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Question 1c

Around seven years ago, Opao Co, a private conglomerate company involved in many different businesses, decided to obtain a listing on a recognised stock exchange by offering a small proportion of its equity shares to the public. Before the listing, the company was owned by around 100 shareholders, who were all closely linked to Opao Co and had their entire shareholding wealth invested in the company. However, soon after the listing these individuals started selling their shares in Opao Co, and over a two-year period after the listing, its ownership structure changed to one of many diverse individual and institutional shareholders.

As a consequence of this change in ownership structure, Opao Co’s board of directors (BoD) commenced an aggressive period of business reorganisation through portfolio and organisational restructuring. This resulted in Opao Co changing from a conglomerate company to a company focusing on just two business sectors: financial services and food manufacturing. The financial press reported that Opao Co had been forced to take this action because of the change in the type of its shareholders. The equity markets seem to support this action, and Opao Co’s share price has grown
strongly during this period of restructuring, after growing very slowly initially.

Opao Co recently sold a subsidiary company, Burgut Co, through a management buy-in (MBI), although it also had the option to dispose of Burgut Co through a management buy-out (MBO). In a statement, Opao Co’s BoD justified this by stating that Burgut Co would be better off being controlled by the MBI team.

Opao Co is now considering acquiring Tai Co and details of the proposed acquisition are as follows:

Proposed acquisition of Tai Co
Tai Co is an unlisted company involved in food manufacturing. Opao Co’s BoD is of the opinion that the range of products produced by Tai Co will fit very well with its own product portfolio, leading to cross-selling opportunities, new innovations, and a larger market share. The BoD also thinks that there is a possibility for economies of scale and scope, such as shared logistic and storage facilities, giving cost saving opportunities. This, the BoD believes, will lead to significant synergy benefits and therefore it is of the opinion that Opao Co should make a bid to acquire Tai Co.

Financial information related to Opao Co, Tai Co and the combined company

Opao Co
Opao Co has 2,000 million shares in issue and are currently trading at $2·50 each.

Tai Co
Tai Co has 263 million shares in issue and the current market value of its debt is $400 million. Its most recent profit before interest and tax was $132·0 million, after deducting tax allowable depreciation and non-cash expenses of $27·4 million. Tai Co makes an annual cash investment of $24·3 million in non-current assets and working capital.

It is estimated that its cash flows will grow by 3% annually for the foreseeable future. Tai Co’s current cost of capital is estimated to be 11%.

Combined company
If Opao Co acquires Tai Co, it is expected that the combined company’s sales revenue will be $7,351 million in the first year and its annual pre-tax profit margin on sales will be 15·4% for the foreseeable future. After the first year, sales revenue will grow by 5·02% every year for the next three years. It can be assumed that the combined company’s annual depreciation will be equivalent to the investment required to maintain the company at current operational levels.

However, in order to increase the sales revenue levels each year, the combined company will require an additional investment of $109 million in the first year and $0·31 for every $1 increase in sales revenue for each of the next three years.

After the first four years, it is expected that the combined company’s free cash flows will grow by 2·4% annually for the foreseeable future. The combined company’s cost of capital is estimated to be 10%. It expected that the combined company’s debt to equity level will be maintained at 40:60, in market value terms, after the acquisition has taken place.

Both Opao Co and Tai Co pay corporation tax on profits at an annual rate of 20% and it is expected that this rate will not change if Opao Co acquires Tai Co. It can be assumed that corporation tax is payable in the same year as the profits it is charged on.

Possible acquisition price offers
Opao Co’s BoD is proposing that Tai Co’s acquisition be made through one of the following payment methods:

(i) A cash payment offer of $4·40 for each Tai Co share, or

(ii) Through a share-for-share exchange, where a number of Tai Co shares are exchanged for a number of Opao Co shares, such that 55·5% of the additional value created from the acquisition is allocated to Tai Co’s shareholders and the remaining 44·5% of the additional value is allocated to Opao Co’s shareholders, or

(iii) Through a mixed offer of a cash payment of $2·09 per share and one Opao Co share for each Tai Co share. It is estimated that Opao Co’s share price will become $2·60 per share when such a mixed offer is made.

Similar acquisitions in the food manufacturing industry have normally attracted a share price premium of between 15% and 40% previously.

Required:
(c) Prepare a report for the board of directors of Opao Co which:

(i) Estimates the value of equity of Opao Co and of Tai Co before the acquisition, and of the combined company after the acquisition; (10 marks)

(ii) Estimates the percentage gain in value for each Opao Co share and Tai Co share, under each of the cash, the share-for-share, and the mixed offers; (12 marks)

(iii) Evaluates the likely reaction of Opao Co’s and Tai Co’s shareholders to the acquisition offers. (7 marks)

Professional marks will be awarded in part (c) for the format, structure and presentation of the report. (4 marks)