LESSON 4 FINANCIAL CONSIDERATION IN MERGERS AND ACQUISITIONS Learning outcomes After completing this lesson, you should be able to: ‘© Evaluate an offer (bid) and calculate the expected gains from takeovers; * Calculate exchange ratio, P/E paid, market value, post-merger or combined EPS and PIE ratio; © Evaluate M&A as a capital budgeting decision 4.1 Evaluating an Offer (bid) and Calculate the Expected Gains from Takeovers When two more companies are combined, there has to be some financial consideration for the amalgamated or acquired company. Mergers can be financed by cash or exchange of shares or combinations of cash, shares and debentures. Evaluating an acquisition is little different from other investments, assuming the motive of the bid is economic rather than managerial, i.e. designed to maximise the post-bid value of the expanded enterprise. It would be worthwhile Company A taking over Company B so long as the present value of the cash flows of the enlarged company exceeds the present value of the two companies as separate entities: Thus, measures the increase in value. The net cost to the bidder is the value of the amount expended less the value of the target as it stands: Vass >Va+ Ve Thus, [Vass - (Va + Vs) ] measures the increase in value. The net cost to the bidder is the value of the amount expended less the value of the target as it stands: Net cost = [Outlay - Ve} so that the net present value of the takeover decision is the gain less the cost, i. NPV = Vavn- (Vat Va) - [Outlay - Va} NPV = Vars- Va -Outlay Department of Financial Management 1 Dr. R-Vijayakumaran‘The NPV will depend on the method of financing and, of course, the terms of the transaction. Essentially, the bidder is hoping to extract the maximum value of any expected cost savings and synergies from the takeover for its own shareholders. Conversely, the offer must be made attractive to the owners of the target to induce them to sell, An example will illustrate the way in which the divi n of the spoils (rewards) can depend on the method of financing. Raman ple is launching a cash bid for Seetha ple, both are quoted companies and both are ungeared. Example: The market value of Raman is Rs. 200 million (10 million Rs.5 shares, market price Rs. 20) and that of Seetha is Rs. 40 million (1 million Rs.Sshares, market price Rs. 40). Raman hopes to exploit synergies, ete., worth Rs. 20 million after the takeover. It offers the shareholders of Seetha Rs. 50 million in cash. The NPV of the bid to Raman is thus: NPV = Vaes— Vs -Outlay = (Rs. 200 m+ Rs.40 m + Rs.20 m) -Rs.200 m -Rs.50 m= Rs.10.m ‘The overall gain from the takeover the synergies of Rs. 20 million) is split equally between the two sets of shareholders. The need to make a higher bid or the appearance of another bidder would probably tilt the balance of gain towards Seetha’s shareholders. If the bid is made in the form of a share-for-share offer to the same value, the arithmetic alters. In this ease, Raman is giving up part of the expanded firm and hence a further share of the gains to Seetha’s shareholders. Assuming a bid of the same value, Raman must offer them (Rs. 50 m/ Rs, 20) 2.5 m shares. This would result in a total share issue of 12.5 million shares, ic. Raman is handing over 20 per cent of the expanded company to Seetha’s shareholders. In this case, the gain enjoyed by Raman’s shareholders will be lower. The NPV of the takeover is still the gain less the cost; but the cost is greater, i.e. the proportion of the expanded company handed over less the value of Seetha as it stands: 2.5m a (a + 2.5m PG 260m ~ Rs.40m = (Rs.S2 M—Rs.40 M) =Rs.12M Hence, the NPV of the takeover from Raman’s perspective is: NPV = (gain in value - cost) = (Rs.20 m - Rs12 m) = Rs.8 m Department of Financial Management 2 Dr. RVijayakumaranRaman’s shareholders are thus left with only Rs. 8 million of the net gains from the takeover, 20 per cent lower than in the cash offer case, which is the same proportion as the share of the expanded company handed to Seetha’s shareholders. A share exchange of equivalent value to a cash bid generally leaves the bidder's shareholders worse off compared to a cash deal because their share of both the company and the gains from the takeover are diluted among the