Identify the variables that are relevant to the capital structure optimization exercise

$10.00

Explain how the capital structure is adjusted and why

 

SKU: solviv9

Alresford Ltd is considering the purchase of 100 per cent of the ordinary shares of the all equity-financed Gibson Ltd. Gibson operates in two divisions – North and South – and a head office. The divisions operate independently of each other; the only joint costs of Gibson, not attributable directly to either division, are those of the head office. Gibson’s management is currently committed to operating both divisions for 4 years and have estimated operating
cash flows and the taxable operating profits of each division as:

The above figures exclude:

1. Head office costs of $ 4,000,000 per year.

2. Planned capital expenditure by North division in year 1 of $ 8 million and its tax consequences. The capital expenditure is necessary for North division’s continued operations and the above figures assume it will be undertaken.

3. The salvage values of Gibson’s assets. Salvage values will be received at the end of year 4 and are estimated at

North division           $ 24 million

South division           $ 12 million

 

Equipment used at head office is all rented on short-term operating leases and therefore has no salvage value to Gibson at any time.

The above details are widely known ‘and would continue to apply to Gibson after any takeover, except that

1. Some of Gibson’s administrative activities would be undertaken by Alresford, resulting in savings of head office costs of 50% in years 1 and 2 and 75% in years 3 and 4.

 

2. At year 4, North division’s assets would be used by Alresford to substitute for capital expenditure of $ 28 million planned for year 4.

 

Alresford’s Director of Strategic Planning has suggested that if a takeover is completed then various options are available to Alresford. She has detailed the options, but has made no attempt to appraise their financial desirability. The details are:

 

1. Early termination of South division’s operations. This would change the estimated salvage values which would be realized immediately on termination of the division’s activities. Early termination would also enable operating cash flows, and taxable profits, to be increased by a constant amount for each year of the division’s revised life, the level of the constant increase being dependent upon the date of termination. The revised figures are:

 

 

Operations terminated at end of year South division Rivised salvage value Increase-in annual cash flows for each year until termination
2 $ 20 million $ 4 million
3 $ 16 million $ 3 million

 

2. Alresford’s own transport department could be used to carry out North division’s deliveries, thereby saving the division $ 600,000 per year in transport costs. However, this policy would cause Alresford’s transport department to modify its planned replacement cycle, and expenditure of $ 1.6 million, scheduled for both year 3 and 5, would be increased to $ 2 million and would occur earlier, in year 1 and year 4. Thereafter all planned replacements would be unchanged.

 

3. By incurring additional advertising of $ 3.6 million in year 1, sales of North division would increase producing additional profit, and cash flow, of $ 2.4 million for each of years 3 and 4.

 

Alresford’s Financial Director believes that an appropriate risk-adjusted after-tax discount rate to be applied to all cashflows relating to the consequences of the proposed acquisition is 18%.

 

The corporate tax rate is 30%, with taxes payable in the year that taxable profits arise.Alresford Ltd. has exclusively overseas resident shareholders, and so is not integrated into the dividend imputation system. To stimulate the economy, the government has recently announced that all capital expenditure may now be fully depreciated at the time it is made for tax purposes (so that capital expenditure can be treated as an allowable expense in this question). All sales of assets will be subject to taxation. Assume all cash flows occur on the last day in each year.

 

Part A of the Assignment

(a) Estimate the market value of Gibson Ltd in the absence of any take-over possibilities.

 

(b) Advise Alresford Ltd. on the maximum amount it should be prepared to pay for Gibson if the Strategic Planning Manager’s suggestions are completely ignored.

 

(c) Determine which of the Strategic Planning Manager’s suggestions should be undertaken and specify the optimum life of South division. Advise Alresford Ltd. of the maximum amount it should now be prepared to pay for Gibson.

 

Part B of the Assignment

With reference to the reading ‘Toward a More Complete Model of Optimal Capital Structure”

(a) List and explain costs and benefits of debt.

 

(b) Identify the variables that are relevant to the capital structure optimization exercise. Explain how the capital structure is adjusted and why.

 

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