ACCA P4 Advanced Financial Management - 2010 - Study text - Emile Woolf Publishing
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Paper P4
Advanced Financial Management
CHAPTER
10
Corporate reconstruction
and reorganisation
Contents
1 Predicting corporate failure
2 Capital reconstructions
3 Business reorganisation
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Predicting corporate failure
Corporate failure prediction models
Z scores (Zeta scores)
Altman’s Z score (Zeta score)
Other Z score models
KMV/Moody’s failure prediction model
Using Z score models
Problems with Z score models
1 Predicting corporate failure
1.1 Corporate failure prediction models
Many user groups, including banks, suppliers, auditors and the government would
like to be able to predict corporate failure. The collapse of a company occurs when it
is unable to settle its liabilities when they fall due. Fierce competition in the market,
high levels of debt and poor liquidity are often the main causes of failure.
It may be possible to assess a company’s risk of failure and insolvency using
financial statement analysis and the calculation and assessment of key financial
ratios. Models have been developed that assess the likelihood that an entity may
become insolvent.
Many failure prediction models are based on a small number of key financial ratios.
These are ratios that have been identified as ratios that help to distinguish between
companies that have a high probability of financial failure and those that do not, in
the short-term or medium-term.
1.2 Z scores (Zeta scores)
The ratios for a company are given weightings by the model, and the weighted
ratios are then added up to obtain a ‘score’. This score might be called a Z score or a
Zeta score. The score provides a measure of the probability of corporate failure.
Multivariate discriminant analysis
The ratios in corporate failure prediction models are based on factors or variables
that are considered significant for the financial ‘health’ of a company. The
probability of failure cannot be based on any single variable or ratio. Several
variables and several different ratios need to be considered.
A corporate failure prediction model may therefore be constructed to carry out
multivariate discriminant analysis, which is simply an analysis of several variables
and ratios, for which weightings are given. The resulting total Z scores for different
companies provide a probability distribution of survival or failure. The probability
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distribution of Z scores is often assumed to be normally distributed, so that
companies whose Z scores are at the extreme low end of the distribution have a
high probability of failure.
1.3 Altman’s Z score (Zeta score)
The most well-known failure prediction model is Altman’s Z score. His original Z
score model was developed in the 1960s and had five key ratios, each with a
different weighting:
Z = 1.2X
1
+ 1.4X
2
+ 3.3X
3
+ 0.6X
4
+1.0X
5
where:
X
1
= working capital/total assets
X
2
= retained earnings/total assets
X
3
= earnings before interest and tax/total assets
X
4
= market value of equity/book value of total debt
X
5
= sales/total assets.
The Z score is obtained by calculating the five ratios, and applying the weightings to
each ratio. The sum of the five weighted ratios provides the Z score.
The original model was then used by comparing a company’s Z score with the
following indicators:
Z score Prediction
Less than 1.81 High probability of corporate failure
1.81 – 2.67 No significance: in the ‘grey area’
Greater than 2.67 Very low probability of failure
1.4 Other Z score models
Other Z score models have been produced, because it has been found that a single
model with fixed weightings for specific key ratios does not apply with equal
accuracy to different types of company and different industries.
Different weightings are appropriate for companies in different industries.
Similarly, the appropriate weightings for small companies may be different from
the weightings that should be used for larger companies.
The terms ‘Z score’ and ‘Zeta score’ are often used as if they have exactly the same
meaning. However, a Z score is a score based on a model that is applied generally to
all companies, and a Zeta score is a ‘customised’ score based on the particular
characteristics of the company and the industry or country in which it operates.
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1.5 KMV/Moody’s failure prediction model
The KMV/Moody’s model is a well-known example of another corporate failure
prediction model. It is based on the Black-Scholes option pricing model. This
model does not use key ratios from the financial statements. Instead, it uses data
about share prices and the values of assets and debts of the company to predict
failure.
