ACCA AFM Syllabus B. Advanced Investment Appraisal - Discounted Free cash flow basis - Past Papers ^{8 / 11}

Nente Co, an unlisted company, designs and develops tools and parts for specialist machinery. The company was formed four years ago by three friends, who own 20% of the equity capital in total, and a consortium of five business angel organisations, who own the remaining 80%, in roughly equal proportions.

Nente Co also has a large amount of debt finance in the form of variable rate loans. Initially the amount of annual interest payable on these loans was low and allowed Nente Co to invest internally generated funds to expand its business. Recently though, due to a rapid increase in interest rates, there has been limited scope for future expansion and no new product development.

The Board of Directors, consisting of the three friends and a representative from each business angel organisation, met recently to discuss how to secure the company’s future prospects. Two proposals were put forward, as follows:

Proposal 1
To accept a takeover offer from Mije Co, a listed company, which develops and manufactures specialist machinery tools and parts. The takeover offer is for $2•95 cash per share or a share-for-share exchange where two Mije Co shares would be offered for three Nente Co shares. Mije Co would need to get the final approval from its shareholders if either offer is accepted;

Proposal 2
To pursue an opportunity to develop a small prototype product that just breaks even financially, but gives the company exclusive rights to produce a follow-on product within two years.

The meeting concluded without agreement on which proposal to pursue.

After the meeting, Mije Co was consulted about the exclusive rights. Mije Co’s directors indicated that they had not considered the rights in their computations and were willing to continue with the takeover offer on the same terms without them.

Currently, Mije Co has 10 million shares in issue and these are trading for $4•80 each. Mije Co’s price to earnings (P/E) ratio is 15. It has sufficient cash to pay for Nente Co’s equity and a substantial proportion of its debt, and believes that this will enable Nente Co to operate on a P/E level of 15 as well. In addition to this, Mije Co believes that it can find cost-based synergies of $150,000 after tax per year for the foreseeable future. Mije Co’s current profit after tax is $3,200,000.

The following financial information relates to Nente Co and to the development of the new product.

Nente Co financial information

Extract from the most recent income statement

Extract from the most recent statement of financial position

In arriving at the profit after tax amount, Nente Co deducted tax allowable depreciation and other non-cash expenses totalling $1,206,000. It requires an annual cash investment of $1,010,000 in non-current assets and working capital to continue its operations.

Nente Co’s profits before interest and tax in its first year of operation were $970,000 and have been growing steadily in each of the following three years, to their current level. Nente Co’s cash flows grew at the same rate as well, but it is likely that this growth rate will reduce to 25% of the original rate for the foreseeable future.

Nente Co currently pays interest of 7% per year on its loans, which is 380 basis points over the government base rate, and corporation tax of 20% on profits after interest. It is estimated that an overall cost of capital of 11% is reasonable compensation for the risk undertaken on an investment of this nature.

New product development (Proposal 2)

Developing the new follow-on product will require an investment of $2,500,000 initially. The total expected cash flows and present values of the product over its five-year life, with a volatility of 42% standard deviation, are as follows:

Required:

Prepare a report for the Board of Directors of Nente Co that:

(i) Estimates the current value of a Nente Co share, using the free cash flow to firm methodology; (7 marks)
(ii) Estimates the percentage gain in value to a Nente Co share and a Mije Co share under each payment offer; (8 marks)
(iii) Estimates the percentage gain in the value of the follow-on product to a Nente Co share, based on its cash flows and on the assumption that the production can be delayed following acquisition of the exclusive rights of production; (8 marks)
(iv) Discusses the likely reaction of Nente Co and Mije Co shareholders to the takeover offer, including the assumptions made in the estimates above and how the follow-on product’s value can be utilised by Nente Co. (8 marks)

Professional marks will be awarded in question 1 for the presentation, structure and clarity of the answer. (4 marks)

Pursuit Co, a listed company which manufactures electronic components, is interested in acquiring Fodder Co, an unlisted company involved in the development of sophisticated but high risk electronic products.

The owners of Fodder Co are a consortium of private equity investors who have been looking for a suitable buyer for their company for some time. Pursuit Co estimates that a payment of the equity value plus a 25% premium would be sufficient to secure the purchase of Fodder Co. Pursuit Co would also pay off any outstanding debt that Fodder Co owed.

Pursuit Co wishes to acquire Fodder Co using a combination of debt finance and its cash reserves of $20 million, such that the capital structure of the combined company remains at Pursuit Co’s current capital structure level.

Information on Pursuit Co and Fodder Co

Pursuit Co

Pursuit Co has a market debt to equity ratio of 50:50 and an equity beta of 1•18. Currently Pursuit Co has a total firm value (market value of debt and equity combined) of $140 million.

Fodder Co, Income Statement Extracts

Fodder Co has a market debt to equity ratio of 10:90 and an estimated equity beta of 1•53. It can be assumed that its tax allowable depreciation is equivalent to the amount of investment needed to maintain current operational levels.

