Free2talk Plc - Advantages and Disadvantages of Restructuring the Company - Case Study Example

RUNNING HEAD: Acquisition and Mergers Acquisition and Mergers of Introduction Free2talk plc, a manufacturer of mobile phones and an operator a mobile network, experienced a very severe fall of its share price to only 10 pence from a high of 180 pence. Prior to this event, the company has borrowed extensively on the international money markets, as a means to finance its offer the latest hand-held video phone technology. Unluckily, the new technology did not make the company’s products and services popular to consumers, thereby causing its sales of new handsets and network subscriptions to fall below forecast. Although capital investments are made in past, the same must be sustained with about £100 million per year for the company to continue operating at current levels. The amount would be divided into £20 million for the manufacturing division and £80 million for the network division. Free2talk’s manufacturing division supplies approximately 25% to its network division. The fall in share prices prompted the company’s board of directors to arrange a crisis meeting and the latter has considered three proposals. One is a corporate structuring, in which debentures are converted to equity, and which gives control of the company to the current debenture holders. Another option is the sale of the company’s shares to Globaltalk plc, which operates a successful rival mobile phone network, for the sum of £50 million. This ideal would be conditional upon the Globaltalk not taking over the liability for any of the Free2talk’s loans. The third proposal is to cease trading and close the company. See Case Study – Freetalks. Acting as independent consultant to the board of the directors of Free2talk, this paper seeks to critically evaluate given financial information by discussing the advantages and disadvantages of two of the three given proposals from the viewpoint of the shareholders and debenture holders. This paper will also identify any other strategy or strategies which might be possible for Free2talk plc based on reasonable assumptions that will be clearly stated in the process. Two of the chosen proposals for discussion include the restructuring and the sale of the company for £50 million Globaltalk plc on the condition that no debt will be assumed by the buyer. 2. 1. The proposal to restructure the company and its advantages and disadvantages Restructuring the business can give the company a fresh start and can put to the company into a better shape for its future operations compared with the past (Pomerleano, Shaw & World Bank, 2005). This offers a chance for the company to become profitable (Weygandt, Kimmel & Kieso, 2009) and make the stockholders wealthier. With restructuring there is a net advantage that is shown in terms of net present value (Shim & Siegel, 2008). Compared to selling the company at £50 million, it is better to restructure for both the shareholders and debenture holders. The company has at present a book value of £96 million from the Shareholders’ funds of £50 million and Reserves of £46 million. Selling therefore the same at such a very low amount would be disadvantageous for the company based on the company’s book value. Of course the book value is not necessarily the present intrinsic value of the company if the chances for better business are factored into the situation. Case facts provide that the decline of the company’s share price was so big from 180 pence to 10 pence and the cause of the decline may be combination of external and internal factors to the company. External factors may include those effect of the macroeconomic environment on the company (Slavin and Slavin, 2010; Arnold, 2008) Case facts mentioned about the highly leveraged position of the company of not less 3 debt to equity (£300 /£96) in 2010 and this has caused its stock price to fall by 18 times the previous price when forecasted plans did not happen. This is after company has borrowed extensively on the international money markets coupled with unpopularity of the new technology to sustain what has been forecasted by the company’s management. Based from the case facts, the company heavily borrowed on the international money markets but its products based on new technology did not deliver what was expected. If company pursues restructuring, the question that should be answered is: Can it really recover when after restructuring? Based on 2009 and 2010 income statements, the company has suffered hefty pre-tax losses of £40 million in 2009 and £60 million in 2010 respectively. If this will continue, there is no reason to continue the business since this would be bring down the company’s resource further down the drain. However, case facts provide the positive points are anticipated after the restructuring proposed. This would include the increase of at least £30 million per year in the net profit earnings. See Appendix A. After recasting the company’s income statement and converting the same into cash flow analysis for the next five years, it was found that the company would produce a net present value of not less £200 