Analyse the current forms of finance available to the Fusion Group.

Evaluate the three debt finance proposals outlined in Appendix five and recommend which
should be chosen.

Fusion Holdings UK
Fusion is a long established transnational1 company which has diversified activities over the
years and is structured around three main operating divisions: (1) Manufacture of children’s toys
(2) Bus passenger transport and (3) Commercial/residential property. (See Appendix 4 for the
Group organisation structure.) Fusion Holdings UK is a private UK limited company with a
diversified shareholder base. The company has its headquarters in London, and as part of a
group structure, wholly owns subsidiary companies in the UK, China and the US. Each operating
division is headed up by a General Manager (GM).
A new chief executive (CEO), Mr. Claude Tamak, was recently appointed by the Board. The
company was previously directed by Mr. Conrad Delburn, who had led the company for ten
years. While the company’s operating performance was in the most part satisfactory during the
leadership of Mr. Delburn, in most recent years performance has stagnated or declined in cases
through a combination of factors including increasing competition and rising costs. Mr. Tamak
has been appointed to reinvigorate the company, and provide growth in the business lines,
ultimately impacting on profitability and the overall value of the company. Mr. Tamak informed
the C-Suite team of the company on his first meeting with them that the strategic direction of the
company would be reviewed within the first 100 days of his term, with the objective of
establishing a new strategic plan which he intends calling ‘Vision 2023’. The call to action has
reverberated throughout the company and the whisper of redundancies has flowed through the
company grapevine. As requested by the CEO, the Chief Financial Officer (CFO), Ms. Ramell
Yitida, presented a detailed business report at the aforementioned c-suite meeting, with the
following extract reflecting key points made.

Extract of C-Suite Meeting 1 April 2017:

(1) Manufacturing Business (See Appendix 3)

This business line has been operational for over 25 years. Fusion manufactures an extensive
range of products within the children’s toy industry. Many of the toys manufactured are protected
through patents and trademarks held by the company. In addition third parties can place orders
with the manufacturing division, subject to spare capacity being available. The manufacturing
business has a small innovation team which is tasked with improving or developing products for
markets. The industry is changing rapidly, with the following key trends impacting the business:

(i) Use of technology in the provision of drones, robots and Toys-To-Life. The Toys-To-Life
combine innovative and affordable technology with traditional toys to provide a 360-degree
interactive play experience for the toy user.

(ii) Family orientated toys bridging the generation gap, as well as providing millennial parents
with the opportunity to use toys from their childhood in the development of social aspects
including family bonding.

(iii) Education STEAM toys that develop the skillset of the child.

The product lines are manufactured at plants in the UK and China, with most sales into the UK,
European and US markets.
The company opened its manufacturing plant in China in 1998, and has seen considerable
developments take place in that country over the intervening period to the present day. One side
effect has been increasing labour costs, which has impacted on product production costs.

The company uses a distributor model to export product into the US and EU markets, while it
sells directly through a network of owned retail presences in the UK. The main terms of the
engagement with the distributors in the US/EU markets include:

1. The distributor purchases the product outright, and provides a mark-up in on-selling to third
parties. The distributor therefore carries the re-selling risk.

2. Distributors are appointed on an exclusive basis for particular regions and are required to
address local sales and after sales enquiries.

3. The currency used by Fusion in invoicing to distributors is negotiated on a case by case basis.

Import duties and tariffs may be applied on the movement of the goods between trading blocks.
Currently children’s goods (HS Code 9503.00.00) shipped from China to the US are subject to a
zero rating tariff. However the company is concerned that political relations between China and
the US may lead to the imposition of a rated tariff on the import of products generally from China,
including children’s toy products.

(2) Bus Transport (See Appendix 1)

The business is focused within the UK. The company operates a number of bus routes against
competing bus passenger service providers, as well as competition from rail and air travel. The
business struggles with a high cost base in a very competitive market. The company has
ventured into new routes but it hasn’t been successful, despite establishing a pricing point for
fares below that of competitors. The head of the business unit is at a loss to explain this, and with
concerns mounting over the viability of the business, the spectre of divestment hangs over the
operating segment.