larger number of shares. ‘The post-bid share prices in these two cases are as follows: Cash bid: (Rs. 260 m/10 m shares) = Rs. 26 Share exchange: (Rs. 260 m/12.5 m shares) = Rs. 20.8 Against this, given that takeovers carry risks, for example, the risk of inability to capture the anticipated synergies, a share-based deal has the merit of transferring a portion of these risks to the targets’ former owners. However, if Raman has to borrow in order to make the cash bid, the increase in gearing may result in shareholders secking a higher return, thus lowering the market price, In addition, the analysis hinges on the existence of an efficient capital market whose assessment of the gains from takeover corresponds with that of the two parties. Practice: Predator is valued on the market at Rs.£1,000 million, and Target at Rs. 200 million. Predator values the expected post-merger synergies at Rs.50 million. If it bids Rs. 230 million for Target what is the NPV of the bid? What is the share of the gains for each firm? 4.2 Exchange Ratio It is the number of acquirer’s shares to be offered to the shareholders of Target company for each shares held by them in the target company. Both the acquirer and the target company conduct valuation of the Target Company and then acquirer determines the maximum price it is willing to pay to the target company and the target company determines the minimum price it is willing to accept. Within these limits the actual agreement price will be fixed based on the relative bargaining power and investment opportunities. Department of Financial Management 3 Dr. R.VijayakumaranThe determination of the exchange ratio (ER) is based on the value of the shares of the companies involved in the mergers as the basic objective of the financial management is to maximize shareholders wealth even the mergers decision is to be taken in the light of wealth maximization hence, a successful mergers would be one that maximize EPS, maker price of the shares of the acquiring company. Offer price Exchange ratio = SU" prite_ Aequring company’ s share price © Number of shares offered to the shareholders of target company = Target company’s shares x Exchange ratio 4.3 Important Financial Considerations in M&A Post-merger EPS or Combined EP‘ Combined earning of acquiring company and Target company Number of shares in acquring company + Number of shares issued totarget company Offer price EPS of Target company PIE pai Market value= EPS x P/E ratio Post-merger P/E ratio OR Combined P/E ratio = P y(PAT,), P yf PAT, E, \ PAT.) E, © \ PAT, Ea= P/E ratio of acquiring company PATy- Profit after tax of acquiring company P/Er - P/E ratio of Target Company PAT? - Profit after tax of Target Company PATc- Combined profit Earnings or EPS Dividend or DPS jend cover = Department of Financial Management 4 Dr. R.VijayakumaranExample 1 ‘The following is the information relative to the acquire company A and target company T. E Earning after tax (Rs.) 100,0000 No of shares" 200,000 EPS (Rs.) 5 PIE ratio 10 Market price per shares (Rs.) 50 Based on the valuation of T, A has agreed to offer Rs 65 per shares to T. This is 30% premium over the pre mergers market price of 50/= i ii iii, iv, vii. viii. ix, Calculate the exchange ratio. Calculate the number of shares offered to T limited and (post EPS) EPS after merger in the company. Assuming that its offer price of Rs.65 is rejected by Target Company and so acquiring company will offer Rs 90 per shares to the target company. Now calculate exchange ratio and compare EPS of acquiring company and Target Company before and after merger at both prices. Calculate P/E in offer price Rs.65 and offer price Rs.90 and comment on your results, Calculate the highest offer price that can be made by acquiring company without dilution of its EPS. Calculate the highest number of shares that should be exchanged to the target company’s shares when there is shares offer for shares without dilution of EPS of acquiring company. Assume that P/E ratio of acquiring company will remain at the same level after acquisition or merger. Now calculate market value of acquiring company and target company and compare your result with pre-merger figures. Calculate maximum ER without dilution of market value of shares