Frequently Asked Questions: Financial management

Question 1: How can spinning off a division increase the overall debt capacity of the group?

Question 2: I often hear the term Revolving Credit, but I don’t know what it means. Could you shed some light on this matter, as it causes me problems when I’m trying to solve financial problems.

Question 3: What advantages are there for a group in spinning off its divisions into subsidiaries? Can this be considered to be a defence against a takeover?

Question 4: I’d like to know what advantages there are in reducing the nominal capital of a company.

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Question 1:

How can spinning off a division increase the overall debt capacity of the group?

Answer:

I’m not sure that spinning off a division can really increase the overall debt capacity of the group by much.

It is true that bankers prefer to have shares in a subsidiary as collateral for a loan, rather than assets, because it’s easier to sell shares than to sell assets. Furthermore, by lending to a group that is organised into subsidiaries, the visibility of the sources of the group’s earnings is much clearer (each subsidiary has its own accounts). Otherwise, all of the earnings just go into one big melting pot.

Finally, it is sometimes possible to get the better of some bankers who may not be very astute, by getting them to lend money twice – once to the parent company and once to the subsidiaries. But they really have to be very dopey bankers and it may not necessarily be in the interests of the company over the medium term, as the bank will work out that it’s been taken for a ride at some stage!

For more, cheek out chapter 43 of the Vernimmen.

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Question 2:

I often hear the term Revolving Credit, but I don’t know what it means. Could you shed some light on this matter, as it causes me problems when I’m trying to solve financial problems.

Answer:

A revolving loan is a line of credit which can be used in successive, renewable drawdowns.

For example, you can use a credit card to buy an oven in a department store, not pay for it immediately, but pay it off in full when you get the money, and then make a second drawdown to buy a washing machine that you’ll pay for later. This credit obviously is not free.

Companies usually make spot drawdowns over periods varying from between one and 12 months. There are also medium term drawdowns that can be used in successive drawdowns.

For more, cheek out chapter 27 of the Vernimmen.

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Question 3:

What advantages are there for a group in spinning off its divisions into subsidiaries? Can this be considered to be a defence against a takeover?

Answer:

Firstly, if a division is spun off into a subsidiary, its real earnings, which are otherwise drowned in the sea of the parent company’s results become clearly visible. This makes it easier to get the managers of the division to take more responsibility and to involve them financially in the company, through a share in the capital, stock options, etc., which sooner or later will be bought back by the parent company, unless the spun off division goes public. The key advantages here are management control and staff motivation.

Secondly, the capital of these new subsidiaries can be opened up to third parties. Accordingly, it is a means of financing, whether third party involvement is through a capital increase (financing of subsidiary) or through the sale of shares (financing of parent company). Its also a way for forge capital-related links (shareholdings, mergers) with a group that may only be interested in the activities of the new subsidiary, but not of the parent company.

Spinning off a division into a subsidiary is not in itself an anti-takeover measure, but opening up the capital of the new subsidiary could be if the subsidiary is large in comparison to the group, and if the third party has negotiated the right to buy the parent company’s (majority) share in the subsidiary in the event of a change in control of the parent company. This sort of mechanism should be set up in advance, and not just before the launch of a takeover bid.

For more information, see chapter 43 of the Vernimmen.

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Question 4:

I’d like to know what advantages there are in reducing the nominal capital of a company.

Answer:

In the strict sense of the term, a capital reduction means that losses incurred are set off by reducing the capital, which is then increased through cash contributions, often made by new shareholders.

What it does is prepare the company for a shift to a healthy financial state, and get it ready to pay out dividends, because dividends can never be paid when there are loss carryforwards.

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