(3) Commercial/Residential Property (development for sale, or build to rent model)

Activities in the UK and US markets include residential and commercial property development, as
well as the provision of facility management (‘FM’) services. In the earlier years of this business
segment, the significant cash flows generated by the manufacturing business were used to fund
the acquisition of property. Subsequently various debt instruments have been introduced into the
funding mix to provide more capital for expansion. With the escalation of property prices in the
Greater London area, the company has gone to the loan market (seeking £250m in finance) and
requested loan debt proposals from banks interested in submitting to the invitation
to tender request. The company does not have the cash resources available to fund any
significant acquisition or further development of its property portfolio itself. Three proposals have
been received to date (Appendix 5).

The CFO also outlined that the company has experienced significant expansion over the years,
with resources focused on the front line rather than in support functions. This has led to an
unbalanced situation where, taking the finance function as an example, there hasn’t been
sufficient resources to manage the foreign exchange and interest rate risk the company is
exposed to. The CFO is convinced significant cost savings can be made in managing these risks
better and has urged for the recruitment of resources with appropriate expertise.

The more recent trend in trade receivables has been the increasing time taken by customers to
make payment. The passenger transport business segment is largely consumer based and
therefore tickets are purchased and paid for in advance of travel. In both the manufacturing and
property business segments there are a number of customers in different markets with aged
customer balances owing. These amounts owed are increasing monthly in certain cases. The
sales teams feel that they need to show more flexibility towards clients, particularly given the
sales volume trends in the manufacturing segment. In the manufacturing business segment there
have been some heated exchanges from certain distributors who have described the products as
slow moving and insisted on increased credit terms to assist their cash flow. Some distributors
have suggested they may have to look at holding less inventory of Fusion’s products, and have
also flagged that other competing product manufacturers offer early settlement discounts.

The sales team have also been approached by potential distributors based in South America and
Asia. To establish a foothold in new markets one of the sales team recommendations has been
to extend the period of credit given to new clients (standard terms 30 days). In the past this
approach has served the company well as it enables long lasting relationships to be established
with new distributors, e.g. in the US and EU markets. At the outset of going into the US market,
the sales director regales the risk culture that was in the company at that time and how it took a
chance on certain distributors and built up large amounts of inventory with them. The new CEO is
supportive of entry into different markets, but is also concerned about selling on credit into
countries that the Group has had no experience of or previous exposure to, particularly given the
fact that the Group does not seem to have a credit policy in place.

The sales team are considering putting forward a proposal to management in relation to
introducing an early settlement discount of 1% for customers that pay ahead of standard trade
terms (i.e. pay within 10 days). Ms. Yitida is unsure on balance whether this would be the best
solution to the escalating trade receivables situation, and would like to explore other options also
as part of the review of the sales team proposal.

End of Extract from C-Suite Meeting 1 April 2017.

Group balance sheet in £m

The establishment of a production facility on the outskirts of Mexico City would cost US$480m.
90% of this investment would be payable at the end of year one, with the remainder payable
now. The Mexican government incentivises foreign direct investment, with incentives including
capital grant funding of up to 50% of the initial capital investment, payable in equal instalments
over 5 years, starting in year 1. No writing down allowance is available on any element of the
capital expenditure as a result of the capital grant provision. The grant funding is repayable if the
company leaves Mexico within 5 years.

In addition a working capital investment of US$96m would be required at the outset of the
investment. A subsidiary company (Fusion Mexico) would be the corporate vehicle through which
the company would operate in Mexico. US$30,000 has already been incurred to date exploring
the legal structure of a company in Mexico.

A loan facility of US$480m would be established with Bank Mexico to finance the construction of
the production facility, with the interest rate cost expected to be 12%. In addition an overdraft
facility of US$100m would be established with an interest rate cost of 15%.

Use the overall Group cost of capital benchmark for investments of this nature of 10% to
appraise this capital proposal.

