Management buyout and leveraged buyout have played a major role in the process of corporate restructuring (Wright et al. 1996). The motivations for corporate restructuring are comprehensive and regard as one of appropriate solutions for the organizational current problems and external potential situations (Kemper and Khuen, 2004).
When organization facing the challenges in rapid and competitive business environment (Nag & Pathak, 2009, p.21), the organization has to concentrate on main competencies by divesting non-core businesses. Kemper and Khuen (2004) suggest that profitable business units should be sold if the business units no longer fit or support the long term business strategy or goal of the organization, even if they will contribute to make profits. These disinvestments can have attractive valuations. In addition, the organization has expanded to the boundary that the original organization has no longer managed the output efficiently and general interests of the organization. Such as, a corporate restructuring may require spin-off the business units become subsidiaries as a means to create the more effective business management model and have tax saving benefits. That would encourage organization to distribute more resource on production process. As a result, organization could gain the long term competitive advantages and a larger market share. Furthermore, the motivation of corporate restructuring is to reduce cost through a host of organizational, portfolio and financial restructuring that are essential to make firms cost competitive and to increase the performance of the organization and shareholder wealth (Hoskisson and Turk, 1990. p.459).
The other objective of corporate restructuring is to enhance shareholders' value. Kemper and Khuen (2004) propose three factors support the view of shareholder value enhancement in corporate restructuring analysis. First of all, shareholders utilize corporate governance mechanisms to influence the operation of organization. Hence, the management decisions will focus on the interests of shareholders. Next, the shareholder dividends are the residual after all other stakeholders' needs are satisfied. Consequently, that implies organization pursues the maximum value creation for all stakeholders. Finally, much of the empirical evidence shows that the performance of firms which are shareholder-oriented is better than other firms.
Corporate restructuring might be particularly occurred by the acquisition of the company from new owners or incumbent management teams. The acquisition may be taken place after a leveraged buyout, a hostile takeover, or a merger that the organization becomes a subsidiary of the controlling corporation. In particular, management buyout (MBO) can be defined as one type of leveraged buyout. After post-MBO, the owners of company are replaced from dispersed public stockholders to concentrate on private owners by the incumbent managers or management group (DeAngelo, 1987, p.38).
The advantage of MBO is that the change of expect profitability is related to the structure of new equity ownership and managers' personal performance and reward. In general, the performance of the acquired firms could gain more equity post-MBO than under public ownership. Managers have the opportunity to become rich or to move from the salaried employee to owner (Bruner and Paine, 1988, p.90). The more managers hold the share of the firm's common stock, the more motivation to operate business efficiently. Also, private firms could have lower agency costs than publicly traded firms, because private firms are usually owned and managed by a small, concentrated group of shareholders (Harris, et. al, 2005). After managers find out the level of private company's debt is extreme high, that would push them work to generate more cash flow, enhance the operation effective, and increase and market value in order to return the personal portfolios to less risky position (DeAngelo, 1987, p.44).
The other potential benefit of MBO can come from the perspective of saving cost, such as, a listed company goes to private could save the transaction costs associated with the dissemination of information and communication with investors. Also, the private company could save the auditing, accounting and legal fees that the necessary to satisfy the regulation of publicly traded companies. As a result, managers could have more time to focus on valuable things rather than to deal with public stockholders and financial analysts and reporters (DeAngelo, 1987, p.44). In addition, DeAngelo (1987) suggests that MBO could bring the tax saving in a buyout transaction that the structure satisfies the requirement of tax code from the additional interest tax shields and an asset value.
Also, MBO is able to enhance the company's competitive position, because privately held company has no obligation to disclose the company strategy and could keep the confidential and sensitive information to product market rivals (DeAngelo, 1987, p.44). Furthermore, a buyout may be the only way to turn a failing company around, or the most appealing way to ward off a hostile takeover which damages the company's operation performance.
In the other hand, a privately held company may face difficulties in raising capital. The new organization structure implies that the chance to access the public equity market and the ready sources of capital is less. The way of approach to the public equity market may enable a firm boosting capital at more attractive terms, also the more diversified risk, and lower expected return on investments then private lenders (DeAngelo, 1987, p.45). Hence, the limited sources of capital investment might lead the managers to abandon profitable projects.
The other drawback of MBO is that the changes in ownership might have the risk of losing key managers or the firm-specific skills, know-how and experience invested in employees which have been accumulated through long time and high cost to substitute (Wright et sl. 1996, p.62). Also, privately held company has the problem in attracting competent managers. The potential costs can arise when managers' personal portfolios are poorly diversified of illiquid because of reduced share marketability under private ownership (DeAngelo, 1987, p.46).
