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1.
CML Group was an entity involved in providing services
to both the mining and construction sectors. The Mining division provided a
complete service for surface and underground operation, from mine development
to materials delivery. The Construction division provided government and
resource sector clients a diverse range of construction capabilities that
incorporated roads and bridges, rail, water and environment, marine and resource
infrastructure.
2.
In early September 2014, the company obtained monthly
data about the operation of its Construction business. This data indicated a
deterioration in the profitability of the Construction business, mainly caused
by a rail project. The company immediately undertook investigations to
establish the reasons for the deterioration and the accuracy of the underlying
data. Upon analysis of further data, the company sent a senior manager to the
rail project to determine the nature and extent of the problem on the earnings.
The project did not achieve the required productivities and the company would
deliver the project within the client’s accelerated timeframe at a significant
loss.
3.
As a result of the event, Nick Hall was appointed to
become the new CEO of the company. A strategic review of CML’s all businesses
was conducted. The outcomes of the review were announced in late October. These
included a reduction in discretionary expenditure and a 10% reduction in the
salaries for senior executives. The most important outcome was to sell the
Construction business given its inconsistent results over recent years so CML
would become a dedicated provider of contract mining services.
4.
A summary of CML’s financial performance over the last
five years was set out below:
For
the year ending 30 June 2014 2013 2012 2011 2010
Revenue
($m) 1871 1254 1254 1486 1244
Underlying
EBIT ($m) 89.6 66.1 55.3 29.8 74.7
Reported
NPAT ($m) 56.1 1.0 37.9 17.2 48.8
Total
assets ($m) 989.0 685.7 580.8 632.8 630.2
Net
debt / (net cash) 82.6 (39.5) (43.8) 1.8 29.2
Shareholders’
funds ($m) 356.8 323.2 336.0 308.2 249.3
Reported
EPS (cents) 7.7 0.1 5.2 3.1 9.2
Dividends
per share (cents) 4.0
- 3.0 1.5 5.5
Gearing
(Net debt/Equity) (%) 23.1 (12.2) (12.9) 0.6 11.6
4.
The Board was comprised of six non-executive independent directors and the CEO.
Meetings were held monthly. The following agenda items were to be discussed in
the November meeting:
i. What
would be CML's company after-tax WACC based on its balance sheet as at
30/06/14?
ii. What
would be CML’s Construction division cost of capital as at 30/06/14?
iii. What
would be the fair value for the Construction division?
iv. A
decision on the new remuneration package for Nick Hall.
v. An
update on CML’s profitability and capital structure.
vi. A
decision on the dividend policy for 2014-15.
5.
CML calculated its company after-tax WACC based on the
market value of the gross interest-bearing debt and equity securities
outstanding at the balance date 30 June 2014. A separate cost of capital was
also established for its two business divisions. The divisional WACC was based
on the respective industry weighted average cost of capital.
6.
CML’s Balance Sheet as at 30 June 2014 showed the following data:
($’000)
($’000)
Payables 306306 Cash
and cash equivalents
134894
Employee
benefits 62825 Receivables 348671
Loans
and borrowings 217474 Inventories 45311
Provisions 22389 Property, plant and equipment 417754
Tax
liabilities 23191 Investments 11300
Share
capital 307963 Intangibles 31066
Reserves (15574)
Retained
earnings 64422
Total claims 988996
Total assets
988996
7.
The equity beta of CML’s 738.6 million outstanding
shares was estimated to be 2. The share price was $0.60. New shares could be
placed with institutional investors at about 57.5 cents. The risk-free rate was
assumed to be 3.0%. CML used a market risk premium of 6.5% in all cost of
equity estimates. The company tax rate was 30%.
8.
