Strategic Financial Management-2

Assignment – A

Q1: New performance Metrics “Economic Value Added (EVA)” explain ?

Q2. Explain the Fisher’s hypotheses of inflation.

Q3. “Rehabilitation of “Sick Enterprises” is necessary for economic growth” comment?

Q4. Highlight the importance of transfer pricing?

Q5. Mention the path of successful merger & acquisition process?

Assignment – B

Q.6 “Working capital is a life blood of an business” how we can manage the working capital? Explain its kinds & different approaches?

Q.7 “Discounted cash flow method of valuation” give an strong base of valuation, justify? Take your own assumptions?

Q.8 Discuss the option of financing the “merger & acquisition “deal. Consider Leverage buy out (LBO’s) one of the option? Explain the procedure of leverage buy out.

 

CASE STUDY

Q9: Highlights the major important point of the deal.

Q10: Specify the term of LBO deal of TATA & TETLY Co.

¹ The Leveraged Buyout Deal of Tata & Tetley’

The case ‘The Leveraged Buyout Deal of Tata & Tetley’ provides insights into the concept of Leveraged Buyout (LBO) and its use as a financial tool in acquisitions, with specific reference to Tata Tea’s takeover of global tea major Tetley. This deal, which was the biggest ever cross-border acquisition, was also the first-ever successful leveraged buy-out by any Indian company. The case examines the Tata Tea-Tetley deal in detail, explaining the process and the structure of the deal. The case helps them to understand the mechanism of LBO. Through the Tata-Tetley deal the case attempts to give students an understanding of the practical application of the concept.

Students are also expected to understand the merits and demerits of the LBO mechanism and the problems in the Indian Financial system, which have had an impact on the acceptance of LBO as a method of financing.

INTRDUCTION

“We were very clear that the burden on Tata tea should be such that the company would be able to absorb it. And it would not materially affect Tata Tea’s bottom line.”

– N.A.Soonavala, Vice-Chairman, Tata Tea.

“It was important to make the right decision on the comprehensiveness of the transaction. The model has been driven by existing and future earnings potential of the Tetley group and the resultant post-acquisition cash flows to immediately justify the business and financial model.”

– Rana Kapoor, MD, Rabo India Finance Ltd., Commenting on
the deal.

In the summer of 2000, the Indian corporate fraternity was witness to a path breaking achievement, never heard of or seen before in the history of corporate India.

In a landmark deal, heralding a new chapter in the Indian corporate history, Tata Tea acquired the UK heavyweight brand Tetleyl for a staggering 271 million pounds. This deal which happened to be the largest cross-border acquisition by any Indian company, marked the culmination of Tata Tea’s strategy of pushing for aggressive growth and worldwide expansion. The acquisition of Tetley pitchforked Tata Tea into a position where it could rub shoulders with global behemoths like Unilever and Lawrie. The acquisition of Tetley made Tata Tea the second biggest tea company in the world. (The first being Unilever, owner of BrookeBond and Lipton).

Moreover it also went through a metamorphosis from a plantation company to an international consumer products company.

Ratan Tata, Chairman, Tata group said, “It is a great signal for global industry by Indian Industry. It is a momentous occasion as an Indian company has been able to acquire a brand and an overseas company.” Apart from the size of the deal, what made it particularly special was the fact that it was the first ever leveraged buy-out (LB0)2 by any Indian company. This method of financing had never been successfully attempted before by any Indian company. Tetley’s price tag of 271 mn pounds (US $450 m) was more than four times the net worth of Tata tea which stood at US $ 114 m. This David & Goliath aspect was what made the entire transaction so unusual. What made it possible was the financing mechanism of LBO. This mechanism allowed the acquirer (Tata Tea) to minimise its cash outlay in making the purchase.

Tata Tea was incorporated in 1962 as Tata Finlay Limited, and commenced business in 1963. The company, in collaboration with Tata Finlay & Company, Glasgow, UK, initially set up an instant tea factory at Munnar (Kerala) and a blending/packaging unit in Bangalore.