The KMV/Moody’s model is able to assess:
default risk, and
the value of a company’s debt capital and the probability that some or all of the
debt will be recovered, in the event of corporate failure.
The additional information provided by this model could be particularly valuable
for bond investors and lending banks.
1.6 Using Z score models
Corporate failure prediction models are used today by auditors and management
consultants. They are also included in database systems used by banks for loan
evaluation. A Z score can be used by a bank to decide whether to include a default
risk premium in the interest rate it charges on a corporate loan, and if so what the
size of the risk premium should be.
1.7 Problems with Z score models
Z score models provide an objective statistical measure. However they have some
problems.
A Z score is only significant when it has an extremely low or high value. Z
scores in the middle range are usually unreliable as predictors of failure. For
example Altman was unable to draw any firm conclusions for a Z score between
1.81 and 2.67.
There is some possibility of statistical error in Z score predictions. A Z score
model might indicate that a company is financially sound when it is in fact about
to fail. Similarly, a Z score might indicate that a company is very likely to fail
when in fact it is financially sound. Statistical errors should be unusual, but they
cannot be avoided.
Since a different model might be appropriate for different types of company and
different industries, companies wanting to obtain Z score information must
usually rely on external specialist consultants for data and advice.
When a company collapses, its financial ratios might deteriorate very quickly, in
the few months or weeks before the collapse occurs. However the most recent
financial statements might be up to a year or more out of date. Z scores might
therefore only indicate in retrospect, after the corporate failure has happened,
that the company was at risk.
A Z score model does not identify how quickly the company might go into
liquidation.
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Capital reconstructions
Definition of a reconstruction
The purpose of a reconstruction
The problems with a reconstruction scheme
Examination questions on reconstructions
2 Capital reconstructions
2.1 Definition of a reconstruction
A capital reconstruction is a major reorganisation of the capital structure of a
company. When a reconstruction occurs, the reason is usually because the company
is in financial difficulties. For example, its Z score might indicate that it is in danger
of financial collapse. It is more probable however that cash flow projections, and
possibly profit projections, indicate that the company cannot avoid financial
collapse and liquidation unless urgent action is taken to ‘reconstruct’ the company’s
finances.
A reconstruction might involve:
the conversion of debt capital into equity
and possibly the conversion of equity shares from one form to another.
Existing equity shareholders might be required to relinquish all their shares and
accept a much smaller quantity of new shares in the reconstructed company. The
majority of the new shares on the reconstructed company might be held by lending
banks or bond investors, who agree to exchange their loans or bonds for new shares
in the reconstructed company. Reconstructions are likely to be subject to regulation
by company law.
2.2 The purpose of a reconstruction
The purpose of a capital reconstruction is to find a way of allowing the company to
continue in business, and avoid insolvency and liquidation. A reconstruction is
therefore only worth considering:
if it is likely to be more beneficial to all the parties concerned than a liquidation
of the company (and the sale of its assets), and
the reconstructed company has a good chance of surviving and restoring itself to
profitability.
A reconstruction will benefit all the parties if it is likely to result in them getting
more cash or more value from the reconstruction than from an enforced liquidation
of the company.
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For example, the effect of a reconstruction scheme might be to:
reduce the total debt of the company (because some debt capital might be
exchanged for new equity), and
defer the repayment obligations for other debt capital.
This reduction in total debt and deferral of interest payments and principal
repayments might allow the company to make a profit and achieve positive cash
flows. If the company is able to recover, it should be able to pay back its outstanding
debts and also create value (in the share price) for the former lenders who are now
equity shareholders.
The parties who must agree to a reconstruction therefore include all the creditors of
the company (or a sufficient number of them, in accordance with the requirements
of national company law) and the shareholders.
2.3 The problems with a reconstruction scheme
There are some major problems with arranging a capital reconstruction. These are:
finding a reconstruction arrangement that will benefit all the parties, and
getting all the parties to agree to the proposal.
