a. Advantages of the acquisition

Mercury Co and Teddy Co appear to be a good strategic fit for a number of reasons. Mercury Co appears to have limited potential for further growth. Acquiring Teddy Co, a company with better recent growth, should hopefully give Mercury Co the impetus to grow more quickly.

Acquiring a company which has a specialism in the area of online testing will give Mercury Co capabilities quicker than developing this function in-house. If Mercury Co does not move quickly, it risks losing contracts to its competitors.

Acquiring Teddy Co will give Mercury Co access to the abilities of some of the directors who have led Teddy Co to becoming a successful company. They will provide continuity and hopefully will help integrate Teddy Co’s operations successfully into Mercury Co. They may be able to lead the upgrading of Teddy Co’s existing products or the development of new products which ensures that Mercury Co retains a competitive advantage.

It appears that Teddy Co’s directors now want to either realise their investment or be part of a larger company, possibly because it will have more resources to back further product development. If Mercury Co does not pursue this opportunity, one of Mercury Co’s competitors may purchase Teddy Co and acquire a competitive advantage itself.

There may also be other synergistic benefits, including savings in staff costs and other savings, when the two companies merge.

Disadvantages of the acquisition

It is not known what the costs of developing in-house capabilities will be. Although the process may be slower, the costs may be less and the process less disruptive to Mercury Co than suddenly adding on Teddy Co’s operations.

It is not possible to tell which of Teddy Co’s directors are primarily responsible for its success. Loss of the three directors may well represent a significant loss of its capability. This will be enhanced if the three directors join a competitor of Mercury Co or set up in competition themselves.

There is no guarantee that the directors who remain will fit into Mercury Co’s culture. They are used to working in a less formal environment and may resent having Mercury Co’s way of operating imposed upon them. This could result in departures after the acquisition, jeopardising the value which Teddy Co has brought.

Possibly Teddy Co’s leadership in the online testing market may not last. If competitors do introduce major advances, this could mean that Teddy Co’s current growth is not sustainable.

b. P/E ratio calculations

Value of Mercury Co’s share = $296m u 14/340m = $12.19

Value of Teddy Co share per original bid = $12.19 u (5/3) = $20.32

Teddy Co earnings per share = $128m/90 = $1.42

Teddy Co P/E ratio implied by original bid = $20.32/$1.42 = 14.3

Teddy Co P/E ratio implied by all Teddy Co’s shareholders taking up the share offer = $12.19 u 2/$1.42 = 17.2

Teddy Co P/E ratio implied by mixed cash and share offer = ($22.75 u 0.4 + $12.19 u 2 u 0.6)/$1.42 = 16.7

Teddy Co P/E ratio implied by all Teddy Co’s shareholders taking up the cash offer = $22.75/$1.42 = 16.0

c. Funding of bid

No extra finance will be required if all Teddy Co’s shareholders take up the share offer.

All Teddy Co’s shareholders take up cash offer

Cash required = 90m u $22.75 = $2,048m

Extra debt finance required = $2,048m – $220m – $64m = $1,764m

60% share-for-share offer, 40% cash offer

Cash required = 40% u 90m u $22.75 = $819m

Extra debt finance required = $819m – $220m – $64m = $535m

(2 marks)

Impact of bid on earnings per share (EPS)

Mercury Co’s EPS prior to acquisition = $296m/340 = $0.87

All Teddy Co’s shareholders take up share offer

Number of shares after acquisition = 340m + (90m x 2) = 520m

EPS after acquisition = ($296m + $128m + $20m)/520m = $0.85

All Teddy Co’s shareholders take up cash offer

Number of shares after acquisition = 340m

EPS after acquisition = ($296m + $128m + $20m – $11.36m – $105.84m)/340m = $0.96

$105.84m is the post-tax finance cost on the additional loan finding required of $1,764m.

Therefore $1,764m x 7.5% x 80% = $105.84m.

$11.36m is the post-tax opportunity cost of lost interest on the cash and cash equivalents surpluses of the two companies of $220m + $64m = $284m. Therefore $284m x 5% x 80% = $11.36m.

60% share-for-share offer, 40% cash offer

Number of shares after acquisition 340m + (90m x 2 x 0.6) = 448m

EPS after acquisition = ($296m + $128m + $20m – $11.36m – $32.1m)/448m = $0.89

$32.1m is the post-tax finance cost on the additional loan funding required of $535m. Therefore $535m x 7.5% x 80% = $32.1m.

(5 marks)

Impact of bid on gearing (using market values)

Mercury Co’s gearing (debt/ (debt + equity)) prior to bid = 540/ (540 + (340 x 12.19)) = 11.5%

All Teddy Co’s shareholders take up share offer

Debt/ (Debt + equity) after bid = (540 + 193)/ (540 + 193 + (520 x $0.85 x 14)) = 10.6%

All Teddy Co’s shareholders take up cash offer

Debt/ (Debt + equity) after anticipated bid = (540 + 193 + 1,764)/ (540 + 193 + 1,764 + (340 x $0.96 x 14)) = 35.3%

60% share-for-share offer, 40% cash offer

Debt/ (Debt + equity) after bid = (540 + 193 + 535)/ (540 + 193 + 535 + (448 x $0.89 x 14)) = 18.5%

(3 marks)

Comments

The calculations suggest that if Teddy Co’s shares are acquired on a share-for-share exchange on the terms required by its shareholders, Mercury Co’s shareholders will suffer a fall in EPS attributable to them from $0.87 to $0.85. This is because Teddy Co is being bought on a higher P/E ratio than Mercury Co and the synergies arising from the acquisition are insufficient to compensate for this.

Use of loan finance to back a cash offer will attract tax relief on interest. The cost of debt will be lower than the cost of equity.

Issuing extra shares will lead to a dilution of the power of Mercury Co’s existing shareholders. If all of Teddy Co’s shareholders take up the share-for-share offer, they will hold around one-third of the shares of the combined company (180m/520m) and this may be unacceptable to Mercury Co’s shareholders.

