C3 B’NESS & C.

FINANCE COVENANT FINANCIAL CONSULTANTS

C3 REVIEW QUESTIONS ON MERGERS AND ACQUISITIONS

QUESTION 01
Dodo co. Ltd is a firm whose CFs after tax but before interest are specified below
After tax (before intrest CFs)
Year TZS millions
20X6 530
20X7 620
20X8 onwards 710
Dodo co. has received a bid to be acquired by Sarwart Co at TZS 2800 millions. Both companies have a
gearing level of 20%. Currently, Dodo co has 8% irredeemable bond of TZS 410 millions trading at per i.e
TZS 100 per bond. Tax rate is at 30%
Dodo company’s risk premium is 7% and the company’s equity beta is 2.0 while risk free rate is standing at
5%.
Required:
a. Find value of Dodo co basing on free CFs before interest
b. Find value of Dodo basing on free CFs after interest
What is the significance of values computed above given the bid received from Sarwart?

QUESTION 02
TWIGA International, a company quoted on the Dar es Salaam stock exchange, has decided to diversify into
a new sector in order to reduce its risk. However, the company has not decided whether to diversify through
acquisition of an existing business in the new sector or to establish a new company (organic growth). TWIGA
International has cash balances of K240 million which are currently invested in short-term money market
deposits.
The company has identified a possible acquisition target, SERENGETI Ltd, a smaller quoted company in
the new sector. Even though SERENGETI Ltd is quoted, approximately 60% of its shares are still owned by
four directors. These directors have stated that they might be prepared to recommend the sale of
SERENGETI Ltd, but they consider the total value of its shares to be worth K235 million. As a Finance
Manager of TWIGA International, you have been asked to establish if the value given by the directors is
reasonable. The following financial information has been provided:

Summarised financial data: Figures in TZS millions

Detais TWIGA SERENGETI
Turnover 530 88
Pre- tax operating cash flow 101 55
Taxation (30%) 30.3 16.5
Post- tax operating cash flow 70.7 38.5
Dividend 12 10.03
Retained earnings 58.7 28.47

Statement of financial position

Non-current assets (net) 218 58
Current assets 185 54

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Current liabilities 149 51

Liabilities and owners equity

Ordinary shares (TZS 50 par for Twiga) and TZS15 par for target 60 4.5
Reserves 139 52.1
12% Debentures 20X7 40 0
10% Bank term loan 15 0
Recent 11% bank loan 0 4.4

Current share price TZS 885 TZS 460

Average dividend growth during the last five years 8% p.a. 10% p.a.
Equity beta 0.85 1.01
Industry data:
Average P/E ratio 9 7
Average P/E of companies recently taken over, based upon the offer
price 10 5
The risk free rate of return is 7% per annum and the market return 15% per annum.
Other information:

1. After the acquisition some land and buildings of SERENGETI would be sold for K8 million (after
tax).

2. Following the acquisition, it’s expected that 145 employees of SERENGETI would immediately be
made redundant at an after tax cost of K10 million. Pre-tax annual wage savings are expected to be
K1 million. Pre-tax advertising and distribution savings are expected to be K750, 000 per year.

3. The four existing directors of SERENGETI would each be paid an after tax consultancy fees of
4. K500,000 per year for four years for consultancy services if the acquisition succeeds. This amount
would not increase with inflation.

Ignore inflation
Required:
a. Estimate the value of SERENGETI Ltd using the following valuation methods:
(i) The comparative P/E
(ii) The dividend valuation model
(iii) The present value of relevant operating cash flows over a fifteen (15) year period.
b. Advise whether, TWIGA International should proceed with the acquisition of SERENGETI Ltd
shares.
Explain whether diversification through mergers and acquisitions is an effective means of reducing risk
and securing future growth for TWIGA International.

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QUESTION 03 (VALUATION OF INTANGIBLES)

a. Leteraha co Ltd is a company specialised in information research and development for on line
marketing. The company is rich in intangible assets and the owners are keen to establish the value
of such intangibles using CIV method.