The following plant projections have been provided and are expressed in current terms:

  Year 1 Year 2 Year 3 Year 4 Year 5

  US$m US$m US$m US$m US$m

Reduced labour costs 40 38 36 34 32

Savings on distribution costs 20 20 20 20 20

By relocating to Mexico it is expected that sales demand will increase 20% compound per annum
over the 2016 sales units achieved from the China plant. The reduced cost base on relocating to
Mexico is expected to enable a reduced pricing point of US$35 per unit of product (on average),
thus generating the additional sales demand. A net margin of 15% is assumed on the additional
sales.

An estimate of US$30m per annum (in current terms) has been computed for the allocation of
central fixed costs of the parent entity to this activity.

Plant closure and wind down costs of the China facility are expected to be equivalent of
US$80m, with 30% payable now, and the balance payable at the end of year 1. As part of the
conditions for the original investment in China (and any incentives received by Fusion), the sale
of the plant and associated lands in China cannot be realised until year 3 post cessation of
activities. The expected net sales value in year 3 is US$260m. The land in China had an original
cost of US$45m.

Ignore inflation.

All transactions have been reflected in US$ as part of the capital proposal generation.

There is no tax impact on transactions included in the NPV analysis associated with the China
facility. The capital grant received from Mexico is not subject to tax in Mexico.

Fusion is looking to compare its weighted average cost of capital with competitors in the market
place. You have been provided with the following comparator information following an analysis
conducted of a competitor which is a publicly quoted company.

Number of authorised ordinary shares  100,000,000

Number of issued ordinary shares 50,000,000

Nominal value of ordinary share £1

Beta 1.5

Retained earnings  £550,000,000

Current share market price   £15.50

Closing balance of loan debt on balance sheet  £465,000,000

Market risk premium  6%

Risk free rate 2%

Credit risk premium  5%

(i) Fusion Trading UK is acquiring new manufacturing equipment from Italy. The contracts have
been signed. The cost of the equipment is €600,000 and delivery is expected next month. Credit
terms of 30 days have been agreed. The current spot rate quoted by a bank is £/€ 1.10 – 1.26,
with the one month forward rate at £/€ 1.08 – 1.24.

(ii) Fusion Trading UK is expecting a payment from an Italian distributor in 3 months’ time of
€1.5m. The current quoted spot rate is £/€ 1.10 – 1.26, with the 3 month forward rate at £/€ 1.07
– 1.23.

(iii) Fusion Property US is purchasing building materials from a third party UK supplier for
£200,000 in 3 months’ time. The current quoted spot rate is $/£ 0.8121 – 0.8161, with the 3
month forward rate at 0.8152 – 0.8192.

(iv) Fusion Property US is seeking to raise an additional amount of debt capital to fund expansion
into the Canadian property market. They are looking to raise CAD$22.5m. The spot exchange
rate is US$/CAD$ 1.00 – 0.75. Fusion Property US can borrow on a 10 year term US$ in the US
at a fixed rate of 4%, and in Canada in CAD$ at a rate of CAD LIBOR +4.8%. A Canadian third
party company (West Canada Inc) wishes to expand into the US, and can borrow in Canada at a
floating rate of CAD LIBOR + 3.5%, but wishes to borrow US$30m in the US. It has been quoted
9% to borrow 10 year money in the US. CAD Libor 3 month is currently 2%. The annual bank fee
for arranging the swap between the parties is 20bps for each party. Both Fusion Property US and
West Canada Inc seek 10 year debt, and any gain on a hedging arrangement will be shared
equally between the parties, with the exchange fixed at the current spot rate.

(v) The following FRA prices are quoted:

3 vs 6               7.05

3 vs 5               7.15

3 vs 8               7.30

Fusion Property US is seeking to buy a property complex in Texas for $40m. The amount is
payable in 3 months’ time. Fusion Property US is disposing of a property in Utah for $50m, and
will use the disposal proceeds to purchase the property in Texas. However the Utah property
disposal is not expected to completed until 5 months from now. Fusion Property US can avail of
short term loan finance at a variable interest rate. The company is concerned that by the time the
loan is taken out and repaid, interest rates will have changed.

(vi) There is a level of intra group activity within Fusion involving the movement of foreign
currency amounts between currency jurisdictions. The Group has no internal policy on this.