The benefits which Teddy Co’s shareholders will gain will be fixed if they take up a cash offer and do not acquire shares in the combined company. If there are significant gains after the acquisition, these will mostly accrue to Mercury Co’s existing shareholders if a significant proportion of Teddy Co’s shareholders have taken a cash offer.

If the forecast for take-up of the offer is correct, even by combining the cash flows of the two companies, the new company will have insufficient funds to be able to pay all the shareholders who are expected to take up the cash offer. Further finance will be required.

The alternative to loan finance is financing the bid by issuing shares. Depending on the method used, this may also result in dilution of existing shareholders’ ownership and also there is no guarantee that the issue will be successful.

There is also no guarantee that the forecast of 40% of the shareholders taking up the cash offer is correct. If all five of the major shareholders decide to realise their investment rather than just two, this will increase the cash required by $512 million (25% x $22.75 x 90m), for example.

Gearing will increase if loan finance is needed to finance the cash offer. If the mixed share and cash offer is taken up in the proportions stated, the gearing level of the combined company will increase from 11.5% to 18.5%. Current shareholders may not be particularly concerned about this. However, if all or most of the share capital is bought for cash, the gearing level of the combined company will be significantly greater, at a maximum of 35.3%, than Mercury Co’s current gearing. This may be unacceptable to current shareholders and could mean an increase in the cost of equity, because of the increased risk, and also possibly an increase in the cost of debt, assuming in any case that debt finance at the maximum level required will be available. To guard against this risk, Mercury Co’s board may want to limit the cash offer to a certain percentage of share value.

(4-5 marks)

Nigel Co may have switched from a strategy of organic growth to one of growth by acquisition, if it was of the opinion that such a change would result in increasing the value for the shareholders.

Acquiring a company to gain access to new products, markets, technologies and expertise will almost certainly be quicker and may be less costly than developing these internally. Horizontal acquisitions may help Nigel Co eliminate key competitors and thereby reduce rivalry and possible overcapacity in its industry; they may also have enabled Nigel Co to take advantage of economies of scale and to compete against large rivals. Vertical acquisitions may help Nigel Co to secure the supply chain and maximise returns from its value chain.

Organic growth may take a long time, can be expensive and may result in little competitive advantage being established due to the time taken. Also, organic growth, especially into a new area, would need managers to gain knowledge and expertise of an area or function, which they are not currently familiar with. Furthermore, in a saturated market, there may be little opportunity for organic growth.

(Note. Credit will be given for alternative relevant comments.)

Nigel Co can take the following actions to reduce the risk that the acquisition of Nemo Co fails to increase shareholder value.

Since Nigel Co has a poor track record of adding value from its acquisitions it needs to review recent acquisitions to understand why they have not added value i.e., it should do a post-audit of these acquisitions.

Nigel Co should also ensure that the valuation is based on reasonable input figures and that proper due diligence of the perceived benefits is undertaken prior to the offer being made. Often it is difficult to get an accurate picture of the target when looking at it from the outside. Nigel Co needs to ensure that it has sufficient data and information to enable a thorough and sufficient analysis to be undertaken.

The sources of synergy need to be properly assessed to ensure that they are achievable and to identify what actions Nigel Co needs to undertake to ensure their achievement. Targets should be set for all areas of synergy and responsibility for achieving these targets should be clearly allocated to members of Nigel’s senior management team.

The board of directors of Nigel Co needs to ensure that there are good reasons to undertake the acquisition, and that the acquisition should result in an increase in value for the shareholders. The non-executive directors should play a crucial role in ensuring that acquisitions are made to enhance the value for the shareholders. Procedures need to be established to ensure that the acquisition is not overpaid. Nigel Co should determine the maximum premium it is willing to pay and not go beyond that figure. Research indicates that often too much is paid to acquire a company and the resultant synergy benefits are not sufficient to cover the premium paid. Often this is the result of the management of the acquiring company wanting to complete the deal at any cost, because not completing the deal may be perceived as damaging to both their own, and their company’s, reputation. Nigel Co needs to ensure that it has proper procedures in place to integrate the staff and systems of the target company effectively, and also to recognise that such integration takes time. Nigel Co may decide instead to give the target company a large degree of autonomy and thus make integration less necessary; however, this may result in a reduction in synergy benefits.

Nigel Co should also have strategies in place to retain key staff in the companies that it is acquiring – these people need to be identified at an early stage and given assurances over their role and responsibilities post-acquisition. Nigel Co should also be mindful that its own and the acquired company’s staff and management need to integrate and ensure a good working relationship between them.

(Note. Credit will be given for alternative relevant comments.)

Approach taken

The maximum premium payable is equal to the maximum additional benefit created from the acquisition of Nemo Co, with no increase in value for the shareholders of Nigel Co. It should be noted that the shareholders of Nigel Co would probably not approve of the acquisition if they do not gain from it, but certainly they would not approve a bid in excess of this.

The additional benefit can be estimated as the sum of the cash gained (or lost) from selling the assets of Department C, spinning off Department B and integrating Department A, less the sum of the values of Nigel Co and Nemo Co as separate companies.

(1-2 marks)

Estimation of cash gained from selling the assets of Department C:

Value created from spinning off Department B into Moon Co

Value of Moon Co =

Present value of $7.62m free cash flow growing at 20% in the first year and discounted at 10%: $7.62m × 1.2 × 0.909 = $8.31m

Add present value of cash flows from Year 2 onwards:

($9.14m × 1.052)/ (0.1 – 0.052) × 0.909 = $182.11m

Less bond taken over by Moon = $40m

Value to shareholders of Moon Co = 8.31 + 182.11 – 40 = $150.42m

Current values

Nigel Co’s current value = $3 × 380m = $1,140m

Nigel Co, profit after tax = $158.2m × 0.8 = $126.56m

Nigel Co, P/E ratio before acquisition = $1,140.0m/$126.56m = 9.01 say 9

Nigel Co, P/E ratio after acquisition = 9 × 1.15 = 10.35

Nemo Co, P/E ratio before acquisition = 9 × 1.25 = 11.25

Nemo Co post-tax profit = $23m × 0.8 = $18.4m

Nemo Co’s current value = 11.25 × $18.4m = $207.0m

Value created from combined company

Post-acquisition 50% of Nemo’s earnings will remain after the disposal of Department C and the spin-off of Department B. So, earnings will become:

$126.56m + (0.5 × $18.4m) + $7m synergy) = $142.76m

So, the combined company should be worth the P/E of 10.35 × $142.76m = $1,477.57m.

