- 30 Marks
Question
The following case relates to a business expansion decision for Abayomi Plc (AP):
Abayomi Plc (AP) is a major electrical company in Nigeria. The directors have recently identified Togo as a priority location for business expansion. Togo uses currency T$. Assume today is 30 August 2021.
Company K3, located in Togo, has been identified as a potential acquisition target. AP already manages two business units in Togo, named K1 and K2, and these have shown strong performance under AP’s ownership.
K3 is particularly attractive to AP because it has its own warehouse, distribution, and logistics network, all of which could be used by K1 and K2, if the acquisition goes ahead. Currently, K1 and K2 send goods to customers from AP warehouses located in Ghana. This involves considerable cost and delay in delivery.
K3 is a private company, and 100% of its shares are owned by the family that founded it. Many shareholders are keen to realize their investment by selling the company to AP.
Both companies are working towards an effective date for the sale of K3 to AP on 1 January 2022.
Financial Data for K3 for 2020:
The statement of financial position of K3 as at 31 December 2020 showed the following balances:
| T$ Million | |
|---|---|
| Long term borrowings | 375 |
| Share capital (T$1 ordinary shares) | 90 |
| Total liabilities | 465 |
| Net assets | 180 |
Additional Data:
AP aims to maintain the same capital structure as AP. That is, gearing (debt/debt+equity) would be 25% based on market values. AP would guarantee K3’s new debt, which can be assumed to have the same risk profile as AP’s debt.
A proxy company has been identified which is also located in Togo and has a similar business model to K3.
Proxy company data:
- P/E ratio of 12.
- Equity beta of 1.7 and debt beta of 0.4.
- Gearing (debt/debt+equity) based on market values of 35%.
Togo has a risk-free rate of 5% and a market risk premium of 4%.
Financial Data for AP:
Latest data available for AP shows:
- P/E ratio of 14.
- Equity beta of 1.5 and debt beta of 0.3.
- Gearing (debt/debt+equity) based on market values of 25%.
- AP pays 6.2% interest on its long-term borrowings.
- Tax rate in Nigeria is 30%.
The spot rate for T$ against Naira today is T$7/₦ (i.e., ₦1 = T$7.00) and is not expected to change in the foreseeable future.
Assume that Nigeria has the same risk-free rate and market risk premium as Togo.
Required:
Assume you are the Finance Director of AP.
a. Advise on:
i. The types of synergistic benefit that might arise from the acquisition of K3. (8 Marks)
ii. Possible reasons why both one-off and ongoing synergistic benefits might not be achieved to the extent expected. (4 Marks)
b. Calculate:
i. A Weighted Average Cost of Capital (WACC) for use in valuing K3 based on the proxy company’s business and country risk and AP’s capital structure. (6 Marks)
ii. A range of values for the equity of K3 in T$ as at 1 January 2022 using the following methods:
- Asset basis. (2 Marks)
- P/E (including bootstrapping). (5 Marks)
- DCF (with and without synergistic benefits). (5 Marks)
(Total 30 Marks)
Answer
a. Types of Synergistic Benefits:
- Revenue Synergies:
- Increased customer satisfaction due to improved delivery times from local warehouses.
- Expansion of market share by leveraging K3’s established customer base.
- Cost Synergies:
- Reduced shipping costs by using K3’s logistics network instead of relying on Ghana.
- Consolidation of administrative functions, such as finance and human resources.
- Financial Synergies:
- Improved bargaining power in negotiations with suppliers due to increased market presence.
a. Reasons Why Synergies Might Not Be Achieved:
- Integration Issues: Cultural differences between AP and K3 may hinder smooth integration.
- Operational Disruptions: Potential loss of key employees at K3 could disrupt business operations.
- Economic Environment: Changes in the economic or regulatory environment could reduce the expected cost savings.
b. Calculations:
i. Weighted Average Cost of Capital (WACC):
- Proxy Data:
- Asset Beta Calculation: Ungeared using the proxy company data.
- Regeared Asset Beta: Adjusted for AP’s capital structure.
- WACC Calculation: Using CAPM, risk-free rate, and market premium.
ii. Equity Valuation of K3:
- Asset Basis:
- Net Assets: T$180 million as given.
- P/E Basis:
- Proxy P/E: Multiple of 12 applied to K3’s operating profit.
- Discounted Cash Flow (DCF):
- Without Synergies: Based on forecasted cash flows without additional benefits.
- With Synergies: Includes both one-off and ongoing benefits after acquisition.
| Method | Value of Equity (T$ million) |
|---|---|
| Asset basis | 290 |
| P/E (proxy company’s P/E) | 408 |
| P/E (bootstrapping using AP’s P/E) | 476 |
| DCF excluding synergistic benefits | 600 |
| DCF including synergistic benefits | 689 |
- Topic: Mergers and acquisitions
- Series: NOV 2022
- Uploader: Dotse