million. See Appendix A. The conversion to cash flows per years includes adding back the depreciation charges to the net losses or profit before taxes per year as depreciation did represent cash charges. The bond holders are technically better off before the proposal to restructure with the market price of debentures £121 as compared to the latter’s par and redemption value of £100. For them to agree to sale without benefiting or that would cause to hold the empty bag. Such option them may be next to impossible since that would be asking them to give up to the shareholders what they could get from the resources or assets. On the other hand, not do anything is not an option for the debenture holders since this market price may eventually fall further until bankruptcy as profit levels will continue to be low because of the high financial leverage of the company. This situation of Free2talk approximates the existence of an optimum capital structure of an organization. Although a company could actually benefit from the high debt due to its ability to have interest expense deducted for tax purposes, it must not do the same if it is too risky that it puts the company too highly leverage that the stock market would have to react unfavourably to such risk. The market price of the stocks is a reflection of how investors perceive the value of the company. When done internally to estimate the value, this could be by discounting the projected cash flows. It is here where the company needs to minimize cost of capital in order to attain it wealth maximization objective (Gitman and McDaniel, 2008). By restructuring the business that would result to new total debt of £100M as compared to equity of £50M. This would result to a debt to equity ratio 2/1 or 2. Although said ratio is still higher than the industry debt to equity of 40/60 or 2/3, its WACC would be lower and this could mean higher shareholder value for the company for purposes of discounting the expected cash flows of the business. If the restructuring would happen, earning before taxes would improve by £30 million year. The net present value therefore of the business is more than £200 million. Selling the company as £50 million definitely inferior since it is already a give-away price for Free2talk. This amount is still not including the estimated cash flows after years or the terminal value. The amount and timing of projected cash flows are a function of how the company will fare in the future. The only seeming disadvantage of restructuring is the reduction of what debenture holders can claim based on the balance book value. However, this disadvantage should be deemed to disappear with the worst thing that could happen if restructuring will not happen. 2.2 The proposal to have the company sold for £50 million to Globaltalk plc Selling the company at 50 million to Globaltalk plc would possibly have saved the company from possible decrease in value should losses continue and the expected increase in cash flow will not happen after restructuring is chosen. In other words, the situation could get worse and the shareholders may end up holding the empty bag. Another advantage of selling the same is the chance that the company could still function as such under another management rather than ceasing operation which leave the company removed from existence. Another obvious advantage of the proposed sale compared to restructuring is that the shareholders could still get something at £50 million compared to nothing. It can be deduced that if that if all the equity will be cancelled just for the purpose of making the company less leverage, the same should not be at the expense of the present decision makers. The debenture holders will also be reducing the £300 million by making a nominal value of £100 million in shareholdings. This would not be easy for them to accept this considering it will really be a big loss for the company. This option may be acceptable to shareholders but not to debenture holders. The debenture holders will therefore be making a choice of at least minimizing the loss and hoping something better for the future in case if they will agree to lower their claim now in the structuring and set aside the choice of holding an empty bag. It can be argued that they would rather choose that the company ceased operation since they will have priority in the assets of the company over the shareholders assuming the company will cease operation. To get this amount the total realizable value of the company’s assets that includes land and building, other fixed asset, stocks and debtors with the book value amount per balance sheet of £120 million, £175 million, £260 and £85 million respectively would have realizable values of £140 million, £50 million, £100 million and £70 million respectively or total of £360 million. The total assets of the company amount at £645 million but the total realizable values stood at £360 million. As to whether the bondholder can get the whole amount is not also a sure thing as there also currently maturing obligations that may also have a claim on the company’s stock and others. Thus it must be assumed before the debenture holders could be