¬¬CFTP Case Study 2015 Spring Semester
1. BAX Group was a diversified industrial company with four main divisions – Construction Products, Garage Doors, Water Products, and Cabinets and Windows. BAX supplied innovative branded products to trade customers in the building products markets. These businesses had evolved through a series of divestments and acquisitions since 2001. BAX business model was to develop a sustainable building products business with market leading brands, capable of performing strongly at any time of the cycle.
2. 2014-2015 was a challenging year for BAX. The company continued to rationalise and reposition its portfolio of businesses and implemented a turnaround programme “Project Restore” across all the divisions. The revenue and EBIT were impacted by the loss-making water products business. The company incurred significant items after tax totalling $25 million loss relating to asset sales. The company’s net debt reduced to $66 million at 30 June 2015 with gearing (net debt divided by net debt plus book equity) at 14%. The final dividend was yet to be decided though an interim dividend of 3 cents per share was paid in March 2015.
3. BAX’s recent financial performance was summarised in the following table:
Financial year ending 30 June 2015 2014 2013 2012 2011
Revenue ($ million)* 460 479 484 513 562
EBIT ($ million)** 32.2 40.3 32.1 33.3 58.3
Amortisation of intangibles ($ million) -5.8 -8.3 -10.8 -15.6 -6.8
Profit after tax ($ million) -13.9 13.6 -124.3 -12.8 58.0
Net debt ($ million) 66 78 129 160 319
Shareholders’ equity ($ million) 406 433 428 551 594
Earnings per share (cents) -14.7 14.4 -132.8 -13.9 67.2
Dividends per share (cents)*** 3 14 7 7 67
Interest cover (times)** 4.4 3.8 3.7 2.5 5.3
* From continuing business
** Before significant items
*** Interim dividend of 3 cents per share paid in March 2015 but final dividend yet to be decided; a special dividend of 5.5 cents per share was paid in 2014 financial year from an asset sale
4. The Board was comprised of six non-executive directors and the Managing Director, John Singleton. The Board met on a regular scheduled basis twenty times a year. The following agenda items were discussed at the last Board meeting:
i. What would be BAX's company after-tax WACC based on its capital structure as at 30/06/15?
ii. Should a different cost of capital be established for the four business divisions? How should each divisional cost of capital be measured?
iii. An update on Singleton’s CEO remuneration.
iv. Should BAX sell its Water Products division and for how much?
v. How should the proceeds of the sale be applied?
vi. How much should be the final dividend for 2015 financial year?
5. BAX had established a capital allocation policy that required NPV to be used in all investment decisions. The after-tax WACC for the company was calculated annually using the market value of the gross interest–bearing debt and equity securities outstanding at the balance date. Singleton reported that the company WACC was about 10 percent at the end of June 2015.
6. BAX’s Balance Sheet as at 30 June 2015 showed the following data:
($’000) ($’000)
Payables 58627 Cash and cash equivalents 3082
Current tax liabilities 4100 Receivables 76651
Loans and borrowings 69000 Inventories 73148
Provisions 21753 Property, plant and equipment 56730
Share capital 418543 Deferred tax assets 11858
Reserves 5519 Intangibles 335307
Retained earnings (18041) Other 2725
Total claims 559501 Total assets 559501
7. The equity beta of BAX’s 94.2 million outstanding shares was estimated to be 1.44. The share price was $1.97. New shares could be placed with institutional investors at about $1.88. The risk-free rate was assumed to be 2.82%. BAX used a market risk premium of 6.5% in all cost of equity estimates. The company tax rate was 30%.
8. BAX reduced the limit of its existing bank loan facilities in April 2015 from $160 million to $130 million. Bank loans were denominated in Australian dollars and were variable interest debt. BAX had utilised $69 million of the loan facilities at the balance date with an interest rate of 7.4%. BAX had also arranged a bank overdraft facility with a $4.8 million limit, but no overdrafts were used in the financial year. The interest rate for the overdrafts as at the balance date was 6.3%. BAX complied with all financial covenants during the year ended 30 June 2015.
