Unit - 4

Corporate Reconstruction

Corporate Reconstruction: It is an activity taken by the

corporate body to alter its capital structure.

I. Corporate reconstruction of a failing company:

• Companies in financial distress often undergo corporate
reconstructions to enable them to remain in business rather
than go into liquidation.
• Corporate reconstruction in a failing company often involves
raising some new capital and persuading creditors/lenders to
accept some alternative to the repayment of their debts. This
will ensure that the business continues in the short term.
• Longer term, the management needs to consider whether the
reconstruction will help the company develop a sustainable
competitive advantage and provide opportunities for raising
further finance.

Options open to failing companies

a. Company Voluntary Arrangement (CVA):
This is a legally binding arrangement between a company and
its creditors. It may involve writing off debt balances on the
profit and loss account against shareholders' capital and
creditors' capital and therefore affects creditors' rights. The
procedure is as follows:
• An application is made to the court, asking it to call a
meeting between the company and its creditors or a class of
creditor, e.g., debenture holders.
• The scheme of reconstruction is put to the meeting and a vote
taken.
Business reorganisation methods - Unbundling companies:
Unbundling is the process of selling off incidental non-core
businesses to release funds, reduce gearing and allow
management to concentrate on their chosen core businesses.
The main aim is to improve shareholder wealth.

Benefits of Unbundling/ Reorganisations:

I. Concentration of growth and maximisation of
shareholder value:
• The splitting-off of non-core activities from the rest of the
business may increase the visibility of an under-valued asset
which is then valued more highly by the market.
• Businesses may be valued more highly in the hands of the
new managers than under the previous management.
• The sale of less profitable parts of the business may be
viewed favourably by the market, result in an increased
valuation for the remainder.
• The performance of the individual businesses may improve,
also resulting in a higher valuation.

II. Reduction in complexity and improved managerial

efficiency:
• Diversified businesses are complex to manage.
• Smaller companies tend to be more flexible and respond
more easily to change.
• Following a demerger, the new companies have a clearer,
more focused management structure.
• Improved managerial effectiveness from the splitting off of
non-core businesses as managers are free to concentrate on
what they do best.
• Changes in the market can also mean that benefits of synergy
no longer exist, and there is no longer any business reason
for the organisation to retain unrelated businesses.

III. The release of financial resources for new investment:

• Selling a loss-making part of the business which is absorbing
funds can release cash to invest in the core businesses or new
activities
• A reduction in the size and complexity of the organisation
can reduce the central management costs, freeing up
resources
• Unbundling generates a lump sum in proceeds which can be
invested in a specific project.

Disadvantages of unbundling companies:

• Lots of parties involved
• The expense related to research
• Customer preference change
• Lack of name recognition

Forms of Unbundling:
a. Spin-offs, or demergers, in which the ownership of the
business does not change, but a new company is formed
with shares in the new company owned by the shareholders
of the original business. This results in two or more
companies instead of the original one.
b. Sell-offs, which involves the sale of part of the original
company to a third party, usually in return for cash.
c. Management buyouts, in which the management of the
business acquires a substantial stake in and control of the
business which they managed.
d. Liquidation, when the entire business is closed down, the
assets sold and the proceeds distributed to shareholders.
This is done when the owners of the business no longer
want it, or the business is not seen as viable.

a. Demergers: The aim of a demerger is to create separate

businesses which together have a higher value than the
original company. Following a demerger:
• shareholders own the same proportion of shares in the new
business or businesses as they did in the previous one
• each company owns a share of the assets of the original
company
• the new company or companies generally have new
management who can take the individual companies in
diverging directions; and each company could eventually be
sold separately
• the original company may no longer exist, with all its assets
distributed to the new business.

b. Sell-offs: A company may sell-off parts of the business for

a number of reasons, such as:
• to raise cash
• to prevent a loss-making part of the business from lowering
the overall performance business
• to concentrate on the core areas of the business
• to dispose of a desirable part of the business to protect the
rest from the threat of a takeover.
 c. Management buy-outs:
Overall, the distinguishing feature of an MBO is that a group of
managers acquires effective control and substantial ownership
and forms an independent business.

Variants of MBO:
• Management buy-out: where the executive managers of a
business join with financing institutions to buy the business
from the entity which currently owns it. The managers may
put up the bulk of the finance required for the purchase.
• Leveraged buyout: where the purchase price is beyond the
financial resources of the managers and the bulk of the
acquisition is financed by loan capital provided by other
investors.
• Employee buyout: which is similar to the above categories
but all employees are offered a stake in the new business.
• Management buy-in: where a group of managers from
outside the business make the acquisition.
• Spin-out: this is similar to a buyout but the parent company
maintains a stake in the business.

MBO v/s MBI:

A management buy-out (MBO) involves the purchase of a
business by the management team running that
business. However, a management buy-in (MBI) is the purchase
a business by a management team brought in from outside the
business.

Drawbacks of a MBO:
• The existing management may lack new ideas to rejuvenate
the business. A new management team, through their skills

 and experience acquired elsewhere, may bring fresh ideas
into the business.
• It may be that the external management team already has the
requisite level of finance in place to move quickly and more
decisively, whereas the existing management team may not
have the financial arrangements in place yet.
• It is also possible that the management of the parent
company and the company being sold off have had
disagreements in the past and the two teams may not be able
to work together in the future if they need to.

