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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

(c)

Payment may be made in ordinary shares, preference shares, some form of debt, often with a conversion or warrant option attached, cash, or some combination of these. From an investor’s perspective cash provides a known, precise sum, and might be favoured for this reason. However, in some countries payment in cash might lead to an immediate capital gains tax liability for the investor. Preference shares and debt are rarely favoured by investors as they alter the characteristic and risk of the investment. Payment with ordinary shares offers a continuation in ownership of the entity, albeit as part of the successful bidder. However, relative share prices will change during the period of the bid, and the owner of shares in the potential victim company will not know the precise post-acquisition value of the bid.

Neither of the potential bids in (a) or (b) could be financed entirely in cash without significant new external borrowing, with its resultant impact on gearing. In part (b) the volatility of dot.com shares might make payment in shares unattractive to investors. Sometimes investors are given a choice in the method of payment, with the logic that different forms of payment might be attractive to different types of investor. This could influence the success or failure of both bids, but is problematic for the bidder in that the cash needs and number of shares to be issued are not known, and the company’s capital structure may alter in an unplanned manner. Ideally a bidder would like to tailor the form of the bid to that favoured by major investors in the potential victim company.

Answer 29 SYNERGY

Briefing Memo: Mergers and acquisitions

(a)

The motive for many mergers and acquisitions is to create incremental value through the existence of synergy when two entities are combined. Synergy means that the value of the new whole is greater than the sum of the previous values of the component parts. Synergy may exist for several reasons:

Operating synergy:

Operating synergies arise from improved productivity, or from cost cutting as a result of the merger. Economies of scale or scope might exist in the larger merged entity. Such economies may relate to production, marketing or finance, the latter including access to capital markets on improved terms. There might also be increased market power, allowing some advantage to be taken of an oligopolistic position.

If the victim company was relatively badly managed it might be possible to eliminate inefficiencies that previously existed. Alternatively better use may be made of talented managers who were not previously utilised to their full potential.

Where a victim company is “cash rich” more efficient use might be made of such cash.

Gains may occur from horizontal mergers where competitors are purchased. Gains occur through rationalisation of research and development, sales and distribution, duplicated facilities and sales outlets, computer facilities etc. Vertical mergers between customers and suppliers can create value by eliminating various co-ordination, security of supply and bargaining problems.

Synergy may exist though the greater ability to transfer resources from one division to another.

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Financial synergy:

Financial synergy may exist after a merger as the new entity may be more diversified. Diversification reduces the risk of cash flows, making the company more attractive to investors and reducing the company’s cost of capital.

There may also be tax synergies, whereby the combined entity is able to fully utilise tax allowances or tax losses that could not previously be utilised.

(b)

Evidence suggests that many mergers and acquisitions do not achieve the forecast synergies, and that shareholders in the target firm reap most benefits from any additional value created. Reasons for not achieving expected synergy include:

The acquisition decision is based upon incomplete or incorrect information

Synergies are difficult to value

Unexpected costs and problems exist when combining two organisations with different organisational structures, cultures and managerial styles

Managers are not given suitable incentives to achieve maximum synergies.

(c)

Mergers purely for diversification may be beneficial as they may reduce the cost of capital as explained above. Other possible benefits from diversification are:

The flexibility of the company may be enhanced

Debt capacity is normally increased

The risk of corporate failure is often reduced

Competitors may find it more difficult to access relevant information about a diversified company, as it is not immediately clear how individual sections of the company are performing, and what is their strategy.

However, it is usually considered that investors can diversify far more efficiently through their portfolios than can company managers.

Answer 30 INTERGRAND

(a)(i)

Organic growth is internal growth, achieved by expansion of existing business or investment in new projects. One advantage is that any investment can be planned exactly to the needs of the organisation. A further advantage is that organic growth tends by definition to be in a related area, thus overcoming the problems which arise from diversification into non-core areas, which might substantially increase the risk of failure. Organic growth also avoids the payment of a considerable premium over the existing market price that is often required in an acquisition. This premium is not always justified by expected savings/synergies.

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

(ii)Acquisitions have the following potential advantages:

Growth, market penetration, access to new markets or productive capacity may be achieved at a much quicker rate by buying existing operations.

High start-up costs are avoided.

Barriers to entry in an industry or country may be avoided.

