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.
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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
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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)
Year |
1 |
2 |
3 |
4 |
Cash flows |
3,277.6 |
16,134.3 |
36,504.7 |
35,683.6 |
Discount factor for 12% |
0.893 |
0.797 |
0.712 |
0.636 |
Present values |
2,926.9 |
12,859.0 |
25,991.3 |
22,694.8 |
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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)