- 30 Marks
Question
Kola Plc. is a large listed company involved in two business sectors. Its main business is in the production of food and drink for supermarkets and other large traders. It also owns a chain of restaurants nationwide. Kola’s Board of Directors (BoD) think that the company is undervalued and is of the opinion that it should focus on the rapid innovation taking place in the food and drink production sector.
Therefore, Kola’s BoD has decided to unbundle the restaurant business into a company called ZK Ltd and Kola Plc can either spin-off or sell ZK Ltd after the demerger so that Kola Plc can focus on its remaining business of food and drink production. Initially, Kola Plc’s shareholders will own ZK Ltd on the basis of owning one ZK Ltd share for every Kola Plc share owned by them.
MK Ltd is a large unlisted company controlled by 20 shareholders who all have a significant stake in the business. MK Ltd owns a number of hotels around the country and is looking to diversify into the restaurant business. MK Ltd has approached Kola Plc about the possibility of purchasing ZK Ltd. MK Ltd will finance the purchase either through a cash-only offer or a share-for-share offer.
If ZK Ltd is demerged, it will be listed on the stock exchange as an independent company. Kola Plc is unsure whether to sell ZK Ltd to MK Ltd or demerge it into an independent company.
Extracts from Kola Plc’s financial statements are as follows:
| NM | |
|---|---|
| Assets less current liabilities | 5,010 |
| Financed by: | |
| Share capital (nominal value N0,50 per share) | 1,000 |
| Reserves | 1,180 |
| Non-current liabilities: Loan notes A (nominal value N100 per loan note) | 2,470 |
| Non-current liabilities: Loan notes B (nominal value N100 per loan note) | 360 |
Kola Plc’s shares are trading at N2.45 each and have an equity beta of 1.3. The part of the business which will become ZK Ltd accounts for 24.5% of Kola Plc’s total equity value.
Kola Plc’s loan notes A currently have a total market value of N2,100m. Loan notes B currently have a total market value of N400m. The pre-tax cost of debt has been determined at 4.3% for loan notes A and 4.1% for loan notes B. After the unbundling, loan notes B will be serviced by ZK Ltd and loan notes A will remain with Kola Plc. but the pre-tax cost of debt for both will increase by 0.3%. It is expected that ZK Ltd will maintain its capital structure after the unbundling.
MK Ltd’s debt to equity ratio is estimated to be 40:60 in equivalent market value terms and it has 1,200 million shares in issue.
The restaurant industry is dominated by Yani Plc, a large listed company which owns many restaurants around the country. The average equity beta for the restaurant industry is estimated at 1.38.
The average debt equity ratio in the restaurant industry is 20:80.
All companies pay corporate tax at a rate of 20% per year and tax is payable in the same year as the profits it is based on. The risk-free rate of return is estimated at 3% and the market risk premium at 7.2%.
The following estimated information will be applicable to ZK Ltd if it is demerged. Kola Plc’s sales revenue is N4,500m currently, of which 20% is attributable to ZK Ltd. It is estimated that after ZK Ltd is demerged, its annual sales revenue growth rate will be 6% and the profit margin before interest and tax will be 21% of sales revenue, for each of the next four years. It can be assumed that the current tax allowable depreciation will remain equivalent to the amount of investment needed to maintain the current level of operations, but that ZK Ltd will require an additional investment in assets of N0.25 for every N1 increase in sales revenue.
After the initial four years, the annual growth rate of the company’s free cash flow is expected to be 2.5% for the foreseeable future.
The following estimated information applies to the acquisition of ZK Ltd by MK Ltd, if ZK Ltd is acquired.
The average price earnings (PE) ratio for the hotel industry is 15.61, however, MK Ltd’S PE ratio is estimated to be 10% lower than this.
Extracts from the current statements of profit or loss applicable to MK Ltd and ZK Ltd are as follows:
| MK Ltd N’M | ZK Ltd N’M | |
|---|---|---|
| Profit before Interest and tax | 305.0 | 161.2 |
| Interest | (91.2) | (14.8) |
| Tax (20%) | (42,8) | (29.3) |
| Profit after tax | 171.0 | 117.1 |
After the acquisition, it is expected that the PE ratio of the combined company will be midpoint between the two individual companies‟ PE ratios. The annual after-tax profits will increase by N62m due to combination of the two companies.
MK Ltd has proposed to pay for acquiring ZK Ltd either through a cash offer of N0.66 for a ZK Ltd share, or one MK Ltd share for every three ZK Ltd shares. MK Ltd will borrow the money needed to pay for the acquisition.
