ADVANCED FINANCIAL MANAGEMENT- MOCK EXAM 01
SECTION A: THIS QUESTION is compulsory and MUST be attempted
QUESTION 01- ANGES CO
Anges Co is a large pharmaceutical company, involved in the research and development (R&D) of medicines and other healthcare products. Over the past few years, Anges Co has been finding it increasingly difficult to develop new medical products. In response to this, it has followed a strategy of acquiring smaller pharmaceutical companies which already have successful products in the market and/or have products in development which look very promising for the future. It has mainly done this without having to resort to major cost cutting and has therefore avoided large-scale redundancies. This has meant that not only has Anges Co performed reasonably well in the stock market, but it has also maintained a high level of corporate reputation.
Carter Co is involved in two business areas: the first area involves the R&D of medical products, and the second area involves the manufacture of medical and dental equipment. Until recently, Carter Co's financial performance was falling, but about three years ago a new Chief Executive Officer (CEO) was appointed and she started to turn the company around. Recently, the company has developed and marketed a range of new medical products, and is in the process of developing a range of cancer-fighting medicines. This has resulted in a good performance in the stock market, but many analysts believe that its shares are still trading below their true value. Carter Co's CEO is of the opinion that the turnaround in the company's fortunes makes it particularly vulnerable to a takeover threat, and she is thinking of defence strategies that the company could undertake to prevent such a threat. In particular, she was thinking of disposing of some of the company's assets and focusing on its core business.
Anges Co is of the opinion that Carter Co is being held back from achieving its true potential by its equipment manufacturing business and that by separating the two business areas, corporate value can be increased. As a result, it is considering the possibility of acquiring Carter Co, unbundling the manufacturing business, and then absorbing Carter Co's R&D of medical products business. Anges Co estimates that it would need to pay a premium of 35% to Carter Co's shareholders to buy the company.
Financial information: Carter Co
Given below are extracts from Carter Co's latest statement of profit or loss and statement of financial position for the year ended 30 November 20X5.
|Profit before interest and tax (PBIT)
|Share capital (50c/share)
Carter Co's share of revenue and profits between the two business areas are as follows:
||Medical products R&D
|Share of revenue and profit
Post-acquisition benefits from acquiring Carter Co Anges Co estimates that following the acquisition and unbundling of the manufacturing business, Carter Co's future sales revenue and profitability of the medical R&D business will be boosted. The annual sales growth rate is expected to be 5% and the profit margin before interest and tax is expected to be 17.25% of sales revenue, for the next 4 years. It can be assumed that the current taxallowable depreciation will remain equivalent to the amount of investment needed to maintain the current level of operations, but that the company will require an additional investment in assets of 40c for every $1 increase in sales revenue.
After the 4 years, the annual growth rate of the company's free cash flows is expected to be 3% for the foreseeable future.
Carter Co's unbundled equipment manufacturing business is expected to be divested through a selloff, although other options such as a management buy-in were also considered. The value of the sell-off will be based on the medical and dental equipment manufacturing industry. Anges Co has estimated that Carter Co's manufacturing business should be valued at a factor of 1.2 times higher than the industry's average price/earnings ratio. Currently the industry's average earnings per share is 30c and the average share price is $2.40.
Possible additional post-acquisition benefits
Anges Co estimates that it could achieve further cash flow benefits following the acquisition of Carter Co, if it undertakes a limited business reorganisation. There is some duplication of the R&D work conducted by Anges Co and Carter Co, and the costs related to this duplication could be saved if Anges Co closes some of its own operations. However, it would mean that many redundancies would have to be made, including employees who have worked in Anges Co for many years. Carter Co's employees are considered to be better qualified and more able in these areas of duplication, and would therefore not be made redundant.
Anges Co could also move its headquarters to the country where Carter Co is based and thereby potentially save a significant amount of tax, other than corporation tax. However, this would mean a loss of revenue for the Government where Anges Co is based.
The company is concerned about how the Government and the people of the country where it is based might react to these issues. It has had a long and beneficial relationship with the country and its people.
Anges Co has estimated that it would save $1,600 million after-tax free cash flows to the firm at the end of the first year as a result of these post-acquisition benefits. These cash flows would increase by 4% every year for the next 3 years.
Estimating the combined company's weighted average cost of capital
Anges Co is of the opinion that as a result of acquiring Carter Co, the cost of capital will be based on the equity beta and the cost of debt of the combined company. The asset beta of the combined company is the individual companies' asset betas weighted in proportion of the individual companies' market value of equity. Anges Co has a market debt to equity ratio of 40:60 and an equity beta of 1.10.
It can be assumed that the proportion of market value of debt to market value of equity will be maintained after the two companies combine.
Currently, Anges Co's total firm value (market values of debt and equity combined) is $60,000 million and Carter Co's asset beta is 0.68.
- The estimate of the risk-free rate of return is 4.3% and of the market risk premium is 7%.
- The corporation tax rate applicable to all companies is 22%.
- Carter Co's current share price is $3 per share, and it can be assumed that the book value and the market value of its debt are equivalent.
- The pre-tax cost of debt of the combined company is expected to be 6.0%.
Anges Co's board of directors (BoD) does not require any discussion or computations of currency movements or exposure in this report. All calculations are to be presented in $ million. Currency movements and their management will be considered in a separate report. The BoD also does not expect any discussion or computations relating to the financing of acquisition in this report, other than the information provided above on the estimation of the cost of capital.
A. Distinguish between a divestment through a sell-off and a management buy-in as forms of unbundling.