Both forms of unbundling involve disposing of the non-core parts of the company.

The divestment through a sell-off normally involves selling part of a company as an entity or as separate assets to a third party for an agreed amount of funds or value. This value may comprise of cash and non-cash-based assets. The company can then utilise the funds gained in alternative, value-enhancing activities.

The MBI is a particular type of sell-off which involves selling a division or part of a company to an external management team, who will take up the running of the new business and have an equity stake in the business. An MBI is normally undertaken when it is thought that the division or part of the company can probably be run better by a different management team compared to the current one.

Report to the BoD, Anges Co

This report assesses the potential value of acquiring Carter Co for the equity holders of Anges Co, both with and without considering the benefits of the reduction in taxation and in employee costs. The possible issues raised by reduction in taxation and in employee costs are discussed in more detail below. The assessment also discusses the estimates made and the methods used.

Assessment of value created

Anges Co estimates that the premium payable to acquire Carter Co largely accounts for the benefits created from the acquisition and the divestment, before considering the benefits from the tax and employee costs saving. As a result, before these savings are considered, the estimated benefit to Anges Co's shareholders of $128 million (see Appendix 3) is marginal. Given that there are numerous estimations made and the methods used make various assumptions, as discussed below, this benefit could be smaller or larger. It would appear that without considering the additional benefits of cost and tax reductions, the acquisition is probably too risky and would probably be of limited value to Anges Co's shareholders.

If the benefits of the taxation and employee costs saved are taken into account, the value created for the shareholders is $5,609 million (see Appendix 4), and therefore significant. This would make the acquisition much more financially beneficial. It should be noted that no details are provided on the additional pre-acquisition and post-acquisition costs or on any synergy benefits that Anges Co may derive in addition to the cost savings discussed. These should be determined and incorporated into the calculations.

Basing corporate value on the P/E method for the sell-off, and on the free cash flow valuation method for the absorbed business, is theoretically sound. The P/E method estimates the value of the company based on its earnings and on competitor performance. With the free cash flow method, the cost of capital takes account of the risk the investors want to be compensated for and the non-committed cash flows are the funds which the business can afford to return to the investors, as long as they are estimated accurately.

However, in practice, the input factors used to calculate the organisation's value may not be accurate or it may be difficult to assess their accuracy. For example, for the free cash flow method, it is assumed that the sales growth rate, operating profit margin, the taxation rate and incremental capital investment can be determined accurately and remain constant. It is assumed that the cost of capital will remain unchanged and it is assumed that the asset beta, the cost of equity and cost of debt can be determined accurately. It is also assumed that the length of the period of growth is accurate and that the company operates in perpetuity thereafter. With the P/E model, the basis for using the average competitor figures needs to be assessed; for example, have outliers been ignored; and the basis for the company's higher P/E ratio needs to be justified as well. The uncertainties surrounding these estimates would suggest that the value is indicative, rather than definitive, and it would be more prudent to undertake sensitivity analysis and obtain a range of values.

Key factors to consider in relation to the redundancies and potential tax savings

It is suggested that the BoD should consider the impact of the cost savings from redundancies and from the tax payable in relation to corporate reputation and ethical considerations.

At present, Anges Co enjoys a good reputation and it is suggested that this may be because it has managed to avoid large-scale redundancies. This reputation may now be under threat and its loss could affect Anges Co negatively in terms of long-term loss in revenues, profits and value; and it may be difficult to measure the impact of this loss accurately.

Whilst minimising tax may be financially prudent, it may not be considered fair. For example, currently there is ongoing discussion and debate from a number of governments and other interested parties that companies should pay tax in the countries they operate and derive their profits, rather than where they are based. Whilst global political consensus in this area seems some way off, it is likely that the debate in this area will increase in the future. Companies that are seen to be operating unethically with regard to this may damage their reputation and therefore their profits and value.