One of CML’s joint venture partners, Henson
Constructions, had made a preliminary offer to acquire the whole construction
business. To ascertain a fair selling price for the Construction division, Hall
decided to construct the cash flow projections of Table 1. He used a 3-year
valuation horizon and a terminal growth rate of 0% to estimate the terminal
value. The cash flows in Year 1 were based on the revised forecasts. Hall
expected the free cash flow in year 2 and beyond to be positive despite a loss
in year 1. Hall used the construction industry after-tax weighted average cost
of capital with a debt/equity ratio of 25% to discount the projected free cash
flows. The industry equity beta was estimated to be 1.3 and the pre-tax
industry cost of debt was 5.4%.
|
Table 1
|
|
Free Cash Flow for the Construction Division ($’000)
|
|
|
|
t=1
|
t=2
|
t=3
|
t=4
|
|
|
Revenue
|
|
440 440000
|
|
|
|
|
|
Variable
cost
|
|
500000
|
|
|
|
|
|
Fixed cost
|
|
40000
|
|
|
|
|
|
Depreciation
|
|
7000
|
|
|
|
|
|
Operating
income
|
|
-107000
|
|
|
|
|
|
Tax (30%)
|
|
32100
|
|
|
|
|
|
Net income
|
|
-74900
|
|
|
|
|
|
Depreciation
|
|
7000
|
|
|
|
|
|
Operating cash flow
|
|
-67900
|
|
|
|
|
|
Investment
in fixed assets
|
|
12000
|
|
|
|
|
|
Investment
in working capital
|
|
-40000
|
|
|
|
|
|
Free cash
flow
|
|
-39900
|
|
|
|
|
|
All figures are
rounded to the nearest thousand dollars.
|
|
Assumptions:
|
Tax rate
|
30%
|
Revenue growth rate in years 2-4
|
-20% per year
|
Variable cost as a percentage of revenue in years 2-4
|
80%
|
|
Fixed cost
growth rate in years 2-4
|
3% per year
|
|
Depreciation
|
Constant
$7 million per year
|
|
Investment in fixed assets in years 2-4
|
$5 million
per year
|
|
Investment in working capital in
years 2-4 is equal to 10% of the change in revenue from the previous year.
|
9.
In light of current market conditions and the impending sale of the
Construction business, a new CEO employment contract was negotiated with Hall
in November 2014. The new remuneration framework shifted the weighting of total
remuneration from fixed pay towards variable ‘at risk’ pay. The goal was to
encourage stronger than market growth in shareholder value over the short and longer
term. The remuneration package was made up of three components: Total fixed
remuneration (TFR), Short-term incentive (STI) and Long-term incentive (LTI).
10.
The TFR was set at above industry median and was benchmarked at the 62.5th
percentile compared to the peer companies in the ASX 101-200. Hall would
receive a TFR of $1 million per annum.
11.
Hall’s STI included the opportunity to earn an annual cash bonus of up to 125%
of fixed remuneration, subject to achieving key performance indicators (KPIs).
The STI plan comprised 60% for financial KPIs, 20% for safety KPI and 20% for
personal KPIs. The financial KPIs included profit after tax, return on equity
and order book growth. The safety KPI was based on the total recordable injury
frequency rate. The personal KPIs were based on a number of personal targets
such as developing and rolling out strategy across the company. 90% of company
budgeted profit, set in July each year, had to be achieved before the gateway
for STI payment would open. Importantly, Hall’s package also included a
clawback provision whereby up to 30% of any STI awarded to Hall could be
reclaimed by the company at any time for up to two years under certain
circumstances.
12.
The Long-term incentive (LTI) was an award of share performance rights which
could be converted into fully paid shares subject to performance criteria being
met and specified time restrictions. The number of performance rights issued to
Hall would be based on an assessment of his ability to increase shareholder wealth.
The LTI plan provided for 100% of performance rights to vest after three years
if performance hurdles on total shareholder return (TSR) and earnings per share
(EPS) growth were met. CML’s TSR performance over a three-year period would be
compared to the median TSR of a group of eight peer entities with similar
businesses over the same period. Vesting of the performance rights, in respect
of half of the LTI grant, would depend on a percentile ranking. No shares would
vest if CML’s ranking was below 50th percentile. Between 50th and 75th
percentile, Hall would receive between 25% and 50% of the LTI entitlement on a
straight line basis. At or above 75th percentile, Hall would receive 50% of the
LTI entitlement.
