Selorne Co
Selorne Co is one of the biggest removal companies in Pauland, offering home and business removals. It has a number of long-term contracts with large businesses, although it has not won any new major contracts in the last two years.

Selorne Co is listed on Pauland’s stock market for smaller companies. Selorne Co is financed by a mixture of equity and short and long-term debt, but its gearing level is below the average for its sector.

Selorne Co has four executive directors, who each own 20% of the company’s share capital, with the other 20% owned by external shareholders.

Selorne Co has paid a constant dividend since it has been listed and its share price has risen slightly over the last three years.

Selorne Co is based in a number of the large cities and towns in Pauland and owns the majority of the sites where it is located. Many of its employees have worked for the company for a long time.

Drivers of the lorries used by Selorne Co are required to have a special, heavy vehicles licence. Salary levels at Selorne Co are relatively high compared with other companies in the sector.

Chawon Co
Selorne Co is currently considering making a bid for Chawon Co, an unlisted company specialising in distribution and delivery services. Chawon Co is owned 100% by its founder, Chris Chawon.

Chawon Co has built up a portfolio of small contracts over time. It has made unsuccessful bids for two larger contracts over the last 12 months, the bids being rejected primarily because Chawon Co was not felt to be big enough to be able to guarantee the level of service required.

Chawon Co is based in many of the same cities and towns where Selorne Co is located, although Chawon’s premises are all rented. The drivers of Chawon’s vehicles do not require a heavy vehicles licence.

Chawon Co has a few long-serving employees who are mostly centre managers. Most of its drivers and staff, however, stay at Chawon Co for only a short time.

Salary levels are low, although Chawon Co pays high levels of overtime and high bonuses if target profit levels are achieved. Chawon Co is highly geared, leading to recent media speculation about its financial viability.

Terms of bid for Chawon Co
In initial discussions about the acquisition, Chris Chawon indicated that he would prefer the consideration to be a share-for-share exchange, the terms being one Chawon Co share for five Selorne Co shares.

Chawon Co has 2 million $1 shares in issue, and Selorne Co has 50 million $0·50 shares in issue. Each Selorne Co share is currently trading at $6·50, which is a multiple of 8 of its free cash flow to equity.

The multiple of 8 can be assumed to remain unchanged if the acquisition takes place. Chawon Co’s free cash flow to equity is currently estimated at $7 million, with an expected annual growth rate of 3%, and it is expected to generate a return on equity of 15%.

Chris Chawon expects that the total free cash flows to equity of the combined company will increase by $5 million due to synergy benefits. He believes that Selorne Co will be able to win more contracts because it is larger and because it will be diversifying the services which it offers.

He also believes that significant operational synergies can be achieved, pointing out the time Selorne Co drivers spend idle during the winter months when removal activity is traditionally lower.

Chris Chawon believes that he can achieve the synergies if he is given management responsibility for the operational reorganisation, including dealing with the staff employment and retention issues. Chris Chawon thinks that synergies could also be achieved in central administration and in premises costs.

The chief executive and the finance director of Selorne Co are in favour of bidding for Chawon Co. However, one of the other executive directors is opposed to the bid.

He is sceptical about the level of synergies which can be achieved and does not want Chris Chawon to be brought into the management of Selorne Co.

He suggests that if the bid is to go ahead, it should be a cash offer rather than a share exchange. Selorne Co’s chief executive has responded that Chris Chawon is likely to ask for a higher equivalent price if the purchase is for cash.

Financing the bid for Chawon Co
Selorne Co’s finance director has pointed out that Selorne Co will need additional funding if Chawon Co is purchased for cash. He has suggested that there may be a number of possible sources of finance:

– A rights issue
– A fixed rate, long-term, bank loan
– A three-year, unsecured, mezzanine loan facility
– Convertible debt, with conversion rights being exercisable in five years’ time

Required:
(c) Discuss the factors which Selorne Co’s board will consider when determining which source or sources of finance are chosen to finance a possible cash bid for the share capital of Chawon Co. (6 marks)