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1. CML Group was an entity involved in providing services to both the mining and construction
sectors. The Mining division provided a complete service for surface and underground
operation, from mine development to materials delivery. The Construction division provided
government and resource sector clients a diverse range of construction capabilities that
incorporated roads and bridges, rail, water and environment, marine and resource infrastructure.

2. In early September 2014, the company obtained monthly data about the operation of its
Construction business. This data indicated a deterioration in the profitability of the Construction
business, mainly caused by a rail project. The company immediately undertook investigations to
establish the reasons for the deterioration and the accuracy of the underlying data. Upon
analysis of further data, the company sent a senior manager to the rail project to determine the
nature and extent of the problem on the earnings. The project did not achieve the required
productivities and the company would deliver the project within the clients accelerated
timeframe at a significant loss.

3. As a result of the event, Nick Hall was appointed to become the new CEO of the company. A
strategic review of CMLs all businesses was conducted. The outcomes of the review were
announced in late October. These included a reduction in discretionary expenditure and a 10%
reduction in the salaries for senior executives. The most important outcome was to sell the
Construction business given its inconsistent results over recent years so CML would become a
dedicated provider of contract mining services.

4. A summary of CMLs financial performance over the last five years was set out below:
For the year ending 30 June

2014

2013

2012

2011

2010

Revenue ($m)

1871

1254

1254

1486

1244

Underlying EBIT ($m)

89.6

66.1

55.3

29.8

74.7

Reported NPAT ($m)

56.1

1.0

37.9

17.2

48.8

Total assets ($m)

989.0

685.7

580.8

632.8

630.2

Net debt / (net cash)

82.6

(39.5)

(43.8)

1.8

29.2

Shareholders funds ($m)

356.8

323.2

336.0

308.2

249.3

Reported EPS (cents)

7.7

0.1

5.2

3.1

9.2

Dividends per share (cents)

4.0

3.0

1.5

5.5

Gearing (Net debt/Equity) (%)

23.1

(12.2)

(12.9)

0.6

11.6

4. The Board was comprised of six non-executive independent directors and the CEO. Meetings
were held monthly. The following agenda items were to be discussed in the November meeting:
i. What would be CML's company after-tax WACC based on its balance sheet as at 30/06/14?
ii. What would be CMLs Construction division cost of capital as at 30/06/14?
iii. What would be the fair value for the Construction division?
iv. A decision on the new remuneration package for Nick Hall.
v. An update on CMLs profitability and capital structure.
vi. A decision on the dividend policy for 2014-15.

5. CML calculated its company after-tax WACC based on the market value of the gross interestbearing debt and equity securities outstanding at the balance date 30 June 2014. A separate cost
of capital was also established for its two business divisions. The divisional WACC was based
on the respective industry weighted average cost of capital.
6. CMLs Balance Sheet as at 30 June 2014 showed the following data:
($000)

($000)

Payables

306306

Cash and cash equivalents

134894

Employee benefits

62825

Receivables

348671

Loans and borrowings

217474

Inventories

45311

Provisions

22389

Property, plant and equipment

417754

Tax liabilities

23191

Investments

11300

Share capital

307963

Intangibles

31066

Reserves

(15574)

Retained earnings

64422

Total claims

988996

Total assets

988996

7. The equity beta of CMLs 738.6 million outstanding shares was estimated to be 2. The share
price was $0.60. New shares could be placed with institutional investors at about 57.5 cents.
The risk-free rate was assumed to be 3.0%. CML used a market risk premium of 6.5% in all
cost of equity estimates. The company tax rate was 30%.

8. One of CMLs joint venture partners, Henson Constructions, had made a preliminary offer to
acquire the whole construction business. To ascertain a fair selling price for the Construction
division, Hall decided to construct the cash flow projections of Table 1. He used a 3-year
valuation horizon and a terminal growth rate of 0% to estimate the terminal value. The cash
flows in Year 1 were based on the revised forecasts. Hall expected the free cash flow in year 2
and beyond to be positive despite a loss in year 1. Hall used the construction industry after-tax
weighted average cost of capital with a debt/equity ratio of 25% to discount the projected free
cash flows. The industry equity beta was estimated to be 1.3 and the pre-tax industry cost of
debt was 5.4%.

Table 1
Free Cash Flow for the Construction Division ($000)
t=1
Revenue

440000

Variable cost

500000

Fixed cost

t=4

7000
-107000

Tax (30%)

32100

Net income

-74900

Depreciation
Operating cash flow

t=3

40000

Depreciation
Operating income

t=2

7000
-67900

Investment in fixed assets

12000

Investment in working capital

-40000

Free cash flow

-39900

All figures are rounded to the nearest thousand dollars.


Assumptions:
Tax rate

30%

Revenue growth rate in years 2-4

-20% per year

Variable cost as a percentage of revenue in years 2-4

80%

Fixed cost growth rate in years 2-4

3% per year

Depreciation

Constant $7 million per year

Investment in fixed assets in years 2-4

$5 million per year

Investment in working capital in years 2-4 is equal to 10% of the change in revenue from the
previous year.

9. In light of current market conditions and the impending sale of the Construction business, a
new CEO employment contract was negotiated with Hall in November 2014. The new
remuneration framework shifted the weighting of total remuneration from fixed pay towards
variable at risk pay. The goal was to encourage stronger than market growth in shareholder
value over the short and longer term. The remuneration package was made up of three
components: Total fixed remuneration (TFR), Short-term incentive (STI) and Long-term
incentive (LTI).

