ProblemsEstimates of the various factors relating to Kane, assuming that it continues to be a
subsidiary of Focus, have been made, and these are shown in notes 1 to 8 below. All
of the cash flows are expressed in terms of current (that is, beginning of year 1) prices.
The years referred to are the accounting years of Focus (and Kane).
1 Sales revenue for year 1 is estimated at either £6 million (60 per cent probable) or
£5 million (40 per cent probable). If sales revenue in year 1 is at the higher level, year
2 sales revenue is estimated at either £4 million (80 per cent probable) or £3 million
(20 per cent probable). If year 1 sales revenue is at the lower level, year 2 sales
revenue is estimated at either £3 million (20 per cent probable) or £2 million (80 per
cent probable). If year 2 sales revenue is at the £4 million level, year 3 sales revenue
is estimated at either £3 million (50 per cent probable) or £2 million (50 per cent
probable). At any other level of year 2 sales revenue, year 3 sales revenue is estim-
ated at £2 million (100 per cent probable).
2 Variable costs are expected to be 25 per cent of the sales revenue.
3 Avoidable fixed costs are estimated at £1 million p.a. This does not include
depreciation.
4 It is expected that Kane will operate throughout the relevant period with zero
working capital.
5 When the closedown occurs at the end of year 3, there will be closedown costs
(including redundancy payments to certain staff ) estimated at £0.5 million, payable
immediately on closure. The premises will be put on the market immediately. The
premises can be sold during year 4 for an estimated £2 million, and the cash would
be received at the end of year 4. This is not expected to give rise to any tax effect.
The plant is old and would not be expected to yield any significant amount. The tax
effects of the plant disposal are expected to be negligible.
6 The corporation tax rate for Focus is expected to be 30 per cent over the relevant
period. It may be assumed that tax will be payable at the end of the accounting year
to which it relates.
7 Focus’s cost of capital is estimated for the next few years at 14 per cent p.a., in
‘money’ terms.
8 The rate of inflation is expected to average about 5 per cent p.a. during the relevant
period. All of Kane’s cash flows are expected to increase in line with this average rate.
Senior managers at Kane disagreed with the Focus directors’ pessimistic view of
Kane’s potential. Shortly after the announcement of Focus’s intentions for Kane, the
Focus board was approached by some of Kane’s managers with a view to looking at
the possibility of an immediate management buy-out, to be achieved by the managers
buying the entire share capital of Kane from Focus. The managers had taken steps to
find possible financial backers and believed that they could find the necessary support
and produce cash at relatively short notice. The board of Focus was asked to suggest
a price for Kane as a going concern.
The Focus board was sympathetic to the Kane managers’ proposal and decided to
set the offer price for the buy-out at the economic value of Kane to Focus, as if Kane
remained a group member until its proposed closedown in three years’ time. The eco-
nomic value would be based on the expected present value of Kane’s projected cash
flows, Focus’s tax position and Focus’s cost of capital. Put another way, Focus was
prepared to sell the Kane shares at a price that would leave the Focus shareholders as
well off as a result of the management buy-out as they would be were Kane to wind
down over the next three years as outlined above.
(a) How much will the Kane managers be asked to pay for the shares? (Work in ‘money’
terms.) ‘