Each of the parties involved in a reconstruction (banks who are lending money,
bondholders, unpaid trade creditors and the shareholders) need to believe that the
reconstruction offers them the prospect of more cash or more value than a
liquidation of the company. Each of the parties will therefore compare what they
will probably receive:
if the construction scheme is agreed, and
if the scheme is rejected and liquidation occurs.
Example
A company has 1 million shares of $1 in issue, $5 million in 6% bonds and trade
creditors of $200,000. The company is in severe financial difficulties and unless a
reconstruction scheme is agreed, the company will be liquidated. The bondholders
would expect to receive $0.40 in the $1 in a liquidation, and the trade creditors and
equity shareholders would receive nothing.
The following reconstruction scheme might be proposed:
The company cancels its existing equity shares and issues, say, 10 million new
shares of $0.05 each.
The bondholders are offered 9.9 million of these shares in exchange for their
bonds.
The remaining 100,000 shares might be offered to the existing equity
shareholders, in a 1 for 10 exchange. The shareholders will surrender their $1
shares in the company and receive one new share of $0.05 each for every 10 of
their $1 shares.
A bank might agree to provide a loan to the newly-reconstructed company.
The trade creditors might be offered $0.30 in the $1 in full settlement of the
unpaid debts.
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This scheme might be agreed, but only if the following conditions are met:
The company will expect to be profitable and to have positive cash flows as a
result of the new structure.
The bondholders believe they will gain more from accepting equity in the
company than forcing a liquidation to receive $0.40 in the $1.
The trade creditors and equity shareholders also agree.
The reconstruction complies with the requirements of company law.
2.4 Examination questions on reconstructions
Company law on reconstructions varies between countries, and it is therefore
unlikely that you will be expected to demonstrate a detailed understanding of the
law. However, you should be aware that some legal process and approval for a
proposed scheme of reconstruction might be required.
Capital reconstruction proposals can be fairly complex, so it is unlikely that in your
examination you will be required to devise and recommend a detailed scheme of
reconstruction for a particular company. However an examination question might
give you some details about a company that is in financial difficulties, and give
details of a reconstruction scheme that has been proposed. You might then be asked
to comment on the proposed scheme.
To answer this type of question, you should consider three aspects to the proposal.
The first step is to make sure that you understand what the capital of the
reconstructed company will be. How many shares will be in issue and who will
own them? How much debt capital will the company have, and what will be the
rate of interest payable on the debt?
Having established what the new capital structure will be, you should make a
financial analysis to decide whether the company is likely to become profitable
and have positive cash flows after the reconstruction has occurred. If the
company is unlikely to survive in its reconstructed form, the reconstruction
proposal should not be supported or recommended.
If you consider that the company will return to profits and positive cash flows if
the reconstruction occurs, you should then look at each of the investor groups in
the company. If any investor group is unlikely to benefit from the
reconstruction, it will not support the reconstruction proposals. For each
investor group – ordinary shareholders, preference shareholders, bondholders
and banks – you should consider what will happen to them:
- if there is no reconstruction
- if the company is reconstructed.
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Business reorganisation
Definition of a business reorganisation
Demergers
Divestments
Management buyouts and management buy-ins
Share buy-back (share repurchase scheme)
Going private
3 Business reorganisation
3.1 Definition of a business reorganisation
A capital reconstruction is a major change in the capital structure and ownership of
a company in financial difficulties. A business reorganisation is similar, in the sense
that it often involves a change in capital structure and a change in ownership.
However, a reorganisation normally involves a company that is not in financial
difficulties as the result of a business strategy decision, such as selling off a non-core
part of the group’s business operations, or de-merging two divisions of a company
into two entirely separate and independent companies.
3.2 Demergers
A demerger is the splitting up of a group of companies into two (or more) separate
and independent companies. Often, the group in a demerger is a conglomerate,
consisting of widely-different businesses. For example, some years ago in the UK,
there was a demerger of chemicals company ICI from pharmaceuticals company
Zeneca. In 2007 Cadbury Schweppes proposed either to demerge its confectionery
division (Cadbury) and soft drinks division (Schweppes) into independent
companies, or to sell off its soft drinks division as part of a strategic review.