(10 marks)

Assumptions

Based on the calculations given above, it is estimated that the value created will be $285.80m.

However, Nigel Co needs to assess whether the numbers it has used in the calculations and the assumptions it has made are reasonable. For example, Moon Co’s future cash flows seem to be growing without any additional investment in assets and Nigel Co needs to establish whether or not this is reasonable. It also needs to establish how the increase in its P/E ratio was determined after acquisition. Perhaps sensitivity analysis would be useful to show the impact on value changes, if these figures are changed. Given its poor record in generating value previously, Nigel Co needs to pay particular attention to these figures.

(2-3 marks)

a. Advantages of growth by acquisition

Acquiring an existing company is a speedier method of entering a new business than setting up a project using internal resources, because an acquired business will already have customers and, hopefully, goodwill. An acquisition may also effectively eliminate a competitor and may allow higher profitability. Other advantages may come from the combination of complementary resources of the acquiring and acquired companies.

Also, because Erik is a major supplier of Saturn, the acquisition will help to secure Saturn’s supply chain and could help reduce costs, which can be important in a competitive industry such as telecommunications. The acquisition could also mean that competitors are forced to seek alternative and perhaps lower quality suppliers.

Problems of growth by acquisition

Frequently, a significant premium must be paid in order to encourage existing shareholders to sell, or to outbid, a rival. This may make it difficult to show a respectable return on the cost of the acquisition.

The acquired company may not produce the exact product or service that the acquirer needs, or may need significant investment before it conforms to quality requirements.

Management problems are also quite common, particularly when the acquiring and acquired companies have different organisational cultures. Disputes may cause the loss of key staff members, resulting in reduced quality or even in the establishment of competing businesses.

b. There are several regulatory, financial and ethical issues that must be considered if Alexa Systems wants to make a bid for Erik Ltd.

Regulatory issues

As a large listed company, we have an obligation to ensure that any remarks made in the public domain will not mislead investors. The City Code in the UK requires the maintenance of absolute secrecy prior to an announcement being made. This requirement falls on the person or persons who hold confidential information (particularly information that might affect share price) and every effort should be made to prevent accidental disclosure of such information.

The City Code specifically states that a false market must not be created in the shares of the ‘target’ company. The remarks made last night no doubt contributed to the 15% rise in Erik’s share price. In accordance with the City Code, Alexa Systems will be expected to make a statement of intention in the light of the effect of the remarks at the dinner.

If it is stated that Alexa Systems are not interested in making a bid, it will not be able to make another bid for six months, unless Erik’s board recommends a bid that might be made by Alexa Systems. Another way in which this restriction could be waived is if another offer is made by a third party.

Financial issues

Alexa Systems are in a strong financial position at the moment which may be one of the reasons the market interpreted the remarks as being significant. The 15% increase in Erik’s share price indicates that the market now sees Erik as being a target for takeover and that Saturn may be interested in buying the company.

One problem is that Alexa Systems is only in the early stages of investigating Erik and has not yet conducted a due diligence study. It does not know what the company is worth as a valuation has not yet taken place. As the remarks apparently contributed to a 15% increase in share price, Alexa Systems will now have to pay more for Erik if it decides to make a bid. This could affect the financial position as it may be unable to raise the extra finance required to cover the additional cost.

As well as the issues above, there is the likelihood of the extra debt affecting the financial risk profile. The acquisition of Erik could also affect the business risk exposure. As a result, Alexa Systems cannot value Erik without revaluing the existing business. If Erik’s value exceeds the increase in Saturn’s value if the acquisition took place, it should not proceed with the purchase.

(10 marks)

Ethical issues

There is now a dilemma of how to proceed. Alexa Systems has made no secret of the fact that it wants to growth by acquisition rather than organically therefore it would not be ethical to deny any interest in Erik. It was one of four potential targets discussed at the last board meeting and investigations have been conducted into the company as well as reviewing the steps necessary to raise the finance for acquisition. In order to maintain its commitment to transparency of information, it is recommended that Alexa Systems clarifies its intentions.

(5 marks)

c. Proposed course of action

Alexa Systems should release a statement to clarify the position regarding Erik. It should confirm that it is looking into the possibility of an acquisition of Erik but make it clear that the board has decided not to make a bid at this time. However, it should be made clear that Alexa Systems reserves the right to make a bid or take any action that would otherwise be prohibited under the six-month rule should Erik’s board agree to an acquisition or if any other company announced its intention to make an offer. This means Alexa Systems still has the chance to complete its investigations and develop a bid proposal before entering into negotiations with Erik’s board.

Given the details supplied, a forward forecast of the statement of profit or loss and of the statement of financial position is a precursor to the cash flow forecast. On the assumptions (as stated in the question but not reproduced here) the following projection is obtained (all figures in $000):

Projected statement of profit or loss

Workings:

(W1) Operating costs

(W2) Non-current assets and depreciation

(W3) Working capital

Initial working capital equals net current assets less cash. Alternatively, the full 270 can be used as working capital as well. Credit will be given for either assumption.

(W4) Taxation

Our estimate of the value of this business on a going concern basis assumes that cash will be generated and reinvestment made according to the above projection. The free cash flow after reinvestment which is potentially distributable and the terminal value of the business assuming a constant rate of reinvestment of 3% forward is as follows:

Value of the firm 2,266

The terminal value is calculated as follows:

Where R_e is the required rate of return of 10% per annum.

