Robinson Investments is a private equity fund specialising in the acquisition of underperforming publicly quoted companies. Its strategy is to buy-out the target company’s shareholders, take the company off the stock market and aggressively restructure its operations with a view to returning it to the stock market within 4 years. The aim is to produce high returns for Robinson’s equity providers.
1. The Investment Opportunity
Donaldson PLC is a leading supermarket chain operating in the UK. Having analysed Donaldson’s Annual Reports for the period from 2011 to 2015, Robinson’s management believes that it is failing to realise its earnings potential and, as a result, is planning a bid for the company. Robinson’s analysis of Donaldson emphasises the following points:
Disposal of Assets
Many of Donaldson’s portfolio of supermarkets have been trading at a loss for some years, making closures and sell-offs necessary in order to improve the company’s longer-term profit potential. Robinson estimates that asset disposals will generate £100 million in 2016 and £250 million in 2017.
The assets will be sold at a loss compared to their book values. The 2016 asset disposals are expected to reduce the 2015 book value of ‘non-current assets’ by £300 million, with the 2017 disposals producing a further reduction of £500 million.
The losses will however reduce the company’s corporate tax liabilities by £40 million in relation to the 2016 disposals and £50 million for the 2017 disposals. Donaldson pays taxes one year in arrears.
The closures and sell-offs will reduce Donaldson’s sales revenues in the short term. The sales estimate for 2016 is £23200 million. For 2017 it is £22500 million. These figures already include the effects of the forecast for price inflation. Thereafter, sales are expected to grow by 3.5% per cent per annum in real terms over the subsequent 2 years.
Cost of Goods Sold
Management of supplies can be improved with the result that the cost of goods sold will average 90% of sales revenues for the 4 trading years from 2016-2019.
Managerial and Administrative Expenses
Robinson would restructure Donaldson’s administrative processes incurring additional expense initially. As a result, the estimate for ‘Administrative Expenses’ for 2016 is £600 million. However, this figure is expected to fall by 5% per year in nominal terms over the subsequent 3 years.
Improvements in Donaldson’s operational efficiency would release £50 million of working capital. This could be achieved by the end of 2016.
Tax and Capital Allowances
Corporate taxes are paid a year in arrears, and Donaldson’s has an outstanding tax liability (including the capital allowances effect) of £102 million payable at the end of 2016.
Assume that the calculation of capital allowances for tax purposes is based on fixed assets whose opening value for 2016 is the same as the figure for ‘Non-Current Assets’ contained in the Balance Sheet.
The non-current assets attract capital allowances averaging 3%, calculated on a reducing balance basis. These allowances are claimed on assets net of the effects of the disposal of assets outlined above. The rate of corporation tax is 20%. Both tax payments and capital allowance claims occur one year in arrears.
Robinson’s Transaction Costs
In 2015 Robinson had already spent £1.5 million in research, legal and consultancy fees associated with its interest in launching a bid for Donaldson. A successful takeover of Donaldson would incur further legal, administrative and consultancy costs of £20 million, payable immediately.
Inflation is expected to average 1% per annum over the next 4 years.
Re-flotation of Donaldson
The plan is to re-float Donaldson on the London Stock Exchange in 4 years’ time. The senior management of Robinson forecasts that Donaldson will be sold at a value equivalent to 6 times the 2019 net cash flow.
2. Financing the Acquisition and Cost of Capital
Acquisition of Donaldson’s Equity Capital Robinson’s Debt Finance
Robinson plans to borrow the additional funding needed to acquire Donaldson’s equity. Robinson’s management has succeeded in negotiating a 4-year loan of £2000 million from a consortium of finance companies. However the consortium, aware of the high level of financial leverage connected to the takeover, would charge an annual fixed rate of interest of 8.5%. The loan would be paid back as a single payment after 4 years.
The remainder of the debt capital required to finance the acquisition would come from fixed-rate, 4-year bond issue. Given the leveraged character of Robinson’s corporate acquisition strategy, a bond issue is likely to be given a B rating by a credit-rating agency (making it non-investment grade). The average yield on B-rated 4-year bonds is 8% above the annual yield on 4-year UK government securities, which is currently 2.9%.