Required:
a. Estimate the value of each ZK Ltd share if it is demerged and listed as an independent company. Note: (Calculate to nearest N1 million except per share data that should be done to two decimal places). (12 Marks)
b. Estimate:
i. the additional equity value created when combining MK Ltd and ZK Ltd. (4 Marks)
ii. the percentage gain to each of MK Ltd’s and ZK Ltd’s shareholder group under each payment method. (4 Marks)
iii. the impact of MK Ltd’s capital structure under each payment method (5 Marks)
c. Evaluate the financial and other factors that both MK Ltd’s shareholders and ZK Ltd’s shareholders would consider prior to agreeing to the acquisition, and the impact of MK Ltd’s capital structure under each payment method. (5 Marks)
Answer
a) Cost of capital of ZK Ltd
• Current value of equity = 24.5% × (N2.45 × 2,000 shares) = N1,200m approximately.
• Total market value of debt = N400m
• Average asset beta in the restaurant industry (βA)
βA = VE / (VE+ VD (1−T)) βE + VD (1−T) / (VE+ VD (1−T))βD =1.38 ×80 / 80+20(1−0.2) + 0 = 1.15
(Assume beta of debt = 0)
• Equity beta of ZK Ltd (βE)
βe= βA+ (βA− βD) VD / Ve (1 −t) = 1.15 + (1.15 −0) 400 / 1,200 1 −0.20 = 1.46
• Cost of equity of ZK Ltd
KE = 3 + (1.46 × 7.2) = 13.51%
• Post tax cost of debt of ZK Ltd = 4.4 (1 – 0.2) = 3.52%
• WACC of ZK Ltd = ((13.51% × N1,200m) + (3.52% × N400m))/(N1,200m + N400m) = 11.01%, say 11%.
Estimate of ZK Ltd equity if demerger is undertaken
• Current sales revenue attributable to ZK Ltd = 20% × N4,500m = N900m
• EBIT Margin = 21% of revenue
• Tax rate = 20%
• Additional asset investment = N0.25/N1 of additional revenue
• Growth in FCFF, after first four years = 2.5%
• Cost of capital = 11% (see workings)
| Cash flows, years 1 to 4 (N’m) | Year 1 | 2 | 3 | Total |
|---|---|---|---|---|
| Sales revenue (R) | 954 | 1011 | 1072 | |
| EBIT (1 – t) = R (0.21)(1 – 0.20) | 160 | 170 | 180 | |
| Additional asset investment* | (14) | (14) | (15) | |
| FCFF | 146 | 156 | 165 | |
| PV at 11% | 132 | 127 | 121 | = 495 |
PV of FCFF years 5 – infinity: 175 × 1.025 / 0.11 −0.025 × 1.11 −4 =1,390
Total value of the company (i.e. VE + VD) =1,885 Less value of debt (20%) 377 Total value of equity (80%) 1,508 Value per share = N1,508m/2000m shares = N0.75
ZK Ltd original value per share = N1,200/2,000m shares = 0.60 Gain = (N0.75 – N0.60) /N0.60 = 25%.
- Additional asset investment: Year 1 = 0.25 × (N954 – 900) =N14m 2 = 0.25 × (1,011 – 954) = N14m 3 = 0.25 × (1,072 – 1011) = N15m 4 = 0.25 × (1,136 – 1072) = N16m
Alternative Method Every item that goes into the calculation of FCFF is related to sales revenue and since the sales revenue grows at 6% in the first 4 years, the FCFF must also grow at 6%. The PV of the FCFF in the first 4 years can be greatly simplified by using growing annuity:
PV = A1 / r – g (1 – (1 + g / 1 + r )^n ) = 146 / 0.11 – 0.06 (1 – (1.06 / 1.11 )^4 ) = 492m
This answer is much accurate than the yearly calculations because it avoids most of the rounding errors inherent in the former. This approach saves a lot of examination time because all the calculations in years 2 – 4 are avoided.