The value of the firm, on the basis of the above projections, is $2,266,000.

This valuation is based upon a number of assumptions which you should consider when reviewing this analysis. We have taken your judgement that 10% fairly reflects the market rate of return required for an investment of this type. This rate should compensate you for the business risk to which your firm is exposed. For an investment held within the context of a widely diversified portfolio the rate of return you should expect will only be conditioned by your exposure to market risk. However, in the context of a sole equity investment then the rate of return you may require could be more than that which would be available from the market for an investment of this type.

In generating our projections, we have assumed the estimates are certain and that the firm is a going concern. In considering this investment further you may wish to explicitly consider the variability attaching to the underlying variables in the projection and the possible range of values that may result. Of particular importance is the assumption of a three-year forecast. In practice the period chosen does depend upon the nature of the business and in particular the uncertainties to which it is exposed.

Finally, we have assumed a terminal value based upon future cash flows from year three forward growing at a compound rate of 3% into the indefinite future. The resulting value will be particularly sensitive to this figure and it may be that you may wish to consider a different rate depending upon what you regard as sustainable in the long term for a business of this type.

Risk diversification, especially into diverse business sectors, has often been stated as a reason for undertaking mergers and acquisitions (M&As). Like individuals holding well-diversified portfolios, a company with a number of subsidiaries in different sectors could reduce its exposure to unsystematic risk. Another possible benefit of diversification is sometimes argued to be a reduction in the volatility of cash flows, which may lead to a better credit rating and a lower cost of capital.

The argument against this states that since individual investors can undertake this level of risk diversification both quickly and cheaply themselves, there is little reason for companies to do so. Indeed, research suggests that markets do not reward this risk diversification.

Nevertheless, for Natalia Co, undertaking M&As may have beneficial outcomes, especially if the sovereign fund has its entire investment in the holding company and is not well-diversified itself. In such a situation unsystematic risk reduction can be beneficial. The case study does not state whether or not the sovereign funds are invested elsewhere and therefore a definitive conclusion cannot be reached.

If Natalia Co is able to identify undervalued companies and after purchasing the company can increase the value for the holding company overall, by increasing the value of the undervalued companies, then such M&As activity would have a beneficial impact on the funds invested. However, for this strategy to work, Natalia Co must:

1. Possess a superior capability or knowledge in identifying bargain buys ahead of its competitor companies. To achieve this, it must have access to better information, which it can tap into quicker, and/or have superior analytical tools. Natalia Co should assess whether or not it does possess such capabilities, otherwise its claim is not valid.
2. Ensure that it has quick access to the necessary funds to pursue an undervalued acquisition. Even if Natalia Co possesses superior knowledge, it is unlikely that this will last for a long time before its competitors find out; therefore, it needs to have the funds ready, to move quickly. Given that it has access to sovereign funds from a wealthy source, access to funds is probably not a problem.
3. Set a maximum ceiling for the price it is willing to pay and should not go over this amount, or the potential value created will be reduced. If, in its assessment, Natalia Co is able to show that it meets all the above conditions, then the strategy of identifying and pursuing undervalued companies may be valid.

In a similar manner to the Competition and Markets Authority in the UK, the European Union (EU) will assess significant mergers and acquisitions’ (M&As) impact on competition within a country’s market. It will, for example, use tests such as worldwide turnover and European turnover of the group after the M&A. It may block the M&A, if it feels that the M&A will give the company monopolistic powers or enable it to carve out a dominant position in the market so as to negatively affect consumer choice and prices.

Sometimes the EU may ask for the company to sell some of its assets to reduce its dominant position rather than not allow an M&A to proceed. It would appear that this may be the case behind the EU’s concern and the reason for its suggested action.

Report to the Board of Directors, Dory Co

Proposed acquisition of Bingo Co

This report evaluates whether or not it is beneficial for Dory Co to acquire Bingo Co. Initially the value of the two companies is determined separately and as a combined entity, to assess the additional value created from bringing the two companies together. Following this, the report considers how much Natalia Co and Dory Co will gain from the value created. The assumptions made to arrive at the additional value are also considered. The report concludes by considering whether or not the acquisition will be beneficial to Dory Co and to Natalia Co.

Appendix 1 shows that the additional value created from combining the two companies is approximately $451.5 million, of which $276.8 million will go to Natalia Co, as the owner of Bingo Co. This represents a premium of about 30% which is the minimum acceptable to Natalia Co. The balance of the additional value will go to Dory Co which is about $174.7 million, representing an increase in value of 1.46% [$174.7m/$12,000m].

Appendix 2 shows that accepting the project would increase Bingo Co’s value as the expected net present value is positive. After taking into account Edward Co’s offer, the expected net present value is higher. Therefore, it would be beneficial for Bingo Co to take on the project and accept Edward Co’s offer, if the tourism industry does not grow as expected, as this will increase Bingo Co’s value.

Assumptions

It is assumed that all the figures relating to synergy benefits, betas, growth rates, multipliers, risk adjusted cost of capital and the probabilities are accurate. There is considerable uncertainty surrounding the accuracy of these, and in addition to the probability analysis conducted in Appendix 2 and the assessments of value conducted in Appendix 1, a sensitivity analysis is probably needed to assess the impact of these uncertainties.

It is assumed that the rb model provides a reasonably good estimate of the growth rate, and that perpetuity is not an unreasonable assumption when assessing the value of Bingo Co. It is assumed that the capital structure would not change substantially when the new project is taken on. Since the project is significantly smaller than the value of Bingo Co itself, this is not an unreasonable assumption.

When assessing the value of the project, the outcomes are given as occurring with discrete probabilities and the resulting cash flows from the outcomes are given with certainty. There may be more outcomes in practice than the ones given and financial impact of the outcomes may not be known with such certainty. The Black-Scholes Option Pricing model may provide an alternative and more accurate way of assessing the value of the project.

