The Examiner's Answers –

F3 - Financial Strategy
Some of the answers that follow are fuller and more comprehensive than would be expected
from a well-prepared candidate. They have been written in this way to aid teaching, study and
revision for tutors and candidates alike.

SECTION A

Answer to Question One

REPORT TO THE BOARD OF DIRECTORS OF F PLC

SUBJECT: Strategic plans for future financing requirements
From: Finance Director, F plc
Date: 1 October 2011

Purpose
The purpose of this report is to address the concerns of the directors regarding the possible impact of
exchange rate movements and liquidity requirements in general on the financial and strategic
decisions of the company.

In particular, the report will focus on:

• the possible impact of a weakening of the euro against British pounds on future performance
and share price
• sustainability of the current dividend policy
• future financing requirements and possible sources of finance

The report will conclude with advice on whether the planned product launches in Europe are
sustainable in the light of the above analysis.

The latest cash flow forecast is attached at Appendix A of the report and the results of this forecast
will be referred to throughout this report.

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Possible impact of exchange rate movements on cash flow and share price (Requirement (b)(i))

Impact on annual and cumulative cash flow

The cash flow forecasts attached at Appendix A demonstrate the significant impact that a decline in
the value of the euro over a three year period from GBP/EUR 1.3000 at 1 January 2011 to GBP/EUR
1.5483 at 31 December 2013 could have on the future results of F plc.

With a growing proportion of revenue forecast from the eurozone, we would expect a growing
disparity between the two forecasts over time and, indeed, the forecasts support this.
nd st
Comparing the results for the 2 forecast against those for the 1 forecast, purely as a result of
changing the assumption on how the exchange rate will behave we can make the following
comments:

• By 2013, operating cash flows would be GBP 54 million lower at GBP 43 million rather than
GBP 97 million.
• The first forecast shows a positive total cash flow after tax, interest and dividends. This is in
stark contrast to the second forecast which shows a cash loss after tax, interest and dividends
in 2012 and 2013, even before deducting the capital investment and RCF repayment cash
flows.
•
nd
Under the 2 forecast, by the end of 2013 borrowings net of cash are forecast to be 30%
greater at GBP 285 million rather than GBP 220 million under the first forecast.

The cash forecasts do not build in any adjustment for the possibility of increasing export prices to
compensate for a fall in value of the euro. However, the volumes that we are able to sell could be
reduced if we were to increase euro prices as our products become less competitive. On the other
hand, if our competitors are facing similar pricing pressures, there may be a general increase in prices
that will help reduce the impact on our performance of a fall in the value of the euro. It is important
that we understand the exchange risk faced by our competitors.

Impact on share price

Any impact of exchange rate movements on future cash flows will clearly also impact on our share
price. A fall in net cash inflows could see a reduction in the share price again despite the recent
gains.

The share price is determined by the market according to the perceived value of the company. One
method used to value the company is on the basis of predicted future cash flows.

Under the semi-strong form of the efficient market hypothesis, we would expect share prices to move
to reflect publicly available information such as movements in exchange rates and the proportion of
export sales – a figure that is publicly available in the notes to F plc’s financial statements.

Sustainability of proposed dividend policy and possible alternative dividend policies

(Requirement (b)(ii))

As we are a quoted company it is important that our dividend policy is consistent in order to keep the
market happy. Any sudden changes in the policy could have a detrimental effect on the share price.

The latest dividend for the year ended 31 December 2010 of GBP 16 million represents a dividend
yield of 4.8% (= GBP 16 million/(GBP 0.60 x 560m).

2
Our proposed policy for 2011 onwards is to pay a dividend which grows at a rate of 8% per annum.
This is ambitious but as our first forecast shows, it is achievable if exchange rates do not change
significantly. Inflation rates are also relevant when assessing how achievable such nominal growth is
– if inflation is running at 5%, dividend growth of 8% in nominal terms is only 3% in real terms.

The cash forecast shows that, if exchange rates move against the company and inflation remains
unchanged, the 8% growth in dividends would appear to be unsustainable. Given that the proposed
policy has already been released to the market care must be taken to keep our shareholders and the
market informed about any potential further change in the policy to guard against a sudden drop in the
share price.

