2

BBS Stores, a publicly quoted limited company, is considering unbundling a section of its property portfolio. The
company believes that it should use the proceeds to reduce the companys medium-term borrowing and to reinvest
the balance in the business (option 1). However, the companys investors have argued strongly that a sale and rental
scheme would release substantial cash to investors (option 2). You are a financial consultant and have been given
the task of assessing the likely impact of these alternative proposals on the companys financial performance, cost of
capital and market value.
Attached is the summarised BBS Stores statement of financial position. The company owns all its stores.

ASSETS
Non-current assets
Intangible assets
Property, plant and equipment
Other assets
Current assets
Total assets
LIABILITIES
Current liabilities
Non-current liabilities
Medium-term loan notes
Other non-financial liabilities

Total liabilities
Net assets
EQUITY
Called up share capital equity
Retained earnings
Total equity

As at
year end
2008
$m

As at
year end
2007
$m

190
4,050
500

4,740
840

5,580

160
3,600
530

4,290
1,160

5,450

1,600

2,020

1,130
890

2,020

3,620

1,960

1,130
900

2,030

4,050

1,400

425
1,535

1,960

420
980

1,400

The companys profitability has improved significantly in recent years and earnings for 2008 were $670 million
(2007: $540 million).
The companys property, plant and equipment within non-current assets for 2008 are as follows:
Land and
buildings
$m
Year end 2008
At revaluation
Accumulated depreciation
Net book value

2,297

2,297

Fixtures,
fittings &
equipment
$m

Assets
under
construction
$m

4,038
(2,450)

1,588

165

165

Total
$m
6,500
(2,450)

4,050

The property portfolio was revalued at the year end 2008. The assets under construction are valued at a market value
of $165 million and relate to new building.

In recent years commercial property values have risen in real terms by 4% per annum. Current inflation is 25% per
annum. Property rentals currently earn an 8% return.
The proposal is that 50% of the property portfolio (land and buildings) and 50% of the assets under construction
would be sold to a newly established property holding company called RPH that would issue bonds backed by the
assured rental income stream from BBS Stores. BBS Stores would not hold any equity interest in the newly formed
company nor would they take any part in its management.
BBS Stores is currently financed by equity in the form of 25c fully paid ordinary shares with a current market value
of 400c per share. The capital debt for the company consists of medium-term loan notes of which $360 million are
repayable at the end of two years and $770 million are repayable at the end of six years. Both issues of mediumterm notes carry a floating rate of LIBOR plus 70 basis points. The interest liability on the six year notes has been
swapped at a fixed rate of 55% in exchange for LIBOR which is also currently 55%. The reduction in the firms
gearing implied by option 1 would improve the firms credit rating and reduce its current credit spread by 30 basis
points. The change in gearing resulting from the second option is not expected to have any impact upon the firms
credit rating. There has been no alteration in the rating of the company since the earliest debt was issued.
The BBS Stores equity beta is currently 1824. A representative portfolio of commercial property companies has an
equity beta of 125 and an average market gearing (adjusted for tax) of 50%. The risk free rate of return is 5% and
the equity risk premium is 3%. The companys current accounting rate of return on new investment is 13% before
tax. You may assume that debt betas are zero throughout.
The effective rate of company tax is 35%.
Required:
On the assumption that the property unbundling proceeds, prepare a report for consideration by senior
management which should include the following:
(a) A comparative statement showing the impact upon the statement of financial position and on the earnings
per share on the assumption that the cash proceeds of the property sale are used:
(i) To repay the debt, repayable in two years, in full and for reinvestment in non-current assets;
(ii) To repay the debt, repayable in two years, in full and to finance a share repurchase at the current share
price with the balance of the proceeds.
(13 marks)
(b) An estimate of the weighted average cost of capital for the remaining business under both options on the
assumption that the share price remains unchanged.
(10 marks)
(c) An evaluation of the potential impact of each alternative on the market value of the firm (you are not required
to calculate a revised market value for the firm).
(6 marks)
Professional marks will be awarded in question 2 for the clarity, presentation and persuasiveness of the report.
(3 marks)
(32 marks)

[P.T.O.