Nonetheless, given that Anges Co is likely to derive substantial value from the acquisition, because of these savings, it should not merely disregard the potential savings. Instead, it should consider public relations exercises it could undertake to minimise the loss of reputation, and perhaps meet with the Government to discuss ways forward in terms of tax payments.

Conclusion

The potential value gained from acquiring and unbundling Carter Co can be substantial if the potential cost savings are taken into account. However, given the assumptions that are made in computing the value, it is recommended that sensitivity analysis is undertaken and a range of values obtained. It is also recommended that Anges Co should undertake public relations exercises to minimise the loss of reputation, but it should probably proceed with the acquisition, and undertake the cost saving exercise because it is likely that this will result in substantial additional value.

Report compiled by:

Date:

(Max 12 marks)

Appendix 1: Estimate of value created from the sell-off of the equipment manufacturing business

Average industry P/E ratio = $2.40/$0.30 = 8

Carter Co's equipment manufacturing business P/E ratio = 8 x 1.2 = 9.6

Value from sell-off of equipment manufacturing business

Share of pre-tax profit = 30% x $2,490m = $747m

After-tax profit = $747m x (1 – 0.22) = $582.7m

Value from sell-off = $582.7m x 9.6 = $5,594m (approximately)

(4 marks)

Appendix 2: Estimate of the combined company cost of capital

Carter Co, asset beta = 0.68

Anges Co, asset beta:

Equity beta = 1.10

Proportion of market value of debt = 40%; Proportion of market value of equity = 60%

Asset beta = 1.10 x 0.60/ (0.60 + 0.40 x 0.78) = 0.72

Combined company, asset beta

Market value of equity, Carter Co = $3 x 7,000m shares = $21,000m

Market value of equity, Anges Co = 60% x $60,000m = $36,000m

Asset beta = (0.68 x 21,000 + 0.72 x 36,000)/ (21,000 + 36,000) = 0.71 (approximately)

Combined company equity beta = 0.71 x (0.6 + 0.4 x 0.78)/0.6 = 1.08

Combined company, cost of equity = 4.3% + 1.08 x 7% = 11.86%

Combined company, cost of capital = 11.86% x 0.6 + 6.00% x 0.78 x 0.4 = 8.99, say 9%

(4 marks)

Appendix 3: Estimate of the value created for Anges Co's equity holders from the acquisition

Carter Co, medical R&D value estimate:

Sales revenue growth rate = 5%

Operating profit margin = 17.25% Tax rate = 22%

Additional capital investment = 40% of the change in sales revenue

Cost of capital = 9% (Appendix 2)

Free cash flow growth rate after 4 years = 3%

Current sales revenue = 70% u $21,400m = $14,980m

Cash flows, Years 1 to 4

Value, Years 1 to 4: $6,309m

Value, Year 5 onwards: [$2,103 x 1.03/ (0.09 – 0.03)] x 1.09–4 = $25,575m

Total value of Carter Co's medical R&D business area = $31,884m

Total value of Carter Co following unbundling of equipment manufacturing business and

absorbing medical R&D business:

$5,594m (Appendix 1) + $31,884m = $37,478m (approximately)

Carter Co, current market value of equity = $21,000m

Carter Co, current market value of debt = $9,000m

Premium payable = $21,000m x 35% = $7,350m

Total value attributable to Carter Co's investors = $37,350m

Value attributable to Anges Co's shareholders from the acquisition of Carter Co before taking

into account the cash benefits of potential tax savings and redundancies = Value following

unbundling ($37,478m) – Carter's debt ($9,000m) – price paid for Carter ($21,000m +

$7,350m) = $128m

(8 marks)

Appendix 4: Estimate of the value created from savings in tax and

employment costs following possible redundancies

Cash flows, Years 1 to 4

Total value = $5,481m

Value attributable to Anges Co's shareholders from the acquisition of Carter Co after taking into account the cash benefits of potential tax savings and redundancies = $5,609m

(2 marks)

(Professional marks for part (b) 4 marks)

The feasibility of disposing of assets as a defence tool against a possible acquisition depends upon the type of assets sold and how the funds generated from the sale are utilised.