acquiring company. Calculate the combined P/E ratio Assume that dividend cover of acquiring company and target company are 3 times and 2 times, respectively. Dividend cover remains constant after merger that is 3 times of acquiring company Now calculate DPS of acquiring company and target company before and after merger. Department of Financial Management 5 Dr. R.VijayakumaranExample 2 A ple acquired 100% of the ordinary shares of B ple by issuing its own shares. A ple share capital consists of 300,000 shares at Rs. 25 each. Its last year profit and loss account of A ple.is as follows: Profit before tax 2,400,000 Tax 50% 1,200,000) Profit after tax 1,200,000 Market price of the A ple’s shares is Rs. 40 each. B ple is an unquoted company and it consists of 100,000 shares of Rs.10. Its last year profit and loss account is as follows: Profit before tax 600,000 Tax 50% 300,000) Profit after tax 300,000 1. In arriving the P/E ratio of unquoted company (B ple), 20 % reductions may be allowed to the PYE ratio of quoted company. A ple is a quoted company. a. Find out market Value of B ple b. Calculate EPS of A ple and B ple before and after merger and compare your result. 2. Inthe above, it is assumed that P/E ratio of B ple is 12 times. Now a, Calculate market value of B ple. b. Calculate new Exchange Ratio, c, Calculate EPS of A ple and B ple before merger and after merger. 3. In the above (2) with P/E ratio 12, assume that A ple raised Rs 3600,000 by borrowing from a bank at an interest rate of 12% or by issuing 12 % debenture or long stock to B ple. Now calculate EPS of A and B ple after merger and compare your result with previous result (2) when there was share issue to target company. 4, In the above (2), it is assumed that for the settlement of consideration Rs 1800,000, 12% debentures are issued and for the balance, new shares of A ple are issued. Now compare earning of shareholders of A plc and B ple before and after merger. Department of Financial Management 6 Dr. RVijayakumaranReview questions 1. A Ltd and B Ltd are public companies in the same industry. It has been decided to merge the companies. For this purpose a new company S Ltd will be formed. A summary of the most recent data available about the two companies is given below. It is estimated that post savings resulting from the merger would be Rs. 200,000 per year. Profit before tax ALtd Yi 852 Yo 828 Y 1081 Ya 1320 Last year Ys 1500 BLid 780 960 708 744 900 Latest balance sheet of the companies are as follows: ALtd (000°) Fixed assets 3000 Current assets 3360 6360 Current liabilities Short term loans 300 2160 Others 1260 (1560) 840 4800. Long term loan 1200 Ordinary shares (at Rs.0.2 each) 960 Reserves 2640 2400 4800 3600 Current share price (MV) 90 cents Dividend cover (PAT/DPS) 3 times You are required: BLid (000°) 3000 3600 6600 3.004 360 ss 600 600 60 cents 2 times i) Calculate the cost of capital of the two companies before merger. ii) Calculate equity value of the new company and the proportion in which its shares should be allotted to the shareholders in A Ltd and B Ltd respectively. (Last year price/earning can be used for necessary calculation) Department of Financial Management 7 Dr. R.Vijayakumaran2. The Raman & Seetha’s data given below refers to the year just ended. Raman Seetha Rs.576,000 Rs.337,500 2,400,000 1,500,000 Rs.0.24 Rs.0.225 Rs.3.60 Rs.2.70 15 12 Rs.0.08 Rs.0.09 Rs.8.64 million | Rs.4.05 million Net profit after tax No. of ordinary shares in issue (at Rs.1) EPS Market price of share PIE ratio Dividend | total market value i, a. [fan offer for the shares of Seetha was made by Raman on the basis of the above share valuations, how many Raman’s shares would be issued in exchange for Seetha shares? b. Calculate the post-merger EPS of Raman based upon the total of both companies’ existing earnings, and the increased number of shares in Raman. ii, If the total post-merger earnings of Raman are valued by the stock market on a PE ratio of 15: a, What would be the value of each Raman’ share after the merger? b. Using the value calculated in ‘a’, compare the effective value of a share held by a shareholder of Setha company before and after the merger. 