Legal and administrative costs associated with borrowing funds are estimated at 1.2% of the amount borrowed and would be paid up-front rather than capitalized.
A successful bid also means that Donaldson’s loans will form part of the acquired operation’s capital structure. Donaldson’s loans, as highlighted in the 2015 accounts, stand at £4075 million and are expected to remain at broadly the same level over the next 4 years. Donaldson is currently paying an average annual rate of interest of 3.95% on the debt. A takeover by Robinson is liable to require renegotiation of some loan arrangements with the effect that the average rate of interest payable will rise to 6%.
1a. Undertake a ratio analysis of Donaldson based on the Financial Statements, and other data provided, for the period 2011 to 2015 (Page 7). Highlight developments in Donaldson’s:
- Shareholder Value
1b. Undertake a comparative analysis of developments in Donaldson’s share price over the period from 2011 to 2015 with reference to developments in the FTSE 100 index and the share prices of its main rivals over the same period (Page 8).
1c. Use the information gained from 1a and 1b to assess the strength of Robinson’s view that Donaldson is an underperforming company whose performance can be radically improved with a change of senior management.
A total of 45 marks are available for Task 1. It comprises 18 marks for the numerical work in parts 1a and 1b, and 27 marks for the assessment of Donaldson’s financial state (1c).
In commenting on the ratio results avoid a narrative that is restricted to simply stating what has happened to a particular ratio, or group of ratios. The aim should be to use the results to judge the company’s financial performance. Bear in mind that whilst trends detected in performance ratios are useful indicators of the financial standing of companies, they do not always lend themselves to straightforward interpretations. The context within which developments unfold, and the type of business being analysed, are important factors to consider when making judgements about how well a business is being managed.
2a. Calculate how much Robinson is prepared to pay to acquire Donaldson PLC.
2b. Based on the valuation of Donaldson in 2a, explain how Robinson would structure the finance required to fund the takeover, assuming that the entire reserve of available equity (£2500 million) is deployed.
2c. Calculate the cost of capital for each component of the finance that Robinson plans to use to fund the takeover.
2d. Calculate the after-tax weighted average cost of capital (WACC) for the investment. You should include the cost of Donaldson’s existing debt as part of the company’s capital structure.
A total of 15 marks are available for Task 2. It does not require an extensive discussion beyond explanations of your approach to solving the problems and summaries of your results.
3a. Using the after-tax WACC as the discount rate, calculate the expected net present value (NPV) of Robinson’s investment in Donaldson on the basis of a 4-year net cash flow analysis. You should incorporate Robinson’s estimated resale value for Donaldson into the NPV of the investment.
3b. Calculate the investment’s expected internal rate of return and discuss whether on the analysis merits Robinson going ahead with the bid.
A total of 30 marks are available for task. It comprises 24 marks for the numerical work and 6 marks for the discussion about whether it is in the interest of the equity providers for Robinson to press ahead with a bid.
Written Report - Present your work in a report to the Robinson’s Management, including
your ratio calculations and a copy of the investment appraisal.
A total of 10 marks will be available. It comprises 5 marks for structure, format and clarity of
language and 5 marks for evidence of team work & quality of the group process reports
Table 1: Donaldson Summarised Income Statements 2011 - 2015
Less Cost of Goods Sold
Less Administrative Expenses
Less Interest Payments
Table 2: Donaldson Summarised Balance Sheets 2011 - 2015
Total Current Assets
Net Assets (Equity)
Table 3: Donaldson PLC Shareholder Value Data 2011 – 2015
Number of Issued Shares
Dividend Per Share
Book Value Per Share
Table 4: FTSE 100 Index Values and Share Prices for Donaldson’s 3 Main Rivals 2011 – 20151
FTSE 100 Index
Toral PLC Share Price
Gleeson PLC Share Price
Gray PLC Share Price
 Share prices and FTSE 100 index levels are closing values on the day corresponding to the end of Donaldson’s trading year.
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