ACCA AFM Syllabus C. Acquisitions And Mergers - The three acquisition types - Past Papers ^{2 / 3}

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:

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

Cigno Co is a large pharmaceutical company, involved in the research and development (R&D) of medicines and other healthcare products. Over the past few years, Cigno Co has been finding it increasingly difficult to develop new medical products. In response to this, it has followed a strategy of acquiring smaller pharmaceutical companies which already have successful products in the market and/or have products in development which look very promising for the future. It has mainly done this without having to resort to major cost-cutting and has therefore avoided large-scale redundancies. This has meant that not only has Cigno Co performed reasonably well in the stock market, but it has
also maintained a high level of corporate reputation.

Anatra Co is involved in two business areas: the first area involves the R&D of medical products, and the second area involves the manufacture of medical and dental equipment. Until recently, Anatra Co’s financial performance was falling, but about three years ago a new chief executive officer (CEO) was appointed and she started to turn the company around. Recently, the company has developed and marketed a range of new medical products, and is in the process of developing a range of cancer-fighting medicines. This has resulted in a good performance in the stock market, but many analysts believe that its shares are still trading below their true value. Anatra Co’s CEO is of the opinion that the turnaround in the company’s fortunes makes it particularly vulnerable to a takeover threat, and she is thinking of defence strategies that the company could undertake to prevent such a threat. In particular, she was thinking of disposing some of the company’s assets and focussing on its core business.

Cigno Co is of the opinion that Anatra Co is being held back from achieving its true potential by its equipment manufacturing business and that by separating the two business areas, corporate value can be increased. As a result, it is considering the possibility of acquiring Anatra Co, unbundling the manufacturing business, and then absorbing Anatra Co’s R&D of medical products business. Cigno Co estimates that it would need to pay a premium of 35% to Anatra Co’s shareholders to buy the company.

Financial information: Anatra Co
Given below are extracts from Anatra Co’s latest statement of profit or loss and statement of financial position for the year ended 30 November 2015.

Post-acquisition benefits from acquiring Anatra Co
Cigno Co estimates that following the acquisition and unbundling of the manufacturing business, Anatra Co’s future sales revenue and profitability of the medical R&D business will be boosted. The annual sales growth rate is expected to be 5% and the profit margin before interest and tax is expected to be 17·25% of sales revenue, for the next four years. It can be assumed that the current tax allowable depreciation will remain equivalent to the amount of investment needed to maintain the current level of operations, but that the company will require an additional investment in assets of 40c for every $1 increase in sales revenue.

After the four years, the annual growth rate of the company’s free cash flows is expected to be 3% for the foreseeable future.

Anatra Co’s unbundled equipment manufacturing business is expected to be divested through a sell-off, although other options such as a management buy-in were also considered. The value of the sell-off will be based on the medical and dental equipment manufacturing industry. Cigno Co has estimated that Anatra Co’s manufacturing business should be valued at a factor of 1·2 times higher than the industry’s average price-to-earnings ratio. Currently the industry’s average earnings-per-share is 30c and the average share price is $2·40.

Possible additional post-acquisition benefits
Cigno Co estimates that it could achieve further cash flow benefits following the acquisition of Anatra Co, if it undertakes a limited business re-organisation. There is some duplication of the R&D work conducted by Cigno Co and Anatra Co, and the costs related to this duplication could be saved if Cigno Co closes some of its own operations. However, it would mean that many redundancies would have to be made including employees who have worked in Cigno Co for many years. Anatra Co’s employees are considered to be better qualified and more able in these areas of duplication, and would therefore not be made redundant.

Cigno Co could also move its headquarters to the country where Anatra Co is based and thereby potentially save a significant amount of tax, other than corporation tax. However, this would mean a loss of revenue for the government
where Cigno Co is based.

The company is concerned about how the government and the people of the country where it is based might react to these issues. It has had a long and beneficial relationship with the country and with the country’s people.

Cigno Co has estimated that it would save $1,600 million after-tax free cash flows to the firm at the end of the first year as a result of these post-acquisition benefits. These cash flows would increase by 4% every year for the next three years.

Estimating the combined company’s weighted average cost of capital
Cigno Co is of the opinion that as a result of acquiring Anatra Co, the cost of capital will be based on the equity beta and the cost of debt of the combined company. The asset beta of the combined company is the individual companies’ asset betas weighted in proportion of the individual companies’ market value of equity. Cigno Co has a market debt to equity ratio of 40:60 and an equity beta of 1·10.

It can be assumed that the proportion of market value of debt to market value of equity will be maintained after the two companies combine.

Currently, Cigno Co’s total firm value (market values of debt and equity combined) is $60,000 million and Anatra Co’s asset beta is 0·68.

Additional information
– The estimate of the risk free rate of return is 4·3% and of the market risk premium is 7%.
– The corporation tax rate applicable to all companies is 22%.
– Anatra Co’s current share price is $3 per share, and it can be assumed that the book value and the market value of its debt are equivalent.
– The pre-tax cost of debt of the combined company is expected to be 6.0%.

Important note
Cigno Co’s board of directors (BoD) does not require any discussion or computations of currency movements or exposure in this report. All calculations are to be presented in $ millions. Currency movements and their management will be considered in a separate report. The BoD also does not expect any discussion or computations relating to the financing of acquisition in this report, other than the information provided above on the estimation of the cost of capital.

(d) Takeover regulation, where Anatra Co is based, offers the following conditions aimed at protecting shareholders:
the mandatory-bid condition through sell out rights, the principle of equal treatment, and squeeze-out rights.

Required:
Explain the main purpose of each of the three conditions. (6 marks)

Makonis Co, a listed company producing motor cars, wants to acquire Nuvola Co, an engineering company involved in producing innovative devices for cars. Makonis Co is keen to incorporate some of Nuvola Co’s innovative devices into its cars and thereby boosting sales revenue.

The following financial information is provided for the two companies:

Makonis Co
Current share price $5•80 
Number of issued shares 210 million 
Equity beta 1•2 
Asset beta 0•9

Nuvola Co
Current share price $2.40 
Number of issued shares 200 million 
Equity beta 1•2 
Asset beta 1.2

It is thought that combining the two companies will result in several benefits. Free cash flows to firm of the combined company will be $216 million in current value terms, but these will increase by an annual growth rate of 5% for the next four years, before reverting to an annual growth rate of 2•25% in perpetuity. In addition to this, combining the companies will result in cash synergy benefits of $20 million per year, for the next four years. These synergy benefits are not subject to any inflationary increase and no synergy benefits will occur after the fourth year. The debt-to-equity ratio of the combined company will be 40:60 in market value terms and it is expected that the combined company’s cost of debt will be 4•55%.

The corporation tax rate is 20%, the current risk free rate of return is 2% and the market risk premium is 7%. It can be assumed that the combined company’s asset beta is the weighted average of Makonis Co’s and Nuvola Co’s asset betas, weighted by their current market values.

Makonis Co has offered to acquire Nuvola Co through a mixed offer of one of its shares for two Nuvola Co shares plus a cash payment, such that a 30% premium is paid for the acquisition. Nuvola Co’s equity holders feel that a 50% premium would be more acceptable. Makonis Co has sufficient cash reserves if the premium is 30%, but not if it is 50%.

Required:

Estimate the additional equity value created by combining Nuvola Co and Makonis Co, based on the free cash flows to firm method. Comment on the results obtained and briefly discuss the assumptions made. (13 marks)