7/29/2019 L 06 Adding Value by Post Loss Financing http://slidepdf.com/reader/full/l-06-adding-value-by-post-loss-financing 1/58 Adding Value By Post-Loss Financing Lecture 6 Dr. Tahir Khan Durrani CEngr, MCIT, ACII, MSc, MPhil, CMBA, PhD “I’m just glad we got out before interest rates went up again.”
This document is posted to help you gain knowledge. Please leave a comment to let me know what you think about it! Share it to your friends and learn new things together.
Transcript
7/29/2019 L 06 Adding Value by Post Loss Financing
Existing Assets: Call these assets K0 - plant, distribution channels, etc. The expected rate of return on assets is r 0, Return in year t, from current assets is net of the cost of
renewing and repairing and replacing these assets in year
t. L is the liquid assets at time t. E(Et)t = K0r 0,t
Where V0(K0;r 0) is the PV, at time 0, of the cash flowsgenerated
7/29/2019 L 06 Adding Value by Post Loss Financing
Plastique makes plastic beads that are sold in to several firms.The firm makes two different formulas, and these aremanufactured separately at two plants, A and B. The projectedpre-loss outputs of these two plants are 100 and 140 units for 10years respectively. The values (replacement cost) of these plantsare £5m and £7m respectively. The firm also has liquid assets,cash, of £5m. One of the plant B is totally destroyed in a fire.Plant A is operating at 90% capacity and thus can increaseoutput to 111 units. The customer list is shown below:
The cost of capital is 10% and transaction (issue) costs are£0.3m(T(0.3)
What are the choices faced by the firm?
Customer 1 2 3 4 5 Total
Units sold 76 35 50 29 50 240
Profit 1.2 0.5 0.6 0.3 0.4 3.0
Dr. Tahir Khan Durrani
17
7/29/2019 L 06 Adding Value by Post Loss Financing
Instead of the fire that destroyed Plant B, Plastique’s has just had a£6m liability award made against it for defects in design that makesits product fail crucial applications.
The post loss evaluation reveals the following: The adversepublicity will dampen demand for its current product such that theexpected profit will fall from £3m per year to £2m. While thereplacement cost of current asset is £12m (5m+7m) and the assetshave a disposable value of only £8m.
The intended new investment, Kl, is for a product that is unrelated
to the existing product line and is not likely to suffer any demandcontamination from the law suit.
After paying law suit, Plastique has internal funds of L+K0r0 – 6m =5m+2m-6m = 1m, which are insufficient to fund the project.
What reinvestment options are available to Plastique?Dr. Tahir Khan Durrani
22
7/29/2019 L 06 Adding Value by Post Loss Financing
The misfortune of Plastique this time is that newregulations on the handling, transportation, and disposal of chemicals used in production cause a significant increasein costs, reducing profit from £3m to £1m, and thereforer0,1 is reduced to 8.333%. (This is a return on replacement
value of 12m, the equivalent return on salvage value of 8mis 12.5%). Should new investment be undertaken, r1, will be reduced to 8%.
Plastique has internal funds of L+r 0,1= 5m+1m = 6m,
which are insufficient to fund the new project. Firm can sell off existing assets for £8m and fund new project.
What post-loss investment options are available to thefirm?
Dr. Tahir Khan Durrani
26
7/29/2019 L 06 Adding Value by Post Loss Financing
Three important issues arise from thisexample: The loss event poses a set of investment
decisions. The first concern replacement of thelost asset. In the previous example, replacementof the asset added value, but under differentcircumstances a value-maximizing strategy can
be to abandon this asset. This can be so if thereplacement requires external financing thatincurs large transaction costs.
Dr. Tahir Khan Durrani
29
30
7/29/2019 L 06 Adding Value by Post Loss Financing
It is important to be able to measure the costof risky events.
For example, an analyst wishing to value a
firm that is subject to liability exposure needsto measure the impact of that exposure onthe stock value.