13.
EPS growth was based on the compounded annual growth rate of CML’s EPS over the
preceding three-year performance period up to the latest balance date. No
shares would vest if the EPS growth per annum was below 6%. Between 6% and 26%
EPS growth per annum, Hall would receive between 25% and 50% of the LTI
entitlement on a straight line basis. At or above 26% EPS growth rate, Hall
would receive 50% of the LTI entitlement.
14.
Gearing, defined by CML as net debt to book equity, was 23.1% as at 30 June
2014. This was within the maximum limit of 35%. Despite a continuing strong
performance from the Mining division, CML was expected to record an overall
loss for the 2014-15 financial year due to the huge operating loss from the
Construction division and an impairment charge (asset write-down) on the
construction business assets. In order to maintain a healthy balance sheet, the
Board would like to have an equity issue to raise about $80 million. Further
the Board would reduce the limit of its existing $475 million syndicated debt
facility by $40 million with the impending exit of the construction business.
The existing syndicated debt facility was secured by fixed and floating charges
over CML’s assets. The facility attracted a variable rate of interest on the
amount drawn down and the interest rate applicable at 30 June 2014 was 7.2%.
Most of the borrowings were for equipment financing. All banking covenants
remained within limits.
15.
The Board targeted a dividend payout ratio of 50%. CML reinstated its dividend
reinvestment plan in 2013. A 1.5% discount would be applied to the price of the
shares allocated under the plan. The plan had attracted a 29 per cent
participation rate from shareholders.
Instructions:
Answer
the following problems. All cash flow and present value figures must be rounded
to the nearest thousand dollars. Show all workings and/or explanation.
1. Calculate CML’s company after-tax WACC,
rounded to four decimal places.
2.
Calculate the construction industry WACC, rounded to
four decimal places.
3.
Complete Table 1 fully, in accordance with the given
assumptions, to show how the free cash flow in years 1-4 is derived.
4.
Calculate the terminal value as of year 3 using the
constant-growth discounted cash flow formula.
5.
Show individually the discounted value, as of year 0,
of the free cash flow in years 1-3 plus that of the terminal value. What would
be the present value, as of year 0, of the Construction division?
6.
If the Construction division were to be sold at the
beginning of year 2, what would be the minimum selling price?
7.
Calculate the economic depreciation in year 1 based on
the free cash flows in Table 1.
8.
Calculate the economic income in year 2 based on the
free cash flows in Table 1.
9.
As a sensitivity analysis, calculate the percentage
drop in the value of the Construction division as of year 0 if the revenue
growth rate in years 2-4 is changed to -22% while other assumptions are
unchanged. All cash flows in year 1 remain the same.
10.
As a scenario analysis, calculate the value of the
Construction division as of year 0 if the growth rate of the revenue and the
fixed cost in years 2-4 are both 0% and the investment in fixed assets in years
2-4 is $12 million per year. Other assumptions and cash flows in year 1 remain
unchanged.
11.
What would be the major reason for CML to set a TFR at
above industry median?
12.
What would be the benefit of imposing a two-year
clawback period in the STI award?
13.
From the viewpoint of the CEO, what would be the best
feature in the design of the relative TSR performance measure? Explain.
14.
Would Hall receive any LTI, based on EPS growth
criterion, in the financial year 2014-15? Explain.
15.
By making adjustments to the balance sheet as at 30
June 2014, calculate CML’s gearing, in percentage, if the company decided to
recognise an extra one-off after-tax impairment charge (asset write-down) of
$45 million and raised $80 million new equity on 30/06/2014.
16.
What would be the impact on CML’s gearing if the limit
of the existing debt facility was reduced by $40 million on 30/06/2014?
Explain.
17. What
should be the amount of the dividend payout for the 2014-15 financial year.
Explain
18.
.
18. Is the 1.5% price discount on the DRP too
high? Explain.
***Do
not use more than 50 words to explain the answer in any question.
***No more than 6 pages
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***single spaced