An alternative could be to undertake a residual policy, whereby we only pay a dividend after all
investments have been made. This would mean in 2012 and 2013 that we possibly would not pay a
dividend at all as we are heavily investing in those years. However, the market does not react well to
such a policy and therefore it is not relevant for us to consider further.

Another alternative could be to reduce the rate of growth from 8% down to say 2%. This is a
significant drop but as long as investors are given sufficient information by us about our plans and
future investments then they may be happy to accept this in the short term.

Financing requirements of F plc (Requirement (b)(iii))

An analysis of financing requirements has been added to the foot of each table at Appendix A.

The first forecast indicates that we will have a shortfall in cash of GBP 60 million at the end of 2013
due to the repayment of the RCF. It therefore shows that despite the growth in the business we will
need to either secure some long term finance (which given that the shortfall is temporary would not be
sensible) or better still re-negotiate the RCF at the end of 2013 when it is up for renewal. It is possible
that we could reduce the amount under the facility to say GBP 70 million, thereby still retaining
headroom of GBP 10 million, hence reducing the commitment fee payable on the unused portion of
the facility.

The picture is quite different, however, in the second forecast. This indicates that the company would
already have insufficient financing in place by the end of 2012, even after drawing down the maximum
GBP 80 million under the RCF. This financing requirement keeps growing each year to
GBP 125 million by the end of 2013.

Gearing would be expected to rise significantly even assuming that the share price remains at 2010
levels. It may therefore prove to be difficult to raise the necessary funds and, indeed, the survival of
the company itself could be under threat.

In terms of sources of finance, there are a number of options as well as the RCF. These are:

• In terms of financing the investments, F plc could seek to raise new equity through a rights
issue. The share price is recovering and investor confidence in the company seems to be
returning – therefore as long as investors were fully informed of the benefits of the
investments and the issue price was appropriate, then this could be a good source of long
term finance to support these long term investments.

3
 •
nd
A bond issue is unlikely to be successful in the 2 scenario if falling cash flows lead to a fall in
the company’s credit worthiness and credit rating. It could be considered in the first scenario
but would not provide the flexibility to pay back funding no longer required from positive cash
flows. A bank loan or an RCF would therefore be a more suitable source of finance for F plc
at this time as it already has long term fixed borrowings in place and requires a more flexible
instrument to meet fluctuating short term liquidity requirements.
• In terms of the operations we could consider an overdraft facility rather than an RCF,
especially under the first scenario when there is a lower borrowing requirement. Although an
overdraft is cheaper to set up, it does not give the protection of a committed facility and can
be withdrawn at any time. An RCF would therefore be the preferred option.
• F plc should consider the use of EUR denominated finance to provide a natural hedge against
movement in the value of the euro.

Advice on the overall impact of possible exchange rate movements and liquidity constraints
on the financial and strategic decisions of F plc (Requirement (c))

This report has highlighted the significant risks to cash flow, share price and liquidity of a significant
and continuing weakening in the value of the euro against the British pound over the next three years.
Based on this intial analysis, there is a clear risk that unfavourable exchange rate movements could
potentially have a major impact on company performance. However, further analysis is required to
evaluate other relevant factors that should be taken account in the preparation of these forecasts.

Relevant foreign exchange issues include:

• Other possible exchange rate outcomes and the probability of each.

• Price elasticity of demand and whether it would be possible to increase euro prices if the euro
were to weaken.
• Competitive position – would competitors’ profits also be ‘hit’ by a weaker euro and hence
also want to increase euro prices?
• Is there a link between the strength of the euro and volume of sales?

The possible liquidity issue identified above cannot be easily resolved without either:

• Significant cuts to the planned dividend.

• Obtaining additional finance.
• Cutting investment.

Additional finance is likely to be hard to obtain due to our high gearing ratio and poor projected cash
flows. A reduction in dividend is therefore likely to be necessary. It would, in any case, be hard to
justify strong growth in dividend which is not matched by strong growth in cash flows and profits.