It is assumed that Bingo Co can rely on Edward Co paying the $50m at the beginning of year two with certainty. Bingo Co may want to assess the reliability of Edward Co’s offer and whether formal contracts should be drawn up between the two companies. Furthermore, Edward Co may be reluctant to pay the full amount of money once Bingo Co becomes a part of Dory Co.

Concluding comments

Although Natalia Co would gain more than Dory Co from the acquisition both in percentage terms and in monetary terms, both companies benefit from the acquisition. If Bingo Co were to take on the project, although it is value-neutral to the acquisition, Natalia Co could ask for an additional 30% of $12.3 million value to be transferred to it, which is about $3.7 million. Hence the return to Dory Co would reduce by a small amount, but not significantly.

As long as all the parties are satisfied that the value is reasonable despite the assumptions highlighted above, it would appear that the acquisition should proceed.

(Max 7 marks)

(Note: Maximum 6 marks if no concluding comments given)

Report compiled by: AN Accountant

Date: XX/XX/XXXX

APPENDICES

Appendix 1: Additional value created from combining Dory Co and Bingo Co

Dory Co, current value = $7.5/share × 1,600 million shares = $12,000m
Dory Co, free cash flow to equity = $12,000 million/7.2 = $1,666.7m

The growth rate is calculated on the basis of the rb model.

Bingo Co, estimate of growth rate = 0.227 × 0.11 = 0.025 = 2.5%

Bingo Co, current value estimate = $76.5 million × 1.025/ (0.11 – 0.025) = $922.5m

Combined company, estimated additional value created = ([$1,666.7m + $76.5m + $40m] × 7.5) – ($12,000m + $922.5m) = $451.5m

Gain to Natalia for selling Bingo Co, 30% × $922.5m = $276.8m

Dory Co will gain $174.7 million of the additional value created, $451.5m – $276.8m = $174.7m

(Max 10 marks)

Appendix 2: Value of project to Bingo Co

Appendix 2.1

Estimate of risk-adjusted cost of capital to be used to discount the project’s cash flows

The project value is calculated based on its cash flows which are discounted at the project’s risk adjusted cost of capital, to reflect the business risk of the project.

Peter Co’s asset beta

Peter Co equity value = $4.50 × 80 million shares = $360m

Peter Co debt value = 1.05 × $340 million = $357m

Asset beta = 1.6 × $360m/ ($360m + $357m × 0.8) = 0.89

Project’s asset beta (PAB)

0.89 = PAB × 0.15 + 0.80 × 0.85

PAB = 1.4

Bingo Co

MVe = $922.5m

MVd

Cost of debt = Risk free rate of return plus the credit spread = 4% + 0.80% = 4.80%

Current value of a $100 bond: $5.4 × 1.048–1 + $5.4 × 1.048–2 + $5.4 × 1.048–3 + $105.4 × 1.048–4 = $102.14 per $100

MVd = 1.0214 × $380m = $388.1 m

Project’s risk adjusted equity beta

1.4 × ($922.5m + $388.1m × 0.8)/$922.5m = 1.87

Project’s risk adjusted cost of equity

4% + 1.87 × 6% = 15.2%

Project’s risk adjusted cost of capital (15.2% × $922.5m + 4.8% × 0.8 × $388.1m)/ ($922.5m + $388.1m) = 11.84%, say 12%

Appendix 2.2

Estimate of expected value of the project without the offer from Edward Co

(All amounts in $000s)

Probabilities are assigned to possible outcomes based on whether or not the tourism market will grow. The expected net present value (PV) is computed on this basis.

PV year 1: $2,926,900

50% of PV years 1 to 4: $32,236,000

PV years 2 to 4: $61,545,100

40% PV years 2 to 4: $24,618,040

Expected present value of cash flows

= [0.75 × (2,926,900 + (0.8 × 61,545,100 + 0.2 × 24,618,040))] + [0.25 × 32,236,000]

= [0.75 × (2,926,900 + 54,159,688)] + [0.25 × 32,236,000] = 42,814,941 + 8,059,000

= $50,873,941

Expected NPV of project = $50,873,941 – $42,000,000 = $8,873,941

Estimate of expected value of the project with the offer from Edward Co

PV of $50m = $50,000,000 × 0.893 = $44,650,000

If the tourism industry does not grow as expected in the first year, then it is more beneficial for Bingo Co to exercise the offer made by Edward Co, given that Edward Co’s offer of $44.65 million (PV of $50 million) is greater than the PV of the years two to four cash flows ($30.8 million approximately) for that outcome. This figure is then incorporated into the expected net present value calculations.

50% of year 1 PV: $1,463,450

Expected present value of project

= [0.75 × (2,926,900 + 54,159,688)] + [0.25 × (1,463,450 + 44,650,000)]

= 42,814,941 + 11,528,363 = $54,343,304

Expected NPV of project = $54,343,304 – $42,000,000 = $12,343,304

(Max 18 marks)

(Professional marks maximum 4)

Organic growth permits an organisation to carefully plan its strategic growth in line with specified objectives.

However, when entering new markets there may be a substantial cost involved with researching markets and/or buying-in expertise.

Lead-times in establishing production facilities are relatively long in comparison with growth by acquisition, which may be a significant factor when trying to establish or to consolidate market share.

Growth by acquisition is often not as carefully planned, and may be a rapid reaction to a perceived market opportunity.

It permits quick access to new markets or new technology, or the elimination of a competitor.

Information about the financial and other attributes of a potential acquisition target is inevitably less complete than a company’s own internal management information.

This makes the valuation of a potential acquisition target difficult, and projections of future cash flows less precise.

The potential for significant savings is often not fully known until after the acquisition, when attempts are made to rationalise and integrate the operations of the two companies.

Growth by acquisition may be the only way to achieve very rapid growth.