If the type of assets are fundamental to the continuing business, then this may be viewed as disposing of the corporation's 'crown jewels'. Such action may be construed as being against protecting the rights of shareholders (similar to the conditions discussed in part (d) below). In order for key assets to be disposed of, the takeover regulatory framework may insist on the corporation obtaining permission from the shareholders first before carrying it out.

On the other hand, the assets may be viewed as not being fundamental to the core business and may be disposed of to generate extra funds through a sell-off (see part (a) above). This may make sense if the corporation is undertaking a programme of restructuring and reorganisation.

In addition to this, the company needs to consider what it intends to do with the funds raised from the sale of assets. If the funds are used to grow the core business and therefore enhancing value, then the shareholders would see this positively and the value of the corporation will probably increase. Alternatively, if there are no profitable alternatives, the funds could be returned to the shareholders through special dividends or share buybacks. In these circumstances, disposing of assets may be a feasible defence tactic.

However, if the funds are retained but not put to value-enhancing use or returned to shareholders, then the share price may continue to be depressed. And the corporation may still be an attractive takeover target for corporations which are in need of liquid funds. In these circumstances, disposing of assets would not be a feasible defence tactic.

Each of the three conditions aims to ensure that shareholders are treated fairly and equitably.

The mandatory-bid condition through sell out rights allows remaining shareholders to exit the company at a fair price once the bidder has accumulated a certain number of shares. The amount of shares accumulated before the rule applies varies between countries. The bidder must offer the shares at the highest share price, as a minimum, which had been paid by the bidder previously. The main purpose for this condition is to ensure that the acquirer does not exploit their position of power at the expense of minority shareholders.

The principle of equal treatment condition stipulates that all shareholder groups must be offered the same terms, and that no shareholder group's terms are more or less favourable than another group's terms. The main purpose of this condition is to ensure that minority shareholders are offered the same level of benefits as the previous shareholders from whom the controlling stake in the target company was obtained.

The squeeze-out rights condition allows the bidder to force minority shareholders to sell their stake, at a fair price, once the bidder has acquired a specific percentage of the target company's equity. The percentage varies between countries but typically ranges between 80% and 95%. The main purpose of this condition is to enable the acquirer to gain a 100% stake of the target company and prevent problems arising from minority shareholders at a later date.

Note. Credit will be given for alternative, relevant approaches to the calculations, comments and suggestions/recommendations.

Workings

1. Taxation

2. Ungeared cost of equity

Blueman Co

MV debt = $225 million x 1·07 = $240.8 million

MV equity = 125 million x $3.20 = $400 million

Ungeared cost of equity

k_e =  + (1 – t) ( – k_d) V_d/V_e

10.5% = + (1 – 0.3) (– 5.4%) (240.8/400)

10.5% + 2.28% = 1.42

= 9%

3. Issue costs

Debt: ($30,600,000/0.96) = $31,875,000

Debt issue costs: $31,875,000 x 0.04 = $1,275,000

4. Tax shield on loan

Use PV of an annuity (PVA) for years 2 – 5 at 5% (assume 5% is cost of debt).

(Note. The risk-free rate of 2.5% could also be used for discounting.)

Subsidised loan: $30,600,000 x (0.025 – 0.003) x 0.3 x (4.329 – 0.952) = $682,000

5. Subsidy

Benefit = $30,600,000 x (0·05 – 0.022) x 3.546 = $3,038,000

Tax relief lost = $30,600,000 x (0.05 – 0.022) x 0.3 x (4.329 – 0.952) = $868,000

6. Financing side effects

Conclusion

If base case net present value is used, the project has a negative net present value of $927,000 and on that basis should be rejected. However, the financing side effects add $1,577,000 to the value of the project, giving a positive adjusted present value of $650,000. On that basis the project should be accepted. The revenues from the project appear to be uncertain and the realisable value at the end of the project may be optimistic. It would be useful to have an indication of the range of outcomes and an idea of the probability that the project will have a negative APV.