Drawbacks of MBI:
• The existing management is likely to have detailed
knowledge of the business and its operations. Therefore, they
will not need to learn about the business and its operations in
a way which a new external management team may need to.
• It is also possible that a MBO will cause less disruption and
resistance from the employees when compared to a MBI.
• If the former parent company wants to continue doing
business with the new company after it has been disposed of,
it may find it easier to work with the management team
which it is more familiar with.
• The internal management team may be more focused and
have better knowledge of where costs can be reduced and
sales revenue increased, in order to increase the overall value
of the company.
Reasons for a management buy-out:
Opportunities for MBOs may arise for several reasons:
• The existing parent company of the 'victim' firm may be in
financial difficulties and therefore require cash.
• The subsidiary might not 'fit' with the parent's overall
strategy, or might be too small to warrant the current
management time being devoted to it.
• In the case of a loss-making part of the business, selling the
subsidiary to its managers may be a cheaper alternative than
putting it into liquidation, particularly when redundancy and
other wind-up costs are considered.
• The victim company could be an independent firm whose
private shareholders wish to sell out. This could be due to
liquidity and tax factors or the lack of a family successor to
fill the owner-manager role.

Advantages of Buy-Outs to Advantages of Buy-Outs to

the Disposing Company the Acquiring Management
If the subsidiary is loss- Preserves their jobs
making, sale to the
management will often be
financially better than
liquidation and closure costs.
There is a known buyer. Offers them the prospect of
significant equity
participation in their
company
Better publicity can be earned Quicker than starting a
by preserving employees' similar business from scratch
jobs rather than closing the
business down.
It is better for the existing Can carry out their own
management to acquire the strategies, no longer having
company rather than it to seek approval from head
possibly falling into the office.
hands of competitors.

Issues to be addressed when preparing a buy-out proposal:

• Do the current owners wish to sell?
• Will the new business be profitable?
• If loss-making, can the new managers return it to
profitability?
• What will be the impact of loss of head office support?
• What is the quality of the management team?
• What is the price?
• Is the deal in the best interests of shareholders?

Sources of finance for buy-outs and buy-ins

Several institutions specialise in providing funds for MBOs.
These include:
• the clearing banks
• pension funds and insurance companies
• merchant banks
• specialist institutions such as the 3i group and Equity Capital
for Industry
• government agencies and local authorities, for example
regional development agencies.
Assessing the viability of buy-outs:
Both the management buy-out team and the financial backers
will wish to be convinced that their proposed MBO will
succeed. It is important to ask the following questions:
• Why do the current owners wish to sell?
• Does the proposed management team cover all key
functions?
• Has a reliable business plan been drawn up, including cash
flow projections?
• Is the proposed purchase price too high?
• Is the financing method viable?

Issues to be considered while financing MBOs & MBIs:

• The form of finance
• Duration of finance
• The involvement of the institution
• Ongoing support
• Syndication
• The need for financial input from the management team
• The need for a business plan
• Other sources of finance like hire purchase, leasing,
government grants
 Unit 5.6 Lease Financing - Financial Evaluation of
Leasing Decision

Lease versus buy: Once the decision has been made to acquire
an asset for an investment project, a decision still needs to be
made as to how to finance it. The choices that we will consider
are ease or Buy.
The NPVs of the financing cash flows for both options are
found and compared and the lowest cost option selected.

Leasing: A Lease can be defined as a contract where a party

being the owner (lessor) of an asset (leased asset) provides the
asset for use by the lessee at a consideration (rental) for a
certain period (lease period) There are two types of lease
contracts:
a. Finance lease: A lease is classified as a finance lease if it
transfers substantially all the risks and rewards incident to
ownership.
Characteristics:
• Lease period usually will be equal to the life of asset
• The lessor recovers the full cost of the asset over the period
of the lease.
• At the end of lease period the asset will be transferred to
lessee
• The risks and major repairs of asset are borne by the lessee
and not lessor

b. Operating lease: A lease is classified as an operating lease

if it does not transfer substantially all the risks and rewards
incident to ownership.
L

Characteristics
• Lease period will not be equal to the life of asset
• The lessor will not be able to recover the full cost of the asset
over the period of the lease.
• At the end of lease period the asset will be not be transferred
to lessee
• The risks and major repairs of asset are borne by the lessor
and not lessee

Significance of Lease financing

• Saves capital requirements - helps liquidity
• No dilution of ownership/capital structure
• Plan cash flows
• Shift the risk of maintenance and obsolescence
• Flexibility and convenience

Limitations of Lease financing

• Higher cost
• Contract restrictions
• Ownership - no alterations in asset

Cashflows associated with buying the asset

• Purchase price of asset
• Residual value of asset
• Tax savings on tax allowable depreciation

Cashflows associated with leasing the asset

• Lease payments
• Tax relief on lease payments
Other considerations:
• There may be other issues to consider before a final decision
is made to lease or buy, for example:
• Who receives the residual value in the lease agreement?
• Any restrictions associated with the taking on of leased
equipment, e.g. leases may restrict a firm's borrowing
capacity.
• Any additional benefits associated with lease agreement, e.g.
maintenance or other support services.