B. Critically evaluate any corporate governance issues that might arise.
Corporate governance is a set of regulation to deal with the relationship between management and shareholders. It coves the mechanisms and processes among decisions related to create and distribute value. The area of corporate governance includes shareholders' rights, transparent information, management and control elements, and the alignment of compensation. Also, corporate governance is different from each company, depending on shareholder structure and nationality (Vernimmed et al, 2009, p.863).
Agency theory is the main base of corporate governance which control management to gain extra advantage of shareholders. The purpose of agency theory is to regulate the decision-making authorities of managers so that to protect stakeholders' rights and interests. Moreover, corporate governance stipulates the financial communication such as provide the information to shareholders and company operates under auditors, eliminating the asymmetry information by ensuing transparency and decreasing potential conflicts of interests between management and shareholders. In addition, agency theory shows that private company and small to medium sized companies have the fewer conflicts of interest and lower agency cost because the managers and shareholders are the same persons. Corporate governance is not a big issue among these companies (Vernimmed et al, 2009, p.870).
In recent years, the growth of auctions for private equity(??) deals and the point highlighted on shareholder value by companies, similarly, corporate governance has become more active, impacts promising returns and the sources of returns (Cumming et al, 2007, p.449). When the internal governance improved, the agency problems may be decreased. Managers are more difficult to manage company by self-interested and reject outsider bid (Cumming et al, 2007, p.452). The entrenchment theory (Vernimmed et al, 2009, p.870) supports this argument. It is based on the assumption that mechanism is not the main motivator of management to run the corporation in line with the interests of shareholders. Some managers make the decision by self-interested and remove other competitions, trying to enhance the opportunity cost for company to replace them. Then they could enlarge the power and discretionary authority. Managerial entrenchment and corporate governance are contradiction.
According to Wright et al (2009) research, it shows that the structure of control ownership and dispersed ownership of public corporation creates agency costs which diminish the wealth of shareholder. However, Jensen (1989) argues that the privately held company which is highly leveraged and has an active investor of private equity institutions could create the necessary incentive and monitoring mechanisms to prompt the maximize wealth (Wright et al, 2009, p.353). Furthermore, Nikoskelainen and Wright (2007) suggest that leveraged buyouts lead corporate governance mechanisms to reduce agency costs and increase company value by operating efficiency improvement. The concentrated ownership structure provides private equity investors have the ability to control and monitor the buyout company's strategy from the board of directors. Namely, buyout returns are significantly enhanced by corporate governance mechanisms (Cumming et al, 2007).
Public to private companies have fewer non-executive directors and have greater board shareholdings. MBOs do not have sub-optimal structure of internal corporate governance as a disciplinary mechanism, the lower portion of outside directors lead them to experience fewer pressures. MBOs still need to fulfill external governance such as government regulation. However, as a private company, MOBs could save the regulation costs and to implement restructuring and growth strategies without public gaze (Weir and Wright, 2006) And avoid the threats from the market for corporate control such as takeover speculation and hostile take-over threats are less in MBOs companies (Weir and Wright, 2006).
Corporate governance stands at the position of protecting shareholders' value. However, MBOs companies are not 100% owned by managers. The right of third party fund investors needs to maintain. Shareholders require high returns on their equity investments and management has self-interested. To solve the conflict between management and shareholders, it is not sufficient only rely on a corporate governance system. The better way is to provide the incentives to managers and motivate them to operate company efficient, so that lead them to act in the best interests of corporate owners.
C. Compute and analyse the risk faced by the company and calculate the cost of capital.
Beta coefficient is a measure of the covariance between security's risks of stock and the market risk. The higher beta value means the higher sensitive to market movements and higher systematic risk (Rosenbaum and Pearl, 2009). The beta coefficient of Burberry group plc was 1.043 as of 15th March 2010 (Source: Bloomberg.com). It shows that Burberry is vulnerable to economic volatility, and the return of Burberry stock is sensitivity to market index.
Burberry is the fashion brand in UK. The company has branded stores, and sells products through concessions in third-party stores, also, Burberry franchises and licensees around the world. Burberry faced the risks come from internal and external which influenced the group performance.
The external risks are not easy to control by Burberry. Such as, global economic downturn has affected consumers' purchase behaviours. It is general situation around all Burberry's competitors. In addition, partly Burberry's sales are obtained by customers who purchase products while travelling. That is, the patterns of travel shifts or the travel volumes decreasing could significantly affect trading results. Next, the profit of Burberry generated from Japanese, United States and Europe increases (Burberry, 2009), it shows that the risk associated with the exchange rate greater than before. Hence, Burberry faced the risk of currency fluctuations. Fashion industries highly rely on the strength of branding and brand trademark. The trademarks of Burberry and the Brand rights are essential to pursue the success and to gain the advantage competitive position in fashion industry. Unauthorized to use 'Burberry' name and logo, and the distribution of counterfeit products will cause damage to Burberry brand image and profits.