Advantages of convertible loan notes

The investors may be happy that directors are demonstrating their commitment to the company by subscribing to convertible loan notes. The conversion rights mean that these directors will benefit if the share price increases, aligning their interests with shareholders.

The conversion terms also mean that the loan notes will not necessarily have to be repaid in a few years' time. This may be significant if Triple line Co does not have the cash available for redemption, then.

Drawbacks of convertible loan notes

The convertible loan notes would be treated as debt, increasing Triple line Co's gearing, which may concern the other shareholders. The interest on the convertible loan notes will be payable before dividends and may leave less money for distribution to shareholders. Shareholders may doubt whether the higher interest burden on the convertible loan notes compared with the subsidised loan is compensated for by the lower costs of Triple line Co not having to fulfil the government's requirements.

The other shareholders may be concerned by the interest rate on the convertible notes being Triple line Co's normal cost of borrowing. The option to convert is an advantage for convertible loan note holders. They would often effectively pay for this option by receiving a lower rate of interest on the loan notes.

Shareholders would want to assess how likely conversion would be, that is how likely it would be the share price will rise above $2·75. The option to convert may also change the balance of shareholdings, giving the directors who held the notes a greater percentage of share capital and possibly more influence over Triple line Co. The other shareholders may be unhappy with this.

The shareholders may also have reservations about the loan note holders having the option to redeem if Triple line Co's share price is low. This reduces the risk of providing the finance from the loan note holders' viewpoint. However, if the share price is low, Triple line Co's financial results and cash flows may be poor and it may struggle to redeem the loan notes. Shareholders may also be concerned that there is no cap the other way, allowing Triple line Co to force conversion if the share price reaches a high enough level.

(Note. Credit will be given for alternative relevant discussion)

Synergies arise from an acquisition when the value of the new, combined entity is greater than the sum of the two individual values before the acquisition. There are three types of synergies: revenue, cost and financial.

Revenue synergies create higher revenues for the combined entity, also creating a higher return on equity and an extended period of competitive advantage.

Cost synergies arise from eliminating duplication of functions and also from economies of scale due to the size of the new entity.

Financial synergies may result from the ability to increase debt capacity or from transferring group funds to companies where they can be best utilised.

In this scenario, there may be financial synergies available as Polly Co has significant cash reserves, but Band Co is constrained by a lack of funds. This means that the new entity may Have the funds to undertake projects that would Have been rejected by Band Co due to a lack of funds. The larger company may also Have an increased debt capacity and therefore additional access to finance. It is also possible that the new entity will Have a lower cost of capital as a result of the acquisition.

Cost synergies may be available, through the removal of duplication in areas such as head office functions, but also in R&D. These synergies are likely to be more short term. Other cost synergies may arise from a stronger negotiating position with suppliers due to the size of the new entity, meaning better credit terms and also lower costs.

Revenue synergies Have the potential to be the biggest synergies from this acquisition, although they are likely to be the hardest to achieve, and also to sustain. Polly Co can help Band Co with the marketing of its products, which should result in higher revenues and a longer period of competitive advantage. Combining the R&D activity and the technologies of both companies may mean products can be brought to market faster too. To achieve these synergies, it is important to retain the services of the scientist managers of Band Co. They Have been used to complete autonomy as the managers of Band Co, so this relationship should be managed carefully.

A major challenge in an effective acquisition is to integrate processes and systems between the two companies efficiently and effectively in order to gain the full potential benefits. Often, this is done poorly and can mean that the acquisition is ultimately seen as a failure. Polly Co needs to plan for this before proceeding with the acquisition.

