SECTION A: THIS QUESTION is compulsory and MUST be attempted
QUESTION 01- NAOMI CO
Naomi Co, an unlisted company, designs and develops tools and parts for specialist machinery. The company was formed 4 years ago by 3 friends, who own 20% of the equity capital in total, and a consortium of 5 business angel organisations, which own the remaining 80%, in roughly equal proportions. Naomi Co also has a large amount of debt finance in the form of variable rate loans. Initially the amount of annual interest payable on these loans was low and allowed Naomi Co to invest internally generated funds to expand its business. Recently, though, due to a rapid increase in interest rates, there has been limited scope for future expansion and no new product development.
The board of directors, consisting of the three friends and a representative from each business angel organisation, met recently to discuss how to secure the company's future prospects. Two proposals were put forward, as follows:
Proposal 1
To accept a takeover offer from Mint Co, a listed company, which develops and manufactures specialist machinery tools and parts. The takeover offer is for $2.95 cash per share or a share-for-share exchange where two Mint Co shares would be offered for three Naomi Co shares. Mint Co would need to get the final approval from its shareholders if either offer is accepted.
Proposal 2
To pursue an opportunity to develop a small prototype product that just breaks even financially, but gives the company exclusive rights to produce a follow-on product within two years. The meeting concluded without agreement on which proposal to pursue.
After the meeting, Mint Co was consulted about the exclusive rights. Mint Co's directors indicated that they had not considered the rights in their computations and were willing to continue with the takeover offer on the same terms without them.
Currently, Mint Co has 10 million shares in issue and these are trading for $4.80 each. Mint Co's price/earnings (P/E) ratio is 15. It has sufficient cash to pay for Naomi Co's equity and a substantial proportion of its debt, and believes that this will enable Naomi Co to operate on a P/E level of 15 as well. In addition to this, Mint Co believes that it can find cost-based synergies of $150,000 after tax per year for the foreseeable future. Mint Co's current profit after tax is $3,200,000.
The following financial information relates to Naomi Co and to the development of the new product.
Naomi Co financial information
EXTRACT FROM THE MOST RECENT STATEMENT OF PROFIT OR LOSS
|
$'000 |
Sales revenue |
8,780 |
Profit before interest and tax |
1,230 |
Interest |
(455) |
Tax |
(155) |
Profit after tax |
620 |
Dividends |
Nil |
EXTRACT FROM THE MOST RECENT STATEMENT OF FINANCIAL POSITION
|
$'000 |
Net non-current assets |
10,060 |
Current assets |
690
______ |
Total assets |
10,750 |
Share capital (40c per share par value) |
960 |
Reserves |
1,400 |
Non-current liabilities: Variable rate loans |
6,500 |
Current liabilities |
1,890
______ |
Total liabilities and capital |
10,750 |
In arriving at the profit after tax amount, Naomi Co deducted tax-allowable depreciation and other non-cash expenses totalling $1,206,000. It requires an annual cash investment of $1,010,000 in non-current assets and working capital to continue its operations.
Naomi Co's profits before interest and tax in its first year of operation were $970,000 and have been growing steadily in each of the following three years, to their current level. Naomi Co's cash flows grew at the same rate as well, but it is likely that this growth rate will reduce to 25% of the original rate for the foreseeable future.
Naomi Co currently pays interest of 7% per year on its loans, which is 380 basis points over the government base rate, and corporation tax of 20% on profits after interest. It is estimated that an overall cost of capital of 11% is reasonable compensation for the risk undertaken on an investment of this nature.