Over the years, the company expanded its operations and also acquired tea plantations. In 1976, the company acquired Sterling Tea companies from James Finlay & Company for Rs 115 million, using Rs 19.8 million of equity and Rs. 95.2 million of unsecured loans at 5% per annum interest. In 1982, Tata Industries Limited bought out the entire stake of James Finlay & Company in the joint venture, Tata Finlay Ltd. In 1983, the company was renamed Tata Tea Limited. In the mid 1980s, to offset the erratic fluctuations in commodity prices, Tata Tea felt it necessary to enter the branded tea market. In May 1984, the company revolutionized the value-added tea market in India by launching Kanan Devan tea3 in polypack.

In 1984, the company set up a research and development center at Munnar, Kerala. In 1986, it launched Tata Tea Dust in Maharashtra. In 1988, the Tata Tea Leaf was launched in Madhya Pradesh.

In 1989, Tata Tea bought a 52% stake in Karnataka-based Consolidated Coffee Limited-the largest coffee plantation in Asia, in order to expand its coffee business. In 1991, Tata Tea formed a joint venture with Tetley International, UK, to market its branded tea abroad. In 1992, Tata Tea took a 9.5% stake in Asian Coffee-the Hyderabad based 100% export oriented unit known for its instant coffee, through an open offer. This offer was the first of its kind in Indian corporate history. Later, in 1994, Tata Tea increased its stake in Asian Coffee to 64.5% through another open offer. This helped it to consolidate its position in the coffee industry. In 1995, Tata Tea unveiled a massive physical upgradation program at a cost of Rs 1.6 billion…

 

De-Mystifying LBO

The Tata-Tetley deal was rather unusual, in that it had no precedence in India. Traditionally, Indian market had preferred cash deals, be it the Rs.10.08 billion takeover of Indal by Hindalco or the Rs. 4.99 billion acquisition of India world by Satyam.

What set the deal apart was the LBO mechanism which financed the acquisition. (See Box item to know about the basics of LBOs). The LBO seemed to have inherent advantages over cash transactions. In an LBO, the acquiring company could float a Special Purpose vehicle (SPV) which was a 100% subsidiary of the acquirer with a minimum equity capital. The SPV leveraged this equity to gear up significantly higher debt to buyout the target company. This debt was paid off by the SPV through the target company’s own cash flows. The target company’s assets were pledged with the lending institution and once the debt was redeemed, the acquiring company had the option to merge with the SPV…

Structure of the Deal

The purchase of Tetley was funded by a combination of equity, subscribed by Tata tea, junior loan stock subscribed by institutional investors (including the vendor institutions Mezzanine Finance, arranged by Intermediate Capital Group Pic.) and senior debt facilities arranged and underwritten by Rabobank International.

Tata Tea created a Special Purpose Vehicle (SPV)-christened Tata Tea (Great Britain) to acquire all the properties of Tetley. The SPV was capitalized at 70 mn pounds, of which Tata tea contributed 60 mn pounds; this included 45 mn pounds raised through a GDR issue. The US subsidiary of the company, Tata Tea Inc. had contributed the balance 10 mn pounds. The SPV leveraged the 7 0 mn pounds equity 3.3 6 times to raise a debt of 235 mn pounds, to finance the deal (Refer FIGURE I). The entire debt amount of 235 mn pounds comprised 4 tranches (A, B, C and D) whose tenure varied from 7 years to 9.5 years, with a coupon rate of around 11% which was 424 basis points above LIBOR…

The Way to Go?

Some analysts felt that Tata Tea’s decision to acquire Tetley through a LBO was not all that beneficial for shareholders. They pointed out that though there would be an immediate dilution of equity (after the GDR issue), Tata Tea would not earn revenues on account of this investment in the near future (as an immediate merger is not planned). This would lead to a dilution in earnings and also a reduction in the return on equity. The shareholders would, thus have to bear the burden of the investment without any immediate benefits in terms of enhanced revenues and profits. From the lenders point of view too there seemed to be some drawbacks…

-Tata Tea one of the largest company in the world was sheltered from competition by a protectionist Indian government for most of its history.