A risk manager knowing his firm is exposed toprospective property loss might seek toreduce the possibility of such loss byimproving safety, such as by installing
Dr. Tahir Khan Durrani
37
38
7/29/2019 L 06 Adding Value by Post Loss Financing
The conditions of the law are fixed inadvance, and if the firm finds itself in asituation in which equity would assume anegative value, it can exercise the option topass the firm to creditors.
Shareholders have the right to sell their equityto creditors at a zero price even though the
residual value of the equity is negative.
In short, this right is an option to put theequity to creditors at a zero striking (or
exercise) price.Dr. Tahir Khan Durrani
44
7/29/2019 L 06 Adding Value by Post Loss Financing
If the value NPV (pre-loss abandonment) ispositive, then value is added by selling of theasset; otherwise there is greater value in use.
Notice that even if the expected cash flowswere to fall dramatically between time 0 andtime L-. it might still make sense to continueproduction if the resale value , KS,L- , where
sufficiently small.
On the other hand, if sometimes makessense to abandon assets.
Dr. Tahir Khan Durrani
50
7/29/2019 L 06 Adding Value by Post Loss Financing
Factors that might have changed since theoriginal investment was undertaken are: Appreciation of abandonment values Revision of Cash flow estimates Revision of the cost of capital Phasing out of old projects
What is the post-loss investment decision?
Post-loss c/f Ct, exceeds the post-loss replacement cost of the destroyed asset KR,L+
Dr. Tahir Khan Durrani
n
1t
LR,K
t)tk(1
tC
LEstment)NPV(Reinve
52
7/29/2019 L 06 Adding Value by Post Loss Financing
DETROIT (Reuters) - Ford Motor Co. (F.N) said on Friday it would cut35,000 jobs worldwide -- 22,000 of them in North America -- and closethree assembly plants in North America.
Ford Chief Operating Officer Nick Scheele said the world's second-largest automaker would close assembly plants in Edison, New Jersey;Hazelwood, Missouri; and Oakville, Ontario. The Canadian and New
Jersey plants build pickups, while the Missouri plant builds the FordExplorer sport utility vehicle.
Scheele also said Ford would close two parts plants in Cleveland, Ohio,and Dearborn, Michigan. In addition, 11 plants will undergo major restructuring, including shift cuts, with production cuts at nine additionalplants.
The cuts come as part of an overhaul of the company aimed atimproving profits by $9 billion by the middle of the decade. Ford said itwould take an after-tax charge of about $4.1 billion in the fourth quarter of 2001 in the restructuring drive.
It said it would cut North American production capacity by 16 percent, to4.8 million vehicles from 5.7 million vehicles, and cut four vehicles -- the
Ford Escort, the Mercury Cougar, the Mercury Villager and the Lincoln-- -
Dr. Tahir Khan Durrani
54
7/29/2019 L 06 Adding Value by Post Loss Financing
Reinvestment decisions are based on post loss estimates of cash flows, where as “q” is based on current estimates.
Post loss reinvestment decisions address a particular assetnot the total loss of firm. The “q” is a rough average of the
(imputed) market to replacement values of assets withallowance for synergies. Thus the overall ratio may not beappropriate for any one destroyed asset.
Management may have information advantage over outsideinvestors in estimating post loss expected cash flows from a
particular asset replacement.
Reinvestment decision should include all cash flows, includingsalvage and disposal costs. These may not be included in “q”
denominator.Dr. Tahir Khan Durrani
57
7/29/2019 L 06 Adding Value by Post Loss Financing
Plastique suffers the property loss described earlier; Plant Bis destroyed in a fire. Using the reinvestment options derivedearlier, determine the optimal post-loss investment decision.
Additional information: Plastique was formed three years ago when it raised £15m in
equity. This money was used to construct the two plants andfor working capital. The investment parameters facingPlastique at inception were that it could make an estimated£3m per annum for 13 years. Calculate NPV
Shortly before the loss, Plastique had identified a new
investment opportunity that would involve a capital outlay of £8m and generate an income stream of £1.35m (16.875%) per year. The opportunity was to be undertaken at the end of thecurrent year (projected income £3m & £5m in cash).
Calculate the pre-loss and post-loss value of the firm.