New product development (Proposal 2)
Developing the new follow-on product will require an investment of $2,500,000 initially. The total expected cash flows and present values of the product over its 5-year life, with a volatility of 42% standard deviation, are as follows:
Year(s) |
Now (total) |
1 |
2 |
3 to 7 |
Cash flows ($'000) |
– |
– |
(2,500) |
3,950 |
Present values ($'000) |
– |
– |
(2,029) |
2,434 |
Required:
a. Prepare a report for the board of directors of Naomi Co that:
i. Estimates the current value of a Naomi Co share, using the free cash flow to firm methodology
(7 marks)
ii. Estimates the percentage gain in value to a Naomi Co share and a Mint Co share under each payment offer
(8 marks)
iii. Estimates the percentage gain in the value of the follow-on product to a Naomi Co share, based on its cash flows and on the assumption that the production can be delayed following acquisition of the exclusive rights of production.
(8 marks)
iv. Discusses the likely reaction of Naomi Co and Mint Co shareholders to the takeover offer, including the assumptions made in the estimates above and how the follow-on product's value can be utilised by Naomi Co.
(8 marks)
Professional marks will be awarded for the presentation, structure and clarity of the answer.
(4 marks)
REPORT
To: The Board of Directors of Naomi Co
From: A N Accountant
Date: X/X/XX
Re: Impact of the takeover proposal from Mint Co and the follow-on project
This report considers the value, to both Naomi Co and Mint Co shareholders, based on a cash offer and also on a share-for-share offer. It discusses the potential reactions of these groups of shareholders to the alternative offers and how best to make use of the follow-on opportunity. All significant assumptions made in the assessments are also explained.
The appendices to this report show the detailed calculations for estimating an equity value for Naomi Co, the value to shareholders of Naomi Co and Mint Co of the acquisition under both a cash offer and a share-for-share exchange and the value of the follow-on product rights to Naomi Co. The results of the detailed calculations are shown here.
Estimated current price of a Naomi Co share |
$2.90 (Appendix 1) |
Estimated increase in share price |
Naomi Co
% |
Mint Co
% |
Cash offer (Appendix 2) |
1.7 |
9.4 |
Share-for-share offer (Appendix 2) |
17.9 |
6.9 |
Estimated value per share of the follow-on product 8.7% (Appendix 3)
The cash offer is unlikely to be accepted by Naomi Co shareholders because the estimated gains are only slightly higher than the current share price, although being unlisted Naomi Co shareholders may not be able to realise the current price should they wish to sell. The share-for-share exchange gives a much larger increase of 17.9% and is much more likely to be acceptable to Naomi Co shareholders. It is also higher than the expected return from the follow-on product and therefore based on the financial data the most attractive option for Naomi Co shareholders is the takeover on a share-for-share exchange basis.
Mint Co shareholders are likely to prefer the cash offer so that they can maximise their own returns and not dilute their control of the company, but they may accept the share-forshare offer as this still offers an increase in value. Mint Co shareholders would need to consider whether these returns are in excess of any other investment opportunities that are available and whether the acquisition of Naomi Co is the best use of funds.
There are a number of assumptions present in the calculations. For example, for calculating the current value of a Naomi Co share the free cash flow model is used. This assumes that the growth rate and free cash flow exist in perpetuity and that the estimated cost of capital is appropriate. The takeover offer analysis is based on the assumption that the proposed synergy savings will be achieved and that the P/E bootstrapping approach is valid. For the calculation of the follow-on product value the option variables are estimates and an assumption is made that these will not change in the period before the decision is taken. The calculated value is based on the scenario that the option can only be exercised after two years, but it appears that the option can be exercised at any time within the two-year period.
The follow-on product has been treated separately from the takeover, but Naomi Co could ask Mint Co to take this into account in its takeover offer. The value of the rights to Naomi Co is $609,021 (Appendix 3) and adds around 25c or 8.8% to the value of a Naomi Co share. If Mint were to increase its offer by this value, or the rights could be sold prior to the takeover, then the return to a Naomi Co shareholder would be 17.9% + 8.8% = 26.7%.
In conclusion, the preferred outcome for Naomi Co shareholders would be to accept the sharefor-share offer and to convince Mint Co to take the value of the follow-on product into consideration. Naomi Co shareholders will need to be assured of the accuracy of the calculations provided in the appendices before they accept the offer.