The Euromarkets can be used for very large borrowings, but if a company wants to borrow a large amount of money from domestic banks it might find that some banks are unwilling or unable to offer such large loans. Syndication might have to be used to spread the risk between several banks.

Domestic banking systems are normally subject to more regulation and reserve requirements than the Euromarkets, leading to wider spreads between borrowing and lending rates.

The cost of borrowing on domestic markets is often slightly more expensive than the Euromarkets, and may involve fixed or floating charges on corporate assets as security for loans.

Few Euromarket loans require security. Domestic market loans may be either fixed or floating rate, but bank loans are more likely to be at a floating rate.

An argument in favour of using the domestic banking system is that banks are specialists in analysing and monitoring debts. If large loans are agreed by banks this is a sign of good credit standing, and may facilitate access to cheaper funds on other capital markets.

c. REPORT

Prepared by AN Accountant

i.

The calculations and estimations for part (i) are given in the appendix. To assess whether or not the acquisition would be beneficial to Orange’s shareholders, the additional synergy benefits after the acquisition has been paid for need to be ascertained.

The estimated synergy benefit from the acquisition is approximately $9,074,000 (see Appendix), which is the post-acquisition value of the combined company less the values of the individual companies. However, once Indie Co’s debt obligations and the equity shareholders have been paid, the benefit to Orange Co’s shareholders reduces to approximately $52,000 (see Appendix), which is minimal. Even a small change in the variables and assumptions could negate it. It is therefore doubtful that the shareholders would view the acquisition as beneficial to themselves or the company.

(16 marks with the appendix (i))

ii.

The limitations of the estimates stem from the fact that although the model used is theoretically sound, it is difficult to apply it in practice for the following reasons.

The calculations in part (i) are based on a number of assumptions such as the growth rate in the next four years, the perpetual growth rate after the four years, additional investment in assets, stable tax rates, discount rates and profit margins, assumption that debt is risk free when computing the asset beta. All these assumptions would be subject to varying margins of error.

It may be difficult for Orange Co to assess the variables of the combined company to any degree of accuracy, and therefore the synergy benefits may be hard to predict.

No information is provided about the pre-acquisition and post-acquisition costs.

Although it may be possible to estimate the equity beta of Orange Co, being a listed company, to a high level of accuracy, estimating Indie Co’s equity beta may be more problematic, because it is a private company.

Given the above, it is probably more accurate to present a range of possible values for the combined company depending on different scenarios and the likelihood of their occurrence, before a decision is made.

(4 marks)

iii.

The current value of Orange Co is $140,000,000, of which the market value of equity and debt are $70,000,000 each. The value of the combined company before paying Indie Co shareholders is approximately $189,169,000, and if the capital structure is maintained, the market values of debt and equity will be approximately $94,584,500 each. This is an increase of approximately $24,584,500 in the debt capacity.

The amount payable for Indie Co’s debt obligations and to the shareholders including the premium is approximately $49,116,500 [4,009 + 36,086 × 1.25]. If $24,584,500 is paid using the extra debt capacity and $20,000,000 using cash reserves, an additional amount of approximately $4,532,000 will need to be raised. Hence, if only debt finance and cash reserves are used, the capital structure cannot be maintained.

(3 marks)

iv.

If Orange Co aims to acquire Indie Co using debt finance and cash reserves, then the capital structure of the combined company will change. It will also change if they adopt the Chief Financial Officer’s recommendation and acquire Indie Co using only debt finance.

Both these options will cause the cost of capital of the combined company to change. This in turn will cause the value of the company to change. This will cause the proportion of market value of equity to market value of debt to change, and thus change the cost of capital. Therefore, the changes in the market value of the company and the cost of capital are interrelated.

To resolve this problem, an iterative procedure needs to be adopted where the beta and the cost of capital are recalculated to take account of the changes in the capital structure, and then the company is re-valued. This procedure is repeated until the assumed capital structure is closely aligned to the capital structure that has been re-calculated. This process is normally done using a spreadsheet package such as Excel. This method is used when both the business risk and the financial risk of the acquiring company change as a result of an acquisition (referred to as a type III acquisition).

Alternatively, an adjusted present value approach may be undertaken.

(4 marks)

v.

The Chief Financial Officer’s suggestion appears to be a disposal of ‘crown jewels’. Without the cash reserves, Orange Co may become less valuable to JKL Co. Also, the reason for the depressed share price may be because Orange Co’s shareholders do not agree with the policy to retain large cash reserves. Therefore, returning the cash reserves to the shareholders may lead to an increase in the share price and make a bid from JKL Co more unlikely. This would not initially contravene the regulatory framework as no formal bid has been made. However, Orange Co must investigate further whether the reason for a possible bid from JKL Co might be to gain access to the large amount of cash or it might have other reasons. Orange Co should also try to establish whether remitting the cash to the shareholders would be viewed positively by them.

Whether this is a viable option for Orange Co depends on the bid for Indie Co. In part (iii) it was established that more than the expected debt finance would be needed even if the cash reserves are used to pay for some of the acquisition cost. If the cash is remitted, a further $20,000,000 would be needed, and if this was all raised by debt finance then a significant proportion of the value of the combined company would be debt financed. The increased gearing may have significant implications on Orange Co’s future investment plans and may result in increased restrictive covenants. Ultimately gearing might have to increase to such a level that this method of financing might not be possible. Orange Co should investigate the full implications further and assess whether the acquisition is worthwhile given the marginal value it provides for the shareholders (see part (i)).

(5 marks)

APPENDIX

Part (i)

Interest is ignored as its impact is included in the companies’ discount rates

Indie cost of capital

Ke = 4.5% + 1.53 × 6% = 13.68%

Cost of capital = 13.68% × 0.9 + 9% × (1 – 0.28) × 0.1 = 12.96% assume 13%

Indie

Sales revenue growth rate = (16,146/13,559)1/3 – 1 × 100% = 5.99% assume 6%

Operating profit margin = approx. 32% of sales revenue

Indie Co cash flow and value computation ($000)

Combined Company: Cost of capital calculation

Asset beta (Orange Co) = 1.18 × 0.5/ (0.5 + 0.5 × 0.72) = 0.686

Asset beta (Indie Co) = 1.53 × 0.9/ (0.9 + 0.1 × 0.72) = 1.417

Asset beta of combined co.

