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
Year |
1
$m |
2
$m |
3
$m |
4
$m |
Sales revenue |
15,729 |
16,515 |
17,341 |
18,208 |
Profit before interest and tax |
2,713 |
2,849 |
2,991 |
3,141 |
Tax |
597 |
627 |
658 |
691 |
Additional capital investment |
300 |
314 |
330 |
347 |
Free cash flows |
1,816 |
1,908 |
2,003 |
2,103 |
Present value of cash flows (9% discount) |
1,666 |
1,606 |
1,547 |
1,490 |
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
Year |
1
$m |
2
$m |
3
$m |
4
$m |
Cash flows (4% increase p.a.) |
1,600 |
1,664 |
1,731 |
1,800 |
Present value of cash flows (9%) |
1,468 |
1,401 |
1,337 |
1,275 |
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)