However, a cut in dividend is unlikely to be sufficient and we also have to consider the more
fundamental question of whether the company has the necessary financial strength to be able to
support the proposed product launches at this time.

Indeed, it may prove to be a time to reduce operations in Europe rather than invest further if we
consider that we do not have sufficient resources to support such expansion in the event of a decline
in the value of the euro.

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Appendix A (the table below has been extracted from Excel and therefore contains rounding differences)

(a) - Cash flow forecasts 1 January 2011 to 31 December 2013

(i) Constant Exchange rate at GBP/EUR 1.3000

Base 2011 2012 2013
data EUR m EUR m EUR m
EUR inflows 280.00 370.00 440.00
GBP/EUR exchange rate 1.3000 1.3000 1.3000 1.3000
GBP m GBP m GBP m
Converted to GBP 215.38 284.62 338.46
Net GBP cash outflows (148.00) (218.00) (241.00)
Net operating cash flow (OCF) 67.38 66.62 97.46
Interest received on cash b/f 3% 0.60 0.60 0.60
Interest paid on borrowngs b/f 7% (16.38) (15.24) (16.28)
OCF after interest 51.60 51.97 81.78
Deduct tax at 35% (18.06) (18.19) (28.62)
OCF after tax and interest 33.54 33.78 53.16
Dividend growing annually at 8% (17.28) (18.66) (20.16)
Investment net of tax (30.00) (20.00)
Net CF 16.26 (14.88) 13.00
Cash balance 20.00 20.00 20.00
Borrowings brought forward 234.00 217.74 232.62
Adjust net CF through borrowings (16.26) 14.88 (13.00)
Borrowings carried forward 217.74 232.62 219.62
Comprising: RCF 57.74 72.62 0.00
Bank loan 160.00 160.00 160.00
Extra financing needs/(cash) 59.62

(ii) The euro weakening against British Pounds by 6% a year

Base 2011 2012 2013
data EUR m EUR m EUR m
EUR inflows 280.00 370.00 440.00
GBP/EUR exchange rate 1.3000 1.3780 1.4607 1.5483
GBP m GBP m GBP m
Converted to GBP 203.19 253.31 284.18
Net GBP cash outflows (148.00) (218.00) (241.00)
Net operating cash flow (OCF) 55.19 35.31 43.18
Interest received on cash b/f 3% 0.60 0.60 0.60
Interest paid on borrowngs b/f 7% (16.38) (15.80) (18.29)
OCF after interest 39.41 20.11 25.49
Deduct tax at 35% (13.79) (7.04) (8.92)
OCF after tax and interest 25.62 13.07 16.57
Dividend growing annually at 8% (17.28) (18.66) (20.16)
Investment net of tax (30.00) (20.00)
Net CF 8.34 (35.59) (23.59)
Cash brought forward 20.00 20.00 20.00
Borrowings brought forward 234.00 225.66 261.25
Adjust net CF through borrowings (8.34) 35.59 23.59
Borrowings carried forward 225.66 261.25 284.84
Comprising: RCF 65.66 80.00 0.00
Bank loan 160.00 160.00 160.00
Extra finance needs 21.25 124.84

5
Answer to Question Two

(a) Calculation of financial benefit to the shareholders of MMM and JJJ assuming synergistic
benefits are realised.

BEFORE AFTER SHARE OFFER AFTER CASH OFFER

Number Price Total Number Total value Number Total value

of shares per value of shares ($ million) of shares ($ million)
(million) share ($ (million) (million)
($) million)
MMM 30 6.90 207.0 30 209.4 30 211.7
($6.98 per ($7.06 per
share) share)
JJJ 5 12.84 64.2 10 69.8 Cash 67.5
($6.98 per
share)
Synergies 8.0
Total 279.2 40 279.2 279.2

Workings
MMM’s market cap is: $207.0 million = 30m shares x $6.90 per share
JJJ’s market cap is: $64.2 million = 5m x $12.84 per share
$209.4 million = 30/40 x $279.2 million
The cash offer is worth $67.5m (= 5m x $13.50 per share)
$211.7 million = $279.2 million – cash offer of $67.5 million

The above table shows that the bid offer is advantageous to both JJJ and MMM shareholders
assuming that synergistic benefits are realised.

