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:
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.
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
|Profit before interest and tax
|Profit after tax
EXTRACT FROM THE MOST RECENT STATEMENT OF FINANCIAL POSITION
|Net non-current assets
|Share capital (40c per share par value)
|Non-current liabilities: Variable rate loans
|Total liabilities and capital
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 $2,500,000 initially. The total expected cash flows and present values of the product over its 5-year life, with a volatility of 42% standard deviation, are as follows:
||3 to 7
|Cash flows ($'000)
|Present values ($'000)
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
ii. Estimates the percentage gain in value to a Naomi Co share and a Mint Co share under each payment offer
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.
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.
Professional marks will be awarded for the presentation, structure and clarity of the answer.