= (0.686 × 140,000 + 1.417 × 40,095)/ (140,000 + 40,095) = 0.849

Equity beta of combined company = 0.849 × (0.5 + 0.5 × 0.72)/0.5 = 1.46

Ke = 4.5% + 1.46 × 6% = 13.26%

Cost of capital = 13.26% × 0.5 + 6.4% × 0.5 × 0.72 = 8.93%, assume 9%

Combined Co cash flow and value computation ($000)

Sales revenue growth rate = 5.8%, operating profit margin = 30% of sales revenue

Synergy benefits = 189,169,000 – (140,000,000 + 40,095,000) = $9,074,000

Estimated premium required to acquire Indie Co = 0.25 × 36,086,000 = $9,022,000

Net benefit to Orange Co shareholders = $52,000

(Total: 50 marks)

Tutorial note: Up to 4 professional marks are available for the presentation of the answer, which should be in a report style.

A management buy-out (MBO) involves the purchase of a company by the management running that company. Hence Ria Co’s current management team would be buying Ria Co from Apple Co. A management buy-in (MBI) involves selling Ria Co to a management team brought in from outside the company.

Apple Co may have sold Ria Co through a MBI for the following reasons. Apple Co’s BoD may have felt that Ria Co’s current management team lacked fresh ideas and strategies which could have driven Ria Co forward successfully. Instead, it may have felt that a fresh team, with skills and expertise gained externally, would have had the required innovative ideas and skills. It may be that the external team of managers may have had the finance available to move quickly, whereas the internal team of managers may not have had the finance in place to purchase Ria Co at that time. It is also possible that the management teams within Ria Co and Apple Co had disagreements in the past, and Apple Co’s BoD may have believed the two management teams would not be able to work together in the future, if needed. Thus, the BoD may have felt that a fresh management team was the better option going forwards.

Portfolio restructuring involves the acquisition of companies, or disposals of assets, business units and/or subsidiary companies through divestments, demergers, spin-offs, MBOs and MBIs. Organisational restructuring involves changing the way a company is organised. This may involve changing the structure of divisions in a business, business processes and other changes such as corporate governance.

The aim of either type of restructuring is to increase the performance and value of the business.

Apple Co, in going from a conglomerate business to one focusing on just two business areas, can be seen as restructuring its portfolio, as businesses and assets which are not part of financial services and food manufacturing are disposed of, and businesses focusing on these areas are acquired. Financial markets may take the view that focusing on food manufacturing and financial services has enabled Apple Co’s senior management to concentrate on areas in which they have expertise. Whereas other businesses in which the senior management are not experts are disposed of. This activity leads to the maximisation of business value.

Shareholders are interested in maximising returns from their investments, which companies achieve through maximising business value, whilst minimising the risks inherent in their investment activity. Shareholders who are closely linked to a particular business do not hold diversified investment portfolios, and therefore benefit from diversification of risk undertaken by a company, investing in many different areas. On the other hand, institutional shareholders and other shareholders, who hold diversified portfolios, would not benefit from a company undertaking risk management through diversification by becoming a conglomerate. Instead, such companies would increase value by focusing on areas in which they have relative expertise, as Apple Co seems to do. So, Apple Co’s changing owner clientele has forced it to change its overall strategy. This strategy change was implemented through portfolio restructuring.

Report to the board of directors (BoD), Apple Co

Introduction

This report provides an estimate of the additional value created if Apple Co were to acquire Mickey Co, and the gain for each company’s shareholders based on a cash offer, a share-for-share offer and a mixed offer. It evaluates the likely reaction of the two companies’ shareholders to each payment method.

Summary of the estimates from the appendices

From appendix 1

Apple Co equity value pre-acquisition: $5,000m

Mickey Co equity value pre-acquisition: $1,000m

Combined company equity value post-acquisition: $6,720m

From appendix 2

Therefore, additional value based on synergy benefits is $720m or 12% ($720m/$6,000m)

Estimated percentage gain in value

Likely reactions

Mickey Co’s shareholders are likely to consider all the offers made, because they all fall within the range of premiums paid in previous acquisitions of 15% to 40%. The cash offer is at the lower end of the range, the share-for-share offer at the top end of the range and the mixed offer in between. It is likely that Mickey Co’s shareholders will be more attracted to the share-for-share offer as it maximises their return. However, this offer is reliant on the fact that the expected synergy benefits will be realised and Mickey Co will probably need to analyse the likelihood of this. Cash payment, although much lower, gives a certainty of return. The mixed offer provides some of the certainty of a cash payment, but also offers a higher return compared to the cash offer. This return is roughly in the middle of the premium range. It may therefore prove to be the better option for Mickey Co’s shareholders.

Apple Co’s shareholders benefit less from the acquisition compared to Mickey Co’s shareholders. In each case, they get less than the additional value created of 12%, with the cash payment offering the highest return of 11.2%, which is just below the 12% overall return. The share-for-share offer gives the least return at just over half (6.4%) of the overall return of 12%. Nevertheless, with this option, cash is retained within Apple Co and can be used for other value creating projects. Apple Co’s shareholders may also prefer the mixed offer, because the return they are expecting to receive is between the cash and share-for-share offers. Also, less cash resources are used compared to the cash offer, and they still benefit from a significant proportion of the additional value created.

Conclusion

Based on the benefits accruing to both sets of shareholders, it is not possible to conclusively say that one method of acquisition payment would be acceptable to both sets of shareholders. However, both sets of shareholders may be persuaded that the mixed offer provides a reasonable compromise between the wholly cash and the wholly share-for-share prices. Given that synergy benefits are shared (even if not equally), both companies’ share prices should increase if the acquisition proceeds, as long as the estimates when estimating the valuations are reasonably accurate.

