- CMLGroupwas an entity involved inproviding services to both the mining and construction sectors. The Mining division provideda complete service for surface and underground operation, from mine development to materials delivery. The Constructiondivision providedgovernment and resource sector clients a diverse range of construction capabilities that incorporated roads and bridges, rail, water and environment, marine and resource infrastructure.
- In early September 2014, the company obtained monthly data about the operation of its Construction business. This data indicated a deterioration in the profitability of the Construction business, mainly caused by a rail project. The company immediately undertook investigations to establish the reasons for the deterioration and the accuracy of the underlying data. Upon analysis of further data, the company sent a senior manager to the rail project to determine the nature and extent of the problem on the earnings. The project did not achieve the required productivities and the company would deliver the project within the client’s accelerated timeframe at a significant loss.
- As a result of the event, Nick Hall was appointed to become the new CEO of the company. A strategic review of CML’s all businesses was conducted. The outcomes of the review were announced in late October. These included a reduction in discretionary expenditure and a 10% reduction in the salaries for senior executives. The most important outcome was to sell the Construction business given its inconsistent results over recent years so CML would become a dedicated provider of contract mining services.
- A summary of CML’s financial performance over the last five years was set out below:
For the year ending 30June 2014 2013 2012 2011 2010
Revenue ($m) 1871 1254 1254 1486 1244
Underlying EBIT ($m) 89.6 66.1 55.3 29.8 74.7
Reported NPAT ($m) 56.1 1.0 37.9 17.2 48.8
Total assets ($m) 989.0 685.7 580.8 632.8 630.2
Net debt / (net cash) 82.6 (39.5) (43.8) 1.8 29.2
Shareholders’ funds ($m) 356.8 323.2 336.0 308.2 249.3
Reported EPS(cents) 7.7 0.1 5.2 3.1 9.2
Dividends per share (cents) 4.0 – 3.0 1.5 5.5
Gearing (Net debt/Equity) (%) 23.1 (12.2) (12.9) 0.6 11.6
4. The Board was comprised of six non-executive independent directors and the CEO. Meetings were held monthly. The following agenda itemswere to be discussed in the November meeting:
i. What would beCML’s company after-tax WACC based on its balance sheet as at 30/06/14?
ii. What would be CML’s Construction division cost of capital as at 30/06/14?
iii. What would be the fair value for the Construction division?
iv. A decision onthe new remuneration package for Nick Hall.
v. An update on CML’s profitability and capital structure.
vi. A decision on the dividendpolicy for 2014-15.
- CML calculated its company after-tax WACC based on the market value of the gross interest-bearing debt and equity securities outstanding at the balance date 30 June 2014. Aseparate cost of capital was also established for its two business divisions. The divisional WACC wasbased on the respective industry weighted average cost of capital.
- CML’s Balance Sheet as at 30 June 2014 showed the following data:
Payables 306306 Cash and cash equivalents 134894
Employee benefits 62825 Receivables 348671
Loans and borrowings 217474 Inventories 45311
Provisions 22389 Property, plant and equipment 417754
Tax liabilities 23191 Investments 11300
Share capital 307963 Intangibles 31066
Retained earnings 64422
Total claims 988996 Total assets 988996
- The equity beta of CML’s 738.6 million outstanding shares was estimated to be 2. The share price was $0.60. New shares could be placed with institutional investors at about 57.5 cents. The risk-free rate was assumed to be 3.0%. CML used a market risk premium of 6.5% in all cost of equity estimates. The company tax rate was 30%.
- One of CML’s joint venture partners, Henson Constructions, had made a preliminary offer to acquire the whole construction business. To ascertain a fair selling price forthe Construction division, Hall decided to construct the cash flow projections of Table 1.He used a 3-year valuation horizon and a terminal growth rate of 0% to estimate the terminal value. The cash flows in Year 1 were based on the revised forecasts. Hall expected the free cash flow in year 2 and beyond to be positive despite a loss in year 1. Hall used the construction industry after-tax weighted average cost of capital with a debt/equity ratio of 25% to discount the projected free cash flows. The industry equity beta was estimated to be 1.3 and the pre-tax industry cost of debt was 5.4%.
|Free Cash Flow for the Construction Division ($’000)|
|Operating cash flow||-67900|
|Investment in fixed assets||12000|
|Investment in working capital||-40000|
|Free cash flow||-39900|
|All figures are rounded to the nearest thousand dollars.|
|Revenue growth rate in years2-4||-20% per year|
|Variable cost as a percentage of revenuein years 2-4||80%|
|Fixed cost growth rate in years 2-4||3% per year|
|Depreciation||Constant $7 million per year|
|Investment in fixed assets in years 2-4||$5 million per year|
|Investment in working capital in years 2-4 is equal to 10% of the change in revenue from the previous year.|
9. In light of current market conditions and the impending sale of the Construction business, a new CEO employment contract was negotiated with Hall in November 2014. The new remuneration framework shifted the weighting of total remuneration from fixed pay towards variable ‘at risk’ pay. The goal was to encourage stronger than market growth in shareholder value over the short and longer term. The remuneration package was made up of three components: Total fixed remuneration (TFR), Short-term incentive (STI) and Long-term incentive (LTI).