b) i) Additional equity created
• MK Ltd P/E ratio = 90% × 15.61 = 14.05 • MK Ltd value of equity = 14.05 × N171.0m = N2,402.6m • ZK Ltd equity value = N1,200m • ZK Ltd estimate of PE ratio = N1,200/N117.1m = 10.25 • Profit after tax of combined company = N171.0m + N117.1m + N62m = N350.1m
• Average PE ratio of combined company = ½(14.05 + 10.25) = 12.15 • Estimate of equity value of combined company = N350.1m × 12.15 = N4,253.7m • Additional equity value created by from combining the two companies = N4,253.7m – (N1,200m + N2,402.6m) = N651.1m
ii) Cash offer Kola Plc‟s shareholders will receive N0.66 per share from sale of ZK Ltd, or N0.66 × 2,000 million shares = N1,320m in total ZK Ltd original value per share = N0.60 Gain = N0.06/N0.60 = 10%
MK Ltd total shareholders‟ value is estimated at = N4,253.7m – N1,320m = N2,933.7m, or N2,933.7m/1,200 million shares = N2.44 share MK Ltd estimate of original value = N2,402.6m/1,200 million = N2 per Share Gain = N0.44/N2 = 22%
Share-for-share offer Additional shares issued by MK Ltd = 2,000 million/3 = 667 million Equity value of combined company = N4,253.7m Per share value = N4,253.7m/1,867 million shares = N2.28
Gain to ZK Ltd‟s shareholders N2.28 – (N0.60 × 3) = N0.48 N0.48/N1.80 = 26.7% Gain to MK Ltd‟s shareholders from combining the company Gain = N2.28 – N2 = 0.28 Gain (%) = 0.28 / 2 = 14%
iii) MK Ltd: Impact on capital structure from the two payment methods MK Ltd, before acquisition Market value of equity: N2,402.6m (see above) Market value of debt = 40/60 × N2,402.6m = N1,601.7m
Combined company, cash payment through debt borrowing Market value of equity: N2,933.7m or 46.9% Market value of debt = N1,601.7m + N1,320m + N400m* = N3,321.7m or 53.1%
(Note: N2,933.7m + N3,321.7m = N6,255.4m; 46.9% = (N2,933.7m/N6,255.4m) × 100% and 53.1% = (N3,321.7m/N6,255.4m) × 100%)
Combined company, share-for-share exchange Market value of equity: N4,253.7m or 68.0% Market value of debt: N1,601.7m + N400m* = N2,001.7m or 32.0%
(Note: N4,253.7m + N2,001.7m = N6,255.4m; 68.0% = (N4,253.7m/N6,255.4m) × 100% and 32.0% = (N2,001.7m/N6,255.4m) × 100%)
- In the above cases, when the two companies are combined, it is assumed that MK will continue to service loan notes B or cancel them by paying them off through an equivalent borrowing.
c) Other factors to be considered by the shareholders
The value estimates are based on predicted variables, both for the demerger valuation and the acquisition valuations. It is likely that there will be changes to the actual variables, and it is recommended that MK Ltd undertake sensitivity analysis and assess the results of this before making the final acquisition decision.
ZK Ltd’s shareholders probably have three areas they would want considered further with respect to the acquisition with the share-for-share exchange.
First, they would become part of a larger company with interests both in hotels and in restaurants and they would own just under 36% (667m shares/1,867m shares) of the share capital of the new combined company. However, they would be minority shareholders. As such, they may feel that they do not have sufficient influence in the major decisions the company makes.
Therefore, ZK Ltd’s shareholders may be of the opinion that operating as a stand-alone demerged independent company may give them a better opportunity to shape the company’s strategy. On the other hand, they may equally decide that they would need to be part of a large company to be able to compete effectively against Yani Plc.
Second, ZK Ltd’s shareholders cannot be certain whether the 26.7% additional value is realistic or not. This may be especially pertinent because MK Ltd is an unlisted company and therefore may keep proprietary/strategic information private, limiting the ability for external parties to undertake a full and effective evaluation.
Third, because MK Ltd is an unlisted company, ZK Ltd’s shareholders may be concerned about how they would be able to exit the company, if they want to. For instance, if their investment portfolios become imbalanced when the companies are combined, they may need to sell some shares to rebalance it. MK Ltd should consider the possibility of undertaking a partial listing in order to make the deal more palatable for ZK Ltd’s shareholders.
In addition to ensuring that the acquisition is financially beneficial for them, MK Ltd shareholders‟ main concern would be that ZK Ltd’s shareholders will own a significant portion of the combined company (just under 36%). This could mean that the new shareholders would have a significant influence on the way the company is run and its strategic direction, which may be different to what MK Ltd’s current shareholders want.
- Tags: Acquisition, Beta, Cost of Capital, Demerger, FCFF Valuation, Gearing, P/E Ratio, Shareholder Value, Spin-off, Synergy, WACC
- Level: Level 3
- Uploader: Samuel Duah