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1 / 9



SECTION A: THIS QUESTION is compulsory and MUST be attempted



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.

  20X5 $m
Sales revenue 21,400
Profit before interest and tax (PBIT) 3,210
Interest 720
Pre-tax profit 2,490
Non-current liabilities 9,000
Share capital (50c/share) 3,500
Reserves 4,520


Carter Co's share of revenue and profits between the two business areas are as follows:

  Medical products R&D Equipment manufacturing
Share of revenue and profit 70% 30%


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.


Additional information

  • 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%.


Important note

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.

(4 marks)

2 / 9

B. Prepare a report for the BoD of Anges Co which:


i. Estimates the 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, and then after taking these into account

(18 marks)


ii. Assesses the value created from (b)(i) above, including a discussion of the estimations made and methods used

(8 marks)


iii. Advises the BoD on the key factors it should consider in relation to the redundancies and potential tax savings

(4 marks)

Professional marks will be awarded in part (b) for the format, structure and presentation of the report.

(4 marks)

3 / 9

c. Discuss whether the defence strategy suggested by Carter Co's CEO of disposing assets is feasible.

(6 marks)

4 / 9

d. Takeover regulation, where Carter Co is based, offers the following conditions aimed at protecting shareholders: the mandatory-bid condition through sell-out rights, the principle of equal treatment, and squeeze-out rights.



Explain the main purpose of each of the three conditions.

(6 marks)

5 / 9




Triple line Co is based in Inkland. It is listed on Inkland’s stock exchange but only has a small number of shareholders. Its directors collectively own 45% of the equity share capital.

Triple line Co’s growth has been based on the manufacture of household electrical goods. However, the directors have taken a strategic decision to diversify operations and to make a major investment in facilities for the manufacture of office equipment.


Details of investment

The new investment is being appraised over a four-year time horizon. Revenues from the new investment are uncertain and Triple line Co’s finance director has prepared what she regards as cautious forecasts. She predicts that it will generate $2 million operating cash flows before marketing costs in Year 1 and $14.5 million operating cash flows before marketing costs in Year 2, with operating cash flows rising by the expected levels of inflation in Years 3 and 4.

Marketing costs are predicted to be $9 million in Year 1 and $2 million in each of Years 2 to 4.

The new investment will require immediate expenditure on facilities of $30.6 million. Tax allowable depreciation will be available on the new investment at an annual rate of 25% reducing balance basis. It can be assumed that there will either be a balancing allowance or charge in the final year of the appraisal. The finance director believes the facilities will remain viable after four years, and therefore a realisable value of $13·5 million can be assumed at the end of the appraisal period.

The new facilities will also require an immediate initial investment in working capital of $3 million. Working capital requirements will increase by the rate of inflation for the next three years and any working capital at the start of Year 4 will be assumed to be released at the end of the appraisal period.

Triple line Co pays tax at an annual rate of 30%. Tax is payable with a year’s time delay. Any tax losses on the investment can be assumed to be carried forward and written off against future profits from the investment.

Predicted inflation rates are as follows:

Year 1 2 3 4
  8% 6% 5% 4%


Financing the investment

Triple line Co has been considering two choices for financing all of the $30·6 million needed for the initial investment in the facilities:

A subsidised loan from a government loan scheme, with the loan repayable at the end of the four years. Issue costs of 4% of the gross finance would be payable. Interest would be payable at a rate of 30 basis points below the risk-free rate of 2·5%. In order to obtain the benefits of the loan scheme, Triple line Co would have to fulfil various conditions, including locating the facilities in a remote part of Inkland where unemployment is high.

Convertible loan notes, with the subscribers for the notes including some of Triple line Co’s directors. The loan notes would have issue costs of 4% of the gross finance. If not converted, the loan notes would be redeemed in six years’ time. Interest would be payable at 5%, which is Triple line Co’s normal cost of borrowing. Conversion would take place at an effective price of $2·75 per share. However, the loan note holders could enforce redemption at any time from the start of Year 3 if Triple line Co’s share price fell below $1.50 per share. Triple line Co’s current share price is $2.20 per share.

Issue costs for the subsidised loan and convertible loan notes would be paid out of available cash reserves. Issue costs are not allowable as a tax-deductible expense.

