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 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

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

d₁ = [ln (2,434/2,500) + (0.032 + 0.5 × 0.422) × ²]/ (0.42 × 2^0.5) = 0.359

d₂ = 0.359 – (0.42 × 2^0.5) = –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)

Naomi Co has an operating profit margin of 14% (1,230/8,780) but the significant interest payments mean that profit after tax is approximately half of the PBIT figure. This profit after tax figure is less than the required annual investment in non-current assets and working capital.

Naomi Co has a high level of financial gearing. When measured by book value, the gearing level is 73% (6,500/ (2,360 + 6,500)). This high level of debt, coupled with rising interest rates, means that the interest payments are high and interest coverage is currently 2.7 times.

Given that future growth levels are only expected to be 2% (from part (a) above) profit after tax is unlikely to increase significantly unless interest rates fall dramatically. The low level of profit after tax means that no dividend has been paid in the most recent period. The business angels will want to see a return on their investment, which is unlikely to be in the form of future dividends given these prospects. Therefore, they are likely to be attracted by the prospect of an exit route through a sale of their equity stake.

The follow-on product should help to increase Naomi Co's growth rate, but with the limited scope for expansion and lack of other product development it would appear that the business angels would need to sell their equity stakes to generate significant returns.

There are a number of possible post-bid defences available to Mint Co.

Attempting to have the bid referred to the competition authorities seems unlikely to be successful, based on the size of Mint Co, and because this is a vertical merger rather than a horizontal one – which means Tiger Co is unlikely to significantly increase its existing market share.

If it is specifically the Tiger Co takeover that Mint Co wishes to defend against, then a white knight defence could be a successful tactic. This involves finding a friendly company to join in the bidding process and eventually acquire Mint Co. The difficulty will be in finding a willing friendly company.

A counter-bid does not seem to be appropriate given the relative market capitalisation of Mint Co compared to Tiger Co. Tiger Co has a current market value of $245 million which is over 5 times the current market capitalisation of Mint Co of $48 million.

A crown jewels defence would involve selling off Mint Co's most valuable assets to make it less attractive as an acquisition. This may mean that Tiger Co is uninterested in continuing the takeover bid, but it could compromise Mint Co's current operations and as such the existing shareholders may object to this.

A poison pill defence attempts to make a company unattractive, normally by giving the right to existing shareholders to buy shares at a very low price. This could be used by Mint Co, but the existing shareholders need to be willing to put additional funds into the business. The shareholders are unlikely to do this if the takeover is actually in their best interest.

A golden parachute involves offering large benefits to key management personnel who would lose their position in the event of a takeover. This would then make the takeover more expensive for Tiger Co and acts as a deterrent. This could be a good option for Mint Co to take to defend against this takeover.

Appraisal of Alternative 2

Net present value (NPV)

The NPV of the project is £1.32 million positive.

Payback

Payback = 2 + (3.17/7.83) = 2.40 years

Discounted payback

Discounted payback = 2 + (4.72/6.04) = 2.78 years

Internal rate of return (IRR)

The IRR can be found by trial discount rates and interpolation. If the discount rate is 15%, the NPV is £ (0.43) million.

By interpolation the IRR is 9% + (15% – 9%) x 1.32/ (1.32 + 0.43) = 13.5% pa

Modified internal rate of return (MIRR)

We can find the MIRR using the formula given in the formula sheet.

MIRR =  ^1/n (1+r^e)-1

PV (return phase – Years 1–3) = £16.95m

PV (investment phase) = £ (15.63) m

MIRR = (16.95m/15.63m)^1/3 x (1 + 0.09) – 1 = 12%

Project duration for Alternative 2

Present value of cash inflows = NPV + initial investment = £1.32m + £15.63m = £16.95m

Duration = 0.3 + 0.7 + 1.08 = 2.1 years

Alternative duration calculation:

Present value of cash inflows = NPV + initial investment = £1.32m + £15.63m = £16.95m

Duration = (5.03 + 11.76 + 18.12)/16.95 = 2.1 years

Significance of results

On average Alternative 2 delivers value over 2.1 years. Compared with Alternative 1 this is a good result as Alternative 1 takes over one year longer to deliver value. The longer the duration, the riskier the project as there is greater uncertainty attached to future returns.

Evaluation of the two alternatives

Summary of the appraisal results

All other things being equal, the project to be accepted should be the one with the higher NPV, which is Alternative 1. NPV shows the absolute amount by which the project is forecast to increase shareholders' wealth, and is theoretically sounder than the IRR and MIRR methods.

In this case the MIRR method backs up the NPV, but the IRR gives the opposite indication. This 'conflict' arises because IRR makes the wrong assumption about reinvestment rates; reinvestment is assumed (in IRR) to be earning the same return as the project (as opposed to earning the average cost of capital which is the assumption made by MIRR).