(Max 8 marks)
APPENDICES
Appendix 1
Estimate of current value of Naomi Co's equity based on free cash flows
Total value = Free cash flows × (1 + growth rate (g))/ (Cost of capital (k) – g)
k = 11%
Past growth rate = (latest profit before interest and tax (PBIT)/Earliest PBIT) 1/no of periods of growth – 1
Past g = (1,230/970) 1/3 – 1 = 0.0824
Future g = 0.25 × 0.0824 = 0.0206
Free cash flow calculation
Free cash flow (FCF) = PBIT + non-cash flows – cash investment – tax
FCF = 1,230,000 + 1,206,000 – 1,010,000 – (1,230,000 × 20%) = $1,180,000
Total value = $1,180,000 × 1.0206/ (0.11 – 0.0206) = $13,471,007
Equity value = $13,471,007 – $6,500,000 = $6,971,007
Number of shares = $960,000/$0.40 = 2.4 million
Equity value per share = $6,971,007/2.4 million shares = $2.90
(7 marks)
Appendix 2
Cash offer
Gain in value to a Naomi Co shareholder = ($2.95 – $2.90)/$2.90 = 1.7%
Additional earnings post-acquisition = $620,000 + $150,000 = $770,000
Additional earnings per share (EPS) = $770,000/10m = 7.7c per share
Using the P/E ratio to calculate the increase in share price = 15 × 7.7c = $1.16
Additional value created = $1.16 × 10 million = $11.6 million
Less cost of acquisition = ($2.95 × 2.4 million) = $7.08 million
Value added for Mint Co shareholders = 11.6 million – 7.08 million = $4.52 million
Gain in value to a shareholder of Mint = $4.52 million/10 million = 45.2c
45.2c/480c = 9.4%
Share-for-share offer
Earnings of combined company = $770,000 (from above) + $3,200,000 = $3,970,000
Total number of shares in combined number = 10 million + (2.4 million × 2/3) = 11,600,000
EPS of combined company = $3.97 million/11.6 million = 34.2c
Expected share price using P/E ratio = 34.2 × 15 = 513c = $5.13
Gain in value to a shareholder of Mint Co = ($5.13 – $4.80)/$4.80 = 6.9%
Current value of three shares in Naomi Co = $2.90 × 3 = $8.70
Gain in value to a shareholder of Naomi Co = ((2 × $5.13) – $8.70)/$8.70 = 17.9%
(8 marks)
Appendix 3
Value of follow-on product
Present value (PV) of the cash inflows |
2,434,000 |
PV of the option cost |
(2,029,000) |
Net present value (NPV) of the new product |
405,000 |
Based on NPV, without considering the option to delay, the project would increase the value of Naomi Co by $405,000.
Value of the option to delay
Price of asset (PV of future positive cash flows) |
$2,434,000 |
Exercise price (initial cost – not discounted) |
$2,500,000 |
Time to expiry of option |
2 years |
Risk-free rate (government base rate = 7% – 380 basis points) |
3.2% |
Volatility |
42% |
d1 = [ln (2,434/2,500) + (0.032 + 0.5 × 0.422) × 2]/ (0.42 × 20.5) = 0.359
d2 = 0.359 – (0.42 × 20.5) = –0.235
N (0.36) = 0.5 + 0.1406 = 0.6406
N (–0.24) = 0.5 – 0.0948 = 0.4052
Value of option = 2,434,000 × 0.6406 – 2,500,000 × 0.4052 × e– (0.032 × 2)
= $1,559,220 – $950,199 = $609,021
This project increases the value of the company by $609,021 or 25.4c per share ($609,021/2.4 million).
In percentage terms this is an increase of about 8.8% (25.4c/290c).
(8 marks)
(Professional marks for part (a) 4 marks)