-In 1999, Tata Tea company faced several new challenges:

-Upcoming deregulation.

-Changing consumer tastes.

-Ban on tea imports scheduled to be lifted in 2001

-Majority of the company’s tea is sold in India, with 12% total international sales only.

-Possibility of future stiff competition from Nestle, Sara Lee Corporation, and Associated British Foods.

Possible Strategies/Solutions

-To enhance its position in the current brand

-Acquire a well-known brand Some disturbing questions???

-Tata Tea company has to beat the growing global competition – but how?

-Any possibilities for further growth in the Indian stagnant market?

-If popular brand in India can penetrate into the global markets?

-Perhaps it would need to develop a brand of international

demand or taste.

-Or acquire an other company

 

These questions become more urgent as Tetley Tea, well-known in the US and UK, unexpectedly comes up for sale. Provide refernce

Pros

-Acquiring Tetley would mean capturing the higher end of the value chain

-Tetley is well-established in international markets

-Tata’s gross margin is 36%, while Tetley’s is a more efficient 55%

-The combination of the two companies would allow for synergies that competitors couldn’t match

-Opportunity to buy a brand the likes of Tetley is rare

Cons

-Tata had already tried acquiring Tetley five years prior and failed

-Tata may have difficulty raising the required £200-300 million purchase price

-The £200-300 million asking price is much higher than the

£190 million the company was valued at in 1995

-The sheer size of the transaction could prove unwieldy

–Wouldn’t investing in building its own global brand be more efficient than buying a foreign brand?

Finally

-TATA choose to acquire Tetley.

-The major challenge was financing

-The value of Tata Tea was $114 million.

-Tetley was valued at $450 million.

The solution was provided by Leverage Buy outing the Deal.

LBO = Definition

–Buyout: The purchase of a company or a controlling interest of a company’s shares.

-Leverage buyout: The acquisition of a company using debt and equity finance. As the word leverage implies,more debt than equity is used to finance the purchase, e.g. 90% debt to 10% equity. Normally, the assetsofthe company being acquired are put up as collateral to secure the debt. (Beatrice Foods by Esmark, Levis Strauss, etc.)

-Going Private: Refers to transformation of a public corporation into a privately held firm.

Example of LBO in daily life -Mortgaging a Home.

-Buying a Car/Taxi, financed by bank. Other similar term

–Management buy-out (MBO) – A private equity firm will often provide financing to enable current operating management to acquire at least 50% of the business they manage. In return, the private equity firm usually receives a stake in the business.

Characteristic

-LBOs are a way to take a public company private, or put a company in the hands of the current management, MBO.

-LBOs are financed with large amounts of borrowing (leverage), hence its name. Debt:Equity ratio can go more than 90:10

-LBOs use the assets or cash flows of the company to secure debt financing, bonds or bank loans, to purchase the outstanding equity of the company.

-After the buyout, control of the company is concentrated in the hands of the LBO firm and management, and there is no public stock outstanding.

LBO Financing

-LBO sponsors have equity funds raised from institutions like pensions & insurance companies

-Balance from commercial banks (bridge loans, term loans, revolvers).

-Banks concentrate on collateral of the company, cash flows, level of equity financing from the sponsor, coverage ratios, ability to repay (5-7 yr)

-Some have “Mezzanine Funds” as well that can be used for junior subordinated debt and preferred

-Occasionally, sponsors bring in other equity investors or another sponsor to minimize their exposure

SPV – Special purpose vehicle

-In our case SPV – Tata Tea Great Britain Ltd., was created.

-The cash flow from the Tetley and hence this SPV, was used to repay the debt.

-SPV merged with TATA after repayment of the debt. Tata Tetley

-First Leveraged Buy-out ( Rs. 2,135 cr)

-Instant access to Tetley’s worldwide operations, combined

turnover at Rs 3,000 crores.

-Financial Innovation at its best

-SPV created to ring fence risk with equity contributed by

Tata Tea and Tata Tea Inc

-Debt of 235 million pounds raised in the form of long term

debt and revolver; charge against Tetley’s brand and

assets.