Leteraha’s income statement for the previous year shows an operating profit of TZS 687Millions
and the company’s statement of financial position showed an asset base of TZS 1,560 Millions. Short
tem growth in earnings is expected to be at the rate of 4% and the firm’s weighted average cost of
capital is 7%.

Sweetners co Ltd has been identified as an appropriate competitor for Leteraha Co Ltd. Sweetners
had a profit of TZS 1,250millions for the past year and an asset base of TZS 7,800millions. Corporate
tax is at 30%.

Find,

i. Value of intangible assets

ii. Total value of assets

b. Hope plc is an exploration company based in Mtwara region. Currently the company incurs heavy
spending in exploring oil and gas reserver in the region. The company has nornalised earnings of
TZS 700 millions.
Hope plc’s monetary assets value has been established as TZS 50 millions while the firm’s tangible
assets amounts to TZS TZS 1850 millions. The company’s cost of capital and growth rate is currently
standing at 12% and 10% respectively. The growth rate is expected to fall to 5% from year six
onwards. The current risk free rate is 4% and the industry’s average returns for the firms trading on
the basis of their intangible assets are currently at 7%.
Calculate the value of Hope plc’s intangible assets using Lev’s knowledge earning method.

QUESTION 4
Serena group of hotels is considering the acquisition of Movenpick hotel at a cost of TShs 4 billion. The
group of hotels' cost of capital is currently 16% due to its high gearing level. Movenpick hotel has no debt.
As a result of this acquisition, the cost of capital for Serena group of hotels will drop to 12%. Total cash
flows will also increase by Tshs 500 million per annum in perpetuity.
Required:
(a) Using the net present value (NPV) approach, advise the management of Serena group of hotels on the
acquisition of Movenpick hotel. (3 marks)

(b) If the acquisition was funded by borrowing so that there is no impact on gearing after acquisition and the
cost of capital was not reduced, advise the management of Serena group of hotels whether to proceed
with the acquisition of Movenpick hotel. (3 marks)

QUESTION 5 (ACCA ADAPTED)

Sigra Co is a listed company producing confectionary products which it sells around the world. It wants to
acquire Dentro Co, an unlisted company producing high quality, luxury chocolates. Sigra Co proposes to pay
for the acquisition using one of the following three methods:
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Method 1
A cash offer of $5·00 per Dentro Co share; or
Method 2
An offer of three of its shares for two of Dentro Co’s shares; or
Method 3
An offer of a 2% coupon bond in exchange for 16 Dentro Co’s shares. The bond will be redeemed in three
years at its par value of $100.
Extracts from the latest financial statements of both companies are as follows:

Sigra Co Dentro Co
$’000 $’000
Sales revenue 44,210 4,680
––––––– ––––––
Profit before tax 6,190 780
Taxation (1,240) (155)
––––––– ––––––
Profit after tax 4,950 625
Dividends (2,700) (275)
––––––– ––––––
Retained earnings for the year 2,250 350
––––––– ––––––
Non-current assets 22,450 3,350
Current assets 3,450 247
Non-current liabilities 9,700 873
Current liabilities 3,600 436
Share capital (40c per share) 4,400 500
Reserves 8,200 1,788
Sigra Co’s current share price is $3·60 per share and it has estimated that Dentro Co’s price to earnings ratio
is 12·5% higher than Sigra Co’s current price to earnings ratio. Sigra Co’s non-current liabilities include a
6% bond redeemable in three years at par which is currently trading at $104 per $100 par value.
Sigra Co estimates that it could achieve synergy savings of 30% of Dentro Co’s estimated equity value by
eliminating duplicated administrative functions, selling excess non-current assets and through reducing the
workforce numbers, if the acquisition were successful.