9. The Board decided that a separate cost of capital should be established for all its business divisions. The divisional WACC would be based on the respective industry weighted average cost of capital. New projects evaluated by each division would be classified into three categories: high risk, average risk and low risk. High risk projects would be evaluated at the yet-to-be-determined divisional WACC plus 2%; average projects at the divisional WACC; and low risk projects at the divisional WACC minus 1.5%.
10. In July 2015 a review of the CEO remuneration was conducted at the direction of the Board, with the assistance of an external independent remuneration consultant. The review recommended a framework that included a new mix of fixed and variable remuneration which sought to maximise the financial performance of the company over time. The fixed annual remuneration (FAR) was pitched at a market median based on the 50th percentile of a selected comparator group of companies that BAX might compete with or were in a similar industry to BAX. Singleton would receive a FAR of $750,000 for the new financial year of 2015/16.

11. Variable remuneration included both short-term and long-term performance incentives. BAX’s Short Term Incentive Plan (STIP) rewarded Singleton for delivering financial performance in line with agreed annual business plans and targets. These measures were profit after tax including significant items, return on net assets and improvements in safety outcomes. The maximum STIP cash payment outcome achievable for Singleton would be 100% of FAR.
12. Long Term Incentive Plan (LTIP) was designed to align executive’s interests with those of BAX’s shareholders. An annual grant of performance rights equivalent to 100% of FAR would be awarded to Singleton. The vesting of performance rights was subject to two performance hurdles, each of which accounted for 50% of the maximum total award and were assessed separately over a three-year period commencing 1 July 2015 and ending 30 June 2018.
13. The first performance hurdle was the compound annual growth in earnings per share (EPS). Vesting of performance rights commenced when EPS growth exceeded 0% and increased on a pro rata basis to 10% EPS growth where the maximum award would be achievable. The EPS base was set at 19.2 cents per share.
14. The second performance hurdle was the total shareholder return (TSR) benchmarked against ASX Small Ordinaries Index. The constituent group of the Small Ordinaries Index was considered to appropriately reflect BAX’s market and competitive position. The minimum ranking required for vesting was the 51st percentile of the peer group, at which point 50% of the TSR portion of the award would vest. Maximum vesting would occur at the 75th percentile or above.
15. The Board received an offer from a private equity group to acquire the Water Products division for $20 million. Despite expecting a turnaround for the water products industry and implementing measures to cut fixed operating costs, the Board was quite keen to divest the division. Singleton pointed out that the selling price ought to reflect the value of an expansion project as further store upgrades and rebranding would be undertaken in a year’s time.
16. To establish the weighted average cost of capital for the Water Products division, Singleton used an industry equity beta of 1.80. Combining it with an industry debt-equity ratio of 0.6 and an industry cost of debt of 7.3%, Singleton was able to work out the industry WACC and used it as the divisional WACC.
17. To ascertain a fair selling price for the Water Products division, Singleton decided to use the latest management estimates of financial forecast for the next five years to construct the cash flow projections of Table 1. BAX used a 4-year valuation horizon and a terminal growth rate of 3% to estimate the terminal value. Singleton applied the industry after-tax WACC to discount the projected cash flows.
18. A $2.2 million store upgrade project of Water Products division would begin in a year’s time. The after-tax cash flows from the upgrade, generated over and above the cash flows expected in Table 1, were projected in Table 2. The cash flow in year 5 in Table 2 had already incorporated the discounted value of all subsequent cash flows beyond year 5. The upgrade project was considered to be low-risk.
19. The Board was divided on how to apply the proceeds of the Water Products division, if the sale was approved. A Board member suggested the proceeds to be used to reduce the gearing level though Singleton preferred a payout to shareholders. There were no major capital expenditure needs in the immediate future.
20. BAX’s normal dividend policy was to have a full year dividend payout ratio of 60-80% of net profit after tax. Due to losses suffered in 2012 and 2013, BAX dramatically cut down its dividend from 67 cents to 7 cents. Singleton suggested a final dividend of 5 cents per share to be paid in October 2015. He also advised the Board that the DRP, which was suspended since 2013, should remain suspended.

