ACCA AFM Syllabus C. Acquisitions And Mergers - Acquisitions and mergers as a method of corporate expansion - Past Papers ^{3 / 6}

Louieed Co
Louieed Co, a listed company, is a major supplier of educational material, selling its products in many countries. It supplies schools and colleges and also produces learning material for business and professional exams. Louieed Co has exclusive contracts to produce material for some examining bodies. Louieed Co has a well-defined management structure with formal processes for making major decisions.

Although Louieed Co produces online learning material, most of its profits are still derived from sales of traditional textbooks. Louieed Co’s growth in profits over the last few years has been slow and its directors are currently reviewing its long-term strategy. One area in which they feel that Louieed Co must become much more involved is the production of online testing materials for exams and to validate course and textbook learning.

Bid for Tidded Co
Louieed Co has recently made a bid for Tidded Co, a smaller listed company. Tidded Co also supplies a range of educational material, but has been one of the leaders in the development of online testing and has shown strong profit growth over recent years. All of Tidded Co’s initial five founders remain on its board and still hold 45% of its issued share capital between them. From the start, Tidded Co’s directors have been used to making quick decisions in their areas of responsibility. Although listing has imposed some formalities, Tidded Co has remained focused on acting quickly to gain competitive advantage, with the five founders continuing to give strong leadership.

Louieed Co’s initial bid of five shares in Louieed Co for three shares in Tidded Co was rejected by Tidded Co’s board.

There has been further discussion between the two boards since the initial offer was rejected and Louieed Co’s board is now considering a proposal to offer Tidded Co’s shareholders two shares in Louieed Co for one share in Tidded Co or a cash alternative of $22·75 per Tidded Co share. It is expected that Tidded Co's shareholders will choose one of the following options:

(i) To accept the two-shares-for-one-share offer for all the Tidded Co shares; or,

(ii) To accept the cash offer for all the Tidded Co shares; or,

(iii) 60% of the shareholders will take up the two-shares-for-one-share offer and the remaining 40% will take the cash offer.

In case of the third option being accepted, it is thought that three of the company's founders, holding 20% of the share capital in total, will take the cash offer and not join the combined company. The remaining two founders will probably continue to be involved in the business and be members of the combined company's board.

Louieed Co’s finance director has estimated that the merger will produce annual post-tax synergies of $20 million. He expects Louieed Co’s current price-earnings (P/E) ratio to remain unchanged after the acquisition.

Extracts from the two companies’ most recent accounts are shown below:

The tax rate applicable to both companies is 20%.

Assume that Louieed Co can obtain further debt funding at a pre-tax cost of 7·5% and that the return on cash surpluses is 5% pre-tax.

Assume also that any debt funding needed to complete the acquisition will be reduced instantly by the balances of cash and cash equivalents held by Louieed Co and Tidded Co.

Required:
(a) Discuss the advantages and disadvantages of the acquisition of Tidded Co from the viewpoint of Louieed Co. (6 marks)

Nubo Co has divisions operating in two diverse sectors: production of aircraft parts and supermarkets. Whereas the aircraft parts production division has been growing rapidly, the supermarkets division’s growth has been slower. The company is considering selling the supermarkets division and focusing solely on the aircraft parts production division.

Extracts from the Nubo Co’s most recent financial statements are as follows:

Year ended 30 November 2013
$m
Profit after tax 166
Non-current assets 550
Current assets 122
Non-current liabilities 387
Current liabilities 95

About 70% of Nubo Co’s non-current assets and current assets are attributable to the supermarkets division and the remainder to the aircraft parts production division. Each of the two divisions generates roughly half of the total profit after tax.

The market value of the two divisions is thought to be equivalent to the price-to-earnings (PE) ratios of the two divisions’ industries. The supermarket industry’s PE ratio is 7 and the aircraft parts production industry’s PE ratio is 12.

Nubo Co can either sell the supermarkets division as a going concern or sell the assets of the supermarkets division separately. If the assets are sold separately, Nubo Co believes that it can sell the non-current assets for 115% of the book value and the current assets for 80% of the book value. The funds raised from the sale of the supermarkets division will be used to pay for all the company’s current and non-current liabilities.