Required:
(a) Estimate the percentage gain on a Dentro Co share under each of the above three payment
methods. Comment on the answers obtained. (16 marks)

(b) In relation to the acquisition, the board of directors of Sigra Co are considering the following two
proposals:

Proposal 1
Once Sigra Co has obtained agreement from a significant majority of the shareholders, it will enforce
the remaining minority shareholders to sell their shares; and
Proposal 2
Sigra Co will offer an extra 3 cents per share, in addition to the bid price, to 30% of the shareholders of
Dentro Co on a first-come, first-serve basis, as an added incentive to make the acquisition proceed
more quickly.
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Required:

With reference to the key aspects of the global regulatory framework for mergers and acquisitions,
briefly discuss the above proposals. (4 marks) (20 marks)

QUESTION 6 (ACCA ADAPTED)

Nahara Co is a private holding company owned by the government of a wealthy oil-rich country to invest its
sovereign funds. Nahara Co has followed a strategy of risk diversification for a number of years by acquiring
companies from around the world in many different sectors.
One of Nahara Co’s acquisition strategies is to identify and purchase undervalued companies in the airline
industry in Europe. A recent acquisition was Fugae Co, a company based in a country which is part of the
European Union (EU). Fugae Co repairs and maintains aircraft engines.
A few weeks ago, Nahara Co stated its intention to pursue the acquisition of an airline company based in the
same country as Fugae Co. The EU, concerned about this, asked Nahara Co to sell Fugae Co before pursuing
any further acquisitions in the airline industry.
Avem Co’s acquisition interest in Fugae Co
Avem Co, a UK-based company specialising in producing and servicing business jets, has approached
Nahara Co with a proposal to acquire Fugae Co for $1,200 million. Nahara Co expects to receive a premium
of at least 30% on the estimated equity value of Fugae Co, if it is sold.
Given below are extracts from the most recent statements of financial position of both Avem Co and Fugae
Co.

Avem Co Fugae Co
$ million $ million
Share capital (50c/share) 800 100
Reserves 3,550 160
Non-current liabilities 2,200 380
Current liabilities 130 30
–––––– ––––
Total capital and liabilities 6,680 670
–––––– ––––
Each Avem Co share is currently trading at $7·50, which is a multiple of 7·2 of its free cash flow to equity.
Avem Co expects that the total free cash flows to equity of the combined company will increase by $40
million due to synergy benefits. After adding the synergy benefits of $40 million, Avem Co then expects the
multiple of the total free cash flow of the combined company to increase to 7·5.
Fugae Co’s free cash flow to equity is currently estimated at $76·5 million and it is expected to generate a
return on equity of 11%. Over the past few years, Fugae Co has returned 77·3% of its annual free cash flow
to equity back to Nahara Co, while retaining the balance for new investments.
Fugae Co’s non-current liabilities consist entirely of $100 nominal value bonds which are redeemable in four
years at the nominal value, on which the company pays a coupon of 5·4%. The debt is rated at B+ and the
credit spread on B+ rated debt is 80 basis points above the risk-free rate of return.
Proposed luxury transport investment project by Fugae Co
In recent years, the country in which Fugae Co is based has been expanding its tourism industry and hopes
that this industry will grow significantly in the near future. At present tourists normally travel using public
transport and taxis, but there is a growing market for luxury travel. If the tourist industry does expand, then
the demand for luxury travel is expected to grow rapidly. Fugae Co is considering entering this market
through a four-yearproject. The project will cease after four years because of increasing competition.
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The initial cost of the project is expected to be $42,000,000 and it is expected to generate the following after-
taxcash flows over its four-year life:

Year 1 2 3 4
Cash flows ($000s) 3,277.6 16,134.3 36,504.7 35,683.6
The above figures are based on the tourism industry expanding as expected. However, it is estimated that
there is a 25% probability that the tourism industry will not grow as expected in the first year. If this happens,
then the present value of the project’s cash flows will be 50% of the original estimates over its four-year life.

