000)
2010, t=0 t=1 t=2 t=3 t=4 t=5
Sales 170000 160000 176000 184800
Variable cost 129200 121600 133760
Fixed cost 52000 30000 30900
Depreciation 5700 4500 4950
Operating income -16900 3900
Tax (30%) 5070 1170
Net income -11830 2730
Depreciation 5700 4500
Operating cash flow -6130 7230
Investment in fixed assets 0 8000 8000
Investment in working capital -2400 -2000 3200
Free cash flow -3730 1230 -1777
Tax rate 30%
Sales in year 1 $160 million
Sales growth rate starting in year 2 10% per year
Sales growth rate starting in year 3 and 4 5% per year
Sales growth rate starting in year 5 and beyond 3% per year
Variable cost as a percentage of sales 76%
Fixed cost in year 1 $30 million
Fixed cost growth rate in year 2 and beyond 3% per year
Depreciation in year 1 $4.5 million
Depreciation growth rate in year 2 and beyond same as sales growth rate
Investment in fixed assets in year 1 and beyond $8 million per year
Investment in working capital in years 1 – 5 is equal to 20% of the expected change in sales from the previous year.
All figures are rounded to the nearest thousand dollars.
After-tax cash flow projections for ‘Upgrade’ of Water Products division next year ($’000)
Year Upgrade Discounted value at a notional rate 10%
t=1 -2000 -2000
t=2 250 227
t=3 350 289
t=4 2000 1503
NPVt=1 = 19
As an assistant to Singleton, you were asked to help out in the following problems before the February 2011 board meeting:
1. Calculate BBC’s company after-tax WACC. The risk-free rate was 4.1%, the market risk premium was 6.0%, the company tax rate was 30%. BBC shares were traded at $1.30. The WACC should be rounded to four decimal places.
2. To cross-check the accuracy of the estimate, use the dividend growth formula re = [(DPS1/Price) + growth rate] to re-estimate BBC’s cost of equity. Assume a growth rate of 4.5%. Explain whether this estimate of re is a better estimate than the one obtained in Question 1.
3. Calculate the Water Products division WACC using the procedures in paragraph 17.
4. What could be said about the relative business risk of the Water Products division compared to other water products providers when Singleton chose to use competitors’ average equity beta in estimating the divisional cost of equity?
5. Point out the inconsistence of Mud’s suggestion of using the industry average debt-equity mix (paragraph 9) with Singleton’s specific method of establishing the Water Products divisional cost of capital (paragraph 17).
6. Complete Table 1 in accordance with the given assumptions, showing the derivation of free cash flow in each year from year 1 to year 5. Do not include the horizon value.
7. Calculate the horizon value as of year 4.
8. Using the appropriate cost of capital and the format of Table 2, show the discounted value of the cash flow in each year from year 1 to year 4 plus and the horizon value. What would be the present value of the Water Products division on its own without expansion or abandonment?
9. Using the appropriate cost of capital, construct Table 2 again to show the correct discounted value of the expansion cash flows in year 1 to year 4. Show the appropriate NPVt=1 as well.
10. Calculate the value of the option for Water Products division to expand as of year 0.
11. If the Water Products division could be sold on its own, without any expansion undertaken, for $21 million in a year’s time, calculate the value of the abandonment option at t=1. Assume BBC had already received the free cash flow of 2011 (t=1).
12. What is the present value of the Water Products division with expansion and abandonment all considered? Explain.
13. Calculate the Economic Value Added in year 1 for the Water Products division. Show workings.
14. Point out one major inadequacy of the proposed EPS hurdle in BBC’s executive remuneration plan. Provide evidence to support your point.
15. Provide evidence that BBC might need to reduce its debt.
16. If BBC were to use the proceeds of the sale of the Water Products division for a payout to shareholders, how should it be done? Explain the details.
17. Irrespective of your answer in Q16, what would be the best way for BBC to apply the proceeds if the Water Products division was sold immediately for $20 million?
Presentation: The assignment is to be typed, doubled spaced with a font size of 12 (no smaller than this font size). The length of the submitted work should not exceed 7 A4 pages including the cover page and any spreadsheet.
Answer each question in correct sequence. Do not separate any table/spreadsheet from the body of the answers. No appendices should be used.
Do not use more than 50 words to explain the answer in any question. No mark will be awarded in any question if exceeding the word limit.
Assessment: Most issues involved in the case would have been covered in classes. Team discussion of all questions helps achieve a better result (about half of the assignments submitted individually were awarded a fail grade in the past).
The following will be considered in assessing the submitted work:
- the correctness of the analysis; reasoning underlying each decision must be presented
- whether the answer is applicable and relevant for BBC; general theoretical statements will not be rewarded
- whether the word limit is exceeded
- the quality of the written expression (grammar, spelling etc...)
- plagiarism will result in zero marks for the assignment (all assignments are marked by the subject coordinator himself)
Note: No plastic cover. Just staple the 7 pages together.
The cover sheet must list alphabetically the name of the students with student number included.