Maximum premium based on excess earnings

Average pre-tax earnings of Band Co = (397 + 370 + 352)/3 = $373m

Average capital employed = [(882 + 210 – 209) + (838 + 208 – 180) + (801 + 198 – 140)]/3 = $869.3m Excess annual premium (pre-tax) = 373 – (869.3 × 0.2) = $199.1m

Post-tax annual premium = $199.1 × 0.8 = $159.3m

PV of annual premium in perpetuity = 159.3/0.07 = $2,275.7m

The maximum premium payable is $2,275.7m.

Maximum premium based on P/E ratio

Band Co's estimated P/E ratio = 16.4 × 1.10 = 18.04

Band Co's post-tax profit (most recent) = 397m × 0.8 = $317.6m

Polly Co's post-tax profit = 1,980 × 0.8 = $1,584m

Polly Co current value = $9.24 × 2,400m shares = $22,176m

Band Co current value = 18.04 × $317.6 = $5,729.5m

Value of combined company = (1,584 + 317.6 + 140) × 14.5 = $29,603.2m

Maximum premium = 29,603.2 – (22,176 + 5,729.5) = $1,697.7m

Current value of a Band Co share = $5,729.5m/1,200m shares = $4.77 per share

Maximum premium % based on excess earnings = 2,275.7/5,729.5 × 100 = 39.7%

Maximum premium % based on P/E ratio = 1,697.7/5,729.5 × 100 = 29.6%

Cash offer: premium % to Band Co shareholder

(5.72 – 4.77)/4.77 × 100 = 19.9%

Cash and share offer: premium % to Band Co shareholder

1 Polly Co share for 2 Band Co shares

Polly Co share price = $9.24

Price per Band Co share = 9.24/2 = $4.62

Cash payment per Band Co share = $1.33

Total return = 4.62 + 1.33 = $5.95

Premium = (5.95 – 4.77)/4.77 × 100 = 24.7%

Cash and bond offer: premium % to Band Co shareholder

Each share has nominal value of $0.25 so $5 is 20 shares

Bond value $100/20 shares = $5 per share

Cash payment per Band Co share = $1.25

Total return = 5 + 1.25 = $6.25

Premium = (6.25 – 4.77)/4.77 × 100 = 31.0%

Tutorial note. Although these evaluations Have been carried out using the current share price given in the question, an equally valid approach would Have been to Have used a post-acquisition share price based on earlier calculations (although this would take longer and is less advisable given that it is likely that about half of the marks are available for the numerical element of this question).

Based on the calculations above, the cash plus bond offer will give the highest return to Band Co shareholders. In addition, the bond can be converted to 12 Polly Co shares, giving a value per share of $8.33($100/12), which is below the current share price and so already in-the-money. If the share price increases over the 6-year period, then the value of the bond should also increase. The bond will also earn interest of 3% per year for the holder.

The 31% return is the closest to the maximum premium based on excess earnings and higher than the maximum premium based on P/E ratios. Thus, this method appears to transfer more of the value to the owners of Band Co.

However, this payment method gives the lowest initial cash payment of the three methods being considered. This may make it seem more attractive to the Polly Co shareholders as well, although they stand to Have their shareholding diluted most by this method, but not until six years Have passed.

The cash and share offer gives a return in between the other options. Although the return is lower than the cash and bond offer, Band Co's shareholders could sell the Polly Co shares immediately if they wish to. However, if the share price of Polly Co falls between now and the acquisition, the return to Band Co shareholders will be lower.

The cash only offer gives an immediate return to Band Co shareholders, but it is the lowest return and may also place a strain on the cash flow of Polly Co, which may need to increase borrowings as a result.

It seems most likely that Band Co's shareholder/managers, who will continue to work in the new entity, will accept the mixed cash and bond offer. This maximises their current return and also gives them the chance to gain in the future when converting the bond. The choice of payment method could be influenced by the impact on personal taxation situations, though.