-Tata Tea’s exposure only to the extent of equity component

of 70 million pounds.

 

Assignment – C

1. ____is equal to the total market value of the firm’s common stock divided by (the replacement cost of the firm’s assets less liabilities).

A) Book value per share

B) Liquidation value per share

C) Market value per share

D) Tobin’s Q

E) None of the above.

 

2. High P/E ratios tend to indicate that a company will_______, ceteris paribus.

A) grow quickly

B) grow at the same speed as the average company

C) grow slowly

D) not grow

E) none of the above

 

3.___________ is equal to (common shareholders’ equity/common shares outstanding).

A) Book value per share

B) Liquidation value per share

C) Market value per share

D) Tobin’sQ

E) none of the above

 

4.__________ are analysts who use information concerning current and prospective

profitability of a firms to assess the firm’s fair market value.

A) Credit analysts

B) Fundamental analysts

C) Systems analysts

D) Technical analysts

E) Specialists

 

5. The_____is defined as the present value of all cash proceeds to the investor in the stock.

A) dividend payout ratio

B) intrinsic value

C) market capitalization rate

D) plowback ratio

E) none of the above

6._________ is the amount of money per common share that could be realized by breaking

up the firm, selling the assets, repaying the debt, and distributing the remainder to shareholders.

A) Book value per share

B) Liquidation value per share

C) Market value per share

D) Tobin’sQ

E) None of the above

 

7. Since 1955, Treasury bond yields and earnings yields on stocks were____

A) identical

B) negatively correlated

C) positively correlated

D) uncorrelated

 

8. Historically, P/E ratios have tended to be___ .

A) higher when inflation has been high

B) lower when inflation has been high

C) uncorrelated with inflation rates but correlated with other macroeconomic variables

D) uncorrelated with any macroeconomic variables including inflation rates

E) none of the above

 

9. The________is a common term for the market consensus value of the required return

on a stock.

A) dividend payout ratio

B) intrinsic value

C) market capitalization rate

D) plowback rate

E) none of the above

 

10. The________is the fraction of earnings reinvested in the firm.

A) dividend payout ratio

B) retention rate

C) plowback ratio

D) AandC

E) BandC

 

11. The Gordon model

A) is a generalization of the perpetuity formula to cover the case of a growing perpetuity.

B) is valid only when g is less than k.

C) is valid only when k is less than g.

D) AandB.

E) AandC.

 

12. You wish to earn a return of 13% on each of two stocks, X and Y. Stock X is

expected to pay a dividend of $3 in the upcoming year while Stock Y is expected to pay a dividend of $4 in the upcoming year. The expected growth rate of dividends for both stocks is 7%. The intrinsic value of stock X________

A) cannot be calculated without knowing the market rate of return

B) will be greater than the intrinsic value of stock Y

C) will be the same as the intrinsic value of stock Y

D) will be less than the intrinsic value of stock Y

E) none of the above is a correct answer.

 

13. You wish to earn a return of 11% on each of two stocks, C and D. Stock C is expected to pay a dividend of $3 in the upcoming year while Stock D is expected to pay a dividend of $4 in the upcoming year. The expected growth rate of dividends for both stocks is 7%. The intrinsic value of stock C_______

A) will be greater than the intrinsic value of stock D

B) will be the same as the intrinsic value of stock D

C) will be less than the intrinsic value of stock D

D) cannot be calculated without knowing the market rate of return

E) none of the above is a correct answer.

 

14. Excess of sales over cost of goods sold in an accounting period is termed as:

A) Net Profit

B) Gross Profit

C) Retained earnings

D) None of the given options

E) None of the above is a correct statement.

 

15. What is the first step in choosing a supply chain?

A) developing an umbrella mission statement

B) understanding the customer

C) making sure the members of the supply chain harmonize with the organizational

D) creating a unifying interorganizational strategy

E) determining what the competition is doing

 

16. Each of two stocks, A and B, are expected to pay a dividend of $5 in the upcoming year. The expected growth rate of dividends is 10% for both stocks. You require a rate of return of 11% on stock A and a return of 20% on stock B. The intrinsic value of stock A_________.