The acquisition may remove an actual or potential competitor from the market.

The bidder acquires an instant market share, probable expertise of local markets, and an existing “reputation” of the acquired company. In a foreign country with different language, culture, business practices and accounting, tax and legal systems such expertise is essential.

They may offer advantages that do not exist with organic growth. These include possible synergy, asset stripping, acquisition of skilled managers or labour, brands, patents and trademarks, acquisition of “surplus” cash or tax losses.

The relative risk of acquisitions and organic growth is important. This is not always easy to quantify, but an acquisition in a foreign country would normally be less risky than an organic start-up situation.

(b)Report on the possible acquisition of Oberberg AG

In financial terms, Oberberg should be purchased if the expected adjusted present value (APV) of the acquisition is positive, in other words the incremental cash flows exceed the price to be paid. However, it is important that the acquisition fits well with the strategic plans of Intergrand, and strategic issues or other non-financial considerations might outweigh the financial findings.

Based upon the data provided by Oberberg’s managers the expected operating cash flows of Oberberg are:

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(i)The free cash flows of Oberberg should be discounted at a rate reflecting the risk of Oberberg. Assuming corporate debt to be virtually risk free, the ungeared beta of Oberberg may be estimated using:

E, the market value of equity is 150,000 shares × 300 Euro per share = E45 million

D, the market value of debt is (E18 million × 1.230) + E30 million = E52.14 million

45

Beta asset = 1·4 × 45+52·14(10-0·25) = 0·75

Using the capital asset pricing model, the cost of equity for Oberberg without gearing is:

4% + (11% – 4%) 0·75 = 9·25%

9% will be used as the discount rate for operating cash flows.

Notes:

(i)Extra taxation. As the tax rate in the UK is 5% higher than in Germany, an extra tax liability would arise after acquisition.

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(ii)The benefit of extra publicity is Euro 1 million per year, less tax relief (as the cost of advertising to Intergrand would have been net of tax relief).

The present value to infinity of this is 0·100·7 = 7·0 million, using Intergrand’s discount rate of 10%.

(iii)The investment should be charged with the lost export cash flows. After tax these are £800,000 × 0·5 × (1 – 0·3) = £280,000 per year. However, using the purchasing power parity theory the pound is expected to fall in value by 1·041·02 = 1·0196 or 1·96% per year.

Expected exchange rates are:

This assumes a constant rate between the Euro and the pound, for example as a result of the UK joining the Euro bloc in 2006.

The total expected PV from lost exports is 4,253, or Euro 4·3 million

(iv)Investment for expansion of Euro 9 million in 2005 is included as its effects have been included in the subsequent cash flows.

The present value of this investment, using Intergrand’s discount rate, is: 9 × 0·751 = 6·8 million.

(v)Tax relief from the use of debt

If we assume the debt will be refinanced into perpetuity: .

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

(vii)Intergrand is an UK company that is primarily concerned with cash flows that are available in pounds. If the Euro continues to appreciate in value the Sterling economic value of the investment might increase, although economic exposure such as this is difficult to quantify. Additionally, it is not known whether or not the UK will join the Euro bloc, and if so when this will occur.

(viii)There is no certainty that the lost exports can be diverted to an alternative market.

(ix)There is no information on the size of Intergrand, and how important the acquisition is relative to the total activities of Intergrand. If it is of major importance much more research needs to be undertaken into the proposed acquisition in terms of how integration would occur, including organisational structures, cultures and human resource policies.

(x)Do alternative investments exist that would be a better strategic fit for Intergrand, or have a higher expected NPV/APV?

(xi)Will the two organisations integrate successfully? Are there significant differences in organisational cultures?

(xii)Will key staff of Oberberg stay on after the acquisition?

(xiii)What will be the effect on morale within Oberberg of the redundancies and asset disposals?

(xiv)Would Intergrand need to make any additional investment in Oberberg?

Answer 31 PAXIS PLC

(a)

The amount of expected synergy created may be estimated by comparing the sum of the preacquisition values of the individual companies with the expected post-acquisition value of the combined company.

Paxis

Free cash flow:

Cost of equity using CAPM:

Ke = 4% + (11% – 4%) 1·18 = 12·26%

Weighted average cost of capital:

(N.B. rounded discount rates, for example 10%, are also acceptable in the solution)

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