Topic: Financial Policy

72oFP Financial Policy Subject Overview

White, M 2004, ‘Financial Analysis with a Calculator’, 5th edn, Burr Ridge Ill, McGraw-

Hill/Irwin.

Assignment

Case Study – Airesford Ltd and Gibson Ltd

Airesford 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:
Operating Cash Flows Taxable Operating Profits

North (5000) South (5000) North (5000) South (5000)
12,000 12,000 8,000 12,000
12,000 8,000 12,000 3,000
15,000 8,000 16,000 3,000
20,000 4,000 24,000 4,000

The above figures exclude:

1. Head office costs of 5 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 5 24 million

South division S 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.

72oFP Financial Policy Subject Overview
2. At year 4, North division’s assets would be used by Alresford to substitute for capital
expenditure of S 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 South division Increase in annual cash
end of year Revised salvage value flows for each year until
termination
$20 million $ 4 million
s 16 million $3

2. Alresford’s own transport department could be used to carry out North division’s
deliveries, thereby saving the division 5 600,000 per year in transport costs. However,
this policy would cause Alresford’s transport department to modify its planned
replacement cycle, and expenditure of S 1.6 million, scheduled for both year 3 and 5,
would be increased to S 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 S 3.6 million in year 1, sales of North division
would increase producing additional profit, and cash flow, of S 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 (12 marks):

Clearly state any assumptions you make and explain all calculations in full. Use an 18% after-

tax cost of capital.

72oFP Financial Policy Subject Overview
(a) Estimate the market value of Gibson Ltd in the absence of any take-over possibilities.
(4 marks)
(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.
(4 marks)

(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.
(4 marks)

Part B of the Assignment (8 marks):

With reference to the reading “Toward a More Complete Model of Optimal Capital

Structure”

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

(4 marks)

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

(4 marks)

NOTE: The Part B of the Assignment will be based on the following article:

Heine, R and Harbus, F 2002, ’Toward a more complete model of optimal capital structure’,

Journal of Applied Corporate Finance, vol. 15, no. 1, pp. 31-45.

Important Instructions

1. Assignments must contain proper citations and referencing using the Harvard style
referred to in the AIB Style Guide, that is:

a. citations (or in-text references) of quoted and paraphrased materials to support
your arguments/comments, and
b. a reference list relating specifically to your in-text references.

2. Your grade will be adversely affected if there is no/poor citations and/or reference list,
as referred to above.

3. Assignments of this nature normally contain between 6 and 12 relevant references
from different sources in the reference list.

4. All references must be from credible sources. Journals sourced from the EBSCO Host
library (see Online Library User Guide on the next page) should be used first, then
books, company documents and other media.

(CE/Australian institute of Business.