MMM shareholders can expect to make a higher financial gain under the cash offer than under the
share offer. Under the cash offer, the share price is expected to increase from $6.90 to $7.06, a gain
of $0.16 per share and $4.7 million in total. Under the share offer, a lower rise in the share price is
expected, from $6.90 to $6.98 per share, a total of $2.4 million.

JJJ shareholders can expect to benefit from an immediate and certain financial gain of $3.3 million
($67.5 million - $64.2 million) under the cash offer. They need to weigh this up against a theoretical
gain of $5.6 million ($69.8 million - $64.2 million) from the share offer. However the share offer
carries greater risk for the shareholders of JJJ because they are exposed to the risk of a fall in the
share price of MMM if the market fails to respond to the merger favourably and/or the potential
synergistic benefits are not realised. They are also accepting a shareholding in a company with lower
growth prospects than JJJ and lower growth in value could wipe out any short term gains.

The value of JJJ assumes a growth rate of 9% which is considerably higher than MMM’s growth rate
of 6%. It is important that MMM’s management is able to manage business activities acquired from
JJJ efficiently in order to protect the higher growth rate associated with these activities. If JJJ’s
activities are simply merged into MMM’s business structure, there is a danger of the growth rate
associated with JJJ’s business area dropping to something closer to MMM’s previous growth rate of
6%. That would clearly have a serious impact on shareholder value.

The cash offer has the advantage of protecting the proportionate ownership of the current
shareholders of MMM. After the share offer there would be 40 million shares on issue, including 10
million held by the previous shareholders of JJJ.

6
However, the cash offer has the problem of accessing the required funds. $67.50 million is a material
value to raise for a company that has a market capitalisation of just $207 million. MMM would need
to consider the impact on gearing levels and earnings per share of the new borrowings. The share
offer also has cash flow implications in paying future dividends on a larger number of shares. This
could have an even greater call on cash over time but has a delayed impact on cash flow.

(b)(i)
Assuming no synergistic benefits, the combined entity would be worth $8 million less at $271.2million.

BEFORE AFTER SHARE OFFER AFTER CASH OFFER

Number Price Total Number of Total value Number of Total value

of shares per value shares ($ million) shares ($ million)
(million) share ($ million) (million) (million)
($)
MMM 30 6.90 207.0 30 203.4 30 203.7
($6.78 per ($6.79 per
share) share)
JJJ 5 12.84 64.2 10 67.8 Cash 67.5
($6.78 per
share)
Total 271.2 40 271.2 271.2

If synergistic benefits fail to be realised, the takeover would ONLY be beneficial to JJJ’s shareholders.

MMM’s shareholders can expect to see a fall in share price under both the share offer and the cash
offer (in the order of $3.6 million for the share offer and $ 3.3 million for the cash bid). The acquisition
will therefore only be attractive to MMM’s shareholders if additional benefits can be realised such as
the synergistic benefits arising from improved IT/IS systems or enhanced future growth throughout the
business.

JJJs shareholders would expect to benefit from an immediate and certain financial gain of $3.3 million
($67.5 million - $64.2 million) under the cash offer and a higher theoretical gain of $3.6million ($67.8
million - $64.2 million) under the share offer. However, the share offer carries greater risk for the
shareholders of JJJ because they are exposed to the risk of a fall in the share price of MMM if the
market fails to respond to the merger favourably and are also accepting a shareholding in a company
with lower growth prospects than JJJ.

(b) (ii)
The realisation of synergistic benefits will depend upon a smooth and efficient integration process.
Key issues to discuss:
• Careful planning – detailed timetable, allocated responsibilities, interim targets.
• Retention of key personnel (programmers and operators) – possibly by offering enhanced
packages and by keeping these personnel fully informed.
• Building good relationships between staff transferring from JJJ to MMM.
• Training of key personnel on how to operate the system.
• Parallel running of the systems and possible test data before going live.
• Looking at post completion audit reports of any such projects that have happened before to
see if any lessons can be learnt.
• Proper management control via regular meetings and involvement of key personnel
throughout.