Table 1
Free Cash Flow for the Water Products division ($’000)
t=1 t=2 t=3 t=4 t=5
Revenue 18000
Variable cost 12600
Fixed cost 3000
Depreciation 600
Operating income 1800
Tax (30%) 540
Net income 1260
Depreciation 600
Operating cash flow 1860
Investment in fixed assets 900
Investment in working capital 200
Free cash flow 760
All figures are rounded to the nearest thousand dollars.
Assumptions:
Tax rate 30%
Revenue growth rate in year 2 10%
Revenue growth rate in year 3 6%
Revenue growth rate in year 4 4%
Revenue growth rate from year 5 onwards 3%
Variable cost as a percentage of sales in years 1-5 70%
Fixed cost growth rate 3% per year
Depreciation growth rate in years 2-5 Constant $600,000 per year
Investment in fixed assets in years 2-5 Constant $900,000 per year
Investment in working capital in years 2–5 is equal to 10% of the change in revenue from the previous year.
Table 2
After-tax cash flow projections for ‘Upgrade’ project ($’000)
Year Cash flow Discounted value at a notional rate 10%
t=1 -2200 -2200
t=2 360 327
t=3 430 355
t=4 470 353
t=5 3800 2593
NPVt=1 = 1431
Instructions:
Answer the following problems. All cash flow and present value figures must be rounded to the nearest thousand dollars. Show all workings and/or explanation.
1. Calculate BAX’s company after-tax WACC, rounded to four decimal places.
2. Calculate the Water Products division WACC, rounded to four decimal places.
3. What was the reason for BAX to set the FAR at the market median?
4. What was the reason to use the financial measure of Return on Net Assets, in addition to profit after tax including significant items, for STIP?
5. Would Singleton be able to receive any LTIP reward, based on EPS growth criterion? Explain.
6. What was the underlying reason for BAX to benchmark its TSR against an external market performance?
7. Complete Table 1 fully, in accordance with the given assumptions, to show how the free cash flow in years 1-5 is derived.
8. Calculate the terminal value as of year 4 using the constant-growth discounted cash flow formula.
9. Show individually the discounted value, as of year 0, of the free cash flow in years 1-4 plus that of the terminal value. What would be the present value, as of year 0, of the Water Products division?
10. Calculate the economic depreciation in year 1 based on the free cash flows in Table 1.
11. As a scenario analysis, calculate the value of the Water Products division as of year 0 if the growth rate of the revenue and fixed cost in years 2-5 are both 3% and the investment in working capital in years 2-5 is equal to 20% of the change in revenue from the previous year. Other assumptions and cash flows in year 1 remain unchanged.
12. Using the appropriate project cost of capital to discount “Upgrade” cash flow projections in Table 2, calculate the NPVt=1 of the “Upgrade” project.
13. Calculate the value of the Water Products division, as of year 0, with the Upgrade project considered.
14. If the Water Products division were to be sold in a year’s time, calculate the minimum selling price. Assume BAX had already received the free cash flow of $760,000 in year 1.
15. Was there any need for BAX to reduce its gearing? Explain.
16. If BAX were to use (part of or all of) the sale proceeds of the Water Products division for a payout to shareholders, in which specific form of payout should BAX choose to use? Explain the details.
17. Provide a valid reason for the DRP to remain suspended.
18. If BAX decided to retain the Water Products division and the firm’s financial position at the commencement of the Upgrade project next year remained the same as at 30/06/2015, name the specific source of finance to fund the Upgrade project.

Presentation: The assignment is to be typed, doubled spaced with a font size of 12 (no smaller than this font size). The length of the submitted work should not exceed 7 A4 pages including the cover page and any spreadsheet.
Answer each question in correct sequence. Do not separate any table/spreadsheet from the body of the answers. No appendices should be used.
Do not use more than 50 words to explain the answer in any question. No mark will be awarded in any question if exceeding the word limit.