AFM – May 2017 – L3 – Q3a & b – Valuation of acquisitions and mergers

Calculating the maximum and minimum prices for Jacobs Ltd's acquisition of Idowu Co Ltd based on future revenue and cost synergies.

Question

Jacobs Limited and Idowu Company Limited both manufacture and sell auto parts. The summarised profit and loss accounts of the two companies for 2014 are as follows:

	Jacobs Ltd (GH¢’000)	Idowu Co Ltd (GH¢’000)
Sale Revenue	1,500	800
Operating Expenses	(800)	(620)
Profit	700	180

Each company has earned a constant level of profit for a number of years, and both are expected to continue to do so. The policy of both companies is to distribute all profits as dividends to ordinary shareholders as they are earned. Neither company has any fixed interest capital. Details of the ordinary share capital of the two companies are as follows:

	Jacobs Ltd (GH¢’000)	Idowu Co Ltd (GH¢’000)
Authorised Ordinary Shares	2,500	2,000
Issued Ordinary Shares	2,000	1,000
Market Value per Share (Ex Div)	3.50	1.50

The directors of Jacobs Limited are considering submitting a bid for the entire share capital of Idowu Co Limited. They believe that, if the bid succeeds, the combined sales revenue of the two companies will increase by GH¢60,000 per annum, and savings in operating expenses, amounting to GH¢50,000 per annum, will be possible. Part of the machinery at present owned by Idowu Co Limited would no longer be required and could be sold for GH¢100,000. Furthermore, the directors of Jacobs Limited believe that the takeover would result in a reduction to 9% in the annual return required by the ordinary shareholders of Idowu Co Limited.

Required:
i) On the basis of the above information, calculate the maximum price that Jacobs Ltd should be willing to pay for the entire share capital of Idowu Co Limited. (6 marks)
ii) Calculate the minimum price that the ordinary shareholders in Idowu Co Ltd should be willing to accept for their shares. (4 marks)

Assume that the takeover price is agreed at the figure calculated in part (ii) above, and that the purchase consideration will be settled by an exchange of ordinary shares in Idowu Co Ltd for the ordinary shares of Jacobs Ltd. Show how the entire benefit from the takeover will accrue to all the present shareholders of Jacobs Ltd. (6 marks)

Answer

The sale of the unused machinery would generate GH¢100,000, so the total value after the acquisition is:

$T o t a l Va l u e = G H ¢9, 900, 000 + G H ¢100, 000 = G H ¢10, 000, 000$

Step 5: Calculate the maximum price
The maximum price Jacobs Ltd should pay is the difference between the value after the acquisition and its current value before the acquisition.

Current value of Jacobs Ltd: 2,000,000 shares × GH¢3.50 per share = GH¢7,000,000
Maximum price for Idowu Co Ltd: GH¢10,000,000 – GH¢7,000,000 = GH¢3,000,000

ii) Minimum price Idowu Co Ltd shareholders should accept

The minimum price that the ordinary shareholders in Idowu Co Ltd should accept is the current market value of their shares.

Market value of Idowu Co Ltd: 1,000,000 shares × GH¢1.50 per share = GH¢1,500,000

Thus, the minimum price the ordinary shareholders in Idowu Co Ltd should accept is GH¢1,500,000.

(Total: 10 marks)

The agreed takeover price for Idowu Co Ltd was GH¢1,500,000, based on the minimum acceptable price for Idowu’s shareholders as calculated in part 3(a)(ii).

We need to determine how the entire benefit from the acquisition will accrue to the shareholders of Jacobs Ltd using a share exchange mechanism.

Step 1: Determine the number of shares to be issued in exchange

Let represent the number of new shares to be issued to Idowu Co Ltd’s shareholders. The total number of shares in issue after the acquisition will be $+ x$ shares (since Jacobs Ltd originally has 2,000,000 issued shares).

The total value of Jacobs Ltd after the acquisition is GH¢10,000,000 (as calculated in 3(a)(i)).

For the benefit of the acquisition to accrue fully to Jacobs Ltd’s shareholders, the value of the shares issued to Idowu Co Ltd’s shareholders should equal the agreed takeover price of GH¢1,500,000. This gives us the following equation:

The market value per share after the acquisition will be:

Before the acquisition, the market value of Jacobs Ltd’s shares was GH¢3.50 per share. After the acquisition, the value of each share increases to GH¢4.25, representing a gain of GH¢0.75 per share.

For Jacobs Ltd’s original 2,000,000 shares:

Thus, the shareholders of Jacobs Ltd will receive the entire benefit from the acquisition, which is GH¢1,500,000, the same as the agreed takeover price.