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Question 2c

Hav Co is a publicly listed company involved in the production of highly technical and sophisticated electronic components for complex machinery. It has a number of diverse and popular products, an active research and development department, significant cash reserves and a highly talented management who are very good in getting products to market quickly.

A new industry that Hav Co is looking to venture into is biotechnology, which has been expanding rapidly and there are strong indications that this recent growth is set to continue. However, Hav Co has limited experience in this industry. Therefore it believes that the best and quickest way to expand would be through acquiring a company already operating in this industry sector.

Strand Co is a private company operating in the biotechnology industry and is owned by a consortium of business angels and company managers. The owner-managers are highly skilled scientists who have developed a number of technically complex products, but have found it difficult to commercialise them. They have also been increasingly constrained by the lack of funds to develop their innovative products further.

Discussions have taken place about the possibility of Strand Co being acquired by Hav Co. Strand Co’s managers have indicated that the consortium of owners is happy for the negotiations to proceed. If Strand Co is acquired, it is expected that its managers would continue to run the Strand Co part of the larger combined company.

Strand Co is of the opinion that most of its value is in its intangible assets, comprising intellectual capital. Therefore, the premium payable on acquisition should be based on the present value to infinity of the after tax excess earnings the company has generated in the past three years, over the average return on capital employed of the biotechnological industry.

However, Hav Co is of the opinion that the premium should be assessed on synergy benefits created by the acquisition and the changes in value, due to the changes in the price-to-earnings (PE) ratio before and after the acquisition.

Given below are extracts of financial information for Hav Co for 2013 and Strand Co for 2011, 2012 and 2013:

Year ended 30 April Hav Co
2013
$million
Strand Co
2013
$million
Strand Co
2012
$million
Strand Co
2011
$million
Earnings before tax 1980 397 370 352
Non-current assets 3965 882 838 801
Current Assets 968 210 208 198
Share Capital (25c/share) 600 300 300 300
Reserves 2479 183 166 159
Non-Current Liabilities 1500 400 400 400
Current liabilities 354 209 180 140

The current average PE ratio of the biotechnology industry is 16•4 times and it has been estimated that Strand Co’s PE ratio is 10% higher than this. However, it is thought that the PE ratio of the combined company would fall to 14•5 times after the acquisition. The annual after tax earnings will increase by $140 million due to synergy benefits resulting from combining the two companies.

Both companies pay tax at 20% per annum and Strand Co’s annual cost of capital is estimated at 7%. Hav Co’s current share price is $9•24 per share. The biotechnology industry’s pre-tax return on capital employed is currently estimated to be 20% per annum.

Hav Co has proposed to pay for the acquisition using one of the following three methods:

(i) A cash offer of $5•72 for each Strand Co share; or
(ii) A cash offer of $1•33 for each Strand Co share plus one Hav Co share for every two Strand Co shares; or
(iii) A cash offer of $1•25 for each Strand Co share plus one $100 3% convertible bond for every $5 nominal value of Strand Co shares. In six years, the bond can be converted into 12 Hav Co shares or redeemed at par.

Required:

Calculate the percentage premium per share that Strand Co’s shareholders will receive under each acquisition payment method and justify, with explanations, which payment method would be most acceptable to them. (10 marks)