Thursday 4 June 2009
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 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 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%.
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;