assured there is need to pay the currently maturing obligations which stood at £249 million. Actually before the £249 million to be paid to short-term creditors, there is also a need to deduct the closure cost of £100 million. If the current creditors are paid from the remaining £270 million, remaining amount would mostly likely be about £20 million. See Case Study- Free2talk. Thus whether the debenture holders who have claim of £300 would agree to have the £20 million to be divided among themselves is really doubtful for is almost nothing. With the uncertainty that it could be less disastrous, they have a chance of making a gambit or a gamble by agreeing to the proposed corporate restructuring compared to sale. Converting their £300 million worth of bonds into £100 million equity would offer them the chance to make it big should the company make a turn around. There is no statement that the industry where the company operates is no longer favourable. Their case was just a case of over expansion by borrowing to much from the international market. The reflected value in the stock price was just therefore a reaction and may not necessarily the correct value of the company that would now tempt or cause proposal to sell the whole company which would only benefit the shareholders. The disadvantage of this proposal is debenture holders will not accept it as they would be left with the empty bag. 2.22. Computation of cost of equity and weighted cost of capital for Free2talk Since Free2talk is not fully financed with equity as earlier determined from its capital structure or debt to equity ratio of more than 3.0 with, there is a need to have a weighted cost of capital (WACC). That is after computing first is cost of equity using the capital asset pricing model (CAPM) (Gitman and McDaniel, 2008) Under the concept, its cost of equity would have the formula: Required (or expected) Return = RF Rate + (Beta * (Market Return - RF Rate)), where RF stands for risk free rate and the rest of the formula is the market risk premium. Free2talk would have a cost of equity at 21.1% if the formula is applied as follows: Required (or expected) Return = RF Rate + Beta (Market Return - RF Rate) = 5% + 1.15 (14%) = 21.1%. The risk free rate of 5%, the beta of 1.15 and equity risk premium of 14% and Kd of 10% are all given from the case study. The WACC is equal to 11.70% using the formula WACC=Ke*E/(E+D)+Kd*(1-t)*D/(E+D), where Ke is cost of equity at 21.1% as computed, E is total equity at £50 million, D is total debt at £100 million, Kd at 10% and t as tax at 30%. See Appendix B for more details. See Case Study – Free2talk. Since this analysis is from the point of view of board of directors who is given the responsibility to act in the best interest of the corporation including the shareholders and the creditors, there is really to strike a balance as to which is most beneficial to all concerned. 3. Conclusion It can be deciphered from the analysis of advantages and disadvantages of the two proposals that it is better to restructure the company by converting the debts into equity than selling the same as it would afford better chances for the company to recover from losses towards the shareholder wealth maximization objective. It can still recover from poor performance in the past if it can reduce its cost of capital by becoming less financially leverage through restructuring as proposed to allow the company to be within the industry and to be perceived as such. The decision should generally be viewed from what would just be favourable to shareholders although it could be unfavourable to creditors and the option to sell may sound good to shareholders. Creditors however may need to approve the sale and most probably they would not. Normally creditors will have control of the assets of the corporation the moment that the company is found bankrupt. However the situation of Free2talk has still not reached that point as there is filing of bankruptcy has been done by creditors. The existing shareholders through the board of directors must therefore prevent that from happening where the company would no longer in in their hands. It is therefore in the interest of the existing shareholders to revive the company and brings it to its regular path towards growth under a better leverage operation. The same would attain the minimum level of its cost of capital which would in effect bring the company to its accomplishment of wealth maximization objectives. Restructuring is therefore a win-win situation for both the shareholders and creditors before the company could eventually become bankrupt due to low level of profitability or continued losses. References: Arnold, R. (2008). Economics. Cengage Learning Case Study - Free2talk plc Gitman, L. and C. McDaniel (2008). The Future of Business: The Essentials Cengage Learning Pomerleano, M., W. Shaw and World Bank (2005). Corporate restructuring: lessons from experience. World Bank Publications Shim, J. & J. Siegel (2008) Financial Management. Barrons Educational Series Slavin and Slavin (2010) Economics. McGraw-Hill Weygandt, J. , P. Kimmel & D. Kieso (2009) Financial Accounting, Wiley and Sons Read More