Following the sale of the supermarkets division and paying off the liabilities, Nubo Co will raise additional finance for new projects in the form of debt. It will be able to borrow up to a maximum of 100% of the total asset value of the new downsized company.

One of the new projects which Nubo Co is considering is a joint venture with Pilvi Co to produce an innovative type of machinery which will be used in the production of light aircraft and private jets. Both companies will provide the expertise and funding required for the project equally.

Representatives from both companies will make up the senior management team and decisions will be made jointly. Legal contracts will be drawn up once profit-sharing and other areas have been discussed by the companies and agreed on.

Pilvi Co has approached Ulap Bank for the finance it requires for the venture, based on Islamic finance principles. Ulap Bank has agreed to consider the request from Pilvi Co, but because the financing requirement will be for a long period of time and because of uncertainties surrounding the project, Ulap Bank wants to provide the finance based on the principles of a Musharaka contract, with Ulap Bank requiring representation on the venture’s senior management team.

Normally Ulap Bank provides funds based on the principles of a Mudaraba contract, which the bank provides for short-term, low-risk projects, where the responsibility for running a project rests solely with the borrower.

Required:

Advise Nubo Co whether it should sell the supermarkets division as a going concern or sell the assets separately and estimate the additional cash and debt funds which could be available to the new, downsized company. Show all relevant calculations. (7 marks)

Nubo Co has divisions operating in two diverse sectors: production of aircraft parts and supermarkets. Whereas the aircraft parts production division has been growing rapidly, the supermarkets division’s growth has been slower. The company is considering selling the supermarkets division and focusing solely on the aircraft parts production division.

Extracts from the Nubo Co’s most recent financial statements are as follows:

Year ended 30 November 2013
$m
Profit after tax 166
Non-current assets 550
Current assets 122
Non-current liabilities 387
Current liabilities 95

About 70% of Nubo Co’s non-current assets and current assets are attributable to the supermarkets division and the remainder to the aircraft parts production division. Each of the two divisions generates roughly half of the total profit after tax.

The market value of the two divisions is thought to be equivalent to the price-to-earnings (PE) ratios of the two divisions’ industries. The supermarket industry’s PE ratio is 7 and the aircraft parts production industry’s PE ratio is 12.

Nubo Co can either sell the supermarkets division as a going concern or sell the assets of the supermarkets division separately. If the assets are sold separately, Nubo Co believes that it can sell the non-current assets for 115% of the book value and the current assets for 80% of the book value. The funds raised from the sale of the supermarkets division will be used to pay for all the company’s current and non-current liabilities.

Following the sale of the supermarkets division and paying off the liabilities, Nubo Co will raise additional finance for new projects in the form of debt. It will be able to borrow up to a maximum of 100% of the total asset value of the new downsized company.

One of the new projects which Nubo Co is considering is a joint venture with Pilvi Co to produce an innovative type of machinery which will be used in the production of light aircraft and private jets. Both companies will provide the expertise and funding required for the project equally.

Representatives from both companies will make up the senior management team and decisions will be made jointly. Legal contracts will be drawn up once profit-sharing and other areas have been discussed by the companies and agreed on.

Pilvi Co has approached Ulap Bank for the finance it requires for the venture, based on Islamic finance principles. Ulap Bank has agreed to consider the request from Pilvi Co, but because the financing requirement will be for a long period of time and because of uncertainties surrounding the project, Ulap Bank wants to provide the finance based on the principles of a Musharaka contract, with Ulap Bank requiring representation on the venture’s senior management team.

Normally Ulap Bank provides funds based on the principles of a Mudaraba contract, which the bank provides for short-term, low-risk projects, where the responsibility for running a project rests solely with the borrower.

An alternative to selling the supermarkets division would be to demerge both the divisions. In this case, all of Nubo Co’s liabilities would be taken over by the demerged supermarkets division. Also, either of the demerged companies can borrow up to 100% of their respective total asset values.

Required:

Discuss whether a demerger of the supermarkets division may be more appropriate than a sale. (6 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:

Assesses whether the Chief Financial Officer’s recommendation would provide a suitable defence against a bid from SGF Co and would be a viable option for Pursuit Co. (5 marks)