The shareholders in the company before the demerger receive shares in both
demerged companies. They can choose to hold all the shares, and be a shareholder
in both companies. Alternatively, they can sell their shares in one of the companies
and remain a shareholder in just one of the demerged companies. (They could also
sell their shares in both companies.)
If the company before the demerger has debt capital, it will have to negotiate with
its banks or representatives of its bondholders, to agree which of the demerged
companies should take on the debt obligations.
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Purpose of a demerger
A demerger requires the consent of the company’s shareholders, and the purpose of
the demerger should be in the best interests of the shareholders. This means that a
demerger is only justified if it is expected to increase the total wealth of the
shareholders.
The reasons that may be put forward for a demerger are as follows:
A conglomerate group of different businesses is often valued at less than the
sum of the value of its separate businesses, if these were independent. This is
because stock market investors often prefer ‘specialised’ businesses to
conglomerates.
‘Specialised’ businesses can focus on their core competencies.
Specialised businesses can develop their own strategies for the future and are
more likely to be successful if they can decide their strategies independently.
There might be some savings in head office costs, no longer incurred after the
demerger.
3.3 Divestments
A divestment is the sale of a business by a company to an external purchaser (or
external purchasers). The business that is sold might be a subsidiary company or a
sub-group of subsidiary companies within the overall group.
Examples of divestments would be:
the sale of a business to another company
the sale of a business to a management team, in a management buy-out (MBO):
the management team, often supported by venture capital finance, become the
shareholders of the divested company
the sale of a business to external buyers who become the management team as
well as the shareholders (a management buy-in).
The company making the divestment should try to ensure that it obtains a
satisfactory price for the subsidiary or division. The buyers should try to ensure that
they pay a reasonable price and that the purchase is financed in the best way
possible.
In contrast to a demerger, where the shareholders of the original company become
shareholders in both demerged companies, a divestment (or ‘spin-off’) involves the
sale of the ownership of a business.
The purchase consideration for a divestment:
normally consists mainly or entirely of cash
although the selling company might retain an equity interest, and continue to
hold a proportion of the shares.
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Purpose of divestments
A divestment can have any of the following purposes:
to raise cash for the company, when it needs additional funding or has liquidity
difficulties
to get rid of a loss-making business
because the company receives a very attractive offer price for selling the
business
for strategic reasons.
The strategic reason most commonly suggested for making a divestment is because
the company is selling off a ‘non-core’ business. The company has a competitive
advantage over rivals in businesses where it has ‘core competencies’, and it should
therefore concentrate on these areas of business. In principle, the divestment should
allow the company to invest all its resources in those parts of the business where it
can make the greatest profits. This will benefit the shareholders.
3.4 Management buyouts and management buy-ins
Management buyouts and management buy-ins are divestments for the company
selling the business, but business ventures for the management team that buys it.
With a management buyout, the purchasers of the divested business include a team
of managers who work for the subsidiary or division that is being sold off, and these
managers will run the business (as entrepreneurs) after they have bought it.
A management buy-in involves the purchase of a divested business by an external
management team, which run the business (as entrepreneurs) after they have
bought it.
With both management buyouts and management buy-ins, it is usually the case that
the management team do not have sufficient capital of their own to afford the
business they are trying to buy, and they have to rely on the support of venture
capital finance.
The structure of venture capital finance
A venture capital firm might be willing to provide capital support to a management
buyout or a management buy-in if it believes that:
the management team have a robust and realistic business plan for the company
the management team appear to have the capabilities to make the company a
success
the management team makes a significant capital contribution to the purchase of
the business, so that they have a strong financial motive for making the business
a success
the financial returns appear satisfactory, allowing for the high business risk in
the project.