3. Alpha company is contemplating conversion of 500 14% convertible bonds of Rs.1,000 each, Market price of the bond is Rs.1,080. Bond indenture provides that one bond will be exchanged for 10 shares. Price-earning ratio before redemption is 20:1 and anticipated price-eamning ratio after redemption is 25:1. Number of shares outstanding prior to redemption are 10,000. EBIT amounts to Rs.200,000. The company is in the 35% tax bracket. Should the company convert bond into shares? Give reasons. 4, Lion Lid is a quoted company whose ordinary shares are valued at Rs. 6.00 (ex. div) on the share market. Ganga Ltd is an unquoted company, which is now the subject of a takeover bid by Lion Ltd. Department of Financial Management 8 Dr. R.Vijayakumaran‘The most recent summarized balance sheet of the two companies are as follows: Lion Ltd Ganga Lid (Rs *000) (Rs *000) Land and Building 150 200 Plant and Equipment 800 200 Other Fixed Assets 250 50 Net current assets 300 50 Ordinary shares of Rs | each 1000 300 Reserves 500° 200 ‘1500, 300" In the year, just ended, the earning per share and dividend per share were as follows. Lion Ltd Ganga Ltd EPS Rs 0.40 Rs 0.33 DPS Rs 0.16 Rs 0.22 There is potential for profits growth in both companies. Lion Ltd expects to be able to invest its funds to eam 13% return. Ganga Ltd expects an annual growth rate in earnings and dividends of 9% per annum. Both companies expect to retain the same proportion of distributable profits in the future years as they have done in the year just ended. Required: (a) Calculate the expected growth in future dividends of Lion Ltd and the cost of equity of Lion Ltd. mn Ltd use a dividend valuation (b) On the assumption that the management of ‘model, determine the price at which Lion Ltd should be prepared to bid for the shares of Ganga Ltd. You may assume that due to the fact that Ganga Ltd is an unquoted company, Lion Lid would require a return from its investment in Ganga Ltd which is 5% in excess of its current cost of capital. (©) On the basis of the price calculated in part (b), suggest the terms of a share for share offer that Lion Ltd might make to the shareholders of Ganga Ltd (4) What is the highest offer that Lion Ltd could make in a share for share offer without diluting the earning of its existing shareholders (based on earnings in the year just ended). Department of Financial Management 9 Dr. R.Vijayakumaran5. The following are the financial statements for A Ltd and T Ltd for the current financial year. Both firms operate in the same industry. Balance sheets Altd TLtd Total current assets 1,400,000 | 1,000,000 Total fixed assets, 1,000,000 | $00,000 Total assets 2,400,000 | 150,000 Equity capital ( of Rs. 10 each) 1,000,000 | 800,000 Retained earnings 200,000 - 14% Long terms debt | $00,000} 300,000 Total current liabilities 700,000 | 400,000 2,400,000 | _1,500,0 Income statements Gross profit 690,000 | 340,000 Operating expenses 296,923 | 145,692 Interest 70,000 42,000 Eamings before taxes (EBT) 323,077) 152,308 | Taxes (35%) 113,077 | 53,208 | Earnings after taxes (EAT) 210,000 | _99,000 ‘Additional information: ALtd TLtd Number of equity shares 100,000 80,000 Dividend payment ratio(DPS) 0.40 0.60 Market price per share(MPS) Rs. 40 Rs. 15 ‘Assume that two firms are in the process of negotiating a merger through an exchange of equity shares, You have been asked to assist in establishing equitable exchange terms, and are required to: i). Decompose the share prices of both the companies into EPS and P/E components and also calculate return on equity (ROE/R) and book value or intrinsic value per share ii), Estimate future EPS growth rates (g) and cost of equity capital (r) for each firm. iii), Calculate the post-merger EPS based on exchange ratio of 0.4:1 being offered by A Ltd. Indicate the immediate EPS accretion or dilution, if any, that will occur for each group of shareholders. iv). Based on 0.4:1 exchange ratio, and assuming that A’s pre-merger P/E ratio will continue after merger, estimate the post-merger market price. Show the resulting accretion or dilution in pre-merger prices. v). What is the highest offer that A Ltd could make in a share for share offer, without diluting the earning of its existing shareholders (based on earnings in the year just ended)? Department of Financial Management 10 Dr. R.Vijayakumaran