10. The TFR was set at above industry median and was benchmarked at the 62.5th percentile compared to the peer companies in the ASX 101-200. Hall would receive a TFR of $1 million per annum.
11. Hall’s STI included the opportunity to earn an annual cash bonus of up to 125% of fixed remuneration, subject to achieving key performance indicators (KPIs). The STI plan comprised 60% for financial KPIs, 20% for safety KPI and 20% for personal KPIs. The financial KPIs included profit after tax, return on equity and order book growth. The safety KPI was based on the total recordable injury frequency rate. The personal KPIs were based on a number of personal targets such as developing and rolling out strategy across the company. 90% of company budgeted profit, set in July each year, had to be achieved before the gateway for STI payment would open. Importantly, Hall’s package also included a clawback provision whereby up to 30% of any STI awarded to Hall could be reclaimed by the company at any time for up to two years under certain circumstances.
12. The Long-term incentive (LTI) was an award of share performance rights which could be converted into fully paid shares subject to performance criteria being met and specified time restrictions. The number of performance rights issued to Hall would be based on an assessment of his ability to increase shareholder wealth. The LTI plan provided for 100% of performance rights to vest after three years if performance hurdles on total shareholder return (TSR) and earnings per share (EPS) growth were met. CML’s TSR performance over a three-year period would be compared to the median TSR of a group of eight peer entities with similar businesses over the same period. Vesting of the performance rights, in respect of half of the LTI grant, would depend on a percentile ranking. No shares would vest if CML’s ranking was below 50th percentile. Between 50th and 75th percentile, Hall would receive between 25% and 50% of the LTI entitlement on a straight line basis. At or above 75th percentile, Hall would receive 50% of the LTI entitlement.
13. EPS growth was based on the compounded annual growth rate of CML’s EPS over the preceding three-year performance period up to the latest balance date. No shares would vest if the EPS growth per annum was below 6%. Between 6% and 26% EPS growth per annum, Hall would receive between 25% and 50% of the LTI entitlement on a straight line basis. At or above 26% EPS growth rate, Hall would receive 50% of the LTI entitlement.
14. Gearing, defined by CMLas net debt to book equity, was 23.1% as at 30June 2014. This was within the maximum limit of 35%. Despite a continuing strong performance from the Mining division,CML was expected to record an overall loss for the 2014-15 financial year due to the huge operating loss from the Construction division and an impairment charge (asset write-down) on the construction business assets. In order to maintain a healthy balance sheet, the Board would like to have an equity issue to raise about $80 million. Further the Board would reduce the limit of its existing $475 million syndicated debt facility by $40 million with the impending exit of the construction business.The existing syndicated debt facility was secured by fixed and floating charges over CML’s assets. The facility attracted a variable rate of intereston the amount drawn down and the interest rate applicable at 30 June 2014 was 7.2%. Most of the borrowings were for equipment financing. All banking covenants remained within limits.
15. The Board targeted a dividend payout ratio of 50%. CMLreinstated its dividend reinvestment plan in 2013. A 1.5% discount would be applied to the price of the shares allocated under the plan. The planhad attracted a 29 percent participation rate from shareholders.
Answerthe following problems. All cash flow and present value figures must be rounded to the nearest thousand dollars. Show all workings and/or explanation.
- Calculate CML’s company after-tax WACC, rounded to four decimal places.
- Calculate the construction industry WACC, rounded to four decimal places.
- Complete Table 1 fully, in accordance with the given assumptions, to show howthe free cash flow inyears 1-4is derived.
- Calculate the terminal value as of year 3 using the constant-growth discounted cash flow formula.
- Show individually the discounted value, as of year 0,of the free cash flow in years 1-3plusthat of the terminal value. What would be the present value, as of year 0, of the Constructiondivision?
- If the Construction division were to be sold at the beginning of year 2, what would be the minimum selling price?
- Calculate the economic depreciation in year 1 based on the free cash flows in Table 1.
- Calculate the economic income in year 2 based on the free cash flows in Table 1.
- As a sensitivity analysis, calculate the percentage drop in the value of the Construction divisionas of year 0 if the revenue growth rate in years 2-4is changed to -22% while other assumptions are unchanged.All cash flows in year 1 remain the same.
- As a scenario analysis, calculate the value of the Construction division as of year 0 if the growth rate of the revenue and the fixed cost in years 2-4 are both 0% and the investment in fixed assets in years 2-4 is $12 million per year. Other assumptions and cash flows in year 1 remain unchanged.
- What would be the major reason for CML to set a TFR at above industry median?
- What would be the benefit of imposing a two-year clawback period in the STI award?
- From the viewpoint of the CEO, what would be the best feature in the design of the relative TSR performance measure? Explain.
- Would Hall receive any LTI,based on EPS growth criterion, in the financial year 2014-15? Explain.
- By making adjustments to the balance sheet as at 30 June 2014, calculate CML’s gearing, in percentage, if the company decided to recognisean extra one-off after-taximpairment charge(asset write-down) of $45 million and raised $80 million new equity on 30/06/2014.
- What would be the impact on CML’s gearing if the limit of the existing debt facility was reduced by $40 million on 30/06/2014? Explain.
- What should be the amount of the dividend payout for the 2014-15 financial year. Explain
- Isthe1.5% price discount on the DRP too high? Explain.