- 12 Marks
Question
Blanco Ltd is listed on the Ghana Stock Exchange (GSE) and is also included in the Ghana club 500 companies. In its recently published accounts, the directors indicated that as part of their growth strategy, the company is negotiating to take over the business of Zinko Enterprise (Zinko), a start-up business in the industry.
Blanco Ltd has in issue 2,480,000 ordinary shares with each share earning approximately GH¢0.79 to give a Price-Earnings ratio of 8. Shareholders expected rate of return is 18%.
The books of Zinko also show that the company has in issue 1,456,000 ordinary shares. The Company’s earnings have increased significantly in the last 4 years from GH¢300,000 to GH¢455,000. The dividend pay-out ratio has been consistent at 45% as a strategy to pay enough funds to shareholders and generate internal resources for future expansion projects. Shareholders expected rate of return is 20%.
Blanco Ltd has estimated that upon completion of the acquisition, the Zinko line of business would generate annual cashflow of GH¢682,500 in the first year, and after that grow at an annual rate of 5% into perpetuity. The investment required for the acquisition will be GH¢1,230,000. However, the funds for this investment would be raised at a cost of capital of 20%.
Required:
a) Use the following valuation methods to estimate the possible prices that Blanco Ltd can offer for the acquisition of Zinko:
i) Price-Earnings ratio
ii) Dividend growth model
iii) Discounted Cashflow (12 marks)
b) Discuss TWO (2) key issues that Zinko management may have with each of the valuation methods used above. (6 marks)
c) Discuss FOUR (4) possible benefits that will accrue to Blanco Ltd if it acquires Zinko. (2 marks)
Answer
a) i) Value based on P/E ratio of Blanco
Market Value = P/E ratio x Earnings = 8 × 455,000 = GHS 3,640,000.00
Price per share is therefore GHS 3,640,000.00 ÷ 1,456,000 = GHS 2.50
(3 marks)
ii) Gordon’s growth model
iii) Discounted Cash flow
b) Problems with the various valuation methods
- P/E ratio:
- The use of another company’s P/E ratio suggests that the two companies have similar characteristics. If Zinko management is not satisfied with the price, they can raise objections.
- The P/E ratio does not take into account the growth prospects of the company. The use of past earnings can be objected to by the management.
- The method is not scientific and hence subjective.
- Dividend growth model:
- The estimation of growth is based on past records, suggesting that the future of the company will be the same as its past, which may be inaccurate.
- The discount factor (expected returns) must be greater than the growth rate for the model to work; otherwise, the results would be negative or zero.
- Non-dividend-related factors are not taken into consideration. This means a company trying to generate internal cash flow to undertake a project that would generate substantial earnings would have a lower value if dividends are not paid.
- Discounted cashflow model:
- Management can raise concerns about how the future cash flows were estimated.
- The growth rate estimate and the fact that it remains constant into perpetuity raises concerns about the objectivity of the method.
- The use of a new cost of capital can be challenged since it may not reflect the risk profile of the operations of Zinko.
- The method is not scientific and hence subjective.
(6 marks)
c) Reasons for the acquisition of another company
- Growth from this transaction is much faster than internally developed growth.
- The companies would have access to new products, markets, and customers, which would have been difficult to achieve by a single company.
- Acquisitions enable companies to break through into other parts of the industry even when there were entry restrictions.
- Acquisitions help to take advantage of the competition, especially where keen competitors had plans of acquiring the target for competitive purposes.
- Acquisitions lead to economies of scale, which means cost savings, higher profits, and higher market value.
- Acquisitions help to access some technical expertise and technologies that may not be readily available on the market.
(4 points @ 0.5 marks = 2 marks)
- Topic: Business valuations, Mergers and acquisitions
- Series: APR 2022
- Uploader: Theophilus