7
Answer to Question Three

(a)
(i) NPV of project at CIP’s existing WACC of 10%

Year Cash Flow Discount Factor PV

EUR @ 10% EUR
0 (6,500,000) 1 (6,500,000)
1 750,000 0.909 681,750
2 950,000 0.826 784,700
3 1,400,000 0.751 1,051,400
4-6 2,100,000 2.487x0.751= 1.868 3,922,800
NPV: (59,350)
(ii) NPV of project at a risk adjusted WACC
To establish the risk adjusted discount rate firstly, it is necessary to establish an appropriate beta for
the project. PPP has been identified as an appropriate proxy and has an equity beta of 1.95. This
firstly needs to be de-geared and then re-geared to give an equity beta that reflects the business risk
of the project and the existing financial risk of CIP.

De-gear

ß u = ßg  VE 
V + V [1 − t ] 
 E D 

So, ßu = 1.95 x ( 4/(1(0.7) + 4 ) ) = 1.66

Re-gear
VD [1− t ]
ßg = ßu + [ßu – ßd] VE

So, ßg = 1.66 + 1.66 x ((1 x 0.7 ) / 3 ) = 2.05

ke = Rf + [Rm – Rf]ß

So, ke = 4% + (9% - 4%) x 2.05 = 14.25%

WACC = ke  VE   VD 
V + V  + k d [1 − t ] V + V 
 E D   E D 

So, WACC = 14.25% x (3/4) +6% x (0.7) x (1/4) = 10.69% + 1.05% = 11.74%, therefore use 12%

Alternative approach using formula Kadj = keu [1 – tL]

keu = Rf + [Rm – Rf] ßu

So, keu = 4% + (9% - 4%) x 1.66 = 12.30%

Kadj = keu [1 – tL]

So, Kadj = 12.30% x [1 – (0.3 x (1/4))] = 11.38%, therefore it would be acceptable to use 11% as
the discount rate

8
NPV calculation at a discount rate of 12%

Year Cash Flow Discount Factor PV

EUR @ 12% EUR
0 (6,500,000) 1 (6,500,000)
1 750,000 0.893 669,750
2 950,000 0.797 757,150
3 1,400,000 0.712 996,800
4-6 2,100,000 2.402x0.712 = 1.710 3,591,000
NPV: (485,300)

(iii) APV of project at a base-case discount rate of Keu

Base–case discount rate

Under APV to discount the project cash flows we need a discount rate that assumes that the project is
fully funded by equity. Therefore the discount rate should be the cost of equity for an all equity
financed company. To establish this we need an asset beta appropriate to the project, which we have
already calculated above as 1.66. This then needs to be applied to the CAPM formula to establish
the ungeared cost of equity.

keu = Rf + [Rm – Rf] ßu

So, keu = 4% + (9% - 4%) x 1.66 = 12.30%

We will round this to the nearest whole number – therefore a rate of 12% should be applied to the
cash flows to establish the base case. Given that this is the same discount rate as above the base
case NPV is therefore negative at EUR (485,300).

Financing side effects

The financing side effects need to be discounted at a rate that reflects the systematic risk of the cash
flows. It is normally assumed that this will be the pre-tax cost of debt, which in this instance is 6%.

PV of tax relief on loan interest

Subsidised loan EUR 6,500,000 x 40% x 1% x 0.3 x 4.917 = EUR 38,353
Bank loan EUR 6,500,000 x 20% x 6% x 0.3 x 4.917 = EUR 115,058
Giving a total of EUR 153,411

PV of subsidy: Interest saving

EUR 6,500,000 x 40% x [(0.06 – 0.01)(1 - 0.3)] x 4.917 = EUR 447,447

Issue costs
EUR 6,500,000 x 60% x 0.01 = EUR 39,000

APV can now be calculated as:

EUR
Base case NPV (485,300)
PV of tax relief on loan interest 153,411
PV of subsidy 447,447
Issue costs (39,000)
APV 76,558

9
(b)

The results of the calculations in part (a) are:

EUR’000 Decision
(i) NPV at CIP’s existing WACC (59) Reject
(ii) NPV at a risk-adjusted WACC (485) Reject
(iii) APV 77 Accept

Based on considering only the financial benefits, the project would be rejected under the two NPV
methods but accepted under the APV method. Therefore before making a recommendation we need
to consider the appropriateness of each of the methods in turn.

