266. Nugfer Co (Dec 10 – Amended)
The following financial position statement as at 30 November 2010 refers to Nugfer Co, a stock exchange-listed company, which wishes to raise $200m in cash in order to acquire a competitor.
| | $m | $m |
| Assets | | |
| Non-current assets | | 300 |
| Current assets | | 211 |
| Total assets | | 511 |
| Equity and liabilities | | |
| Share capital | 100 | |
| Retained earnings | 121 | |
| Total equity | | 221 |
| Non-current liabilities | | |
| Long-term borrowings | | 100 |
| Current liabilities | | |
| Trade payables | 30 | |
| Short-term borrowings | 160 | |
| Total current liabilities | | 190 |
| Total liabilities | | 290 |
| Total equity and liabilities | | 511 |
The recent performance of Nugfer Co in profitability terms is as follows:
| Year ending 30 November | 2007 | 2008 | 2009 | 2010 |
| | $m | $m | $m | $m |
| Revenue | 122.6 | 127.3 | 156.6 | 189.3 |
| Operating profit | 41.7 | 43.3 | 50.1 | 56.7 |
| Finance charges (interest) | 6.0 | 6.2 | 12.5 | 18.8 |
| Profit before tax | 35.7 | 37.1 | 37.6 | 37.9 |
| Profit after tax | 25.0 | 26.0 | 26.3 | 26.5 |
Notes:
(1) The long-term borrowings are 6% bonds that are repayable in 2012.
(2) The short-term borrowings consist of an overdraft at an annual interest rate of 8%.
(3) The current assets do not include any cash deposits.
(4) Nugfer Co has not paid any dividends in the last four years.
(5) The number of ordinary shares issued by the company has not changed in recent years.
(6) The target company has no debt finance and its forecast profit before interest and tax for 2011 is $28 million.
Required:
A. Evaluate suitable methods of raising the $200 million required by Nugfer Co, supporting your evaluation with both analysis and critical discussion.
Nugfer Co is looking to raise $200m in cash in order to acquire a competitor. Any recommendation as to the source of finance to be used by the company must take account of the recent financial performance of the company, its current financial position and its expected financial performance in the future, presumably after the acquisition has occurred.
Recent financial performance
The recent financial performance of Nugfer Co will be taken into account by potential providers of finance because it will help them to form an opinion as to the quality of the management running the company and the financial problems the company may be facing. Analysis of the recent performance of Nugfer Co gives the following information:
| Year | 2007 | 2008 | 2009 | 2010 |
| Operating profit | 41.7 | 43.3 | 50.1 | 56.7 |
| Net profit margin | 34% | 34% | 32% | 30% |
| Interest coverage ratio | 7 times | 7 times | 4 times | 3 times |
| Revenue growth | | 3.8% | 23.0% | 20.9% |
| Operating profit growth | | 3.8% | 15.7% | 13.2% |
| Finance charges growth | | 3.3% | 101.6% | 50.4% |
| Profit after tax growth | | 4.0% | 1.2% | 0.8% |
Geometric average growth in revenue = (189.3/122.6)0.33 – 1 = 15.6%
Geometric average operating profit growth = (56.7/41.7)0.33 – 1 = 10.8%
One positive feature indicated by this analysis is the growth in revenue, which grew by 23% in 2009 and by 21% in 2010. Slightly less positive is the growth in operating profit, which was 16% in 2009 and 13% in 2010. Both years were significantly better in revenue growth and operating profit growth than 2008. One query here is why growth in operating profit is so much lower than growth in revenue. Better control of operating and other costs might improve operating profit substantially and decrease the financial risk of Nugfer Co.
The growing financial risk of the company is a clear cause for concern. The interest coverage ratio has declined each year in the period under review and has reached a dangerous level in 2010. The increase in operating profit each year has clearly been less than the increase in finance charges, which have tripled over the period under review. The reason for the large increase in debt is not known, but the high level of financial risk must be considered in selecting an appropriate source of finance to provide the $200m in cash that is needed.
Current financial position
The current financial position of Nugfer Co will be considered by potential providers of finance in their assessment of the financial risk of the company. Analysis of the current financial position of Nugfer Co shows the following:
Debt/equity ratio = long-term debt/total equity = 100 × (100/221) = 45%
Debt equity/ratio including short-term borrowings = 100 × ((100 + 160)/221) = 118%
The debt/equity ratio based on long-term debt is not particularly high. However, the interest coverage ratio indicated a high level of financial risk and it is clear from the financial position statement that the short-term borrowings of $160m are greater than the long-term borrowings of $100m. In fact, short-term borrowings account for 62% of the debt burden of Nugfer Co. If we include the short-term borrowings, the debt/equity ratio increases to 118%, which is certainly high enough to be a cause for concern. The short-term borrowings are also at a higher interest rate (8%) than the long-term borrowings (6%) and as a result, interest on short-term borrowings account for 68% of the finance charges in the statement of profit or loss.
It should also be noted that the long-term borrowings are bonds that are repayable in 2012. Nugfer Co needs therefore to plan for the redemption and refinancing of $100m of debt in two years’ time, a factor that cannot be ignored when selecting a suitable source of finance to provide the $200m of cash needed.
Recommendation of suitable financing method
There are strong indications that it would be unwise for Nugfer Co to raise the $200m of cash required by means of debt finance, for example the low interest coverage ratio and the high level of gearing.
If no further debt is raised, the interest coverage ratio would improve after the acquisition due to the increased level of operating profit, i.e. (56.7m + 28m)/18.8 = 4.5 times. Assuming that $200m of 8% debt is raised, the interest coverage ratio would fall to ((84.7/(18.8 + 16)) = 2.4 times and the debt/equity ratio would increase to 100 × (260 + 200)/221 = 208%.
If convertible debt were used, the increase in gearing and the decrease in interest coverage would continue only until conversion occurred, assuming that the company’s share price increased sufficiently for conversion to be attractive to bondholders. Once conversion occurred, the debt capacity of the company would increase due both to the liquidation of the convertible debt and to the issuing of new ordinary shares to bond holders. In the period until conversion, however, the financial risk of the company as measured by gearing and interest coverage would remain at a very high level.
If Nugfer Co were able to use equity finance, the interest coverage ratio would increase to 4.5 times and the debt/equity ratio would fall to 100 × (260/(221 + 200)) = 62%. Although the debt/equity ratio is still on the high side, this would fall if some of the short-term borrowings were able to be paid off, although the recent financial performance of Nugfer Co indicates that this may not be easy to do. The problem of redeeming the current long-term bonds in two years also remains to be solved.
However, since the company has not paid any dividend for at least four years, it is unlikely that current shareholders would be receptive to a rights issue, unless they were persuaded that dividends would be forthcoming in the near future. Acquisition of the competitor may be the only way of generating the cash flows needed to support dividend payments.
A similar negative view could be taken by new shareholders if Nugfer Co were to seek to raise equity finance via a placing or a public issue.
Sale and leaseback of non-current assets could be considered, although the nature and quality of the non-current assets is not known. The financial position statement indicates that Nugfer Co has $300m of non-current assets, $100m of long-term borrowings and $160m of short-term borrowings. Since its borrowings are likely to be secured on some of the existing non-current assets, there appears to be limited scope for sale and leaseback.
Venture capital could also be considered, but it is unlikely that such finance would be available for an acquisition and no business case has been provided for the proposed acquisition.
While combinations of finance could also be proposed, the overall impression is that Nugfer Co is in poor financial health and, despite its best efforts, it may not be able to raise the $200m in cash that it needs to acquire its competitor.
