P4 Advanced Investment Appraisal

2 Section E: Corporate Reconstruction and Re-organisation E1. Financial reconstruction E2. Business re-organisation Designed to give you the knowledge and application of:

3  Assess a company situation and determine whether a financial reconstruction is the most appropriate strategy for dealing with the problem as presented.  Assess the likely response of the capital market and/or individual suppliers of capital to any reconstruction scheme and the impact their response is likely to have upon the value of the firm.  Recommend a reconstruction scheme from a given business situation, justifying the proposal in terms of its impact upon the reported performance and financial position of the firm. E1: Financial reconstruction Learning Outcomes

4 Assess company situation and determine if financial reconstruction is appropriate Corporate Restructuring Results in changes to:  Capital structure  Operations  Core business assets  Workforce / management Objectives:  Improving firm’s value  Enhancing shareholders’ wealth  Reviving company in financial distress Categories Business reorganisation Portfolio reconstruction Organisational reconstruction Financial reconstruction

5 Is part of corporate reconstructing in which the capital structure of a firm is changed. Reasons for financial reconstruction Reduce debts to manageable levels (debt-equity swaps) Stabilise company so investors inject new equity Reorganise corporate capital structure Enable core business units to operate effectively Survive recession Remove sources of cash flow drainage Avoid liquidation of the company Revalue overvalued / undervalued company assets

6 Difficult to devise reconstruction scheme beneficial to all Difficult to receive approval from majority of stakeholders Difficulties with regulatory authorities in approving the scheme Procedure of financial reconstruction Different types of reconstruction schemes to solve different problemsShould be carried out in compliance with relevant laws of the country Must obtain court’s permission to launch a series of reconstructions Need to obtain maximum votes of members and creditors in favour of reconstruction Problems of financial reconstruction

7 Response of capital market, individual suppliers of capital to any reconstruction & its impact on the value of the firm Response of individual suppliers of capital  Capital markets respond positively to financial reconstruction that increases debt level of the company  Leveraged buy-outs are also favourable as they improve the cash flow of the company  Speculation increases when financial reconstruction leads to lower dividends. Shareholders should be informed in advance about future prospects of the company and reasons for retaining more profits.

8 Response of individual suppliers of capital Secured lenders Liquidation Will respond negatively if they cannot recover their entire amounts due Financial reconstruction Will respond positively if scheme is more attractive than liquidation Preference shareholders Liquidation Can suffer lower amount of loss as compared to ordinary shareholders Financial reconstruction Respond positively if they are given a share in equity or enhancement in the rate of dividend

9 Response of individual suppliers of capital Unsecured creditors Liquidation They are at higher risk of losing money Financial reconstruction Will vote in favour of financial reconstruction if they hope to recover the maximum claims Ordinary shareholders Liquidation Last in line to receive repayment of their capital Financial reconstruction Respond positively if they retain their stake in the company and achieve better value for shares upon reconstruction

10 Impact of response on value of firm Share price change Growth rate change Beaver’s univariate approach Equity beta E+D(1-t) = asset beta x E = asset beta x [1+(1-t)D/E] g = b x r e Where, g=growth rate of dividends b = proportion of profits reinvested / rate of retention r e = post tax return on equity D o (1+g) P O = (r e -g) Systematic risk changeDividend growth model Gordon’s growth approximation Impact of response on value of firm

11 Reconstruction scheme Devising a reconstruction scheme 1 2 Calculate the amounts that would be received by all the affected parties if company is liquidated Work out revaluation of assets & calculate effect on reserves 3 Consider how net loss is to be allocated among creditors 4 Consider sources of new finance secured by better management 5 Consider future earnings forecasts & review cash flow projections  Companies in financial difficulties can escape failure by restructuring their financial position  Lenders, specifically unsecured lenders, seek a solution that may allow recovery of value

12 Recap  Assess a company situation and determine whether a financial reconstruction is the most appropriate strategy for dealing with the problem as presented.  Assess the likely response of the capital market and/or individual suppliers of capital to any reconstruction scheme and the impact their response is likely to have upon the value of the firm.  Recommend a reconstruction scheme from a given business situation, justifying the proposal in terms of its impact upon the reported performance and financial position of the firm.