There are some internal financing risks of Burberry. For example, Burberry has to hold raw materials and inventories of finished good which cannot be converted into cash quickly. Also, the products normally sell on credit, therefore, the trade receivables risk raised. Moreover, when Burberry finances the borrowing, the financial gearing occurred. It is the commitment to pay the interests. If the borrowing is too heavy, that might lean to a significant financial burden and increase the risk of insolvent. Although, the borrowing from others could create more returns to owners, however, a small decrease in operating profit will lead to a greater decrease in the returns. The borrowing increases the risk to shareholders (McLaney and Atrill, 2008).
The cost of capital calculation
The cost of capital also called WACC (Weighted Average Cost of Capital) represents the minimum investment return rate of the company that can satisfy the required of funds providers, such as shareholders and debt-holders, to finance the company's investment projects (Vernimmen et al, p.1000). That is, the cost of capital is thus the company's total cost of financing (Vernimmen et al, p.447). In order to calculate Burberry group plc's cost of capital, the number of cost of equity and cost of debt should be figured out first then put into WACC formula.
Which:
kE is the cost of equity
kD is the cost of debt
E is the value of equity
D is the value of debt
V is the value of the company, defined as V=E+D
tC is the corporate tax rate
Firstly, to calculate the value of kE (the cost of equity), it should be based on the Capital Asset Pricing Model (CAPM) which means the expected return as a function of systematic risk and provide a market determined discount rate for investment evaluation (Whitfield, 2010). Based on CAPM, there are some elements related to calculate the number of kE.
Which:
kE is the cost of equity
RF is the return on UK benchmark 10-year bonds= 3.75% (Source: Bloomberg.com)
Beta =1.043 (Source: Bloomberg.com)
RM is the annualized equity premiums at U.K. =4.43% (Dimson, et al, 2006)
Table 1: The value of cost of equity
CAPM
RF
3.75%
+ Beta * (RM - RF)
1.043 * (4.43% - 3.75%)
= kE
4.46%
Secondly, the amount of debt could be found at the balance sheet of Burberry group plc 2008-2009 annual report in order to count the value of KD. From the table 2, the value of KD (cost of debt) = 2.82%
Table 2: The value of KD
Amount £M
Interest Rate
%
Bank overdrafts
199.3
2.50%
81.45%
Bank borrowings
45.4
4.23%
18.55%
　Total Debt
244.7
2.82%
100%
(Source: Burberry Group Plc 2008-2009 annual report)
Notes of table 2:
According to Burberry Group Plc (2009), the amount of bank overdrafts is £199.3M representing balances on cash pooling arrangements in the Burberry group. The effective interest rate for the overdraft balances is 2.5%.
At 31 March 2009, the amount drawn down from bank was £45.4M. Interest is charged on this loan at LIBOR plus 2.00% (Burberry Group Plc, 2009). The LIBOR rate at 16 March 2009 was 2.23% (Source: Fubon.com).
Thirdly, the value of equity at 15 March 2010 was £2,985 M (Source: bloomberg.com). As a result, the company value (V) equal to the value of equity (E) plus the value of debt (D) presented at table 3.
Table 3: The value of Burberry group plc
　
Amount £M
%
Market Cap (E)
2,985
92.42%
Debt (D)
244.7
7.58%
Total (V)
3,230
100.00%
Next, Burberry group plc annual 2008/2009 report shows that the value of tC (the corporate tax rate) is 28%. After figured out all the elements of WACC, the value of WACC can be calculated as below. As a result, the cost of capital which is the minimum expected return rate of capital providers is 4.28%.
Table 4: All the elements of WACC
kE
4.46%
E
2,985 M
V
3,230M
KD
2.82%
D
244.7
tC
28%
= 4.46% * (2,985/3,230) + 2.82% * (244.7/3,230) * (1-28%)
= 4.28%
D. Using appropriate valuation techniques calculate the company's value.
DCF (Discounted cash flow) analysis is a basic appraisal methodology broadly used on calculate company's value. DCF uses forecast future free cash flow (FCF) and discounts at a present value which is used to evaluate the potential for investment. The DCF has a wide range of applications, including valuation for various M&A situation, IPOs, restructurings, and investment decisions.
A DCF plays an important role as a check on the prevailing market valuation for a publicly traded company (Rosenbaum and Pearl, 2009). Also, DCF anaylsis is based on the company's real economic performance (Vernimmen et al, 2009, p.657).