However, Fodder Co will require an additional investment in assets of 22c per $1 increase in sales revenue, for the next four years. It is anticipated that Fodder Co will pay interest at 9% on its future borrowings.

For the next four years, Fodder Co’s sales revenue will grow at the same average rate as the previous years. After the forecasted four-year period, the growth rate of its free cash flows will be half the initial forecast sales revenue growth rate for the foreseeable future.

Information about the combined company

Following the acquisition, it is expected that the combined company’s sales revenue will be $51,952,000 in the first year, and its profit margin on sales will be 30% for the foreseeable future.

After the first year the growth rate in sales revenue will be 5•8% per year for the following three years. Following the acquisition, it is expected that the combined company will pay annual interest at 6•4% on future borrowings.

The combined company will require additional investment in assets of $513,000 in the first year and then 18c per $1 increase in sales revenue for the next three years. It is anticipated that after the forecasted four-year period, its free cash flow growth rate will be half the sales revenue growth rate.

It can be assumed that the asset beta of the combined company is the weighted average of the individual companies’ asset betas, weighted in proportion of the individual companies’ market value.

Other information

The current annual government base rate is 4•5% and the market risk premium is estimated at 6% per year. The relevant annual tax rate applicable to all the companies is 28%.

SGF Co’s interest in Pursuit Co

There have been rumours of a potential bid by SGF Co to acquire Pursuit Co. Some financial press reports have suggested that this is because Pursuit Co’s share price has fallen recently. SGF Co is in a similar line of business as Pursuit Co and until a couple of years ago, SGF Co was the smaller company. However, a successful performance has resulted in its share price rising, and SGF Co is now the larger company.

The rumours of SGF Co’s interest have raised doubts about Pursuit Co’s ability to acquire Fodder Co. Although SGF Co has made no formal bid yet, Pursuit Co’s board is keen to reduce the possibility of such a bid.

The Chief Financial Officer has suggested that the most effective way to reduce the possibility of a takeover would be to distribute the $20 million in its cash reserves to its shareholders in the form of a special dividend.

Fodder Co would then be purchased using debt finance. He conceded that this would increase Pursuit Co’s gearing level but suggested it may increase the company’s share price and make Pursuit Co less appealing to SGF Co.

Required:

Prepare a report to the Board of Directors of Pursuit Co that evaluates whether the acquisition of Fodder Co would be beneficial to Pursuit Co and its shareholders. The free cash flow to firm method should be used to estimate the values of Fodder Co and the combined company assuming that the combined company’s capital structure stays the same as that of Pursuit Co’s current capital structure. Include all relevant calculations; (16 marks)

Pursuit Co, a listed company which manufactures electronic components, is interested in acquiring Fodder Co, an unlisted company involved in the development of sophisticated but high risk electronic products.

The owners of Fodder Co are a consortium of private equity investors who have been looking for a suitable buyer for their company for some time. Pursuit Co estimates that a payment of the equity value plus a 25% premium would be sufficient to secure the purchase of Fodder Co. Pursuit Co would also pay off any outstanding debt that Fodder Co owed.

Pursuit Co wishes to acquire Fodder Co using a combination of debt finance and its cash reserves of $20 million, such that the capital structure of the combined company remains at Pursuit Co’s current capital structure level.

Information on Pursuit Co and Fodder Co

Pursuit Co

Pursuit Co has a market debt to equity ratio of 50:50 and an equity beta of 1•18. Currently Pursuit Co has a total firm value (market value of debt and equity combined) of $140 million.

Fodder Co, Income Statement Extracts

Fodder Co has a market debt to equity ratio of 10:90 and an estimated equity beta of 1•53. It can be assumed that its tax allowable depreciation is equivalent to the amount of investment needed to maintain current operational levels.

However, Fodder Co will require an additional investment in assets of 22c per $1 increase in sales revenue, for the next four years. It is anticipated that Fodder Co will pay interest at 9% on its future borrowings.

For the next four years, Fodder Co’s sales revenue will grow at the same average rate as the previous years. After the forecasted four-year period, the growth rate of its free cash flows will be half the initial forecast sales revenue growth rate for the foreseeable future.

Information about the combined company

Following the acquisition, it is expected that the combined company’s sales revenue will be $51,952,000 in the first year, and its profit margin on sales will be 30% for the foreseeable future.

After the first year the growth rate in sales revenue will be 5•8% per year for the following three years. Following the acquisition, it is expected that the combined company will pay annual interest at 6•4% on future borrowings.

The combined company will require additional investment in assets of $513,000 in the first year and then 18c per $1 increase in sales revenue for the next three years. It is anticipated that after the forecasted four-year period, its free cash flow growth rate will be half the sales revenue growth rate.