A) will be greater than the intrinsic value of stock B

B) will be the same as the intrinsic value of stock B

C) will be less than the intrinsic value of stock B

D) cannot be calculated without knowing the market rate of return.

E) none of the above is true.

 

17. ________is the integration and organization of information and logistics across firms n a supply chain for the purpose of creating and delivering goods and services that provide value to consumers.

A) Supply chain management

B) Logistics management

C) Point-to-point management

D) Just-in-time management

E) Cost-effective flow

 

18. If the expected ROE on reinvested earnings is equal to k, the multistage DDM reduces to

A) Vo = (Expected Dividend Per Share in Year l)/k

B) Vo = (Expected EPS in Year l)/k

C) Vo = (Treasury Bond Yield in Year l)/k

D) Vo = (Market return in Year l)/k

E) none of the above

 

19. Low Tech Company has an expected ROE of 10%. The dividend growth rate will be _______if the firm follows a policy of paying 40% of earnings in the form of dividends.

A) 6.0%

B) 4.8%

C) 7.2%

D) 3.0%

E) none of the above

 

20. Net profit is equal to:

(a) Sales less cost of sales and operating expenses

(b) Gross profit less operating expenses

(c) Sales less operating expenses (d)Both(a)&(b)

 

21. Medtronic Company has an expected ROE of 16%. The dividend growth rate will be ____if the firm follows a policy of paying 70% of earnings in the form of dividends.

A) 3.0%

B) 6.0%

C) 7.2%

D) 4.8%

E) none of the above

 

22. High Speed Company has an expected ROE of 15%. The dividend growth rate will be _______if the firm follows a policy of paying 50% of earnings in the form of dividends.

A) 3.0%

B) 4.8%

C) 7.5%

D) 6.0%

E) none of the above

 

23. Light Construction Machinery Company has an expected ROE of 11%. The dividend growth rate will be ________if the firm follows a policy of paying 25% of earnings in the form of dividends.

A) 3.0%

B) 4.8%

C) 8.25%

D) 9.0%

E) none of the above

 

24. Xlink Company has an expected ROE of 15%. The dividend growth rate will be ______if the firm follows a policy of plowing back 75% of earnings.

A) 3.75%

B) 11.25%

C) 8.25%

D) 15.0%

E) none of the above

 

25. Think Tank Company has an expected ROE of 26%. The dividend growth rate will be _________if the firm follows a policy of plowing back 90% of earnings.

A) 2.6%

B) 10%

C) 23.4%

D) 90%

E) none of the above

 

26. Bubba Gumm Company has an expected ROE of 9%. The dividend growth rate will be _________if the firm follows a policy of plowing back 10% of earnings.

A) 90%

B) 10%

C) 9%

D) 0.9%

E) none of the above

 

27. A preferred stock will pay a dividend of $2.75 in the upcoming year, and every year thereafter, i.e., dividends are not expected to grow. You require a return of 10% on this stock. Use the constant growth DDM to calculate the intrinsic value of this preferred stock.

A) $0,275

B) $27.50

C) $31.82

D) $56.25

E) none of the above

 

28. A preferred stock will pay a dividend of $3.00in the upcoming year, and every year thereafter, i.e., dividends are not expected to grow. You require a return of 9% on this stock. Use the constant growth DDM to calculate the intrinsic value of this preferred stock.

A) $33.33

B) $0..27

C) $31.82

D) $56.25

E) none of the above

 

29. A preferred stock will pay a dividend of $1.25 in the upcoming year, and every year thereafter, i.e., dividends are not expected to grow. You require a return of 12% on this stock. Use the constant growth DDM to calculate the intrinsic value of this preferred stock.

A) $11.56

B) $9.65

C) $11.82

D) $10.42

E) none of the above

 

30. A preferred stock will pay a dividend of $3.50 in the upcoming year, and every year thereafter, i.e., dividends are not expected to grow. You require a return of 11% on this stock. Use the constant growth DDM to calculate the intrinsic value of this preferred stock.