10. The TFR was set at above industry median and was benchmarked at the 62.5th percentile
compared to the peer companies in the ASX 101-200. Hall would receive a TFR of $1 million
per annum.

11. Halls STI included the opportunity to earn an annual cash bonus of up to 125% of fixed
remuneration, subject to achieving key performance indicators (KPIs). The STI plan comprised
60% for financial KPIs, 20% for safety KPI and 20% for personal KPIs. The financial KPIs
included profit after tax, return on equity and order book growth. The safety KPI was based on
the total recordable injury frequency rate. The personal KPIs were based on a number of
personal targets such as developing and rolling out strategy across the company. 90% of
company budgeted profit, set in July each year, had to be achieved before the gateway for STI
payment would open. Importantly, Halls package also included a clawback provision whereby
up to 30% of any STI awarded to Hall could be reclaimed by the company at any time for up to
two years under certain circumstances.

12. The Long-term incentive (LTI) was an award of share performance rights which could be
converted into fully paid shares subject to performance criteria being met and specified time
restrictions. The number of performance rights issued to Hall would be based on an assessment
of his ability to increase shareholder wealth. The LTI plan provided for 100% of performance
rights to vest after three years if performance hurdles on total shareholder return (TSR) and
earnings per share (EPS) growth were met. CMLs TSR performance over a three-year period
would be compared to the median TSR of a group of eight peer entities with similar businesses
over the same period. Vesting of the performance rights, in respect of half of the LTI grant,
would depend on a percentile ranking. No shares would vest if CMLs ranking was below 50th
percentile. Between 50th and 75th percentile, Hall would receive between 25% and 50% of the
LTI entitlement on a straight line basis. At or above 75th percentile, Hall would receive 50% of
the LTI entitlement.

13. EPS growth was based on the compounded annual growth rate of CMLs EPS over the
preceding three-year performance period up to the latest balance date. No shares would vest if
the EPS growth per annum was below 6%. Between 6% and 26% EPS growth per annum, Hall
would receive between 25% and 50% of the LTI entitlement on a straight line basis. At or
above 26% EPS growth rate, Hall would receive 50% of the LTI entitlement.

14. Gearing, defined by CML as net debt to book equity, was 23.1% as at 30 June 2014. This
was within the maximum limit of 35%. Despite a continuing strong performance from the
4

Mining division, CML was expected to record an overall loss for the 2014-15 financial year due
to the huge operating loss from the Construction division and an impairment charge (asset
write-down) on the construction business assets. In order to maintain a healthy balance sheet,
the Board would like to have an equity issue to raise about $80 million. Further the Board
would reduce the limit of its existing $475 million syndicated debt facility by $40 million with
the impending exit of the construction business. The existing syndicated debt facility was
secured by fixed and floating charges over CMLs assets. The facility attracted a variable rate of
interest on the amount drawn down and the interest rate applicable at 30 June 2014 was 7.2%.
Most of the borrowings were for equipment financing. All banking covenants remained within
limits.

15. The Board targeted a dividend payout ratio of 50%. CML reinstated its dividend
reinvestment plan in 2013. A 1.5% discount would be applied to the price of the shares
allocated under the plan. The plan had attracted a 29 per cent participation rate from
shareholders.

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 CMLs company after-tax WACC, rounded to four decimal places.

2. Calculate the construction industry WACC, rounded to four decimal places.


3.

Complete Table 1 fully, in accordance with the given assumptions, to show how the free
cash flow in years 1-4 is derived.

4.

Calculate the terminal value as of year 3 using the constant-growth discounted cash flow
formula.

5.

Show individually the discounted value, as of year 0, of the free cash flow in years 1-3
plus that of the terminal value. What would be the present value, as of year 0, of the
Construction division?

6.

If the Construction division were to be sold at the beginning of year 2, what would be the
minimum selling price?

7.

Calculate the economic depreciation in year 1 based on the free cash flows in Table 1.

8.

Calculate the economic income in year 2 based on the free cash flows in Table 1.

9.

As a sensitivity analysis, calculate the percentage drop in the value of the Construction
division as of year 0 if the revenue growth rate in years 2-4 is changed to -22% while
other assumptions are unchanged. All cash flows in year 1 remain the same.

10.

As a scenario analysis, calculate the value of the Construction division as of year 0 if the
growth rate of the revenue and the fixed cost in years 2-4 are both 0% and the investment

in fixed assets in years 2-4 is $12 million per year. Other assumptions and cash flows in
year 1 remain unchanged.
11.

What would be the major reason for CML to set a TFR at above industry median?

12.

What would be the benefit of imposing a two-year clawback period in the STI award?

13.

From the viewpoint of the CEO, what would be the best feature in the design of the
relative TSR performance measure? Explain.

14.

Would Hall receive any LTI, based on EPS growth criterion, in the financial year 201415? Explain.

15.

By making adjustments to the balance sheet as at 30 June 2014, calculate CMLs gearing,
in percentage, if the company decided to recognise an extra one-off after-tax impairment
charge (asset write-down) of $45 million and raised $80 million new equity on
30/06/2014.

16.

What would be the impact on CMLs gearing if the limit of the existing debt facility was
reduced by $40 million on 30/06/2014? Explain.

17.

What should be the amount of the dividend payout for the 2014-15 financial year. Explain

18.

18. Is the 1.5% price discount on the DRP too high? Explain.

***Do not use more than 50 words to explain the answer in any question.
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***font size 12
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