It can be assumed that the asset beta of the combined company is the weighted average of the individual companies’ asset betas, weighted in proportion of the individual companies’ market value.

Other information

The current annual government base rate is 4•5% and the market risk premium is estimated at 6% per year. The relevant annual tax rate applicable to all the companies is 28%.

SGF Co’s interest in Pursuit Co

There have been rumours of a potential bid by SGF Co to acquire Pursuit Co. Some financial press reports have suggested that this is because Pursuit Co’s share price has fallen recently. SGF Co is in a similar line of business as Pursuit Co and until a couple of years ago, SGF Co was the smaller company. However, a successful performance has resulted in its share price rising, and SGF Co is now the larger company.

The rumours of SGF Co’s interest have raised doubts about Pursuit Co’s ability to acquire Fodder Co. Although SGF Co has made no formal bid yet, Pursuit Co’s board is keen to reduce the possibility of such a bid.

The Chief Financial Officer has suggested that the most effective way to reduce the possibility of a takeover would be to distribute the $20 million in its cash reserves to its shareholders in the form of a special dividend.

Fodder Co would then be purchased using debt finance. He conceded that this would increase Pursuit Co’s gearing level but suggested it may increase the company’s share price and make Pursuit Co less appealing to SGF Co.

Required:

Discusses the limitations of the estimated valuations in part (i) above; (4 marks)

Pursuit Co, a listed company which manufactures electronic components, is interested in acquiring Fodder Co, an unlisted company involved in the development of sophisticated but high risk electronic products.

The owners of Fodder Co are a consortium of private equity investors who have been looking for a suitable buyer for their company for some time. Pursuit Co estimates that a payment of the equity value plus a 25% premium would be sufficient to secure the purchase of Fodder Co. Pursuit Co would also pay off any outstanding debt that Fodder Co owed.

Pursuit Co wishes to acquire Fodder Co using a combination of debt finance and its cash reserves of $20 million, such that the capital structure of the combined company remains at Pursuit Co’s current capital structure level.

Information on Pursuit Co and Fodder Co

Pursuit Co

Pursuit Co has a market debt to equity ratio of 50:50 and an equity beta of 1•18. Currently Pursuit Co has a total firm value (market value of debt and equity combined) of $140 million.

Fodder Co, Income Statement Extracts

Fodder Co has a market debt to equity ratio of 10:90 and an estimated equity beta of 1•53. It can be assumed that its tax allowable depreciation is equivalent to the amount of investment needed to maintain current operational levels.

However, Fodder Co will require an additional investment in assets of 22c per $1 increase in sales revenue, for the next four years. It is anticipated that Fodder Co will pay interest at 9% on its future borrowings.

For the next four years, Fodder Co’s sales revenue will grow at the same average rate as the previous years. After the forecasted four-year period, the growth rate of its free cash flows will be half the initial forecast sales revenue growth rate for the foreseeable future.

Information about the combined company

Following the acquisition, it is expected that the combined company’s sales revenue will be $51,952,000 in the first year, and its profit margin on sales will be 30% for the foreseeable future.

After the first year the growth rate in sales revenue will be 5•8% per year for the following three years. Following the acquisition, it is expected that the combined company will pay annual interest at 6•4% on future borrowings.

The combined company will require additional investment in assets of $513,000 in the first year and then 18c per $1 increase in sales revenue for the next three years. It is anticipated that after the forecasted four-year period, its free cash flow growth rate will be half the sales revenue growth rate.

It can be assumed that the asset beta of the combined company is the weighted average of the individual companies’ asset betas, weighted in proportion of the individual companies’ market value.

Other information

The current annual government base rate is 4•5% and the market risk premium is estimated at 6% per year. The relevant annual tax rate applicable to all the companies is 28%.

SGF Co’s interest in Pursuit Co

There have been rumours of a potential bid by SGF Co to acquire Pursuit Co. Some financial press reports have suggested that this is because Pursuit Co’s share price has fallen recently. SGF Co is in a similar line of business as Pursuit Co and until a couple of years ago, SGF Co was the smaller company. However, a successful performance has resulted in its share price rising, and SGF Co is now the larger company.

The rumours of SGF Co’s interest have raised doubts about Pursuit Co’s ability to acquire Fodder Co. Although SGF Co has made no formal bid yet, Pursuit Co’s board is keen to reduce the possibility of such a bid.

The Chief Financial Officer has suggested that the most effective way to reduce the possibility of a takeover would be to distribute the $20 million in its cash reserves to its shareholders in the form of a special dividend.

Fodder Co would then be purchased using debt finance. He conceded that this would increase Pursuit Co’s gearing level but suggested it may increase the company’s share price and make Pursuit Co less appealing to SGF Co.

Required:

Estimates the amount of debt finance needed, in addition to the cash reserves, to acquire Fodder Co and concludes whether Pursuit Co’s current capital structure can be maintained; (3 marks)