To calculate the company's value by DCF analysis, there are four steps. Firstly, it is needed to compute the value of FCF0 and forecast for a period of 5 years FCF values from 2009 to 2013. The FCF0 value is calculated as below:
Table 5: FCF0 calculation
Year to 31 March(£M)
2008
Operating income (EBIT)
-9.9
deduct
Corporate income tax
-11
add
Depreciation & Amortisation
49.6
deduct
Capital expenditure(CapEx)
89.9
deduct
Change in working capital
5
FCF0
-44.2
Note of table 5:
The corporate income tax is positive £11.0M because of adjustment of tax from 30% to 28%, adjustments in respect of prior years, and adjustments to deferred tax relating to changes in tax rates (Burberry annual report 2008/2009).
From table 5, the value of FCF0 is £-44.2M. It is important to note that negative free cash flow is not bad in Burberry. It represents a sign that Burberry invested large amount (£89.9 M) on purchasing tangible and intangible fixed assets on 2008. If these investments could help Burberry to earn a high return, the strategy has the potential to pay off in the future. Next, estimating Free Cash Flow from 1 April 2009 to 31 March 2013 and calculate the PV value.
Table 6: Historical Period and projection period of FCF
Year to 31 March(£M)
t0
t1
t2
t3
t4
t5
FY2005
FY2006
FY2007
FY2008
FY2009
FY2010
FY2011
FY2012
FY2013
　
Operating income (EBIT)
154.5
157
201.7
-9.9
120
132
145.2
159.72
175.69
　
% change
　
1.62%
28.47%
-104.91%
1312.00%
10.00%
10.00%
10.00%
10.00%
deduct
Corporate
income tax
50.6
46.1
60.5
-11
36.00
39.60
10.00
47.92
52.71
　
Tax rate %
30%
30%
30%
28%
30%
30%
30%
30%
30%
add
Depreciation & Amortisation
24.9
27.7
32.7
49.6
55.55
62.22
69.68
78.05
87.41
　
% change
11.24%
18.05%
51.68%
12.00%
12.00%
12.00%
12.00%
12.00%
deduct
Capital expenditure(CapEx)
30.7
34.3
48.5
89.9
94.40
99.11
104.07
109.27
114.74
　
% change
　
11.73%
41.40%
85.36%
5%
5%
5%
5%
5%
deduct
Change in working capital
112.6
3.9
19.4
5
5
5
5
5
5
　
% change
　
-96.54%
397.44%
-74.23%
0
0
0
0
0
FCF
　
　
　
40.16
50.50
95.81
75.58
90.66
Actual
Forecast
(Source: Burberry group plc 2008/2009 annual report)
Note of table 6:
Project the change of operating income is 10% annual. According to Financial Times (2010) shows that the average growth rate of global luxury market is around 15%. Global economic was upturn at 2009; hence, the operating income in FY2009 might increase. The annual report of FY2009 will be released on Jun 2010.
Predict the tax rate, depreciation and amortization, and change in working capital remain at the reasonable increasing percentage. And forecast the percentage of change rate of capital expenditure is 5%.
In addition, WACC is a broadly accepted standard for use as the discount rate to calculate the present value of a company's projected FCF and terminal value. The terminal value is used to quantify the residual value of the target at the end of projection period (Rosenbaum and Pearl, 2009). From table 6, use the free cash flow of 2013 to count the terminal value.
Terminal value =
FCF5 (1+g)
WACC-g
(1+WACC)6
Table 7: The related number for determining terminal value
FCF5
£90.66 M
g
2%
WACC
4.28%
Terminal value = £3,154.06 M
Note of table 7:
The 2% of g is the assumption of growth rate.
Finally, collect all the require number for calculating the firm value. The assumption of firm value is equal to present value of free cash flow plus present value of terminal value. And the value of equity is firm value minus total debt.
Table 8: Calculate firm value and value of equity
PV of FCF
£306.88 M
+ PV of Terminal Value
£3,154.06 M
= Firm value
£3,460.93 M
- Total Debt (D)
£244.70 M
= Value of equity (E)
£3,216.23 M
Table 9 listed the comparison of market value and DCF analysis. The market cap is £2,980M and the value of equity comes from DCF analysis is £3,216.23M. It shows that the company value and the share price of Burberry group plc are undervalued.