In initial discussions, the majority of the board favoured using the subsidised loan. The appraisal of the investment should be prepared on the basis that this method of finance will be used. However, the chairman argued strongly in favour of the convertible loan notes, as, in his view, operating costs will be lower if Triple line Co does not have to fulfil the conditions laid down by the government of Inkland. Triple line Co’s finance director is sceptical, however, about whether the other shareholders would approve the issue of convertible loan notes on the terms suggested. The directors will decide which method of finance to use at the next board meeting


Other information

Blueman Co is a large manufacturer of office equipment in Inkland. Blueman Co’s geared cost of equity is estimated to be 10·5% and its pre-tax cost of debt to be 5·4%. These estimates are based on a capital structure comprising $225 million 6% irredeemable bonds, trading at $107 per $100, and 125 million $1 equity shares, trading at $3·20 per share. Blueman Co also pays tax at an annual rate of 30% on its taxable profits.



a. Calculate the adjusted present value for the investment on the basis that it is financed by the subsidised loan and conclude whether the project should be accepted or not. Show all relevant calculations.

(17 marks)

6 / 9

b. Discuss the issues which Triple line Co’s shareholders who are not directors would consider if its directors decided that the new investment should be financed by the issue of convertible loan notes on the terms suggested. Note. You are not required to carry out any calculations when answering part (b).

(8 marks)

7 / 9


Polly Co is a publicly listed company involved in the production of highly technical and sophisticated electronic components for complex machinery. It has a number of diverse and popular products, an active research and development department, significant cash reserves and a highly talented management who are very good in getting products to market quickly.

A new industry that Polly Co is looking to venture into is biotechnology, which has been expanding rapidly, and there are strong indications that this recent growth is set to continue. However, Polly Co has limited experience in this industry. Therefore, it believes that the best and quickest way to expand would be through acquiring a company already operating in this industry sector.


Band Co

Band Co is a private company operating in the biotechnology industry and is owned by a consortium of business angels and company managers. The owner-managers are highly skilled scientists who have developed a number of technically complex products, but Have found it difficult to commercialise them. They have also been increasingly constrained by the lack of funds to develop their innovative products further.

Discussions Have taken place about the possibility of Band Co being acquired by Polly Co. Band Co's managers Have indicated that the consortium of owners is happy for the negotiations to proceed. If Band Co is acquired, it is expected that its managers would continue to run the Band Co part of the larger combined company.

Band Co is of the opinion that most of its value is in its intangible assets, comprising intellectual capital. Therefore, the premium payable on acquisition should be based on the present value to infinity of the after-tax excess earnings the company has generated in the past three years, over the average return on capital employed of the biotechnological industry. However, Polly Co is of the opinion that the premium should be assessed on synergy benefits created by the acquisition and the changes in value, due to the changes in the price/earnings (P/E) ratio before and after the acquisition.


Financial Information

Given below are extracts of financial information for Polly Co for 20X3 and Band Co for 20X1, 20X2 and 20X3:

  Polly Co Band Co
Year ended 30 April 20X3








Earnings before tax 1,980 397 370 352
Non-current assets 3,965 882 838 801
Current assets 968 210 208 198
Share capital (25c/share) 600 300 300 300
Reserves 2,479 183 166 159
Non-current liabilities 1,500 400 400 400
Current liabilities 354 209 180 140


The current average P/E ratio of the biotechnology industry is 16.4 times and it has been estimated that Band Co's P/E ratio is 10% higher than this. However, it is thought that the P/E ratio of the combined company would fall to 14.5 times after the acquisition. The annual after-tax earnings will increase by $140 million due to synergy benefits resulting from combining the two companies.

Both companies pay tax at 20% per annum and Band Co's annual cost of capital is estimated at 7%. Polly Co's current share price is $9.24 per share. The biotechnology industry's pre-tax return on capital employed is currently estimated to be 20% per annum.


Acquisition proposals

Polly Co has proposed to pay for the acquisition using one of the following three methods:

  1. A cash offer of $5.72 for each Band Co share;
  2. A cash offer of $1.33 for each Band Co share plus 1 Polly Co share for every 2 Band Co shares; or
  3. A cash offer of $1.25 for each Band Co share plus one $100 3% convertible bond for every $5 nominal value of Band Co shares. In 6 years, the bond can be converted into 12 Polly Co shares or redeemed at par.



a. Distinguish between the different types of synergy and discuss possible sources of synergy based on the above scenario.

(9 marks)

8 / 9

b. Based on the two different opinions expressed by Polly Co and Band Co, calculate the maximum acquisition premium payable in each case.

(6 marks)

9 / 9

c. Calculate the percentage premium per share that Band Co's shareholders will receive under each acquisition payment method and justify, with explanations, which payment method would be most acceptable to them.

(10 marks)

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