The duration of the alternatives shows that Alternative 1 is riskier as it takes longer to recover half the present value. This is also backed up by the payback figures showing that Alternative 1 takes longer to recover the original outlay.

Before making a decision, however, there are a number of other important factors that must be taken into consideration.

Alternative 1

• Alternative 1 has a high risk of lowering the firm's reputation for quality and causing confusion among the customer base. The overall effect may be to lose existing customers but not to gain many new ones.
• It also removes the focus from the business. Marketing a wider range of products may be more difficult than is anticipated and may stretch resources.
• Duration is longer, which might put management off, particularly if they are averse to risk.

Alternative 2

• Alternative 2 represents a fundamental change in the nature of the business from a niche manufacturer to a value-added
• The firm may be able to add successfully its brand reputation for quality to mass market products, but this will only be possible if the US 'flat packs' are of guaranteed quality and consistency, and the varnishing and assembly work are carried out to a high standard.
• The change in the nature of the firm's work may require substantial new equipment.
• This alternative may also result in a loss of skilled workers, with the risk of lower quality.
• However, the shorter duration of the project suggests lower financial risk to the firm, which may be a deciding factor if management are struggling to distinguish between the alternatives in other ways.

Given the similarity in the NPVs between the two projects, the decision will almost certainly depend on non-financial factors.

There is frequently a mix of good and bad reasons behind a takeover bid. Among the good reasons, the most significant is the possibility of creating synergy, which means that the value of cash flows from the combined business is higher than the value of cash flows from the two individual businesses. Although CarCare and Laughs are in different market sectors, there are a number of areas which may generate synergy.

1. Elimination of duplicated resources. The most obvious areas are the marketing systems, the call centre systems and local offices and training facilities for mobile repair/emergency staff. Head office overheads may also be reduced.
2. Cross-selling. Opportunities exist to cross-sell products to customers on the other company's database.
3. Building a critical mass for non-core business. This might apply to the financial services areas of both businesses. The credit card and insurance businesses may gain from a combined brand name.
4. Reduction in the risk of the company's cash flow profile. CarCare receives membership subscriptions in advance, whereas Laughs’ customers will pay mainly in arrears. The combined cash flows will be perceived as less risky by shareholders and lenders.
5. The takeover of CarCare will abolish its mutual status and will allow equity funds for expansion to be raised more easily, by share issues made by the parent company, reducing the cost of capital.

Among the many possible bad reasons for takeover are:

1. The directors of Laughs seeking the prestige of a larger company
2. Diversification with no real strategic objective
3. Laughs using up surplus cash, again with no strategic objective

Stakeholders

The major stakeholders of CarCare are its members, who are both owners and customers, its directors and employees, and its creditors. Competitors will also be highly interested in the takeover.

Members

The members will have mixed reactions. The replacement of mutual status with marketable equity shares or cash will give them an immediate 'windfall' gain, which many will welcome. However, the cost of this is lost influence on the future direction of CarCare. As customers, many may fear a reduction in the quality of service, particularly in the light of increased competition in the market and the fact that Laughs has to demonstrate that it is making a return on its investment. Others may disagree, on the basis that Laughs will be able to raise money for expansion, modernisation and improvements more easily than CarCare could as a mutual organisation.

CarCare's directors have a duty to ensure that they act in the best interest of members. However, they will also be concerned about their own positions after the takeover and will wish to seek suitable positions in the new company's management structure. Some may fear loss of their jobs.

Employees

Employees will have mixed reactions depending on whether they are likely to be presented with additional opportunities or loss of status or redundancy. There is likely to be some rationalisation of the workforce except for those with highly specific skills, and for those who remain there may also be the threat of relocation. Employees will be seeking answers to these questions before the takeover happens, but are unlikely to receive comprehensive answers.

Payables

Payables, including bankers, will probably be happy with the merger provided that Laughs has no financial problems.

Competitors

Some competitors will fear that they will lose market share if the takeover enables new finance for expansion, improvement and marketing of CarCare. Others will be more optimistic, believing that CarCare will become less sensitive to the needs of customers.

Laughs may face a number of problems after the takeover has been achieved.

i. Former members of Laughs who did not agree with the takeover, and who may have been actively resisting it, may decide to change their service provider to another organisation. The parent company will have to be proactive in giving confidence to all its CarCare customers.

ii. The two organisations probably had different management styles, Laughs being a stock exchange quoted company with a clear need for financial results and CarCare being more orientated to serving its customers and acting as a pressure group to represent their needs. Conflicts may arise between directors, managers and employees of CarCare after the takeover as a result of an enforced change in management style from Laughs.

iii. Actual and feared redundancies, relocations, changes in work practice, training methods and other problems may demotivate CarCare employees, causing resistance and a drop in productivity. In this respect, delays in information provision and decision making can make the situation worse.

iv. Competitors may take advantage of reorganisation problems at CarCare in order to gain market share.