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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 company’s medium-term borrowing and to reinvest

the balance in the business (option 1). However, the company’s 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 company’s financial performance, cost of 

capital and market value.

Attached is the summarised BBS Stores’ statement of financial position. The company owns all its stores.As at As at

year end year end

2008 2007

$m $m

ASSETS

Non-current assets

Intangible assets 190 160

Property, plant and equipment 4,050 3,600

Other assets 500 530–––––– ––––––4,740 4,290

Current assets 840 1,160–––––– ––––––

Total assets 5,580 5,450–––––– ––––––

LIABILITIES

Current liabilities 1,600 2,020

Non-current liabilities

Medium-term loan notes 1,130 1,130

Other non-financial liabilities 890 900–––––– ––––––2,020 2,030

–––––– ––––––

Total liabilities 3,620 4,050–––––– ––––––Net assets 1,960 1,400

–––––– ––––––

EQUITY

Called up share capital – equity 425 420

Retained earnings 1,535 980–––––– ––––––

Total equity 1,960 1,400–––––– ––––––

The company’s profitability has improved significantly in recent years and earnings for 2008 were $670 million

(2007: $540 million).

The company’s property, plant and equipment within non-current assets for 2008 are as follows:

Fixtures, Assets

Land and fittings & under

buildings equipment construction Total

$m $m $m $m

Year end 2008

At revaluation 2,297 4,038 165 6,500

Accumulated depreciation (2,450) (2,450)–––––– –––––– –––– –––––––

Net book value 2,297 1,588 165 4,050–––––– –––––– –––– –––––––

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

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In recent years commercial property values have risen in real terms by 4% per annum. Current inflation is 2·5% 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 valueof 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 medium-

term 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 5·5% in exchange for LIBOR which is also currently 5·5%. The reduction in the firm’s

gearing implied by option 1 would improve the firm’s 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 firm’s

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 1·824. A representative portfolio of commercial property companies has an

equity beta of 1·25 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 company’s 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 shareprice 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)

5 [P.T.O.