Report compiled by:

Date

(Max 7 marks)

APPENDICES:

Appendix 1 (Part (c) (i)):

Equity value of Apple Co prior to acquisition

$2.50/share × 2,000m shares = $5,000m

Equity value of Mickey Co prior to acquisition

Free cash flows to firm = $132.0m + $27.4m – $24.3m – ($132.0m × 0.2) = $108.7m

Company value = $108.7m × 1.03/ (0.11 – 0.03) = $1,399.5m, say $1,400m

Equity value = $1,400m – $400m = $1,000m

Equity value of combined company post acquisition

All amounts in $ millions

Combined company value: years 1 to 4 = $2,705m

Combined company value: after year 4 = 923 × 1.024/ (0.1 – 0.024) × 1.1 4 = $8,494m

Total combined company value = $11,199m

Equity value (60% × $11,199m) = $6,719.4m, say $6,720m

(Max 10 marks)

Tutorial note: Your answer to part (c) (ii) depends on the numbers calculated in part (c) (i). The markers are told to be aware of this when they are marking the real exam. As long as your method is correct, you will score full marks in part (c) (ii) even if your numbers are incorrect due to errors made in part (c) (i).

Appendix 2 (Part (c) (ii):

Percentage gains for Mickey Co and Apple Co shareholders under each payment method

Estimate of additional value created from acquisition due to synergy benefits

$6,720m – ($5,000m + $1,000m) = $720m

Mickey Co, value per share = $1,000m/263m shares = $3.80/share approx.

Cash offer

Mickey Co shareholders, percentage gain

($4.40 – $3.80)/$3.80 = $0.60/$3.80 = 15.8%

Apple Co shareholders, percentage gain

Amount of additional value created going to Mickey Co shareholders = $0.60 × 263m shares = $157.8m

Amount of additional value created going to Apple Co shareholders = $720m – $157.8m = $562.2m

As a percentage = ($562.2m/2,000m shares)/ $2.50 = 11.2%.

Share-for-share offer

Share of additional value to Mickey Co shareholders = $720m × 0.555 = $399.6m

Share of additional value to Apple Co shareholders = $720m × 0.445 = $320.4m

Apple Co equity value after acquisition = $5,320.4m

Apple Co, estimated share price after acquisition = $5,320.4m/2,000m shares = $2.66/share

Apple Co shares to be allocated to Mickey Co shareholders = ($1,000m + $399.6m)/$2.66 = 526m shares approximately

Therefore, share-for-share offer will be 2 Apple Co shares for 1 Mickey Co share [526/263 = 2]

Mickey Co shareholders, percentage gain

($2.66 × 2 shares – $3.80 × 1 share)/ ($3.80 × 1 share) = 40%

Apple Co shareholders, percentage gain

($2.66 – $2.50)/$2.50 = 6.4%

Mixed offer

Mickey Co shareholders, percentage gain

(($2.60 + $2.09) – $3.80)/$3.80 = $0.89/$3.80 = 23.4%

Apple Co shareholders, percentage gain

Amount of additional value going to Mickey Co shareholders = $0.89 × 263m = $234.1m

Amount of additional value created going to Apple Co shareholders = $720m – $234.1m = $485.9m

As a percentage = ($485.9m/2,000m shares)/$2.50 = 9.7%

(Max 12 marks)

(Professional marks for part (c) 4 marks)

The initial public offering (IPO) is the conventional way to obtain a listing where a company issues and offers shares to the public. When doing this, the company will follow the normal procedures and processes required by the stock exchange regarding a new issue of shares and will comply with the regulatory requirements.

Undertaking a reverse takeover enables a company to obtain a listing without going through the IPO process. The BoD of Ria Co would initially take control of a ‘shell’ listed company by buying some shares in that company and taking over as its BoD. The ‘shell’ listed company was probably a normal listed company previously, but is no longer trading. New equity shares in the listed company would then be exchanged for Ria Co’s shares, with the external appearance that the listed company has taken over Ria Co. But in reality, Ria Co has now effectively got a listing, having taken control of the listed company previously. Normally, the name of the original listed company would then be changed to Ria Co.

Compared with an IPO, the main benefits of undertaking a reverse takeover are that it is cheaper, takes less time and ensures that Ria Co will obtain a listing on a stock exchange. An IPO can cost between 3% and 5% of the capital being raised because it involves investment banks, lawyers, and other experts. A marketing campaign and issuing a prospectus are also needed to make the offering attractive and ensure shares to the public do get sold. A reverse takeover does not need any of these and therefore avoids the related costs. The IPO process can typically take one or two years to complete due to hiring the experts, the marketing process and the need to obtain a value for the shares. Additionally, the regulatory process and procedures of the stock exchange need to be complied with. With a reverse takeover, none of these are required and therefore the process is quicker. Finally, there is no guarantee that an IPO will be successful. In times of uncertainty, economic downturn or recession, it may not attract the attention of investors and a listing may not be obtained. With reverse takeover, because the transaction is an internal one, between two parties, it will happen and Ria Co will be listed.

However, obtaining a listing through a reverse takeover can have issues attached to it. The listed ‘shell’ company may have potential liabilities which are not transparent at the outset, such as potential litigation action. A full due diligence of the listed company should be conducted before the reverse takeover process is started. The IPO process is probably better at helping provide the senior management of Ria Co with knowledge of the stock exchange and its regulatory environment. The involvement of experts and the time senior management need to devote to the listing process will help in this regard. Due to the marketing effort involved with an IPO launch, it will probably have an investor following, which a reverse takeover would not. Therefore, a company which has gone through an IPO would probably find it easier to raise extra funds, whilst a company which has gone through a reverse takeover may find it more difficult to raise new funding.

Overall, neither option of obtaining a listing has a clear advantage over the other. The choice of listing method depends on the company undertaking the listing and the purpose for which it is doing so.