Varieties of buyouts: Two oft-quoted varieties of buyouts are:

Leveraged buyouts (LBO) and management buyouts (MBO)

LBO is the purchase of assets or the equity of a company where the buyer in which the purchaser uses a significant amount of debt and very little equity capital of his own for payment of the consideration for acquisition. It has often been described as buying a business with other people's money.

MBO is the purchase of a business by its management, who when threatened with the sale of its business to third parties or frustrated by the slow growth of the company, step in and acquire the business from the owners, and run the business for themselves.

The financing of an MBO is similar to the LBO model, namely, debt funds are used by the buyer to pay the purchase consideration.

Companies ripe for an LBO/MBO: Many companies have their share prices below its net asset values. The company would usually have a steady income, but is unlikely to increase its annual profits in multiples. Additionally, the steady profit growth is not sufficiently reflected in its share price also. New investors are thus attracted, and make a bid for acquisition, for either of two reasons:

a) they are confident of growing the company at a much faster rate; or

b) they recognise that the real value of company's its assets when sold, is a significant multiple of its book value.

Required, return

MR A CAN earn a return of 16 per cent by investing in equity shares on his own. Now, he is considering a recently announced equity-based MF scheme in which initial expenses are 5.5 per cent and annual recurring expenses are 1.5 per cent. How much should the mutual fund earn, to provide Mr A return of 16 per cent?

Assumptions made in the following computations are: a) value of one unit is Rs 10; b) period of holding is one year; c) annual recurring expenses (ARE) is on initial investment; and d) return of 16 per cent expected by the investor is on his investment of Rs 10.

i) Let us take that money raised is Rs 10

ii) SEBI guidelines require that the initial expenses of a MF should be written off in entirety in the period in which it is incurred. The impact and effect of this stipulation is that, where initial expenses of an MF is 5.5 per cent, its initial NAV will be correspondingly lower by that percentage. The NAV at commencement, after absorbing initial expenses will be Rs 10 minus 0.55 paise, that is, Rs 9.45.

iii) Money available for investment with MF is, therefore, Rs 9.45.

iv) The earnings of the fund should be such as would meet a) returns expected by investors, and ARE of the fund.

v) After meeting ARE, the NAV at the end of period should be Rs 11.75 (10.00 + 0.15 + 1.60)

vi) The fund should grow from the initial base of Rs 9.45 to Rs 11.75; a growth of Rs 2.30 on a base of 9.45.

vii) Translated in percentage terms, this represents 24.338 per cent or, say, 24.34 per cent

viii) If, however, ARE are assumed to be on the initial base of Rs 9.45, NAV at the end of the period should be Rs 11.74; and this represents a return of 24.23 per cent.

Finding beta

THE rates of return on the security of Company X and the market portfolio for 10 periods are given in Table 6.

i) What is the beta of security X?

ii) What is the characteristic line for security X?

Solution: The beta value of a security is determined by variance of the market divided by covariance between the security and market. For determining this, the following steps are adopted.

The beta value can be thereafter be derived as

[summation of nxy] minus [n*X{circ} Y{circ}] divided by [summation of x{+2} (minus) nX{circ}{+2} ] (See Table 7.)

= 2157 minus 10 (12)(15) / 2146 minus 10(12){+2} = 2157 (-)1800 / 2146 (-) 1440 = 357/640. Beta value of security X is = 0.50566 (or 0.50)

The alternative approach in arriving at the beta value is shown in Table 8.

Beta is covariance divided by square of variance of market, 357/706 = 0.50

Characteristic line: To find the characteristic line, we review the past data, say, for ten periods, as indicated in the problem, and compare the share's risk premium with the market portfolio's risk premium or the stock market index premium. The risk premium is an element that represents actual return over risk-free return. For each period, the risk premium element for a) the market; and b) security X can be derived from the relevant risk-free rates. For each period, we get a pair of data. (The problem is eloquently silent on the risk-free rate).

These pairs are plotted in a scatter diagram, and a regression analysis undertaken to identify the alpha and beta value coefficients of the regression equation, and from this scatter graph, we can draw a regression characteristic line.

This regression characteristic line shows link between market risk premium and the share's risk premium. What we derived with the help of a statistical model is the beta value of the regression equation. The `b' coefficient (the beta) describes the slope of the characteristic line, and so indicates the degree to which the share's risk premium reacts to changes in the market portfolio's risk premium.

Many situations are possible. But, important among these are:

i) If the slope of the beta coefficient is {gt} 1, it indicates that movements in the share's risk premium will be more than the movement in the market risk premium.

ii) Conversely, if the slope of the beta cefficient is 1, it indicates that movements in the share's risk premium will be less than the market risk premium

c) If the slope is `1', then movements in the share's risk premium will tend to be the same as that of market's.

In the given case, the slope is less than one (half of one). It indicates that movements in the share's risk premium will be less than movements in risk premium in the market portfolio.

Pricing debentures

AGFA Industries is planning to issue a debenture series on the following terms:

Face value Rs 100: Term of maturity 10 years

Yearly coupon rate: 1-4, 9 per cent; 5-8, 10 per cent; and 9-10, 14 per cent.

The current market rate on similar debentures is 15 per cent per annum. The company proposes to price the issue in such a manner that it can yield 16 per cent compounded rate of return to investors. The company also proposes to redeem the debentures at 5 per cent premium on maturity. Determine the issue price of debentures.

Solution: The issue price of debentures should be equal to the present value computed at 16 per cent discount factor of the future cash flows from the debentures, such that it yields an IRR at 16 per cent. The cash flows comprise both interest paid to investor annually, and the redemption value emerging on terminal date. The computation at 16 per cent is shown in Table 9.

The initial investment (taken as a negative figure) of Rs 71.2944 gives a return of 16 per cent on the debentures.

Ignoring any other issue costs, the recommended issue price is Rs 71.29.

(Suggested answers to November 2003 CA (Final) paper on management and financial analysis.)

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