NPV at existing WACC

The company’s existing WACC is not appropriate here as both the business risk and financial gearing
of the project are different from those of the company itself prior to the project.

The proposed project carries a higher level of risk than CIP’s current business activities. In addition,
the benefit to the company of the subsidy on the government borrowing and access to higher levels of
debt (leading to higher tax relief) is project-specific have not been taken into account.

NPV at risk adjusted WACC

The risk adjusted WACC is superior to the existing WACC in that it provides an adjustment to reflect
the business risk specific to the project. A proxy company’s beta is used for this purpose.

However, this method does not solve the financing issues identified previously in the discussion of the
use of the existing WACC.

APV
APV can be used in situations where a project has special financing features such as providing
access to subsidised financing or where the financing structure of the project is more relevant to the
project appraisal than the financing structure of the company itself (e.g. where the project represents
a new area of business for the company where a different capital structure is appropriate).

For CIP, the APV approach has the advantage of taking into account:
• The NPV of the subsidy on the government borrowing (net of issue costs).
• Greater tax benefit due to the higher level of debt funding supported by the project.

By using the ungeared cost of equity derived from the proxy company, APV is correctly based on the
project risk rather than CIP’s current business risk.

(c)

Advise on whether to proceed with the project

Based on APV we should accept this project.

We should, however, recognise that this decision relies on the underlying assumptions of APV
analysis, including the important assumption that it is appropriate to use the actual gearing level for
the project where different projects support different levels of debt, as appears to be the case here.

10
Answer to Question Four

Briefing notes

For use in: TS Management Team meeting

Date prepared: 1 October 2011
Prepared by: X, independent advisor to the management team of TS
Subject: Possible MBO

(a) Mr. A - Managing Director of TS

Mr A is concerned that the directors of YY will not see the benefit to them of an MBO and hence
would firstly like to identify how the MBO management team would increase the returns of the
business and secondly how to convince the Board of YY to accept an MBO rather than a trade sale.
A balance is required here between making YY an attractive offer but without revealing forecast
bullish returns that could result in a higher price and greater interest from other interested parties.

Greater returns are likely to be achieved by the management of TS under an MBO for the following
reasons:
1 The managers and employees of TS understand the telecommunications industry probably
better than the YY board. They can identify their own objectives and long term strategy which
do not have to be subject to review and possible censure by a holding company that views it as
“peripheral”.
2 There is likely to be more flexibility in day to day decision making as top management and
decision makers will only have one company on which to focus.
3 The TS cost base is likely to be lower as there will no longer be any centrally administered
management charges. However, it is possible that some economies of scale could be lost as a
result of no longer being part of a larger group.
4 If the managers and employees own 20% of the company with the eventual possibility of
owning a greater percentage they have greater personal motivation to succeed.

In respect of an MBO versus a trade sale, the main benefits to YY are that the administrative costs of
the MBO would be borne by the management of TS and valuable management time would not be
taken up in finding a suitable trade purchaser. Also, the managers of TS are aware of its financial
strengths and weaknesses which might allow a speedier agreement on the sale price.

(b) Ms B - Financial Manager of TS

Ms B is concerned about the involvement of a venture capital company and wishes to identify
alternative methods of finance.

The advantages and disadvantages of venture capital finance can be summarised as follows:

Advantages
• The main advantage of a venture capitalist is that this type of investor shares in the risk – in
fact takes most of the risk – and has money readily available.
• VC’s can also provide valuable support and advice to the management team (especially in the
early days and in the run up to any potential IPO in the future) on matters such as dealing
with banks and markets.

