Divestiture (Divestment)

October 27June 29Firmsconsulting 1 Comment

Divestiture, which is also called divestment, refers to a company selling (divesting) parts of its business or specific assets because it believes that by following such an action the value of the business will be improved. As an example, a company may sell part of its operations which is not a core business so that it can focus its full attention on the core business and invest money obtained from the sale on expansion of the core business.

Sometimes selected operating units or departments are sold to its current management. Such transactions are usually financed via leveraged buyouts (LBOs).

Spin-off is another way to undertake divestment. This occurs when a certain operating unit becomes an independent business.

If a buyer cannot be found for part of the business or specific assets the business no longer would like to keep, then liquidation of the business or assets is another option in which divestiture can be accomplished. Liquidation is, for obvious reasons, the least attractive option to accomplish divestiture.

It is often the case that an organization’s breakup value is greater than its current value. Breakup value, which is also called private market value (PMV), refers to the sum of values of each part of the business that could have been sold independently. A company with a high breakup value is more attractive acquisition target for acquiring company. This is because the acquirer can keep the valuable parts and sell the parts it does not need at a high price and use the money to pay down the price of the original acquisition.

Unsophisticated capital budgeting techniques

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Simple (unsophisticated) capital budgeting techniques include average rate of return (ARR) and the payback method (also called PB or payback period).

Average Rate of Return

Average Rate of Return (ARR) is an unsophisticated budgeting technique and generally considered to be ineffective. Average Rate of Return (ARR) evaluates relative profitability of the investment. In other words, it evaluates how project affects accounting profits. Average Rate of Return (ARR) is calculated as follows:

ARR = Average income / Average investment

Average income refers to annual average net profits after tax (refer to income statement to see how net profits after tax are determined). Annual average net profits after tax is found by taking total net profits after tax over the useful life of the project and dividing it by number of years over useful life of the project. Average investment refers to average investment over the economic life of the project. The ARR capital budgeting technique does not consider the time value of money. It also considers net profits rather than cash inflows. Consequently, the technique overlooks the possibility of reinvestment of returns.

The positive side of this technique, as compared to payback period discussed below, is that it considers returns on investment over entire useful life of the project. However, this technique is generally not recommended.

Payback method

Payback period (PB), also called a payback method, is another unsophisticated budgeting technique. It determines how long it takes to recover the initial investment by taking into account cash inflows from the investment. If we deal with an annuity (an equal periodic cash flow over a specific period) than all we need to do is to divide initial investment by an annuity.

However, if we deal with a mixed stream of cash inflows (unequal cash flows during specific period with no precise pattern) than we need to add up cash flows until the initial investment is recovered.

Management needs to subjectively determine the maximum payback period and then projects are evaluated according to this. If the project’s payback period is below maximum than the project is acceptable and vice versa.

The payback period budgeting technique measures business’s risk exposure because the project’s risk level depends on how long it takes to recover the initial investment. However, it does not explicitly consider the time value of money.

Moreover, this budgeting technique is weak because it is subjective in nature since the minimum payback period is subjectively determined. Furthermore, it does not take into account the cash flows that occur after the payback period.

A variation of payback period capital budgeting technique allows to account for time value of money and risk (due to usage of discount rate which incorporates risk). Such variation is called discounted payback period technique. This technique determines how long it takes for discounted cash flows to recover the investment. However, this variation still does not consider cash flows after the payback period.

Test Yourself

ABC Corp has a proposed project A, which has expected cash inflows of $4,000 over 10 years period. The initial investment is $30,000. Find the payback period.

SOLUTION:

Payback period = 30,000/4,000 = 7.5 years

This means that it will take 7.5 years for ABC to recover its investment in project A.

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Operating Cash Inflows

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Operating cash inflows is a second variable that we must take into account when determining cash flows from the project. It refers to incremental (additional) cash inflows over the duration of the project. The cash inflows do not take into account interest payments and are calculated as follows:

Revenue

LESS: Expenses (excluding depreciation and interest

= EBDIT (Earnings before depreciation, interest and taxes)

LESS: Depreciation

= EBIT (Earnings before interest and tax)

LESS: Taxes

= NOPAT (Net operating profit after taxes)

ADD: Depreciation

= OPERATING CASH INFLOWS

Initial investment in capital budgeting decisions

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Within context of capital budgeting decisions, initial investment refers to the cash outflow at the beginning of the project and is calculated by taking the total cost of the new asset (cost plus all expenses required to make asset operational), less after-tax proceeds from sale of the old assets and further adding or subtracting change in the net working capital, as shown below.

Initial investment (Initial cash outflow) determined as follows:

Total cost of the new asset (cost plus installation)

Less: After-tax proceeds from sale of the old asset (proceeds from sale of the old asset less cost of removing asset less tax on sale of the old assets.

Less or Add: Change in net working capital

Tax on the sale of the old asset is only paid if the asset sold for more than asset’s book value. Book value of an asset refers to the total cost of the asset (cost of the asset at the time it was purchased + installation cost) less accumulated depreciation.

Accumulated depreciation refers to the collective depreciation of an asset up to a point under consideration. For example, if asset were bought exactly 5 years ago, than accumulated depreciation will include sum of individual depreciation amounts for each of the five years.

If the asset sold for more than its book value than any value above original total cost of asset referred to as capital gain and any value above book value and up to original total cost of asset referred to as recaptured depreciation.

If asset is sold for less than book value than tax credit is generated, provided the country specific legal requirements for such tax credit to be effective are met.

As stated above, an initial investment is affected by the change in net working capital. This occurs because organization’s working capital requirements will change if project will be undertaken and it should be incorporated into calculations. A change in net working capital is calculated as change in current assets (e.g. accounts receivable and inventories) less change in current liabilities (e.g. accounts payable and accruals).

If net working capital increased (increase in current assets larger than increase in current liabilities) than we treat it as cash outflow and add it to the initial investment amount in calculation of the initial cash out flow. This is because the company’s investment in current assets increased due to the new project being undertaken. Therefore, it is an additional cash outflow.

If, however, an increase in current liabilities was higher than increase in current assets (if net working capital decreased) than we subtract this change in net working capital from the initial investment amount in calculating initial investment (outflow at time zero).

Commonly, there is an increase in net working capital (cash outflow) at the beginning of the project life. Such cash outflow is recovered at the end of the project when the terminal cash flow is calculated.

When determining cash flows we also need to consider opportunity and sunk costs.

Opportunity costs

Opportunity costs refer to the cash inflows that could have been earned in case of alternative employment of the asset. Therefore, it should be taken into consideration when determining cash flows.

For example, if success of the proposed project requires use of the equipment which organization already owns, the usage of equipment should be considered as a cost as if it would have to be bought or rented. Moreover, if such equipment could generate higher cash inflows in alternative use than this also should be incorporated.

Sunk costs

Sunk costs refer to the costs associated with the asset which is already was incurred in the past and cannot be recovered in spite of whether the particular project is undertaken or not.

An example of sunk costs is the feasibility study cost or marketing expenses which were already incurred for the project. In other words, any past costs that were incurred are not pertinent. Since sunk cost cannot be recovered – it should not affect decision regarding whether proposed project should be undertaken. In other words, sunk costs are not taken into account when cash flows for the potential project are calculated.

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An understanding of how the initial investment is calculated is an important first step in understanding how to properly make capital budgeting decisions. Make sure you gained a good understanding of concepts discussed above before moving on to further sub-sections on capital budgeting decisions.