Table 9: Comparison DCF value and market value
DCF calculation
Market value
Value of equity
£3,216.23 M
£2,980 M
Share number
4.34 M
Share price
741
687
Market share price
(15th March 2010)
E. Analyse the alternatives available for financing the MBO.
There are two types of MBO. One type is incumbent managers have sufficient financial resources to purchase the publicly held common stock without taking outside equity or increasing corporate debt. The other types is the managers cooperate with third-party investors who provide the fund, such as bank debt, private equity, venture capital and PV, to purchase the publicly held common stock to a large degree (DeAngelo, 1987, p.38). Managers are not always having the money for MBO, as a result, they need an equity partner who provides capital support and access to debt financing through established investment banking relationship (Rosenbaum and Pearl, 2009).
For financing the MBO, manager might firstly look for the capital from bank because bank debt is the least costly source of debt financing (Rosenbaum and Pearl, 2009). The typically interest rate is LIBOR or the Base Rate which is the benchmark rate, plus an appropriate margin based on the borrower's credit (Rosenbaum and Pearl, 2009). However, leveraged buyout is too risk for a bank to load. Bank analyses the target's business and projects the generated cash flow to make sure the payment of future interests and repayment at maturity. Bank debt is secured by various forms of collateral; strong asset base of company increases the amount of bank debt available to the borrower.
The private equity is another common way for financing MBO. The private equity is organized into funds and usually built as the limited partnership serve as passive investors. The investors wish to obtain the high return from their investment and focus their efforts on the boards of MBO company that can provide high income. Research shows that MBOs have offered private equity firms more consistent returns than venture capital-type investments (Jelic et al, 2005). Private equity is the promoter of a management buyout. There is a enormous benefit by private equity in financing an MBO that is backed by a strong management team. Research (Johnson, 2007) shows that MBOs could provide more return to private equity firms than venture capital investments. MBO companies which are the leading or within a market niche may be more attractive by private equity firms. Also, a company's ability to generate cash flow, reinvest for growth, and service debt are highlighted by private equity films. As a result, private equity can be a great resource in helping business owners and executives to fulfill strategic goals (Rosenbaum and Pearl, 2009).
From the calculation of DCF, Burberry needs £3,460.93M for financing the MBO. The suggestion of financing sources is from bank and private equity. Burberry could loan from bank by 60% which is £2,076.56M and borrow from private equity by £1,384.37M.
Table 10: The suggestion of financing the MBO
Financing source
%
Amount £M
Bank debt
60%
£2,076.56
Private Equity
40%
£1,384.37
Total
100%
£3,460.93 M
F. Your conclusions and recommendations to the management team in the light of current economic conditions.
Integrated all the evaluation, it shows that now is a good timing to take MBO of Burberry company. There are several reasons to support this suggestion. Firstly, from Burberry 2008/2009 annual report, it shows that the operation income of fiscal year 2008 decreased dramatically. That is because Burberry invested huge amount (£89.9M) on purchase of tangible and intangible fixed assets and high amount of operation cost. As a result, the free cash flow and EBIT were negative. However, the discounted cash flow analysis presented at Table 8 demonstrates that the film value of Burberry is £3,460.93M and the value of equity is £3,216.23M. Compared to the value of market cap of Burberry which was £2,980M at 15th March 2010, it indicates that Burberry group plc undervalued by £236M. Moreover, from DCF ananlysis, the calculated share price is 741p and there is a gap by 54p which means the share price also undervalued. In addition, the fiscal year of Burberry is from 1 April of last year to 31 March of this year, it implies that the performance of Burberry might has the great progress on 2009, because the global economic turn up and the global average sales increased by 30% in luxury goods industry at 2009. Also, the forecast of luxury goods industry is optimal and will up 30% year on year.
When the company undervalued, the main sources of shareholder wealth gains also disregarded of the pre-transaction target firm. Supported by Weir and Wright (2006) that the major occasion for company go private in the U.K. is the period when the value of this company is undervaluation. Burberry management has private information that is not aware to the public market and they understand the public of view to Burberry is not correct. There is a benefit to buyout this company and to remain in charge of it rather than let the market continue to undervalue it.
Moreover, Burberry has to face the competition in the luxury goods industry and many markets which are more intension recently. The competition with other international luxury goods groups who own numbers of luxury brands and may have stronger financial supports and powerful negotiation position deal with suppliers, third parties and land lessor (Burberry 2009), is cruel. If Burberry is not able to compete with them successfully, the operation results and sales may be adversely influenced. Furthermore, one of the disadvantage of MBO is company might lose key employees due to the organization change or corporate restructuring. Burberry's performance relies largely on higher level managers and designers. The key persons resign and Burberry is unable to recruit the right skills and experience talent might adversely Burberry's future business growth. The employees are most important asset of a company. When taking the action of MBO, the new owners of Burberry have to consider how to attract competent employees.
