- 14 Marks
FM – L2 – Q123 – Mergers and acquisitions
Question
The Directors of Kofi Ltd (Kofi), a large listed company, are considering an opportunity to acquire all the shares of Ama Ltd (Ama), a small listed company with a highly efficient production technology.
Kofi has 10 million shares of common stock in issue that are currently trading at GH¢6.00 each. Ama Ltd has 5 million shares of common stock in issue, each of which is trading at GH¢4.50.
If Ama is acquired and integrated into the business of Kofi, the production efficiency of the combined entity would increase and save the combined business GH¢600,000 in operating costs each year to perpetuity.
Though Kofi operates in the same industry as Ama, its financial leverage is higher than that of Ama. Kofi’s total debt stock is valued at GH¢40 million, and its after-tax cost of debt is 22%. The beta of Kofi’s common stock is 1.2. The return on the risk-free asset is 20% and the market risk premium is 5%.
Required:
Suppose Kofi offers a cash consideration of GH¢25 million from its existing funds to the shareholders of Ama for all of their shares.
(a) Calculate the NPV of the acquisition, and advise the directors of Kofi on whether to proceed with the acquisition or not.
(b) Calculate the value of the combined entity immediately after the acquisition.
Answer
(A) Appraisal of the proposed acquisition
| Shares in issue | Market price | Value of equity | Value of debt | After-tax cost of debt |
|---|---|---|---|---|
| Kofi Ltd | 10 million | GH¢6.00 | 60,000,000 | 40,000,000 |
(a) Computation of NPV:
The NPV of an acquisition is the gain from the acquisition less the cost of the acquisition:
The gain from the acquisition is the PV of synergy from the acquisition:
Gain (PV of synergy) = Cost saving / Cost of capital = 600,000 / 0.244 = 2,459,016
Cost saving = given as GH¢600,000 every year perpetually
As the firm has both equity and debt in its capital structure, the appropriate cost of capital to use as discount rate is the WACC.
WACC = [(V_e / (V_e + V_d)) × k_e] + [(V_d / (V_e + V_d)) × k_dt]
WACC = [(60 / (60 + 40)) × 0.26] + [(40 / (60 + 40)) × 0.22] = 0.244
Cost of equity, k_e is estimated from the CAPM:
k_e = r_f + β_i (E(r_m) – r_f)
k_e = 0.2 + 1.2(0.05) = 0.26
Cost of the acquisition is the excess of the purchase consideration over the value of the target:
Cost = Cash offer – Value of Ama
Cost = GH¢25,000,000 – GH¢22,500,000 = GH¢2,500,000
The NPV is then computed as Gain less Cost:
NPV = Gain – Cost = GH¢2,459,016 – GH¢2,500,000 = (GH¢40,984)
Advice based on NPV:
The negative NPV suggests that if the acquisition happens, the value of Kofi would reduce by GH¢40,984. Therefore, the directors of Kofi should discard the acquisition plan.
(b) The value of combined entity:
Post-acquisition value = Value_Kofi + Value_Ama + PV of Synergy – Cash offer
Post-acquisition value = GH¢60,000,000 + GH¢22,500,000 + GH¢2,459,016 – GH¢25,000,000 = GH¢82,459,016
(c) Share exchange ratio (ER)
The number of shares Kofi should issue to shareholders of Ama can be calculated based on market price as under:
ER = Market Price of Ama / Market price of Kofi = 4.5 / 6.0 = 3/4 = 0.75
The share exchange ratio between Kofi and Ama may be expressed as 3:4 or 0.75:1. That is Kofi should issue 3 shares of its ordinary stock for every 4 shares in Ama (or 75 shares of Kofi for every 100 shares in Ama).
- Tags: Acquisitions, Business valuations, ergers, Market price, Share exchange ratio
- Level: Level 2
- Topic: Mergers and acquisitions
- Uploader: Samuel Duah