It is also estimated that if the tourism industry grows as expected in the first year, there is still a 20%
probability that the expected growth will slow down in the second and subsequent years, and the present
value of the project’s cash flows would then be 40% of the original estimates in each of these years.
Lumi Co, a leisure travel company, has offered $50 million to buy the project from Fugae Co at the start of
the second year. Fugae Co is considering whether having this choice would add to the value of the project.
If Fugae Co is bought by Avem Co after the project has begun, it is thought that the project will not result in
any additional synergy benefits and will not generate any additional value for the combined company, above
any value the project has already generated for Fugae Co.
Although there is no beta for companies offering luxury forms of travel in the tourist industry, Reka Co, a
listed company, offers passenger transportation services on coaches, trains and luxury vehicles. About 15%
of its business is in the luxury transport market and Reka Co’s equity beta is 1·6. It is estimated that the asset
beta of the non-luxury transport industry is 0·80. Reka Co’s shares are currently trading at $4·50 per share
and its debt is currently trading at $105 per $100. It has 80 million shares in issue and the book value of its
debt is $340 million. The debt beta is estimated to be zero.
General information
The corporation tax rate applicable to all companies is 20%. The risk-free rate is estimated to be 4% and the
market risk premium is estimated to be 6%.

Required:
(a) Discuss whether or not Nahara Co’s acquisition strategies, of pursuing risk diversification and of
purchasing undervalued companies, can be valid. (7 marks)

(b) Prepare a report for the Board of Directors of Avem Co, which:
(i) Estimates the additional value created for Avem Co, if it acquires Fugae Co without
considering the luxury transport project; (10 marks)
(ii) Estimates the additional value of the luxury transport project to Fugae Co, both with and
without the offer from Lumi Co; (18 marks)
(iii) Evaluates the benefit attributable to Avem Co and Fugae Co from combining the two
companies with and without the project, and concludes whether or not the acquisition is
beneficial. The evaluation should include any assumptions made. (7 marks)

QUESTION 7 (ACCA ADAPTED)

AggroChem Co is undertaking a due diligence investigation of LeverChem Co and is reviewing the potential
bid price for an acquisition. You have been appointed as a consultant to advise the company’s management
on the financial aspects of the bid.
AggroChem is a fully listed company financed wholly by equity. LeverChem is listed on an alternative
investment market. Both companies have been trading for over 10 years and have shown strong levels of

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profitability recently. However, both companies’ shares are thinly traded. It is thought that the current market
value of LeverChem’s shares at 331/3% higher than the book value is accurate, but it is felt that AggroChem
shares are not quoted accurately by the market.
The following information is taken from the financial statements of both companies at the start of the
current year:
AggroChem LeverChem
$’000 $’000
–––––– ––––––
Assets less current liabilities 4,400 4,200
–––––– ––––––
Capital Employed
Equity 4,400 1,200
5-year floating rate loan at yield rate plus 3% 3,000
–––––– ––––––
Total capital employed 4,400 4,200
–––––– ––––––
Net operating profit after tax (NOPAT) 580 430
Net amount retained for reinvestment in assets 180 150
It can be assumed that the retained earnings for both companies are equal to the net reinvestment in assets.
The assets of both companies are stated at fair value. Discussions with the AtReast Bank have led to an
agreement that the floating rate loan to LeverChem can be transferred to the combined business on the same
terms. The current yield rate is 5% and the current equity risk premium is 6%. It can be assumed that the risk
free rate of return is equivalent to the yield rate. AggroChem’s beta has been estimated to be 1.26.
AggroChem Co wants to use the Black-Scholes option pricing (BSOP) model to assess the value of the
combined business and the maximum premium payable to LeverChem’s shareholders. AggroChem has
conducted a review of the volatility of the NOPAT values of both companies since both were formed and
has estimated that the volatility of the combined business assets, if the acquisition were to go ahead, would
be 35%. The exercise price should be calculated as the present value of a discount (zero-coupon) bond with
an identical yield and term to maturity of the current bond.

Required:
Prepare a report for the management of AggroChem on the valuation of the combined business
following acquisition and the maximum premium payable to the shareholders of LeverChem. Your
report should:
(a) Using the free cash flow model, estimate the market value of equity for AggroChem Co, explaining
any assumptions made. (9 marks)

(b) Explain the circumstances in which the Black-Scholes option pricing (BSOP) model could be used
to assess the value of a company, including the data required for the variables used in the model.
(5 marks)

(c) Using the BSOP methodology, estimate the maximum price and premium AggroChem may pay
for LeverChem. (9 marks)

(d) Discuss the appropriateness of the method used in part (iii) above, by considering whether the
BSOP model can provide a meaningful value for a company. (5 marks)

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