A) $0.39

B) $0.56

C) $31.82

D) $56.25

E) none of the above

 

31. A preferred stock will pay a dividend of $7.50 in the upcoming year, and every year thereafter, i.e., dividends are not expected to grow. You require a return of 10% on this stock. Use the constant growth DDM to calculate the intrinsic value of this preferred stock.

A) $0.75

B) $7.50

C) $64.12

D) $56.25

E) none of the above

 

32. Suppose that the market price of Company X is $45 per share and that of Company Y is $30. If X offers three-fourths a share of common stock for each share of Y, the ratio of exchange of market prices would be:

A) .667

B) 1.0

C) 1.125

D) 1.5

 

33. In the long run, a successful acquisition is one that:

A) enables the acquirer to make an all-equity purchase, thereby avoiding additional financial leverage.

B) enables the acquirer to diversify its asset base.

C) increases the market price of the acquirer’s stock over what it would have been without the acquisition.

D) increases financial leverage.

 

34. A tender offer is

A) a goodwill gesture by a “white knight.”

B) a would-be acquirer’s friendly takeover attempt.

C) a would-be acquirer’s offer to buy stock directly from shareholders.

D) viewed as sexual harassment when it occurs in the workplace.

 

35. You are considering acquiring a common stock that you would like to hold for one year. You expect to receive both $2.50 in dividends and $28 from the sale of the stock at the end of the year. The maximum price you would pay for the stock today is ______if you wanted to earn a 15% return.

A) $23.91

B) $24.11

C) $26.52

D) $27.50

E) none of the above

 

36. The public sale of common stock in a subsidiary in which the parent usually retains majority control is called

A) a pure play.

B) a spin-off.

C) a partial sell-off.

D) an equity carve-out.

 

Use the following to answer questions 37-40:

 

Paper Express Company has a balance sheet which lists $85 million in assets, $40 million in liabilities and $45 million in common shareholders’ equity. It has 1,400,000 common shares outstanding. The replacement cost of the assets is $115 million. The market share price is $90.

 

37. What is Paper Express’s book value per share?

A) $1.68

B) $2.60

C) $32.14

D) $60.71

E) none of the above

 

38. One means for a company to “go private” is

A) divestiture.

B) the pure play.

C) the leveraged buyout (LBO).

D) the prepackaged reorganization.

 

39. What is Paper Express’s replacement cost per share?

A) $1.68

B) $2.60

C) $53.57

D) $60.71

E) none of the above

 

40. What is Paper Express’s Tobin’s q?

A) 1.68

B) 2.60

C) 53.57

D) 60.71

E) none of the above

 

41. One of the problems with attempting to forecast stock market values is that

A) there are no variables that seem to predict market return.

B) the earnings multiplier approach can only be used at the firm level.

C) the level of uncertainty surrounding the forecast will always be quite high.

D) dividend payout ratios are highly variable.

E) none of the above.

 

42. The most popular approach to forecasting the overall stock market is to use

A) the dividend multiplier.

B) the aggregate return on assets.

C) the historical ratio of book value to market value.

D) the aggregate earnings multiplier.

E) Tobin’s Q.

 

Use the following to answer questions 43-44:

 

Sure Tool Company is expected to pay a dividend of $2 in the upcoming year. The risk-free rate of return is 4% and the expected return on the market portfolio is 14%. Analysts expect the price of Sure Tool Company shares to be $22 a year from now. The beta of Sure Tool Company’s stock is 1.25.

 

43. At the end of the year, goods that are unsold are deducted from:

1) Finished goods

2) Closing stock

3) Cost of goods sold

4) Opening stock

 

44. What is the intrinsic value of Sure’s stock today?

A) $20.60

B) $20.00

C) $12.12

D) $22.00

E) none of the above

 

45. If Sure’s intrinsic value is $21.00 today, what must be its growth rate?

A) 0.0%

B) 10%

C) 4%

D) 6%

E) 7%