a.(i) Types of synergistic benefit

Synergistic benefits can generally be broken down into three main types, which are • Revenue synergies; • Cost synergies; and • Financial synergies.

These can be considered in the context of the acquisition of K3 by AP.

Revenue synergies: These result in higher revenues for the combined entity and higher return on equity. Examples of these include: • Elimination of inefficiency – The greater strength of AP’s marketing

department could also help to enhance K3’s market penetration; • Market Power – Horizontal combinations (the type in the scenario) can

enable a company to dominate a market. This is one of AP’s main objectives in acquiring K3, to become the market leader in the region; and • Customer satisfaction – customers will benefit from speedier deliveries,

leading to increased customer satisfaction and growth in sales. Cost synergies: These result mainly from reducing duplication of functions and related costs. In this scenario: • Economies of scale – Savings could be made in respect of existing operations

in Togo by using K3’s distribution network to service customers of K1 and K2, saving transport costs and reducing delivery times. Savings could also be made by removing some local administration in areas such as marketing and finance, combining these operations more efficiently on a centralized basis; • Complementary resources – Increases in efficiency may also be possible by

using AP’s knowledge and expertise to improve the efficiency of operation of K3; and • Bulk purchase of key supplies – leading to bulk purchase discount. Financial synergies: These are the type of synergies that result from lowering the cost of capital, which include: • Diversification: Given that K3 is in a market in which AP already operates it

is unlikely that there will be any significant benefit of diversification; • Debt finance: It is possible that post acquisition K3 may be able to secure

cheaper debt finance as a result of being part of a larger group. This would lead to an increase in earnings and a reduction in the cost of capital;

• Surplus cash: AP has significant cash in its statement of financial position at

31 December 2020 and therefore, acquiring K3 enables AP to obtain higher returns from this surplus cash.

(ii) Possible reasons for failure to achieve expected benefits

Reasons why the acquisition might fail to meet expectations are:

Lack of fit syndrome

The success of the acquisition depends on the ability of the current management of K3 to work within AP’s management structure and culture.

Lack of industrial or commercial fit There is also a risk that K3’s reputation/intangible value is not as high as anticipated or that the distribution network cannot easily be adapted to accommodate the needs of K1 and K2.

Integration costs too high Turn-around costs to adapt the distribution network and integrate K3 management and systems might prove to be considerably higher than estimated, undermining the expected financial benefits of the acquisition.

Price paid too high It would clearly also affect expected returns if the price agreed proves too high in relation to the actual value of K3 to AP. There is a risk that AP over-values K3, especially given the assumption of growth in perpetuity – the longer the time frame, the less reliable the forecast.

Failure to integrate There may be technical or logistic reasons why the distribution networks could not be integrated or management and systems combined.

Inability to manage change Careful planning and management is required to oversee the change process. AP has much experience of acquiring companies and managing change and so it is likely that it would have the necessary expertise to be able to manage change effectively.

a) i) WACC for use by K3 following acquisition

 Ungear the proxy company’s equity beta i.e. convert equity beta to asset

beta.

βA = VE (VE + VD(1 −T)) βE + VD(1 −T) (VE + VD(1 −T)) βD

= 65 × 1.7 65 + 35(1 −0.30) + 35 1 −0.3 × 0.4

65 + 35(1 −0.30) = 1.3441

• Regear beta i.e. convert the asset beta to equity beta – using AP’s D:E

ratio and its debt’s beta:

βE = βA + (βA − βD)

VD VE (1 −t)

= 1.3441 + 1.3441 −0.3 25

75 1 −0.3 = 1.5877

• Use CAPM to calculate cost of equity (KE)

KE = RF + βE(RM – RF)

= 5 + (1.5877 × 4) = 11.35%  Compute WACC

WACC = (11.35 × 0.75) + 6.2(1 – 0.3) (0.25) = 9.60%

Alternative approach to calculating WACC  First ungears the proxy company’s asset beta as above = 1.3441  Use CAPM to calculate KEU, i.e. the cost of equity if the company has no

debt finance: KEU = RF + βA (R M – RF)

= 5 + 1.3441(4) = 10.376%  Calculate WACCg – using the formula:

WACCg = KEU 1 − VDt

Vg

= 10.376 1 − 25 × 0.3

75 + 25 = 9.60%

(Notes: KEU = WACCU, Vg = VEG + VD, using the given D:E ratio of AP)

ii) Calculate a number of values for K3

Asset based approach TS million

Net asset value:

665

Less borrowings

(375)

Book value of equity

290

Alternative approach TS million Share capital

90 Reserves

200 Book value of equity 290

P/E based approach The P/E valuation is based on earnings (profit after financing costs and tax), so first calculate earnings:

TS million

Operating profit

75

Less financing costs (26) (= TS375 million x 7%)

49

Less tax at 30%

(15)

Earnings

34 (= profit after tax)

Value of KS in TS million

At the proxy company’s P/E of 12: 408 (= 12 x 34 m)

At AP’s P/E of 14 (bootstrapping): 476 (= 14 x 34 m)

DCF approach

Excluding synergy (TS million) PV of free cash flow to the firm (FCFF) = FCFF1/(WACC – g)

= 54.60/(0.096 – 0.04) = 975 Less borrowings

375 Total value of equity

600

Including synergy (TS million) Total as above

600

One-off synergy = 8/1.096 =

7.3

Perpetual synergy = (5/(0.096 – 0.04))/1.096 = 81.5 88.80

688.80 Or (say)

689

Summary of results

Method Value of equity TS million Asset 290 P/E (using proxy company’s P/E) 408 P/E (using P plc’s P/E, ie bootstrapping) 476 DCF excluding synergistic benefits 600 DCF including synergistic benefits 689

Examiner’s report The question tests many aspects of acquisition and related business valuation. In part (a) (i), candidates are expected to identify the types of synergistic benefits expected from the given acquisition. In part (a) (ii), candidates are expected to explain why it might be difficult to achieve synergistic benefits in practice. In question (b) (i), candidates are expected to calculate risk-adjusted WACC needed for the valuation. In question (b) (ii), candidates are expected to value the equity of the company using different valuation methods. Being a compulsory question, large number of the candidates attempted it but the level of performance was disappointingly low.

Question                                                                                                                                                                                                                         (a) (i) that was designed to be mark booster was badly attempted in the sense that candidates provided generic solutions having no bearing to the scenario painted in the question.

In question                                                                                                                                                                                                                    (b) (i), candidates lost easy marks due to the following factors:

 Use of wrong formulae in the process of ‘ungearing’ (computing asset beta)

and ‘regearing’ (computing equity beta); and  Poor understanding of the various financial gearing formulae: D/E ratio, D/(E + D) ratio, etc. and when to use each one of them.

In question (b) (ii), candidates lost marks due to their:

 Failure to adjust the operating earnings (i.e. EBIT) for interest and tax, when

doing valuation using P/E ratio; and  Failure to make use of the appropriate formulae when discounting the cash

flows with delayed growth.

Candidates are advised to practice past questions, using the pathfinder and cover the syllabus comprehensively, when preparing for future examinations.