D1. Financial reconstruction Flashcards
Capital reconstruction schemes.
Is a scheme whereby a company reorganises its capital structure by changing the rights of its shareholders and possibly the creditors. This can occur in a number of circumstances, the most common being when a company is in financial difficulties, but also when a company is seeking floatation or being acquired.
Capital reconstruction schemes.
Financial difficulties.
If a company is in financial difficulties it may have no recourse but to accept liquidation as the final outcome. Typical financial difficulties:
- Large accumulated losses.
- Large arrears of dividends on cumulative preference shares.
- Large arrears of debenture interest.
- No payment of ordinary dividend.
- Market share price below nominal value.
However, it may be in position to survive, and indeed flourish, by taking up some future contract or opening in the market. The only major problem is the cash needed to finance such operations because the present structure of the company will not be attractive to outside investors. To get cash the company will need to reorganise or reconstruct.
Possible reconstruction.
The changing or reconstruction of the company’s capital could solve these problems. The company can take any or all of the following steps:
• Write off the accumulated losses.
• Write of the debenture interest and preference share dividend arrears.
• Write down the nominal value of the shares.
To do this the company must ask all or some of its existing stakeholders (shareholders and creditors) to surrender existing rights and amount owing in exchange for new rights under a new or reformed company. Existing shareholders are likely to see a large dilution of their holding as reconstruction often involve issuing many new shares to creditors.
Why would the stakeholder be willing to do this? Reconstruction.
The answer to this is that it may be preferable to the alternatives which are:
• To accept whatever return they could be given in a liquidation.
• To remain as they are with the prospect of no return from their investment and no growth in their investment.
Generally, stakeholders may be willing to give up their existing rights and amounts owing (which are unlikely to be met) for the opportunity to share in the growth in profits which may arise from the extra cash which can be generated as a consequence of their actions.
General guidelines (principles) in reconstruction
For a reconstruction to be successful the following principles are to be followed:
• Creditors must be better off under reconstruction than under liquidation. If this is not the case, they will not accept the reconstruction as their agreement is a requirement for the scheme to take place.
• The company must have a good chance of being financially viable and profitable after the reconstruction.
• The reconstruction scheme must be fair to all the parties involved, for example preference shareholders should have preferential treatment over ordinary shareholders.
• Adequate finance is provided for the company’s needs.
In solving reconstruction questions, the following steps can be followed:
- State the principles of reconstruction.
- Estimate the position if insolvency proceedings go ahead. Restate assets at realisable value and repay according to legal framework. Note the sequence of creditor priorities as followings:
o Taxes and unpaid wages
o Secured debts, including unpaid interest – fixed charge
o Secured debt – floating charge
o Unsecured creditors
o Preference shareholders including unpaid dividend
o Ordinary shareholders.
- Check the sufficiency of the amount of finance that will be raised from the scheme. This includes proceeds from the sale of investment, existing assets when new assets are to be bought to replace them, and reduction in working capital.
- Check if the parties will be better off under the proposed scheme than under liquidation.
- Assess the fairness of the scheme.
- Assess the post-reconstruction financial viability and profitability of the company by calculating post-reconstruction EPS and P/E ratio.
- Conclude.
Reconstruction.
Value creation.
Value creation. Reconstruction schemes may also be undertaken by companies which are not in difficulties as part of a strategy to create value for the owners of the company. The management of a company can try and improve operations and increase the value of the company, by:
• Returning cash to shareholders using a share repurchase scheme
• A significant injection of further capital, either debt or equity, to fund investments or acquisitions
• A leveraged buy-out (taking company private): where publicly quoted company is acquired by a specially established private company which funds the acquisition by substantial borrowing.
Reconstruction.
Share repurchase.
Share repurchase. Share repurchase is an alternative to dividend policy where the company returns cash to its shareholders by buying shares from the shareholders in order to reduce the number of shares in issue. Therefore if a company has surplus cash and cannot think of any profitable use of that cash, it can use that cash to purchase its own shares.
So what will actually happen?
• The company’s CASH will go DOWN. Because the company is buying the shares back.
• The number of SHARES will go DOWN.
The effect on EPS (EPS = Earnings / Shares). Earnings will stay as they are. But you will have less shares. Therefore, EPS will INCREASE.
Share repurchase.
Shares may be purchased either by:
- Open market purchase – the company buys the shares from the open market at the current market price.
- Individual arrangement with institutional investors.
- Tender offer to all shareholders.
Reasons for share repurchase
- Readjustment of the company’s equity base
- Purchase of own shares may be used to take a company out of the public market and back into private ownership.
- Purchase of own shares provide an efficient means of returning surplus cash to the shareholders.
- Purchase of own shares increases earning per share (EPS) and return on capital employed (ROCE).
- To increase the share price by creating artificial demand.
Problems of share repurchase
- Lack of new ideas. Shares repurchase may be interpreted as a sign that the company has no new ideas for future investment strategy. This may cause the share price to fall.
- Costs. Compared with a one-off dividend payment, share repurchase will require more time and transaction costs to arrange.
- Resolution. Shareholders have to pass a resolution and it may be difficult to obtain their consent.
- Gearing. If the equity base is reduced because of share repurchase, gearing may increase and financial risk may increase.
Reconstruction.
Procedures for going private.
Procedures for going private. A public company goes private when a small group of individuals, possibly including existing shareholders and/or managers and with or without support from a financial institution, buys all the company’s shares. The reasons for such move are varied, but are generally linked to the disadvantages of being in the stock market and the inability of the company to obtain the supposed benefits of a stock market quotation.
Going private adv and disadv
Advantages:
• The costs of meeting listing requirements can be saved
• The company is protected from volatility in share prices which financial problems may create
• The company will be less vulnerable to hostile takeover bids.
• Management can concentrate on the long-term needs of the business rather than the short-term expectations of shareholders
• It may be felt that the stock is undervaluing the company.
Disadvantages. The main one is that company loses its ability to have its shares publicly traded. If the share cannot be traded it may lose some of its value.
Reconstruction.
Debt covenants.
Debt covenants. Debt finance involves ‘covenants’ – these are conditions that the borrower must comply with and, if they do not, the loan can be considered to be in default and the bank can demand repayment.
• Positive covenants. These involve taking a positive action to achieve objective. This could involve achieving certain levels for financial ratios (gearing, interest cover etc). In addition, it may also include the need to provide the bank with regular financial statements/forecasts, to maintain assets used as security and to insure key assets and staff.
• Negative covenants. These place restrictions on the borrower’s behaviour (no borrowing from other lenders, disposal of assets, dividend pay-out limits or limit to major investments)
Forecasting and debt covenants.
In any type of financial reconstruction care will need to be taken that debt covenants are not breached. It may be necessary to forecast company’s profits and statement of financial position to assess whether positive covenant relating to financing ratios has not been broken.
Forecast profit statement. This will allow the following to be identified:
• Profits before interest and tax – required for interest cover calculation
• Interest – required for interest cover calculation
• Profits after interest and tax – required for earnings per share calculation
• Retained earnings – affects the book value of equity
Forecast statement of financial position.
• Book value of equity (share capital plus retained earnings (from profit statement forecast)) – required for gearing calculation.
• Non-current liabilities – required for gearing calculation.
• Current assets and liabilities – required for liquidity ratios (current).