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Disadvantages
• VC’s always require a high annual return on their investment – often in the region of 25% per
annum. The management of TS therefore needs to be confident in their forecasts of the
future to ensure that the VC’s returns can be met.
• VCs will always look for an exit route which will, typically, be to sell their shares on the market
either via a placing or offer for sale (which would involve an IPO) or to another venture capital
entity. If the exit route is by IPO, the majority of the returns will almost certainly go to the
venture capitalist.
• Valuing shares for an IPO in, say, 5 years’ time is difficult and the issue could be frustrated by
market factors beyond the control of either the VC or TS.
• Control would be surrendered as here the VC would own up to 80% of the company. Decision
making could therefore become problematic.

If TS performs well, the manager/employee shareholders might be able to buy back their shares via
an earn-out basis. This method allows the venture capitalist to sell shares back to the owners on the
basis of the entity achieving certain levels of returns, often on an annual basis.

The only realistic alternatives are:

1 An investment bank. Such a company is unlikely to provide 80% of the finance. Even if it did,
the servicing costs would be prohibitive.
2 Ask YY to continue to own a shareholding. This would, in effect, mean YY acting as a venture
capitalist. If YY wishes to divest the subsidiary it is unlikely to want to continue to own a
substantial stake. However, if YY has no immediate investment opportunity readily available, as
implied by the FD, then it might be willing to consider a phased sale.
3 A combination of methods of finance. This might be difficult, costly and time consuming to
arrange.

(c) Mr C - Marketing Manager of TS

Mr C is concerned with the valuation of TS at $1,000 million. In answer to his specific concerns:

The FD’s valuation is based on YY’s P/E ratio as Ms B has explained and will have been applied to
TS’s earnings. The market capitalisation of YY based on the latest financial information is $16,380
million (525 million shares at $31.20 per share). Therefore, YY’s P/E ratio is 13 (market capitalisation
of $ 16,380 million divided by earnings of $1,260 million). On this basis TS’s value is therefore $975
million (earnings of $75 million multiplied by 13).

The book value of TS’s net assets is $735 million as at 31 August 2011. This represents
approximately 9% of YY’s total net assets compared with only 6% of its total earnings. However, as a
manufacturing company TS will have a relatively high level of tangible assets which might explain the
differential. In addition, TS may have a different gearing ratio to YY. Even so, this value has little
relevance (because by definition it is based upon the statement of financial position which excludes
important intangible assets such as brand strength and goodwill) except in specific circumstances
such as a liquidation or break up of the subsidiary. Neither of these situations applies here as YY wish
to divest the entire subsidiary and it is a going concern.

In addition, the net assets figure is given after deducting borrowings. If these are intra-group
borrowings, these need to be added back to the net assets figure to obtain the aggregate figure that
YY needs to raise by the disposal of TS. However, if the borrowings are from external sources and
are to be assigned to the new owner, they do not need to be added back when arriving at a valuation
of the equity for sale.

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In terms of alternative valuations we could consider using a different P/E ratio. TS is in an unrelated
business to YY and its shares are unlisted so a P/E of 13 might not be accurate. In the case of an
unlisted entity, a P/E ratio that is representative of similar quoted entities might be used as a starting
point for arriving at an estimated market value. If we use the telecommunications industry average
P/E of 15 given in the scenario, TS would have an even higher value of $1,125 million (earnings of
$75 million multiplied by 15). Again it could be argued that this P/E is not appropriate as TS
manufactures telecoms equipment which is only one part of the telecoms industry as a whole. In
addition, TS’s gearing ratio may not be typical of the industry as a whole as it is a wholly owned
subsidiary.

In terms of alternative methods TS should undertake a valuation of its business using discounted
cash flows. This involves discounting net cash flows as far into the future as reasonably possible at a
discount rate that reflects the risk of the operation. Determining an appropriate discount rate can be a
difficult process but TS should be able to obtain an approximation using a similar company’s data. As
TS is a wholly owned subsidiary, a WACC based on pre-interest free cash flows may be more
appropriate than the cost of equity applied to post-interest free cash flows post-interest. It may be
possible to obtain a suitable WACC from a proxy company in the same business as YY. The bid
company is likely to use its own WACC when valuing TS.

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